24/12/2014: House of Rubles: Bulgaria's Capital on Ruble Crisis

Here is an article in Bulgarian Capital on the subject of the Russian currency crisis, with comments from myself: http://www.capital.bg/politika_i_ikonomika/sviat/2014/12/19/2442567_kushta_ot_rubli/. My original comments in English:


1. What triggered the acceleration of the rouble crisis and why the drastic raise of the interest rates didn't help?

In a currency crisis, raising interest rates usually has little effect on currency valuations because the motives for dollarisation or a switch away from the domestic currency rest outside the scope of deposits and savings.

Russian crisis has been driven by rapid collapse of oil prices and by the growing demand for dollar and euro liquidity from banks and companies forced to repay foreign borrowings due to lack of access to the foreign credit markets.

Several larger Russian firms, facing billions of dollars of debt redemptions in Q4 2014 have moved into the market in the last 10 days, buying up dollars and using ruble loans from the Central Bank to fund these purchases. In addition, new estimates that came out last week showed Central Bank of Russia witnessing accelerated rate of capital outflows suggesting that Q4 outflows will match those in Q1 and that the total volume of outflows will total $134 billion, matching 2008-2009 crisis peak. This triggered a run on the Ruble that started on Monday and continued through Tuesday. Tuesda run was further exacerbated by the dollarisation of the household deposits, with many Russian households rushing to convert Ruble savings into dollars and euros.

In a way, 10.5 percentage points hike in interest rates enacted by the Central Bank added fuel to the fire. Firstly, it signalled to the markets that capital outflows are reaching crisis proportions. Secondly, it increased the demand for loans from the households trying to secure credit before rates rise even higher, and also drove more companies and households toward conversion of their deposits into dollars.

In the short run, the interest rate hike also led to a more aggressive shorting of the ruble, especially by algorithmic trading programmes, by acting to suppress supply of dollars out of Russian deposits into ruble trades, while leaving external supply of dollars available for backing shorts unaffected. The short-term nature of such strategy was evident in the abrupt reduction in net short positions in the market.


2. What options do Russian authorities have now to deal with the situation? Will Russia need to use capital controls?

So far, Russian Central Bank spent around USD10 billion on foreign currency interventions (through the first two weeks of December). The ministry for finance further openly committed to injecting additional USD7 billion. Simultaneously, the CBR adopted measures to ease balance sheet pain for the banks. The CBR also dramatically expanded its repo operations. All of this had an effect of calming the markets down - the effect witnessed on Wednesday.

However, the underlying causes of the crisis remain unaddressed and the current reprieve can be temporary, unless the CBR and the Russian Government adopt more drastic measures. One measure that will be effective in dealing with the underlying drivers of the crisis is limited capital controls. These can reduce dollarisation of the domestic household and corporate deposits and also restrict, in part, outflows of funds abroad. However, the second problem - mounting weight of debt redemptions by sanctions-impacted banks and companies - requires a different solution. One possible solution could be freezing redemptions for entities directly covered by sanctions, allowing ill up of interest to avoid outright default. Both measures are what we can term the 'nuclear' solutions and to-date the Russian Government has balked at adopting them. However, the Government is already applying pressure on Russian companies to stop hoarding foreign currency. The Government is also diverting 10% of the Russian National Pension Fund receipts toward supporting domestic banks.

Should the crisis regain momentum, even the 'nuclear' - in economic terms - options are going to be on the table.


3. How close is Russia to a repeat of the 1998 crisis?

The 1998 crisis was very different in nature and causes, so the parallels to it are tenuous at best. In the 1998 crisis, Russian Government was carrying unsustainable levels of external debt and it was running huge deficits. The country external balance of payments was in a persistent deficit. None of these factors are present today. Russian Government fiscal surplus is in excess of 2 percent and devaluation actually improves the Federal Government position in the short term. Current account is in a surplus and even with oil going to USD50/bbl, current account position is well-supported in the short run by collapsing imports. The entirety of Russian Government debt redemptions for 2015 is just over USD2.8 billion.

