Debt and Ponzi Games

In a recent article at the NY Times Gary Becker and Kevin Murphy explained how the U.S. Government has set a bad reference saving banks that failed. It is easy to agree further with them, all of us who praise market as a superior allocation mechanism can go harsh on the current administration, why won't they use chapter eleven or some bankruptcy tool? Letting them disappear.

Although I usually would agree with this view, I think that the alternative would have been economic depression. It is true, all plans to stimulate the economy are inherently imperfect, however, the common phrase "doing nothing is not an alternative" is most appealing now. Martin Wolf has recently put a lot of work in making a case for coordinated action next April in London, in an extremely opposite approach.

Three questions remain: can a country with high debt spend it's way out of recession? Can a non-Ponzi game condition not be imposed to countries? Can the U.S. take advance of its seniorage position forever?

The immediate answer is: as long as there is a creditor, this country can do it. There is an underlying assumption here: the money borrowed will make the economy growth enough to allow debt re-payment. Moreover, there is another effect, the latter increase in bond supply should press interest rate in the opposite direction than the one desired by the FED, how this should be addressed?

John Cochrane offers a feasible solution. Lasts week announcement by the FED, saying it would buy 300 billion dollars of public debt, can be the first step into Cochrane's solution. The remaining step is in the Treasury's side, it could now buy first quality debt issuing public debt instead.

This measure should have two major features. First, it should help the U.S. to change external public debt for national, deleveraging from China and forcing it to spend (or appreciate its currency). Second, it is far easier to remove bonds from public than social programs, this is, when recession ends, government spendig should be reduced, and bonds provide an easier mechanism to do it.

Thus, Cochrane's proposal should not be dismissed and it deserve further analysis. Although it is fairly straight that the U.S. can issue as much debt as it needs as long as there exists a huge trade surplus at China, a central point should be to securing Treasuries reputation as the safest asset, Ponzi games can destroy this reputation causing caos. Furthermore, all efforts to make the economy grow should always be evaluated in the face of future inflation, history has shown that great increases in money supply will end up reflecting higher prices.

Car owners tax

Mexico has a sui-generis tax system. Tax revenues account for only 8 per cent of GDP, however there is a tax tool that is rather efficient. It is levied on car owners at a decreasing rate according to the car age -from 0 to 10 years inversely- thus it taxes wealthiest set of population.

This tax is federal, but it's totally redistributed across states, this is, all political cost is shouldered by federal government while benefits are fully enjoyedl by states.

There are all kinds of pervasive incentives with the current setting. Last week at Congress a debate about ending this tax became alive. It was clearly a political move since this summer's election is just around the corner.

It is considerably appealing to remove taxes without increasing marginal rates, clearly it is impossible to do so without the issue of more debt.

The best option there is, consist on change the federal-nature of the tax into a state-nature. The latter has several advantages. First, incentives for accountable spending will subside. States would have to absorb political cost.

Second, in terms of economics, the tax would be flexible in the following sense: every state will be able to decide whether to levy the tax or not. This in turn could be decided according to particular needs. Take, for example a state with a city that has heavy car traffic. In order to incentive the use of the public transport the marginal tax rate can be positive.

In a polar example, take a state that has a relatively high poverty level, in this case the tax can not exist in the first place.

A final example may refer to states that host a car manufacturer, thus depending heavily on jobs it creates. The tax can be address to a particular subset of population and encourage, this way job creation.

However unpopular, a serious assessment of the tax can shift the current approach to one that explains to Mexicans how it can be used as an environmental tax of some sort.

A stronger foundation for levy a tax like the one discussed here is to treat it like a car-traffic tax. Let us not forget that every time we drive a car we increase the probability of an accident occurrence. Moreover, car traffic is inherently increased. If the last two arguments are not enough, it can always be assumed that the use of street soil is taxed.

It is plausible to conclude that, despite it's unpopularity -it can be argued that there is no such thing as a popular tax- a subtle change in it's nature would do a lot in it's defense. It may be true that changing the pay schedule - to several monthly payments from one per year- can be a start. Changing be federal nature of a state one would almost do the entire transformation.

Finally some good news?

The recent rally in world financial markets has indeed relieved some strains in several fronts. One of them is the Mexican peso appreciation.

Mexican peso has showed a remarkable positive path on the last four sessions gaining from it's record price, 15.60 pesos per dollar, 1.10 pesos to 14.50.

