Recalibrating Argentina’s Ponzi Program

Restoring stability Argentina pdf plus technical annex.

TODAY’S SHARP ARS adjustment from 45.3 per USD on Friday to about 53.0—a depreciation of 14½%—comes as no surprise to anyone who has been studying Argentina’s macro-financial policies in recent years.

The catalyst for the sell-off in Argentine assets, of course, was the outcome of yesterday’s primary election—where the opposition Fernandez-Kirchner ticket defeated the so-called market-friendly incumbent, President Macri, by 15½ percentage points. A return of populism to Buenos Aries can be expected.

However, as so often the case, while politics will be seen as the turning point for Argentina’s program, a further sharp adjustment of ARS was already baked in the cake—only the timing was uncertain. Rather, failed macroeconomic policies are to blame. Why?

To understand Argentina’s inevitable demise, it is necessary to recognize that the monetary-fiscal program currently in place—including as part of the IMF’s largest ever program—is a Ponzi scheme. And as with all Ponzi schemes, it’s demise is inevitable. In short, Argentina’s central bank (BCRA) has very few interest-earning assets, but pays a large interest on its sterilization operations—currently Leliqs, previously Lebacs and various other instruments. Without the real resources needed to fund its operations, BCRA has no choice but to monetize the cost of its operations. But to prevent the impact of this on base money, with associated pressure on the exchange rate, BCRA must issue ever greater sterilization instruments as an offset. However, over a long enough horizon, this policy implies BCRA’s monetary plus sterilization liabilities will grow exponentially relative to reserves assets. Inevitably, this must at some point unravel—all that was needed is a catalyst. Yesterday’s election duly delivered.

Understanding Argentina’s Ponzi program with the IMF, therefore, is a prerequisite for beginning to sketch how things will unfold from here—the true implications for sustainability and necessary and sufficient debt restructuring under any new administration. The mistake investors have been making until now is to believe there is a positive “market friendly” outcome, whereas under any administration the true challenge of restoring fiscal sustainability brought only downside for Argentine assets. Today’s adjustment represents a belated imposition of fundamentals.

The evolution of BCRA balance sheet

To appreciate Argentina’s monetary-fiscal dilemma, we need to dig deep into the BCRA balance sheet—and monetary-fiscal interactions in particular. Every year, around July, BCRA produces an annual financial statementfor the previous calendar year. By piecing the information together from these statements, we can build links between BCRA and the fiscal authorities since 2011.

Table 1 shows the net interest income received by BCRA between 2011 and 2017, capturing the end of the previous Kirchner administration and the first part of Macri’s term. In 2011 BCRA was running a deficit of 0.4% of GDP in terms if net interest income. Interest received of ARS3.8 billion, mainly on government securities and international reserves, was more than offset by interest paid of ARS12.9 billion, mainly on BCRA securities. This deficit was roughly unchanged (in % of GDP) through 2013, but increased every year since to reach deficit of 1.9% of GDP in 2017. Interest received increased to ARS29 billion in 2017 while interest paid reached ARS233 billion. Interest received increased 8-fold on a lower base, interest paid increased 18-fold.


Not shown in Table 1, the 2018 financial statement reveals the interest paid on BCRA securities increased to reach ARS383 billion in 2018, from ARS210 billion in 2017—despite a sharp fall in outstanding absorption instruments (more on which shortly.)

And so, while not counted in the fiscal position of the Federal government, BCRA has been running a growing deficit in recent years—to reach 2.2% of GDP in 2018. This hidden deficit is the essential challenge for restoring macro-financial sustainability in Argentina, as we discuss. But first, where has it come from?

            Since at least 2011, BCRA has been a source of finance for the Federal government in various ways. One of the several ways has been through the transfer of BCRA net income (including valuation adjustment) to the Federal government.

Table 2 shows the stock of BCRA capital, reserves, and retained earnings, as well as the contribution to the change in BCRA capital due to net income. Note, this net income measure includes valuation adjustments. Since BCRA has a positive net open position in foreign currency, owing to holdings of international reserves, whenever ARS depreciates this creates positive valuation gains. And ARS was on a secular depreciation path over the period—something continued today—meaning there were positive valuation gains throughout. However, this did not result in large upward valuation of BCRA capital and reserves. Why not?


The Federal government implemented a profit sharing rule whereby net income from the previous year—including these valuation gains—was transferred to the Federal government as income. This was not quite 100% in the final years shown, but exactly true for the first 5 years. Consider how net income including valuation gains of ARS78 billion in 2014 was transferred in full in 2015 to the Federal government. Thus, even though there as negative net income cash flows throughout the period, the valuation adjustment was to more than enough to offset this. And so, despite negative realized cash income, BCRA was continuing to transfer profits to the Federal government throughout. Over the 7 years covered, BCRA transferred ARS375 billion to the government, averaging 0.9% of GDP per year. Crucially, it was valuation gains that were being transferred, even if these valuation gains were yet to be realized and all the while BCRA capital was shrinking from 1.4% of GDP in 2011 to 0.7% of GDP in 2017.

But this wasn’t the only source of financing between BCRA and Federal government over the period. 

            Table 3 provides the best decomposition of contributions to changes in base money in Argentina possible (by me at least) from the varying annual financial statements. The change in base money of ARS840 billion cumulative, averaged about 2.4% of GDP, whereas the change in contributions owing to transactions with the government of various kinds summed to ARS1279 billion, averaging about 3% of GDP. These transactions on behalf of the government include the purchase of FX in later years (when international markets were open for borrowing), the drawdown of deposits, temporary advances to the government, and transfer of BCRA earnings noted above. With respect to the latter, there is a difference between the flows reported in BCRA income statement (Table 2) and the smaller implied cash flow (Table 3) which is assumed without investigation an accrual versus cash distinction.


In any case, the decomposition shown in Table 3 reveals fiscal dominance in Argentina over the period 2011-17. Most important, to contain the creation of base money, BCRA expanded the total stock of outstanding securities—sterilization instruments—by about ARS380 billion (or 3.5% of 2017 GDP.) Crucially, this is a net figure, meaning the interest on outstanding BCRA securities which would otherwise contribute to greater base money creation is being mopped up here; the total increase is considerably larger.

