# Videos: Famous Professors On Fiscal Stimulus vs Austerity

I have compiled some of the best discussions with famous professors of economics on their thoughts around the current issue of fiscal stimulus versus austerity. I tried to give a fair voice to each side of the aisle, and in that spirit I start out with a few dialogues where both sides are represented. These are followed by monolouges from each side of the aisle respectively. If you know of any other videos that should be included in the list, please leave a link in the comments section!

The Dialouges: Austerians vs Keynesians

Paul Krugman vs John Taylor (CNN, June 2009)

via CNN

Paul Krugman vs Kenneth Rogoff (CNN, August 2011):

via CNN

Robert Barro vs James Galbraith (Bloomberg, 2011)

And then some monolouges by stimulus supporters:

Justin Wolfers (Bloomberg, April 2013)

Paul Krugman (CNN, June 2013)

via CNN

And last some monolouges by austerity supporters:

John Cochrane (Bloomberg, February 2013)

John Cochrane (Bloomberg, September 2009)

Niall Ferguson (CNBC, November 2013) [A lot of babble and politics in between the actual arguments]

On Morning Joe to Discuss Debt and Civility | Niall Ferguson | VideoNiall Ferguson, MA, D.Phil., is Laurence A. Tisch Professor of History at Harvard University. He is also a Senior Fellow at the Hoover Institution, Stanford University, and a Senior Research Fellow at Jesus College, Oxford.

Greg Mankiw (Bloomberg, March 2012)

John Taylor (Bloomberg, June 2010)

# An introduction to SA bank balance sheets (graphs)

To get a sense of the credit market in South Africa, it is useful to see who funds whom. Most credit in SA is extended via the banking sector. The banks act as intermediaries: savers deposit cash in checking or savings accounts and the bank then lends the majority of these deposits to other individuals or businesses who demand credit. The bank earns a profit by charging a higher rate on the lending than it pays on its borrowing (in SA, banks appear to earn profit on their borrowing as well, by paying a rate on deposits below inflation). The following graphs plot the different components of the aggregate balance sheet for all South African banks.

I first plot the total liabilities of South African banks. This adds up to a bit more than 3 trillion rand, of which 2.7 trillion is deposits. The remainder consists of repo transactions (Borrowed Funds), foreign currency funding, and subordinated debt securities (Other Liabilities).

Deposits in checking and savings accounts as well as money market funds is the channel through which we ordinary citizens lend money to banks. Banks can then lend the funds to other households and businesses. However, a closer look reveals that deposits include much more than just household savings. The figure below illustrates the importance of both financial firms (fund managers, money market funds, pension funds, insurers etc) and non-financial corporations. Household deposits only account for a fifth of total deposits. The role of fund managers and money market funds have clearly become a very important channel of directing savings onto bank balance sheets. The remaining liabilities of banks are categorised as “Other Borrowed Funds”, “Foreign Currency Funding” and “Other Liabilities”. The “Other Borrowed Funds” are mainly repurchase transactions, typically short term debt where the borrower submits collateral for the entire amount. This is typically used to cover short term needs for cash, often to cover the required reserve ratio with the South African Reserve Bank. Banks can also use this as temporary financing to extend loans without having to wait for customer deposits to fund the lending.

It is slightly surprising to see that repo borrowing actually increased to a higher permanent level after the global financial crisis. It was this type of borrowing, on a much larger scale, that enabled US financial institutions to build massive leverage with an extreme maturity mismatch. The maturity mismatch refers to the short term nature of the debt, often overnight funding, combined with the long term nature of their assets, often household mortgages with maturity over several years. This is not a major concern in South Africa – despite the increased use of repo funding it still only accounts for approximately R100 billion out of an aggregate balance sheet of R3000 billion.

Foreign currency funding, plotted above saw a huge leap during the financial crisis, and has stayed high ever since. But as was the case with repo funding, foreign currency funding still accounts for only R100 billion out of a total balance sheet of R3000 billion.

