Analisis Sobre EZ Tras La Cumbre 28-29

THE BIG PICTURE
June 29, 2012
Between a Rock and a Hard Place: Trying to Scale the G20 and EZ Summits
By Arnab Das G20 Summiteers planted a red flag too far, aiming for a roadmap for eurozone (EZ) integration from the June 28-29 European Council Summit. But this Summit overlooks more valleys than peaks, as Brussels sprouts ideas that Berlin bashes into donuts. A roadmap is unlikely now, with hope for the December Summit or later, but direct ESM/EFSF bank recapitalization and bond market intervention seems likelya step forward. Shorts were being covered in case the EZ pulled itself together. But even if and when the EZ pulls an integration roadmap in addition to banking supervisory union out of its hat, the relief rally would not last: o Fissile tension is rising in Europe: Fear and loathing of the EZ PIIGS will persist, as political discourse about EZ exits has begun to percolate in Italy and the core. EZ/EU tensions are proliferating as urgent reforms threaten to widen the gap between EZ ins and opt-outs (e.g., France/Germany vs. the UK). A roadmap can no more keep EZ member states on track or ensure they reach the final destination of an optimal currency union than fiscal rules and sanctions kept them on the straight and narrow.
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In contrast to current conventional wisdom (all will be well if the EZ pulls itself together for banking/fiscal union), precedents suggest pressures will persist for a long time, and that getting the balance right is critical: o The whole wide world would worry about such risks even if there is a great leap toward deeper integration, because EZ fractiousness across and within countries suggests the long march ahead will be a rocky road. Precedents from single-state monetary unions are worrying; the EZ-17 within a customs union of 27 points to a compounding of coordination challenges... Creditor and debtor EZ members will remain at odds based on their here-and-now incentives and the bigger historical picture: Moral hazard and break-up risk en route to deeper integration would discourage creditor countries, just as cheaper credit and free-riding would encourage net debtors. The EZ would not be able to fulfill its role and responsibility as the worlds second monetary union, for immediate self-stabilization with a commensurate contribution to global stability and recovery. We therefore continue to suggest a healthy distance from the EZ, with at best light exposures for those wishing to ride political waves; selling into strength for others. The best hope for global stability and recovery is that the EZ entire goes into quarantine, while it sorts itself out one way or another
o o
Annex: We stroll down memory lane, surveying select, durable modern fiscal/monetary/political unions: o Experience confirms that fiscal/banking/political union helps confer survivability upon monetary unions; but does not necessarily optimize a currency area; and unification is rarely fast, orderly, or smooth. Just heading for EZ optimality may entail years or even decades of uncertainty, with high risks of fiscal, financial and political instability, and of failure. Even so, disintegration can and has followed political/fiscal union, with terrifying consequences. Integration imposed from the top down and held together by fear of the alternative lacks legitimacy.
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After the Los Cabos G20 Summit early in June, market participants and the Rest of the World (RoW) briefly dared hope that the EZ would lay out a roadmap to fiscal integration as early as the current EU Summit. President Page | 2 Obama, among others, beseeched Germany and its EZ partners to unite, in effect pre-committing the EZ to a roadmap to fiscal and banking union. But Germany is at best ambivalent, reckoning political integration and joint tax and spend decisions must come before Eurobonds/bills; checks and balances before moral hazard; and risk management above credit, inflation and break-up risks. EZ elites are distancing themselves from rapid integration as Brussels keeps doing its thing, sprouting utopian fantasiesfiscal/liability/transfer/banking/regulatorysupervisory union plansthat may degenerate into dystopian nightmares if not politically finessed. So, we evaluate the prospects of a roadmap to deeper integration, based on EZ politics and experience elsewhere, just in case the EZ takes such a great leap forwardor signals a plan for a roadmap to get there. The height of the nth EZ Summit is a good moment to consider the lessons of other monetary unions for the longer term, lest EZ signals raise hopes once again, only to dash them on the hard rock of reality. Signals of a fiscal/financial/liability unioneven if couched as a banking unionand above all a political union would precipitate a more profound short squeeze, perhaps even a real relief rally. But a roadmap is unlikely to work even if laid out; simply signaling fiscal union won't suffice any longer, and why it is not likely to happen in any case. All of which points to resumed financial turbulence and the threat of severe economic dislocation. I. Why Wouldnt the EZ Coalesce Around a Roadmap in the First Place? After all, EMU is threatened with all manner of existential threats, depending on the EZ vantage point: Speculative attack by hordes of foreign locust hedge funds; miscreant rating agencies; and a veritable Anglo-Saxon conspiracy. And EZers to this day point out that the fiscal imbalances of public debt and deficits are in aggregate