In fact, the total stock of BCRA securities increased from ARS89 billion end-2010 to ARS1,160 billion end-2017 (Figure 1). This exponential increase in BCRA securities, later rolled off somewhat in the crisis of 2018, is a pictorial representation of the challenge of monetary stability with inadequate central bank resources. In effect, to achieve monetary stability BCRA was issuing its own securities in lieu of government debt. This quasi-fiscal debt sits on BCRA balance sheet instead of government. This ought not be overlooked in assessing overall macro-financial sustainability, however.


To assess overall sustainability, of course, requires consolidating the Federal government with BCRA to produce a true assessment of overall State position. But to do so would have stretched to breaking point the intellectual capacity of the Fund—their debt sustainability framework has no meaningful role for consolidated public sector assessment—while working against the political imperative to be seen to support Argentina’s efforts to reintegrate into the international community. And so the IMF’s program was fudged.

The IMF program: death foretold

In brief, the IMF program—amounting so far to a prospective USD56 billion, of which about USD50 billion is a done deal, the largest in Fund history—took note up front of the lack of BCRA capital and the need for action in the future on this, but decided not to deal with this as a prior action. For example, the staff reportat program initiation notes the need to update accounting standards at BCRA while setting as a “structural benchmark” for end-2019 the need to “Recapitalize the central bank to ensure it has the adequate level of capital as percent of the monetary base plus the outstanding stock of LEBACs.”

But such measures, which would have clear fiscal implications, including for sustainability assessments, were illogically postponed. As a result, staff could present a more favourable picture of Federal debt sustainability. However, this overlooked a fundamental inconsistency within the program. While Federal government sustainability requires secular real appreciation, BCRA sustainability in contrast requires secular real exchange rate depreciation to continually revalue foreign assets relative to local currency liabilities.

Absent real depreciation, the BCRA’s monetary policy would be exposed as a Ponzi game in which the value of liabilities would grow exponentially larger than net foreign assets (at any prevailing exchange rate.)

This inherent contradiction sits at the heart of the Argentina program today—as it has from the start. Thus, BCRA securities and overall liabilities (including base money)—despite the apparently tight monetary stance—would far exceed the local currency value of net foreign assets in finite time. The latest IMF 4thReview forecast of this is shown in Figure 2. The only way to correct the imbalance of growing local currency liabilities is through discrete ARS depreciation, to revalue international reserves relative to local currency liabilities. With substantial dollarization of Federal government liabilities, however, this will reveal Federal government debt to be larger relative to GDP than previously thought—as in 2018. Thus, the quasi-fiscal debt of the government imposed on BCRA will show up when BCRA resolves her own unsustainable position.


All this has made ARS adjustment inevitable at some point. For example, the average Leliq interest rate—the interest rate on 7-day absorption instruments—during January through July this year was 61%. The stock of Leliqs was less than ARS500 billion in October 2018, but was on track to exceed ARS1,800 billion by end-2019. BCRA Leliqs were destined in a few weeks from now to exceed base money in size once again. By end-2020, the IMF was forecasting M0 plus Leliqs in Argentina to be nearly double net foreign assets—despite expected exchange rate weakness. Roughly speaking, in the past few weeks, BCRA has been rolling over into 7-day liquidity absorbing instruments about ARS250 billion per day—that’s about 20% of base money each working day. On each occasion, the holders of these claims on BCRA have to ask whether the reward of a 60%-70% annualized interest rate on this one week lending to the central bank is worth the risk that on one of the next 4 days other holders will decide to liquidate the claims and try to purchase USD. If on any day there is a reason to fear rollover in the next week, there is an incentive to run for the exits—precipitating a currency crisis. This is due to the lack of BCRA capital and resources to fund monetary stability, and the ultimate need to monetize the cost of monetary policy.

Ultimately, the need to recap BCRA by end-2019 will have an impact on the fiscal position of the Federal government that has so far been swept under the carpet. The precise size of the recap is impossible to say, but it’s easy to generate (that is, simulate) steady states with an increase of Federal government debt of between 10% and 30% of GDP; with assumed 5% coupon on this debt transferred to the government, this could create an additional interest cost of 2% of GDP per year. This implies the fiscal adjustment in the program would require further painful future efforts to restore monetary sustainability. Alternatively, given the monetary-fiscal adjustment so far has taken a huge toll on the population, fiscal adjustment will likely be paused in favour of substantial debt restructuring. This will be the case regardless of who wins the election in October. It’s time to restore macro-financial stability to Argentina. I believe the existing fiscal DSA ought to add around 20% of GDP in debt in perpetuity to do so, which upends all existing assumptions about fiscal sustainability and the need for restructuring.


A note on debt sustainability in Argentina

THE LATEST International Monetary Fund (IMF) program document for Argentina—the 3rdReview—was published earlier this month. This document sheds light on the drivers of the public debt sustainability analysis (DSA) that underpin the program.

Since the issue of debt sustainability in Argentina will recur after the upcoming Presidential elections, it’s worth asking: What are the assumptions that underpin the latest IMF document? Do they make sense? And what does this imply for investors?

Let’s start with the evolution of projected public debt since program initiation in June 2018. At the time of program initiation in June 2018, debt-to-GDP was expected to peak below 65% in 2018 before falling below 55% in 2o23. The latest review has debt-to-GDP peaking above 85% in 2018 though falling to below 60% in 2024. The convenience of extending the forecast horizon a year allows the economically meaningless though apparently optically necessary 60% debt-threshold to be met by 2024. (When will the IMF disabuse us of this meaningless number?)


What has changed over these different reviews? The most important recent driver of the debt stock relative to GDP is the valuation adjustment of foreign currency-denominated debt given nominal exchange rate depreciation. As of end-2017, 68% of public debt was denominated in foreign currencies (largely dollars); by end-2018, with program borrowing and another dollar bond issued in 2018Q1, 76% of public debt was fx denominated.

It’s useful therefore to review the exchange rate assumptions that underpinned the respective documents. Now, the precise exchange rate assumptions are hidden deep within the documents. But we can back out the implied USDARS exchange rate from the national income (period average) and monetary account tables (end of period). The left side in the chart below shows the expected year average exchange rates implicit at program initiation, where ARS was expected to depreciate only 56½% against USD from 2016 through 2023, with most of this deprecation happening by 2019. Instead, the nominal exchange rate adjustment was much sharper, with USDARS reaching 38 by end-2018, well above that initially expected for 2023; the valuation adjustment on the stock of fx denominated debt therefore drove up the stock of public debt up by about 30 percentage points of GDP, considerably above that anticipated only last June.

