Weekend reading links

1. Ananth points to this article on the floatation of Virgin Galactic, the loss-making $2.3 bn valued space tourism company for the immensely rich. Some of the comments are delicious,

And while 3 bn persons need fresh water and healthy food we all wish you a nice flight...

I'm sure the Vision Fund will invest in this...

New 'beyound meat'!

2. FT has an article on China's strategic investments in metals. This about the Chinese state-owned Citic Metals in Ivanhoe Mines in Democratic Republic of Congo,

Chinese companies already own some of the richest deposits of copper and cobalt in the DRC and beyond, metals that are critical to the switch away from fossil fuels to renewable energy. They have invested at least $8bn in Congolese mining assets since 2012, with miner China Molybdenum buying the Tenke copper and cobalt mine from Freeport-McMoran for $2.65bn in 2016... China has long coveted the idea of having a large mining company to rival western groups such as BHP, Anglo American and Rio Tinto, which they see as controlling the world’s best deposits.

3. Is Mark Zuckerberg the epitome of everything that is wrong with Big Tech? It is hard to not come away from watching his Congressional deposition on Libra without feeling concerned about the competence of Facebook's leadership.

4. Bloomberg points to the likely source of the next round of financial market crisis - CLOs. Sample this,

CLOs own about 54% of all leveraged loans outstanding... An alarming number of leveraged loans—29% by some estimates—are rated B- by S&P Global Ratings or B3 by Moody’s Investors Service. For both ratings companies, that’s just one rung above CCC, the very lowest tier before default.

5. How many times will this repeat? The latest episode of African debt defaults appear on the horizon. High fiscal deficits, fraud and deception, and the increased share of non-concessional commercial debt have all been contributors. Sample the signatures of troubles in frontier market debt,

Almost half of frontier market countries are either at high risk of falling into debt distress or are already distressed, the IMF has said, up from zero as recently as 2014. The warning comes as issuance of hard currency frontier market debt is set to hit a record high this year, with $38bn set to be raised, according to the IMF... Mozambique is already in default after it borrowed more than $2bn, much of it concealed from the IMF and donors, ostensibly to finance a tuna fishing fleet and maritime security projects, only for much of the money to be diverted to kickbacks for bankers and government officials, according to US prosecutors. The Republic of the Congo, Africa’s third-largest oil producer, Zimbabwe, The Gambia and Grenada are also on a list of nine states the IMF classes as being “in debt distress”. A further 24 countries, including Ethiopia, Ghana, Zambia, Haiti, Laos and Tajikistan are deemed to be at “high” risk of following suit, by far the highest level since comparable records began in 2010... The outstanding stock of such debt has already tripled to $200bn over the past five years with the median issuer now labouring under a debt pile equivalent to 7 per cent of gross domestic product and close to half its gross reserves, compared with 3 per cent and 20 per cent respectively in 2014. In terms of debt to GDP, the median frontier issuer now has a ratio of about 55 per cent, a rise of almost 20 percentage points since 2013.

Despite the growing risks frontier market yields have fallen from 8.2 per cent in November 2018 to 6.2 per cent as investors search for yields.

But with global monetary accommodation most likely in its final phase, this graphic on debt redemption (or roll-over) schedules looks ominous.

6. FT on the changing face of American capital markets. The abundance of private capital has led to an almost having of listed companies in the US.

7. In the context of the RCT focused Nobel Prize, some very good articles - Sanjay G Reddy, Ingrid Harvold Kvangraven, TCA Srinivasa Raghavan, Jean Dreze, and this one unravels the actual story behind the claims made here. 

The "confidence fairy" trumps Keynes in UK!

Even as a fierce debate rages about the policies required to address the Great Recession across the developed economies, among the major economies Britain has made a decisive choice to embrace fiscal austerity to restore market confidence. The land of Keynes appears to have blinked on the face of massive fiscal strains and chosen to break with Keynesian policies and follow the path of balancing government finances to revive economic growth.

In recent days, France has decided to raise the minimum retirement age to 62 from 60 and the age for a full pension to 67 from 65. Earlier Greece, Spain, and Ireland had embraced deep spending cuts in an attempt to avoid sovereign bankruptcies.

The Conservative Government in Britain last week followed its other European partners by annoucing the country’s steepest public spending cuts in more than 60 years in an effort to eliminate government deficits by 2015. This comes as Britain faces one the worst public debt problems among all developed economies - 11.5% public deficit and 61% public debt. It is hoped that these steep cuts will repair government's fiscal balance, improve market confidence, stimulate the private sector and restart growth.