On the other hand, Russian economy today is in the same structural cul de sac as in 1998. Core driver for growth - high energy and commodities prices - is gone and it is unlikely to return any time soon. Consensus forecasts suggest oil price averaging around USD80/bbl in 2015, so at the very best, Moscow can expect moderate improvement in pressures compared to current situation.


4. Is now a deep recession a certainty for Russia in 2015? And how much worse can things get?

It is most likely that the Russian economy will slip into the recession over Q4 2014 - Q2 2015. The only question is - how deep the recession can be. Based on USD60/bbl assumption for the price of oil, the Central Bank estimates that Russian economy will contract 4.5-4.7% in 2015. At USD80/bbl, the contraction is likely to be closer to 0.8-1%.

The former is a heavy toll on the economy, while the latter is relatively mild and consistent with Euro area experience in 2012-2013. And beyond that, 2016 is also promising to be a tough year. Russian economy desperately needs two things: investment for developing non-extraction sectors, modernising the capital and technological bases; and structural reforms, reducing red tape, corruption, arbitrary enforcement of laws, reducing bureaucracy and altering labour markets. It will be extremely hard to deliver investment boost in current financial conditions and in the presence of sanctions. It will be virtually impossible to deliver reforms with current power brokers' so heavily dependent on continuation of the status quo of power and wealth distribution. But, at least reforms are a function of internal will.

There are added risks to the downside of the above forecasts, however. If capital outflows remain at peak levels consistent with Q1 and Q4 2014, interest rates will have to rise even further. Meanwhile, devaluation of the ruble will require offsetting nominal increases in spending on pensions, social supports, as well as investment in imports substitution. The result will likely be even more severe recession than forecasted above.


5. Could the rouble crisis shake Putin's grip on power?

At this stage, it is very hard to imagine any significant shift in the power balance in Moscow. The reason for this is two-fold. There is no momentum for such a change in the electorate and amongst the elites. Most recent public opinion surveys show steady 80% and higher support for President Putin and similar broad approval ratings for the Government.

Economic hardship is something the Russian society endures when it is faced with geopolitical adversity. Sanctions, in a way, are reinforcing current balance of power in favour of President Putin. The Crimean Euphoria effect is now almost gone. Eastern Ukraine offers much lower support base within the Russian society, with roughly 60% of population approving Russian Government providing support for the separatists there. But the juxtaposition of Russia vis-a-vis the West is now forming the main basis for President Putin's popularity. Whether we, in the West, like it or not, Russians do feel that their interests are not being served by cooperative engagement with Nato and the West. And much of the fault for this antagonism is based in both sides actions and rhetoric.

In addition, Russia lacks viable alternative to the current power balance. Existent opposition is even more vested into nationalist rhetoric and represents more extreme positions both in economic policies terms and geopolitical outlook. Opposition currently visible outside Russia has no support base within Russia. It is a power vacuum, absent the current Presidency. And, frankly, I cannot convincingly say that external opposition offers anything other than Putinism 2.0. The head of state change is not equivalent to structural reforms and so far, democratisation rhetoric from the Western-based Russian opposition is shallow, unbacked by any serious proposals for reforms and offering no alternatives to the 'power vertical' systems put in place from ca 1995 on, from the late Yeltsin era through today.

That said, if the crisis persists beyond 2015, we are likely to see growing pressure on the President and the emergence of potential challengers. Whether they will offer any serious prospect of reforms, while providing pragmatic road map for stability and governability is another question altogether.


6. What is more likely now - the economic agony to make the wounded Russian bear even more belligerent, or to force Putin to soften his position and to seek lifting of the sanctions?