Mexican authorities put in motion a program of dollar auctions in order to re-gain confidence in Mexico's currency, it was rather difficult to attach the 50 per cent depreciation to the economy's health, reasons were to be found in the slump of capital flows into emergent economies -capital on-flows in 2009 are projected to reach only one third of 2008.

Another key factor of Mexican currency depreciation is the increase of the trade deficit attached to the fall of U.S.' imports. Mexican foreign trade is highly dependent of exports to be U.S.

This last factor will abide until power of purchase is re-gained in the north. Financial factors, however, are in dis-stress this week should prove as a big test in order to claim a frank recovery.

Corolary

It is ever more clear that the 819 billion package will do little to improve the U.S. economy's outlook. In the current situation, precautionary savings are growing at a higher rate than consumption. It is possible to conclude the latter since the monetary base has grown more than two fold since monetary easing begun in mid 2007 and prices along with consumption have fallen.

Let's thing of a stimulus from an increase in spending.This kind of stimulus has a 100 per cent probability of being spent, however, political strains must be pulled in order to allocate efficiently those resources. This is costly both in terms of time and effectiveness. Of course this policy will increase public debt since there is no promise of a tax increase nor a future spending reduction.

About a decrease in the tax burden, it has the clear advantage of preserve progressivity -assuming a correct design- and create the right incentives to work and invest. Against the latter, government would be taking the risk of implement tax rebates with an increase in savings. Moreover, it increases debt too.

The 820 billion stimulus is composed of both expanding demand policies, it is natural to distinguish ups and downs of the stimulus package, but a more important question must be address soon: is an stimulus package the only way to deal with the crisis? Clearly not. It is not the best way either. Why?

China's trade balance surplus implies a net capital outflow. Chinesse capital must be allocated. "Assume" China's government is risk averse -actually every government outside Arabia is-, thus an increase in the demand of the "safest" asset in the world occurs. If the so called safe assets are U.S. Trasuries, the latter story explains how the "twin" deficits grew to the current levels. There is an ever growing consensus about the latter.

Furthermore, this explains how was it possible to have a constant level of unemployment after the recession of 2000-2002, and an increasing rate of economic growth. It turns out that there was not subemployed techonology, nor an expansion of U.S.' productivity, the economy was "overheathing" -economic growth was pulled by agggregate demand only- financed by mortgage loans.

Sadly an stimulus package is an attempt to cure a disease with the very cause of it. Further increases in government spending -or tax cuts- without a schedule of tax increases -or government spending cuts- will imply increases in loans to the U.S. in the form of Treasuries. They would probably increase spending in the short run, but just through the demand side, overheathing againg the economy. Officials hope that the stimulus package works as a "jump start" for the economy, however likely, this would just delay reality: U.S.' ctizens and government must reduce their indebtness.

In fact there are some figures that lead to conclude that people from the U.S. are actually reducing their debt. At least, savings are growing as pointed above. So, this is a great hint of what should economic or financial policy should address: provide a jump start to the financial markets without increasing debt, and if possible, reducing it. The latter must not imply to use public funds to save private banks. John Cochrae provides a feasible way to accomplish this. It does implies to re-open the credit markets for firms, this would prevent layouts and maybe, just maybe will increase exports.

Another advantage of this alternative plan is that it is easier to take back debt, selling private debt, than cutting public spending, this is an overlooked fact by U.S.' policymakers. Understandibly they are in a hurry to stop economic downturn, but it is important to preserve long run stability and low inflation. Not to mention a plan to repay debt.

The latter provides a feasible alternative for the U.S.' to re-start economic growth in a sustainable fashion, more government spending is just a band-aid waiting for failure. It is true that the situation claims drastic measures, but history and science can not be ignored. Increases in spending are not among any macroeconomist's prescription, just policy makers.

Balancing unbalances: is expanding public expenditure the answer to the slowdown and the financial crisis?

It is a major consensus among economists -along all the political spectrum- that bubbles are caused by an excess in supply of available funds for lending. Maybe it is time to look closer into those causes of the latter. One natural place to look at is China's current account surplus. Let's not forget that this implies that China must allocate great amounts of savings. Let us assume that Chinese savings are use to buy US Treasuries, the latter makes US bond's prices go up and the benchmark interest rate go down.

Thus, we have a recipe for a bubble. Going deeper, it is a pervasive cycle, though a plausible one, to conclude that increases of the US' borrowings caused evermore borrowing. It is now clear to everyone that the latter is unsustainable.

Let us look now into the proposed solutions to the current economic slowdown and financial crisis. They're founded in either tax rebates or debt increases... both policies imply a further increase of US' borrowings. It is troublesome to argue that in the long run, expanding public spending is a key element to go back to a sustained growth path.