The proposed measures include a reduction of expenditures in government departments by an average of 19% (£83 billion or about $130 billion) by 2015, sharp cuts in welfare benefits, increase in the retirement age from 65 to 66 by 2020 (saving $ 8 bn a year), and elimination of 490,000 public sector jobs (out of a total of 6 million jobs or 8% of the total) over the next four years. Further, payments to the long-term unemployed who fail to seek jobs will be cut saving $11 billion a year, and a new 12-month limit will be imposed on long-term jobless benefits, and measures will be taken to curb benefit fraud.

This follows an earlier decision to stop paying its hitherto universal child benefit payments ($32 a week for a first child and $21 for each subsequent one) to people earning more than around $70,000 a year. There is also a proposal to accept the findings of the Browne Review on subsidies for university education, which suggests dramatic cuts on university education spending.

The Browne review advocates scrapping of the present system that caps a year's tuition fee at £3,290 ($5,275) in favor of a free-market approach paid for by the students themselves — but only after they graduate and are earning more than £21,000 a year. It is being suggested that the government could then cut about 80% of the current $6.2 billion it pays annually for university teaching, and about $1.6 billion from the $6.4 billion it provides for research. To make up for the shortfall, universities would have to raise tuition to an average of more than $11,000.

On the revenues front, the British Government has already announced plans to levy a one-time 50% marginal tax on bankers' bonuses of more than £25,000 ($40,700). This would be levied not only British banks but also the London subsidiaries of Wall Street giants. The move is more symbolic than substantial since it would raise only £550 million.

Such a hair-trigger alarmist repsonse from Britain is surprising, and far from engendering market confidence may end up rousing market anxiety and even panic. Unlike fellow Europeans like Greece and Ireland, despite its high 11.5% fiscal deficit, Britain is nowhere close to bankruptcy or reeling from any bond-vigilantes. There were no bond-market panics and inteerest rates have remained low. Public debt at 61%, while high, is not so large as to press the panic button. And all these macroeconomic indicators are similar to that in the US (fiscal deficit of 10.7%), which is debating the extent of accommodation - monetary and fiscal - required. Further, there will be serious questions about the need to eliminate government deficits at all, and that too within such a short-time and starting from an aggregate demand shrinkage driven recession.



These dramatic measures carries with it considerable risks and even goes against the grain of historical record of countries which faced similar situations. In simple terms, the spending cuts are made on the assumption that the private sector will be able to able to make up for the 19% and 8% cuts in government spending and employment respectively, over the next four years.

However, this private sector growth in output and job creation to cover up for the government's exit would have to be a top-up on the regular growth. And regular growth itself will have to be large enough to bridge the yawning output gaps that shows no signs of narrowing. In simple terms, Britain will have to grow at its highest rate in the post-war era, close to double digits, just to return to normalcy. What makes this even more formidable is the fact that this momentum will have to get generated immediately and there appears nothing in the horizon among the private sector that could trigger off such a dramatic spurt in growth.



And all this has to start immediately, since any delays would only end up pushing the can further down the road and widening the output and employment gaps, necessitating even more higher rates of growth and job creation. There are serious and well-grounded fears that such optimism may be misplaced.

It is also hoped that these measures will restore market confidence and encourage the private sector to come forward with their investment and spending plans. However, as the evidence so far from Ireland, which has been similarly savage with its spending cuts, shows, such assumptions may fall through. After its initial round of spending cuts failed to enthuse the markets and trigger any recovery and make any dent on its stupendous budget deficit of 32% of GDP, Ireland is set to announce another round of cuts, which would take the total cuts to 14% of its GDP.

As Joseph Stiglitz wrote in response to the British decision, the excessive faith in the confidence fairy and attendant spending cutbacks "will weaken Britain, and even worsen its long-term fiscal position relative to well-designed government spending". He wrote,

"There is a shortage of aggregate demand – the demand for goods and services that generates jobs. Cutbacks in government spending will mean lower output and higher unemployment, unless something else fills the gap. Monetary policy won't. Short-term interest rates can't go any lower, and quantitative easing is not likely to substantially reduce the long-term interest rates government pays – and is even less likely to lead to substantial increases either in consumption or investment. If only one country does it, it might hope to gain an advantage through the weakening of its currency; but if anything the US is more likely to succeed in weakening its currency against sterling through its aggressive quantitative easing, worsening Britain's trade position...

The few instances where small countries managed to grow in the face of austerity were those where their trading partners were experiencing a boom... Lower aggregate demand will mean lower tax revenues. But cutbacks in investments in education, technology and infrastructure will be even more costly in future. For they will spell lower growth – and lower revenues. Indeed, higher unemployment itself, especially if it is persistent, will result in a deterioration of skills, in effect the destruction of human capital, a phenomena which Europe experienced in the eighties and which is called hysteresis. Lower tax revenues now and in the future combined with lower growth imply a higher national debt, and an even higher debt-to-GDP ratio."

