The ‘fiscal space’ charade – IMF becomes Moody’s advertising agency

The IMF has taken to advertising for the ratings agency Moody’s. It is a good pair really. Moody’s is a disgraced ratings agency and the IMF has blood on its hands for its role in less developed nations and for its incompetence in estimating the impacts of austerity in Europe. Neither has produced research or policy proposals that can be said to advance the well-being of nations. Moody’s has shown a proclivity to deceptive behaviour in pursuit of its own advancement (private largesse). The IMF struts around the world bullying nations and partnering with other institutions to wreak havoc on the prosperity of citizens. Its role in the Troika is demonstrative. Anyway, they are now back in the fiscal space game – announcing that various nations have no alternative but to impose harsh austerity because the private bond markets will no longer fund them. They include Japan in that category. Their models would have drawn the same conclusion about Japan two decades ago. It is amazing that any national government continues to fund the IMF. It should be disbanded.

As background to this blog, please read my blogs:

1. Ratings firm plays the sucker card … again

2. S&P decision is irrelevant

3. Time to outlaw the credit rating agencies

4. Ratings agencies and higher interest rates

5. Moodys and Japan – rating agency declares itself irrelevant – again

The IMF define – Fiscal Space – to be the :

… room in a government´s budget that allows it to provide resources for a desired purpose without jeopardizing the sustainability of its financial position or the stability of the economy. The idea is that fiscal space must exist or be created if extra resources are to be made available for worthwhile government spending. A government can create fiscal space by raising taxes, securing outside grants, cutting lower priority expenditure, borrowing resources (from citizens or foreign lenders), or borrowing from the banking system (and thereby expanding the money supply). But it must do this without compromising macroeconomic stability and fiscal sustainability – making sure that it has the capacity in the short term and the longer term to finance its desired expenditure programs as well as to service its debt.

It is always good to work with first principles as they will rarely lead you astray. They cut out all the humbug in the media, the statements by politicians and the ideological ravings of vested interests.

The above definition is not based on first principles but is an ideological statement. It assumes that the government in question has the same constraints that restricted governments during the gold standard when currencies were convertible and exchange rates were fixed.

Here are the relevant first principles, which many of you will know well by now.

In a fiat monetary system:

• A sovereign government is not revenue-constrained which means that fiscal space cannot be defined in financial terms.
• The capacity of the sovereign government to mobilise resources depends only on the real resources available to the nation.
• A currency-issuing government can always meet the liabilities it issues in its own currency.
• Nations that have ceded their sovereignty by entering currency zones (such as the Eurozone); by dollarising their currencies; by running currency boards; and similar arrangements clearly are not sovereign and face the same constraints that a country suffered during the gold standard era.

On September 1, 2010, the IMF released Staff Position Note SPN/10/11 – Fiscal Space. It contained some econometric modelling that sought to define how much scope there was for governments to expand their deficits.

It is a very dodgy piece of analysis (more later).

On December 20, 2011, the credit rating agency Moody’s released a special report – Fiscal Space. This paper informs Moody’s – fiscal space tracker, which purports to present a “fundamentals-based measure of the risk of sovereign debt default”.

The analytical framework used by Moody’s comes directly from the 2010 IMF paper. The credit rating agency just mimics the approach outlined in that 2010 Staff Position Note.

I do not recommend reading either paper. I have done the due diligence for you and I conclude that you are better to watch the grass grow or count socks in your drawer. Something like that.

This week (June 2015), the IMF released a new Staff Discussion Note (SDN/15/10) – When Should Public Debt Be Reduced? – which essentially attempts to repeat the same spurious arguments and methodology presented in the 2010 paper ((some of the authors of the 2010 paper overlap here).

In this new attempt, the IMF is now taken to advertising the work of Moody’s, which was just an application of its own work.

But they clearly thought that the fancy looking, multi-coloured graphic that Moody’s presented is worth repeating as a pedagogical device to ram homethe message.

Here is the graph (Figure 1 in the 2015 IMF paper). The graph has 30 nations which are classified as having either grave risk, significant risk, caution or safe in terms of an alleged “distance to debt limit”.

So it is bright enough! But not very smart.

Let’s apply those first principles. Here are the 30 nations with some extra relevant information.

