Shaking Hands

The peculiar high five of the invisible hand of the markets and the visible hand of the government has been shaping a new form of capitalism: state capitalism (SC). After reading the January 21^st – 27^th The Economist edition’s great special report on state-capitalism (a must-read) I’ve been wondering about the sustainability of this model. Using some pillars of the free-market capitalism (FMC – I’ll use freely expressions like free market and liberal for the same sort of capitalism, without worrying about conceptual differences that may exist), the state capitalists countries’ companies compete with the developed nation’s rivals under the government’s protection (i.e. subsidies, cash infusion, credit supply, “benevolent” legal environment, exchange rate manipulations, etc.).

Of course some attempts made by the state are equivocate and the fact that in SC the government points the finger for those who will be succeeded (letting open here the meaning of success) may give some space for distrust. From my point of view, in order to make that new form of capitalism live as long as it can, it is fundamental that the policymakers understand/assume that the “selected” companies should be such that i) the govern is boosting its country’s comparative advantages and let other sectors/segments free to compete and ii) it’s a business that the state has a minimum level of competence.

One example of comparative advantages is due to endowment differences. Take China for instance. It is a labor-intensive country with low (though rising) real wage and has an export-oriented growth strategy. Adding an artificially undervalued (real) exchange rate improves its situation and becomes hard to compete with. On the other hand, it’s not a leading-in-innovation country, so maybe investing in a copy of the Silicon Valley wouldn't be a good strategy (using state-owned companies).

It’s well known that state-owned companies are less productive and they are better in infrastructure than consumer goods and innovation as the foresaid report points out. But there are other problems. Corruption is, as far as I can see, the greatest tumor. As brilliantly mentioned in the report, the SC model arises from countries with problematic states. There’s a huge room for corruption in a system that is responsible for regulating itself and in a country where it’s institutional architecture is not very solid.

The report quotes the idea that the like the socialism, the state capitalism cannot survive only in one country. I will go further. It depends also on liberal capitalism in other countries. Think about it. One great advantage of state capitalism is the use of the capitalist toolkit backed up by the government’s safety net when copying the freer capitalist’s ideas and implementing them with its own competition model. But without FMC, who’s going to innovate? What would be the non-state-backed-up enterprises that would consolidate the state support as an advantage? This could worsen the whole innovation process in the limit, given the fact that it’s not the strength of SC countries to manage the innovation. (One could argue that they could learn, well, I’ll let this open without worrying about this particular point).

After a few considerations regarding benefits and issues of the SC (for a really comprehensive text go to the report), the situation as I see it is one where the new model will impose some difficulties to the FMC, but not in a way that only one should remain at last. It may be more in a sense that the reign of the developed countries are now challenged in the next years by a model that shares the weapons, but boosts them differently (and also has other sort of weaknesses). I’m not sure that is a system for remaining after some development threshold. There could be a point where this model may have to open space for another one (a sort of a macro creative destruction), and the country must prepare itself before reach this threshold. Some economists are already arguing that China should change its growth model from export-oriented with government investment playing a huge role, to a more domestic consumption-focused approach. If this is true, what would be the implications on SC? I personally don’t know. (One may remember that Brazil is a relative closed economy and has its own SC model; well, it’s a different SC than the one adopted in China as far as I can see).

P.S.: I want to make a remark about the role of the state and what I have been defending about other topics such as the crisis’ response. I’m very inclined to the Keynesian approach and I've been using its tools (specially the static IS-LM and AS-AD framework) for illustrating as simple as I can what I think. This has nothing about my concerns about the SC. Briefly, (New?)Keynesian economics is, in my opinion, a) recognizing not only the importance of the monetary policy in affecting business cycles, but also that the fiscal policy can impact the output in the short-run, and sometimes is all the policymakers really got (e.g. within a liquidity trap); b) that imperfections, asymmetries, rigidities and other deviations from perfect competition are real things and sometimes public policy (taxation, regulation, and so on) is necessary for minimizing distortions (even though they may also be the cause); c) the importance not only of the expectations, but the animal spirits in the people’s behavior as well, i.e. being aware that some schizophrenic outcomes may happen and multiple equilibria may be a real issue. (Yes, there are several more points about Keynesian economics; I just want to highlight the difference of fiscal stimulus and state participation in other layers of the economy).