The figure below plots “Other Liabilities” which consists mainly of subordinated debt securities. Here we see the same pattern again, of a sharp increase in recent years. This type of lending adds up to approximately R200 billion out of the total R3000 billion. Again not a very large amount.

As one would expect from ordinary banks, we have seen that deposits account for the vast majority of their funding. We call this “core liabilities”. The more unconventional funding of banks, mainly repo transactions, foreign currency funding and subordinated debt securities were each of less significance. However, if we add up all these “non core liabilities” we see that the use of such alternative funding has greatly increased in recent years. This may be a consequence of a strong demand for credit combined with low rates of savings. It also indicates that banks are eager to lend out money; so eager that they choose not to wait for deposits to come in, but rather use alternative borrowing to fund such credit extension. This may be a good thing in an economy with lackluster growth, but this is a risky business and a crash in these markets will have dire consequences for the real economy. So keep watching these numbers, they do give a good sense of how South Africa is doing.

# South African banks borrowing more in foreign currency

The picture above shows how SA banks have increasingly relied on foreign currency and foreign sector funding in the last year. (The increase is significantly larger in Rand terms due to the recent rand depreciation). I don’t know the reason for the increase, but research from the US suggests that such borrowing is a consequence of banks extending new loans at a faster rate than their deposits increase. In such circumstances the bank must borrow from domestic money markets, or from international markets to fund their lending (ie, they become increasingly market based). This is a sign that SA banks are eager to lend, whilst the supply of savings in South Africa is lacking.

About half of the rapid increase was retraced in the second quarter of 2013. The question now is whether this reversal will continue, or will these liabilities return to levels seen in the first quarter? If the foreign liabilities remain high, it suggests an increased demand for credit which is generally considered to be a bullish sign for the SA economy. That said, rapid increases in foreign liabilities have been a leading indicator of past financial crises in emerging markets. So, no matter how you interpret it, this will be an important indicator to follow in the coming months!

# Timing the Taper – are markets overreacting?

This week the markets are again hit by a fresh round of tapering fear. The odd thing about these tapering induced market swings is that the end of QE is certain to happen at some point and must have been priced in already. The only uncertain factor here is the timing. But can the timing of tapering really explain these violent market moves?

To begin with, QE can affect stock prices in two ways:

1. QE pushes down bond yields and so it pushes down the discount rate. This makes the present value of future dividends greater, and thus the stock prices are higher.
2. QE (i.e. lower borrowing costs) will increase demand in the economy and thus increase profits by firms. This increases expected dividends.

Of these, it seems likely that the first effect, via the discount rate, is the one that would be most prone to daily volatility due to tapering timing revisions. But how does the timing of the end to QE affect today’s stock price? And can this explain the volatility in the market today?

Below I do a simplistic back of the envelope analysis which will illustrate that the market has very good reason to be sensitive to the timing of QE tapering. I use a standard dividend discount model calibrated to current data. First we begin with the basic price equation:

$P_t=E\bigg( \sum_{i=1}^{\infty}{\frac{D_{t+i}}{(1+d)^i}} \bigg)$

For simplicity, assume that QE will end abruptly at period N, and that the discount rate then changes from $d_1$ to $d_2$. This gives a price equation as follows:

$P_t=E\bigg( \sum_{i=1}^{N}{\frac{D_{t+i}}{(1+d_1)^i}} + \frac{1}{(1+d_1)^N} \sum_{j=N+1}^{\infty}{\frac{D_{t+j}}{(1+d_2)^j-N}} \bigg)$

Which gives:

$P_t=E\bigg( \sum_{i=1}^{N}{\frac{D_{t+i}}{(1+d_1)^i}} + \frac{P_{t+N}}{(1+d_1)^N} \bigg)$

