Wednesday, 25 January 2012

I don’t think we are in Davos anymore

In his celebrated 1984 Brookings paper   “I don’t think we are in Kansas anymore”,  Cuba-born economist Carlos Diaz-Alejandro chose in his title and analogies to place the 1980s international debt crisis in the Land of Oz. As Jeff Sachs pointed out then in his comment, few people realize that the original Wizard of Oz by L. Frank Baum is itself partly an economic parable in which the Wicked Witch of the East represents Eastern capitalists who dehumanize kindly laborers.  And the word OZ was probably constructed by a one-letter transposition of NY, home of those predatory capitalist who played hardball (years before the Brady Plan) with the highly indebted Latin American governments.
At the start of his paper, Diaz-Alejandro announced that hispaper will argue that what could have been a serious but manageable recession has turned into a major development crisis unprecedented since the early 1930s mainly because of the breakdown of international financial markets and an abrupt change in conditions and rules for international ending. The nonlinear interactions between this unusual and persistent external shock and risky or faulty domestic policies led to a crisis of severe depth and length, one that neither shocks nor bad policy alone could have generated. Large capital outflows, in most cases encouraged by unconditional currency convertibility, provided a particularly explosive environment for the interaction of external shocks and imperfect policies”.

 Sounds vaguely familiar, no?

Today, we find ourselves in deep illusionment with market capitalism, so deep that I get increasingly worried about the “economic consequences of peace”, of attempts to fix the beast by do-it-yourself economists (or, rather, non economists).

Take  Klaus Schwab, the founder of the Davos World Economic Forum (WEF), the arch venue of capitalists and billionnaires who pay big sums to enjoy the Alpine scenery and snow network benefits that the gathering of 2,500+ influential people can bring. (TheDavos WEF was never a place, by contrast, to learn about new ideas or from little known thought leaders; that aspect – intellectual exchange to produce ‘actionable’ concepts – has just been pure decoration, in my judgement). Schwab ahead of the annual meeting: “Capitalism in its current form no longer fits the world around us”.

What is it? Capitalism? In its current form?

Is France capitalist, with a public spending more than half of GDP? Are the United States, a country where contestability and equal access  to, say, education, is severely compromised? The high-growth emerging giants in China and India which are graduating from decades of heavy state intervention? Is it perhaps technology that obviates the need for large-scale employment in sectors other than servisec? Please define, Herr Schwab! What are the alternatives? Communism? Libertarian capitalism? Ordo liberalism? Die Soziale Marktwirtschaft?

In any case, rising evidence of wealth and income inequality in the statistics, partly the result of a long period of Lewis labour markets in China and India that starts to close, the high dose of state intervention in these high-growth countries, their competitive manufacturing industries: all those trends activate polcymakers, especially those with elections coming up.

To be sure, today’s problems are severe (and have been made more severe than necessary by people who open this year’s WEF and some of those who attend it). But are these problems inherent to today’s form of market capitalism? Or can they be fixed by monetary and fiscal measures suggested by the Keynesians? What are the alternative economic-model paradigms?

One thing is sure: Don’t expect any insights from Davos. What you will get are tons of familiar buzz words (as ill-defined as ‘capitalism-in-its-current-form’): Inclusive growth; social cohesion; newish,  greenish, skill sources of growth; ‘industrial’ policies to enhance ‘competitiveness’ and ‘innovation’; less private finance and more state capitalism? The list of questions may suffice to alert to the  many risks and traps on the way of the little Kansas girl to the fantasy world.

