The Power and the Money

The trillion dollar coin

The trillion-dollar coin ideas seems completely irresponsible on its face. Here you have a law that lets the U.S. Treasury mint commemorative platinum coins with whatever face value that it wants. So let’s have the Treasury mint a coin with “One Trillion Dollars” stamped on it and use that to finance the federal government if Congress refuses to raise the debt limit.

Uh … okay? That seems inflationary and rather banana-republic like. Crazy, actually.

But weirdly, it’s not crazy. There are two ways that the government can use the trillion-dollar coin to get around the debt limit without affecting inflation at all. One involves the active cooperation of the Federal Reserve; the other does not.

Here’s how it works. Start with the fact that the Federal Reserve (the “Fed”) has a balance sheet. Cash in circulation and bank deposits held at the Federal Reserve are liabilities of the Fed. Why is cash a liability? Well, at some point in the past the Fed printed it up and used it to purchase assets or reduce other liability accounts. So in accounting terms, it’s a liability.

More intuitively, cash is to the Fed what writing an IOU is to me. If I write an IOU and give it to you, it’s a liability. The IOU isn’t enforceable, though. (Well, unless you’re my brother and I’m 12 years old, in which case, yeah, it is.) So it’s a liability I don’t have to pay off unless I choose to. And if I do, say, sell an asset of mine to somebody in return for that IOU, I just throw the IOU in trash. A IOU to someone that I wrote isn’t an asset to me; what, I owe resources to myself?

So let’s start with the Fed’s balance sheet from September 30, 2021:

STEP ZERO:

ASSETS		LIABILITIES
U.S. Treasury securities	5,431,056	2,197,401	Currency in circulation
Federal agency debt securities	2,347	1,702,347	Repo agreements
Mortgage-backed securities	2,494,684	4,524,350	Deposits from banks
Mark-to-market adjustment	338,797	27,447	Treasury accounts
Loans	105,509	45,866	Other liabilities and capital
Foreign exchange	26,421
Other assets	35,704
Gold	11,041
Coins and treasury currency	50,853
TOTAL	8,496,412	8,496,412

On the liability side, we have the federal government’s deposit account. The federal government basically uses the Fed as its bank. (It would be so damn much easier to teach this to undergraduates if the United States would just call its central bank “The Central Bank of the United States” instead of the “Federal Reserve.”) Look at the two bold-faced categories. The Fed’s biggest asset is debt issued by the federal government: $5.4 trillion worth. It also holds reserves of coins and what is called “treasury currency”: i.e., old-fashioned dollar bills issued by the U.S. Treasury instead of the  Federal Reserve. The Fed is legally obligated to accept these when the U.S. government deposits them in its accounts at the Fed.

In other words, if the Treasury minted up a trillion-dollar coin, it could then go down to the Federal Reserve and deposit said coin into it’s deposit account. The balance sheet of the Federal Reserve would then look like this:

STEP ONE: Deposit the trillion-dollar coin

ASSETS		LIABILITIES
U.S. Treasury securities	5,431,056	2,197,401	Currency in circulation
Federal agency debt securities	2,347	1,702,347	Repo agreements
Mortgage-backed securities	2,494,684	4,524,350	Deposits from banks
Mark-to-market adjustment	338,797	1,027,447	Treasury accounts
Loans	105,509	45,864	Other liabilities and capital
Foreign exchange	26,421
Other assets	35,704
Gold	11,041
Coins and treasury currency	1,050,853
TOTAL	9,496,412	9,496,410

STEP TWO: Spend the money in the Treasury’s account

The federal government now has a trillion dollars deposited at the Fed, and the Fed has a trillion-dollar coin sitting in a vault somewhere. The federal government, of course, now wants to spend the money sitting in its deposit account. So it will! Presumably its spending will wind up in the checking accounts of recipients (although some will likely end up as cash in circulation) so for simplicity’s sake I’ve moved the liabilities from the Treasury’s account at the Fed to the deposit accounts that banks keep at the Federal Reserve.

ASSETS		LIABILITIES
U.S. Treasury securities	5,431,056	2,197,401	Currency in circulation
Federal agency debt securities	2,347	1,702,347	Repo agreements
Mortgage-backed securities	2,494,684	5,524,350	Deposits from banks
Mark-to-market adjustment	338,797	27,447	Treasury accounts
Loans	105,509	45,864	Other liabilities and capital
Foreign exchange	26,421
Other assets	35,704
Gold	11,041
Coins and treasury currency	1,050,853
TOTAL	9,496,412	9,496,410

Isn’t that inflationary?

Well, by itself, no. And not just because (as we’ve discovered over the past 13 years) printing money isn’t always inflationary.

STEP THREE: Fed open-market operations counteract increases in the monetary base

The move will not be inflationary because the Federal Reserve can simply sell its holdings of Treasury securities. People will buy those holdings for cash. I’ve assumed here that they will buy those holdings using deposit accounts at various banks, which will ultimately lead those banks to hold fewer deposits at the Fed, but it could show up as a reduction in any of the Fed’s liabilities.

And voila! We are back more-or-less where we started. 

ASSETS		LIABILITIES
U.S. Treasury securities	4,431,056	2,197,401	Currency in circulation
Federal agency debt securities	2,347	1,702,347	Repo agreements
Mortgage-backed securities	2,494,684	4,524,350	Deposits from banks
Mark-to-market adjustment	338,797	27,447	Treasury accounts
Loans	105,509	45,864	Other liabilities and capital
Foreign exchange	26,421
Other Federal Reserve assets	35,704
Gold	11,041
Coins and treasury currency	1,050,853
TOTAL	8,496,412	8,496,410

But now all the Argentines reading this are screaming. We’ve discovered is a way to subvert the independence of the Federal Reserve and force it to finance federal spending by printing money! Isn’t that a problem?

STEP FOUR: Replace the coin with new debt

Well, I can understand that we might not want to set a precedent here. Congress can get it’s act together after-the-fact, abolish the debt ceiling, ban the minting of new trillion-dollar coins, and issue one trillion in federal debt to make up for the coin-based spending. It can then order the Treasury to hand over the newly issued trillion-dollars in debt to the Fed in return for the coin, which can then be melted down (or, preferably, demonetized and put in the American History Museum at the Smithsonian).

ASSETS		LIABILITIES
U.S. Treasury securities	5,431,056	2,197,401	Currency in circulation
Federal agency debt securities	2,347	1,702,347	Repo agreements
Mortgage-backed securities	2,494,684	4,524,350	Deposits from banks
Mark-to-market adjustment	338,797	27,447	Treasury accounts
Loans	105,509	45,864	Other liabilities and capital
Foreign exchange	26,421
Other Federal Reserve assets	35,704
Gold	11,041
Coins and treasury currency	50,853
TOTAL	8,496,412	8,496,410

There is an alternate path that solves the inflation worries, although it sets an even spookier precedent. If the Federal Reserve agrees, we could just jump straight to Step 3, except instead of selling Treasury securities on the open market the Fed sells $1,000,000,000,000 worth of federal debt back to the U.S. government in exchange for the trillion-dollar coin. Poof, $1 trillion in debt is wiped out and the U.S. government finds itself back below the debt limit, with no worries about money creation.

What are the counterarguments? Well, it would set a lousy precedent, but as we explained above, Congress can easily close the loophole if it wanted to.

Minting a trillion-dollar coin does represent yet another transfer of authority from the legislature to the executive, but the United States has had a dysfunctional legislature (at least on some things) for quite a long time—and playing chicken with the debt ceiling represents a particularly dangerous kind of legislative dysfunction. 

(Senatus delenda est. Senatus delendus est.)

The real worry is that Congress won’t do anything and we will wind up paying off more and more of the federal debt with trillion-dollar coins. That seems unlikely to me, but I think everything about the present-day U.S. Congress — particularly the Senate’s advanced state of decay — would have seemed unlikely to me back in 1990.

I suspect that it won’t come to this. I fear, however, that it will come to what I consider a more dangerous route: the Biden administration simply declares that the debt ceiling violates the sentence in the 14th Amendment that reads, “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.”

The legal argument is that Congress authorized the issuance of debt when it passed the budget, so the debt ceiling therefore questions the validity of the debt. I am not a lawyer, but I don’t find that convincing. The last thing the country needs is more executive aggrandizement.

Unless the alternative is chaos.

Dammit.

Observatorio argentino 49: Post-election roundup

The left-wing ruling party in Argentina appears to be in the middle of a complete collapse.

Background

The party, called the Frente de Todos (or “Everyone Front” or “Front for All” both of which sound as clunky in English as it does in Spanish so don’t ask me to explain the name choice) is a coalition of all the old Peronist parties. Peronism is a big tent without much coherence, but it would not be inaccurate to say it is currently divided between moderates and a more radical faction led by Vice-President Cristina Fernández de Kirchner, aka “CFK.”

CFK and her followers are genuinely radical — a long time ago I met the current Governor of Buenos Aires province, Axel Kicillof. He seemed to be the real deal and I have to admit that I have some respect for the way he dealt with the country’s foreign creditors.

But CFK herself is also spectacularly corrupt. She’s under a legal cloud, protected by her position as Vice-President.

The current president, Alberto Fernández (no relation) is a moderate. Rather than fight it out with him for the nomination in the 2019 primary — and thereby risk losing, and thereby risk jail time — she joined him on the ticket as Veep.

The Election

So, as you know, the Frente got hammered in Sunday’s primary elections. The opposition held some actual primaries; the Frente for the most part did not. What the election was for the Frente was a preview of what the real election in November will look like, and it was bad.

For a good overview of the election (well, besides mine, ahem) see Maia here. I like her take on Javier Milei, a seriously batshit insane libertarian candidate for Congress. Seriously, watching the stunned look on an Argentine reporter’s face as he discovers that a woman in one of the capital’s poorest neighborhoods voted for Milei is priceless.

Votante de Javier Milei en la Villa 31 pide que se terminen los planes sociales, "le sacan al que está en blanco para darle a gente que no quiere laburar". Estamos frente a un evento histórico.pic.twitter.com/33OxJIqbth

— Pregonero 🗽 (@PregoneroL) September 15, 2021

But Milei is an aside, at least for now. The key question here is why the Frente did so badly.

For the answer to that question, you can really begin and end with Covid. Massive lockdowns failed to prevent its spread — Argentina did not become Australia. The economy failed. Then the government botched the vaccination rollout, getting into a food fight with Pfizer over legal immunity. Finally, President Fernández got into some Gavin-Newsom-level bad optics for flouting his own rules. Leticia Abad and I are going to try to write a more rigorous paper about the election, but Maia has a great overview.

The Normal Reaction

As I expected, the Frente immediately rolled out a slew of populist economic policies intended to provoke an electoral recovery by November. Minimum wage up 10%. Zero-percent government loans to wage laborers. A US$32 bonus to senior citizens. One that really annoys me: natural gas subsidies between 30% and 50%. One that doesn’t: lots of construction. (See right for a picture of a commuter rail line they rolled out in 2019 at a speed that would impress China and makes the U.S. look very very sad.)

Argentina also has a small universal basic income (IFE) put in place during the Covid recession. The government will now means-test it but also make it bigger for poor families.

And from where will come the cash? First, they intend to go tell the IMF to screw off and forget about getting principal payments for a while. (Interest will be paid, so no default, and honestly the IMF has rolled over for greater demands in the past.) Second, they’ll keep on printing more money and transferring it to the Treasury:

Hey, it could staunch the bleeding by November, and to be honest the economic cost probably won’t be that high.

The Crazy Reaction

Only, well.

CFK seems to think she’s actually running the administration from behind the scenes. She demanded that the actual President fire a whole bunch of his cabinet and put a bunch of her people in place.

And then CFK’s achichincles started yelling that the President is actually a “squatter” in the Casa Rosada. One congresswomen put it this way. “He’s renting the office, he doesn’t understand that he’s renting. The owner of the votes, the legitimate owner, the owner of popular support, the owner of the base that sustains this government and one that put him there is Cristina! Alberto Fernández couldn’t dream of even being an alderman.”

You’re not supposed to make the subtext into text when you’re trying to run things from behind the scenes!

If CFK was really pulling strings the way that, say, Plutarco Calles did back in the day in Mexico, well, then she wouldn’t need to send messages telling the nominal President to fire people. She would just wave a finger somehow and the people would get fired.

But although she is many things but she is not a Plutarco Calles. President Fernández isn’t going to quietly back down, because CFK isn’t really in control and she has given him no graceful way to give her what she wants. All she is managing to do is make the Peronists look really really bad to swing voters.

It is possible seeing try to CFK bludgeon her way back into the driver’s seat will inspire Peronists who stayed home this Sunday to make their way to polls to support the Frente in November.

But how likely is that? First, as I mentioned, you can’t replace candidates now: unless enough the Frente candidates on enough slates proclaim their loyalty to Cristina, any votes for the Frente will be votes for Alberto’s people. “Vote for Alberto’s useless incompetents because you need to do that in order to vote for Cristina” is not an inspiring message.

And are there really all these uninspired Peronists sitting out there? It is true that turnout collapsed during the primary. But … Covid, maybe? And maybe people are realizing that PASO isn’t a real election?

In short, I’m not seeing much here that makes it look like November will be any better for the Frente and I am seeing a lot of things that could make it look much much worse for them. Shiny new infrastructure notwithstanding.

Make Canada Greater: What would change if New York joined Confederation?

I am reading “Divided We Fall” by David French. He may be the first thoroughly mainstream commentator to seriously posit that the American federation may break up under the weight of our political differences. Cheery reading for another happy election day, or not.

Even a mutual breakup of the United States would be a tragedy, but not because of American exceptionalism or any such thing. No, any collapse of a political union is a tragedy. It means that differing peoples could not share a fate or manage a common endeavor. It means shrinking horizons and cramped futures. Even when divorce is better than the realistic alternatives, it is still a tragedy. 

But there is one way that the American federation could break up and avoid such a tragedy! Instead of retreating into smaller polities, blue American states that wanted out (or were being thrown out) could replace one expansive continental dream with another. They could link their fate with their better-governed neighbors to the north!

Such a move would also be amazing validation of the Great White North—for Canadians to reject it would show a lack of confidence and a fear of dreaming big. Canadians should have confidence and dream big! (Yes, I thought Maximum Canada was a great read, why do you ask?)

One Canadian certainly has no fear of success: the Prime Minister invited American states to join as new provinces!

But enough with the blather. Let’s say something happened to crack the American federation. What would a switch entail in practical terms? In order to get my mind off the damn election (and grading exams) I decided to take a preposterous idea seriously. What would happen if New York State became the Province of New York?

The name

Well, first, NYS would not need to rename itself. Canadian law can handle a province that calls itself a “state” as easily as the U.S. constitution handles states that call themselves “commonwealths.” But let’s call the new jurisdiction “New York Province” anyway, just to make things easier.

Integrating the judicial systems

The biggest issue isn’t the one you’d think. (Although I’m getting there.) The biggest issue is that under current Canadian law, state criminal law will be replaced by the Canadian federal criminal code. The transition would be tough. State judicial elections would go out the window. I think you could continue to elect the Attorney General, but her authority would shrink considerably. You could probably continue to have elections for sheriff, but it would also be a departure from Canadian norms. The Canadians would also have to decide how much leeway to give New York in its civil codes. If they mandate that New York conform to the Canadian system, then civil courts will lose much of their power and many trials that were previously decided by juries will switch to judges.

Integrating the two systems would be a major headache for judges and lawyers. I have no idea how long it would take them to adapt. One year? Two? Ten? Canada would have to agree to long phase-in period during which the New York court system would be linked to Canada’s but not integrated into it. During this time every lawyer in New York State will have to effectively retrain. Law schools would also have to revamp their curricula.

Alternatively, the Canadians could work out an exception for the new province(s). Conceptually, such an exception would be relatively easy to implement and administer. (Australia and the United States do it and New York allows certain municipalities to create their own criminal offenses.) It would be a departure for Canada but it would not mean that the federal criminal code would cease to apply to New York. Rather, it would mean that New Yorkers were subject to two (or three) separate criminal codes, much as they are today.

Business ownership

In some industries, American companies operating in the state that weren’t locally owned would be required to pull out and sell their assets in that state to a Canadian company. (Canada would of course now include New York and any other states that made the switch.) These industries are pretty broad, including transportation, airlines, railways, shipping, publishing, financial services and telecommunications.

Telecoms and airways are pretty straightforward. U.S.-owned airlines would need to divest their operations for point-to-point flights between New York and other parts of Canada. Ditto, telecoms companies would need to sell or spin off their New York operations. Canada has been pretty liberal with allowing foreign ownership of transportation companies, so there shouldn’t be major problems for trucking or railroads. Some retail chains might want to spin off their New York operations, but that won’t be that difficult.