In my view, the current situation is very volatile and highly unpredictable. We can certainly hope that the crisis is going to move both Russia and the West toward reconciliation of their respective positions. We need a constructive dialogue across a range of geopolitical issues. And we need Russia to be a strong, but cooperative participant in this process. The core point here is that it takes two to tango. The West needs to moderate its position on sanctions and Nato, Russia needs to be offered a way out of the Ukrainian crisis, while Ukraine's independence and territorial integrity must be preserved. Russia, in return, must step away from brinksmanship in both Ukraine and vis-a-vis Nato. The former is a disastrous strategy that will not deliver on Russian longer-term objectives and will continue to antagonise the Ukrainian population, moving the country away from any future good will-based cooperation with Russia. The latter is a tragedy waiting to happen - close calls in fly-bys between Russian military aircraft and civilian airlines in the Baltic Sea region are the proof of this.

Can 2015 be the year when we see some positive changes in these directions? I certainly hope so. But the indications are, we will see escalation of the crisis, before we see resolution being put forward.

21/8/2014: Thomas Piketty: Powerful Questions, Questionable Answers

This is an unedited version of my article for the Village magazine, August-September 2014


Thomas Piketty's "Capital in the Twenty First Century" (Harvard University Press, 2014) has ignited both public and professional debates around economic theory of income and wealth distribution not seen since the days of the Interwar period a century ago when applied Marxism collided with the laissez faire economics.

To give the credit due to the author and his book, this attention is deserved.

Like Marx's opus, Pikkety's volume is sizeable enough to provoke an instantaneous submission of the readers to its perceived academic (meticulously factual and theoretically all-encompassing) virtues. Like "Das Kapital", "Capital in the Twenty First Century" is impenetrable to anyone unequipped with an advanced degree in political economy and understanding of economic theory. Like Marx's tome, Piketty's work is an attempted herald of a New Revolution; the one that, in the end, boils down to exactly the same Revolution that Marx foresaw: the dis-endowed against the endowed. Like Marxist debates of the 1930s, Piketty’s thesis comes at the time of a major upheaval and crisis.

Thus, Piketty's work is destined to stay with us for a long, long time. Looming at the horizon line, its thesis of the coming age of chaos rising from the chain reactions of growing wealth inequality will be fuelling activists' imagination for decades into the future.

Yet, perhaps to the surprise of the majority of non-specialists, the book has, within a month of its publication, faded into the background in the world of economics. The reason for this is the book’s comprehensive ambition at creating a unified theory of future economic development renders it an easy target for criticism, challenge and, ultimately, negation.

Before diving deeper into Piketty's work, let me state three facts.

Firstly, I admire Piketty for his audacity to challenge the orthodoxy of macroeconomics and tackle a broad-ranging set of targets. 99.9 percent of economics literature explores the minutiae of some empirical or theoretical cul-de-sac in a specific sub-division of a sub-field of economics. Piketty falls into the 0.1 percent of economists who pursue the big picture.

Secondly, witness to the vitriol with which Piketty’s book was greeted in the economic policy circles, I have defended his work in the media and on my blog.

Lastly, having read Piketty's academic publications and working papers in the past, I found his book to be inferior to his academic publications. "Capital in the Twenty First Century" is too long and stylistically un-engaging to be worth returning to it in the future.

The last fact means that you should read Piketty's thesis and be aware of his core evidence, as well as the growing evidence of its shortcomings.  The best means for acquiring this information is by reading Piketty's articles and interviews, as well as taking in the debates surrounding his book. But you should not buy "Capital in the Twenty First Century", unless you are endowed with a desperate propensity to impress your image of a couch intellectual onto the receptive minds of your friends and colleagues. In the latter case you should avail of Flann O'Brien's gentlemanly service that can get the tome thumbed, marked and annotated for you with scientifically-sounding marginalia.


Core Theses

Piketty's core thesis is based on what he defines to be the 'fundamental laws' of Capitalism. Both of these laws stem directly from his view that the economic inputs can be grouped into only two categories: capital (something that can be bought and sold, and thus accumulated without a bound) and labour (something that cannot be sold, although it does collect wage returns, and cannot be accumulated without bounds). Incidentally, beyond undergraduate economics, this division remains valid only in the literature pre-dating the 1980s.