Now, let us do a rough calibration to the current market by looking at the S&P 500. Today’s price is approximately $1700, the dividend yield is approximately 2%, and thus we have a monthly dividend of approximately$3. For now, we assume a discount rate of 0.5% per month during QE. Once QE ends, this is assumed to increase to 0.8% per month (I will show results for different assumptions later). If QE is expected to end after 12 months, we simply get:

$1700=E\bigg( \sum_{i=1}^{12}{\frac{3}{(1.005)^i}} + \frac{P_{t+12}}{(1.005)^12} \bigg)$

This implies a forecasted price in 12 months of \$1765. We will stick to this implied forecast going forward. Now, if Bernanke makes an announcement that QE will end in 11 months, rather than the expected 12 months, the new price will be:

$P_t=E\bigg( \sum_{i=1}^{11}{\frac{3}{(1.005)^i}} + {\frac{3}{(1.005)^{11}*(1.008)^1}}+ \frac{1765}{((1.005)^{11}*(1.008)^1} \bigg)=1689$

Thus, if markets expected the end of QE in 12 months, and news suddenly revealed it would end in 11 months, the current stock price would fall by approximately 0.49%.

Simulations
I wrote a little program in Matlab that repeats this simulation for an announced end to QE in everything from 1 month up to 12 months compared to an expected end varying between 1 month and 12 months. Some results are plotted in the figure below.

Figure 1: Discount rate during QE = 0.5% per month. Discount rate after QE = 0.8% per month.

The simulations suggest that if the market expects QE to end in for example three months (top left panel) and a surprise announcement by the FED states that it will actually end QE in 2 months, the current stock prices will fall by approximately 0.3%. The fall is fully caused by the revelation that discount rates will increase one month sooner than expected. Remember, here I have assumed that QE keeps the discount rate artificially low at 0.5% per month instead of 0.8% per month. If I change the assumptions so that the end of QE will see a much smaller increase from 0.5% to 0.55% per month, we get the results below:

Figure 2: Discount rate during QE = 0.5% per month. Discount rate after QE = 0.55% per month.

As you see, if QE is assumed to keep monthly discount rates only 5 basis points lower than what they would otherwise be, the current price is still relatively sensitive to the timing of the end to QE. Under this scenario, if we assume the market expects QE to end in 3 months and an announcement today states it will end in 2 months, the current price will fall by 0.1%. If the market expects QE to end in 12 months, and an announcement states it will end in 2 months, the current price will fall by 0.5% (bottom right panel). On the other hand, if the market expects QE to end in 6 months, and an announcement states it will end in 12 months, the current price will increase by 0.3% (top right panel).

Thus, all together, despite the fact that the end to QE is already priced in the market, the market has good reason to be sensitive to its timing. It is easy to say the market is overreacting to news (the reason I started writing this post is because I thought this was the case), but this analysis shows that the current market swings may be completely justified. Any surprises here is guaranteed to induce volatility as markets readjust their expectations of when the FED will begin tapering.

PS: Also note that the day tapering actually begins, the market is practically guaranteed to fall as long as at least one market participant failed to predict the taper to start that day. The simple reason being that no participants will expect taper to begin on a past date (as they would have observed this if it happened), and thus any expectations of tapering to begin on a future date must pull the average expected taper beginning to a future date. This average expectation means that stock prices will never price in an immediate end to QE, no matter how imminent it is. (Of course, the effect of this may be negligible).

# Keynes vs Austerians: Is inflation the solution?

Inflation with fiscal deficits is the last remaining tool to get our economies back on track. That is; if the goal is to increase GDP and reduce unemployment, these economies can no longer rely on monetary stimulus alone. A short revisit to basic economic theory may refresh our understanding before I lay out a brief (and admittedly simplistic) argument.

Remember first that we have two sides to any market; supply and demand. The supply side is not the problem this time around: GDP is not low because we lack capacity to produce. The high unemployment rates give ample evidence that there is plenty of spare capacity around. What is needed here is demand. Thus, if you care about getting the economy back to its long run sustainable level, you must for now accept some Keynesian thinking and leave your supply side arguments for the different discussion of how to maximize long term growth (yes this is just as important, but not the focus of this post).