Some banks with equity of $8 billion or more and large demutualized insurance companies would need to be restructured. Canadian law requires that no person may own more than 20 percent of any class of voting shares or 30 percent of any class of non-voting shares. In addition, a majority of the board of directors and the CEO of every bank or federal insurance company would need to be Canadian residents.

Publishing is a weird one. Existing operations would only need to sell their operations to Canadian buyers if they intended to acquire an existing Canadian company. But it’s equally likely that you’d have big New York publishing houses would not qualify for Canadian subsidies or be able to acquire smaller Canadian competitors. It would probably get weird very quickly, but there shouldn’t be any constitutional problems. The Canadian government could continue to protect small Canadian operations against large New York-based Canadian operations. Of course, how long that would last once the New York representatives from the federal branch of the Working Families Party entered the Canadian parliament is a different question …

Unions

New York employers are going to be unpleasantly surprised. Most New Yorkers are going to love it. Of course, a lot depends on what the politicians in Albany do with their liberation from the strictures of American labor law.

Gun laws

There may be some disquiet in parts of upstate (as there is in rural Canada) but most New Yorkers are going to love this as well.

Fiscal federalism

Canada channels significantly fewer resources through its federal government than does the United States. Gross federal spending in New York (sans interest payments and direct purchases of goods and services) came to 13.2% of state GDP; the equivalent number for Ontario was only 10.9%. (The high level of direct purchases in Ontario is due to the fact that the federal government is based in Ottawa.)

Let’s take each category in turn. For retirement spending, the transition would be smooth. Canada could take over Social Security payments for existing retirees without much problem while transitioning younger workers into the Canada Pension Plan and Old Age Security.

For other transfers (not including medical care) the Canadian federation is about as generous as the United States, giving a bit more directly to individuals and a bit less to the governments of rich provinces like Ontario. (The whole thing is actually distorted by Alberta’s oil money, but let’s leave that for now.) On the margin, New York Province will receive a bit less non-health federal aid than New York State.

Federal spending and taxation as a % of jurisdictional GDP

	Retire-ment	Medical care	Revenue sharing	Individual transfers	Goods and services	Total spending	Gross federal taxation	Surplus to Feds
Ontario	5.1%	1.7%	1.8%	2.2%	4.0%	14.8%	(18.2%)	(3.4%)
NY State	4.6%	4.7%	2.5%	1.5%	1.4%	14.7%	(16.3%)	(1.6%)
NY Province	4.6%	1.1%	1.6%	2.2%	1.4%	10.9%	(18.2%)	(7.2%)

But health care … oh boy. A back-of-the-envelope calculation (using 2014 numbers, so at the beginning of Obamacare) shows that public and private entities in New York state spent about 8.4% of GDP on covered medical services. That’s more than most Canadian provinces, since health care is more expensive in the USA, but not prohibitively so: the Province of Ontario spent 7.1% of GDP in 2014.

New York is going to have a problem under the Canada Health Act. Medicare and Medicaid transfers from the U.S. federal government will dry up, and here (somewhat perversely) the United States is way more generous than the Canadian confederation. New York will lose Medicare and Medicaid money worth 4.7% of GDP. The Canadian Health Transfer (CHT) would come to only 1.1% under the current formula, blowing giant holes in the New York provincial budget. New York State currently spends about 2.0% on Medicaid, but adding the Canadian Health Transfer to that leaves a minimum budget hole of 5.3% of GDP (8.4% covered spending that will need to be made free – 2.0% existing spending – 1.1% CHT.)

And that figure of 5.3% is a minimum since Medicare and Medicaid are (again, perversely, I know) more generous than Canadian health care, even though they require co-pays. (More generous for the minority of people that they cover, that is.) You can’t tell seniors that they are going to be worse off now that they are Canadian, can you? That would be thoroughly un-Canadian!

New York Province could fill the hole with a VAT rate of 12% on top of existing sales taxes, or a tripling of state income taxes, or some combination thereof. That’s not an impossible thing. In this world where the U.S. peacefully divorces passing some version of Medicare-for-all should be popular. But it would be very expensive. Add to that the fact that the province would be passing upwards of 7% of GDP to Ottawa and becoming Canadian looks like a bad deal, even with all the benefits from being part of a big continental federation. 

Only there is here the outline of win-win deal for everyone involved, which is simply that New York Province is going to be a huge net payer into the Canadian federal budget.

The Canadian federal government could sign a Medicare Accession Grant Agreement (MAGA) with New York Province that would kick back, say, half the cost of establishing single-payer system. New York would get a federal tax point transfer worth 4.2% of GDP, and the Canadian taxpayers would still come out ahead with a net transfer of 3.0% of New York’s GDP. Win-win for everyone!

TLDR: Joining confederation would be a headache and New York would lose some fiscal revenue from the federal government. But if Ottawa is willing to be flexible it could be a win-win for everyone involved. 

I leave the effect on Canadian politics as an exercise for the readers ...

Macri and motivated reasoning

Abad and Maurer here, with some thoughts on the next 50 days. 

President Macri has only one chance at re-election. That is to villify his opponent. The markets tanked when it looked like Fernández might win, he has to say. Fernández will turn us into Venezuela. Fernández is corrupt. And Fernández is a sock puppet for the other Fernández, Cristina, who plans to eventually turn the keys over to her idiot son. 

In other words, he has to go negative in a way that would make Donald Tr ... well, in a way that Donald Trump would be entirely comfortable with doing. 

Now, the polls show that Macri is underwater by a lot; it is that they show Fernández breaking the magic 45% you need to avoid a second round. One poll had it 55% to 33%. Another put it at 49% to 32%. You can see a whole bunch of similar results here from Clarín. Worse yet, most of the public blames Macri for the crisis. 

So villifying Fernández probably won’t work. But it might. There is private polling data (obtained by Leticia Abad) that indicates he could pull it out. And the election is 46 days away (as of September 11), which is a long time in politics. People engage in motivated reasoning all the time. Macri could easily convince himself that mudslinging will work, and even if it doesn’t, he has to try anyway to keep those evil Peronists out of the Casa Rosada.

The thing is, Macri has to avoid that temptation.

Argentina’s creditors won’t talk to Macri unless the next administration gives at least its tacit agreement. Moreover, Argentina would be well-served by having the lame duck president rip off the band-aid. That would not just make economic sense, it would make it much easier politically for Fernández to fight political pressures to make things worse. 

In other words, Macri should admit that he is a lame duck (at least in private) and get Fernández on board. Hell, in the long run it might even get him a good spot in the history books. 

All he needs to do is overcome basic human nature and hope his opponent can do the same.

More on that in our next post ... 

Argentina tries to stem the panic

Leticia Abad and Noel Maurer here again, reporting on some news that while not unexpected, has arrived unexpectedly prematurely. 

Imagine you are a banker in the mid-19^th century. All of a sudden, you observe more and more people demanding that your banknotes be converted to hard currency. After a couple of days, this is getting serious and you see your reserves plummeting: this is a bank run!

If the bank were in a weak position to start with, then this bank run could have been warranted. The banker will stop paying when she runs out of reserves. But sometimes bank runs are just panic for panic’s sake. Then, as a banker you could refuse to convert these notes to restore sanity, to calm people down.

Now, replace “ban”k with Argentina. The bank run is a peso run. Welcome to President’s Macri’s life.

Since the last post, our dear country has not managed to hold a steady course. The Central Bank keeps on hemorrhaging dollars and technically the country has defaulted, well, selectively, according to rating agencies.

Right now, the federal government is facing substantial payments on its dollar-denominated debt over the next few months. (See the below chart.) That means that the federal government will need to dive into the market to get dollars make the payments. (The Argentine federal government, not surprisingly, collects tax money in pesos.) That will lead to one of two things: (1) A further fall in the value of the peso against the dollar, which would be very bad; or (2) A big drain on the Central Bank reserves as the bank provides the government with the dollars it needs, which would also be very bad, since those reserves are falling fast. 

So what to do? 

Well, ask creditors to let you postpone the payments.

On August 28th, to hold on to its foreign currency reserves, the government tried short-term debt management. It unilaterally extended the payment of short-term bonds on August 28th. That lasted a day. Then the government came up with a plan for further extending repayment — or as they call it a“reprofiling.”  (Check #reperfilar for the corresponding memes).

My favorite: Reprofiling is the new “we need to talk.”

The renegotiation applies only to firms; individual creditors will receive payments as expected. This move should free up around $13.4 billions of reserves.

In other words, let’s kick the can down the road!

This strategy to ease the peso run failed quickly. The dollars kept on leaving the Central Bank’s vault.

To quell the panic, the Macri administration’s second move was the national equivalent of having the banks close their doors to depositors during a run. Capital controls ensued, first for foreign banks to repatriate profits. Then yesterday (on Sunday!) the government issued an emergency decree establishing good ol’ capital controls. All firms now require authorization to operate in foreign currency. Individuals have a cap of $10,000 per month on how much money they can change. Today will be the opposite of a banking holiday, withthe Central Bank extended banking hours until 5 pm (normally banks close at 3 pm).

President Macri decided that it’s better to adjust now when he has lots of reserves than adjust later. Will that stop the panic and make Argentine and foreign investors calm down?

It is clear that this is a last resort, as President Macri denounced capital controls during his presidential campaign. Since the primaries, he is facing an uphill battle to, at best, make it to a second election round. Hence, he is trapped between being a president and a candidate. From the quasi-populist policies announced two days after the elections to the imposition of capital controls binding for firms, he is trying to stabilize the country in hopes of attracting more votes. At the very least, he is trying to avoid to leave De-la-Rua-style — i.e., in a helicopter — before the end of his term.

All this, of course, has implications for the election and what the next president will do. Wait for the next post!

Buying Greenland

Back in 2009, I made the modest proposal that Iceland become an unincorporated territory of the United States. It wasn’t serious. 

But it looks like the Trump administration is serious about buying Greenland. Or, well, “serious,” because it is the Trump administration. To start with, they want to negotiate with the government of Denmark, when they should be negotiating with the government of Greenland. Constitutionally, Denmark does not have the authority to transfer the sovereignty of Greenland to anyone but the duly-elected government of Greenland.

But the government of Greenland, well, it can do whatever it wants.

So what the hell! I have seen some numbers out there and I think that I can do better. What price would make sense and make it hard for the Greenlanders to refuse?

The administration could offer every resident of Greenland a cool one million dollars, or $57 billion. It could also promise to take over the $535 million Danish annual transfer payment. In fact, the U.S. could do Denmark one better: in 2009, Denmark froze the transfer in nominal terms. (See Kevin McGwin, Denmark’s annual state of the kingdom report paints a rotten picture of Greenland’s economy, The Arctic Journal, April 20, 2017.) For some reason the number $750 million keeps getting thrown around, so let’s say we up our subsidy offer.

So would that be overpaying? Well, it turns out that in 2014 the Danes estimated that the mineral and oil rights under Greenland would bring in a cool $69.8 billion over the next 40 years. At the current U.S. 30-year-bond rate of 2.07%, that would have a net present value of about $47.9 billion. Subtract from that the $20.3 billion 40-year NPV of the subsidy, and you have a get that Greenland’s mineral rights are worth about $27.6 billion, or $485,000 per Greenlander. 

Is there a strategic value to Greenland? Yes, but we already have that! A 1951 Treaty gives the U.S. carte blanche to do pretty much whatever we think we need to do, subject to a potential Danish veto over the establishment of new military facilities. Is getting rid of that veto worth $27.6 billion? 

No, but come on. We all know that Trump wants to buy Greenland because it would be cool and awesome. That would be worth $27.6 billion. Or he could just offer each Greenlander $485,000 and see if they bite. 

Any Greenlanders out there? Could you get a majority to vote to become an unincorporated territory of the United States for somewhere between a half-mil and a mil for every woman, man, and child on the island?

Of course, getting concurrent majorities in the House and Senate or getting two-thirds of the Senate to approve the resulting agreement would be ... difficult. Still, somehow Jimmy Carter managed to get the supremely unpopular Panama Canal Treaty passed.

That said, Donald Trump has not exactly proven himself to be a master of the Senate. 

And that, of course, is why this boneheaded idea is not going to go anywhere. I suspect that President Trump could bribe the Greenlanders to switch metropoles. I do not for a minute believe that he can bribe Moscow Mitch (let alone Nancy Pelosi) to get them to agree to drop $27.6 billion (let alone $57 billion) on this vanity project.

I have to admit, though, that the sheer craziness of the fact that I am writing this as an analysis of a real proposal by the POTUS has me quite amused. And scared, but mostly, for the moment, amused.

Observatorio argentino 42: nobody is suggesting another default

I am in Argentina, my favorite country among all countries. Some of you may know that Argentina is in the middle of a presidential election campaign.

Background: The two main tickets are Macri-Pichetto and Fernández-Fernández. Mauricio Macri is the current president. He dumped his previous running mate in favor of a moderate Peronist, in order to (he hopes) siphon off some Peronista votes. Alberto Fernández was the chief of staff under the Peronist presidencies of Néstor Kirchner and Cristina Fernández de Kirchner (CFK). Everyone expected CFK to run for president, but she pulled a fast one and decided to run as Vice-President with Alberto (no relation) fronting the ticket. 

The controversy: Alberto Fernández declared that he was going to finance higher pensions by halting interest payments on “Leliq” bonds issued by the central bank. A firestorm ensued ... although not in the financial markets. They did not care. But the big agribusiness head convened at the La Rural exhibition to denounce default. Pichetto announced that it would cause a currency crisis. Everybody went running for cover.

Except ... well. Here is the thing. Leliqs are seven-day bonds issued by the central bank. Fernández proposed to stop paying interest on new ones. After all, they turn over every week. He did not propose defaulting on outstanding debt.

Now, all is not well with Fernández policy. After all, it is not clear how having the central bank stop interest payments on short-term notes is going to free up money for the federal government. In addition, the central bank conducts much of its monetary policy via the issuance of Leliqs, which it uses to mop up excess liquidity. That will not really work if they pay no interest. So the idea is kinda silly.

But nobody is proposing another default.

Yet.

Reposted without comment from March 2016: How much could President Trump win from our s̶a̶t̶r̶a̶p̶i̶e̶s̶ allies?

 So, Donald Trump wants to turn America’s hegemony into a protection racket. Okay, then. How would those negotiations go?

First thing to do is estimate how much the U.S. could save by pulling out of Germany, Japan, and South Korea.

First take: billions and billions! The link goes to a 2009 study by the Commonwealth Institute. They get a cost of $127.1 billion for fiscal 2010: $132.1 billion in cost minus tribute host payments of $5 billion. (Page 9.) But that estimate is dumb. It simply pro-rates the defense budget by the number of personnel stationed overseas. Now, maybe some president might save all that money by simply downsizing the military. (Well, the Army would be “downsized” in that scenario; the Navy would be gutted.) 

Since Trump has made it clear that he has no intention of shrinking the military, then those personnel will simply be redeployed back to the United States. 

Second take: In 2013, the U.S. Senate took a look at basing costs. It estimated costs around $10 billion, 70% in Germany, Japan, and South Korea. (Page 1.) These costs do not include personnel costs or overhead: rather, they are the direct costs of keeping up the bases in those countries. German bases cost $4 billion. South Korean bases cost $1.9 billion. (Page 18.) Japanese bases cost $2.5 billion. (Page 40.)

But South Korea and Japan, unlike Germany, pay pretty large portions of the U.S. cost! (Hold that thought on Germany; this is based entirely on the Senate report.) In South Korea, U.S. taxpayers foot only $1.1 billion of the cost; South Koreans make up for $800 million. (Page 21.) Japan, meanwhile, covers more than 70% of U.S. costs, to the tune of $1.8 billion per year. Until 2010, in fact, Japan covered all U.S. basing costs. (Page 41.) So President Trump might wrap up the American empire-by-invitation in Asia for savings of ... $1.8 billion. Get out of Germany at the same time and you save $5.8 billion per year. 

Only you don’t! Consider the cost of transferring 7,000 Marines from Okinawa to Guam: $19.3 billion. (Page 49.) Scale that up by the other 43,000 American forces in Japan and you get $119 billion to withdraw without demobilization. Add in the 29,000 forces in South Korea and you get $197 billion. Throw in the 36,000 troops planned to still be in Germany in 2017 and you get $296 billion. 

Now, that is a one-time cost, not an annual flow. And it is likely exaggerated, since most of the Naval and Air Force personnel overseas will not be as expensive to relocate as the Marines. So lets arbitrarily cut the cost by 60%. 30-year treasury bonds are currently yielding around 2.5%. Call it an annual expense of $5.8 billion between 2017 and 2047. 

$5.8 billion ≈ $5.8 billion. No savings. With interest rates at a near all-time low and shaving 60% off the topline estimate. Huh!

And now lets return to the German issue. Germany pays a share of American construction costs for our bases, but those costs are lumpy. In  2009, Rand estimated total German support to total $831 million. (Page 154.) If that number is accurate for other years, then the U.S. pays only $5.0 billion for our three main overseas presences. And $5.8 billion > $5.0 billion.