Tough times require bold actions 2: the Fed’s attempt

The FOMC decided not only keeping the policy rate low until 2014, but also has changed its way of doing monetary policy trying to act via expectations, reducing uncertainty and creating a more translucent relationship with the market. As I’ve pointed out in the last post (here), today the FOMC released forecasts for real GDP growth, inflation and unemployment. It’s also the first time the monetary authority commits itself with an explicit inflation target.

These are tough times and require bold actions (see here my post about it). This may be one. Inasmuch as the entity discloses these forecasts, it is trying to anchor expectations about recovery and price dynamics, providing short-run estimates and long-run references.

Anchored expectations is important regardless what kind of environment you are dealing with. The US households are amid a deleverage process, lacking aggregate demand and stuck within a liquidity trap. If expectations are out of control, it would be one more (big) problem to handle and since a few options are available.

The zero-low bound of nominal interest rate is binding, so monetary attempts cannot be the conventional ones; however the toolkit is getting scarce. Fiscal policy has its own issues. First of all, there’s a lag between the conception and implementation. Second, the debt level amid a not-very-favorable political process makes a stimulus plan hard to be implemented.

Therefore, the initiative of the Federal Reserve in communicating with the market in a way that would induce a convergence of expectations may be in the right direction. I’m only not sure if it will do much effect. Publicizing the 2% target it’s just ratifying something that people already expect. On the other hand, what can indeed be interesting are the estimates regarding short-run economic growth and unemployment, since these are drivers for several economic decisions.

Federal Reserve's projections

Seeking to decrease uncertainty and make monetary policy conduction more clear, the Federal Reserve released its forecasts for real GDP growth, inflation and unemployment (source):

(click on the table to see better)

More on this subject later.

Top Think Tanks

Congratulations to Fundação Getúlio Vargas (I received my Master's degree in Economics at São Paulo School of Economics of Fundação Getúlio Vargas) for being among the International Top 30 Think Tanks (full publication here).

Click on the table to see better:

Recommended reading

A few interesting texts:

- Does Austerity Promote Economic Growth? (Robert Shiller)

- Will Emerging Markets Fall in 2012? (Jeffrey Frankel)

- Leilão de Aeroportos (Cristiano M. Costa)

- The Ongoing Debt Transformation (Paul Krugman)

- The uncoupling of decoupling: Latin America's experience (Luciano Cohan and Eduardo Levy Yeyati)

A model of a debt crisis

Prof. Paul Krugman gets the essence, as usual. Olivier Blanchard has already warned about financial markets schizophrenic behavior regarding austerity plans and the possibility of multiple equilibria. I’ll try to elaborate it with a simple model of debt crisis.

i) The model

The model is presented in David Romer’s Advanced Macroeconomics book. All derivations I took from there, any mistakes are my own.

- Quantity of debt: D;

- Debt interest rate factor is R;

- The government will obtain revenue from next period taxes, T (think as net taxes, after expenditures and transfers), that follows a random continuous distribution;

- If T > DR, than the government pays its debt. Default occurs otherwise;

- Investors are risk neutral;

- The risk free rate is given by Rf;

- The default probability is “p”;

- In equilibrium, the expected return on governments debt should be equal to the risk free:

(1 – p)R = Rf

Rearranging it yields:

p = (R-RF)/R

Plotting the probability of default as a function of the debt interests gives us:


(click on the graphs to see better)

When Rf = R the probability of default is zero. If the taxes vary randomly in the interval [Tmin, Tmax], the probability of default is given by:

Where if R< Tmin/D, the amount of taxes is sufficient for covering all the debt and its interests, so the government pays. If R > Tmax/D, the government certainly defaults. Combining the two graphs yields:

There are three equilibria. The point A where R = Rf is a stable equilibrium with no default. The point B is an unstable equilibrium with a high probability of default and a high interest rate paid by the government. The third equilibrium is the default. An increase in the risk free rate would produce the following result:

Note that in this situation, the unstable equilibrium rate (B²) is lower than the previous situation (B), meaning that a self-fulfilling debt-default can occur with lower rates.

ii) Policies

To handle with this debt crisis, policymakers within the Euro Zone have implemented wrong timing fiscal attempts, such as a stability union, in order to contain the high indebted trouble countries situation, when debt sustainability is questioned and they have been suffering the consequences of the monetary arrangement.

They have diffused the expansionary fiscal austerity doctrine that lies in a sort of Ricardian equivalence where austerity would induce households to consume and firms to invest since the today’s saving by the government could have led to lower taxes in the future, augmenting lifetime income. It’s not working. Maybe the share of Ricardian families in the reality is not enough to produce this outcome, and the majority faces liquidity constraints and relates its consumption path with current income. Moreover, the fact of being unemployed may be a problem.

I’m not a (very) fan of rating agencies, but the S&P downgrade was done based on the harm of austerity programs in the debt repayment capability. It’s easy to see why. Less government purchases, lower aggregate demand, lower income, lower taxes, etc…

iii) Worries

The model presented is a textbook model. That means that policymakers know about it. Self-fulfilling equilibrium due to the dynamic of expectations is a real threat and may impose additional pain in those countries that have not only to recover from the problems of the 2008 crisis and the nowadays crisis, but to accommodate its economies to the single currency area as well. The commitment with the euro is yet strong, but the survival of the currency that was prematurely implemented is threatened not by the markets, but by how this crisis has been conducted. It’s a political crisis with severe economical impacts. It’s also a dispute of schools of taught, but when this remains on the academic field, just a few individuals are hurt. When this transposes to reality, the collateral damage is huge. Instead of learn with the mistakes of past we are repeating it and hopping for different results. 

Labor market and nominal rigidity: the role of the inflation differential

The situation within the Euro Zone is extremely delicate (see some context here) and not only the natural adjustment to the monetary arrangement may impose some difficulties (see here), but also the proposed policies may add additional pain (see here, here and here).

The focus of this post is the dynamic of the labor market and the importance of correctly managed inflation differentials to help the recovery. I've compared Germany and Portugal and used some numbers to demonstrate what some economists having been arguing. I must stress that the values are only references and were calculated with some assumptions in order to facilitate the calculations. Real life is more complex but this analysis may indicate a good path.

i) Some data

The unemployment rate of Portugal has demonstrated a positive trend since 2001. The unit labor cost ratio (Portuguese unit labor cost index divided by German unit labor cost index) has also an increase trend. From my point of view, this indicates a correction done via quantities since nominal wages are (very?) stick in Portugal and inflation is not well behaved. The following graphs show the seasonally adjusted monthly unemployment rate in Portugal, the unit labor cost ratio and the annual variation of the consumer price indexes of Portugal and Germany (HICP – excluding energy):


(click on the graphs, tables and demonstrations to see better)

ii) Math

From equation (3) we know that the marginal productivity ratio is equal to the inflation ratio times the wage ratio (the superscripts stand for the country and the subscripts for the time). The following table tries to see this relation. In the first column the inflation ratio and the marginal productivity ratio are given by the historical average between 2001 and 2006 and the wage ratio was calculated. The same logic for the other two columns, just changing the “calculated variable”.

