Of Raising Rates and the Stakes

So WHO exactly is raising interest rates at the moment? Or even thinking of doing so? The knee jerk response to this particular question would seem to be; not too many people. On the contrary, most major central banks and now also their peers in the emerging world seem to have come to the conclusion that to counter the crisis, they need to apply both conventional as well as unconventional monetary policy measures. Especially, among the major central banks quantitative easing is the name of the game with only the ECB still clinging on to the proverbial fig leaf. So, I ask you just one more time, in this sort of situation just who exactly is raising rates?

Well, it is far from being a done deal yet, and at this week’s rate setting meeting the bank baulked at the idea, if you want to know what it means to be stuck between a rock and a hard place at the moment, you could do worse than take a look at Hungary which, even among its CEE peers, gives every impression of being rather battered and bruised. And just to make matters worse, Hungary received another blow to the kidneys last weekend as Prime Minister Ferenc Gyurcsany announced that he was resigning his position. On the face of it, it is difficult to blame the guy since with Hungary being the first economy in Eastern Europe to secure a loan from the IMF to the tune of 20 million euros the corresponding budgetary cuts demanded look almost cartoonishly unrealistic relative to the economic situation.

Even as he presided over a reduction of the budget deficit from 9.2 percent of GDP in 2006 to about 3.3 percent last year, Gyurcsany was criticized in February by some opposition parties and the central bank for his proposed 900 billion forint ($4.1 billion) tax shuffle to boost growth. Critics said more spending cuts were needed to stabilize the economy in the short run and boost growth in the long run.

“The government no longer had any room to maneuver,” Gyorgy Barcza, chief economist at KBC NV’s Hungarian unit, said yesterday. “Without new measures, the budget deficit would be more than the target.”Failure to continue austerity measures could result in a downgrade of the country’s credit rating, David Heslam, Director of Fitch Ratings’ sovereign team, said in a statement today. The agency rates Hungary’s debt BBB, the second-lowest investment grade, with a negative outlook.

The Socialist Party is less than half as popular as its biggest rival. Backing for the government started slipping when it introduced austerity measures to close a budget gap in 2006. The resulting economic decline was worsened by the global crisis, forcing the country to seek international aid. The party had 23 percent support last month, the lowest in 10 years, compared with 62 percent for the largest opposition party, Fidesz, pollster Median said on its Web site on March 18. Gyurcsany’s popularity fell to 18 percent, making him the most unpopular premier since communism. The poll of 1,200 people has a margin of error of 2 to 6 percentage points.

As Edward put it recently, it is difficult not to note a irrevocable pattern in the (unfortunate) countries subject to IMF intervention whereby they collapse under the yoke of the measures demanded in trade for the loan. Of course, we should not only shoot at the IMF since in the context of e.g. the EU one wonders the extent to which western Europe can just idly watch a country such as Hungary spiral into the abyss without extending some kind of bilateral help. Note in passing here that Gyurcsany’s resignation marks the second case of government jitters in an IMF supported economy. The second would be Latvia where the government resigned recently.

As it could have been expected the market was none to happy about the PM’s resignation which brings us to question of raising those rates. Consider consequently that the Forint which have already been pounded relative to the Euro completed a 2.6 percent drop to 308.62 against the euro (click on image for better viewing).

Consequently and following the Prime Minister’s resignation the central bank was forced to move with comments that all tools would be deployed to avoid the Forint depreciation to spiral out of control. Now, I would not want to contradict myself here and let me very clear then; I think that a weak Forint is a fundamental part of whatever future Hungary may have but in the near term and with the rating agencies thoroughly marking the outlook for Hungary with the negative label it is a tightrope walk for policy makers not least because we still have the unresolved issue of translation risk whereby liabilities are denominated in foreign currency (mostly swiss francs though) and assets in Forints. Conclusively, it is difficult to see why, given the economic reality, the central bank would want to raise rates, but it is also difficult not to concur that they need to do something with respect to ensuring some kind of order vis-à-vis Hungary’s stakeholders not to mention investors. Perhaps this duality more than anything shows us the almost impossible situation Hungary now finds itself in.

Raising the Stakes?

Meanwhile and moving across the pond for a minute it appears that US authorities have just raised the stakes in the dramatic jeux d’horrible that is the unfolding economic crisis. Thus and following the Fed’s shock and awe treatment of the markets last week as Bernanke rolled out measures to buy treasuries (presumably) in the primary market we got the long awaited details in Timothy Geithner’s plan on how to deal with those toxic assets and consequently how to restore confidence in markets so that we just might go back to normal whatever that is these days.

Quite naturally, the plan (see also here and here) which includes most notably a public-private partnership scheme designed to take care of about 1 trillion USD worth of toxic asset has been parsed by many of the most astute economic pundits. From the horses own mouth this is how it is described;

The Public-Private Investment Program will purchase real-estate related loans from banks and securities from the broader markets. Banks will have the ability to sell pools of loans to dedicated funds, and investors will compete to have the ability to participate in those funds and take advantage of the financing provided by the government.