Piketty’s First Law states that capital's share of income is a ratio of income from capital (or return to capital times the quantum or stock of capital) divided by the national income (for example, GDP).

As anyone with a basic knowledge of economics would know, this is not a law, but an accounting identity. Furthermore, any undergraduate student of economics would spot a glaring problem with the above definition: it applies to all forms of capital, including the ones that Piketty omits.

This brings us to the first major problem with Piketty's core thesis: capital itself is neither homogeneous, nor yields a deterministic and singular rate of return. Instead, capital takes various forms. There is financial capital - the one to which the rate of return is measured in form of equity returns, bond returns, financial portfolio returns and so on. There is also intellectual capital that can be traded. This generates financial returns to the holders/investors, but also yields productivity gains to its users, including workers. There is human capital - which generates (alongside other inputs into production) returns to labour (wages and performance-related bonuses), but also returns to entrepreneurship, creativity of employees and so on. There is managerial and technological know-how that can be invested in and transferred or sold, albeit imperfectly, in so far as it often attaches to labour and skills.

To measure income share of all of these forms of capital, one simply needs to divide income from the specific form of capital by total income. Ditto for labour's share and for any other input share. This is neither Piketty's discovery, nor a law of Capitalism.

The problem is that in many cases we cannot easily measure returns to the more complex forms of capital. And a further problem is that returns to one form of capital are linked to returns to other forms of capital. A good example here is urban land. Return to this form of capital is strongly determined by the returns to human capital that can be deployed on this land, as well as by know-how and technology that attaches to economic activity that can take place on it.

Piketty's second fundamental law is a theoretical proposition derived from the mainstream macroeconomic theory. The author claims that the ratio of the stock of capital to income will be equal to the ratio of the savings rate to the sum of growth the growth rates in technology and population. Together with the first law this implies that income share of capital equals to the ratio of the product of the return on capital and savings rate to the combined growth rate in technology and population.

Piketty's main thesis is that over time, as growth rates in technology and population fall, capital's share of income will rise resulting is a sharp rise in inequality.

The core corollary of this is Piketty's call for a global tax on capital (or wealth) coupled with a massive rise in the income tax on super-earners. These measures, in his view, can ameliorate the increase in the income share of capital triggered by slower growth.


Mythology of the Piketty’s ‘Laws’

There are numerous and significant problems with Piketty's analysis and even more problems with conjectures he draws out of data.

Although Piketty presents numerous factual arguments describing the rise and fall and the rise again in income and wealth inequalities, his factual arguments are tangential to his theoretical proposition. Per Krusell (Stockholm University) and Tony Smith (Yale University) pointed out that "Piketty’s forecast does not rest primarily on an extrapolation of recent trends that he has uncovered in the data..."

Krussell and Smith go on to show that Piketty’s second 'fundamental law' relies not on data, but on an assumption that the ‘net’ saving rate is constant and positive over time. This means that capital stock rises by an amount that is a constant fraction of national income.

Now, suppose that Piketty is correct. And suppose that the growth rates in population and technological progress fall to near-zero. Piketty’s assumption then implies that ever greater share of economy’s output will have to be used to maintain capital stock. This will crowd out investments in education, health or new technologies. Eventually capital formation will have to consume the entire GDP. This has never been observed in the past and cannot be true in the future.

Now, personally, I do believe we are staring into the prospect of diminished rates of growth in the advanced economies. But I also believe that savings follow growth over the long run, implying that, the gross investment - investment including replacement of capital depreciation and amortisation - is relatively constant as a ratio to national income. At times of structurally slow growth, therefore, savings are also low.

This belief is supported by historical evidence and contradicts Piketty's conjecture. Furthermore, this evidence is supported by data from individual consumers’ behaviour. In cyclical recessions, households do engage in increased savings, known as precautionary savings. But this phenomena is short-lived and does not contribute to increased investment. Over time, slower growth in income equals lower rates of savings.


Piketty’s Tax Fallacy

Aside from the above, Piketty's suggestion that a wealth tax can stem the rise of inequality is illogical.