Perhaps most interesting, the latest review further revises the exchange rate over the forecast horizon. Instead of ARS reaching 46 in 2023 as at the 1stand 2nd Reviews, it is now expected to depreciate to touch 63 on average that year and 67 by end-2024. Thus, from ARS depreciation of 15% from 2019 to 2023, the latest review builds in a 33% depreciation over this period against USD. This is a substantial revision to the projected nominal exchange rate path, especially given the high share of fx-denominated debt and the extraordinarily tight monetary policy that has been initiated under the program— including zero base money growth, substantially negative in real terms.


The assumed nominal exchange rate depreciation means the large share of USD-denominated public debt will continue to increase over the forecast horizon when measured in local currency, contributing to deteriorating debt dynamics. How then is the program document able to show a declining stock of public debt when measured relative to GDP? The answer is in large upward revisions to nominal GDP in local currency—mostly coming from upward revisions to expected inflation as measured by the GDP-deflator. Again, while the original program assumed NGDP to grow 17% on average per year from 2016 to 2023, the latest program has growth of 26%—given the lower path of real GDP since initiation, the program now implies much higher average inflation rate. The compounding of higher nominal GDP growth therefore drives GDP to above ARS44 trillion by 2024, though in USD terms only slightly higher than the 2017 flow of USD650 billion.


Again, in contrast to the extraordinarily tight monetary policy agreed for 2019 under the program, the Fund now assumes continued nominal exchange rate depreciation as well as large GDP-deflator inflation over the forecast horizon. The expected higher inflation and exchange rate weakness also coincides with base money growth picking after 2019—so recent control of base money is apparently not expected to last.

To assess the two factors side-by-side, the next chart shows the cumulative growth in nominal GDP, GDP deflator, and ARSUSD from 2016. Note, the latter measures the percent change in the number of local currency units that can be bought with 1 dollar; this represents a 77% depreciation properly measured against USD over the horizon.

Crucially, while the nominal exchange rate has “overshot” through 2019, the program has NGDP growth racing ahead of the weaker exchange rate to bring down the stock of debt-to-GDP—with about ¼ of this is due to the GDP deflator. For this reason, the program document emphasizes “projected real peso appreciation in 2019 will improve debt dynamics.” The 3rd Review does not reveal that this is not expected to materialize alongside continued nominal peso depreciation, with inflation catch up and surge ahead of the exchange rate adjustment. Of course, the real exchange rate proper will be impacted in addition by the average inflation rate amongst trading partners, so these comments leave out this important aspect. But it demonstrates the key contributors to falling debt-to-GDP—namely cumulative NGDP growth, including due to the GDP deflator, running ahead of the weaker exchange rate from 2018.


Put another way, the IMF’s DSA hinges on “financial repression”—or, negative real interest rates for investors in both local and foreign currency debt when measured with respect to the local GDP.

How realistic is that local investors will continue to finance the rollover of domestic debt at substantially negative real yields? Given the risk of default, will non-residents continue to fund Argentina—including the roll-off of IMF funding—at manageable rates? Is the implied nominal interest over the forecast horizon reasonable?

Here’s where the challenge of interpreting debt sustainability gets messy for Argentina. It crucially hinges on the definition of Federal government and the portfolio choices of non-Federal-government public sector. In short, there’s a lot hanging on the definition of government. The original program document focussed on “gross federal government debt, which includes intra-public-sector debt” including debt owed to the central bank (BCRA, apparently at effectively zero interest), social security (ANSES), and other public sector entities (including provinces). As of end-2017, 48% of Federal debt was owed to other public sector bodies; as of the latest program “About 35 percent of the federal government’s debt is held by other public-sector entities and provinces. Nearly 70 percent of this intra-public-sector debt is denominated in US$, and within this, the majority are low-interest Letras Intransferiblesheld by the BCRA.”

Against this, when it comes to presenting the Federal government fiscal balance, the interest paid to other public sector entities is removed—see footnote 4 of Table 4 on page 32, where the interest paid “excludes all interest paid to other public sector entities, in line with authorities’ definition.”

So, the Federal debt stock includes intra-public sector holdings, while the Federal fiscal balance strips out public sector interest flows—so the interest flows in the DSA have to add back the interest paid to other public sector entities. Fortunately, the DSA template includes the effective interest rate paid on Federal debt, including to other public sector bodies, as shown in the chart below (page 50).


The effective interest rate, “defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year,” dips to 5.1% in 2019, before increasing to 8.2% at the end of the forecast horizon. It is not clear why the effective nominal interest rate dips this year. At program initiation, the effective interest rate for 2019 was pencilled in at 8.6%, though admittedly with lower expected IMF purchases. Regardless, using the debt stock anticipated over the program (Table 7, page 40) we can back out the implied interest paid on Federal debt, including that to other public-sector entities. And the effective interest rate paid increases to ARS2.0 trillion in 2024 (8.2% of ARS24.7 trillion debt as of end-2023) which compares to interest of only ARS0.9 trillion according to the fiscal balance. The document therefore appears to imply an ever-greater share of interest on Federal debt will be paid to other public sector bodies, including the central bank and social security fund. Indeed, by 2024 it seems to imply about 2% of GDP in interest will be paid to other public sector bodies. Regardless, since the program assumes non-Federal public sector rollover of debt—including capitalization of interest by non-financial public sector bodies—sustainability hinges on a high inflation and therefore a negative real effective interest, much to other public sector bodies, through 2024.


There is much more that can be said about Argentina’s program—looking at the balance of payments, monetary accounts, and likely future path of GDP. But narrowing in on the DSA is enough to get a smell-check as to the realism of the program. And there are substantial problems with the sustainability analysis. But future adjustment will likely take a different form—with larger compression of domestic demand, greater current account adjustment, and a surplus of domestic saving that can be used to finance public sector in outer years as the economy stabilises.

But it is most likely that nominal and real interest rates will be higher, and the stock of debt stuck at a higher level for longer—but the economy will stabilise and inflation moderate. This will raise the prospect of debt restructuring after the elections in October, once the IMF narrows in on more sensible macroeconomics. In the meantime, the greater damage to real incomes that will be materialise creates the possibility of a less outward-looking and more populist government. Will the IMF agree to rollover the program with a permanently higher stock of debt under a Macri government? Or will the IMF look to restructure debt in an orderly way? Or will Cristina decide to turn away from financial markets, creating a disorderly resolution to Argentina’s external debt challenge once more? A sensible view of the DSA suggests any of these outcomes could materialise.


