Wednesday, November 27, 2013

The Economic Exhortation of Pope Francis

I'm glad to see Pope Francis' apostolic exhortation Evangelii Guardium featured so prominently in the media. With a 224-page document and a 2000 year Church history, however, media coverage is bound to include some oversimplifications. One is the title of Emma Green's piece in the Atlantic, "The Vatican's Journey From Anti-Communism to Anti-Capitalism." While the article includes a lot of good information, it does oversimplify historical Church teaching on the economy. Green writes:
Throughout 224 pages on the future of the Church, he condemns income inequality, “the culture of prosperity,” and “a financial system which rules rather than serves.” 
Taken in the context of the last half-century of Roman Catholicism, this is a radical move. Fifty years ago, around the time of the Second Vatican Council, Church leaders quietly declared a very different economic enemy: communism. But Pope Francis’s communitarian, populist message shows just how far the Church has shifted in five decades—and how thoroughly capitalism has displaced communism as a monolithic political philosophy.
The Catechism of the Catholic Church, published in 1992, "presents Catholic doctrine within the context of the Church's history and tradition." According to the Catechism,
2425 The Church has rejected the totalitarian and atheistic ideologies associated in modem times with "communism" or "socialism." She has likewise refused to accept, in the practice of "capitalism," individualism and the absolute primacy of the law of the marketplace over human labor. Regulating the economy solely by centralized planning perverts the basis of social bonds; regulating it solely by the law of the marketplace fails social justice, for "there are many human needs which cannot be satisfied by the market. Reasonable regulation of the marketplace and economic initiatives, in keeping with a just hierarchy of values and a view to the common good, is to be commended.
The Church has a long history of rejecting both communism and capitalism in their pure forms. The Catechism elaborates on private property:
2403 The right to private property, acquired or received in a just way, does not do away with the original gift of the earth to the whole of mankind. The universal destination of goods remains primordial, even if the promotion of the common good requires respect for the right to private property and its exercise. 
2404 "In his use of things man should regard the external goods he legitimately owns not merely as exclusive to himself but common to others also, in the sense that they can benefit others as well as himself." The ownership of any property makes its holder a steward of Providence, with the task of making it fruitful and communicating its benefits to others, first of all his family. 
2405 Goods of production - material or immaterial - such as land, factories, practical or artistic skills, oblige their possessors to employ them in ways that will benefit the greatest number. Those who hold goods for use and consumption should use them with moderation, reserving the better part for guests, for the sick and the poor. 
2406 Political authority has the right and duty to regulate the legitimate exercise of the right to ownership for the sake of the common good.
The following passages concerning economic activity and profit are also quite relevant:
2423 ...Any system in which social relationships are determined entirely by economic factors is contrary to the nature of the human person and his acts. 
2424 A theory that makes profit the exclusive norm and ultimate end of economic activity is morally unacceptable. The disordered desire for money cannot but produce perverse effects. It is one of the causes of the many conflicts which disturb the social order. 
2425 A system that "subordinates the basic rights of individuals and of groups to the collective organization of production" is contrary to human dignity. Every practice that reduces persons to nothing more than a means of profit enslaves man, leads to idolizing money, and contributes to the spread of atheism. "You cannot serve God and mammon." 
These passages from the Catechism are based on a long history of Catholic teaching on economic justice, including Encyclicals from the Popes. Quadragesimo Anno, for example, written by Pope Pius XI in 1931, responded to economic conditions and inequality following the Great Depression. More recently, Pope Benedict in Caritas in Veritate stated that "Profit is useful if it serves as a means towards an end that provides a sense both of how to produce it and how to make good use of it. Once profit becomes the exclusive goal, if it is produced by improper means and without the common good as its ultimate end, it risks destroying wealth and creating poverty."

I am very grateful for Pope Francis' exhortation. I do not think it represents a radical shift in Church teaching, but rather a renewed and louder cry for the teaching to be taken seriously. His cries that "The dignity of each human person and the pursuit of the common good are concerns which ought to shape all economic policies." I hope the world will listen.

Friday, November 8, 2013

Financial Networks and Contagion

"Financial Networks and Contagion," a recent paper by Matthew Elliott, Benjamin Golub, and Matthew Jackson, uses network theory to study how financial interdependencies among governments, central banks, investment banks, and other institutions can lead to cascading defaults and failures.

Source: Elliott et al. 2013

While the model is quite technical, the main theoretical findings are fairly intuitive. They define two key concepts, integration and diversification. Integration refers to the level of exposure of institutions to each other through cross-holdings. Diversification refers to how spread-out the cross-holdings are; in other words, whether a typical organization is held by many others or just a few. The key finding is that at very low or very high levels of integration and diversification there is lower risk of far-reaching cascades of financial failures. The risk of a far-reaching cascade is highest at intermediate levels of integration and diversification. The authors explain:
"If there is no integration then clearly there cannot be any contagion. As integration increases, the exposure of organizations to each other increases and so contagions become possible. Thus, on a basic level increasing integration leads to increased exposure which tends to increase the probability and extent of contagions. The countervailing effect here is that an organization's dependence on its own primitive assets decreases as it becomes integrated. Thus, although integration can increase the likelihood of a cascade once an initial failure occurs, it can also decrease the likelihood of that first failure... 
With low levels of diversification, organizations can be very sensitive to particular others, but the network of interdependencies is disconnected and overall cascades are limited in extent. As diversification increases, a "sweet spot" is hit where organizations have enough of their cross-holdings concentrated in particular other organizations so that a cascade can occur, and yet the network of cross-holdings is connected enough for the contagion to be far-reaching. Finally, as diversification is further increased, organizations' portfolios are sufficiently diversified so that they become insensitive to any particular organization's failure."
Near the end of the paper, they illustrate the model using cross-holdings of debt among six European countries. The figure above is their representation of financial interdependencies in Europe. They conduct something akin to stress tests, simulating cascades of failures under various scenarios that very roughly approximate conditions in 2008. The simulations find that, following a first failure in Greece, Portugal is fails from contagion. After Portugal fails, Spain fails due to its large exposure to Portugal. The high exposure of France and Germany to Spain causes them to fail next in most simulations. Italy is always last to fail due to its low exposure to others' debt. They emphasize that this is intended only as an illustrative exercise at this stage, but could eventually be refined and incorporated into analysis of failure and contagion risk.

*Edited to fix my mistake pointed out by Phil.

Monday, November 4, 2013

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.


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.