Third take: This big Rand report. It is long and complicated and does not cover the complete withdrawal option. But their minimum posture saves around $2.9 billion per year ... assuming that foreign contributions remained unchanged.

In other words, the American defense perimeter does not cost all that much. 

Now we need to figure out what these cost estimates imply for the negotiations.

President Trump, in this world, cannot simply threaten to walk away, because that would cost him. He needs to make one of two additional threats:

1. He is willing to incur costs to the United States if negotiations break down. That is, he tells his counterparts in Berlin, Tokyo and Seoul that he is willing to pay money to bug out unless our satraps allies fork over even more money. Good luck with that one.

2. He is willing to bug out and downsize the American military budget. Now those cuts do not have to be large for us to come out ahead — we are talking maybe 1% of the total defense budget — but they would need to be made. 

So, yeah, I suppose a cost-cutting President Trump could threaten to cut American military spending unless those foreigners pay us more. But unless he is willing to resort to an outright protection racket, he would net us 1% of the military budget on the threat of making a 1% cut in the military budget. 

Yeah, that makes sense. Totally worth it. After all, it isn’t like you could just, you know, cut the military budget without threatening our allies ... 

Why not just let the Argentine peso fall?

I wrote this almost a week ago, but forgot to hit “post.” With today’s further fall in the peso to 25 per dollar, it sadly remains relevant. So ...

Why is Argentina going to the IMF at all? Why not just let the peso fall?

Answer: currency mismatch. Argentina seems to be shot through with foreign borrowings. Some of these borrowings are hard to understand.

Other foreign borrowings are not as hard to understand. Consider the gross data on Argentine financing through international capital markets. When President Macri took office, the country regained access to foreign lending. It then proceeded to take full advantage of that new access to raise needed capital. Together the federal government, provinces, and the state-owned oil company (YPF) have borrowed about $48 billion (gross) under the Macri administration through the end of 2017. (There are credible reports that these figures may be understated by a factor of two.)

Now, I’m not saying that borrowing caused the run on the peso. Nor am I saying that it’s a huge amount for a ~$545 billion economy. But it would be rough if the capital suddenly stopped flowing, which is what would happen if the authorities just threw up their hands and let the peso plummet. Budget deficits would still need to be plugged and expiring debts would still need to be rolled over, only at much greater cost in peso terms. 

But wait it gets worse! Argentina’s financial system is heavily dollarized. That means people and businesses denominate their debts in dollars, not pesos. Why they do this is not clear: there are plenty of other countries with as checkered a monetary history, yet debts and contracts are made in the local currency. Nonetheless, many Argentine businesses write their debt contracts in dollars, even though most of them make sales in pesos. 

How serious is this problem? Well, I once again turn to the Argentine central bank. In 2016, 39% of manufacturing industry debts were in dollars, along with 37% of farm debts and 32% of service businesses. Only commerce (17%) and construction (12%) had less dollar debt … but even those numbers are pretty high. Twelve percent of construction business liabilities, the nontradable par excellence, are in foreign currencies?

Should the peso crash, those debts would become overwhelming. In fact, according to the Institute for International Finance, the situation has become a lot worse in the last two years: they report that a whopping 64% of Argentina’s combined government and corporate debt is denominated in dollars. Imagine if the value of 64% of your debts doubled over the course of a few days.

It follows that Argentine banks are exposed to depreciation. As of September 2017, 9% of bank loans were denominated in dollars, against 15% of their liabilities. The weight of those liabilities could soar if the peso crashed. Moreover, considering as most of those loans are probably to Argentine entities who earn in pesos, those dollars loans would start looking shakier as well.

In short, jacking up interest rates and going to the IMF is bad. But letting the peso just fall as far and as fast as the market will take it is also bad. It might even be worse. In other words, cry for Macri, Argentina: it is a terrible and unavoidable choice. 

Environmental disasters are hard to stop, even in the Netherlands

The rash of earthquakes afflicting Oklahoma is old news. The cause appears to be backwash from fracking operations being pumped into old abandoned oil and gas wells. Lubricated rocks slip, and thus earthquakes where none were before. 

But now Groningen, in the Netherlands, is suffering from quakes! I am kind of embarrassed to learn about this now, since I was only recently in Groningen. (Disclosure: I am a Dutch citizen, passport and everything. Yes, I am also a U.S.A. veteran and short and olive-skinned and Spanish-speaking. ¿Tienes algún problema con eso? Daar heb ik geen moeite mee.) 

For those on the wrong side of the paywall: these quakes appear to be due to the rapid depletion of the Groningen gasfield to the east of the city. A 3.6 earthquake in 2012 wrecked thousands of homes (as you might imagine, Dutch houses are not built for tremors); on January 8th of this year another 3.4 did likewise. From the Financial Times:

Gert-Jan Veldink was at home when a 3.4-magnitude earthquake struck the northern tip of the Netherlands last month. First came the tremors, then the chimney broke and floor-to-ceiling cracks appeared in the hallway. Later, an engineer confirmed his 200-year-old farmhouse was filled with carbon monoxide from a damaged gas pipe. “The quake hit our house with all its force,” says Mr Veldink, an academic from the small town of Kiel-Windeweer, near Groningen, the regional capital. “If there’s another earthquake the same as before then the roof will collapse.”

Labor Party politicians estimate the number of houses that need rebuilding at around 90,000. The fields are operated by NAM, a 50-50 joint venture between Royal Dutch Shell and ExxonMobil. NAM has paid out about 80,000 claims, although their value is unknown.

The field has been in operation since 1959, but number of quakes started rising around the turn of the century. For an amazing visualization, click here.

Since 2013, production has fallen precipitously, but the number and intensity of the quakes has remained steady. The implication is that the ground has already been weakened; the number of quakes will fall slowly even if production stops immediately. Of course, if production doesn’t stop, then the quakes will get worse ...

Why does the government let production continue? The industry is highly taxed, with the Dutch state taking 80% of revenues. But that amounts to only 0.8% of total public revenue, down from 5% in 2013. In addition, the Dutch state is highly centralized and subsoil resources are not owned by the surface title-holder, so there is not much of a local lobby pushing for more production the way there would be in most of the United States. 

Which leaves three reasons to keep production going, albeit at a capped level. First, there are legitimate worries that lowering production caps would lead to big variations in monthly production, since NAM would want to sell more in the winter when prices are high. That could lead pressure to fluctuate, making earthquakes worse.

Of course, a total shutdown would solve that problem, but that brings us to the other two problems: 

1. The Netherlands still relies on natural gas for heat and light. Shutting Groningen, at least in the short term, means more imports from Russia. Nobody likes Russia. In fact, Dutch politicians dislike Russia so much that they see votes in lying about their knowledge of Russian “plans to expand the country’s borders and create a ‘Great Russia’ that would include Belarus, Ukraine, the Baltic countries and possibly Kazakhstan.”
2. Lobbying and legal issues. Even with the high government take, NAM makes a lot of money from the gas fields. They will not take it lying down.

So there you have it. Conventional gas production is causing earthquakes in the Netherlands. But even as wind power gets cheaper and more reliable, nobody can quite figure out how to shut it down.

Observatorio argentino 37: A long hot summer of pension reform

It is summer in Buenos Aires. And it is proving to be a hot one. 

Political violence right before Christmas is a recent Argentine regularity. In December 1999, a protest by workers owed back salaries in Corrientes province grew out of hand and resulted in two deaths. In December 2001, the forced conversion of people’s dollar bank deposits into pesos worth a third as much provoked riots that killed 39 people. In November 2005, I was in Mar de Plata for the riots around a visit by President Bush. In December 2010, thousands of Paraguayan and Bolivian immigrants occupied a park in the southwestern reaches of the city. As you can imagine, the locals did not react well: Mayor Mauricio Macri called in the police and four people died before the federal Gendarmerie and naval special forces broke it up and cleared the area. In December 2013 the police themselves went on strike; in Córdoba, the result was looting, the arrival of the Gendarmerie, and at least one death. 

And now there is December 2017. Nobody has died, so far, but at last count 81 people were in the hospital ... 48 of whom are cops. A general strike is on, shutting the airports and the subway. That is today; on Thursday there was an earlier wave of rioting resulting in busted windows and burning cars. 

What is it all about? Short answer: pension reform. On November 29, the Senate voted 43-23 to advance an administration proposal to rejigger the formula for state pensions.  Rejigger how, exactly? Well, that has been giving me a headache but I think I have got it. 

The current pension formula adjust pensions as follows. Every six months, the pension fund averages the wage index (the higher of the Ripte or Indec indexes) and the nominal growth in total social security tax receipts. The resulting number (plus a top-off that I still do not understand) gives the percentage hike in pensions. The law has a floor: nominal pensions cannot fall even if nominal salaries and nominal tax collections decrease. (To be frank, in an inflationary economy like Argentina, a nominal fall in anything is unlikely in the extreme.) 

On paper, this does not seem like a bad system. It links changes in outflows to changes in inflows. Pension spending might be too high given the level of tax collection, but they should not grow out of control, at least not because of the formula.

But ... the formula does make pensions volatile. For example, in 2015 pensions grew by 4% in real terms, but they fell 6% in 2016, only to recover 3% this year. In other words, there is a case for pension reform beyond the vague “pensions are too expensive” that you usually hear. 

Of course, that case would be more persuasive if, well, pensioners were the ones pushing the reform.

The real issue is that the pension system has been underfunded ever since President Kirchner granted state pensions to slightly more than 2 million elderly who had never worked in the formal sector. It does not matter if the current indexing formula is a fine one if the system is paying out more than it takes in. Something needs to be done and this is something. 

The proposed change (text here) switches the index to the following: 70% inflation and 30% wage increases, plus a top-up for GDP growth that I do not understand. The adjustments will be switched from every six months to every three months. The reform implies that the pension administrator will miss a top-up during the changeover to the new system, so it proposes an extra one-time adjustment, aka “the splice.” Weirdly, however, the adjustments will still be delayed six months: the end-of-March increase, for example, will reflect inflation in October-December, not January-March.

Does your head hurt yet? Mine certainly did. I found a nice chart at Infobae that runs down the difference between the old and new systems. Short version: most pensioners will come out behind under the new scheme compared to the old one. It might save around $4 billion in the short term, perhaps. In the long term, who knows? But it is likely to reduce expenditures relative to the old formula.

The vote sailed through the Senate based on a deal President Macri struck with the state governors. As part of that deal, he got the governors to agree to let him transfer quite a lot of money to Governor María Eugenia Vidal of Buenos Aires province. Vidal is a member of Macri’s political party, the Republican Proposal (PRO); he needs her to succeed. So it is hard to get past the idea that President Macri is using pension reform to finance Governor Vidal. 

The lower house had to cut off debate when it looked like it was about to devolve into a fistfight.

So there you have it. The reform is basically a cut in pensions. Most of the short-term savings will go to the provincial governments in return for their agreement to drop a lawsuit claiming funds from the federal government. The big winner if it passes will be B.A. province, where a PRO governor recently took it back from the Peronists for the first time in 30 years. But the formula change is tinkering around the edges of a massively underfunded pension system; very little economic gain for a lot of political pain.

That said, by current American standards the whole debate seems refreshingly honest, wholesome, fair and open. And no, that is not something I thought I would have written a year ago.

Demasiado largo, no lo leí: Catalonia needs Spain

Here is the TL;DR version of the last post.

Catalonia runs a budget deficit with the rest of Spain. That is disguised because Madrid kicks back a large chunk of Catalonia’s tax revenue in the form of soft loans. In other words, Catalonia has been taking debt owed private investors as it comes due and transforming it into debt owed to the central government. (This far to the tune of €52 billion.) That means that an independent Catalan state would need outside financing if it declared independence as its debt came due, to the tune of €4 billion per year; such financing would be impossible in a contested divorce. Even if Catalonia renounces its share of the national debt, Spain can lock it out of financial markets. The result will be crushing ... and that is before accounting from the trade shock that will come from Catalonia’s hard exit from the European Union.

(Note that tax revenues are lumpier than spending: even a state with a budget surplus needs access to short-term financing to make its payments. Losing access to finance will be crushing.)

Rough numbers for Spain:

Explanation: Spain in 2014 received a net transfer from Catalonia worth 0.8% of GDP. Losing the territory would cause an increase in spending of 0.3% of GDP, since the new smaller country would have to cover the same burden of fixed costs. (Defense, foreign affairs, regulatory authorities, public research, etcetera.) If Catalonia also renounced its share of the national debt, then the rest of Spain would also have to assume an addition 0.6% of GDP in interest costs. The total cost, then is either 1.1% of GDP or 1.7%, depending on what happens to the national debt. 

Rough numbers for Catalonia:

Explanation: with independence, the soft loans go away. Catalonia will be in deficit unless it renounces its share of the national debt or allows net taxes to rise substantially. Note, however, that Catalonia will still need access to short-term financing. Also note that these figures make no account for the inevitable trade shock that Catalexit from the E.U. will bring. That trade shock will depress revenues and raise spending, making access to capital even more critical. 

La economía de la secesión en la madre patria

We have moved down the game tree one step towards sensibility! Premier Puigdemont declared that Catalunya has the moral right to secede but will not declare independence. Relief!

Except, well, now the Spanish government needs to decide its response. The sensible thing, of course, is to do nothing. Either nothing nothing, or possibly a more active form of nothing where nobody speaks about secession but Catalan representatives in Parliament meet with other parties to see if they can hammer out an acceptable constitutional reform. Some politicians, like Socialist leader Pedro Sánchez, are doing just that. Prime Minister Rajoy, unfortunately, appears to be doing his best to push the Catalan leader into a corner by insisting that he loudly and unequivocally back down.

It is never a good idea to leave your opponent with no face-saving exit, especially when you have just won. I would bet on Puigdemont trying to give Madrid what it asked for without a full about-face.  (After all, Puigdemont has to keep his own hardliners onside.) 

Rajoy should accept the offer. 

But if he does not and we re-enter the conflict, it is worth discussing what is at stake. The answer: less downside than you might think for Spain, and rather more for Catalonia. 

First the figures for Spain. Catalonia is a net payer into the national budget. The reason that Catalonia is a net payer is that individual Catalans are richer than elsewhere.  

The baseline calculation is straightforward. Spain in 2014 ran a budget deficit of 3.5% of GDP. Excluding Catalonia , the Spanish state collected €305 billion and spent €345 billion, over a GDP of €840 billion. That implies a budget deficit of 4.8% without Catalonia .

Except, well, it seems plausible that Madrid would assume all of the fixed costs of the Spanish state: defense, foreign affairs, research and development, debt interest and the like. That would increase spending to €353 billion and the deficit to 5.7%. That is not comfortable, but it is far from an economic disaster.

So there you have it, a net cost of 2.2% of GDP ... with one more complication. Spain currently provides a fund to help the autonomous communities. The fund lends cheaply to the communities, as in at zero interest for three years and 0.834% thereafter. These expenditures do not count as part of the Spanish State’s budget deficit since they are technically loans: the central government increases its public debt in return for accounts payable given to the communities. That said, the account represents a flow of resources that somehow needs to be financed. Along with sundry other loans from the central government, Catalonia received €4.7 billion in such soft credits in 2014. If it seceded, Spain would no longer need to borrow that money. That said, this should probably not be counted as a benefit to Spanish taxpayers, considering as the costs are (in theory) borne by Catalan taxpayers. Of course, if you do not believe that the debt will ever really be paid back, then the calculation changes and losing Catalonia would cost only 1.6% of GDP.

What about the Catalan side? Total spending at all levels of government there currently comes to about €66.3 billion, while taxes amount to €70.4 billion. That would give the Republic of Catalonia an additional 2.1% of GDP. 

But it gets more complicated. The Spanish treasury assigns Catalonia a share of fixed costs and interest payments. Right now, that comes to about €2.6 billion in fixed costs and €5.0 billion in interest payments. 

The €2.6 billion share of fixed costs is about 1.3% of Catalonia’s GDP. That is less than the independent country would have to spend to set up its own army, foreign service, statistical agency, tax authority, additional courts, weather service, competition authority, securities regulator, and everything else now done by the central government. In the long-term, you are looking at a rise of about 0.2% of GDP (bringing it up to roughly what Spain spends). 

In the short-term, you are looking at much higher expenses as Catalonia ramps up, but I have no idea how to estimate that. So let’s run with a baseline saving of 1.9% of GDP. This is not small, but it is less than transformative. 

Except, well, those pesky financing operations from the central government. They give Catalonia about €4.7 billion every year. Even if you expect Catalonia to pay back the loans, they represent a liability that will need to be financed somehow. Which means independence would blow at least a temporary hole in the Catalan budget on the order of 2.4% of GDP. There go the cost savings!

