BSP's loan to the IMF: Costs are Not Benefits

The simmering debate over the proposed loan to the IMF by the Bangko Sentral ng Pilipinas (BSP) can be summarized as:

For the anti-camp, the issue is largely one of purse control or where to spend the government (or in particular the BSP’s money) seen from the moral dimensions.

For the pro-camp or the apologists for the BSP and the government, the argument has been made mostly over the opportunity cost of capital or (Wikipedia.org) or the expected rate of return forgone by bypassing of other potential investment activities, e.g. best “riskless” way to earn money, appeal to tradition, e.g. Philippines has been lending money to the IMF for decades, and with some quirk “foreign exchange assets …are not like money held by the treasury” which is meant to dissociate the argument of purse control with central bank policies.

I will be dealing with latter

This assertion “foreign exchange assets …are not like money held by the treasury” is technically true or valid in terms of FORM, but false in terms of SUBSTANCE.

Foreign exchange assets are in reality products of Central Banking monetary or foreign exchange policies of buying and selling of official international reserves (Wikipedia.org)

This means that foreign exchange assets and reserves are acquired and sold by the BSP with local currency units, or the Philippine Peso, prices of which are set by the marketplace

It is important to address the fact that the local currency the Peso has been mandated as legal tender by The New Central Bank Act or REPUBLIC ACT No. 7653 which says

Section 52. Legal Tender Power. -

All notes and coins issued by the Bangko Sentral shall be fully guaranteed by the Government of the Republic of the Philippines and shall be legal tender in the Philippines for all debts, both public and private

This means that ALL transactions made by the BSP based on the Peso are guaranteed by the Philippine government. This also further implies that foreign exchange assets held by the BSP, which were bought with the Peso, are underwritten by the local taxpayers. Therefore claims that taxpayer money as not being exposed to the proposed BSP $1 billion loan to the IMF are unfounded, if not downright silly. We don’t need to drill down on the content of the balance sheet and the definition of International Reserves for the BSP to further prove this point.

The more important point here: whether foreign exchange or treasury or private sector assets, we are dealing with money.

And money, as the great Austrian professor Ludwig von Mises pointed out, must necessarily be an economic good, the notion of a money that would not be scarce is absurd.

As a scarce good, money held by the National government or by the BSP is NOT money held by the private sector.

Therefore the government or the BSP’s “earnings” translates to lost “earnings” for the private sector.

Costs are not benefits. To paraphrase Professor Don Boudreaux, that the benefit the BSP gets from investing in the asset markets might make sacrificing some unseen private sector industries worthwhile does not mean such sacrifices are a benefit in and of itself.

The public sees what has only been made to be seen by politics. Yet the public does not see the opportunities lost from such actions. Therefore, the cost-benefit tradeoff cannot be fully established.

Besides, any idea that loans to the IMF is risk free is a myth. There is no such thing as risk free. The laws of economics cannot be made to disappear, or cannot become subservient, to mere government edicts as today’s crisis has shown. Remember the IMF depends on contributions from taxpayers of member nations. And for many reasons where taxpayers of these nations might resist to contribute further, and or where the loan exposures by the IMF does not get paid, then the IMF will be in a deep hole.

As I pointed previous out the risk to IMF’s loan to crisis nation are real. There hardly has been anything to enforce loan covenants or deals made with EU's crisis restricted nations.

Also, it is naïve to believe that just because the Philippines has had a track record of lending to the IMF, that such actions makes it automatically financially viable or moral. This heuristics (mental short cut) wishes away the nitty gritty realities of the distinctive risks-return tradeoffs, as well as the moral issues, attendant to every transaction. Here the Wall Street saw applies: Past performance does not guarantee future outcomes.

It is further misguided to believe that the government (in particular the BSP) behaves like any other private enterprises.

As a side note, I find it funny how apologists use logical verbal sleight of hand in attempting to distinguish central bank operations from treasury operations but ironically and spuriously attempts to synthesize the functionality of government and private enterprises.

Two reasons:

1. Central banks are political institutions with political goals.

As the great dean of Austrian School of economics, Murray N. Rothbard pointed out,

The Central Bank has always had two major roles: (1) to help finance the government's deficit; and (2) to cartelize the private commercial banks in the country, so as to help remove the two great market limits on their expansion of credit, on their propensity to counterfeit: a possible loss of confidence leading to bank runs; and the loss of reserves should any one bank expand its own credit. For cartels on the market, even if they are to each firm's advantage, are very difficult to sustain unless government enforces the cartel. In the area of fractional-reserve banking, the Central Bank can assist cartelization by removing or alleviating these two basic free-market limits on banks' inflationary expansion credit.

2. The guiding incentives and structure of operations for government agencies (not limited to the BSP) is totally different from profit-loss driven private enterprises.