Australia – sovereign issuer, freely convertible currency, no or negligible foreign currency debt.
Canada – sovereign issuer, freely convertible currency, no or negligible foreign currency debt (only for central bank reserve management).
Iceland – sovereign issuer, freely convertible currency, some foreign currency debt.
Israel – sovereign issuer, freely convertible currency, some foreign currency debt.
Japan – sovereign issuer, freely convertible currency, no or negligible foreign currency debt.
New Zealand – sovereign issuer, freely convertible currency, some foreign currency debt
Norway – sovereign issuer, freely convertible currency, no or negligible foreign currency debt.
South Korea – sovereign issuer, freely convertible currency, some foreign currency debt.
Sweden – sovereign issuer, freely convertible currency, some foreign currency debt.
Taiwan – sovereign issuer, freely convertible currency, some foreign currency debt.
UK – sovereign issuer, freely convertible currency, no or negligible foreign currency debt.
USA – sovereign issuer, freely convertible currency, no or negligible foreign currency debt.
Singapore – sovereign issuer, freely convertible currency, no foreign currency debt.
Switzerland – sovereign issuer, freely convertible currency, some foreign currency debt.
Denmark – sovereign issuer, loose peg to euro, some foreign currency debt.
Hong Kong (China) – sovereign issuer, pegged to USD

Austria – non sovereign in currency.
Belgium – non sovereign in currency.
Cyprus – non sovereign in currency.
Finland – non sovereign in currency.
France – non sovereign in currency.
Germany – non sovereign in currency.
Greece – non sovereign in currency.
Ireland – non sovereign in currency.
Italy – non sovereign in currency.
Luxembourg – non sovereign in currency.
Malta – non sovereign in currency.
Netherlands – non sovereign in currency.
Portugal – non sovereign in currency.
Spain – non sovereign in currency.

So those sovereign-issuing nations with no or negligible debt denominated in foreign currency have no default risk on their public debt associated with factors such as size of deficit, outstanding debt stocks etc. Their government’s can always meet their liabilities and would only default as an insane act of politics.

There are no financial risks associated with their debt.

I haven’t done a complete analysis of the proportions of debt that are denominated in foreign currency for the other currency-issuing nations. My feeling is (from old data) that the proportion varies but is small.

At any rate, these nations can always meet their domestic obligations (including servicing debt denominated in their own currency which is held by foreigners) but in some weird situation might find it hard to service their foreign-denominated debt. Highly unlikely but there is a smidgen of risk.

For the non-sovereign in currency nations – all of which are ‘happily’ ensconced in the failed Eurozone, they all face public debt default risk. The risk varies but they all are exposed to it.

So the first thing we conclude from this vacuous study by the IMF, which Moody’s thinks is useful for their purposes too (that should be warning in itself that something is not robust), is that it is a meaningless exercise to combine truly sovereign nations with no default risk with another block of nations, all of which face default risk.

The IMF concept of fiscal space is outlined more fully in the 2010 paper I cited above. Basically, they conduct a very contentious econometric exercise where they estimate the “debt limit” of each nation.

How do they do that?

They relate the primary fiscal balance (difference between government spending and revenue net of interest payments) to the outstanding public debt in what they term a “primary balance reaction function”.

This tells them what governments do with respect to fiscal policy at different debt levels.

They claim when debt is low, the primary balance is relatively unresponsive but as the debt levels rise, the primary balance “responds more vigorously but eventually the adjustment effort peters out as it becomes increasingly more difficult to raise taxes or cut primary expenditures further.”

So there is allegedly some debt level where the:

… primary balance does not keep pace with the higher effective interest payments (equal to the interest rate-output growth rate differential multiplied by the debt ratio), there will be a debt level above which the dynamics become explosive, with the public-debt-to-GDP ratio rising without bound. At that point, the government must either undertake extraordinary fiscal adjustment (i.e., primary adjustment beyond the country’s historical response to rising debt) or default on its debt. It is natural to consider this point the debt limit-and the distance to it from the current debt ratio to be the available fiscal space.

Effectively, they claim that the debt limit is when the private bond markets stop ‘funding’ the government and radical austerity is required.

They relate that reaction function with an “effective interest rate schedule”, which tells the government the rate at which interest payable exceeds the real growth rate of the economy multiplied by the outstanding debt. It is a growth-adjusted interest payments relationship. The technicalities need not concern us.