So independence would cost 0.5% of GDP? Not exactly. What would actually be happening is that borrowing from the Spanish central government would need to be replaced by borrowing from other sources. In a mutual divorce, nothing would change save a small rise in the interest charged on the loans. 

But in a contested divorce, it would mean that Madrid has some substantial leverage. Rather more than the headline figures would indicate.

What about the national debt? If Catalonia assumes its share of the national debt, then Spanish expenditures rise to €348 billion: for an additional cost of 1.6% of GDP compared to the status quo. On other hand, if Catalonia dumps the entire current national debt onto Madrid, then (as calculated above) Spain’s fiscal burden will rise by 2.2% of GDP. 

Catalonia, on the other hand, would save €5.0 billion in interest payments. That is more than enough to cover the loss of financing from the central government. Hooray!

Except ... well ... this will get ugly. Spain can tie the new republic up in legal knots, made worse by the fact that the republic’s banks will have all moved their headquarters to Spain. Interrupted payments, attached accounts, you name it. The fiscal squeeze will be immense. 

The good thing, ironically, is that if its banks flee to Spain proper then they will still have access to ECB support. So that would slightly lower the pressure on Catalonia, since depositors will not have to fear an Argentine-style corralito. But they would still face corralónes: the Catalan government will likely limit withdrawals to prevent capital flight. And the new republic would also find itself unable to finance its current level of operations, and that would be horrendous.

Anything else for a Catalexit? Yes! Even assuming that Spain does not close the border, Catalonia will crash out of the E.U. with no WTO schedules and no trade agreements. In other words, Catalonia will suffer all of the effects that a hard Brexit would impose on the U.K., only with the added problems of having no independent currency and no way to access capital markets. Spain would also suffer a recession, of course, as trade fell with Catalonia ... but Spain will only have problems with Catalonia whereas Catalonia will have problems with everywhere. 

TL;DR: Both Spain and Catalonia will lose on the long-term fiscal side, even if independence is negotiated. But Catalonia borrows a lot more than people realize, and losing that in a unilateral secession will crush its national economy. The result will be a terrible financial crunch (even if the banks survive by relocating to Spain). Falling out of the European Union will add insult to injury. Spain will be battered, but as long as the ECB supports it the impact will be less than the 2008 crisis ... while Catalonia goes the way of Greece.

¿Qué sigue en la madre patria?

The Catalan election descended into utterly predictable chaos. The secessionists won, on poor turnout. But the Spanish national police idiotically decided to wade in wearing full stormtrooper gear, and now nobody knows what will happen. The Catalan premier, Carles Puigdemont, has been coy about whether he will issue a unilateral declaration of independence (UDI, to use the abbreviation first used in 1965). 

So what will happen? Last night, in a bit of insomnia, I jotted down a game tree to help me think this through. I present it below. You can click to enlarge it. I have colored the boxes with the flag of the party making the decision to make things clear. (I am sorely tempted to write, “time for some game theory.”)

Right now the Catalans are deciding whether to declare independence. Their other option is to begin negotiations with Madrid on the precondition that secession will not be on the table. If they take that option, we can breathe a sign of relief: what follows will be contentious but not catastrophic.

But what if they declare independence? The ball goes into Madrid’s court. The Spanish government will have three options. The first would be to agree to negotiations. With a UDI in the background, that seems unlikely ... but if they agreed would could again breathe a sign of relief. 

The other options, however, are more likely. One is to do nothing, the bottom tree on the chart above. The other is to invoke Article 155 of the Constitution and suspend the Catalan government. What if Spain does nothing? Literally, just lets Catalonia go ahead and declare independence but takes absolutely no positive steps to remove Spanish authority. Well, that would give the Catalan authorities two choices:

1. Do nothing as well. That would leave Catalunya in a sort of limbo, with an autonomous  community exercising nothing more than its constitutional authority as part of Spain while claiming to be independent. Weirder things have happened. Life would go on, taxes would be collected, services would be delivered. Eventually they would talk.
2. Organize a parallel state. That would mean having Catalan bodies and bureaucrats take over functions currently carried out by the central government. Eventually, of course, there would be a conflict: a firm would refuse to pay Spanish taxes, two police forces would quarrel, a court order would be ignored, something. 

That would throw the ball back to Madrid. Assuming that voluntarily acquiescing to Catalan independence would not be an option, the Spanish government would have two choices:

1. Crack down with the full authority of the state. We got a taste of that yesterday.
2. Uncooperative withdrawal. Pull out without recognizing Catalan independence. 

Here is where backward induction is helpful. In both cases, the Catalans would have to deicde: give in to Spanish pressure or hold their ground. Problem is, by this point backing down would be political suicide. People would be angry. But resisting a crackdown means civil war. Not necessarily a repeat of 1936-39, but sustained political violence. 

And resisting an uncooperative withdrawal means complete economic collapse. First, the banks would fail as their headquarters pulled back operations; without ECB support euros would become scarce. Second, all contracts would be tied up in legal knots, dropping a paralyzing web of uncertainty. Third, all transfer payments from Madrid would stop; Catalunya would have to replace them ... only Catalunya would not have euros. So it would introduce a proto-currency, which would plummet in value, fueling a wave of defaults ... and so on, until you have something that looks like Greece, at best.

Except, well, backing down by the point would end the career of any politician who tried it, Thus, the big X’s through that option.

The lower tree does not look good. What about the upper one, where PM Rajoy invokes Article 155?

Well, that would give the Catalans a choice: acquiesce and fight it out inside the institutions of the Spanish State or organize mass civil disobedience. The first gets us into a nicely talking world. The second put Madrid in the position of deciding whether to negotiate in the face of mass resistance or resist Catalan demands. If they resist we are ... back on that lower game tree. (The upper and lower tree are the same after that point.)

The implication is that this is a no-win situation for the Catalans. Resistance ends in civil war or economic collapse. (Ironically, the European Union makes it easier to impose that economic collapse: the ECB cannot support Catalan banks if Catalunya is no longer a member.) The smartest thing is to do nothing. If there must be a UDI, then nobody should do anything. Nobody speak, nobody get choked!

Meaning that nobody should do anything, even if the other side does something. Nothing is the  best option. Do nothing at all. Nada. Nothing. 

I am hopeful that in this case that strategy will in fact dominate. But, well, game theory does not really a good record in these sorts of situations. If it did, the morons in Madrid would have never gotten us to this point. (In fact, I suspect that the Catalan nationalists are surprised at their own catastrophic success.) But here we are, so we can only hope that the politicos backwards induct correctly.

Unless ... gulp ... unless the game tree missed something, some option or payoff that makes the bad state good for someone. In which case we are jodi ... thoughts?

The Brazilian fiscal cap still makes no sense

McDevite is not answering my call. I am sad. 

But I am not as sad as the people of the Federal Republic of Brazil, right across border from here! (“Here” is Uruguay, on my way to Buenos Aires. And while I am in parentheses and can be pedantic, allow me to point out that “federative” is not a word in American English and the proper translation of “federativa” is “federal.”)

Over in Brazil, Michel Temer is mired in a growing corruption scandal. His woes are compounded by his blatant reactionary conservatism. The man worked to keep women and black people out of his cabinet. He also shoved through a constitutional amendment that insures public spending will shrink no matter what over the next decade. All that plus corruption! Brazil is, once again, a mess.

Now come Filipe Campante and Dani Rodrik with a short essay reiterating just how incredibly stupid the fiscal handcuffs will be for Brazil. They draw a parallel with Argentina. By the 1990s, Argentine governments had racked up a long history of irresponsible monetary policy. So they decided that the best way to promise to no longer inflate would be to throw away the printing presses. The Convertibility Act stated that the Argentine central bank could only issue pesos 1-for-1 with the dollars it had on reserve. 

Of course, the fact that Argentina had no control over its monetary policy meant that an otherwise manageable mild balance-of-payments crisis turned into a depressionary nightmare. The country abandoned the link in a moment of political chaos. 

Campante and Rodrik make the point that the fiscal limit is as problematic as convertibility. If it succeeds in bringing down interest rates and sparking growth, then it will no longer be necessary ... but will by its past success be perceived as a vital totem and therefore be incredibly hard to remove even should it start to cause damage. Meanwhile, if it is unsuccessful it will unsuccessful because the limit itself will become an early focus of political conflict. Either way, Brazil will lose, unless it somehow manages to dodge all economic bullets over the next decade.

So I am at a loss as to why the cap might even be remotely a good idea! But I know people disagree with me. So, Lee Allston, Aldo Musacchio, and anyone else in the know, once again, could you please give me the counter-arguments? Surely I am missing something. 

Sometimes the simplest things are the hardest: explaining the $2 trillion Trump budget error to Uruguayans

Some of you may have heard of the ridiculous error in the Trump budget.

The error, in fact, is so ridiculous that you may have some trouble following the explanations. Matt Yglesias and Larry Summers, for example, managed to confuse me about something super simple. So how was I going to explain this to a bunch of incredulous Uruguayan economists? 

Finally, here is what I told them.

1. The Treasury Secretary published a bunch of tax cuts that would cost $4 trillion. But he then said: hey, no worries, the cuts will speed economic growth so their actual cost will be only $2 trillion.
2. The budget director took that estimate and said: we have tax cuts that cost $2 trillion, but hey, no worries, the cuts will speed economic growth so their actual cost be zero.

Uh ... yes, the error is that stupid. Thus, it was weirdly hard to explain.

Governor Moonbean taxes ships to the Moon

When Jerry Brown was governor of California the last time around, he received the moniker “Governor Moonbeam,” in part because he proposed that the state start its own space program back in 1978. Now he’s back, with regulations that would tax space launch companies.

More accurately, the regulations specify how much of the income earned by a space-launching company should be considered to have been earned in California. The state could legitimately say, “Launch in California, earn in California” and be done with it. But they are instead doing something clever. (And, in effect, a tax break for SpaceX.) 

First, multiply income by a mileage factor. For California launches, the numerator of the mileage factor will be 62 miles. That is, all launches within the state will be considered to travel 62 statutory miles before leaving the jurisdiction of California, regardless of where they actually launch from. The denominator will be the distance traveled by the time of final payload separation. That is, the company will considered to be selling travel to Low Earth Orbit (more or less) with the portion of that travel within the state of California being taxable. 

The formula gets a little more complicated than that, but not much. For those of you who want to know, the mileage ratio is multiplied by 0.8. Then the ratio of all launches from California to all launches by the company is multiplied by 0.2. Those two things are added together, and then total revenue is multiplied by that to determine gross taxable revenue. 

Anyway, it is simple, clever, and a big giant tax cut for California-based launch companies. Go figure! The Hoover institution would approve.

Why did the Trini government stop paying salaries in 2015?

Front page headline in the Sunday T&T Newsday?  “Easter backpay for 16,000 health workers: $636M blessing.” Short version: 16,000 government employees are going to receive US$5,923 per person in unpaid salaries. This in a country where average annual government expenditure on wages and salaries per employee came to US$10,606 in 2015 and US$9,930 in 2016. The arrears are big.

Health workers were not the only ones to go without pay: when I was last here in April, the big news revolved around the way the previous government had randomly suspended salaries. You heard that right: in response to falling oil prices, the government stopped paying salaries.

At first glance, this does not seem unreasonable. Consider the below chart: total government revenues (in millions of U.S. dollars) fell 30% in 2016, from $8.8 billion to $6.1 billion. (Figures are only available through August 2016; data is annualized based on the first eight months of data.) That is one hell of a fiscal adjustment!

But at second glance, it’s crazy. First, in 2014 had Trinidad a debt-to-GDP ratio of only 51%; by 2016, that had risen to only 58%. There was plenty of scope for borrowing to ease the transition. Second, Trinidad could have let the exchange rate depreciate, spreading the pain. Third, the arrears started proliferating in 2015, before the big meltdown in revenue. 

Finally, and here is the kicker: expense on wages and salaries barely went down. The government spent US$1.6 billion in 2015 and US$1.4 billion in 2016. Public employment slid from 150,600 to 144,100. Per worker expenditures barely budged. 

So what the hell?? Tens of thousands of people without salaries in 2015? Where did the money go? 

Obviously, people think corruption. It does not help that Jack Warner (of FIFA scandal fame) said that he witnessed PM Persad-Bissessar accept TT$8.3 million in checks from ... wait for it ... Ishwar Galbaransingh. Now, I would not trust Jack Warner at all about anything ... but the atmosphere here is febrile, considering the apparent mismanagement of the Persad government. 

AFAICT, the new government is on track to meet its commitment of clearing the arrears by the end of this calendar year. But the whole episode is inexplicable. You cannot find much evidence of the arrears in the government accounts (which are putatively on a cash flow basis) and you cannot find much evidence in the audit accounts.

But you can find lots of evidence among the government workers who were not paid and the current politicians who seem to be moving heaven and Earth to make them whole! 

The new government could do a lot more to make its accounts transparent. It is not doing so. So while employees are getting paid (that I can confirm, although contractors are still SOL) there still seems to be no good understanding of just what happened last year. No wonder cynicism is higher than I have ever seen it, and this is not exactly an idealistic trusting place to begin with. 

The border tax and climate change

I am opposed to a 20% tariff aimed at Mexican manufactured goods. I am more ambivalent about the 20% border adjustment tax (BAT) floated by the Trump administration. In fact, I may support it. 

The basic idea is simple. U.S. companies would pay a 20% income tax. Companies could deduct domestically-sourced inputs from their income but not imported goods or services. Those imports would then, in effect, have to be at least 20% cheaper than equivalent domestic competitors. 

The idea is to make the U.S. corporate income tax look like a value-added tax (VAT). If a corporation in Mexico buys an input from overseas, it pays the Mexican VAT on the purchase. If it sells something domestically, then it also pays the Mexican VAT. But if it sells something to a company in France, then it does not pay the Mexican VAT ... but the French buyer will pay the French VAT. Under the BAT, if a corporation in the U.S. buys an input from overseas, then it pays the U.S. BAT on the purchase. Ditto it pays the BAT on all earnings from domestic sales. But if it sells something to a French buyer, then it will not pay the U.S. BAT ... but the French buyer will pay the French VAT.  

As it stands, the BAT will apply to oil imports. So an American refinery that buys foreign crude would have to pay the 20% BAT on those purchases! Right now, WTI trades around $54 per barrel. A refinery using American crude would pay $54; a refinery using imported crudes at a similar grade would pay $65. American oil prices would rise, world oil prices would fall.

And that is good for the world! Higher U.S. oil prices mean less U.S. oil consumption. Moreover, the burden will fall particularly on dirtier forms of oil. Most American crude oil imports (60% in 2015) are heavy grades. Almost half of that consists of heavy crudes from Canada, which  release about significantly more carbon during the production process than other grades of oil. (So much so that the Section 526 of the Energy Security Act of 2007 theoretically banned U.S. federal agencies from purchasing it, although that has had no concrete effect.)

Lower world prices will, of course, stimulate more world consumption. But there are two wrinkles that will reduce that impact. First, transport links lock in most Canadian output to American markets. Last year, the Trudeau government approved an expansion of the Trans-Mountain pipeline from 300,000 to 890,000 bpd, which would allow Canada to divert as much as 28% of its current U.S.-bound exports to other markets. But that will take a long time and is a drop in the bucket of world production. Second, American refineries are optimized to use heavy crudes. They will switch away, but slowly, even if the cost of their primary input rises. Finally, inasmuch as world prices do fall, that will discourage foreign exploration and development, keeping some carbon in the ground for the long-run. 

Winners:

1. Our children;
2. American heavy oil plays, of which there are not many outside Alaska;
3. American light tight oil plays (hooray!);
4. Andrés Manuel López Obrador (see below).

Losers:

1. American oil consumers, who will likely see prices rise about 30₵ per gallon;
2. Refiners who use imported crude oil—although not by very much;
3. Canadian, Ecuadorean, Venezuelan and Mexican heavy oil producers, who are locked into the U.S. market;
4. Mexican consumers, who rely on gasoline produced in the United States from Mexican heavy crude.

As far as energy is concerned, this does not strike me as a bad policy, even if it will impact Mexico quite seriously. At 2015 prices, a 20% BAT would have raised about $2.0 billion from Mexican crude oil imports, although most of that burden would fall on American consumers. The real hit for Mexico is that the increase in U.S. gasoline prices will be passed on to either Mexican consumers or the Mexican government. Inasmuch as the Peña administration hands Mexican voters a second gasolinazo, then it will be another fillip for AMLO’s chances in the 2018 elections.

So a good policy for energy: a net plus for domestic production and a net plus for decarbonization. Probably pretty good Harley-Davidson, as well.

But as far as other products markets are concerned, I’m still undecided as to whether the BAT is a good idea. Thoughts?

Border adjustment, the Mexican peso, and Hoyt Bleakley

It now looks like the administration won’t (for now) be using its Economic Powers Act authority to impose a tariff on Mexican goods. Instead, he is going to ask Congress to create a border adjustment tax, which would stop American companies from deducting imports from their taxable income. At the same time, it would leave their exports untaxed. (Full explainer from Forbes, here.) 