Is euroarea monetary control now in the hands of official reserve managers?

Euroarea monetary control pdf version.

It’s remarkable how the euroarea crisis elevated arcane relations between central banks within the Eurosystem to dinner table talk for households across Europe. After decades of disregard, central bank balance sheets and liquidity management are fashionable once more.

Largely unnoticed, however, a more recent set of connections between central banks of potentially greater significance has emerged. This time, the links are not withinthe Eurosytem but external—between euroarea national central banks (NCBs) and non-euroarea central banks (NEACBs) and their reserve asset managers. That is, growing deposits by NEACBs with NCBs since the European Central Bank’s (ECB) asset purchase program (APP) have the potential to distort future liquidity control—indeed, they are now crucial for projecting Eurosystem liquidity, the yield on euroarea safe assets, and the euro itself.

Let’s take a step back. Since June-2015, the share of “currency and deposits” in total reserve assets held by NEACBs, as reported to the IMF, increased from roughly 3% to 8% (Figure 1). That is, reserve managers rotated assets from global coupon-bearing securities towards deposits with other central banks. Of a stock of reserve assets of near €9½ trillion, the increase was about €400 billion.

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What does this have to do with the Eurosystem? Well, over the course of APP roughly €600bn of euros that would otherwise sit as excess liquidity at domestic banks were “sterilized” due to: larger cash buffers held by resident governments on increased bond issuance (€150bn); financial intermediaries not subject to reserve requirements selling into APP and deposited with NCBs (€100bn); and, most importantly, growing non-euroarea resident deposits (largely NEACBs, €350bn).

Indeed, as of December, non-resident euro deposits at NCBs exceeded €400bn. Two forces appear to have driven these growing claims. First, as reserve managers sold bonds into APP, or saw claims mature, they recycled into euro cash at NCBs rather than securities. This accounts for the secular increase (perhaps €300bn). Second, quarter-end shortages of dollars amongst private banks in core countries, subject to new regulatory requirements, evolved a reliance on NEACBs providing dollar securities to pad their balance sheets. Euros posted as collateral in these repo operations wash from banks into reserve manager accounts, mainly at the Bundesbank—imprinted also in quarterly TARGET2 moves.

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Why does this matter? Five reasons:

First, Eurosystem excess liquidity is now closely linked to official reserve manager portfolio allocation, not fully within the ECB’s control (something not factored into Praet’s projections). Indeed, if NEACB claims on NCBs remained unchanged since 2014, excess liquidity today would be above €2.1trn instead of €1.8trn. And these reserves—larger than total APP purchases in 2018—are waiting to be redeployed as yields normalize. Alternatively, should yields remain compressed, growing NEACB claims couldsqueeze excess liquidity further.

Second, it challenges the narrative that an important part of the global impact on the ECB’s APP has been through the recycling of non-resident portfolio claims to the outside world (see Coeure). Not so. Rather, given asset prices, perhaps half net non-resident portfolio sales during APP instead rotated into euro deposits. Isolating portfolio flows in the balance of payments without looking at other investment is distorting. And perhaps the biggest global impact of APP, therefore, has been on reserve manager portfolio allocations.

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Third, the yield on euroarea safe assets is now determined by the marginal interest rate available to NEACBs (Figure 2). The Bundesbankreveals an interest on the unspecified excess float held by reserve managers at the deposit rate minus15bps—thus currently -55bps. As a result, absent alternate safe assets, NEACB claims on the Eurosystem increased most when the yield on short-end bunds fell below -55bps. This provides a cap on short-end yields, therefore.

Fourth, quarter-end shortages increase the links between NEACBs and the Eurosystem, providing for the former an opportunity to offset some of the cost of negative yielding euro assets. However, these flows challenge any interpretation of quarterly changes in IMF reserve asset allocation data: how should these repo operations between NEACBs and euroarea banks be unpacked? For example, using the IMF’s CPIS and allocation of international reserves data, as well as ECB NCB balance sheet data, it is apparent a growing share of reserve manager claims on the euroarea is now in the form of deposits with NCBs (Figure 3 provides an estimate for end-2017). The increasing dollar-liquidity provision needs to be factored in when estimating quarter-end euro allocations.

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Fifth, interlocking global central bank balance sheets are now of greater interest than intra-system TARGET2 balances. Indeed, the fact that numerous central banks today likely hold more than one-third of their reserve assets in the form of negative yielding deposits at the Eurosystem (e.g., perhaps Australia, Czech Republic, Denmark, Turkey) is remarkable (Figures 4 and 5). This is a tax on non-euroarea residents.

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In summary, the legacy of the ECB’s APP is more nuanced than often supposed. Growing links between the Eurosystem and national central banks outside the Eurosystem have the potential to challenge liquidity management in the future. This also represents postponed APP purchases, since these deposits can be recycled back into euroarea assets raising liquidity once more. For example, over the past 4 weeks, non-euroarea euro deposits have declined €27 billion, defying the seasonal pattern of accumulating deposits in 2017 and 2018 (Figure 6). This suggests anticipation of today’s dovish ECB meeting caused reserve managers were rotating into euroarea fixed income assets to benefit from the rally in asset prices. This is as large a flow as APP purchases each month during 2018H1.

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But all this is just another way of underlining the flaws in euroarea fiscal policy—and the shortage of global safe assets. Should euroarea fiscal failings, alongside reserve manager portfolio choices, eventually hinder euroarea liquidity management, then flaws in euroarea macro-financial design will once more be laid bare for all to see.


The UK’s Referendum on the European Union: What Happens Next? [throwback from June 2016]

[Having just reviewed what I imagined to be the outcome in the event of Leave in the week before the Brexit referendum, I thought I’d drop it online for posterity. This is an abridged version (nothing added, only the scenarios that did not emerge and irrelevant details removed) from that written during the week between the devastating murder of MP Jo Cox and the referendum in 2016. With hindsight, the strength of public finances and the economy is clearly wrong and remains a puzzle to resolve; the business cycle more generally has held up–something to ponder in the period ahead; the prediction of a new PM in Bojo was also (thankfully) wrong; while I completely failed to foresee the recalcitrance of Labour to push back meaningfully against Brexit alongside a few other details… but still, our current predicament was in broad brush terms there to foresee. As to Article 50 extension, which i thought would not be granted, it now seems more a question of whether the UK asks rather if the EU grants, but let’s wait and see. I give myself 6/10, perhaps optimistically.]