Wealth taxes tend to decrease the quantity of capital, thus raising the scarcity and the quality of it. The result - higher returns to capital in the long run that will at least in part neuter the wealth tax effects on stock of capital. More scarce goods tend to command higher prices.

The problem with wealth inequality rests with the distortionary nature of taxation, not with tax levels per se.

To see this, take three forms of capital: financial assets, intellectual property and human capital.

Tax rates on financial assets normally run close to zero, due to availability of various off-shore schemes for tax optimisation for those well-off enough to afford legal and financial engineering services required to attain such rates. Each 1 percentage point in return to financial assets held by a wealthy Irish owner attracts a tax of under 10 percent (inclusive of costs of tax optimisation). For the mere mortals, capital gains rates run also well below income tax rates. In Ireland today, the headline rate is 30%. Intellectual property is facing an effectively near-zero tax rate.

Whereby professional or institutional investors in traditional capital collect roughly 85-90 cents on each euro of gains, intellectual property investors collect closer to 90 cents and retail investors pocket around 70 cents. On the other hand, human capital returns are taxed at an upper marginal tax. Thus a professional consultant will collect around 45 cents on each euro returned to her from added investment in education and skills upgrading.

The result of this asymmetric treatment of returns from various forms of capital is that households simply have no surplus income left to invest and accumulate wealth. Instead, wealth accumulates in the hands of those who can afford living off rents and start their lives with inherited capital.

To make things worse, Peketty also calls for raising dramatically upper marginal tax rate - to hit the high earners. This too is directly contradictory to the objectives he claims to pursue.

Upper marginal income tax rate hits those who live off the wealth of the businesses they built and skills they acquired. Capital gains tax hits those who either dispose of the businesses they built or sell capital they accumulated or inherited. Two of these groups of earners are collecting on value added they created. One is collecting on what others created for them. Treating them all with one brush will simply reduce future rates of growth and/or reduce rates of return on non-capital income. In other words, Piketty's income tax policy proposal will lead to higher wealth and income inequality in the long run under his own model.

The solution to this dilemma is not to tax all capital more, but to equalise the rates of taxation on all capital: physical, financial, technological and human. And focus on what Jacob Hacker of Yale University calls 'pre-distribution' of labour income. The latter requires simultaneously addressing three determinants of market wages: education and skills (increasing skills of the low income segments of population), focused enterprise policy (supporting demand for these skills) and improved mobility and efficiency of the labour markets (increasing returns to skills and human capital).


The Economic ‘Bad’ of Inequality

Piketty's work deserves huge credit for bringing to the fore of the economics debate legitimate concerns with inequality. However, here too the book is open to criticism for being based on occasionally thin evidence.

"Capital in the Twenty First Century" is premised on the assumption that wealth inequality is tearing societies apart, leading to violent conflicts and breakdowns of the civic and state institutions. There is very little evidence to support this assertion amongst the advanced economies. Extreme inequality, measured in absolute terms, can be exceptionally dangerous. So much is true. But relative inequality to-date has not been a major flashing point for revolutions whenever such inequality is anchored in some meritocratic foundations for wealth distribution. All of the recent disturbances in the advanced economies have referenced income and wealth inequality if one were to listen to activists involved in these events. But all have been linked to either public policies relating to income and opportunities available to the less well-off groups or to diminished growth rates in the local economies.

More importantly, current research shows that individual perceptions of relative income and wealth inequality strongly depend on which reference group one selects for benchmarking against.

For example, Daniel Sacks, Betsey Stevenson and Justin Wolfers paper "The New Stylized Facts About Income and Subjective Well-Being (published by CESIfo in 2013) find that there is little evidence to support theories of relative income. In simple terms, if you are concerned with inequality, you should focus on increasing the rates of growth in the economy, not depressing the rates of return on capital.