The funds established under this program will have three essential design features. First, they will use government resources in the form of capital from the Treasury, and financing from the FDIC and Federal Reserve, to mobilize capital from private investors. Second, the Public-Private Investment Program will ensure that private-sector participants share the risks alongside the taxpayer, and that the taxpayer shares in the profits from these investments. These funds will be open to investors of all types, such as pension funds, so that a broad range of Americans can participate.

Third, private-sector purchasers will establish the value of the loans and securities purchased under the program, which will protect the government from overpaying for these assets.

The new Public-Private Investment Program will initially provide financing for $500 billion with the potential to expand up to $1 trillion over time, which is a substantial share of real-estate related assets originated before the recession that are now clogging our financial system. Over time, by providing a market for these assets that does not now exist, this program will help improve asset values, increase lending capacity by banks, and reduce uncertainty about the scale of losses on bank balance sheets. The ability to sell assets to this fund will make it easier for banks to raise private capital, which will accelerate their ability to replace the capital investments provided by the Treasury.

This program to address legacy loans and securities is part of an overall strategy to resolve the crisis as quickly and effectively as possible at least cost to the taxpayer. The Public-Private Investment Program is better for the taxpayer than having the government alone directly purchase the assets from banks that are still operating and assume a larger share of the losses. Our approach shares risk with the private sector, efficiently leverages taxpayer dollars, and deploys private-sector competition to determine market prices for currently illiquid assets. Simply hoping for banks to work these assets off over time risks prolonging the crisis in a repeat of the Japanese experience.

Macro Man offers nothing but a sigh, Paul Krugman is in despair, Calculated Risk also seems skeptical that this is the right approach and finally Yves Smith also chimes in with a “thumbs down”. I tend to agree with the skeptics and even though I have not really studied the proposal in detail the principal problem for me is that the government is putting up money for assets of which some are surely worthless and others may be work significantly less than current book value. In this way, it does nothing to solve the underlying issue and the risk for the taxpayer seems substantial.

Ah well, perhaps I and the rest of the gang above are just party poopers. What is certain is that the markets liked it and in fact Macro Man may have hit the proverbial nail on the head when he recently, and once again, evoked March Madness (click on image for better viewing).

Of course, if there ever was something resembling a sucker rally it is this but so far things look as they are working. Also we cannot rule out that this initiative may just be what it takes to allow these assets to be marked to (a credible) market which would mean that we had taken one important step in moving forward. One thing which I do like by the activism in the US is that it is just that; activist which flies in the face of ostrich attitude prevailing on this side of the pond.

Rates and Stakes

So, what do Hungary and the US have in common here? Except being in the midst of their worst economic crisis of, arguably, all time not a whole lot I guess. However, they are both being forced to move into uncharted waters when it comes to fighting off the current mess in the global economy and her financial system. It will be very interesting to see whether raising rates as well as the stakes will bring forth the intended effects.

12 thoughts on “Of Raising Rates and the Stakes

  1. Pingback: Golden fetters II - Paul Krugman Blog - NYTimes.com

  2. “Note in passing here that Gyurcsany’s resignation marks the second case of government jitters in an IMF supported economy. The second would be Latvia where the government resigned recently.”

    Don’t forget Iceland. The government resigned not long after the IMF package was negotiated.

  3. Hi Gerter,

    Ah yes, how could I forget poor Iceland, and me being a Dane too :).

    Anyways, you are of course right although I am not sure the IMF is to “blame” here but the correlation does represent something of a dark spot on the whole international intervention punt.

    Claus

  4. just to make matters worse *all* major political parties, think tanks, media outlets etc. that have any influence at all in HU advocate massive spending cuts, “tightening our belts” and so on to “fix the economy” in the midst of a deflationary recession… these measures would really plunge HU’s economy into a full-blown depression. someone might want to send a macroeconomics textbook (not by Hayek, if possible) to policy makers in Hungary.

  5. There is no deflation in Hungary. Inflation yes (much more than the official numbers show). Massive spending cuts is exactly what is needed, too few people work (because of all kinds of state support) and pay too high taxes (~50%). You should throw out your macroeconomics textbooks, because those books (and the belief in self-regulating markets) are what caused the whole problem in the first place. There is time for change. The Hungarian National Bank is doing the right thing, but the governments of the last 20 years didn’t. There is time for change.

  6. Taurus: you are joking, I presume. Spending cuts in the midst of a severe recession (by definition) subtract demand from the economy, and will push it into a full-blown depression (as it did in Argentina 2000-2001), causing an enormous SURGE (not fall) in unemployment, and REDUCE the number of people at work.
    The neoclassical myth that the low employment rate is “caused” by “rigidities”, state subsidies etc. is not supported by evidence.
    In reality, high unemployment, low employment and low growth is largely (though not solely) a result of depressed demand and the crackpot neomonetarist-restrictive policies followed by the ECB and – even more so – by the MNB.
    By the way: it is wage suppression (and pushing countries to rely on exports and cut down on internal demand) coupled with financial deregulation and the resulting asset bubbles that are responsible for the severity of the unfolding crisis, but the religious fanatics of the HU establishment of course would never come to admit this. (of course, they don’t read anything, so haven’t heard about any of this, but that’s another story)
    what they want is straightforward: money to be siphoned away from HU’s pensioners, rural poor, and unemployed – who are, as it is widely known, living in such extreme luxury, eh? – to bondholders and CEOs of investment funds.
    this massive upward redistribution of wealth is what they mean by “sacrifices” – sacrifices for pensioners living on 200 euros a month, big fat profits secured for bondholders.

    anyway, I would just add a small note of caution for the Hungarian political-economic establishment: don’t push it too hard, ’cause you might get burned. people are already furious and they might not take it any more.