So what would that do to the auto industry? Well, let us proceed in two stages.

1. What is the immediate impact on an American auto producer? Well, the border adjustment tax is less harmful than a tariff. The auto companies would not be able to deduct the cost of goods coming in from Mexican affiliates and suppliers, but they also would not be taxed on the cost of goods going out to Mexican affiliates and suppliers. But they would still have an incentive to source more inputs at home.
2. Except that the peso would fall (or the dollar would rise, same thing) in response to the tax. A 20% depreciation in the peso puts the auto company back where it started. 

But would Mexico allow the peso to fall that much? In the past, the Mexican central bank has acted terrified that depreciation would hammer Mexican corporations that had borrowed in dollars. That is a reasonable fear ... in theory.

In practice, it might not be. My friend and colleague, Hoyt Bleakley (with Kevin Cowan) looked at 450 non-financial firms in five Latin American countries. 

We consistently find that, contrary to the predicted sign of the net-worth effect, firms holding more dollar debt invest more than their counterparts in the aftermath of a depreciation. We show that this result is due to firms “matching” the currency denomination of their liabilities with the exchange rate sensitivity of their profits. Because of this matching, in equilibrium, the negative balance sheet effects of a depreciation on firms holding additional dollar debt were more than offset by the larger competitiveness gains of these firms.

In other words, depreciation might not be that harmful.

The other reason the central bank might not want to let the peso fall is fear of inflation. But that depends a lot on the reputation of the central bank and the structure of wage bargaining. Banxico is very credible and Mexico has weak unions, so while a fall in the peso will lead to a one-time increase in costs, it seems likely that Mexican workers would just have to suck up the fall in their living standards. It is hard to see how they could demand the kind of compensating wage increases that you would need to set off an inflationary spiral.

So yes, the peso could fall.

In short, the Trump tax would likely make Mexicans poorer with no compensating gains for American workers. But also no losses for fans of big American cars like the amazing Dodge Challenger, like my son. In other words, a gratuitous punch in the nose of those perfidious foreigners! And you can pretend that the tax flows are coming from those foreigners, when they are really coming from American consumers. 

Yeah, I can see why this might actually happen. 

Department of corrections: the Gasolinazo did not raise tax revenue

Here I am, in Mexico, as the 45th presidency of the United States begins. The talk among the intelligentsia is about NAFTA and, weirdly, the prospects of a war between the United States and China. So I am going to talk about the gasolinazo. Which still has a lot of people upset, as you can see from the image of this angry soldadera pointing a carbine at President Peña.

Now the notionally right-wing National Action Party is trying to escape blame for the price hike. It isn’t the reform what caused the spike, it’s “the tax structure what obscenely raises the price!” says Ricardo Anaya, the head of the party.

Well, not quite. On January 6th, I reported that the price rise was essentially a tax hike. Turns out that is wrong. All of the rise is going to Pemex, to cover the costs of refining or importing the stuff. 

El @gobmx no recibirá ni un centavo por el incremento en el precio de la gasolina⛽️ pic.twitter.com/JaQZ2f9Mpv

— SE México (@SE_mx) January 7, 2017

Moreover, decontrol of gasoline prices was part of the reform that the PAN did indeed vote for. Now, it is true that the price of gasoline in Mexico is now higher than in the United States. But that is because Pemex is a mess, both in terms of refining the stuff at home and transporting it from the United States at a reasonable price. 

Right now, taxes on internal fuel sales serve as a buffer against price swings. When the international price rises, government revenues fall and vice versa. The plan, logically, is for those swings to now be passed on to the consumer. Government revenue will stabilize. 

The problem is that Mexican voters, well, they liked price stability. Still, even with the recent riots, I suspect that the administration will follow through on its plans for full liberalization. 

⛽️ What have they go to lose? Besides the next election, but that ship, I suspect, has already sailed.

 

Fiscal insanity in Brazil

 I have to admit that I do not understand the conventional wisdom that pins Brazil’s current recession on Dilma’s fiscal policies. I kind of understand that profligacy made the situation worse, by forcing the central bank to raise interest rates by more than it otherwise might have done in the face of higher inflation. But that is a second-order effect. I completely understand the argument that most federal spending in Brazil is misplaced and the state serves as a drag on long-term growth. But that is a long-term problem that has to do with the nature of federal spending and not the absolute level. 

In other words, the proposed constitutional amendment to limit the level of Brazilian spending to the level of inflation for the next 20 years seems crazy. But it is actually even crazier than that. The amendment would not include the following:

1. The 61% of all federal spending that happens via federal agencies outside the executive, legislative, and judicial branches;
2. The revenue that the federal government has to turn over to the states under Articles 157 and 159 of the constitution (49% of all income tax revenue, 10% of VAT revenue and 29% of all hydrocarbon revenues);
3. Guaranteed education spending under Article 212 (18% of all revenue);
4. Police and fire spending in Brasilia.

These categories are overlapping, so it is not clear how much total spending is exempted. But it is a lot. Unfortunately, a lot of basic state functions are hit, like, you know, police, courts, universities, public defenders, and most regulatory agencies. But not the fastest-growing ones and not the ones that generate the most waste.

In other words, it is crazy on every level. It is a crazy proposal that gets worse in implementation!

I call on Aldo Musacchio or Lee Alston for help. Help? Why is President Temer pushing this?

The GOP lost even bigger on the grand bargain than Vox says

Short recap: in 2011, President Obama offered to cut Social Security and Medicare in return for tax hikes. The GOP said no. As a result, the tax hikes happened anyway and social insurance was not cut. This was, a Matt Yglesias writes, a disaster for anyone who honestly believes that the American state should redistribute no more income that necessary to prevent absolute penury among the elderly.

But it is even worse than that. The GOP would have eventually won an election; cutting taxes when that happens will be easy with a Congressional majority. Cutting entitlements, however, may be off the table forever. 

I think Paul Ryan knows that. (Click the link. It’s big news, even if not quite an endorsement.)

How big is the threat that oil exports will be seized in a Venezuelan default?

 It is pretty clear that oil exports could be attached if PDVSA defaulted on its bonds. It would work as follows. PDVSA would sell oil to a refinery in the United States. Creditors would sue. The refinery would still get the oil, but a U.S. court would attach its payment to PDVSA and transfer it to the creditors. PDVSA, therefore, would get nothing from its exports.

If the Venezuelan government defaulted, however, the legality would get a bit dicier. It is possible that American courts would “pierce the corporate veil” and conclude that PDVSA is an instrumentality of the Bolivarian Republic, but that is not certain. Still, it is the way many investors and lawyers (inclduing myself) would bet. 

So in theory sovereign default would lead to a fall in oil prices, as exporting countries with state-owned companies cast around for alternative markets.

In practice, however, the courts are slow and (as mentioned above) the legalities are far from certain. It is quite possible that a defaulting country would merrily continue selling oil while its buyers merrily continued buying. After all, the buyers might not care. They would still get the oil; what do they care if the seller wouldn’t get its money?

But the seller would still want its money. It would likely therefore sell to middlemen who would demand a discount and then resell the oil at some legal risk to themselves. In other words, the price of oil exports would certainly go down.

The empirical question, however, given all the legal uncertainties, is how quickly it would go down. It is quite plausible that the export price of a country’s oil would not be affected by default for months or years.

Well, Ecuador provides a nice test of that question!

Let me walk you through the data. This is going to be a little chart heavy, so I ask readers to comment if it is ever unclear or you lose the chain of the argument.

Ecuadorean oil generally trades a discount to the WTI benchmark price. That is because its oil is heavier than WTI and needs to travel from Ecuadorean fields to (mostly) Californian refineries. The below chart shows the percentage discount on Ecuadorean oil between the start of 2006 and the end of 2009. It shows a very steep fall in November 2008.

That seems convincing, until you add a control. Mexico also exports heavy oil to the United States. Its discount on WTI also widened in November 2008, although Mexico did not default.

Still, the increase in the discount on Ecuadorean oil was greater than the discount on Mexican oil. Might that have something to do with the default? Certainly! But to be sure of that, you need to also account for the fact that Ecuador and Mexico sell into two different geographic markets. Ecuadorean oil goes primarily to refineries in California, whereas Mexican oil goes overwhelmingly to the Gulf Coast of the United States. The price of crude oil can vary by several dollars per barrel between the two locations, given transport costs and varying demand conditions. 

The below chart, therefore, compared the export price of the two countries’ blends to the price paid by refineries in California and the Gulf Coast (60% in Texas), respectively. Once you account for the fact that the price of oil in California fell more than the price of oil on the Gulf Coast, then the oil price dynamics in the two countries look pretty similar between 2006 and the end of 2008. This chart compares the price received by the exporting countries and the price paid by their primary customers:

 

The dynamics look similar when you express the discounts in dollar terms, rather than as percentages of the sale price. The stark increases in November 2008 go away completely, as artifacts of the general fall in oil prices. Mexican crude is a bit more volatile in the lead-up to November, but otherwise looks similar to Ecuadorean:

It is true that Mexican oil recovered faster than Ecuadorean oil. In fact, after January ‘09, Pemex managed to sell its oil for roughly the average price paid by all Gulf Coast refineries, elimating a long-standing discount. PetroEcuador also managed to improve its position relative to the pre-crisis era, but it took rather longer. 

I do not know what happened in the Gulf Coast oil market. There are two hypotheses to explain the Ecuadorean recovery, however. One is that the Ecuador announced the form of its default in mid-2009 — a form brilliantly and perfectly designed to leave creditors without legal recourse. Freed of fears of attachment, therefore, the discount fell.

The other is that May is around when PetroEcuador began selling its oil to state-owned Chinese middlemen at a significant premium. The discount on Ecuadorean oil fell because Chinese companies absorbed it. 

It is still possible, of course, that without the default Ecuadorean oil prices would have bounced back in January 2009 like Mexican ones and without the need to involve the People’s Republic of China. But there is no direct evidence for that story.

The next thing to do would be to nail down an explanation for the disappearance of the Mexican discount in January 2009. If an explanation for that can be found that Ecuador could not possibly have replicated, then the hypothesis that the Ecuadorean default affected the export price of its oil is likely incorrect. On the other hand, if the strategy employed by Pemex was one that Ecuador was prevented from using because it was in default, then the default cost Ecuador.

To be frank, my prior is that whatever happened to Mexican oil in January 2009 was likely idiosyncratic. I doubt that Ecuador suffered in oil markets for its big sovereign default.

Now, this is not to say that default would be costless for Venezuela. It could prove very costly! Eventually, Venezuelan receivables would probably be attached; sooner if PDVSA debt goes into default rather than Venezuelan sovereign debt. But in both cases Venezuela could continue to sell oil.

In short, the evidence from the Ecuadorean default of 2008 is not completely clear-cut ... but the preponderance of the evidence seems to be that any fall in oil prices will take some time to manifest.

Sources tell me that Venezuelan ministers fervently believe that default will lead to cut off in immediate oil exports, or at least a drastic fall in realized oil prices. I suspect that they are wrong ... but it is a good thing for creditors that they do not know that they are wrong.

And now for something completely different

 Venezuela! An economy in such bad shape that the Economist is now comparing it to Zimbabwe circa 2001.

The immediate question is: will Venezuela default? Ricardo Hausmann says yes. The markets say maybe. And Francisco Rodríguez says no. 

Here is the logic behind a “no.” Venezuela has $52 billion of liquidatable external assets. It has internal assets that include 7,000 tons of gold deposits, worth about $274 billion. (Admittedly, that is gold under the ground.) Moreover, while Venezuela is importing a lot, the level of those imports is due to the country’s distorted exchange rate. 

Of course, the Bolivarian Republic would default if default were costless. But it’s not. First, the country has a lot of external assets that creditors could try to seize. Second, Venezuela would run the risk that the receipts from its oil exports could be attached. According to Rodríguez, Ecuadorean oil prices fell almost 20% against Brent when that country defaulted and did not rise again until the 2009 buy-backs. He estimates that something similar happening to Venezuela could cost the country $5.2 billion per year. Third, if the price of Venezuelan oil goes back to $42, the country will be fine, and that will happen within a year or so.

If oil prices stay low, Venezuela will need to finance $25.4 billion in 2016. If they rise, those needs will drop to $20.3 billion. Either way, they can be financed, as this table shows:

2016 oil price	$ 24.9	$ 41.3
External financing needs (bn)	$ 25.4	$ 20.3
Sources of financing:
Chinese fund renewal	$ 5.0	$ 5.0
Use of existing Chinese deposits	$ 2.5	$ 1.5
Mining concessions	$ 2.5	$ 2.0
Bond swap	$ 3.1	$ 3.1
Asset-backed loans	$ 5.0	$ 3.5
Sale of Petrocaribe trade credits	$ 2.0	$ 1.0
Net bond sales	$ 0.5	$ 1.2
Change in reserves	$ 4.8	$ 3.0

Not all of these would be easy. Mining concessions means mining concessions granted by a government with a long history of expropriation. Asset-backed loans means issuing loans against assets (like Citgo refineries and stations) that might be attached in event of default. And as for the cost of default, well, I do not think Francisco is correct when he argues that Ecuadorean oil prices took a hit when the country failed to pay.

I suspect that Venezuela will avoid default his year, because it can. But in the next two posts, I will explain why it won’t be easy to take loans out against Citgo and show that Ecuadorean oil prices suffered no hit when that country defaulted. In other words, Venezuela will put off default for another year, but the costs will be higher and the benefits rather lower than Francisco calculates.

Is Ecuador’s resource nationalism hurting it in the oil price crash?

 In comments, reader Cad points out that Ecuador’s oil policy has a downside: the same fixed-price policy that lets the country take all of a price windfall exposes the government to large losses in the event of a price crash. 

Under the best-known service contracts, the Ecuadorean government pays private companies a fixed price per barrel. It then resells the oil at the market price. In other words, it takes all the upside from price rises. (This new policy was the cause of several of the country’s big expropriation disputes.) A subset of service contracts allow private companies to help Ecuador’s state-owned companies (Petroamazonas and Petroecuador) extract oil, also at a per barrel fee.

Finding out Ecuadorean operating costs has proven remarkably hard, although there is some rough evidence that costs have recently risen rather dramatically. What we do know, however, is how much money crude oil extraction has generated for the Ecuadorean state. That revenue, in real terms, has fallen 55% since 2013. On a per barrel basis, revenue for the state has fallen 56%.

Of course, prices have also fallen. Ecuadorean exports fetched $95.63 per barrel in 2013, $84.14 in 2014, and $42.00 in 2015. (Those are weighted averages.) That is a ... 56% decline, which is the same as the per barrel decline in state revenue. 

So not much evidence that resource nationalism has hurt revenues from those data.

What about international comparisons? Sadly, the data for Colombia only runs through 2014, but the Mexico data is available through 2015. In Mexico, oil revenues declined 55% in 2013-15. Revenues per barrel, however, declined by only 50%. So Mexico did slightly better than Ecuador at squeezing the upstream oil sector. (These figures do not count revenues from excise and value-added taxes on refined products.) 

In short, Ecuador’s oil policy has not led the country to do worse than would be expected given the crash in oil prices ... but it is possible that an alternative policy would have kept government revenues from falling quite as far. 

Now, Mexico’s oil tax policy is not particularly recommended. It is fiendishly complex, but it essentially boils down to a tax on Pemex’s gross revenues. The result is a company starved of resources and declining production. (Down 10% on 2013, whereas Ecuador is up 3%.) It is not clear that Mexico is an example to emulate.

But at least from these data it appears that Cad was incorrect when he wrote, “Mashi Correa’s greedy and short-sighted gamble was a disaster and now the people of Ecuador stand to suffer.” Rather, thus far his oil policy seems to be holding up remarkably well both in comparison to the price crash and to at least one benchmark comparison. Colombia may have done better; when we have the numbers, I will analyze them.

Ecuador and falling oil prices

 In comments, reader Cad points out that Ecuador’s oil policy has a downside: the same fixed-price policy that lets the country take all of a price windfall exposes the government to large losses in the event of a price crash. 

Evaluating the size of the problem means constructing a counterfactual: how much income would the government be taking in under a different fiscal regime? As of this moment, I do not yet have the data to construct that counterfactual.

We do, however, have the data to get a general idea of how the oil price crash has affected Ecuadorean public finance. Now, it should be noted that Ecuador is much more oil-dependent than Mexico. In addition, it does not have its own currency. As a result, an oil price crash will hurt Ecuador through channels other than public finance. That said, public finance is still the main channel; it is also the main way in which Ecuador’s policy of paying companies a fixed price to extract the oil will hurt the country should oil prices crash.

This post is not going to evaluate the cost of Ecuadorean resource nationalism. It is just going to lay down the fiscal context for such an evaluation.