The disagreement is not whether demand needs stimulus (it does), but how it can be achieved. So, this leaves us with two schools of thought to battle this out: The traditional Keynesian would suggest the use of fiscal deficits (i.e. government spending) to kick start demand directly, and thereby increase the income of consumers who then will increase their demand; and so the multiplier goes. This will increase both debt and GDP, but because the Keynesian multiplier is assumed to be greater than one, we will see GDP growing faster than the stock of debt. Conveniently, this leaves us with a lower debt to GDP ratio, and we are all happy.

The counter argument is that of the now so-called “Austerians” who have little faith in the government’s ability to stimulate demand. They will argue that there is no Keynesian multiplier. The reasoning tends to take one of the following shapes:

(1) Consumers are not stupid and understand that government debt is just another name for future taxes. And if we expect higher future taxes, we must start saving now in order to maintain a smooth (and optimal) inter-temporal consumption pattern. This implies Ricardian Equivalence: an increase in Government spending will be met by an equal off-setting increase in private saving – leading to higher government debt and zero net change in GDP. (2) Debt itself is damaging to the economy. It increases risks and interest rates which hurts private investment. It makes us pessimistic about the future which has a negative impact on consumer confidence. And last but not least, it is unfair to future generations. (It also implies more tax-payer money to be distributed by politicians whose incentives may not be perfectly aligned with the needs of our economy).

Personally, I do believe fiscal stimulus could give a strong boost if combined with further rounds of QE, both in the US and in Europe. However, I am also worried about the potential risks of rapidly increasing debt to GDP levels. Thus, I have no intentions to close this debate. All I have to say is: More inflation will make the pain easier. And I strongly suspect inflation is the outcome our policy makers are aiming for. We will continue to see economists with a taste for easy money to be placed in the driver’s seat of our central banks (think of Carney at the Bank of England, Kuroda at the Bank of Japan and possibly Yellen at the Fed). And I think that’s a good thing. Easy money will make the expansive fiscal policy more powerful and less costly. This even neutralizes the Ricardian equivalence argument: If consumers see the fiscal deficits today and expects higher inflation tomorrow, they will see that the real value of future taxes is lower than the real value of spending today. Thus the increase in government spending will be met by a less than one-for-one increase in private savings, and there is a net positive impact on demand today.

There will of course be pockets of pundits who predict widespread hyperinflation as a consequence. And yes, that is a real risk, but the question is with what probability? And then the next question is: what is the highest probability of hyperinflation we are willing to accept in order to get our economy back on track today?

# Banking: Where is the rumored consumer credit boom in South Africa?

Just posting a quick note on a novelty in SA markets. There has been much talk about the unprecedented consumer credit boom (and much feared bust) in South Africa. See for example Bloomberg’s “South Africa: Unsecured credit boom may not bust” or an older piece on Moneyweb referring to assurances from the SA Reserve Bank that the unsecured credit boom is no bubble.

The figure below illustrates the total credit card debt owed to banks operating in South Africa.

The next figure plots credit card debt owed to the top five banks separately:

And the last figure illustrates the credit card debt owed the top five banks as a ratio of their total assets:

I will leave the long story for someone else to tell, but I have a couple of comments. The first figure clearly shows that South African households and corporates do have an increasing amount of credit card debt to SA banks. Most strikingly is the sharp jump in November 2012. Prior to November 2012, we saw a healthy growth in credit card debt, though not nearly as rapid as prior to the global financial crisis. Adjusted for inflation, this growth seems rather modest and does not give much reason for concern.

