A Financial-Fiscal Trilemma

Financial crises and sovereign debt crises are, of course, not a new phenomenon. But the strong connection between fiscal crises and financial crises is relatively recent, primarily developing since the Great Depression and especially since the 1980s. In a new and ambitious NBER working paper, Michael Bordo and Chris Meissner survey the literature on financial and fiscal crises and their interconnections, providing both a history of thought and a catalog of open questions.

The key to the growing link between fiscal and financial crises, they explain, is the increased use of government guarantees of financial institutions. This means that banking crises are often followed by a rise in the debt-to-GDP ratio that can be partially attributed to costs of reconstructing the financial sector. Based on a synthesis of the research in this area and some preliminary empirical analysis, Bordo and Meissner posit that countries face a “financial/fiscal trilemma.” As they explain:

This financial/fiscal trilemma suggests 43 that countries have two of the following three choices: a large financial sector, a large bailout package, and a strong discretionary reaction to the downturn associated with financial crises. The logic is as follows by way of an example. Assume a country with a large financial sector faces a banking crisis. If so, then the government can provide a bailout package of a size that is commensurate with the size of the financial sector. If so it uses up its fiscal space. Otherwise it could lower the size of the bailout and devote its fiscal space to discretionary fiscal policy. With a smaller financial sector, and the same amount of fiscal space, since the size of the bailout would by definition be smaller, the size of the rise in debt due to expansionary policy could rise (p. 42-43). 

They use data from Laeven and Valencia (2012) on 19 systematic banking crises to estimate the equation:

Fiscal costs refer to the fiscal costs of bailouts in the three years following a crisis. Discretion is the change in debt not due to the fiscal costs of bailouts, also in the three years following a crisis. The estimation results, with standard errors in parentheses, are:

Notice that the estimated coefficients on the fiscal cost and discretion to GDP ratios sum to approximately 1, suggestive of a tradeoff. If the financial sector is smaller, or if the bailout package is smaller, then the change in fiscal costs to GDP ratio is likely to be smaller, which could allow a larger change in the discretion to GDP ratio, hence the "trilemma." The trilemma is illustrated by Figure 5, below. The discretion to GDP ratio is on the y-axis and the fiscal costs of bailout to GDP ratio is on the x-axis. For a given change in the debt to GDP ratio, the regression estimates imply an "iso-line" showing the fiscal costs of bailouts and discretion to GDP ratios that are possible.

Source: Bordo and Meissner (2015)

As further evidence of the trilemma, they present Figure 6, which illustrates that countries with a larger financial sector, as measured by the domestic credit to GDP ratio, tend to have a larger rise in the share of the debt to GDP ratio explained by bailouts.

Source: Bordo and Meissner (2015)

This evidence of a new "trilemma" certainly merits more rigorous empirical evaluation. As the authors note, however, empirical studies of financial and fiscal crises face the challenge of inconsistent classification and measurement. Alternative crisis chronologies lead to contradictory results. Bordo and Meissner thus propose the following:

If economists and policy makers truly believed that crises were an important phenomenon to understand and possibly avoid then it might be the case that an independent crisis dating committee could help set the standard in much the same way the NBER business cycle dating committee works. The advantage of following this model is that the NBER is a respected non-governmental, non-partisan organization. Other organizations such as the IMF are not sufficiently politically independent. If crises are becoming increasingly global and crisis fighting is a global public good, then the importance of such a reform should be obvious. 

Argentine Inflation Saga Approaches Critical Moment

Argentina's time is up. In February, the IMF censured Argentina on account of its notoriously dubious inflation statistics. Under terms of the censure, Argentina was given until September 29, 2013, to improve the flawed data. The deadline has passed, and IMF Chief Christine Lagarde will report to the IMF Executive Board by November 13 on Argentina's progress (or, likely, lack thereof.)