However, there is a great difficulty to find an alternative to the latter. It is clear that the existing unbalance of US' borrowings will only grow further and that there still exists a great amount of resources available for lending, particularly in the BRIC's economies. US citicens will have to honor their debt, although the Treasury department can go along with the FED printing money, they should start thinking how to balance the capital account deficit.

Are we all Keynesians now?

As the financial crisis has developed, economic indicators weaken consistently. A recession has been declared by the NBER, surprisingly since December of 2007. But it is even more important to look at the the trend in every major indicator: it is downward. There are indeed some signs of deflation at the US, which combined with relatively high unemployment and the grim attitude toward risk in the financial sector resemble some features of the Great Depression.

Since the cure for slow growth in those nasty years is closely related to high levels of public spending, is natural to start looking in these policies for a cure to the current crisis. It is remarkable how all policy makers and some scholars had change their attitude toward temporal public deficits, ending an "era" of fiscal discipline as the key for sustainable economic growth. Moreover, spending money is the best way to get the financial system into tough regulation, since it forces bailed out firms to follow the guidelines that the government dictates. But how exactly will this increase in public spending change the outlook of the economy? How will expectations and the attitude toward risk be affected? It seems complicated to link throwing-money-at-like solutions to a feasible stable growth path.

A higher level of public spending, as old-school keynesians ask, does not necessarily stimulates the level of employment of the economy, as professor Mankiw's post says, there is hard evidence proving that lowering the tax burden would constitute a more powerful way to make the economy grow. Furthermore, Lawrence Summers published recently an article with more details of the Obama administration spending targets. Those aim at schooling, alternative energies and infraestructure. Even though it is not detailed in how it will be financed, it is clear that no limits on debt are bounding.

So even though government's balance sheet is almost unchanged in either policy -tax cuts and debt growth- the odds that a tax cut policy work seem more effective that throwing-money-at a problem. It allows every economic agent to make the best decisions in allocating resources. There still one problem, how can government create incentives for people to spend their "new" income?

Clearly, tax rebates should not be allocated to the unemployed, since this would create a negative incentive for them to work. This is a question to be answered soon: which tax structure poses a premium in looking for a job? Furthermore, would this tax structure lead to an increase in consumption of the employed? There is a recent paper recommended by Mankiw from the IMF on this. This is a loose end that the incoming administration will have to address to provide sustainability and reinforce credibility in the stimulus plan.

Energy Reform in Mexico

Since March of 2008 the energy reform has been in the public agenda. Government proposed to allow private investment in refinery and transportation of oil. It pretended also to allow risk-sharing contracts in offshore exploration and oil extraction. Political opposition forced to a two-month debate in the Senate. As a result, two more proposals were sent to Congress.

As the financial crisis deepened last September, Government decided to give PEMEX independence in its investment and budget planning. This constituted the first step towards three more reforms. All those changes in the opposite direction of the official proposal. The approved reform will indeed provide PEMEX with more independence, however, it will not allow for more oil extraction, thus limiting the original purpose. It is a reform in the right direction, but it is considerably short.

Two substantial changes will privilege Mexican suppliers, although there are not many firms that can provide the machinery necessary to find oil in deep water in Mexico’s Gulf.

Yet another important figure compels to incentives for contractors to increase efficiency in their assignments, this scheme is just in the borderline of risk-sharing contracts. However, according to industry ‘s legal experts, big oil firms would not have enough incentives to participate in contract allocations for exploring.

After long debates that exposed different views over the legal boundaries of the official proposal in the risk-sharing contracts it is for certain that economic rent from oil extraction must be well defined, and that this particularly complicated task will make the difference every time the sector face a possible reform. Strictly speaking, there is economic rent only when oil is extracted, and not when oil is refined or sold as gasoline, for example. Opposition thinks different: defining economic rent as all the money oil can generate at any stage in industry.

The latter approach cannot answer a simple question: why is public sector forced to absorb every single penny oil generates, even in advanced stages?

There is no incentive for public firms to do it efficiently, clearly, there is wealth lost in the process.

Furthermore, important limits that recent reforms did not correct are that incentives for contractors to reveal information remain low. This is, since there will not be any reward for extracting oil, then PEMEX supports all the risk instead of sharing it.

This reform can be labeled as one that prevented private investment from Mexican oil, but the cost is, necessarily to have less oil available for exportations. Since oil revenues account for almost 40 percent of public expenditure, this will only make a new fiscal reform a clear urgency.