So how is Ecuador doing? So far, surprisingly well considering that (unlike Mexico) the country has neither hedged oil income nor imposes any significant domestic petroleum taxes. Here are the basic figures for government revenue, in current dollars:

Oil income has plunged since 2012, but the government has made up for it via other taxes. (Of course, those taxes do impose a burden on the domestic economy, so it is not a free lunch.) Oil revenue is down 63% since 2012 (a fall of $3.8 billion), replaced by a 43% hike in income taxes (raising an additional $1.4 billion), an 18% increase in VAT ($1.1 billion), a 30% rise in tariffs ($0.8 billion), and a whopping 92% increase in other nickle-and-dime taxes ($1.4 billion). 

This is painful, but it is responsible. It also explains much of why President Correa causes such outrage among a certain class of Ecuadoreans: taxes on wealthy people really have increased quite substantially during his administration, especially in the last three years. His opponents are not responding to his rhetoric. They are responding to real economic pain that he has imposed upon them, although it is worth noting that even now income taxes in Ecuador raise revenue equal to only about 5% of GDP, up only a single percentage point since 2012 and two percentage points since Correa took office in 2007. 

On the spending side, the decline in oil income has cut the country’s ability to borrow. (In comments, Federico and I discussed this point in July 2015) Nominal public spending fell by 10% in 2015, with most of those cuts falling on fixed capital investment. (I.e., roads, bridges, railroads, buildings, sewers, etcetera.) This chart shows the basic outline:

In short, the adjustment to lower oil prices in Ecuador has been hard but not catastrophic. It is not immediately obvious what other course the government should have taken; in fact, if you take 2012 as a starting point, the situation has been well managed. 

Of course, it is not unreasonable to take 2007 as a starting point. Perhaps Ecuador should have spent less during the boom, but that is at best unclear: the country’s physical infrastructure was in woeful shape and has improved substantially. Its Human Development Index went from 0.698 in 2005 to 0.732 in 2013. The improvement is not stunning, but it is not terrible. (It is roughly the same proportional rise as in Mexico.) Perhaps Ecuador could have achieved that without the run-up in public spending, but that is not clear. 

What is clear is that Ecuador is not Venezuela.

Which brings us back to Cad’s implicit question: could Ecuador have avoided the 63% fall in oil revenue after 2012? We will take that up in another post; but first, any comments?

Reconciling Mexico’s public spending numbers

 Close readers have noticed that this post about Mexico’s public finances labeled federal revenue at around 18% of GDP. Conversely, this earlier post about the recently announced budget cuts said that the Mexican government took in roughly 28% of GDP. What explains the difference?

Well, the 18% number comes from the Mexican finance ministry (SHCP, for its initials in Spanish). It includes only revenues earned by the federal government the way most people would think of it. The 28% number, on the other hand, comes from the IMF and it includes all public entities, including Pemex.

So what does that mean? Well, the SHCP numbers include only the tax payments that Pemex makes to the federal government. The IMF numbers, on the other hand, include all Pemex gross revenues. That is, they include every single penny of hydrocarbon sales. The same applies to other state enterprises, including the Comisión Federal de Electricidad ... meaning that every penny of retail electricity sales is also counted as government revenue under the IMF reckoning.

For the purposes of each post, the relevant number is used. 

The Greek problem for dummies

 Since I am really not well versed on Greek finances, I’ve been looking at the numbers. The bottom line is that debt forgiveness will help the Greeks, but not by a whole lot this year. They just do not have a lot of money to spend.

The Greek state ran a primary surplus of 1.2%, according to the Ministry of Finance. This is rather less than the 4.5% target for 2016. It is even less than the 1.5% that the IMF projected for 2014.

Greece needs to make interest payments of 2.9% of GDP in 2015, assuming zero growth. It also needs to make principal payments worth 8.6% of GDP. Greece will receive payments from the ECB via the Outright Monetary Transactions program (formerly the Securities Market Programme) worth 2.2% of GDP.

Upshot: unless there is growth in tax revenues (good luck) the country will have only 0.5% of GDP to use for stimulus. (1.2% primary surplus + 2.2% from the ECB − 2.9% interest = 0.5% total balance.) That assumes that all of its principal due is rolled over or refinanced.

On the other hand, the Greeks still do not have a whole lot of room for manuever. A full default would net them only 1.2% of GDP and even that would depend on default being orderly. Moreover, their primary surplus jumps around a lot, so they will still need a lot of short term borrowing to keep the lights on.

In numerical terms, the whole battle is over 0.7% of Greece’s GDP.

Of course, that isn’t really the battle. The Greeks want two things (1) independence from Brussels/Frankfurt/Berlin and (2) avoiding the further spending cuts and tax hikes that the troika wants for this year. Much more austerity would be needed to hit the 3.0% primary surplus the troika demands for 2015. 

It would seem to me that it would not be terribly hard for the Germans Europeans to relax the austerity targets for this year and next. No need for write-downs or anything that would disturb a cranky German voter. In fact, it would seem to be easy to concede 0.7% of GDP to the Greeks in a way designed to avoid offending German sensibilities. But instead we are in full fire drill mode. Why? Is the answer really only that the Greeks have been too loud about asking?

Heed the ZEDE

 Tom Bell of Chapman University has found a copy of the Honduran charter city enabling legislation. 

According to Tom’s analysis, the legislation is pretty far-reaching. Inside the “Zonas de Empleo y Desarrollo Económico” (aka, ZEDE) a presidentially-appointed “Committee on the Adoption of Best Practices” replaces the old Transparency Commission. A “Technical Secretary,” selected by the Committee, runs the place. It then gets to opt-out of the existing Honduran tax system. (I do not if that includes social security taxes.) It also gets tariff-free status.

Not quite a charter city under the original conception: no foreigners running anything, except possibly on the Committee. (I do not know if Committee members or the Technical Secretary have to be Honduran.) Foreign courts can be used, but as far as I can tell only if the parties to the dispute agree.

Nor is opting out of Honduran taxes particularly beneficial: Honduran income tax rates top out at 25%, corporate dividends are expensed and evasion is easy. (To be fair, the Honduran state does not operate very well, so those taxes do not provide as many public goods as in say, Nicaragua.) Even if you believe that low taxes would attract investment and generate growth, we do not know how low taxes will be: there is a requirement that the charter city provide “adequate education, health care, social services, labor rights, and environmental protections” and the cities will need to kick up 12% of their revenue to the central government.

In other words, it seems like a free trade zone in which democratic governance is suspended. (Moreover, a free trade zone in a country that already enjoys free trade with the United States.) That seems not like a recipe for growth. What am I missing? 

Philippine mining taxes are being reformed ... we think

Colombia is in the midst of a controversy over mining taxes. In fact, wrangling over taxes is a lot of the reason why I’m here.

Coincidentally, the Philippines is about to overhaul its mining tax regime. According to the Financial Times, the idea is to replace a hodge-podge of taxes (a 2% excise tax, 5% royalties on federal lands, and a share for indigenous people of at least 1% — see page 37 of this review of mining tax regimes and page 12 of this overview of Philippine excise taxes) with a simple flat 10% excise tax on sales, using the average monthly price in London. More importantly, the government will also take a windfall tax when prices rise above a certain level.

What’s not to like? Well, three things.

First, the basic reform does not change very much. I am not seeing where these tenfold increases in revenue are supposed to come from. Below is the current revenue from mining taxes (data here) in millions of pesos:

		Government revenues from mining
	Output	Royalties	Excises	Other	Local govt
1997	₱ 33,100		₱ 114.8	₱ 921.5	₱ 70.7
1998	₱ 37,700	₱ 34.9	₱ 123.9	₱ 798.6	₱ 116.7
1999	₱ 30,900	₱ 37.5	₱ 241.1	₱ 1,016.9	₱ 180.9
2000	₱ 31,000	₱ 51.2	₱ 243.3	₱ 1,279.1	₱ 152.1
2001	₱ 29,000	₱ 66.3	₱ 129.8	₱ 647.6	₱ 138.4
2002	₱ 35,200	₱ 58.5	₱ 303.6	₱ 823.8	₱ 204.8
2003	₱ 41,100	₱ 79.8	₱ 155.8	₱ 1,039.2	₱ 226.9
2004	₱ 43,400	₱ 120.1	₱ 232.5	₱ 2,769.1	₱ 358.5
2005	₱ 50,200	₱ 210.2	₱ 251.4	₱ 4,733.6	₱ 453.5
2006	₱ 72,200	₱ 192.1	₱ 489.6	₱ 5,313.2	₱ 395.0
2007	₱ 102,200	₱ 774.0	₱ 942.1	₱ 8,371.7	₱ 359.8
2008	₱ 87,100	₱ 557.4	₱ 660.3	₱ 5,949.5	₱ 522.2
2009	₱ 106,100	₱ 396.2	₱ 718.8	₱ 10,272.5	₱ 992.8
2010	₱ 145,300	₱ 800.6	₱ 1,305.9	₱ 10,187.9	₱ 1,070.8
2011	₱ 163,200	₱ 1,180.8	₱ 6,985.8	₱ 12,736.2	₱ 1,176.9
2012	₱ 100,800	₱ 1,644.1		₱ 5,817.8	₱ 496.6

Discounting 2011 (the leap in excise revenues seems to be a temporary effect of a decision by the Bureau of Internal Revenue to impose a 7% tax on gold sales) taxes have already been bumping around 10% of total revenues.

Most of the revenues are not from specific mining taxes, but rather general impost and fees. The below chart recasts the above data in terms of the percentage of total gross mining sales paid in taxes:

Which brings us to the second problem with the reform: the trouble isn’t in the Philippine mining tax code, it’s in enforcement. Excise tax collection runs only around half the statutory 2%. In a report by Maita Gomez, on page 20, government officials blamed widespread evasion (which is odd, considering that the Department of Environment and Natural Resources has the production statistics) and the central bank’s willingness to buy gold without tax payments. (Hence the 2011 special tax.) Royalty payments are even less, since they only apply to companies operating in special reservations.

How can we be sure that a higher 10% excise will be enforced better than the current 2% + 5% royalty? Switching to London prices won’t do much, because page 21 of this IMF report on Philippine mining taxes states that London prices are already used. Moreover, excise taxes have an additional problem: when commodity prices drop, they can drive projects into the red. (By definition, a well-crafted income tax cannot do that.)

And so the third thing not to like: what will matter about the new law is precisely what we do not yet know. How will it treat windfalls from high prices? The details will matter a lot, and that is what has not yet been decided.

In short, if that third leg is well-designed, then the Philippines could start pulling in a lot more public revenue when prices are high. But if it is not, then the rest of the reform won’t make much difference.

Brazil imposes a tax on atomic energy to promote atomic energy

Brazil is about to place a 10% tax on the gross revenue generated by the sale of nuclear electricity.

This is a strange idea. As a revenue-raising device, it is improbable. Nuclear energy is not cheap: there are no ex ante rents to seize. Post hoc, it is possible to grab value from the financiers — capital expenditures are what drive up nuclear’s costs — but that would serve only to disincentivize reactor construction.

As a disincentive, however, a 10% revenue tax is a lousy one. First, most of the costs can be passed on to consumers: electricity demand is not very elastic. Second, regulators can prevent those costs from being passed on, but regulators can also stop nuclear power plants from being built. Heck, almost any policy uncertainty can stop a nuclear power plant from being built. In short, using a tax to disincentivize reactors is either ineffective or unnecessary.

So, why?

The key feature to note is that the revenue from the tax will go to local governments, not the federal authorities. It is actually a way to build local support for reactors.With the tax, localities will have some skin in the game.

In fact, that was how they did things in Japan.

In 1974, Japan created a special purpose tax on electricity. The government funneled most of the revenue into Electric Power Sites Account, which went to local governments that allowed power plants to be built in their jurisdictions. Most of those plants, not surprisingly, turned out to be nuclear. Between 1997 and 2007, 68.4% of Electric Power Sites Account grants went to nuclear power plants, against 27.3% for thermal power and 3.9% for hydroelectric.

To give an example, seven Tepco-owned nuclear re­ac­tors in Kashiwazaki City in Niigata Prefecture in western Honshu generated cumulative amounting to ¥113.3 billion from 1978 to 2009; the combination of central grants and sub­sidies (plus direct taxes on Tepco)], accounted for 34.5% of Kashiwazaki City’s revenue.

The Japanese designed the system to reduce local opposition to new plants. The government front-loaded the subsidies so that most of them went to the local government between the start of construction and five years after beginning operation. That gave localities strong incentives to approve new plants in order to prevent a decline in public revenue.

By 2011, parts of the Japanese business press were calling the subsidy system a “drug” for local governments and plant neighbors. Of course, that was the intent! It took the Fukushima disaster to change public opinion.

It remains to be seen if Brazil will be as successful in creating a constituency for nuclear power. There are a lot of differences between the two nations, not least of which that Brazil plans five new reactors over the next decade (at best!) while Japan rolled out 35 over the ten years following the 1974 law. But it could work. As long as regulators let utilities pass on the cost of the tax — not a certainty in Brazil — then a tax on nuclear power designed to promote nuclear will be an ingenious step in the never-ending battle against NIMBY.

Ecuador is not a colony of China

Since its big default on its foreign debt (which I should really write about, it was ingenious) Ecuador has made a lot of oil-for-loans deals with China. The FT reported that Ecuador sold oil at $14-$15 per barrel. Felix Salmon wrote a post entitled “How Ecuador sold itself to China.” Neat stuff.

But exaggerated. The Bolivarians in Quito have not sold their sovereignty to China. Here’s the deal. The China Development Bank (CDB) loans money to Ecuador. Petroecuador repays by shipping oil to China. The Chinese pay for the oil at market prices. The money is deposited in the CDB, which withdraws 21% of the revenue to repay the loan. China has made three of these loans, at fairly cheap interest rates: 7.25% for the first , 6% for the second and 6.9% for the third, at a time when Ecuador basically could not borrow and paid 8.45% on its outstanding issues.

OK, so no Chinese empire ... but is China freeing Ecuador from dependence on the United States? (We will ignore that whole dollarization thing.) Not really. There are some reports that the country is now exporting all its crude to China and Latin America. The official figures for the first half of 2012, however, tell a different story. By value, 59% of oil exports went to the United States; another 11% went to Chile and 10% to Peru. Only 2% worth (or $137 million) went to China. Ditto, imports of refined products from the U.S. of A. came to 55% of Ecuadorian petroleum imports; an additional 8% came from Panama. Only 5% came from Venezuela and nothing from China. Ecuadorian crude isn’t the best quality, but it’s good enough for Chinese refineries ... except they do not seem to really want it.*

(A useful resume of different oil blends is here: scroll to Table 1.)

OK, then. Unless something drastically changes, Ecuador is going to pay Occidental. Maybe not for a while, but it will pay. And China does not have a colony across the Pacific, fun as it is to imagine such a thing.

I should mention that the international courts thing runs both ways. Maybe Ecuador will pay Occidental with assets taken from Chevron ...

* UPDATE: I imagine that Petroecuador is swapping its oil for oil from other sources to send to China. PDVSA does this all the time, so it would not be unprecedented, and it would explain why the Central Bank reports almost no crude exports to the PRC despite the loan deals.

Financing the Revolution

 In an earlier post, I marvelled at Hugo Chávez’s mishandling of PDVSA. The same applies, however, to the fellow’s handling of the Bolivarian Republic’s fiscal accounts. There is something truly amazing about watching an oil-rich republic run into severe budget problems at a time of record oil prices. The upshot is that Venezuela might be even less able to thumb its nose at ICSID than people currently believe.

How bad are Venezuela’s budget problems? Francisco Rodríguez, whose work has been mentioned three times before on this blog, has done the dirty work of digging into the Bolivarian Republic’s accounting. That isn’t easy, because Venezuela has increasingly resorted to off-budget accounts, which now account for about a fifth of all public spending.

Let’s take them in turn. The first is Fonden. Fonden is ... well, it’s hard to say. The “National Development Fund” gets part of its money from PDVSA and part from the Central Bank. The Central Bank turns over “excess reserves” to Fonden. What does that mean? Answer: a sneaky way of financing the government by printing money. Consider: the Venezuela central bank prints bolívares and exchanges them for dollars. It then hands the dollars over to Fonden. If Fonden uses the money to import stuff, then the process ends. But if Fonden buys domestic goods and services, then it has to hand the dollars back to the central bank in exchange for bolívares. As of the end of 2009, $30.1 billion of Fonden $58.1 billion has come from the Central Bank. (See page 121.) This is, in effect, borrowing.

The second are the Chinese funds, financed by loans from ... duh ... China. Venezuela has borrowed $12 billion from China, going through PDVSA, and an additional $30 billion that is entirely obscure. (The $30 billion is a 10-year financing facility; it does not seem that the Bolivarian Republic has yet drawn any money from it.) It pays back interest and principal on the $12 billion by shipping back oil. How much oil? Well, PDVSA makes it impossible to tell, by mixing fuel oil and crude in the statistics. (See page 127.) You gotta love that.

