Are we on the verge of a debt crisis?

This was my presentation at the Political Economy Research Institute (PERI) last summer. I was supposed to revise it, but never found the time. So it is now available on Substack. Fundamentally says that the current situation is very different than the debt crisis of the 1980s, and the period between the Tequila, in 94/95 and the Argentine Convertibility default in 2001/02.

Debt cycles and the long term crisis of neoliberalism

My talk at the IDEAS/PERI conference a few weeks ago. As I said there, I hate to be the optimist in the room, but I'm a bit more skeptical about the risks of a generalized sovereign debt crisis in the Global South. The two papers I cite are these (in their PERI Working Paper versions) two (one and two).

Argentina, Financial Times and the next default

It's been a while since I wrote about Argentina. In all fairness, because it is difficult given all the mistakes of the last few years since Macri's victory. I discussed the prospects of what to expect back then. Since then I posted here and here on the supposed improvement in 2017, and the beginning of the still unfolding crisis in 2018. And this could simply be an "I told you so post," since I did warn about most things that would happen. But there are important and interesting news about Argentina, now that there is at least some clarity about who will run against Macri this year.

Cristina Kirchner finally announced she's running for the vice-presidency, and that her husband's chief of staff (when Néstor was president), Alberto Fernández, will be at the top of the ticket. Some have suggested that this is a great move that will allow to unify Peronism, which might lead to victory in the election later this year. As a response, the editorial board of the Financial Times (FT) published a piece in which it suggests that given the low popularity of Macri's austerity measures backed by the International Monetary Fund (IMF) policies, that a return of Peronism, would be possible, but a huge mistake for Argentina.

There are many problems in FT's analysis. FT's piece suggests that "Mr. Macri's austerity programme is broadly on track to deliver long term gains for Argentina." There is a fundamental misconception in their argument. Argentina's problems are not fiscal, caused by excessive government spending, but external caused by excessive borrowing in foreign currency. Mr. Macri took over in 2015 with foreign debt at around 70 billion dollars, and proceeded to more than double it to approximately 160 billion dollars, as shown in the figure below (elaborated by Juan Matías De Lucchi, for a paper we co-authored in Spanish and that should be published soon). Foreign denominated debt is now higher than it was before the 2002 default, if smaller as a share of GDP (red line).

Note that while Macri inherited a situation of high inflation, significant fiscal deficits (those are in domestic currency), and an external constraint, mostly associated to an energetic external deficit (that one in foreign currency), the external debt situation was deemed sustainable by everybody back then. Note that inflation was ultimately the result of a sequence of small devaluations, and significant wage resistance during the years of Kirchnerism, and that the external constraint resulted from an inability to diversify exports, and particularly of reducing import necessities in the energy sector. The fiscal situation was not problematic, and there was no problem with financing domestic spending, and no serious inflationary pressures coming from the Central Bank financing the Treasury.

The Macri government established those propositions. His team, stacked with very 'serious' mainstream economists like Federico Sturzenegger, who argued that increase in the domestic energy price bills would have no inflationary impact, believed that inflation could be solved in a simple way by stopping the financing of the Treasury. Inflation was in Monetarist fashion a question of too much money. They also believed, to some extent, that a devaluation would solve external problems if it happened. But they expected a surge in foreign investment that would lead to growth and also put pressure for the appreciation of the peso. Of course, the outcome of their liberalization of the foreign exchange market, and their Monetarist experiment led to higher inflation and depreciation.* Fiscal adjustment and the firing of many government workers led to a recession, and higher unemployment. That was the macroeconomic package of the government, even before the IMF.**

Note that there was no need at that point to borrow in international markets in foreign currency. The current account deficit was manageable, foreign debt obligations were relatively low, and the capital flight caused by the liberalization of the foreign exchange market could had been stopped, to some extent, with a hike in the interest rate. Of course they should have been more careful about the liberalization of the external accounts, but that was probably too much to ask from this government of financial operators with deep ties to Wall Street and international financial markets (and a president with accounts in tax havens, documented in the Panama papers).

Macri's government renegotiated the debt with the vultures, the final step for Argentina to re-enter financial markets, under conditions that were excessively generous, one might add. And note that the external debt had already been significantly reduced by the successful renegotiation of the Kirchners with 93 percent of debt holders (and the Macristas talked about a heavy inheritance!). Minor increases in the rate of interest in the US, which in most places led to minor depreciations, coped with interest rates that at times were negative in real terms, led to massive flight. But the government continued to borrow in foreign currency, when almost every country in the periphery has been able to borrow in domestic currency.