June, 2016, LONDON

THE TRAGIC murder the the United Kingdom MP Jo Cox—Member of Parliament for Batley and Spen, a small consistency in West Yorkshire—has prompted welcome introspection across the political spectrum about the divisive and confrontational style of the EU referendum campaign. Whether this horrific crime will have any impact on the outcome of the referendum remains to be seen—and will no doubt be debated for years to come. And whether the tone of British politics subsequently changes for the better will take time to reveal. But still the referendum goes ahead—representing the most significant political event in the United Kingdom (and perhaps the European Union) for a generation.

… In recent weeks a string of opinion polls put Leave in the lead. Markets have since woken to the possibility of the unthinkable—the exit of a major country from the European Union. Here we speculate on the contours of global politics after the vote. How will things unfold if Remain wins? And what if the unthinkable happens: what will happen if the UK Leaves the European Union?

Two Leave Scenarios: Happy and Unhappy Divorce

First, happy divorce. Amicable divorce is difficult to foresee. But it would look something as follows. Within the UK, it is agreed PM Cameron delivered his manifesto commitment to hold a referendum and should complete his term and negotiate exit from the EU. In Brussels, it is recognized the costs of a protracted breakup negotiation for the economy and regional relations would be large, so a relatively smooth renegotiation of the UK’s relationship should occur—including continued reciprocal access to goods and service trade. While the process could take longer than 2 years, mutually beneficial agreements to avoid disruption during the transition would reassure private investors. Such a “business as usual” solution would keep disruption and uncertainty to a minimum, freeing up the private sector to undertake productive investment; the impact on the European and Global economy from the UK divorce would be relatively pain-free.

Second, unhappy divorce. We can be sure that initial noises from all sides in the aftermath of a Brexit vote will be conciliatory and kind. Separation from the EU will be unlikely smooth, however.

UK politics. A huge march on Downing Street by those in favor of remaining in the European Union—including by those, such as EU nationals, without a vote in the referendum—will be an attempt to reopen the vote. But PM Cameron will likely have to resign—his tenure entirely overshadowed by the historic withdrawal from the EU. The resulting Tory leadership contest will shift the party to the right under PM Johnson. Fearful of the economic backlash, Westminster MPs—who are in largest part in favor of Remain—could refuse to back legislation needed to withdraw the UK from the single market and deliver on the referendum outcome. Meanwhile, the negative impact on the public finances of the economic slowdown would raise concerns about growing deficits and public sector debt—and the prospect of more austerity.

Domestic politics could delay triggering Article 50 of the Lisbon Treaty—which contemplates withdrawal from the EU. A new General Election will be necessary to add legitimacy to the government—whose mandate will be dominated by the need to renegotiate EU membership and revisit the public finances. The question of what the “correct” limit for net migration into the UK should be will be become a political football. UK political parties will be asked by the electorate to set out their positions on how the accumulated influence of EU laws in UK legislation should be revisited—opening up large areas of the social compact. Such minutiae will ultimately take decades to resolve. Meanwhile, given that EU law is incorporated directly into the devolved statutes in Scotland, Wales, and Northern Ireland, the division of regional competencies within the UK will be reopened. Scotland will quickly look for another independence vote—and will likely vote to leave the UK. The free movement of people across the border in Ireland will also be in question, given the scope for migration from Europe through this route. At a time of reemerging sectarian influence, the peace process in Northern Ireland could be called into doubt. Overall, as well as relations with the EU, many aspects of domestic political order will be open to scrutiny.

EU politics. It is typically argued that since the UK runs a trade deficit with the Euroarea (exports to EUR being about GBP40 billion per year; imports nearly GBP65 billion) it is in the interests of the European Union to deliver a swift renegotiation of the UK’s trading relationship. But this overlooks the legitimate concern that smooth EU exit will facilitate additional future withdrawals—at potentially huge cost for the European core. The main pre-occupation will therefore be to prevent others contemplating leaving the club. This could be done positively through measures to solidify the Eurozone—for example, by meaningful fiscal transfers and risk sharing. But such measures remain politically unpalatable. Most likely, therefore, renegotiation with the UK will become protracted and contentious. While Article 50 of the Lisbon Treaty allows for the unanimous extension of the 2 year renegotiation period, agreement will be unlikely. The UK will fall back on WTO trade arrangements once the 2 year period expires. Negotiations could drag on for a decade or more. The possibility of retaliation against trade in services with the UK or restrictions on the movement of UK citizens cannot be ruled out—especially if the UK migration limits begin to bind. A string of important parliamentary or presidential elections (Spain next week [2016], the United States in November; France and Germany in 2017; Italy and Russia in 2018) makes the constellation of political power and influence difficult to predict.

The resulting negative macroeconomic impulse in the UK and Europe of Brexit—as investment decisions are postponed—will be folded onto the already difficult ongoing global adjustment—in particular, the slowdown and adjustment across the EM world. More precisely, the compression of the UK current account deficit—and associated GBP depreciation—and wider Eurozone current account surplus will add to global deflation pressures. Pressure will grow on Germany to use fiscal policy counter-cyclically. And if China’s current account surplus continues to widen… additional pressure will be exerted on asset prices to equilibrate global saving-investment balances. Renewed USD appreciation and commodity price deflation could follow; major central banks will seek new tools to head off deflation.

Finally, some additional complications for the EU are likely to emerge if the UK leaves. First, Schengen and free movement of people. The previously sacrosanct notion that the free movement of people should accompany the free movement of goods and capital in the European Union will be increasingly questioned. A challenge to free movement of labor could accompany the next political cycle in Europe. Second, the EU budget. If the UK leaves the EU, other member states will have to fill a roughly EUR7 billion hole in the EU budget. Interestingly, due to a special ¾ reduction for Germany, Austria, Netherlands and Sweden in financing the UK’s rebate, the largest cost from Brexit will fall on these four countries (roughly EUR4½ billion of the EUR7 billion shortfall being met by these four, EUR3 billion falling to Germany alone.) With the cost of EU budget transfers already unpalatable, the EU budget formula will likely be open to renegotiation for the next multiannual financing framework (beginning 2021) with an outcome likely be negative for the balance of payments across Eastern Europe. Third, as noted above, momentum amongst anti-establishment parties will likely deliver another EU referendum in the near future.