smaller than U.S., UK, Japanese deficits. So, pulling together to mutualize debt and share the cost of financial stabilization would make a lot of senseespecially for debtor nations. But the EZ is often at odds with itself about how to proceed: For creditor countries, pre-committing and pre-announcing a roadmap to fiscal union, is a recipe for private-credit/public-debt moral hazard. Consider the hazardous detours of optimal currency union historical experience suggests that putting political union first, and with strong institutions and checks and balances, is the key to success, but is no guarantee: Avoiding moral hazard requires strong fiscal rules as well as sequestration of systemic credit/default-risk exposures in the banking systemreducing some benefits of EZ convergence, as regional/sub-federal public debts are treated as having permanent but varied and variable, procyclical rather than counter-cyclical, credit risk. This stands in stark contrast to pure sovereign debt of a central government that is contiguous with its central bank, where interest rates carry inflation or deflation risk premiums. This is a lesson of U.S. experience, about which more below. Managing moral hazard requires deeper control than current EZ practicesuch as enforcement of the fiscal compact and creditor-debtor burden sharing, rather than burden sharing across EZ tax payers. This appears to be the current German/creditor-country position, and reflects the relative success of the U.S. experience compared with that of many other monetary/fiscal/political unions. Mismanaging moral hazard in the future might reprise past bad experienceswhether the current EZ fiasco; or cascading defaults, aggressive deleveraging and deflation; or if fully financed and monetized, could result in deteriorating credit quality or even (hyper-)inflation; or if fully financed in the absence of debt intolerance but with inflation intolerance, could require financial repression to manage the public debt. These are the lessons of early U.S. experience and various emerging market (EM) experiencesincluding disorderly disintegration, about which more below.
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II. Let's Go Down the Metaphor: Why Might a Roadmap Not Offer a Clear Direction and a Sustained Rally?
A roadmap is a guide to the long march ahead, not a diktat or a set of rules, let alone a constitution or a treaty Page | 3 that would constrain sovereignty en route and thereby achieve a great leap forward. A roadmap would delineate a logical path from A to B, but could not require the drivers of EZ vehicles to stay on track let alone arrive on time. Speed limits, obstacles, navigation, fuel all affect whether, when, how soon the travelers arrive, or lose their way. Imagine a large, extended family en route to their joint goal in, say, 17 vehicles. Each has its own, strong-willed driver who wants to stay at the helm, with passengers in their seats, belts fastened. One vehicle has to be in the front of the procession, another bringing up the rear, with the rest occasionally jockeying for pole position from back to front. Yet, there are different views within each vehicle as to what route to take between A and B, since each family decides what to do by internal consensus. But this caravan has to coordinate across all the drivers and their passengers, if all the vehicles are to stick to the same route to the same destination. Some drivers and their families may just fall by the wayside and be left behind, as their vehicles break down, breaking up the caravan. Of course, this family affair is even more complicated than that; some EU and EZ families have quarreled and feuded for generations. Today, another 10 agree to disagree with the 17taking different routes to different destinations at their own speeds. What unites them? Large sections of road are parallel, the road generally goes in the same directionthough often it seems to go on forever with no chance of transfer from one to the next. But theyre part of this extended family, albeit at one or more removes. Their path and relationships are affected by their own decisions and those of the extended family proper. They may rebel or chafe at the idea of having to follow the same path, or pay some of the tolls, even though they take the high road or the low roadnever the same road. During nearly three years of existential crisis, EZ-ers, EZ bulls and apologists have all asserted that the EZ itself is the apex of the EU project; that it is a political project; that EZers would do anything to save the euro. Well, at this point, if they are ready for historic decisions to integrate along all these axes, it's worth a brief stroll down memory lane to elicit what the immediate future might hold for the EZ and the RoW. We do so with the thematic angles of vanishing, talking and weak points of monetary unions past and present. As such, we elaborate on past examples broached in the previous edition of The Big PictureEZ (Dis-)Union: Half-Way House or Half-Baked Idea. Before we go back in time, a bit of navel gazing and crystal balling: It is increasingly difficult to see how either creditors or debtors can back down, given the fractious politics on either side. The political quid-pro-quo of strong conditionality as the basis for lending scarce domestic resources is already breaking down, now that the Spanish banking crisis is being addressed without conditionality, despite lending to a sovereign. Plus, the markets are clearly signaling that many EZ sovereigns are now or soon will be insolvent individuallygiven