On page 9, Rodríguez estimates that the country ships about 89 million barrels to China every year in loan payments. At $97 per barrel, that will be $8.6 billion, so either Venezuela is going to pay that debt off very quickly or China is charging an insanely high interest rate. (Inasmuch as PDVSA is shipping fuel oil instead of crude, the loan will paid off even faster.) Private sources estimate  the rate is LIBOR plus 2.85%, about 4.0% at the moment. That is a very low rate, consistent with a very short payback period for the loans. Nonetheless, I would not discount the possibility that China may be, in fact, running away with the store.

Finally, PDVSA has taken over many state functions directly, and the Bolivarian government carries out a lot of functions outside the official bureaucracy. That increases both spending and revenues.

The upshot, as a % of GDP:

That’s a pretty phenominal level of mismanagement for a country in the middle of an oil boom. The estimate is that the deficit was 7.9% in 2011, and will be 10.9% in 2012. The government will have access to $10.9 billion of central bank reserves (e.g., printed money), $7.7 billion of new Chinese lending, $15 billion of internal debt, and at least $15 billion of external debt. The reason I say at least is because Venezuela does not issue external debt solely to finance the government; Venezuela also issues external debt to prop up its exchange rate. For example, in the first half of 2011, the government needed only $12 billion, but tapped external financing sources totaling $24 billion.

Venezuelan debt financing:

The result is that at least until the country devalues (which would solve a lot of the financing problems, by raising the bolívar value of oil exports) Venezuela will need access to foreign financing. If that is going to come from private markets, then ExxonMobil will be able to attach it in order to pay any ICSID judgments. If that is going to come from multilateral lending institutions, then Venezuela will need to satisfy the U.S. government: Argentina is the only country to have ignored an ICSID judgment, and the Obama administration has declared that it will oppose new lending to that country. (The relevant testimony comes in this video at minute 41:40; more details here.) Venezuela will likely face even greater opposition. Lastly, if the money is going to come from the Chinese government, then China is going to attach strings (or charge quite a bit) ... and it is far from clear that China would want to weaken the existing system of investor-state arbitration.

Either way, Venezuela’s fiscal problems are a bit stunning to behold. It’s an impressive accomplishment, in its own strange way.

De tocho morocho, dice el IMF a la madre patria

 The IMF just published its report on the Spanish economy. It isn’t good. As for what to do? Well, the boffins at the Fund recommend a little of everything:

• Fix the wage-bargaining system ... the IMF thinks an agreement will be ready by May, not apparently realizing that it already is May;
• Lower severance payments to fired workers;
• Change to an “opt-in” rather than “opt-out” system for collective bargaining, whatever that means;
• Eliminate indexation;
• Speed up implementation of the E.U. Services Directive (although the madre patria has done pretty well on this tip;
• Liberalize more product markets (big boxes and power centers, here you come!);
• End the subsidies to homeowning over renting;
• Cut the deficit by 5 percentage points in 2010 and 2011;
• Cut tax subsidies and raise VAT and excise rates;
• Raise the retirement age to 67 right now;
• Do something to get spending by the Autonomous Communities under control — they recommend Belgium as a role model;
• Fix the damn banks, mostly via consolidation;
• Reform the savings banks, basically by eliminating them as a category.

Sort of like an evil twin version of Wilson’s Fourteen Points. It might even work. But it is a very full menu — the government is being asked to reform basically everything — and it will require a great deal of social solidarity. It is not clear to me that Spain has it. The unions don’t really trust the Socialist Party, and the People’s Party hasn’t been able to resist making political hay out of the eurocrisis. (I mean, really?) It is asking a lot of a government to try to alter the labor market, financial system, pension scheme, tax structure, and federal relations all at once. De tocho, indeed. Of course, presumably the consequences of doing nothing will be worse, but it is hard to sell people on stuff that will make them suffer by using counterfactual reasoning.

That said, Spain is in the lucky position of being able to get rid of its army if need be. How many other countries have gone into fiscal crises with that luxury? Maybe tis time to revisit that old EDC treaty ...

Do tax systems matter? Evidence from Mexico

 Many politicians like to claim that low taxes are good for growth. it is not at all clear that low taxes do anything for growth. What makes me say that? Well, if they were, Mexico should be a powerhouse. After all, KPMG just declared that it had the best tax system in the world, with an overall burden only 60% of the United States and a third of France! So it should be growing like gangbusters, right?

Some argue, sensibly, that low taxes only work when budget deficits are low. Otherwise the beneficiaries of low taxes act as if they have received a tax postponement rather than a tax cut. Anticipating higher taxes (or inflation) in the future, they work less now. The problem? Mexican budget deficits are very low, as are its overall debt burdens.

 

Obviously, other things are going on. But having slow-growing Mexico get the top score for a business-friendly tax system should make one wonder about the importance of tax systems to actually doing business.

Public pension systems

  A few posts back, Megan McArdle took issue with my taking issue over her depiction of the social security reform debate of 2005.  (Follow that?)  Our differences fell into two boxes.  The first is whether the Bush Administration was willing to countenance payroll tax hikes.  She says that Andrew Biggs claims that they were.  On balance, I think she was right.  I found an L.A. Times piece from February 18, 2005, that claimed that the President “said earlier this week that he would not rule out paying those transition costs by raising the current wage cap of $90,000.”   The actual quote from President Bush is a little vaguer: “The one thing I'm not open-minded about is raising the payroll-tax rate, and all the other issues are on the table, and that's important for people to know.”  That said, the papers all seemed to think it was a genuine offer. 

In short, the Bush Administration showed some sign that it was willing to countenance a tax hike to pay for transition costs.  McArdle right, Maurer wrong.  That latter bit is sadly not uncommon.  I think Megan was too busy to point me to this post, which is where I think she got her claim from, but I understand.  She has a demanding job.  I do have to say, however, that Biggs’ account comes entirely from the same secondary sources that I’ve linked to here. 

The other debate was more abstruse.  “Carve-outs” and “add-ons” and other such wonkery.  The problem with such conservations is that all too often the conversators forget what exactly it is that public pensions systems do.   When you drill down into the issue, the difference between a pay-as-you-go (e.g., “paygo”) systems, like Social Security, and a privatized forced-saving scheme, like they have in Chile, becomes much less than it seems at first glance. 

So what is it that public pension systems actually do?

Long wonkish discussion below the fold.

The value of hairshirts

  You ever have a thought that you were having trouble formalizing?  I’m there, and not just because I just got through spinning my wife around and yelling, “Jeter!  Jeter!”  Rather, it’s because I’m trying to express an argument that I think is wrong. 

Last week, I tried to understand why the Mexican federal government was busy cutting spending in the middle of a depression.  GDP is down 10 percent -- that’s a horrendous number, in the full depression zone, far worse than 1995.  Why would you cut spending in the middle of such a collapse, especially when the markets don't seem to be worried about the fiscal situation?  It has gone so far to prompt Mexican Ph.D. students at Ivy League universities to start wondering if the Labor Party has a point when it runs ads saying that things would have better under AMLO.   

Some smart observers whom I respect, however, support the government cuts.  Gancho draws attention to a column by Macario Schettino, an economic historian.  Schettino argues that Mexico's fiscal problem isn’t just a short-term problem caused by the Great Recession; rather, it’s a sign of long-term trouble, namely the decline of the country’s oil revenues:

“To respond to that we have only two options. One is to do the same as always, which we know how to do: fake change and place the country in debt. It’s a direct and, unlike on other occasions, short path off the cliff. ... The other path is more complicated. It implies recognizing the secular failure of a political project and making decisions of the same size as the crisis: historic.” 

But why can’t you have it both ways?  Run up the debt now, when doing so will prevent unnecessary suffering, and raise non-oil taxes later.  There isn’t any economic problem with that.  What I think Schettino fears is a political problem:  without economic pain now and a very hard budget constraint, the Mexican political system won’t make the tough decisions until it is too late. 

Of course, there is a slight contradiction in the sense that Mexico’s hard budget constraint is self-imposed.  Right now, Mexico still has oil revenues (albeit slowly declining) and the markets remain willing to lend.  Nothing is forcing (or even incentivizing) the government to refrain from borrowing more.  To use a strained analogy, Schettino seems to view the Mexican political system as a recovering drug addict who just got into a serious accident.  Painkillers would speed recovery and ease suffering, but he fears that their use could provoke a relapse.  The argument is a stronger version of the suggestions some of my colleagues (notably David Moss and Aldo Musacchio) made against Argentina’s debt repudiation back in 2005:  repudiation might make economic sense, but freedom from debt will also give the Argentine government freedom from the discipline imposed by the need to meet repayments.  That could open the door to damaging irresponsibility later.   In the Argentine case, Moss and Musacchio seem to have been more right than I was, as shown by the Argentine government’s subsequent faking of inflation statistics and general mismanagement under President Fernández.  

While the Argentine example is a strong one, I am not sure of the general principle.  Is a self-imposed constraint really a constraint?  Is the Mexican political system really so sclerotic that it needs a crisis now to avoid a crisis later?  And even if it is, why not wait for that hypothetical future crisis to arrive instead of plunging the country into a deeper depression now?  None of this is to say that I think the Schettino argument is specious.  It isn’t ... but I still don’t think it’s a good reason to cut government spending right now.   

But I’ve been wrong before. Does Mexico really need to impose pain on itself in order to reform?  Or is that just a good way to lose elections?  Thoughts welcome.

Canadian oil taxes: too high, too low, or just right?

  Even if the occasional bout of Canadian sanctimoniousness can make me want to try to bloody some noses, I am a huge admirer of the Great White North.  Which is why, among other reasons, I am trying to figure out whether said country’s tax policy towards its oil and gas industry is too lenient, too onerous, or just right. 

Statistics Canada publishes some very good statistics on the “conventional oil” industry, which, confusingly, includes natural gas but excludes the Albertan oil sands.  Their numbers include operating costs, capital expenditures, and exploration costs.  They also include taxes and royalty payments to provincial governments.  (The Canadian constitution reserves authority over natural resources to the provinces.)  You have to do some digging to get the equivalent numbers from the oil sands, including some figures from the Albertan Ministry of Energy that might not be entirely equivalent, but it can be done.

And the results?  Well, Alberta produced C$79 billion worth of hydrocarbons in 2007, C$22,687 for every man, woman, and child in the province.  Of that, conventional hydrocarbons made up C$55 billion.  The companies that produced those hydrocarbons spent C$4 billion on exploration, C$17 billion on development, and C$10 billion on operation.  That left them C$24 billion in net income, of which the government of Alberta took C$9 billion in taxes and royalties.  Add in another estimated C$2 billion in income tax payments, and you have a total take around 65% of the industry’s net cash flow before financing, which is what the measure really is.  Crushing socialism!  Or, put another way, a sensibly high tax rate, since the royalties are structured in such a way as to essentially exempt new investments until the initial costs are recovered.

That fact, however, suggests that maybe net cash flow isn’t the right denominator.  After all, income taxes are generally applied before investment expenditures.  Alberta is trying to subsidize them.  In that case, isn’t operating income the right measure?  Okay ... using operating income as the denominator, the effective tax rate on conventional hydrocarbons in Alberta drops to 22%.  That seems pretty low.  And, of course, if you just use the government take as a percent of revenues for your calculation, then you get a rate of only 18%.  That is almost tax-free compared to such left-wing hotbeds as Alaska.

The numbers for the oil sands are even stranger.  On the one hand, taxes and royalties as a percentage of operating income was only 28%, and as a percentage of gross revenues were only 19%.  On the other hand, if Statistics Canada is to be believed, the industry reinvested all of its operating profits and then some in 2007.  Royalties came to 150% of net cash flows before financing.  If the idea is to encourage investment despite low profits, then maybe the system is about as high tax as it can get.

So what’s the “right” number?  Are taxes high or low?  For what it is worth, other provinces, like Saskatchewan and Newfoundland, turn out to be even lower tax than Alberta ... but don’t have anything like the amount of investment.  Companies there are taking the money and running. 

Thoughts?

Happy tax day!

  So today is tax day in the United States.  I feel like celebrating.  Man, taxes are low in this country.

My wife and I don't own a home (yet) or have children (yet) and pretty much don't qualify for any special tax deductions.  No home office, no capital gains (who had any in 2008?), some moving expenses and plenty to charity but not enough to make itemizing worth our while.  So we pretty much paid the statutory rate.  And what did that come to?  A whopping 32%, including what we paid the Commonwealth of Massachusetts.  Our combined marginal rate was a little higher, a hair under 40%, all told. 

We're pretty high up in the income distribution, according to this table. 

What about indirect taxes?  There are two ways to calculate that.  If you assume that people pay indirect taxes in rough proportion to their income, they added (including corporate income taxes as "indirect") about 16 percent to our tax bill.  But that's not right --- indirect taxes are fairly regressive.  If you assume that indirect taxes are paid as lump sums, then they took about 4 percent of our income.  But that's probably too low.  Let's split the difference, call it 10 percent.

So the entities that provide us with old-age wage insurance, old-age health insurance, police, basic education, pirate-killing, roads, regulation, and whole lot of other things took only four-tenths of our income in 2008. 

That seems cheap.  We could pay quite a bit more.  At least until we have children. 

Even more humorless, I am

I'm losing my sense of humor about the election.  (Yes, I know that some of my readers believe that I never had any.  They're probably correct.)  I could handle the lying, that's what Republicans do, and anyway, we've hit back.  (McCain doesn't really oppose stem cell research and McCain isn't really anti-immigrant, although he really doesn't like Social Security and won't say how much he'd like to cut it.) 

But this crap is too much.  Senator McCain lies about suspending his campaign.  Then he flies to Washington for a big meeting.  At which he takes no stance.  The congressional GOP procedes to propose a plan which makes absolutely no sense.  Viz, as far as I can understand it:

(1)  Insure all mortgages.  Charge premiums high enough to make the insurance self-financing.  Okay ... but the mortgages currently in default never paid any insurance premiums in the past.  So how are you going to pay to insure existing mortgages?  Magic?  Brazilian foreign aid?  I think Brazil might have enough foreign reserves to do that, and they owe us ... oh, wait, no, they don't owe us.

(2)  Cut taxes to get private money to recapitalize the banks.  Uh, okay ... but y'all aware that people who have underwater assets are currently subsidized by the tax code?  Cut taxes, and you cut those subsidies.  They want to cut capital gains taxes on assets that are already underwater to encourage financial institutions to sell them?  Huh? 

Besides which, why is raising expected returns from 4% to 4.6%, or 10% to 11.5%, or whatever, going to enough to persuade that tidal wave of capital to unlock itself and pour into financial institutions?  Spreads are already huge and nobody wants to lend. 
                        
(3)  Require that Fannie and Freddie no longer securitize unsound mortgages.  Wait, didn't you just call for the federal government to insure said mortgages?  Oh.

Now, normally this nonsense wouldn't mean anything.  Nancy Pelosi controls the House; with Bush in office, she wants Republicans to sign on for political cover.  Meanwhile, over in the Senate, they only need to peel off nine Republicans to pass the Dodd plan.  But now McCain is refusing to commit himself and has made positive noises about the above bit of gobbledygook, meaning that nothing will get done for forty days.  At least.  Okay ... but why all the sturm-und-drang from McCain then? 

The political logic escapes me.  The economic logic escapes me.  John McCain appears to have escaped the bounds of gravity.      

Policy of Attraction, part 2

  The Philippines came under American military rule in 1898.  In 1902, Congress authorized a civilian government known as the Philippine Commission, which ruled the place until the Philippine Autonomy Act of 1916. 

 

By the admittedly low standards of colonial governments, the Philippine Commission ran the islands rather well.  It spent heavily on infrastructure and education.  It purchased rice overseas during shortages and sold it at subsidized prices.  It ran a wide array of public enterprises, including a credit system.  It even ran an agricultural research program that managed to double crop yields. 

How did it pay for this?  By taxing the Philippines quite highly by contemporary standards.  Strangely, an entire literature has developed around the idea that the Commission government undertaxed the Philippines.  That literature simply happens to be wrong.    

Here are some international comparisons from 1920:

		Revenue per capita	GDP per  capita	Gov't revenue as a % of GDP
	Philippine Islands	$4	$36	10.5%
	Puerto Rico	$15	$190	7.9%
	United States	$85	$803	10.6%
Asian colonies	India			6.0%
	Malaya	$16	$181	9.0%
	Korea	$4	$42	9.5%
	Dutch East Indies	$5	$52	9.6%
	Taiwan	$7	$64	10.5%
	Burma	$5	$43	11.7%
	Vietnam	$3	$21	14.2%
Latin American states	Peru	$6	$163	3.4%
	Mexico	$9	$176	5.1%
	Argentina	$17	$444	3.9%
	Cuba	$25	$375	6.6%
	Brazil	$8	$69	11.3%

The Philippines only seemed undertaxed because few outside observers bothered to estimate how low nominal incomes actually were.  In fact, Philippine tax collection was even more advanced, because the implementation of full free trade between the U.S. and the Philippines in 1909-13 utterly devastated trade tax revenue.  The Philippine government, therefore, needed to develop a remarkably efficient system of internal taxation for such a poor nation.