Lagarde's impending report follows a long and nearly unbelievable saga (see timeline at the end of this post.) The gist of the matter is that officially-reported inflation has been in the vicinity of 10% for the past few years, while a variety of private estimates place the true value at 25% or higher. Oh, and the independent economists who publish these private estimates are threatened with criminal prosecution. This September, economist Orlando Ferreres published his estimate that June monthly inflation was 1.9%, compared to the official estimate of 0.8% (with compounding, that's a big difference) and could face a two-year prison sentence. I searched for Ferreres' website on November 3, and it appears to have been hacked (see image below.) I could not find Ferreres' independent inflation estimates on his site; only official estimates appear.

Red flags were raised in earnest in 2007, when then-President Néstor Kirchner dismissed several staff statisticians at INDEC, the statistics institute that publishes the official consumer-price index (CPI) for Argentina. The government takeover of INDEC included the demotion of Graciela Bevacqua, director of the inflation index, who had prepared the inflation data for six years. In 2005, Bevacqua estimated that inflation was over 12% and rising. Bevacqua says that Interior Commerce Secretary Guillermo Moreno began pressuring her to underreport inflation data in May 2006. From then until her demotion, Moreno harassed her unrelentlessly, challenging her data and methodology and demanding more "favorable" estimates. Bevacqua refused to comply, resulting in her demotion and eventual resignation from government.

The 2007 Presidential elections certainly contributed to the pressure for more "favorable" inflation data. With Kirchner's appointees in place at INDEC, end-of-year inflation "fell" from 12.3% in 2005 to 9.8% in 2006 to 8.5% in 2007. Christina Fernandez de Kirchner, wife of Néstor Kirchner, was elected President. After the elections, the data manipulation had to continue, to cover the previous manipulation.

In Argentina, inflation statistics have political significance that extends even deeper than their economic significance, as is common in countries with a history of hyperinflation. In the 1970s, like several other Latin American countries, Argentina borrowed heavily to fund its industrialization efforts. A variety of factors combined to exacerbate a debt crisis in the 1980s, which was accompanied by high inflation in Argentina and neighboring countries. Argentina faced quadruple-digit inflation in 1989 and 1990, with a hyperinflationary peak in March 1990. The disastrous consequences of hyperinflation, including stagnation of growth and capital flight, prompted structural reforms in the 1990s, under direction of the IMF, which restored inflation to low levels. For a time, Argentina was viewed as a model of success.

The situation in Argentina took a turn for the worse around the time of the Brazilian devaluation in 1999. A protracted recession erased most of the decade's gains in poverty reduction. As the federal government deficit widened to 2.5% of GDP in 1999, the IMF advised the De la Rúa administration to implement austerity measures. Distress escalated to full-scale crisis, climaxing with the largest debt default in history in December 2001. Following the default, Argentina faced exclusion from international capital markets and 41% inflation in 2002. Legal battles with a subset of the bondholders continue to this day.

With this history, it is not surprising that both inflation and IMF relations are sensitive issues for Argentina. Bevacqua says that Secretary Moreno "said that if we didn’t aim for zero inflation, we were unpatriotic.” The  irony is that the deceptive data, intended to improve appearances, fooled no one, and made the country look worse rather than better. Consumers in Argentina are well aware that inflation is several times the official rate. A consumer survey run by Torcuato di Tella University has measured inflation expectations near 30% for several years.

Source: Torcuato di Tella University. Yellow bars indicate median expectation and gray line indicates mean expectation.

MIT economist Alberto Cavallo published an investigation into Argentina's official price index in the widely-read Journal of Monetary Economics in 2012. Here is the abstract:

Prices collected from online retailers can be used to construct daily price indexes that complement official statistics. This paper studies their ability to match official inflation estimates in five Latin American countries, with a focus on Argentina, where official statistics have been heavily criticized in recent years. The data were collected between October 2007 and March 2011 from the largest supermarket in each country. In Brazil, Chile, Colombia, and Venezuela, online price indexes approximate both the level and main dynamics of official inflation. By contrast, Argentina’s online inflation rate is nearly three times higher than the official estimate.

Cavallo suggests that "the way the data is being altered is far simpler than commonly assumed. INDEC is a large organization, with many employees involved with the data collection and construction of the price indexes. Instead of changing the prices at the item level, it is probably easier for the government to change the aggregate numbers, which are seen by just a handful of people at the end of the CPI calculation process."