Since we are talking about averages and the real world has several imperfections, I think the results are pretty good (i.e. the calculated values are not too far from the observed ones).

iii) Conclusion

I used the marginal productivity ratio for determining a “healthy equilibrium” in which the Euro Zone internal dynamic would be more favorable to the peripheral countries represented by Portugal. In a nutshell the German inflation should be higher (in our particular example is just a steady state rate, in order to get there fast the differential should be even greater) than the trouble countries in order to create a faster adjustment with less pain given that the wages have been demonstrating nominal (and in some particular years even real) rigidity. But Germany has a huge inflation fear, what make things complicated. This equilibrium do not contemplate a fall in Portuguese wages or a lower growth than in Germany in order to adjust. This may happen since with rising unemployment in the medium-run wages also may adjust and the inflation differential may be lower. But until then...The whole situation by itself would imply in costs emerging from the labor market (e.g. rise in unemployment), but with the 2008 crisis and the debt crisis now, the correction will occur in a worse scenario, with financial market pressure (and schizophrenic behavior) and contestable policy decisions, resulting in huge losses for households.

The harm of wrong timing in austerity programs

European countries have been dealing with a high debt level for a while now (see my post about debt regimes here), and its sustainability has been questioned (see my remarks about it here). For managing this debt crisis European policymakers have agreed about a Fiscal Stability Union plan, with serious procyclical implications (see my post about it here). The recession in Europe in the following periods is more likely than ever, especially with the policymaker’s decisions regarding government expenditures. Private spending (consumption and investment) has no incentive to grow, given an extremely uncertain horizon. I presented a briefly discussion about the international environment here. In this post, I took an opposite way, more or less. Let’s analyze the impacts of the timing of austerity programs via a simple household utility static exercise.

i) Static Analysis

The social welfare will be evaluated based on a representative agent utility function and, just for simplicity, I’ll assume that depends only of consumption level. Usually people are assumed to be risk averse, so we need a concave utility function (for diminishing marginal utilities, i.e. as the level of utility increases the utility gained with the additional consumption unity is less than the utility gained with the last consumption unity). I used a very simple functional form as the following graph will show:

Assume the consumption level during a recession before the austerity being implemented is 50 and after is 40. It represents a loss of 27.1% in the household’s utility level. Now consider that the consumption level during an expansion is 70 and after is 55 (the cut is higher since the debt level grew until the implementation of the austerity plan). It represents a loss of 25.6%, less than the previous situation.

ii) Remarks

- The utility function utilized is very simple, but this does not compromise the analysis. One can think about other features of the utility function such as leisure, money, government spending and so on and may infer that they would not hurt the logic (leisure may not behave well, but I’m not sure that containing your own labor supply in a expansion has the same impact that containing it amid a recession);

- One argumentation is that households maximize intertemporal utility function and increases in future consumption due to austerity today may compensate the loss in consumption today. Well, it depends on several things, discount rates, interest rates, expectations and so on. I still do not see why the future consumption level would increase since a consistent fall in GDP due to a too long recession could induce in lower levels of the natural and even the Walrasian GDP, what would imply in lower future consumption.

iii) Conclusions

Debt is a problem in several countries, but a wrong policy may also be a problem. Austerity is needed but not right now. The social welfare impact of correcting government indebtedness amid a recession is greater than doing the same procedure but during an expansion. This is just an exercise to express the logic in a sort of microeconomic framework, but seems consistent with a "macro approach" that fiscal austerity is contractionary in the end. And yes Prof. Paul Krugman, Keynes was right indeed. 

The international economic environment

picture from Bloomberg

The first post of 2012 is for organizing thoughts about the US and Euro countries and maybe infer what we can expect for this year.

i) The situation as I see it

After several years of prominent growth in an extremely liquid and low regulated framework (fatal combination) the world experienced the Great Recession, a huge impact on several economies after the burst in the US housing bubble transmitted trough complex structures and derivatives that were designed to protect investors. Some emerging markets (e.g. Brazil) that once were more vulnerable to problems in developed nations showed not only resilience, but also economic response capability to contain the fall in GDP. They have launched an “unorthodox supplement of the inflation target setting” (see Velasco here on the subject).

In the industrialized world the situation is different. Unemployment rates have increased and remain in a noxious high level, with a possible NAIRU harmful hysteresis if the circumstances are not reversed soon (consulting important authors like Reinhart and Rogoff we know that after the fall developed countries may take ten years to register unemployment rates compatible with pre-crisis levels). A lack of aggregate demand and the low level of the interest rates stuck the US in the so-called liquidity trap.