the euro and excessively high real interest rates and steep yield curvesor are at risk of exit. The need for clear signals toward a joint and several unification of banks, deposit insurance, public debts and, hence, fiscal accounts and politics might be met. But the hard truth is that there is no straight, fast road to implementing even the best intentions. There will be sustained political uncertainty. Intra-EZ, EZ-EU and EZ-RoW disputes and distrust may proliferate. III. Is it All Smoke and Mirrors, or Do Smoke Signals Imply Theres Fire, in the Belly? Signaling fiscal/political integration will not restore financial stability and economic growth by itself, although it would arrest collapse. Implementation will be critical, the route treacherous, failure all the way, a material risk. Consider the uneasy history of some of today's durable monetary unions, the problems and solutions of subfederal fiscal incontinence in durable monetary unions (elucidated in the Annex, below). Each is a cautionary tale: Most monetary/fiscal/political unions have survived; but few have contributed to global financial and economic stabilityindeed, many have only undermined their own stability and growth, while failing to have much impact on flows of goods, services or investment in modern times.
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The EZ is front and center in the ongoing global financial crisis, as the worlds second-largest monetary union; in practice, the second-largest economy; and, in principle, the reservoir of the worlds largest stock of net wealth (at Page | 4 least for now). Thus, the EZ must become not just viable, but successful and as close to optimal as possible, as fast as possible, if it is to contribute to global stability and recovery rather than detract from growth and render recovery even more fragile, as it has for nearly three years; and achieve greater internal and external legitimacy. None of this is meant to excuse the RoW, or minimize the serious problems of other key monetary unions like the United States, China, India, Brazil, Japan or the United Kingdom. That these sovereign states, united under a single currency, government, and overarching fiscal, structural and regulatory policies, are all in dire straits each in their own way, only demonstrates that full-blown union is not a panaceajust the price of admission for stability. What the EZ needs and the world needs from the EZ is a clear roadmap that is achievable, as well as carrots and sticks for each of the memberscreditor and debtor aliketo stay the course, stick to the straight and narrow in the thick and thin that lies ahead. There needs to be performance conditionality, but at the same time the threat of disorderly or cascading defaults or precipitate exits by systemic members needs to be eliminated, at the word go. Without that, the palliatives of ECB lending or EFSF-ESM funding and restructuring wont work except briefly. Alternatively, the EZ could organize an amicable divorce complete with (p)alimony. If not, the threat of early exits from the microstates or key states of the core or periphery, already starting to percolate, will only proliferate. In sum, even if the EZ endgame is given and a roadmap laid out, that is no surety of successas the weight of historical experience in all those other single-state monetary unions shows. Add in the fact that the closest modern EZ precedents for multi-state/multi-nation monetary unions are the gold standard and the Soviet Unionand the outlook in the best case is not much better than the current maelstrom of instability. Neither orderly dismantling nor integration in a formalized, crisis-free manner seems to be around the corner. The difficulty of coordinating among disparate polities suggests that deeper integration would take ages with plenty of mini, and potentially maxi or macro, crises along the way. All of this argues for continuing to reduce EZ exposure as rapidly as possible. IV. In Conclusion: Is History at Risk of Repeating Itself? There is a material risk that the EZ is repeating well-trodden but treacherous ground that has contributed to global and regional financial instability, banking panics and deflationary depressions. The EZ is neither a monolith nor is it one, but 17 sovereignties, with four critical sovereigns of a similar order of magnitude in economic size and systemic financial risk, plus a non-federal, weak capital in Brussels, led by a bureaucracy that lacks democratic legitimacy. All major monetary unions have been dominated by a single center of power, rather than face-offs among comparably sized/systemic economiesin all of the cases above, there are no large monetary unions in modern times with multiple competing centers of sovereignty. Yet, even dominant federal governments have often had difficulty imposing regional fiscal control, as sub-federal units externalize and socialize local deficits across the federation. Recent EZ experience points to the difficulty of applying these lessons here and now. The Kingdom of Spain in practice amounts to a loose fiscal federation in which the Government of Spain has not been able to contain either patronage and financing at the level of autonomous regions and their local piggy banksthe Cajas. The Federal Republic of Germany has been unable to control the munificence of the Lnder or their use of their own piggy banks, the Landesbanken, for funding pet projects or favored firms. Nor has the EZ/EU bureaucracy been able to fully enforce the rules of fiscal and financial probity down to the national or regional levels.