That of course was no mistake. This government has promoted a massive increase in foreign debt to finance large amounts of capital flight. The IMF has essentially validated this model, by allowing the government to use the loan to contain the exchange rate. This government has created conditions for a huge amount of dollars to be purchased by essentially their friends in financial markets. It is a financial racket. This is obviously not sustainable, and a relative safe position has been turned into a possible default soon. Not surprisingly the specter of Peronism haunts Argentina.

* On some level the government wanted higher inflation, in order to reduce real wages, something I noted back in 2015. They also wanted a recession, to help reduce the bargaining power of workers.

** As I often say, our elites don't need the IMF, they carry the orthodox gene in their economic DNA.

A Tale of Two Currency Crises: A Short Comment

So the Turkish foreign exchange crisis is all over the news. But the Argentine one is less conspicuous in the international media. Turkey's economy has had many similarities with Latin American economies over the years, in terms of the incomplete process of industrialization, and the types of crises associated with neoliberal reforms over the last three decades. Note, however, that the Argentine nominal depreciation has been larger than the Turkish (the same is true if you go back to the previous big crisis in both countries in the late 1990s and early 2000s, respectively) and one should expect more coverage (perhaps Erdogan has worse press than Macri, but the authoritarian credentials of the latter should not be dismissed; neither the neoliberal ones of the former, I might add).

In all fairness the NYTimes does cite Argentina (and other emerging markets; not a fan of the term, as I think I discussed before on a post about... wait for it... an external crisis in Argentina and Turkey four years ago) in the piece about it today, saying that:

"For nearly 10 years now, the flood of cash from global central banks has financed shopping malls in Istanbul, booming cities in China and 100-year bonds in Argentina. Today, many of the malls are empty, property developers in China are riddled with debt, and Argentina has just submitted to a bailout from the International Monetary Fund."

That seems to suggests that the reason for the crisis is to some extent that central banks created too much liquidity (printed too much money), allowing too much spending (perhaps by the government, wink, wink, nudge, nudge, say no more: it's a fiscal problem), and that's why we are having these problems. However, the NYTimes does get the external problem, the current account, which I always suggest is the way you should go if you are looking for fundamentals (here another discussion from 4 years ago on currency crisis, this one more theoretical). The NYTimes says:

"A country runs a current account deficit if it takes in more money — in investments and trade — from foreigners than it sends to other countries. That leaves the country at the mercy of international investors to keep it afloat financially, and those investors could find other markets more enticing — particularly when emerging markets see their currencies lose value. That is precisely what forced Argentina to go to the I.M.F., the first major emerging market to take such a step during this period of uncertainty."

However, as I noted on my earlier post on the Argentine situation, while I do think that current account positions are the relevant fundamental (the other would be international reserves) for a currency crisis (and that fiscal positions are the result not the cause of a crisis, since they are in domestic currency for the most part), it worth noting that the Turkish situation is not, at least looking at recent data, particularly bad.

Note that there is a secondary axis for the Turkish current account as a share of exports (the right hand side one), and that Turkey has a much larger deficit with respect to exports than Argentina, but not one that is deterioration drastically (these are based on IMF estimates, btw). This suggests that the current account, even though it is crucial in the long run, is probably not driving the crisis (as I noted in May, I still don't the current account is the cause of the crisis; same post as above, btw).

The fact that this is a global phenomenon (the depreciation of currencies of developing countries) suggests that the hike of the interest rate in the US plays a role. It seems also that the financial deregulation and the financial position of some developing countries explain why they are having more trouble than others (e.g. Brazil, which is in the middle of a serious economic and political crisis, but sitting on top of US$ 380 billion in reserves). I haven't found more recent data (this from the World Bank goes only to 2016), but the graph below shows the short-term debt to international reserves ratio; the reverse of the Guidotti-Greenspan rule).

Clearly the ratio has been growing in both countries (mildly in Turkey) and is higher in Argentina. Argentina has also increased its debt exposure in dollars, and somewhat incredibly the central bank has announced that it will retire debt in pesos, and will use precious reserves in dollars for that (apparently with support from the IMF). This suggests that they are clueless about the causes of the crisis. The only solution at this point is higher interest rates (and in domestic currency to reduce demand for dollars) and significant restrictions on the foreign exchange market.

Are we on the verge of a new crisis in the periphery?