This leaves a puzzle, of course:  why didn't the Philippines capitalize on its relatively efficient tax system?  The modern Philippines collects only 14 percent of GDP in taxes, barely above its revenues in 1920.  That is not enough to fund education, infrastructure, a modern judicial system, defense, police, public health, and (perhaps) anything resembling modern social insurance.

It's a mystery, along with other failings of the Commission government that will be the subject of later posts.   

El Hugo del extremo norte

In a previous post, I wrote that total taxes as percentage of revenues on hydrocarbon extraction in Alaska were 25 percent.  Well, I've just had a chance to play with the data, and it turns out that my estimate was flawed.  (It failed to take into account that profit margins in Alaska are substantially higher than the overall profit margins in hydrocarbon extraction across the United States.)  Direct taxes on Alaskan oil & gas actually turn out to be 32 percent of gross revenues ... 33 after Governor Palin's tax hikes. 

One-third of revenues is a nice round number that you can use to put hydrocarbon tax burdens in other countries into perspective.  Bolivian taxes, for example, had fallen impressively low by the time Evo Morales assumed office, and some revision was almost certainly in order.  Time will tell whether he found the right level, and the means by which he raised taxes caused unnecessary uncertainty, but a substantial tax hike on the industry was the right thing to do by the people of Bolivia.  Regardless of whether you're a Bolivarian.

The Barber of Buenos Aires

On March 1st, 2005, President Nestor Kirchner effectively repudiated Argentina's obligations to those bondholders who refused its final offer to restructure its debts. 

Four years earlier, during the chaotic month of December 2001, Argentina defaulted on its dollar-debts. Over that evil month, the economy was reduced to barter, mobs sacked bank buildings, and the country went through five presidents in eleven days ... starting with the unlucky fellow in the blue shirt, Fernando de la Rúa. 

After President Néstor Kirchner took office in 2003, Argentina began negotiating over the debt in Dubai.  The Argentine side did everything possible to flummox its creditors, up to and including bringing very scantily clad female “assistants” to meetings with high-ranking American women.  The Argentine chief negotiator also played doornail dumb, honestly confusing the Americans and Italians across the table (unsurprisingly, the half-naked assistant ploy discomfitted the Americans rather more than the Italians) about whether he was uncannily brilliant or honestly didn't understand what a bond was.  (I've met the man, and I don't know either.) 

The Argentines put a truly fascinating offer on the table:  the creditors would forgive past-due interest would be forgiven, and the old bonds would be swapped for new ones worth 35 cents on the dollar.  In return, however, the new bonds would include a GDP “kicker.” The kicker — pronounced “keek-care” by everyone involved — promised the creditors additional payments equal to one-twentieth of the dollar value of all GDP growth above a initial threshold of 4.2% per year, which would eventually fall to one-twentieth of all growth over 3%. 

The creditors rejected the offer, preferring a “haircut” of 40% on the face value of the debt, no interest-forgiveness, and no kicker.  In response, Kirchner told them, and the IMF, and the U.S. Treasury, and eventually even President Fox of Mexico (don't ask), that the bondholders could take his haircut or drop dead.  On March 1st, 2005, the president finally told the holdouts to drop dead, and repudiated their bonds.

Below my friend Aldo contemplates the question: was that the right thing to do?

A year ago, I would have unhesitatingingly answered, “Yes.”  Now, I still think it was the right thing to do ... but I'm worried about what the Fernández Administration intends to do with its hard-won fiscal freedom.  More below the fold.

Update: Global Tax Credits, corrected

The Knicks seriously suck.  Luckily for Eric, he's a Celtics fan.  Not that last season was any good, but this one is looking much better.  Luckily for me, I have every plan to abandon the hapless Knickerbockers the second the Nets put "Brooklyn" on their new jerseys.

Over email, Eric pointed out an error in my reasoning in the last post.  Here's our interchange:

Interlude: Global Tax Credits

Eric Werker, an assistant professor here at HBS, co-authored a rather provocative piece in the New York Times a week ago.  In it, he argued that the U.S. should replace its foreign aid program with a 39-percent tax credit for foreign investment in targeted countries. 

Now, let me start by saying that Eric is a brilliant colleague.  His work is clever, interesting, and iconoclastic.  He hasn’t written a paper that I didn’t wish I’d thought of first.  He’s also got a ton of real world experience in development work in the hairier places on the planet.  I think I’ve probably seen more dead bodies than he has, but I’m not sure.  Other than that, Eric’s got me beat cold on the travel-to-serious-places and do-serious-things tip.  In fact, to be brutally frank, he’s got me beat cold in pretty much everything.  Eric is smarter than me, taller than me, better-looking than me, younger than me, and he dresses hella better than I do. 

Nevertheless, this proposal seems, well, wrong. 

The first assumption is that the welfare gain from a dollar of foreign investment is more than the welfare gain from 39¢ of foreign aid.  Is that true?  I accept that only 40% of aid dollars actually go to “economic development,” which today means providing public goods of some sort.  So that 39¢ becomes 16¢.  We’ll further assume that the 16¢ of spending only produces 16¢ of welfare gains:  that is, there are no benefits to aid spending other than the value of the spending itself. 

So, in order to match the welfare gains of the one dollar of aid, our hypothetical dollar of investment spending would also have to produce 16¢ in welfare, a social rate-of-return of 16%.  That’s not low, I don’t think.  It’s higher than the social returns that Carlos and I calculated for the Panama Canal, and I’m just not sure I believe that a textile factory in Madagascar will generate social returns twice as high as the Big Ditch. 

In fact, another colleague of mine — the equally-brilliant Laura Álfaro — has some papers showing that foreign direct investment (FDI) produces no spillovers in very poor countries.  Their institutions — what an MBA student would call the “business environment” — are just tan jodido.  (That last is a technical term.)  Of course, there are plenty of places where FDI generates lots of spillovers — Trinidad comes to mind — but Trinidad and countries like it aren’t that poor and aren’t the kind of place that this program would target. 

The proposal also assumes that the big problem facing poor countries is a lack of investment.  That’s certainly possible, but I have some doubts.  First off, real interest rates are rather low in a broad swathe of underdeveloped nations, which is not consistent with the idea that there are all these investment opportunities going unseized for lack of capital.  Second, while a 39% rise in your return on capital is very hefty, you have to wonder about the elasticity of investment with respect to returns in very poor — and hence pretty risky — nations.  Are there that many marginal projects sitting around out there?  I’m remembering my own flirtation with trying to encourage economic development in the Tzotzil-speaking parts of Chiapas:  I’ll be damned if I can think of any projects where we muttered to ourselves, “If only our effective hurdle rate could be reduced from 9.8 percent to six!”  (Which is not to say that more profit isn’t preferable to less.)  Third, if public goods aren’t universally-provided, then subsidizing private returns is going to exacerbate whatever distorted investment patterns already exist:  e.g., investment goes to the places in the poor country that already have decent roads, electricity, and public health.  And that, of course, reduces the social rate of return on the investment. 

Of course, there’s another problem:  how do you know that companies won’t just use the tax credit to build factories that they would have anyway?  In fact, even if you’re pretty sure that the project would not have been built in that country without the credit, it’s going to be really hard to be sure that it would not have been built at all without the tax credit.  Now, if countries were really good proxies for economic deprivation, this wouldn’t be a problem — but do you really want to subsidize Nicaraguan textile factories at the expense of, say, Mexican ones?  Mexicans are a lot richer than Nicaraguans; it isn’t clear that Mexican textile workers are a lot richer than Nicaraguan textile workers.  And it’s even less clear how much subsidizing more textile factories will help peasants in either place.

I’d rather American taxpayers build schools and roads and immunize children and maybe even pay for (or provide directly) teachers and police, than make private goods cheaper.  If aid programs aren’t providing those public goods, and most of them aren’t, better to change the programs than junk them for a tax credit.  And if they can’t provide the goods — a result that would make the do-gooder in me very unhappy, but if that turns out to be the case, then I’ll just have to accept it — it would probably be better to get rid of aid altogether, except where we openly wanted to use our money as a political weapon. 

(Eric, in fact, has an absolutely brilliant paper showing how aid inflows go up when countries get elected to a seat on the Security Council, a perfect example of using money as a political weapon.  And the paper really is brilliant, systematically demolishing any other possible explanation for the temporary increase in aid.  As a left-wing imperialist and a patriotic peace-loving American, I highly approve of bribing other governments to get what we want.) 

The op-ed uses the New Market Tax Credit passed in the waning days of the Clinton Administration as an example of how the tax credit approach has been “a resounding success.”  Well, maybe it has, but I’m not so sure.  The problem is that the only metric of success that they give is that, “Seven years later, so many businesses want to invest in poor areas that only a quarter of the companies that applied for tax credits in 2006 received them.”  That’s kinda weak gruel on the success metric tip.  We’d need to know whether the companies that didn’t get credits abandoned their investments.  We’d also need to know how the investments affected employment, wages, poverty, educational attainments, public health, and crime in the areas they invested in.

You can see how the New Market credits are used in Carlos’s motherland here.  Another report is here.  If you read through them, the projects financed by New Market money don’t sound like stuff that wouldn’t have happened without it.  Even the frozen-pizza plant in the Menomonee River Valley, which quite possibly would not have been built there without the program, just moved 85 jobs from Illinois. 

I should also point out that New Market is far from a free-market initiative.  The companies that get the credits need to have local community members directly involved in decision-making, which means that they tend to go to public-private partnerships and the like.  I don’t think that the Global Tax Credit proposal envisions anything similar.  Now, that’s probably a good thing.  (If you’re going to give tax credits to FDI, it would probably be a bad idea to put local government officials on the project’s board.) But it does make the domestic and foreign programs even less comparable. 

En fin, I have very few doubts that ending the New Market program and spending the money on expanding the Earned Income Tax Credit or State Children’s Health Insurance Program would do quite a bit to reduce poverty in the United States.  In other words, the domestic programs lauded in the op-ed aren’t the best use of American tax dollars to fight poverty within our country, and they don’t provide much of a model for how we should use our tax dollars outside it. 

Eric tells me that the proposal is serious.  I’m not so sure, because Eric is beginning to make a habit of making outrageous proposals in the popular press — in one astoundingly entertaining piece, he suggested that we let corporations run for mayor.  But regardless of Eric’s intentions, there a lot of insane people — also known as “Republican congresspeople” — who will be all over this proposal like foul odors on excrement.  Since I for one happen to be a bit more agnostic about the idea that old-fashioned aid is useless — and this after getting down close to the dirt in Afghanistan, which should be enough to make even the most fervent aid proponent doubt that old-time religion — I’d like to hope that traditional aid isn’t replaced by tax credits that seem very unlikely to have any effect on growth or welfare in the countries that they’re intended to help. 

Plus, I’ve got my own crazy proposals to fund.  More on them some other time.  Comments, criticisms, counter-arguments?  All very welcome. 

The Never-Ending Story

 

I suppose I have to talk about the status debate at some point.

If you stroll out of the old city, the boulevards broaden and you’ll pass the impressive white dome of the Capitolio and its associated government buildings.  There’s a memorial to World War 1 veterans right to the south, where you can see Puerto Rican status debate in living color.  Quite literally. 

The Capitolio flies the flag that’s been official since 1995, whereas the monument flies the flag that was official between 1952 and ’95. 

Between 1952 and 1995, the canton on the Puerto Rican flag was the same navy-blue as the American flag.  Independence supporters, however, flew a flag with a lighter blue canton designed by Antonio Vélez Alvarado in 1892 at his apartment at 219 West 23rd Street.  That flag reversed the colors of the Cuban rebel flag. 

In 1995, the pro-statehood governor, Pedro Roselló, played an act of political jiu jitsu when he made the Vélez flag official.  Now anyone who flew the U.S.-blue flag was indicating that they favored statehood, while flying the Cuban-blue flag lost political significance.  Some nationalists started to fly flags with an even-lighter blue canton reminiscent of Ferdinand Marcos’s Philippine flag redesign.  That hasn’t exactly proved to be popular:  I've seen exactly one, in Bayamón, and I’m still not sure if it wasn’t an official flag that had simply been left out in the sun too long. 

None of it means that Puerto Rico is any closer to statehood.  Unless Congress forces the issue, I doubt that Puerto Rico will ever become a fully United state, even if it loses every single special benefit that its  Freely Associated status bequeaths.

What are those advantages?  Well, not a whole lot these days.  Corporations have lost their tax-exemption from investing here.  Individuals retain their exemption from federal income taxes, but the overall tax burden is only slightly lower, because Puerto Rican income tax rates are not low.  It collects a smaller percentage of GDP from those taxes than the federal government does on the mainland, but that’s because Puerto Ricans are poorer than mainlanders. 

Since Puerto Rican tax rates are not low, imposing federal taxes would create a very large fiscal burden.  Income taxes provide the island’s government with about 21 percent of its income, and would be difficult to replace. 

On the other hand, the problem is solvable.  First, the federal deduction for state taxes would eliminate about a quarter of the additional hit in total, and more for upper-income residents. 

Second, other taxes in Puerto Rico are lower than in most U.S. states, although a recent fiscal crisis prompted the imposition of a 5.5% state sales tax. 

Third, a State of Puerto Rico that lost the adjectives of "associated" and "free" would receive more federal revenue sharing.   (To be fair, the island already does pretty well on that tip.  Its "resident commissioners" don’t vote on the House floor, but they do in committee, and they’ve used their leverage quite effectively.) 

How much more is unclear.  The big gain would be come from Medicaid.  Puerto Rico Medicaid enrolled 938,000 people in 2004, 2.2 percent of the U.S. total, but the island received only 0.1 percent of the federal spending.  In theory, Puerto Rico could get up to $4 billion, gross.

In practice, it's net gain would be rather less than $4 billion, probably an order of magnitude less. The reason is that the Free State can define its own poverty line.  Puerto Rico’s eligibility requirements for Medicaid are therefore much tighter than on the mainland.  Bringing those rules in-line with the rest of the U.S. would force the state formerly known as "freely associated" to increase its own Medicaid spending, and therefore the taxes to pay for it.

Finally, under statehood individual Puerto Ricans would be able to benefit from the Earned Income Tax Credit (EITC).  For the Britons reading this blog, the EITC is the U.S. equivalent of the working tax credit.  For non-gringo non-Brit readers, the EITC is a negative income tax that subsidizes workers who make below a certain threshold—currently around $7,000 for a single individual and $15,000 for a family with two children. The maximum benefit for a single person is $412; the maximum benefit for a family with two kids is $4,536.  (I managed to qualify in 1996.  I received $36.)  Above the threshold, the credit is phased out at a marginal rate of 7.7% for a single person and 21.1% for a family.

Given how low incomes are in Puerto Rico, a lot of people would qualify.  The estimates are that the EITC would almost wipe out the island’s net federal income tax liability.  (With a few small exceptions, mostly excises, Puerto Ricans already pay other federal direct taxes.) 

The catch is that there would be distributional effects.  Rich Puerto Ricans would lose.  (So would foreigners who own investments in Puerto Rico.)  Poor working Puerto Ricans would gain.  American taxpayers would see pretty much a wash, give or take a billion. 

It’s rarely wise to bet against the interests of rich people. 

But why aren’t poor working Puerto Ricans clamoring for a change in status?  The reason isn’t economic.  Rather, it’s that Puerto Ricans have managed to pull off the postmodern hat trick of being loyal to the United States while still not feeling American.   

Consider that the island, after proper vetting through the courts, has just re-introduced the rather meaningless category of Puerto Rican citizen.  Also consider, however, that any U.S. citizen resident on the island is eligible.  In the same vein, the Popular Democratic Party just submitted a bill to the Puerto Rican legislature would would require the island’s Secretary of State to inform Washington that Puerto Rico no longer wishes the federal government to represent it in international organizations.  Will it pass?  No.  Does the Popular Democratic Party want to it pass?  Hell, no.  Do they think that it’s a worthy bit of posturing?  Oh, yeah.  Does it mean that the Popular Democratic Party supports independence?  Absolutely, categorically, and unequivocally not. 

I suspect that Puerto Rico will remain an associated free state unless and until Congress tells them, "Become a full state or f—k off."  At which point they’ll become a state. 

The readers of this blog are an eclectic and intelligent bunch.  I’d really like to know what you think should be done about Puerto Rico's status.  A choice between independence and statehood?  A "compact of free association" a la the former Trust Territory of the Pacific Islands?  Nothing?