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V. Annex: A Stroll Down Memory LaneSurveying the Experience of Other Monetary Unions
We worry about the proposition that a roadmap can do much more than take the short-term pressure off the EZ Page | 5 and the global recovery. It is true that staving off disaster is a valuable accomplishment. But just as EZ bailout programs or EZ liquidity via the ECB balance sheet have become shiny new objects for market mavens to refocus on repeatedly in the now nearly three years of crisis, offering a roadmap may simply take the pressure off without solving anything. If this time is to be different, whether in this mid-year EU Summit or in the end-year event, which is now being touted as the summit to top all other summits, we will need to see clear signals that the design of the end-state and the path to it will avoid the pitfalls of both theory and experience. Given the strong political pressures to cater to different national interest groups, we harbor grave reservations and continue to sail in search of safe harbors rather than drive off into uncharted territory The presence of a single banking system with a single central bank does not confer any guarantee of success or optimality, if various other conditions of a practicable fiscal federalism are not in place. One has only to look to various EM experiences with financial instability and fiscal federalism to see that simply ensuring political, fiscal and/or financial union is not enough to ensure stability and prosperity. We run briefly through examples of monetary/fiscal union with poor federal or central control of regional or even central budget deficits and public debts, in which these are not sequestered from the banking system. These experiences comprise sovereign default and/or inflationary financing as the fiscal problem is passed up the chain to the federal government and central bank; financial repression to keep the debt fully financed while avoiding a classic debt trap; and serial bailouts as a way to maintain the growth and financing model. A. The Political Union ProblemHow to Balance Comparable Sovereignties and Federalism? U.S. history provides proof positive and negative that a strong federal center is necessary to legislate, regulate, reform, finance and subordinate regions to federal coordination. Today, the United States benefits from a strong federal government, with a constitutionalif not always cleardivision of labor between the responsibilities, sovereignty and rights of the states and the Feds. But it was not always so. The Articles of Confederation, under which those United States were initially governed, arranged a modus vivendi of comparable sovereignties of the original 13 colonies. The several United States failed well even though they were joined at the hip from birth, because the federal government was weak and underfunded, while the states retained too much sovereignty for the whole to function cohesively. The states enjoyed the power to tax, but were under no compulsion to transfer resources to the federal government, which lacked executive authority, and even a titular head of state. The fiscal basket case that those United States became after the revolutionary war of independence was the critical among many dimensions in which the sum of the parts was less than the whole. The potential of hanging together was undermined by the desire of each state to have its own way and its own sway. Public and private finances were in dire shape, according to most accounts; the only available creditors were foreign, particularly other sovereigns with political rather than commercial objectives, which charged usurious interest rates. Congress printed currency that soon became unacceptable because it lacked fiscal authority and depended on the states. Does this history sound familiar? Lets hope it stops there... Shays Rebellion (aka, the First Civil War), after tax increases required to finance Massachusetts deficits and debt, precipitated a crisis that ultimately spawned a new constitutional convention, a new Continental Congress, a new Constitution and new rules of the republic. Back in the day of federal-state comparability, the country was not one but several even in name as in practice, referred to as these United States. A singular term, the United States, arose only after the Civil Wareven after fiscal,
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monetary and political union, the fissile tendencies continued and came to a head after the economies of the north and south diverged, fomenting monetary and political disunion, as the South issued the Confederate dollar. B. The Liability Union Problem: Moral Hazard! Moral hazard and the associated financial instability has been rife in a variety of long-standing monetary unions. The United States of today began life as a constitutionally mandated political union in 1789, legislated as a fiscal union complete with a liability union under the Public Credit Act and Assumption Act. These had the immediate, upfront benefit of transforming very rapidly what had been a fiscal basket case after the revolutionary war of independence, into