Another study, by Maria Dahlin, Arie Kapteyn and Caroline Tassot, titled "Who are the Joneses?" (CESR, June 2014) shows that individuals are "much more likely to compare their income to the incomes of their family and friends, their coworkers and people their age than to people living in the same street, town, …or in the world." We reference our own wellbeing against wellbeing of those close to us socially. In this case, Piketty's policy prescription should call for taxing rich people with greater familial networks at a higher rate than those with fewer familial ties. Which, of course, is absurd.


The World is Non-Marxian

Perhaps the greatest error in Piketty's logic is the failure to account for other forms of capital – an error exactly identical to that committed by Marx.

I named these forms of capital above in the discussion of Piketty’s two Fundamental Laws. Ricardo Hausmann from Harvard ("Piketty’s Missing Knowhow", Project Syndicate) shows that Piketty's argument completely falls apart at the national accounts level in the case of advanced and emerging economies. Furthermore, his argument dovetails with my view that hiking upper marginal tax rates to combat income and wealth inequality is simply counterproductive.

Piketty's assumption that the rate of return to capital is following a historically constant trend of 4-5 percent per annum is also questionable. Dani Rodrik of Princeton University reminds us that the return to capital is likely to decline if the economy becomes too rich in capital relative to labor and other resources and the rate of innovation slows down. So if innovation were to fall, as Piketty assumes, rate of return to capital is likely to decline in line with diminished economic growth. This decline is going to be further accelerated by the rise in the quantum of capital accumulated prior to the economic slowdown.

Lastly, since capital is non-homogenous, even constant average return can conceal wide variations in returns to various forms of capital. For example: agricultural land vs industrial property, private equity vs listed shares and so on – all command different and over-time varying returns. Imposing a uniform tax on all wealth will raise cost of investing in more productive and less certain (thus 'pricier') capital associated with new technologies and new industries. In turn, this will only reduce mobility of wealth in the society, increasing, not lowering long-run wealth inequality and supporting currently endowed elites at the expense of any challengers.

Truth is, Marxian world of the epic confrontation between labour and capital has been surpassed by reality. Today, we live in a highly complex, more dynamic and less homogenous economy. This does not mean that the burdens of rising income and wealth inequality should be ignored. But it does mean that policy responses to these challenges must be based on more complex, behaviourally and macroeconomically-anchored analysis.

Piketty’s "Capital in the Twenty First Century", spectacularly succeeded in raising to prominence the debate about income and wealth distributions. But it also failed in delivering both the analytical frameworks and policy responses to these twin challenges.

Tax and reallocation measures - whether through aid or charity, force of compulsion or financial repression - are neither sufficient to restore balance between returns to physical capital, technology and human capital, nor conducive to delivering continued growth of human-centric economic systems. Instead, there is a dire need for direct, markets-based repricing of the sources of value added in the society. This repricing must recognise the simple fact of nature: people add value to capital, not the other way around, and people with skills and productive attitudes to work do so more than those without both or either.

There is a need for closing tax incentives that favour physical capital over human capital, and there is a need for rebalancing our tax system to allow for greater rewards to flow to those creating new value in the economy. But there is also a need for the state systems to stop treating workers as captives for tax purposes, whilst capital remains highly mobile and tax efficient.

15/9/2013: BIS Quarterly: a tale of two banking systems

Two hugely revealing charts from the BIS Quarterly Review, September 2013 (http://www.bis.org/publ/qtrpdf/r_qt1309e.pdf) show exactly the remaining adjustments yet to be undertaken by the banking sector in Europe, compared to the US.

Here they are:

 and

 
note how European banks lag US banks in assets deleveraging, and in raising capital, and are slightly lagging in terms of changes in the ratio of risk-weighted assets. In risk-weighted capital ratios, the european banks are about 1/3rd of the way shy of the US, and in terms of capital, roughly 1/2 of the adjustment to the US levels is still required.

And per operational weaknesses of the European banking system? Next we have a table:

Although different across periods, the divergences between the European and US banks are still qualitatively the same for pre-crisis and crisis periods. In particular, US banks operate at higher cost than European ones, but generate more interest income and other income.