In summary, the result of the EU referendum is unlikely to bring an end to the challenges facing Europe and the UK. Of most concern, it is difficult to build a benign baseline. For now, the best outcome would be a decisive victory for remain. However, regardless of the outcome of this historic vote, until there is some meaningful leadership from the core, the future of Europe will continue to be in doubt.

On the prospects for global macroeconomic policy coordination

AS NEW ECONOMIC Counsellor and Director of Research Department (RES), Gita Gopinath, settles into her new role at the IMF, what might her priorities be to make an imprint on the world’s premier monetary institution? Here’s a suggestion. She might begin by taking control of the IMF’s global forecasts—and do so with a view to rekindling the prospects for global macroeconomic policy coordination.

Let me explain. Already, RES is the conduit for the IMF’s macroeconomic forecasts—by collating and aggregating country-level forecasts produced by each team within the Fund, RES publishes at least twice a year through the World Economic Outlook (WEO) a forecast for the global economy. And while this process promises something of a consistency check on country-level forecasts, in truth this is little more than an aggregation exercise. This is witnessed in the left chart below, which shows the IMF’s forecast of the global current account (discrepancy) for different vintages of the WEO from 2008. The red lines are actual data, the blue lines the forecast for each vintage. Two things stand out. First, the world in the aggregate records a current account surplus of around USD400 billion. Historically, the world recorded deficits, mainly due to supposed under-reporting of investment income amongst advanced economies undertaking tax avoidance. But since the mid-2000s this global discrepancy has turned to a surplus. And this is now due to inconsistencies in the goods and service balance—advanced economies, like the UK and euroarea, both record bilateral service surpluses, for example. And it might be linked to growing world trade and emerging market predominance in the 2000s. But who knows?

screenshot2019-01-31at19.05.38Regardless, the second thing that stands out in the data is the IMF’s forecast of this discrepancy resemble the flailing legs of a wet spider crawling out of a swimming pool. Recall, this forecast is just the aggregate of individual country current accounts. Each mission chief undertakes to forecast, together with their team, macroeconomic variables for their assigned country, including the external current account. And RES, with a tweak here or there, aggregates these. As a result, the world might be seen to have an ever-larger current account surplus discrepancy as each country-team decides to forecast export-led recovery, as in 2008/09 when the discrepancy was expected to reach USD800 billion. Alternatively, and more often, IMF teams project domestic-demand led growth, with imports being absorbed and the global discrepancy shrinking—though the imports not being drawn from elsewhere, rather from thin air. The latest WEO, from October 2018, provides a good example of this. The global current account discrepancy was expected to shrink from a USD400 billion surplus in 2017 to a deficit of about USD100 billion by 2023. See right chart. Despite being joined at the hip, with near-mirror image current accounts, both the United States and China were expected to contribute, according to the Fund, by having a shrinking surplus (China) and increasing deficit (US). Meanwhile, Germany and Japan are expected to have widening surpluses, but nowhere near enough to match adjustments in China and the US. And so there is an asymmetry in numbers (>100 countries will contribute by moving towards larger deficits) and magnitudes, such that the world as a whole is seen to be moving towards restoring the aggregate deficit discrepancy by 2023. How can the US deficit be widening by USD300 billion over 6 years without other countries providing the imports for the US? Gibberish.

The problem with this is obvious. If the global discrepancy cannot be explained, it would be best to hold it constant in any global forecast—or if it does adjust, to have a very clear explanation for why it is adjusting, something the IMF does not have. But this also reveals that each country-team within the Fund is acting with little constraint on their forecasts, meaning they bring “country-level” knowledge in their forecasting without any “global consistency” to their analysis. In an increasingly integrated global economy, the failure to contemplate global consistency is a huge blind spot which cannot be compensated for by any amount of country-specific, institutional knowledge.

A household would not budget without making sure income and spending match over time. Yet the IMF does not care for such nuance at the global level.

Global inconsistency is politically convenient, of course. It allows each mission chief to verify, or deviate minimally from, the official forecasts provided by their country authorities. But it also makes a mockery of the notion that the IMF is the institution uniquely tasked with steering the global economy and helping coordinate policies to sustain global aggregate demand. If each country’s policies are evaluated in isolation, and the global forecast merely a simple aggregation exercise, there can be no prospect for policy coordination. The IMF cannot act as guardian of the global economy if she has no clue where the global economy is headed. And the principle of effective demand, the starting point for macroeconomics as a science, is rendered irrelevant if output is simply expected to fall like manna from heaven—and not be the product of spending by someone, somewhere, at some point.

Such is the case today, however. It has been clear for some time that China has become the key driver of global aggregate demand, the investor of last resort. And it has also been clear that China cannot, and should not be expected to, sustain a credit bubble to drive global growth. Rebalancing growth is both a China problem (lowering domestic saving) and a global challenge. Yet global forecasts ignore the need for monetary-fiscal-financial balance sheets to expand in a sustainable manner to deliver reasonable growth. These forecasts do not provide any meaningful guide to future developments. And so China has been expected, and is still expected, to punch above her weight in driving global growth, while Germany continues to abrogate her responsibilities agreed at Bretton Woods. And the IMF is rendered almost irrelevant, except at the margin, in delivering balanced and stable global growth.

So there is indeed a great deal indeed Ms. Gopinath can do to improve the IMF’s work, if she is willing to challenge the stale thinking and vested interests inside the institution. Otherwise, as with her predecessor-but-one, Mr. Blanchard, she can instead expect events to catch her off guard. Indeed, in this respect we ought recall the crucial role of a “kid” in prompting the IMF’s work refuting austerity—the greatest policy mistake in a generation or more—as told by Mr. Blanchard himself:

“The honest truth is, I had not focused on the assumptions which were made in the programs [in the euroarea] … or the forecasts we were making for other countries. And then at some point in 2010 and 2011 all these economies did much worse than forecast… And so I did, as the Head of Research, what anybody should have done, [and asked] where did these forecast errors come from? …

And then at a meeting, a kid, I mean just an intern, drew a graph of fiscal consolidation… and the forecast errors for output… and there was an amazing relation between the two. And so I realised… fiscal consolidation was much worse in terms of its effect on output than had been assumed in our projections and by the Europeans. And I thought it was an important result, but I didn’t realize how important it was.”