New paper co-authored with Nate Cline published by the Political Economy Research Institute (PERI). Abstract says:

In this paper we develop a simple model of currency crises, which emphasizes the role of currency mismatches and the balance of payments constraint. In our model, crises are driven by external shocks, particularly foreign interest rate and terms of trade shocks, which drive payments imbalances. In a reversal of conventional causality, we show how a currency crisis can then produce a domestic fiscal crisis. We then discuss the historical relevance of the model, tracing the major waves of currency and fiscal crises. The paper concludes with an assessment of the current situation of the peripheral countries in light of our model and argues that concerns of a renewed wave of currency crises may be overstated.

Full paper here or here. 

More on currency crises and the euro crisis

I wrote a while ago about currency crises (see here). There I suggested that classical-Keynesian or post-Keynesian views on currency crises invert the causality between fiscal and balance of payments problems in a currency crisis. Currency crises are not caused by excessive fiscal spending financed by monetary emissions, which would lead to inflation, and eventually after a run on the currency and depletion of reserves to a devaluation, but on current account problems.

There two key problems with the conventional view. On the one hand, the very monetarist notion that increases in money supply have direct impact on prices, and no effect on quantities. That would be an extreme natural rate hypothesis. But also that these models presume that fiscal deficits and debt denominated in domestic currency are the problem in currency crises, when the relevant debt is the foreign one, related to the current account deficit, and denominated in foreign currency. In other words, whereas default in the former is not possible, in the latter it clearly is. The mismatch between government receipts in domestic currency and foreign debt obligations in foreign currency is the key problem in currency crises.

Fiscal deficits might play a role in a currency crisis, but it is ultimately an indirect one. If the fiscal deficit, by leading to an increase in the level of activity (not prices) leads to a current account deficit, then it does exacerbate the external constraint of the economy, and might contribute to the eventual depreciation. Note that this suggests that the variations of the level of income are more relevant for the adjustment of the balance of payments, than changes in the exchange rate, something noted for the case of peripheral economies, in particular Argentina during the Gold Standard, by A. G. Ford (for a discussion of that go here).

In a classical-Keynesian view the fiscal crisis might be a result of the currency crisis, and not vice versa (as I discussed for Brazil here). If the crisis leads to a recession, then fiscal revenues collapse, and spending increases, particularly unemployment insurance expenditures, welfare spending, and transfers, exacerbating the fiscal problems. Further, the central bank might hike the domestic interest rate, to preclude capital flight and further devaluation and that would have an additional effect on interest payments on domestic debt, also worsening the fiscal stance.

This currency crisis story might have some relation to the current debate between Marc Lavoie and Sergio Cesaratto on whether the European crisis should be seen as a a monetary sovereignty problem (Marc) or balance of payments crisis (Sergio). Both would agree that the crisis is not the result of fiscal problems, as described above. Even in Greece, that had higher fiscal deficits than others, the relevance of those deficits, and the enforcing of brutal austerity afterwards, has been associated to the current account. Note that in common currency areas, like the United States, federal fiscal transfers (and not just inter-state transfers) would allow for imbalances to continue without leading to contraction of output to reduce the regional balance of payments constraints, as noted by Nate Cline and David Fields here.

Alternatively, in the absence of fiscal transfers from a federal European government, if the European Central Bank (ECB) had the ability to buy euro denominated bonds of peripheral countries and keep their borrowing costs low, fiscal policy could be used by member countries, without risk of default. That's what Marc Lavoie has argued, that at the heart of the problem there is a monetary sovereignty problem. Basically the ECB could transform what is effectively a foreign currency problem, since peripheral countries have a constraint in euros, into an essentially domestic problem with no risk of default. On the other hand, it is also true that the manifestation of the euro crisis is in the form of a regular balance of payments problem, as noted by Sergio Cesaratto. In a sense, both are correct. The imbalances in the current account, which Sergio puts at the center, become relevant because in the absence of fiscal transfers, and of a monetary authority providing a zero risk asset for governments to borrow in times of crisis, as emphasized by Marc, the adjustment is done by variations of the level of income.

The difference might lie not so much in the diagnostic, which is basically the same (they also agree on Keynesian fashion that the current account adjustment is done by variations in quantities not prices), but on the policy alternatives. Sergio's emphasis seems to suggest that exit is the best alternative. Marc's views would indicate that reforming the institutions would be better (mind you, they might think differently, I'm suggesting what the different emphasis might imply). It is unclear to me that depreciation and exit from the euro would solve the problems of peripheral countries (on the role of depreciation on solving the external problem in Greece, that is, Greexit, go here). On the other hand, the reform of the European institutional framework has proceeded at pace that seems too slow for the magnitude of the problems faced in the peripheral countries. There is no good alternative.

PS: The Troika's solution is austerity, since the the crisis is seen as a fiscal problem, as in conventional currency crises models. And the ECB should in that framework remain concerned only with inflation.