Again Professor Rothbard,

Proponents of government enterprise may retort that the government could simply tell its bureau to act as if it were a profit-making enterprise and to establish itself in the same way as a private business. There are two flaws in this theory. First, it is impossible to play enterprise. Enterprise means risking one's own money in investment. Bureaucratic managers and politicians have no real incentive to develop entrepreneurial skill, to really adjust to consumer demands. They do not risk loss of their money in the enterprise. Secondly, aside from the question of incentives, even the most eager managers could not function as a business. Regardless of the treatment accorded the operation after it is established, the initial launching of the firm is made with government money, and therefore by coercive levy. An arbitrary element has been "built into" the very vitals of the enterprise. Further, any future expenditures may be made out of tax funds, and therefore the decisions of the managers will be subject to the same flaw. The ease of obtaining money will inherently distort the operations of the government enterprise. Moreover, suppose the government "invests" in an enterprise, E. Either the free market, left alone, would also have invested the same amount in the selfsame enterprise, or it would not. If it would have, then the economy suffers at least from the "take" going to the intermediary bureaucracy. If not, and this is almost certain, then it follows immediately that the expenditure on E is a distortion of private utility on the market — that some other expenditure would have greater monetary returns. It follows once again that a government enterprise cannot duplicate the conditions of private business.

In addition, the establishment of government enterprise creates an inherent competitive advantage over private firms, for at least part of its capital was gained by coercion rather than service. It is clear that government, with its subsidization, if it wishes can drive private business out of the field. Private investment in the same industry will be greatly restricted, since future investors will anticipate losses at the hands of the privileged governmental competitors. Moreover, since all services compete for the consumer's dollar, all private firms and all private investment will to some degree be affected and hampered. And when a government enterprise opens, it generates fears in other industries that they will be next, and that they will be either confiscated or forced to compete with government-subsidized enterprises. This fear tends to repress productive investment further and thus lower the general standard of living still more.

From here we derive the third view that distinguishes from the two mainstream camps:

Government is NOT supposed to “earn” money. Government should leave the private sector to earn from productive undertakings. Whatever “surpluses” or “earnings” should be given back to the taxpayers. How? By reducing taxes, by cutting down government spending and or by paying down public debt.

The “returns” from these actions will surely outweigh gains made from political speculations. Unfortunately this has been unseen.

As the great Frederic Bastiat once remarked

Between a good and a bad economist this constitutes the whole difference - the one takes account of the visible effect; the other takes account both of the effects which are seen, and also of those which it is necessary to foresee. Now this difference is enormous, for it almost always happens that when the immediate consequence is favourable, the ultimate consequences are fatal, and the converse. Hence it follows that the bad economist pursues a small present good, which will be followed by a great evil to come, while the true economist pursues a great good to come, - at the risk of a small present evil.

Changing Dynamics In Central Bank Management, Quasi Boom Policies

``With the economic improvement and steepening yield curve that our US team expects, commercial banks may find it a good risk/return decision to move these funds into the real economy rather than simply earn an interest rate in the neighborhood of the risk-free IOR. The risk therefore is that these methods of draining reserves simply postpone the macro problem of burgeoning excess reserves.”-Manoj Pradhan ER, RR, IOR and RRR

It’s a simple fact that the world constantly changes.

Even the management of central banks given today’s monetary conditions has been exhibiting such changes. Traditional tools don’t seem to have the same measured ‘efficacy’ due to the drastic stimulus-response feedback loop mechanism applied by authorities in response to the rapidly changing environment. I would posit that the past successes had not been out of bureaucratic skills but out of happenstance; the emergence of globalization had engendered the era of the “great moderation”.

For instance, in an effort to curb the incidences of bank failures during the latest crisis, central banks have rapidly deployed the unorthodox (nuclear option) means of providing emergency loans against ‘dubious’ forms of collateral and importantly the purchasing of specific types of bubble ‘tainted’ assets directly from the market.

The proceeds from the central bank loans or sales have led to the intensive ballooning of excess reserves (ER) of banks, which until today, has been warehoused in the central bank. Considering the extent of balance sheet impairments of the US banking system, the temporary measures have not yet adequately resolved the chronic woes, nor has these excess reserves been converted into end user or consumer loans. Not yet anyway.

Hence, the huge buildup of excess reserves has apparently altered the scalability of the tools required to deal with balance sheet management of the central bank.

Morgan Stanley’s Manoj Pradhan describes the transition, ``The traditional way of draining reserves was to sell T-Bills to commercial banks. This would mean that commercial banks would replace cash on the asset side of their balance sheet with the T-Bill of an equivalent quantity. However, ER held by the Fed now stand at US$1.1 trillion and the size makes it difficult for reserves to be drained in the traditional way.” (emphasis mine)

In other words, the change in the discount rates or possibly even the Fed Fund rate may seem more symbolic than functional. And perhaps this may be one reason why the markets appear to have discounted the recent actions by the Federal Reserve.

The Federal Reserve has thus been tinkering with experimental tools such as reverse repo, term deposit facilities and interest rates on reserves.