Monday, 16 January 2012

Boom and Bust and Sovereign Ratings

France joined Austria in losing its top credit rating after government-bond markets closed last week, on Friday 13(!) January.The nations were cut one level to AA+ from AAA and face the risk of further reductions, according to Standard and Poor's, with Moody's and Fitch the world's leading rating agency. While Finland, the Netherlands and Luxembourg kept their AAA ratings, they were put on negative outlook. Spain and Italy were also among the nations downgraded and Portugal was cut two steps to BB. However, on Monday 16 January, French bonds advanced as borrowing costs fell at the nation’s first debt sale since Standard & Poor’s stripped it of its top credit rating and cut the grades of eight other euro-area countries. So what to expect for sovereign risk spreads of the downgraded Europeans against German sovereign risk, holding the euro region’s only stable AAA grade? Further widening, I am afraid.

For what it's worth, let's consult a paper that I wrote with Julia von Maltzan in 1999*, a rating event study exploring the market response for 30 trading days before and after rating announcements. The Figure shows the mean of relative yield spreads before and after 103 rating events. 

In general, the Figure conveys that a change in the risk assessment by the three leading rating agencies is preceded by a similar change in the market’s assessment of sovereign risk. The pattern is particularly clear when countries have been put on review for possible downgrade or upgrade. During the 29 days preceding a review for possible downgrade, relative spreads rise by about 12 percentage points.

For the Euro countries down graded before the weekend another of our result augurs badly, notwithstanding France's successful bond auction today:  Implemented negative rating changes seem to exert a sustained impact on bond yield spreads: the rating downgrade is largely unanticipated. After a country’s rating has been downgraded, the market appears to vindicate the agencies’ assessment over the next 30 trading days with an upward movement in relative yield spreads.

Implement downgrades of emerging-market bonds were shown in our study to produce a strongly significant market reaction: During 30 trading days, from ten days before the press release issued by the rating agency to 20 days thereafter, relative yield spreads widen significantly by an accumulated 12.7 percentage points.

* Helmut Reisen and Julia von Maltzan (1999), "Boom and Bust and Sovereign Ratings", International Finance, Vol.2:2, pp.273-293.

Monday, 9 January 2012

The Tobin tax: can it work (if you stay alone)?

French President Nicolas Sarkozy is due to discuss the Tobin tax today in Berlin over lunch with German Chancellor Angela Merkel. France could table the tax for parliamentary approval next month even if it had to go it alone. Does this make sense? After all, the Swedish experience of introducing a 0.5% transaction tax on the purchase or sale of equities was disappointingly low, despite (or because of) a subsequent doubling of the tax rate. Taxable turnover in equity trading shrank until the tax was discontinued in 1989 from when trading volume recovered. Until further evidence, I retain the scepticism about the revenue potential of the Tobin tax that I expressed ten years ago in the OECD Observer (1). 

 He was against the Tobin tax: James Tobin

Please find some excerpts of what I wrote then: "...the tax was proposed in 1972 by the US economist, James Tobin, as a way of throwing sand in the wheels of international finance, and so combat market volatility. Basically, it would involve taxing currency market transactions. What may explain its appeal to some governments and NGOs is that even a very small tax rate imposed on such a large tax base as the foreign exchange market would, at least in theory, yield sizeable revenues to finance 'global public goods', like the environment, health programmes, poverty reduction, etc. Estimates of between US$50-250bn per year have been waved about, based on tax rates of between 0.05% and 0.25%.

But how realistic are these figures? A look at the structure of currency markets suggests they are probably exaggerated. Currency markets are characterised by a lot of intra-day clearing and netting, a feature likely to be fostered by the growing use of electronic broking....Also, despite the growing role of electronic brokering, trading between dealers (rather than with other financial institutions or with non-financial customers) makes up more than half of foreign exchange market turnover. The largest part of the daily transactions are done for purposes of hedging between traders to avoid over-exposure in currencies accumulated from deal-making. Hedging activities are known as 'hot potato trading', as any speculative selling of, say, the US dollar could leave the seller with a supply of unwanted euros, which he or she will then try to off-load to other dealers. The practice helps to spread risk more evenly. The Tobin tax would discourage hedging, though, because its multiple transactions would each be taxed. Consequently, the tax base of daily foreign exchange transactions would shrink.