Now, back to the spike in November 2012. This looks a lot more dangerous and does warrant a minor investigation. Now, the investigation is very simple: if you have paid attention to the markets recently, you would perhaps have picked up on the news that ABSA acquired Edcon’s account receivables, including all purchases made on credit at Edgars, Jet and Boardmans. This purchase is clearly reflected in the second and third figures where you will see that the entire jump in November 2012 was driven by Absa’s balance sheet. In other words, there was no jump in credit indebtedness, this was rather a move of existing credit from the balance sheet of retailers onto the balance sheet of banks. This number gives no indication of how much credit is still outstanding to the retail sector in South Africa. It does however remind us that the retail sector has become a huge player in the unsecured credit market, where the debt of one retail group makes a great impact on the total credit outstanding to South African banks.

The conclusion to draw from this is that bank balance sheets give us a surprisingly poor view of the indebtedness of the population. The purchase of Edcon’s credit receivables had a huge impact on the total credit card debt owed to banks. If there is such a thing as an unsecured credit bubble in South Africa, it is not caused by bank’s recklessness, but rather by the retail sector’s trust in its own ability to judge the consumers’ creditworthiness. Absa is now the odd bank out, with credit card debt accounting for as much as 35% of its’ total assets and 46% of its total equity.

# Weak rand tied to current account deficit

Despite the fact that trade in actual goods and services only account for a fraction of rand turnover, the current account may still have a certain impact on the rand exchange rate. As I explained in a previous post, the consistent trade deficit of South Africa requires a consistent appetite for rands by foreigners for the currency to keep its strength. A trade deficit means that South Africans must purchase foreign currency (paid for in rands) in order to pay for these foreign goods. However, we can only purchase foreign currency if there are foreigners out there willing to sell it in return for rands. If the rand is too expensive (strong) for foreigners to find it worth purchasing, we have two choices: (1) Either we consume less foreign goods and let the trade deficit narrow, or (2) we accept to pay more rands per foreign currency so we can maintain our consumption level of foreign goods. Because our consumption and production is slow to respond to price changes, it seems likely that the latter option will occur in the short run. To quote my blog post from 6th December:

My prediction is that South Africa’s trade balance will remain unchanged in Q4, but demand for South African assets (and indirectly the rand) will fall short of current account deficit at the current exchange rate. This will require a further rand depreciation to allow South African’s to maintain their current consumption level. Given the low growth rate in Q3, one may have reason to hope that the Bank does not respond to rand induced inflation pressure by raising rates.

This is exactly how events played out. Inflation came in slightly higher than previous months, and despite this the repo rate was announced at yesterday’s MPC press conference to remain unchanged. The trade deficit for Q4 is still unknown, but is expected to be at least as high as Q3 due to seasonal consumption, low mining output, etc. With little change in the appetite for rand this may have caused the strong depreciation to 9 rands to the dollar. In her MPC statement, SARB governor Gill Marcus stated that:

The exchange rate has been impacted by the widening deficit on the current account of the balance of payments during 2012 and changing global and domestic risk perceptions, particularly relating to the adverse developments in the South African labour market, and the downgrades by the various ratings agencies.

These are all good points, but the labour unrest and rating downgrades should have been priced into the rand exchange rate for a while already. In addition, with the VIX being at record lows, global risk perceptions do not seem to explain this recent depreciation any better. Ms Markus also points out in her statement that non-residents already own a third of South African government debt and may simply be hesitant to purchase more of it. Non-resident net purchases of SA government bonds are still positive but much lower than their record high in June 2012. It may be that the government’s consistent budget deficit combined with the SA consumer’s continued appetite for imported goods is the true cause of this weakness. However, while I in december expected a further depreciation of the rand, I am now inclined to think the risk is to the upside (for a stronger rand). Despite low net purchases of SA bonds by non-residents, they did rapidly increase their purchases of South African equities. This may be caused by the reduced global risk premia as can be seen in the low VIX. With continued easy monetary policy in the US, Europe and now Japan, the rand should be well placed to start attracting more foreigners to SA debt and equity.