a relatively strong credit. This was largely achieved because an arch-federalist, Alexander Hamilton, soon to be the first Secretary of the Treasury, won the debate against the anti-federalists, led by Thomas Jefferson and Aaron Burr (who later shot Hamilton in a duel). Federalism carried the day because the prior system of a weak center and strong states was not viable. Even so, quid pro quos were required to get the deal done, including shifting the proposed federal capital from New York, the purview of Hamiltons finance-sector cronies, to a new capital, Washington. George Washington wanted a standing army because a British presence continued. Under Hamiltons Assumption Act, a new Federal Treasury assumed states debts, partly in exchange for their surrender of fiscal and other sovereignty, financed with dedicated revenue from federal import tariffs, providing protection into the bargain. But the aversion to a strong centralized, monarchical government was so strong that it might have gone the other way. Even creating a strong federal center, complete with a liability union, failed to establish and sustain a stable monetary, fiscal, financial and political union for the first century of the republic. This was substantially because the flip side of federal assumption of the states debt was moral hazard. The states, reincarnated with zero debt and no constraints on their borrowing, expected not to bear the full cost of their fiscal excesses, if need be, by free riding on the fiscal probity of more creditworthy states and the union. Sound familiar? The problem was not pre-empted but solved the hard way; the banking panics of the 1800s, the ensuing depressions and balanced-budget amendments in state constitutions owed substantially to the moral hazard of Hamiltons munificence. Bitter experience of failure was required to overcome the actual bailout precedent created by the Assumption Act, and eradicate ambiguity about the supremacy of federal law and federal debt, over the capacity of any individual state to socialize its local problems across the republic. It became a condition of membership in the U.S. monetary/fiscal/political union to have a state-level constitutional balanced-budget rule. The sole exception was (The Socialist Republic of) Vermont, which even today runs among the largest state-level deficits. Yet, severe constraints on independent state-level fiscal policy that can be socialized across the United States are taken very seriously. Even the Republic of Texas, whose state flag flies in line with the Union flag, uniquely in recognition of its historical status as an independent sovereign prior to its accession to the Union, had to cede fiscal control; symbols of sovereignty are one thing, true fiscal sovereignty is another. To solve this problem of fiscal incontinence, moral hazard and excessive debt once and for all, state debts had to be restructured; and rules instituted to prevent their recurrence. Much local government debt was eventually subjected to court-adjudicated workouts under Chapter 9 of the federal Bankruptcy Code. States, their sovereignty th enshrined in the 10 Amendment, were not so lucky; some states have spent decades in sovereign default. Against this backdrop, of course, sub-federal U.S. public debt is subject to far-tighter hard-budget constraints as well as lacking direct access to the central bank or reserve money; so U.S. muni and state debt hardly figure in the banking system. Furthermore, federal tax exemptions available only to residents investing in state and muni debt, localizes state and muni debt within its neighborhood, further insulating the republic from regional mismanagement.
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Indeed, the general quid-pro-quo is that countercyclical federal support during downturns is the benefit in kind for general fiscal probity that does not foist economic benefits and political gains on one state as cost on others. The Page | 7 structure of bicameral representation in Congress, where most tax and spend authority resides, speaks to this pointa mix of proportional and equal representation across the states. Of course, this does not mean the system is perfectfar from it, since Congress itself can be manipulated into doling out local pork barrel projectsbut such decisions are taken in the federal government rather than in local government. Lest anyone think this ancient history or abstract Americanization of fiscal federalism is irrelevant in the current context, let us not forget that U.S. state and municipal deficits, although extreme enough to lead to real concerns about their solvency, has not threatened the banking system in the current crisis or many others since the 1900s. Furthermore, radical fiscal adjustment in some states and reductions in their social security spending have not yet thrown the current recovery off course. And it is precisely the lack of regional fiscal discipline and its concatenation with the banking system that produces fiscal and financial instability or explains extended financial repression in other monetary unions, to which we now turn. C. The Transfer Union Problem: Sustainability?