He adds, in conclusion, that "There is no obvious reason for why the government continues to manipulate the official price indexes. Some economists point to lower interest payments for inflation-linked bonds, while others highlight the fact that, by using artificially low inflation estimates in the budget, the government can avoid distributing any excess tax income to the provinces. However, these short-term resources are negligible next to the negative effects and uncertainty the manipulation has introduced in the economy."

Regarding Argentina's inflation-linked bonds, doubts about data accuracy began to wipe away their market in 2007. Argentina originally issued inflation-linked bonds in 1973, and the "linkers" came to play a large role in public debt management. Even as late as 2009, a third of Argentine debt was linked to inflation. But in September 2009, Argentina launched a new bond, the Bonar 2015, as part of a debt swap that replaced much of the inflation-indexed paper.

The collapse of Argentina's inflation-indexed bond market, though destructive, pales in comparison to the harms that have been inflicted on workers and consumers. A government-imposed price freeze implemented in February, and another in June, appear unsurprisingly ineffective. The mismatch between official data and generally perceived cost-of-living increases makes satisfactory wage negotiations between trade unions and the Ministry of Labor impossible. Erosion of purchasing power is likely much worse in the informal sector, which accounts for an estimated 40% of Argentine workers. In addition, strict capital controls fuel a large currency black market.

Lagarde describes the IMF censure of Argentina as a "yellow card." When Lagarde makes her report to the IMF Executive Committee later this month, if the data is not suitable, she will give a "red card." It is not clear how harmful any potential IMF sanctions could be. Argentina is already the only Group of 20 country that refuses to allow the IMF to conduct an annual review of the economy known as the Article IV consultation, and may not be overly concerned with further deterioration of relations with the IMF. A likely, if unsatisfactory, outcome is some knuckle-rapping and maintenance of the status quo for all practical purposes. The IMF could suspend Argentina's voting and related rights and begin the process of compulsory withdrawal from the fund. A top international priority should be the minimization of contagion to other emerging markets-- which should be possible, since the situation is sufficiently Argentina-specific. The way out of the mess in Argentina is difficult to foresee. The way into the mess is outlined in the timeline below.

Timeline

1970s: Argentina borrows heavily to fund industrialization efforts.

1973: Argentina issues inflation-indexed bonds.

1980s: Argentine inflation heats up in the midst of Latin American debt crisis.

March 1990: Argentina's hyperinflation reaches peak.

1990s: Argentina implements IMF-directed structural reforms.

1998-2002: Argentina suffers severe recession.

June 31, 2001: Argentina swaps $29.5 billion of debt and defers $7.8 billion in interest payments. 

December 5, 2001: IMF announces it will not release $1.3 billion in aid to Argentina because austerity measures are insufficient.

December 23, 2001: Argentina defaults on $100 billion in debt.

May 25, 2003: Néstor Kirchner becomes President, succeeding Carlos Menem.

2007: Kirchner replaces several statisticians at INDEC with political appointees.

December 10, 2007: Christina Fernandez de Kirchner becomes President.

September 2, 2009: Argentina swaps 16.7 billion pesos ($4.34 billion) of inflation-linked bonds for newly-issued 2014 and 2015 bonds to extend maturities and reduce financing costs.

January 2010: Standoff between Central Bank President Martín Redrado and President Kirchner over use of central bank reserves to pay debt. Redrado is fired, then reinstated by courts.

January 30, 2010: Central Bank President Redrado resigns. Redrado accuses government of data manipulation.

February 3, 2010: Mercedes Marcó del Pont appointed President of Central Bank.

February 1, 2012: IMF Executive Board gives Argentina 180 days to implement specific measures to address quality of inflation data.

September 17, 2012: IMF Executive Board determines Argentina has made insufficient progress in implementing remedial measures.

February 1, 2013: IMF Executive Board censures Argentina.

February 4, 2013: Argentina announces two-month price freeze.

September 29, 2013: Deadline for Argentina to address concerns with inflation and GDP data.

November 13, 2013: Deadline for Christine Lagarde's report to IMF Executive Board on Argentina's progress.