In the one-currency-several-too-different-countries the business cycles disparities between the core and the periphery have been highlighted in the sovereign debt market. From a financial crash to a debt crisis (see Reinhart and Rogoff), the countries under the monetary arrangement are facing a huge problems to respond to the crisis without monetary tools, with its debt levels questioned and the fiscal policy efficacy in discussion. The euro survival is threatened.

ii) Policy discussion

What can be done? Well, the answer will depend on who’s answering. There has been a hot discussion among the economists about the next policy steps. The Keynesian view would prescribe that fiscal stimulus should be implemented in order to boost the aggregate demand, increase income, consumption, investment, employment, etc and put the economy back on track. This has been questioned by those who support their disbelieves in the Ricardian Equivalence, in which temporary increases in government purchases would not stimulate the aggregate demand since the households would know that it would be financed in the future by higher taxes, so they would save more now. In this situation they recommend the exactly opposite: by implementing fiscal austerity the households and the firms would be more confident about the economic situation in the future and would start to consume and invest now and prepare themslves for the higher taxes in the future. I stand with the Keynesian view.

In the old continent after the countries facing problems to recover and paying the price of the euro (here), the single currency without a single budget issue is not latent anymore, and the euro leaders agreed with a fiscal arrangement that assures the Maastricht treat (or at least penalizes those countries that do not accomplish it). After some math and analyzing the situation with a simple, but powerful model, I’m worried about it (see here what I mean).

iii) What’s next?

Some conjectures about the possible outcomes of the euro crisis postulated by Roubini were discussed in this blog before (here). The probability of a disruptive event (i.e. disordered breakup) is increasing since the policymakers do not take definitive measures and even the investors doubt benefit has been taken away (an issue that Olivier Blanchard has pointed out; link here).

If the situation remains the same, i.e. the policymakers announcing palliative measures and neither fixing the structural problems (or at least creating a credible and feasible plan for them) nor coordinating a new arrangement, the breakup may be postponed, but one day the pressure might be too high (2013?). In some countries (e.g. Portugal) the accommodation to the euro due to productivity differentials that reflects on the real exchange rate may result in an adjustment in labor market not in the prices (since nominal wages are stick and the low inflation makes the velocity of equalization of productivity adjusted real wages), but rather in the quantities (NAIRU’s hysteresis), as I’ve briefly discussed here.

In the US the economy has been shown a better shape, but far from a great picture. The political debate is influencing the economic policy on the fiscal side and until the households’ deleveraging process ends, given that there’s a little space for an effective monetary attempt, the GDP may remain far from the potential and the labor market could take those ten years to achieve good levels.

If the scenario it’s not cheering, we can add some boom-burst housing bubble in China (here) and then things will became interesting. Welcome (volatile) 2012!

Ho Ho Ho

Four lessons by Olivier Blanchard

A must read.

Debt (un)sustainability

European debt has been a hot topic for a while now. Even though I think this is rather a how-to-keep-a-non-optimal-currency-area-issue (for some background, see here, here and here) rather than a debt crisis, it’s important understand why the markets are so nervous. In my last post I explored the high debt regimes established in some trouble countries since the 80s. The question in this post is: are they sustainable?

I don’t know.  But we can do a few calculations to get some ideas.

Considering Italy, Portugal and Spain, using IMF data estimates I calculated the required government primary surplus to maintain debt stable for four scenarios (interest rates at 4%, 5%, 6% and 7%). Any level above will decrease the debt, and any level below will increase the debt. Let’s see the graphs:

(click on the graphs to see better)

We have three different stories here. Italy does not seem to have a problem to get back on track and finance its debt. For Portugal if the environment is not very friendly, things can get pretty messy. For Spain, well, the problem just deepens.

I will ratify my opinion that what these countries need right now is fiscal stimulus. Why? Well, first of all, they have already given up monetary policy for committing with the monetary union. And the ECB interest rate is low, new cuts will produce only marginal effects and they take too long to be implemented.