It is notoriously difficult to sustain a full transfer union within countries, let alone across borders, for both political and economic reasons. Naturally, this problem is the opposite one of controlling the fiscal excesses of the sub-federal constituents of a federation: By the time that the hard-budget constraints at the central or federal level have become binding, transfers and subsidies have vitiated the balance sheets of the federation and/or even its richest, most creditworthy constituents. The cross-border transfer union problem is perhaps the most serious one, since it can and has contributed to disorderly break-up. The Soviet Union is the front-burner example. The Russian Republic was not only the mainstay of the USSR as the largest and most powerful of the Soviet Republics. It was also the richest, and it was a permanent payer into the Soviet federal budget, thereby subsidizing most of the other Republics, so much so that Soviet-era complaints of Russians about the better living conditions in other Soviet Republics are apocryphal. Naturally, when economic and financial conditions deteriorated with the collapse of oil prices after the two oil shocks and the Volcker monetary shock, the ability and willingness of the Soviet Union and the Russian Republic to fund its fiscal largesse to the regions also collapsed. The public and external debt of the Soviet Union rose unsustainably high. Although the rating agencies maintained exceptionally high sovereign ratings for much of the time, the rising external and internal imbalances rapidly became unmanageable. Refinancing eventually dried up, exacerbated by accelerating political instability, as leaders of four key constituent republics demanded autonomyRussia, Ukraine, Belarus, and Kazakhstanfrom the Soviet Union. Disorderly dissolution was the result, accompanied by disorderly default and a hyperinflationary collapse of the rouble into rubble as budget deficits had to be monetized. In this Soviet case, not only did the monetary union fragment in stages with massive dislocations and eventually hyperinflation as prices were freed and massive public deficits and debt were monetized; but the fiscal union had to be dismembered, along with the banking union, fiscal union and, of course, the political union. One of the most complex elements, dismantling the liability union, was made much easier than it might have been because of the predominance of the Russian Republic in the political and economic affairs of both the USSR and CIS. Russia was politically willing, although it proved financially and economically incapable, of being the successor state, so took over the external assets and liabilities of the Soviet Union and also shouldered Tsarist-era debt, which the USSR had previously repudiated as odious debt. But in the first post-Soviet decade, extreme political, economic and social instability made it impossible to carry this debt burden; the lack of fiscal discipline and serious structural issues resulted in excessive and rapid debt buildups in some of the post-Soviet republics including Russia
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and Ukraine, and repeated restructurings. Monetary union was more cumbersome; initially a rouble zone was maintained among some post-Soviet republics, but trust broke down as the use of monetary financing became a Page | 8 means of transferring the cost of one sovereigns fiscal incontinence to the rest. There are of course other transfer unions that survive, in some cases despite themselves or because federal political processes legitimizes these transfers. Italys Mezzogiorno is of course well known for receiving substantial fiscal transfers from the richer states of the north. While this holds together, or at least it has since the unification of Italy, there are issues. The Northern League used to want to secede from the rest of Italy; now (along with former Prime Minister Silvio Berlusconi) it has begun taking aim at the euro, putting Italian EZ secessionism on the table. Some U.S. states are almost always payers into the federal budget; others are recipients. This system seems to work because of the shared national interest and the ability of the federal budget to cushion national recessions using the national power to tax and issue debt. D. The Gold StandardAn EZ Precedent for Non-Fiscal/Non-Political/Non-Banking (Dis-)Union The best counter-example to the unprecedented political, economic and financial impact of the EZ is the gold standard, both the classical gold standard and the Bretton Woods gold-dollar exchange standard. And here, too, the history is not especially encouraging. While the euro is a fiat currency with a fully formed and free central bank, todays EZ shares key features of the gold standard. There was no political/banking/fiscal union and the lender-oflast-resort function of central banks was constrained (by the requirement for gold backing for money creation sometimes, creditor countries would make gold loans to distressed debtors in the hope of recouping national claims and stabilizing the system). Eventually, when the difficulty of reconciling excessive public or external debt with the need for internal devaluation proved too much to take, countries would exit the gold standard and devalue to restore competitiveness and growth, despite the financial instability. E. The Banking/Financial/Regulatory Union Problem: Financeability and Financial Repression
There are a wide range of alternative models and examples around the EM world of financial instability and economic underperformance in durable political/fiscal/monetary unions. The main object lesson for the EZ is that such models are not directly applicable to the current framework of rulesopen capital accounts and inflation targeting with market-determined interest rates. If the EZ ends up opting willy-nilly for one of these sorts of suboptimal currency union arrangements or some combination, a more profound quarantine will follow 1. Financial RepressionThe Indianization of Regional and Federal Fiscal Incontinence