So while the Fed desires to see ample liquidity in the system, withdrawing the huge stack of bank reserves underlines the apparently emerging distinct objectives- the task of liquidity and interest rate management.

Reviving The Credit Process By Fueling Bubbles

On our part, we understand the fact the Fed is dabbling with generally untested tools relative to the new circumstances it is faced with brings about greater risks than what the mainstream expects.

For one, it is becoming clearer that credit demand hasn’t been the underlying problem as alleged by many, instead it looks more likely to be a ‘supply’ problem, where tight lending from banks have stifled the credit process.

As proof, many in the US, have turned to local ‘scrip’ currencies in the face of money shortages to conduct business or trade [see Emerging Local Currencies In The US Disproves The 'Liquidity Trap']. There are as many as 100 local currencies operating in the US today.

Next, banks that have benefited from government’s bailout have reportedly been averse at lending to small business.

According to CNN Small Business,

``Small business loans continue to dry up at the nation's biggest banks. Eleven top TARP recipients -- including Wells Fargo, by far the nation's largest lender to small companies -- cut their collective small business loan balance by more than $2.3 billion in December, according to a Treasury report released late Tuesday.

``The drop marked the eighth consecutive month of declines for the 11 banks. In that time, their total loan balance has fallen 7%, to $169.4 billion. Seven of the reporting banks have cut their small business loan balance every single month.

``"Credit is still tight for many small businesses," the Treasury acknowledged in a Feb. 10 report.

Another, government interventions in the housing market through a recent tax credit subsidy program compounded by low interest rates could spark the process of inflating yet another property bubble.

But this time bubble signs appear to have surfaced in homebuilder lots, according to Doug French of the Mises Institute, (bold highlights mine)

``Last November, President Obama signed the Worker, Homeownership, and Business Assistance Act of 2009, which, as many people know, extended unemployment benefits and the first-time-homebuyer tax-credit program. But quietly included in this legislative lasagna was a provision allowing big businesses to offset the losses of 2008 and 2009 against profits made as far back as 2004. This provision will generate corporate tax refunds of $33 billion, the New York Times reports. Previously, only small companies could offset losses against past years' profits.

``Big home builders are the prime beneficiaries. After racking up monster profits during the housing boom, the industry has booked huge losses in the bust, accentuated by write-downs of their land positions totaling $28.5 billion for the 14 largest publically traded homebuilders. Now these large homebuilders are recapturing some of what Uncle Sam took away during the boom years. According to the Times, Pulte Homes has a refund of $450 million coming, Hovnanian Enterprises will get back $250–275 million, while Standard Pacific and Beazer Homes will recoup $80 million and $50 million of their profits respectively.

``And while returning taxes to businesses is a wonderful thing, home builders are reading the distorted economic tea leaves. These seem to say that low interest rates and tax credits will eventually bring buyers back to their subdivisions, while many of the big builders' smaller competitors were washed away for good by the housing tsunami — so ramp up the higher-stage and durable-production process by investing capital in building lots…

While it is true that there are still enormous housing inventories to reckon with as to successfully reignite a bubble, improving trends in the sales of homebuilder lots could signify as important clues to a brewing bubble.

Adds Mr. French, ``The lot-buying homebuilders may be irrational, but they aren't yet exuberant. The National Association of Home Builders' housing-market index rose just 2 points to 17 in February — far below the bullish readings of 50 that haven't been seen since April 2006. But the 528 residential developers surveyed say that the tax credits being offered along with low mortgage rates are spurring some demand.” (bold highlights mine)

This seem to reconcile with our view that if we are correct, the record steepness in the yield curve will likely generate belated credit traction 2-3 after a recession [see What’s The Yield Curve Saying About Asia And The Bubble Cycle?]. We may probably see some signs of revitalization in the credit process of the US by the end of the year.

And what else could stoke the credit process than a new bubble!

Remember considering that homebuilder losses have been allowed to be offset via tax refunds, essentially, the carryover losses has been borne by the US government.

So there lies the issue of the moral hazard problem. What should stop these economic agents from resuming reckless and imprudent risks, when they know that Big Brother would backstop their activities?

Moreover, these homebuilders are only responding to the incentives set by the government: Government gives them money from which they employ based on inherent familiarity, and government provides the conditions-low interest rates and the moral hazard issue/risk free environment- for them to take a stab at new risks. Besides, government subsidies tend to immunize economic agents from the sentience of profits and losses.

So the US government’s approach to gradually disengage itself from the housing market appears to be to stir up a new bubble.

The US government is simply fundamentally following the dogma of sustaining the perpetuity of a quasi boom.

From John Maynard Keynes, ``The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.” A quasi boom kept as permanent policy would lead to a prolonged depression and a reduction of the nation’s living standard.

Also this should put into rigorous tests the effectiveness of the new set of tools, strategies or the new doctrines for the Federal Reserve to deal with its humongous excess reserves.

Where to bet our money? Against the success of the Federal Reserve, of course.