Essentially, the debt limit is reached when the debt and interest payments are so high that:

… there is no sequence of positive shocks to the primary balance (in the absence of an extraordinary fiscal effort) that would be sufficient to offset the rising interest payments. Therefore, debt becomes unsustainable, and the interest rate effectively becomes infinite.

Close down government time!

They put the numbers in the graph (above) to these concepts by econometric modelling. Essentially they run regressions which include explanatory variables such as:

Debt
Output gap
Trade openness
Inflation
Oil prices
Dependency ratio
Political stability
etc

The results should be treated with a grain of salt. I only list a few issues – there are many statistical issues that one could raise but in the interests of keeping this blog readable I will demur.

First, they do not differentiate between currency-issuers (as above) and the Eurozone nations (currency-users).

Second, they use technical dodges (ad hoc autoregressive corrections) to mop up estimation problems. These usually indicate a mis-specified econometric relationship and means that the model is incorrect.

Third, they admit that “the coefficients on the debt ratio, however, are common across countries; this is necessary because (as hypothesized) the response of the primary balance varies by the debt level, but the full range of debt is not observed for any individual country.”

That point is in a small print footnote to the results Table 1. What does it mean. It means they have not been able to freely estimate the most important unknowns in their model (the relationship between the primary balance and debt) and so they have just imposed the relationship on all nations.

In econometrics, this is called imposing a restriction on the model to simplify the estimation process. The problem is that such impositions should be stochastically ‘tested’ using significance tests. One examines the difference between the restricted model and the unrestricted model and uses special tests to determine whether these differences are statistically significant or not. If not, the imposition of the restriction is acceptable and simplifies the estimation process.

They did not do that. So the coefficients on the debt variables are essentially ‘made up’ and cannot be applied with confidence to all the nations (especially those with no relevant data).

Fourth, conceptually, the model ignores basic realities. The central bank of a sovereign nation can set whatever yield on public debt that it considers desirable. These nations might pretend they at the behest of the private bond markets but when push comes to shove, the central bank always dominates.

Please read my blog – Who is in charge? – for more discussion on this point.

So the idea that a government has to stop net spending or needs harsh austerity if the private bond markets start pushing up yields to ridiculous levels is ridiculous.

Even the ECB in the Eurozone has demonstrated it can control yields whenever it wants by buying up government bonds in secondary markets.

Fifth, a sovereign, currency-issuing nation does not even have to issue debt to maintain deficit spending levels at whatever level they desire. It can instruct the central bank to credit bank accounts at will. Given the propensity of such governments to impose voluntary restrictions on themselves, such a move might require a legislative change.

But the fact is that when the crisis hit these governments had no trouble getting cash.

Sixth, the case of Japan. The IMF/Moody’s modelling would have declared Japan to have zero fiscal space nearly two decades ago. This has been a repeated claim.

Since that time, Japan has continued to run large deficits and issue bonds and very low yields. It reached the IMF debt limit from their models years ago.

So how do they explain that?

In this blog – Moodys and Japan – rating agency declares itself irrelevant – again – I discussed earlier attempts by Moody’s to impose this moronic framework on Japan in 2011.

Even earlier, the same pantomime was played out in the 1990s. Japan is an advanced nation with currency sovereignty. In November 1998, the day after the Japanese Government announced a large-scale fiscal stimulus to its ailing economy, Moody’s Investors Service began the first of a series of downgradings of the Japanese Government’s yen-denominated bonds, by taking the Aaa rating away.

The next major Moody’s downgrade occurred on September 8, 2000.

Then, in December 2001, Moody’s further downgraded the Japan Governments yen-denominated bond rating to Aa3 from Aa2. On May 31, 2002, Moody’s Investors Service cut Japan’s long-term credit rating by a further two grades to A2, or below that given to Botswana, Chile and Hungary.

In a statement at the time, Moody’s said that its decision “reflects the conclusion that the Japanese government’s current and anticipated economic policies will be insufficient to prevent continued deterioration in Japan’s domestic debt position … Japan’s general government indebtedness, however measured, will approach levels unprecedented in the postwar era in the developed world, and as such Japan will be entering ‘uncharted territory’.”

The then Japanese Finance Minister responded (with some foresight):

They’re doing it for business. Just because they do such things we won’t change our policies … The market doesn’t seem to be paying attention.

Indeed, the Government continued to have no problems finding buyers for their debt, which is all yen-denominated and sold mainly to domestic investors.