There is also the question of how to impose the tax to maximise revenue. Many deals are done throughout a single day and are settled together when the markets close. Taxing these settlement sites where the currencies are transferred to the books of the central banks may seem the simplest approach. However, according to a key study by Professor Peter Kenen (2), the tax should be levied on each trade at the dealing sites. It would then capture the total value of the deals, whereas settlement involves netting the day's transactions, and so would produce a lower taxable amount.
Tax avoidance would probably grow too, further reducing the Tobin tax's ability to yield revenue. Two principal types are likely: first, the migration of the foreign exchange market to tax-free jurisdictions; and second, the substitution of tax-free for taxable transactions.

Migration would occur unless all jurisdictions with major foreign exchange market turnover adopted the tax. Trading could be drawn to new sites, such as an offshore tax haven somewhere. This migration could be prevented by a punitive tax on all transactions with that haven, enabling trading to continue with complying sites. This penalty would reduce the risk of a migration flood gate being opened by a 'first mover'. But it would only work with small jurisdictions. If one of the larger established markets, like Frankfurt or Hong Kong for instance, did not adopt a Tobin tax, plenty of dealers would shift to that tax-free market and trade among themselves, without being affected by any punitive measures. The tax base would clearly be eroded as a result.

To stop substitution of taxable foreign exchange transactions by tax-free ones, the Tobin tax would have to cover several financial instruments and keep up with new ones created to circumvent the tax. For instance, a tax on spot transactions can be avoided easily by using short-dated forward transactions. So, these would have to be taxed as well. And as swap transactions combine a spot with an offsetting forward contract, they would also have to be taxed. Moreover, taxing currency swaps alone will not do, as a foreign exchange transaction can be replicated by a combination of a currency and treasury bill swap, thereby evading the currency market (and the tax) to some extent.
Even assuming the Tobin tax was feasible to operate, would it be economically desirable? Put another way, would it lower distortions in international capital markets and encourage less volatility, or crisis-prone investment and help alleviate poverty?

The original purpose of Mr Tobin's proposal -- to reduce 'excessive' exchange rate volatility -- has moved to the background. After all, the size of the monthly changes in the relative value of key currencies has not grown in line with the rise in international capital mobility of recent decades. On the contrary, as we have seen, the Tobin tax might well reduce the liquidity of foreign exchange markets. And because it reduces hedging activities in the market, it would encourage more pure speculation and hence lead to more, not less, volatility.

Most observers are less concerned with short-term volatility (which can be hedged) than with longer term misalignment of exchange rates, notably those of emerging markets. Such misalignment may at times be rooted in boom-bust cycles of private lending and investment to developing countries. But the Tobin tax would not be large enough to counter these cycles, whose risk-adjusted returns would, given the sudden swings from euphoria to panic, require extremely high tax rates to balance them.

(1) "Tobin Tax: Could It Work?", OECD Observer, No 231/232, May 2002
(2)  Kenen, P., "The Feasibility of Taxing Foreign Exchange Transactions", in The Tobin Tax: Coping with Financial Volatility (M.ul Haq, Inge Kaul, et al, eds.), Oxford, 1996.

Wednesday, 4 January 2012

A New Year's Review to ShiftingWealth 2011

All the best - health, power and prosperity - to you the readers of this blog. Since I started it in April 2011, ShiftingWealth has been viewed more than 6.500 times, not bad a number for an OECD scribbler, I like to think.

The most popular post were (if you want to re-read, just click the link)

Popular Posts 2011
10 April
  5 April
  7 November
25 May
26 September
28 September
  3 May
12 August
18 July
16 November

Where is the audience for this blog? Mostly in advanced countries, with France, United Kingdom, United States and Germany clearly in the lead. Brazil, India and Russia are the frontrunners among the converging countries; China, alas, is not listed as Chinese readers are still forced to enter through foreign web addresses. My wish for 2012? That China allows full internet access. And that this blog makes you rich!