Hidden flows: Asset prices and eurosystem balance sheets

To suppose large and successive [external] balances to be formed into a debt is to assume an accumulation of debt which is almost equally incredible.

Henry Thornton, Paper Credit, 1805

PDF: Hidden information_FINAL.

Charts: Hidden information_chartpack.

THERE WAS ONCE a time when international macroeconomics was conducted largely through the prism of the central bank’s balance sheet. Absent all but patchy data or guesswork on external current or financial transactions—such as the overall goods and service balance or net lending abroad—changes in central bank reserve assets, typically specie, served as the only real indicator of net flows against the rest of the world—if not, of course, internal drain. Thus, monitoring balance sheets became crucial for investors.


While often neglected today, the central bank balance sheet continues to prove essential for parsing private financial flows and investor sentiment. This was brought into sharp relief when the eurosystem’s TARGET2 clearing system, and network of credits and debits across national central banks (NCBs), became essential for tracking financial flows at the height of the euro area crisis.

More recently, the ECB’s asset purchase program (APP) has provided liquidity across the system that has resulted in widening TARGET2 balances once more—and ever-increasing uneven distribution of eurosystem liquidity. Figure 1.

Germany’s TARGET2 credit, at €913bn in July, has come to mirror the combined debit position of Italy and Spain—at €471bn and €403bn respectively. And at first blush, the TARGET2 debits of Italy and Spain, which have steadily increased since the inception of APP, appear of the same genus—the two giants of the periphery experiencing broadly comparable net private financing flows as expressed through their debit balance.

However, care in interpretation is needed; not all TARGET2 debits are alike. How so?

While most of the public-sector purchase program (PSPP) is undertaken according to the eurosystem capital key, there are other aspects of APP—the ABS, covered-bond, and corporate sector purchase programs—which are also important and implemented by the ECB and select NCBs. Thus, while the total stock of assets held under APP amounts to €2.5trn as of August, only 82 percent of this total related to PSPP purchases; €0.45trn relate to the smaller purchase programs. Figure 2.


Moreover, within PSPP, purchases are split between national government bonds as well as supranational debt—initially supranational purchases were 12 percent 0f total PSPP, decreased to 10 percent in April, 2016. Figure 3.

And purchase of supranationals is determined by “a specialisation approach, [whereby] only a few NCBs buy securities issued by European supranational institutions… independent of the domicile of these international or supranational institutions” (emphasis added.)


These supranational assets include the European Investment Bank (EIB), European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM), for example.

Consider the following. The ECB balance sheet component of the eurosystem is only published annually. Between end-2014 and end-2017, ECB holdings of assets for monetary policy purposes increased €211bn, the counterpart to an increase in intra-eurosystem liabilities (i.e., TARGET2 debit) of €193bn, visible in Figure 1.

However, the system-wide increase in ABS, covered-bond, and corporate sector purchases, as well as purchases of supranationals within PSPP, over the same period was €573bn. In other words, under the totality of APP there are roughly €360bn in assets held for monetary policy purposes—beyond national government bond purchased by capital key under PSPP—which show up on the asset side of NCBs of the eurosystem.

For this reason, interpretation of the evolution of TARGET2 debits becomes nuanced. Imagine a NCB buying a supranational on behalf of the system, not domiciled locally. Then there will be an automatic increase in that NCB’s assets and, mechanically through TARGET2, liabilities. But this in no way reflects net private flows to the economy in question. For example?


Begin with the case of the Banco de España (BdE) which, thanks to the continuation of historical balance sheet reporting beyond euro membership, still provides a geographical breakdown of asset holdings. Table 1 summarizes BdE stock of assets as of end-2014 and end-July 2018.

Total assets of the BdE increased €363bn over the period, as expected during APP. However, domestic asset holdings only increased €251bn—comparable with cumulative purchases, through August, of SPGBs and related local assets of €254bn under PSPP. An additional €67bn assets over this period, however, relates to claims on the rest of the world—i.e., non-euroarea assets. And ECB reporting of total Spanish asset holdings for monetary policy purposes of €328bn as of August 3rd suggests BdE has engaged in the purchase of non-domestic assets under APP.

Given that most supranational assets eligible under APP are domiciled in the EU but not euroarea, the above data would be consistent with Spain undertaking supranational purchases under the PSPP on behalf of the system, for example.

Regardless, this is also confirmed by the balance of payments (BOP) data.

Figure 4 shows the net financial flows of BdE as reported by in Spanish BOP. Witness, since 2015, the steady accumulation of portfolio investment assets by BdE alongside other investment liabilities, meaning TARGET2 debits.


Figure 5 shows BdE holdings of euro-denominated securities by non-resident geographical breakdown. The imprint of PSPP is apparent in claims on rest of the world (ROW.)

Hidden_F5Why does this matter? It means some of the “deterioration” in the Spain’s TARGET2 balance since APP-inception—perhaps €20 billion per year—does not represent net private flows, rather the mechanical accumulation by BdE of foreign assets. And just as this might mislead as to private transactions today, the necessary future financial inflows to offset APP sales later will be correspondingly reduced.

Put another way, we can adjust Spain’s TARGET2 debit over the period for the accumulation of foreign assets. And this “shadow” TARGET2 debit would be a better indicator of cumulative private flows since APP.

Next contemplate Italy, the other giant of the euroarea periphery. Banca d’Italia (BdI) does not provide a comparable decomposition of assets by geographical location, so far as I am aware. But we do know the following.

BdI holdings of securities issued by euroarea residents from end-2014 through August increased €306bn. This compares with the ECB reporting on cumulative PSPP purchases of BTPs over the same period of €356bn, although the former represents transactions beyond those only for monetary policy purposes.

Alternative reporting by BdI puts the stock of assets held for monetary policy purposes at end-July of €383bn. Since data reporting only goes back to 2017 on this measure, we cannot make a comparable assessment of the change in asset holdings since 2014. But it suggests BdI has not been engaged in comparable non-resident asset purchases under APP. And this is indeed played out in the BOP data.

Witness Figure 6. BdI has hardly engaged in the purchase of non-resident portfolio assets. Roughly speaking, in contrast to Spain, the entire accumulation of TARGET2 debits in Italy therefore represents net flows of private investors.

Hidden_F6Recall Figure 1. Indeed, Italy’s TARGET2 debit drifted below Spain’s for the first time in 2016. But this might be expected given Italy’s larger size and thus purchases under APP.