In the New York Times (July 6, 2002) the logic of the rating decision was questioned:

How … could a country that receives foreign aid from Japan have a better rating than Japan itself? Japan, with an economy almost 1,000 times the size of Botswana’s, has the world’s largest foreign reserves, $446 billion; the world’s largest domestic savings, $11.4 trillion; and about $1 trillion in overseas investments. And 95 percent of the debt is held by Japanese people …

Former Moody’s President, John Bohn Jr. had in 1995 claimed that: “We’re in the integrity business: People pay us to be objective, to be independent and to forcefully tell it like it is.” (Reference: Ratings Trouble, Institutional Investor, October 1995: 245).

Integrity business history lesson

In January 2011, the – US Financial Crisis Inquiry Commission – which had been formed by the US government to “examine the causes of the current financial and economic crisis in the United States”, issued its final – Report.

Among the key conclusions were the following:

1. The “financial crisis was avoidable” – it was the “result of human action and inaction … The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essential to the well-being of the American public.”

2. “there were warning signs. The tragedy was that they were ignored or discounted.”

3. “The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not.”

4. “We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets … the financial industry itself played a key role in weakening regulatory constraints on institutions, markets, and products. It did not surprise the Commission that an industry of such wealth and power would exert pressure on policy makers and regulators. From 1999 to 2008, the financial sector expended $2.7 billion in reported federal lobbying expenses; individuals and political action committees in the sector made more than $1 billion in campaign contributions.”

5. “We conclude dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this crisis … Too many of these institu- tions acted recklessly … Our examination revealed stunning instances of governance breakdowns and irresponsibility”.

6. “We conclude a combination of excessive borrowing, risky investments,and lack of transparency put the financial system on a collision course with crisis … leverage was often hidden – in derivatives positions, in off-balance-sheet entities, and through ‘window dressing’ of financial reports available to the investing public.”

7. “We conclude there was a systemic breakdown in accountability and ethics”.

And in the context of today’s blog:

8. “”We conclude the failures of credit-rating agencies were essential cogs in the wheel of financial destruction:

The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors re- lied on them, often blindly. In some cases, they were obligated to use them, or regulatory capital standards were hinged on them. This crisis could not have happened without the rating agencies. Their ratings helped the market soar and their downgrades through 2007 and 2008 wreaked havoc across markets and firms.

The Commission used Moody’s as a case study. They said that the agency “rated 45,000 mortgage-related securities as triple-A. This compares with six private-sector com- panies in the United States that carried this coveted rating in early 2010”.

They found that “83% of the mortgage securities rated triple-A” by Moody’s in 2006 “ultimately were downgraded”.

The financial firms paid the ratings agencies to get these triple-A endorsements, while the ignorant public considered the ratings to be ‘independently’ derived from sound modelling. Nothing of the sort occurred.

Earlier, on April 23, 2010, the US Congress Permanent Committee on Investigations commenced a hearing – Wall Street and the Financial Crisis: The Role of Credit Rating Agencies.

After deliberations and evidence, the Committee, which has used Moody’s and Standard & Poor’s as “case studies” reported that “those credit rating agencies allowed Wall Street to impact their analysis, their independence, and their reputation for reliability. And they did it for the money”.

They found that the rating agencies “were operating with an inherent conflict of interest, because the revenues they pocketed came from the companies whose securities they rated … like one of the parties in court paying the judge’s salary”.

Further, the Committee found that the ratings agencies gave top ratings to financial products that they knew would not be “unlikely to perform”. For some products, up to 97% that had been given triple-A ratings were downgraded to junk status.

The Committee found the “credit rating models” were built on wrong assumptions, which was admitted by Moody’s and S&P.

Evidence showed the S&P operatives knew that there had been “rampant appraisal and underwriting fraud in the industry for quite some time” but the credit rating agencies “failed to adjust their ratings to take … [this criminality] … into account”.

A tawdry story no doubt.

Conclusion

It is amazing to see the IMF and Moody’s playing tag with each other and peddling the myths together. One is a disgraced ratings agency and the other had blood on its hands for its role in less developed nations earlier and more recently for its incompetence in estimating the impacts of austerity in Europe.

A good match I guess. Both should be disregarded.

That is enough for today!

(c) Copyright 2015 William Mitchell. All Rights Reserved.