Cyprus Levy: Historical Precedents

In 1991, in response to considerable debt management concerns among European nations, Barry Eichengreen wrote a paper called "The Capital Levy in Theory and Practice." A capital levy on wealth-holders with the goal of retiring public debt was perhaps the most controversial proposed solution to the European public debt problem. Eichengreen provides a theoretical framework for considering the effects of such a levy, a list of challenges to successful implementation, a "catalog of failed levies," and an example of an exceptionally successful levy. Eichengreen's framework and lessons from history are useful for considering the levy on savings in Cyprus that is planned as part of Cyprus' 10 billion euro bailout.

Eichengreen's model uses insights from the literature on time consistency and government reputation. If governments could commit to only issuing capital levies under certain circumstances (in technical terms, if capital taxation is a state-contingent claim with full commitment mechanism), then governments could optimally issue levies when government obligations are unusually high, social returns to spending are unusually high, and/or conventional revenues are unusually low. "If the contingencies in response to which the levy is imposed are fully anticipated, independently verifiable, and not under government control," he writes, "then saving and investment should not fall following the imposition of the levy, nor should the government find it more difficult to raise revenues subsequently."

Of course, there are major practical impediments  First, full government commitment technology does not exist. If a government were to precommit to a plan for how its capital taxes would respond to future contingencies, it would end up having an incentive to renege on its commitment. Knowing this, savers would shift their capital to tax havens. Reputational concerns can partially get around this problem. The model describes how a "reputational equilibrium" can result if savers refuse to repatriate their capital for a certain amount of time following a government's decision to renege on its commitment. Another major impediment is the following:

"In a democracy, there is no independent authority to verify to the satisfaction of savers that the realization of the state of the world in fact justifies a capital levy. Even if savers recognize that capital taxation is a contingent claim, they retain the incentive to dispute that the relevant contingency has arisen. Neither is there a mechanism to prevent the government from pursuing policies that strengthen the case for capital taxation -- for example, increasing ordinary expenditures as levy receipts roll in. Savers will accuse the government of succumbing to moral hazard and resist the levy on those grounds... If the levy is imposed at all, typically this will occur only at the end of a protracted and divisive political debate...If there is an extended delay between proposal and implementation of the levy, capital flight is likely to render the measure ineffectual."

In light of these impediments to the successful use of a capital levy, Eichengreen analyzes a number of previous levies, mostly in the aftermath of World War I, and explains why they obtained varying degrees of failure or partially success. His first example, however, is not from post-WWI but rather from the ancient Greeks. They used periodic capital levies of one to four percent which, it is said, were "phenomenally successful because property owners, out of vanity, overstated the value of their assets!" Capital levies were also proposed, but not adopted, following the Napoleonic wars, the Franco-Prussian war, and other periods of major military expenditure. But the end of WWI was the true hey-day of the capital levy.

Italy imposed a capital levy in 1920. The rates ranged from 4.5 to 50 percent; however, payment could be stretched out over 20 years. Thus, it was successful but not too comparable with the Cyprus levy, which would be paid at once. The Czech levy of 1920 is more comparable with the Cyprus levy, and was more successful than levies in Austria, Hungary, and Germany at that time. In Czechoslovakia, a levy on all property was imposed, with progressive rates from 3 to 30 percent, with a separate surtax on the wartime increment up to 40 percent. There are two main reasons this levy was relatively successful. First, the levy fell mainly on a small ethnic German minority, which was unable to mount effective political resistance to delay adoption, so capital flight was minimized. Second, the government budget was structured so that levy revenue was completely separate from day-to-day government operations. The levy was explicitly devoted to extinguishing debts and meeting the special costs of establishing a newly-independent nation. This "lent credibility to claims that the levy was an extraordinary tax whose repetition was unlikely."

Other countries' levies were less successful. In Austria, political delays dragged on so long that asset holders had more than a year to prepare, so capital flight was extensive; moreover, hyperinflation liquidated levy obligations. Similarly, delays in other countries enabled capital flight. In Britain, a levy was long debated but never imposed. Keynes himself weighed in, initially in support of the levy, but later opposing it by the mid twenties, when postwar exceptional circumstances were further in the past.