It is being argued in some circles that the apprently contrasting responses (atleast till now) on both sides of the Atlantic to addressing the Great Recession comes from their respective different historical experiences and the attendant institutional memories. The memories of the Great Depression and the human sufferings and long-term damage inflicted to the economy is thought to inform the relative acceptance of fiscal and monetary accomodation in the US. In contrast, Europeans are driven by even more recent experiences with government deficits that have resulted in sovereign defaults and episodes of run-away inflation. In particular, it is being claimed that the Conservative Government's decision now is grounded in memories of Britain’s economic collapse in the 1970s, when the International Monetary Fund had to come to the rescue just as it has done recently in Greece.

Joe Stiglitz should have the last word,

"Austerity converts downturns into recessions, recessions into depressions. The confidence fairy that the austerity advocates claim will appear never does... Consumers and investors, knowing this and seeing the deteriorating competitive position, the depreciation of human capital and infrastructure, the country's worsening balance sheet, increasing social tensions, and recognising the inevitability of future tax increases to make up for losses as the economy stagnates, may even cut back on their consumption and investment, worsening the downward spiral...

Britain is embarking on a highly risky experiment. More likely than not, it will add one more data point to the well- established result that austerity in the midst of a downturn lowers GDP and increases unemployment, and excessive austerity can have long-lasting effects... it is a gamble with almost no potential upside. Austerity is a gamble which Britain can ill afford."

Calculating a bank tax

Among the proposals under consideration for financial market regulation reforms in the aftermath of the sub-prime crisis, have been those relating to placing limits on the size of TBTF institutions and raising resources to finance future bailouts. While the former has not made much headway, the later has received considerable attention in many countries in the form of bank taxes.

Like on many other initiatives during the recent crisis, Britain has been first off the block with the new coalition government's decision in its austerity budget to impose a levy on banks to raise £2 billion per year. The levy will start at 0.04% of banks’ riskier liabilities — excluding Tier 1 capital and insured deposits — in 2011, rising to 0.07 percent in 2012, and will be imposed on banks with liabilities of more than £20 billion. Following the British decision, France, Germany, and the EU too have thrown in their weight behind a bank tax with the "aim to ensure that banks make a fair contribution to reflect the risks they pose to the financial system and wider economy, and to encourage banks to adjust their balance sheets to reduce this risk".

In the US, President Barack Obama's proposed tax of 0.15% of net bank liabilities to raise up to $117 billion over 10 years, has met with stiff opposition and is not likely to sail through. However, one of the biggest challenges with these bank tax proposals has revolved around arriving at a widely acceptable approach/formula to decide on the optimal tax rates.

Calculating the appropriate tax for a financial institution with debt guarantees requires measuring the quantity of taxpayer risk and then pricing that risk. The latter can be accomplished through options markets designed specifically to price risk accurately. However, calculation of the former by regulators comes up against severe information asymmetry problems and other market failure risks.

In this context, Narayana Kocherlakota, President of the Minneapolis Fed proposes a new market-based method for determining the quantity of tax to be paid by financial institutions so as to internalize their risk externalities. He proposes that governments should provide debt guarantees to all firms in the financial sector and the resultant risk externality (created by this guarantee) be controlled by appropriate regulation should control. He writes,

"For a particular financial institution, the government should sell 'rescue bonds' paying a variable coupon linked to the size of the bailouts or other government assistance received by the institution or its owners. Coupon prices will reflect the market’s judgment of an institution’s risk profile and can therefore be used to set the tax.

... (say) the rescue bond pays a variable coupon equal to 1/1,000 of the transfers actually made from the taxpayer to the financial institution or its stakeholders. Much of the time, this coupon will be zero. However, just like the financial institution’s stakeholders, the owners of the rescue bond will occasionally receive a large payment. In theory, or in a perfectly functioning market, the price of this bond is exactly equal to the 1/1,000 of the expected discounted value of the transfers to the financial institution’s stakeholders. Thus, the government should charge the financial institution a tax equal to 1,000 times the price of the bond...

In principle, the government need not figure out in advance which institutions are systemically important and which are not. Instead, the market would provide this information through the pricing of rescue bonds... A well-designed tax system can entirely eliminate the risk externality generated by inevitable government bailouts."

Bank tax : cost recovery fee or deterrent tax?

So finally, the Obama administration has bitten the bullet and announced a Financial Crisis Responsibility Fee (FCRF) "that would require the largest and most highly levered Wall Street firms to pay back tax payers for the extraordinary assistance provided so that the TARP program does not add to the deficit".