What Figure 1 hides, however, is relative purchases of external assets under APP—purchases which mechanically drives a TARGET2 debit without reflecting meaningful action on the part of private investors. Thus, APP has in some sense exaggerated Spain’s debit position relative to Italy.

Figure 7 shows Spain’s actual TARGET2 debit as well as one estimate of the adjusted, or “shadow” debit—which adjusts for euro securities held against ROW.


What does this have to do with asset prices? Consider Figure 8 which shows—from July, 2012—Spain’s adjusted TARGET2 position minus Italy’s debit (right scale, € billions) against the Italy bond yield spreads over Spain (left scale, bps).

Net private transactions against non-residents, as reflected in residual liability claim by the respective NCB on the eurosystem, have steadily deteriorated for Italy relative to Spain. From about €150bn larger debit position at the time of Draghi’s “whatever it takes” speech, Spain’s TARGET2 (a smaller economy) has improved relative to Italy such that today Italy is about €120bn worse off.

Hidden_F8And these net private flows are reflected in the yield spread of Italy over Spain. Where Italy traded through Spain in 2012, this has now reversed. Arguably, the relative TARGET2 balance is suggestive of the future yield spread.

For amusement, Figure 9 shows the BdE asset and liabilities by residency (ignoring “unclassified” items.) The increasing role of claims on ROW is evident, as is the overall impact of PSPP, reflected in liabilities to the euroarea. But a growing pocket of domestic liabilities—bank deposits—represent a relatively recent trend, suggestive of improved net private flows serving as a buffer for the local economy against future adverse flows.


Is there more to be said on the growing nuance needed when interpreting TARGET2 today? Consider another, more egregious case. It is well known that Greece does not participate in the PSPP—they are precluded from the program and it looks unlikely they will benefit from substantial purchases before the program ends. But this does not mean the Bank of Greece (BoG) is not engaged in other aspects of APP. And they have indeed been accumulating their own small share of assets held for monetary policy purposes across the eurosystem. Figure 10.



BoG assets for monetary policy purposes bear the imprint of the earlier Securities Market Program (SMP) from 2010, but these were small and were steadily rolling off. Then, in 2015 Greek holdings of assets grew sharply—from €6bn end-2014 to €64bn end-August.

Since BoG also produces a breakdown of assets by geography, Table 2 gives the decomposition previously shown for Spain.


Since end-2014 total assets held by BoG are hardly changed—up by €3bn. But domestic assets—relating to emergency liquidity assistance and repo operations by the domestic banking system—have fallen €44bn, while foreign assets have increased €47bn. These foreign assets relate, of course, to the implementation by BoG of non-PSPP aspects of the APP.

We can apply a similar adjustment to Greece’s TARGET2 (plus banknote related liabilities) to get a measure of the true “shadow” balance therefore. Figure 11 does this. And in the case of Greece this balance notionally turned positive around the turn of the year. Were it not for APP purchases, net private capital inflows to Greece (and banknotes returned from beneath the mattress) would have been enough to generate a TARGET2 credit by now. It seems likely that over the next year or so if private capital inflows remain robust, Greece will attain an actual credit balance on TARGET2—remarkable for a country that has been constantly berated for being a debtor to the eurosystem.


As a corollary of this, BoG recently attained the largest net foreign asset position since euro inception. Figure 12.

Other countries that witnessed capital inflows and a turnaround from debtor to creditor within the eurosystem—such as Cyprus, Ireland, and Slovakia—also saw a sharp compression in government bond yields. One technical constraint for Greece that prevents such compression relates to the continued limits on domestic banks from buying GGBs which remain largely in non-resident hands.


Still, growing liquidity within Greece will contribute to improved credit creation, growth, ratings upgrades, and eventually a new set of investors to drive down yields—closer to peripheral comparators. If the shadow TARGET2 position is any indicator, Greek assets remain the cheapest in the euroarea by a considerable margin.


On debt sustainability, functional finance, and the transfer problem

Here are some notes on public debt sustainability. Since WordPress apparently cannot tolerate equations I am forced to post the pdf version here and the introduction and main themes below: On debt sustainability

Anyone invested in Argentina right now will benefit from reading till the end.

More generally, feel free to dip in. Comments welcome.


HOW OUGHT sustainability of public debt be assessed? And how should this assessment inform public taxation and spending decisions now and in future?

There are few questions of greater import in macroeconomics today. Yet answers remain elusive; often, discussions of fiscal policy are anchored by the need to attain a 60 percent debt-to-GDP ratio—or, more simply, the notion that public debt is too high. But why? What grounds are there for any debt target?

More worrying, perhaps, is the fact the international community struggles to understand lessons from the past decade. What is the correct stock of public debt? Why exactly was it necessary for Greece to default, but not Portugal? Is Argentina’s public debt today sustainable? We’ll get these questions.

Yet upon the opportunity to rethink debt sustainability analysis (DSA) in 2011, IMF staff acknowledged previous analysis “often turned into a routine exercise, with mechanical implementation of the DSA template, little discussion of DSA results, and limited linkages between the DSA and discussion of macroeconomic and financial policies” (¶2). At this crucial opportunity to fundamentally challenge and rethink sustainability—including key metrics such as the 60% debt-to-GDP target, the meaning of fiscal space, and the link between fiscal and external sustainability—the Fund doubled down on the pre-existing framework. We are stuck in the same old grooves of pre-crisis thinking.

That the framing of public debt and fiscal policy has barely moved on from a decade ago is a matter of huge concern. Absent policy tools following any near-future macroeconomic malaise, we ought carefully reassess our thinking. It is crucial we do not succumb to irrational fear of public debt; we need to sustain the flow of aggregate spending in the years ahead. We ought also educate the public against the false notion that public debt is always a burden—in fact, it can be a public good.

Unfortunately, economics lacks fresh thinking—groping in understanding, deflationary in mindset, atavistic in morality-of-debt thinking.

Fortunately, a conference in Washington, DC tomorrow offers an opportunity to set the record straight. Let’s pre-empt therefore five messages on public debt that ought emerge from this conference.

First, public debt need never be repaid.

Second, a 60% debt-to-GDP target is unnecessary, and for the public misleading.

Third, public debt reflects private savings.

Fourth, the complete, consolidated state balance sheet matters.

Fifth, sometimes the balance of payments matters most.