India's solution to the above problems of local or federal fiscal incontinence is financial repression. Banks were summarily nationalized in 1966 and subjected to stuffing with government debtsfederal and state. A ring-fence of capital controls, reserve requirements and other forms of financial repression, which today might find euphemistic apologia as macro-prudential regulation, enabled the Indian sovereign to carry inordinately large federal- and state-level debt and deficits for decades. Even the significant reduction of deficits in recent years owes largely to the national and global growth boom and therefore represents a passive rather than active fiscal adjustment. The system of subsidies and regional transfers carried out through the federal budget, not unlike the complex systems of U.S. or Brazilian fiscal federalism, does permit a sustained transfer union from richer to poorer states. But the bigger picture is the appropriation of private savings by both federal and state governments at fiat interest rates, which are often negative in real terms. The picture of financial repression as a tool for managing fiscal excess is rounded out by the complete absence of hard-currency sovereign bonds and still-tight quotas on foreign investment in domestic fixed-income securities. This is all part of the firewall that permits the fiscal and monetary authorities to manage the budget, the debt and monetary policy with a generally floating rupee and an
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increasingly liberal external trade regime, but without too much interference in the capital account from shifts in foreign portfolio flows. The latter are limited to the equity market, where asset price volatility would not directly Page | 9 affect the ability of the state to finance its deficits and subsidy regime. 2. Serial Bailout/DefaultThe Sino-fication of Regional of Federal Fiscal or Financial Incontinence
The Peoples Republic of China is widely regarded as a paragon of fiscal virtue within the EM world by rating agencies and many analysts, given central government debt of around one-fifth of GDP or less. But the truth is more complex. Regional and local governments run substantial deficits financed by off-balance-sheet borrowing through investment corporations and indirectly through state banks, along with the central government. Ultimately, as in most other developed markets and EMs with state-owned or controlled banks, these are vehicles for related-party lending, favoritism, patronage and clientilismthat is, they are vehicles for extending and carrying bad loans. Eventually, the losses must be recognized, the banks recapitalized and the investment and other vehicles wound down, sometimes complete with default, particularly where foreign creditors are concerned. But the serial bailouts continue, without changing behavior, leading to an iterative credit boom/bust/bailout process, often centered around periodic changes in administration and the political succession process. This system, it could be said, works, in that it delivers the high growth required to keep a lid on social instability and maintain the legitimacy of the Communist Partys monopoly on power. But it does impose a substantial deadweight loss on society, in particular the people in the Peoples Republic, who enjoy a far lower share of household income in GDP than most other countries. Fortunately, this is more than self-financed given high household and corporate savings in China, so this incontinence does not yet pose a systemic financial threat to global stability. That said, there are likely to be global spillovers when this unsustainable model eventually hits a brick wall and slowing Chinese growth imposes output or growth losses on trading partners 3. Inflation or DefaultLatin-Americanizing Regional/Federal Fiscal/Financial Incontinence
Argentina, which has been in sustained decline for 100 years, is plagued by weaknesses in fiscal federalism that undermine the financial stability and creditworthiness of the entire federal construct and its single money. Under the revenue- and expenditure-sharing arrangements known as co-participation, Argentine states were able to count on revenue transfers from the federal government, but not raise their full share of state and local tax revenue. Often, on top of this indirect form of subsidy, the states were also able to either borrow or direct credit in state-owned or state-near banks for favored projects, patronage and other questionable credit practices. The result was ultimately that sub-federal fiscal incontinence was passed up the chain to the federal government and even the central bank. Local deficits were compounded by federal deficits, partly by gaming the system of coparticipation and repeatedly blocking its reform; and partly because of federal incontinence. The result was monetary financing, hyperinflation and eventual sovereign defaultrepeatedly. Brazil suffered elements of a similar problem, due to the inability of successive federal governments to induce local and state government, again, to raise their fair share of tax revenue, while continuing to undertake excessive spending commitments, usually financed by recourse to state-owned banks. As in Argentina and elsewhere, the can was kicked upstairs to the federal government and central bank for monetary and external financing, leading to default and inflation.
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THE BIG PICTURE

June 29, 2012

THE BIG PICTURE

THE BIG PICTURE

THE BIG PICTURE

THE BIG PICTURE

THE BIG PICTURE

THE BIG PICTURE

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