Second, for some countries like Italy, the situation is not as bad as it seems, so the government can help the economy recover. For the countries that are more in trouble, well, if you cut government expenditures and increase primary surplus, may still be not enough to stabilized the debt, so all the hurt in the economic activity may not worth. Notwithstanding, if instead of cutting expenditures the government increases it with a medium-run debt restructuring program planned, it will be easier to manage the debt after the economy is growing again.

Some remarks:

- This is just an exercise based on estimates. As the horizon of the forecasting increases, the accuracy decreases. But decisions must be based on the available data, and corrected after new data is available.

- I used this logic to calculate the required primary surplus.

Debt regimes

Several economic models consider the “household’s problem” as an intertemporal decision between consumption and saving influenced by interest rates, preferences and risk averseness. Using the mathematical apparatus based on rational agents, we solve these models optimizing the consumption path subject to a budget constraint. Well, if you have read any of my posts before you know that I’m not very fan of this “rational agents” approach, but the whole idea of choosing a consumption path given some budget constraint is interesting. 

Roughly speaking, the budget constraint tells us that in the limit, the maximum consumption level must be less or equal than our wealth. It seems just a long-run restriction. But sometimes it’s binding. And I think it’s binding right now for some European trouble countries. In other words, they are now paying the bills of the high level of consumption. Adding the fact that they are less competitive than their core-Europe neighbors, the situation gets tough.

I used Markov Switching Regressions (MSR) to analyze the debt regimes of Portugal, Spain and Italy using the Historical Public Debt Database of the Fiscal Affairs Department of the IMF. The following graphs show the debt/GDP ratio during several years for each country, and the estimated probability of the country being in the high debt level regime (I used only two regimes and allowed changes in the mean and the variance):

The three countries have some common features like the last time they have entered in the high debt regime was almost in the same epoch (near the year they joined the European Economic Community). I do not think this is a debt crisis. I do think that it’s something much more problematic than this. I’ve been writing about the currency union for a while (recent posts: here, here and here; if you know Portuguese also here, here and here) and I do think that the problems that were triggered by the 2008 financial crisis are challenging the euro existence.

If you look at the graphs and the estimated probabilities you may wonder why now? I mean, they have been in this high level regime for a while, and why now they have a crisis?

I have a guess. From my point of view, the Euro Zone (and maybe also just the precedent European Economic Community) created a pooling (unstable) equilibrium in which countries were priced in an optimistic way. In this scenario, the “bindness” of the budget constraint was postponed due to cheap capital inflows from the core to the periphery (and from other parts of the world also). “Everybody was Germany”.  So even in the high debt level regime, they were considered safer than they really were, so they could afford to consume more than it could (or should). But maybe the 2008 shock was too strong to postpone even more.

If I’m saying that the budget constraint is now binding, why I state that this is not a debt crisis?

Well, from my point of view the real problem today it’s not the debt level of the countries (this is more a medium/long-run problem), but the incapacity of manage a high level of debt and expand their economy since they are stuck in a monetary arrangement in which they cannot use monetary tools to boost their output and fiscal policy is questioned for those who are concerned with debt levels. They are stuck in a liquidity trap. They are less competitive than the core countries and do not have the nominal exchange rate to adjust it. Fiscal policy is need today and a debt restructuring program is need tomorrow. But they are going in the opposite way. 

Fiscal stability union, math and procyclical implications

Recently the European Union leaders have announced a plan for what they’ve called as Fiscal Stability Union. With exception of the Britain, all members have joined the attempt. Let’s analyzed what has been proposed.

Roughly speaking (actually writing, but anyway), there will be some mechanisms in order to guarantee (or at least stimulate) that countries will fulfill the targets of maximum debt/GDP and govern balance/GDP.