The Japanese levy after World War II is Eichengreen's example of the exception that proves the rule. It was successful because the typical impediments to success were negated by the exceptional circumstances. Capital flight was limited, and the levy applied primarily to a small minority of individuals considered to have profited greatly from the war. In 1946-47, Japan's sovereignty was severely abridged by occupation forces. Thus "with important elements of democracy in suspension, the levy could be quickly and effectively implemented. One might go further and argue that only when political sovereignty is suspended can the measure be pushed through with such alacrity." Also, since the levy was essentially imposed by outsiders, it did not damage the Japanese government's reputation too much or adversely impact the ability of the Japanese government to raise revenue subsequently.

Lessons for Cyprus

A common theme of levies in the 20th century is that delays, usually politically-induced, cause capital flight and prevent the levy from raising a successful amount of revenue. The Cypriot parliament has already delayed its vote on the deposit levy to Monday. We will see how long the proceedings drag on. In Cyprus,  the levy will fall in large part on foreign depositors, particularly Russians, like the Czech levy fell mainly on Germans. It is not clear whether foreign depositors will prove as unable to mount political resistance in Cyprus as the Germans were in Czechoslovakia.

The levy in Cyprus is progressive, like it was in Czechoslovakia, although not to the same extent. The rate is 6.75% on deposits less than 100,000 euros and 9.9% on larger deposits. According to Eichengreen, a crucially important feature of the successful Japanese levy was the "sociopolitical argument," or the fact that the levy was imposed on people who were seen as having profited unjustly from the war. Engineers of the Cypriot levy may make the case that it is imposed on Russian money launderers or other wealthy depositors funneled their money there for less than admirable reasons. This case might be easier to make if the levy were more progressive-- if it hit bigger accounts harder, and were easier on the small accounts.

The Japanese levy did not adversely impact future Japanese governments' ability to borrow because it was imposed by outsiders. The Cypriot government may also be able to point to the IMF and EU as the masterminds behind this levy. The bigger issue, though, is whether other EU countries will suffer reputational penalties by virtue of association.

Finally, what worked really well for Czechoslovakia was that the levy revenue was totally separated from other tax revenue and dedicated strictly to paying off debt and to the needs of the extraordinary circumstances. It was not used to fund day-to-day operations of the government. That made it seem less likely that the government would be tempted to impose another levy in the near future. That is a feasible option for Cyprus, which they will hopefully employ.

International Lending with Moral Hazard and Risk of Repudiation

Yesterday I presented the paper "International Lending with Moral Hazard and Risk of Repudiation" by Andrew Atkeson (1991 Econometrica) at the Berkeley Macroeconomics Lunch. My slides are here.

The paper presents a model to explain why countries sometimes face capital outflows when they suffer an adverse macroeconomic shock. With complete markets and perfect insurance, we wouldn't see such a situation. But in the model, the markets aren't complete. The borrower is a sovereign nation, and hence can repudiate the loan. Moreover, the lender cannot observe whether the borrower invests the loaned funds productively or uses them for consumption. The only way to incentivize the borrower to invest some of the funds in equilibrium is if insurance is incomplete, so that the borrower's future utility has some dependence on their investment choice. Thus, moral hazard imposes an insurance-incentives tradeoff.

While preparing for the presentation, I came across an interesting paper by Drelichman and Voth (2011) called "Lending to the Borrower from Hell: Debt and Default in the Age of Philip II.” Here's the abstract:

What sustained borrowing without third-party enforcement in the early days of sovereign lending? Philip II of Spain accumulated towering debts while stopping all payments to his lenders four times. How could the sovereign borrow much and default often? We argue that bankers’ ability to cut off Philip II’s access to smoothing services was key. A form of syndicated lending created cohesion among his Genoese bankers. As a result, lending moratoria were sustained through a ‘cheat-the-cheater’ mechanism. Our article thus lends empirical support to a recent literature that emphasises the role of bankers’ incentives for continued sovereign borrowing.