  7. No, I’m not joking, I think Hungary needs to cut spending. But I do agree with you that what the leaders mean by cutting spending, is in fact just another way to stuff their own pockets, so it will do no good.

    At the moment in Hungary many people who could work are living on disability pension (800 thousand disabled, as opposed to 70 thousand in Slovakia), on child support, on agricultural subventions etc. This should be stopped, so that people would start working and producing. Why is it that Hungary is not a major agricultural producer? Is the land worse than before the first world war, when we fed Europe? Is the weather so much worse? Even with productivity increased at least 10 times (grains harvested for grain planted)?

    I say ease the regulations for small businesses, producers etc. and let the competition work.

  8. The major problem in HU is that people think like Taurus, there are jelous on the poor people getting social benefits. They assume they just simply don’t wanna work. The east of HU is more similar to 18th century as to 21st, there is simply no chance to find a job, in Budapest, West-Hungary there is lack of labour force.

    The main problem is informal economy, the reports suggest that black enconomy is 20-25% of economy, mainly foreign owed companyies and some bigger hungarian ones are only paying taxes.

    The tax system is really unfair that way, only few pay a lot – that makes people flustrated and so it is easy to blame the poor for all the mass. But if you take this little money from poor people consumption will fall sharply, crime rate will grow – i guess it has more costs.

    There are plenty other oppurtunities how to cut on deficit which is not reducing consumption: the first would be to do sthg. with the railway comp. MÁV – it takes yeary 1-2 billion euros and offers poor services. That money is more than waht is spent on social benefits.

    The politics are also rotten, the socialist never wanted to hurt noone, the populist right wing is living in a dream world, does not understand global economy. If politics does not respect economics and reality, it is hard.

    The article is really interesting and good, but I wish the rates would be the biggest problem. You can correct the the monetary policy quiet fast but to form a society’s thinking is much more harder if not impossible.

  9. you don’t seem to get it taurus. a cutback of X percent in gov spending during a recession means – at the minimum! – a further corresponding X pt decline in GDP. In HU’s case this would mean pushing the economy intentionally into total collapse, say a depression of more than 10 pt GDP-decline. this would mean a chain of bankruptcies, insolvencies hitting the banikng system, exploding unemployment, social unrest and so on. it happened to Argentina in 2000-2001 thanks to the crackpot policies of the IMF. is that what you want?

    later on i’ll get back to the other points…

  10. Since 20 years the Hungarian governments are not doing anything else but buying votes by giving all kinds of support to poor people. This is the problem.

    What they should do, is to take these things away and give incentives for people to start their own little companies, provide education for them, loosen regulations so that it would be easy to start companies, make laws that are simple and do not change every 6 months etc. Basically allow the market to develop. In addition to this, they should develop infrastructure (highways, MAV reform etc). This is the solution.

    Of course, while the governments only care about their own pockets and while people can be bought with all kinds of support, nothing will change.

    You say that if you take away the support from the poor, consumption will decrease. I don’t know why do you think that consumption financed by state support financed from treasuries is the way to go. This is the wrong direction and it should be stopped.

  11. “a cutback of X percent in gov spending during a recession means – at the minimum! – a further corresponding X pt decline in GDP.”
    Yes, it’s true, if it’s not done right. But if you stop buying votes by spending money on stupid things and you decrease taxes, effectively leaving that money for the people who use it and produce with it, we would all be better off, the economy might even grow.

    For example: if in my household I am spending more than I can afford, when the creditors are banging on my door, the answer is not how to find more credit. The answer is balancing the budget, creating a “trade surplus” (which in a household can mean going to work, not buying the newest iPod, selling the car that I cannot afford) and slowly paying back my liabilities. But If I do cutbacks by not paying for health insurance, for education, for the heating in my house, then yes, the outcome will not be nice. Consumption should be decreased for unnecessary stuff and infrastructure should be built. Don’t get me wrong: if I stop paying for a cell phone, it can be good or bad: if I am only using it for entertainment and convenience, it is good not to spend the money on it, but if it is essential for my work (part of infrastructure), it would be bad to stop paying for it. Same goes for a car. The question is always: is it a good consumption, will it generate return, or not. Giving disability pensions to at least 600.000 people who are not entitled to it, does not generate any return.

  12. One more comment about this:
    “a cutback of X percent in gov spending during a recession means – at the minimum! – a further corresponding X pt decline in GDP.”

    Excuse me? GDP is generated by government spending? What exactly is the government producing?

    If this was true, there are two possibilities:
    1. the way the GDP is calculated is fundamentally flawed (BTW, this is true, but it’s beyond my point)
    2. the economy depends solely on government spending = hard times are ahead of us.

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