As Kevin O’Rourke have pointed out here, this quite different from the sort of fiscal arrangement Europe needs right now. What has been proposed has important procyclical issues rather than countercyclical benefits of transfers’ mechanisms amid recessions. Let’s work on it with simple math and simple good models of the economy.

i) Some math

Let’s consider the debt/GDP ratio, an important measure of countries fiscal health and that is in the kernel of the recent events. During recessions, GDP falls. If everything remains constant, debt/GDP goes up. But whenever a country tries to implement fiscal stimulus, actually the debt can also goes up, so the debt/GDP ratio may increases even more. The designed plan for this situation is: fiscal austerity.

I’ll quote Kevin O’Rourke: “one lesson that the world has learned since the financial crisis of 2008 is that a contractionary fiscal policy means what it says: contraction. Since 2010, a Europe-wide experiment has conclusively falsified the idea that fiscal contractions are expansionary. August 2011 saw the largest monthly decrease in eurozone industrial production since September 2009, German exports fell sharply in October, and now-casting.com is predicting declines in eurozone GDP for late 2011 and early 2012”.

Now, let’s consider the govern balance/GDP. During a recession govern revenues fall but the government expenditures have some downward rigidity since there is some kinds of spending that it has (by law or just to make things working) to keep. So the revenues will fall more than the spending, and the result will be a lower govern balance (probably more negative). Only this would be a problem, but remember that GDP will fall also, so the ratio will increase more. What’s the plan for it? Fiscal austerity.

ii) Implications

Let’s use the old and good IS-LM framework to analyze what can emerge from this plan to trouble countries (and by trouble countries today we mean the periphery, but in the future, who knows?). Just a quick background, the IS-LM shows the aggregate demand dynamics emerging from the interaction between goods and services markets (IS) and the money market (LM). The model endogenous variables are the output level (Y) and the interest rate (r).

- Imagine that the economy is in a given equilibrium:

- Then, a demand shock put the economy in trouble:

- Next, the indicators show that, based on what has been accorded, fiscal austerity must be implemented (since debt/GDP and govern balance/GDP will rise):

iii) Considerations

In an optimistic point of view (not mine as you can see), one can imagine that the agreement between the countries under monetary union may serve as a signal in the right direction so the markets can interpret in a good way and the pressure will fall, the debt interest rates will fall and the economies will have a little more space for maneuvers.

Personally, I just think that they have gained some time. The adjustment among periphery countries paying the price for been in the euro (here) is not over, and if a sequence of policies such as the ECB committing with the lender of last resort role, fiscal integration in a way that creates transfers mechanisms and some really expansionary stimulus, the situation may became even uglier.

Monetary policy transmission and Brazilian economy

In the last COPOM meeting (the Brazilian “version” of the FOMC) the entity has decided to cut 50 bps of the policy rate, achieving the 11% per year level. The government is worried about the impacts of the international crisis on the Brazilian growth. It has used fiscal and monetary attempts in order to sustain the expansion in the next year. Some tax cuts have been implemented, and the Brazilian Central Bank (BCB) keep cutting the SELIC and seems to continue this trend for at least more two meetings, when the rate could achieve a level of 10% per year (if the situation became uglier the intensity of the cuts might be stronger).

The inflation prognostic still worries me (see my post about it, here). But I’ll work on the monetary policy channels in this text and try to see what the BCB has in mind.

First of all a picture that illustrates the monetary policy transmission channels:


(click on the graphs and pictures to see better)

i) The Credit Channel

The first channel analyzed is the credit channel. Basically through the monetary policy the central bank tries to stimulate the financial market to concede loans lowering costs and/or making more resources available. The picture of Brazilian credit market behavior is the following:

As we can see, passed the short period of contraction during the 2008 crisis, the growth is robust and has been around the 15% 12-month growth average for 17 months.