The fee is to be levied on the debts of only those financial firms (banks, thrifts and insurance companies) with more than $50 billion in consolidated assets and having the most leverage, and is expected to be a deterrent against excessive leverage. The proposed fee would be 15 bps of covered liabilities per year, and the liabilities would be determined by the formula

Covered Liabilities = Assets - Tier 1 capital - FDIC-assessed deposits (and/or insurance policy reserves, as appropriate)

The fee would amount to about $1.5 million for every $1 billion in bank assets subject to the fee. It would apply to about 50 companies and would impose the greatest burden on firms that rely less on customer deposits.

The fee, to go into effect on June 30, 2010, is expected to remain in place for 10 years, so as to fully re-pay the TARP expenditures incurred by the Government. If the costs have not been recouped after 10 years, the fee would remain in place until they are paid back in full. In its estimations for imposing the Fee, the Obama administration has scaled down its projected cost of TARP from $341 billion in August, 2009 to $117 billion. Over sixty percent of revenues will most likely be paid by the 10 largest financial institutions. The fee would be imposed on both US financial institutions and US subsidiaries of foreign institutions.

In many respects, the FCRF is a political balancing act between strong calls for taxing windfall bonuses for executives announced by many of the largest financial institutions who benefited from the TARP bailout at the peak of the crisis, and the more broader advocacy of a tax on cross-border speculative transactions. Further, by avoiding the use of the word "tax" and using the more benign "fee", the administration hopes to take the sting out of the big government war mongers who get genetically attracted into mounting campaigns against such any form of taxation.

However, by indicating its intent to levy the fee only till the TARP costs are recovered, it risks becoming a case of post-facto cost-recovery on a specific past event, and may do little to exercise any deterrent effects. Achieving deterrence against running up leverage and loading on excessive risks would require permanently institutionalizing such levies on specifically systemic risk creating TBTF institutions.

The reactions to the FCRF is available here and here. Mark Thoma advocates recouping the bailout money and increase the safety of the system at the same time through a tax on assets (to get at the too big to fail problem) and a tax on leverage (to reduce the damage the big banks can cause if they do fail).

Mark Thoma also feels that the proposed fee will fuel moral hazard concerns in so far as banks will now be encouraged to take risks in the belief that they will not only be bailed out but will not have to ebar the full costs of their actions. Instead of paying an ex-ante insurance claim, they are now left to pay a far lower ex-post fee.

Update 1
Douglas Diamond and Anil Kashyap propose taxing banks based on the difference between their assets at the end of August 2008 and their current level of capital, on the grounds that the "support these firms received was based on the size of assets before the financial panic began, not the size of those assets today". This tax would be equivalent to insurance premiums that should have been charged ahead of time on institutions who took the bailout money which ended up effectively insuring its bondholders and other creditors.

Update 2
Sweden has imposed a permanent 'stability fee' or direct tax on banks so that they pay for their own bailouts. Unlike the American TARP cost recovery fee, the Swedes hope to ensure that when another banking crisis occurs, as it surely will, the tools are in place to manage and pay for it. The levies are allocated to a stability fund, managed by the National Debt Office and the government plans to keep the tax until it hits a total of 2.5% of GDP in 15 years, the amount estimated to be required to cover for a full-blown banking crisis.

The fee will be due annually, starting at 0.018 percent of each institution’s liabilities, excluding equity capital and some junior debt securities, based on audited balance sheets. The bank levy will rise to 0.036 percent of liabilities in 2011, when the government is planning to introduce a weighted charge as well. Companies with riskier balance sheets would pay more.

Update 3
Thomas Cooley has three suggestions - modify the bankruptcy code and create mechanisms to allow for the orderly failure of these institutions; impose a tax on them that is proportional to the risk to the system that they create; and treat that tax as an insurance premium to cover the cost of future problems, just as the FDIC charges banks for deposit insurance.

He feels that this tax should have two parts - "a portion to cover the risk a firm creates for itself and its investors by taking on excessive leverage, and a portion to cover the risk that leverage creates for the system as a whole".

Mark Thoma weighs in here.

Update 4 (26/5/2010)

David Leonhardt argues that in view of the inevitability of a bailouts, a bank tax is the only way to ensure that tax payers do not get saddled with the costs of the bailout.

Matthew Richardson and Viral Acharya argue that while firm-specific risks can be diversified away, "systemic risk" (joint failure of financial institutions or freezing of capital markets) cannot be and will remain with the firm and as recent events have shown such risk can have catastrophic consequences for the broader economy at large. Further, the management, shareholders, and creditors do not bear the full systemic costs of a failure, while the real economy feels the burden and society pays the price, whether in the form of bailouts, lost productivity or unemployment. While profits remain privatized in good times, downside risks are socialized. They therefore argue that the only way out of is to force these firms to internalize the systemic costs they impose on the rest of the economy by a bank tax. They propose a tax on "each financial institution an amount equal to the expected systemic costs of a crisis multiplied by that institution's percentage contribution to financial sector losses".