Credit to households also presents a robust growth. Even with the downward trend in the recent 12-month growth rate (mainly due to macroprudential measures implemented in December 2010), it’s still above 20%. I don’t see reasons to stimulate, actually I’m still worried about the velocity of the growth. 

ii) The asset price channel

The asset price dynamics influences aggregate demand through the wealth channel (a rise in asset prices will make investor richer and, hold everything else constant, will increase consumption and investment) and through the credit channel (“a la” Kiyotaki-Moore dynamics, a rise in asset prices will increase the value of the collaterals augmenting credit concessions, boosting the aggregate demand). But the definition of “asset” is a little broad, one can think about land, houses, stocks and other things. Since in Brazil the data available of housing market is not very reliable (if you know Portuguese I worked with an index for housing market in São Paulo, here, and presented some worries about a possible bubble). For the stock exchange however, the data is good. The value of the companies listed in the Bovespa can be seemed in the graph below:

As we can see, the recent developments have impacted the growth of the value of the companies. From January 2010 to October 2011, the nominal growth was only 5,06%. Cuts in the interest rates may stimulate the stock market (I have an idea based on a paper of Blanchard why this might not happen, maybe I’ll write about it later) but also fuel the housing market that is already a possible problem.

iii) The real rate channel

The “Keynesian” channel of monetary policy tells us the relation between aggregate demand and interest rates (or money supply if the central bank chooses it as the policy instrument). The idea is that the agents (households and firms) base their decisions, among other things, on the real interest rate.

A lower interest rate would stimulate consumption since the opportunity cost would decrease and households would have less incentive to postpone consumption (the utility gained with the increase in the future consumption would compensate less the disutility of not consuming today). At the same moment, firms would be induced to invest for the same reason, and more projects would be attractive (i.e. imagine a project that yields a 10% per year of return; it will be attractive with a rate of 8% per year, but not with a rate of 12% per year).

The following graph shows the evolution of aggregate consumption and gross fixed capital formation (aggregate investment):

These private components of the aggregate demand have stabilized at the margin in the last quarter. Since the BCB assumes that the impacts of the international environment on the Brazilian economy will be strong (see again here), one possible reading is that something has to be done. Expectations are very important for decisions such as durable goods consumption, housing acquisitions and firms’ investment, for instance, and uncertainty contributes to mess with them, so the aggregate demand could growth less or even contract due the contagion. I’m still not sure. Yes, it will hurt the economy, but the impact will be big enough in the aggregate consumption and investment decisions? I don’t know.

iv) The exchange rate channel

Another channel is the exchange rate. Lower interest rates would attract less capital (or actually produce an outflow of fixed income portfolio foreign investment) and would reduce the value of the domestic currency (a lower interest rate could in the medium-run produce more inflation, another way to devalue the domestic currency). Assuming a Marshall-Lerner condition, this would stimulate exports and, holding everything else constant, would increase the GDP, income, consumption, investment, etc.

Well, since mid-2011 the BRL has been devalued and since a great part of the Brazilian exports are commodities, a) there are already some evidences of a low influence of the exchange rate in basic goods (if you know Portuguese I recommend this work of my former two professors , here), so the impact would be more in the inefficient industry goods (there are better ways to promote efficiency and stimulate it) and b) the external demand for industry goods will probably decrease with the crisis, so the impact of an exchange rate devaluation could be null.

Anyway, let’s see a graph of the exchange rate (BRL/USD, probably it would be better to see the real effective exchange rate, but let’s use it anyway:

v) Final remarks

If you remember the first picture of this post, the channels of the monetary policy, the last box was…inflation. As I have already written in this blog, in Brazil the problem is not the lack of aggregate demand, but the concomitant management of external shocks and a robust aggregate demand. I showed that two components of aggregate demand have stabilized at the margin in the last quarter, what do not mean that the robustness is over.

For a while now the 12-month past inflation has been above the upper-bound of the target (the target is 4,5% but who cares now?). OK, the BCB might target the future inflation, not the past (or current, given the monetary policy lags), but there’s some inertial component and this may anchor expectations in a high level. If the external damage in the next months hurts the economy in a way that these preventive actions of the BCB (and the Government as whole in the fiscal front) will not boost inflation, the timing is perfect. However, if the entity is not right, the bet may cost a lot in terms of social welfare. Let’s see what happens.