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REVISTA DE ECONOMASegunda poca

Volumen 18 Nmero 2 Noviembre 2011

Conferencia: Problemas Fiscales y de Deuda en el Hemisferio Norte ............5Cosima Barone

Philip SuttleJulio de Brun

Understandng Unconventional Monetary Policy:A New Monetarist Approach ....................................................................43

Stephen D. Williamson

Anlisis de las Calicaciones de Riesgo Soberano:El Caso Uruguayo .....................................................................................71

Fernando Borraz

Alejandro Fried

Diego Gianelli

La Demanda de Dinero en una Economa Dolarizada:Una Estimacin para Uruguay ................................................................101

Conrado Brum

Elizabeth Bucacos

Patricia Carballo

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The World at a Crossroad

The world is revealing itself as an extraordinary unstable place.Economic imbalances, wealth disparities and unwieldy nance, allcontribute to the current situation bugging global nancial markets. Ofhistorical and unprecedented nature are the global expansion of debt andthe central bank monetization trend of recent decades. Undoubtedly, themassive growth of debt and ballooning central bank balance sheets nurturea myriad of vulnerabilities, resulting from speculative nance and leadingto boom and bust dynamics.

Nowadays, the global sentiment is shifting. Optimism on thesustainability of global recovery is dimming. And the general economicsoft-patch talk is turning into possible double-dip scenario in the largesteconomies, while some red-hot emerging economies are sliding into soft-

patch growth territory.

1. Major Power Shifts

I shall begin with my area of experience and tell you what I haveobserved from the particular angle of Wall Street and global nancialmarkets during the last decades.

A main event, that I would like to mention here is when, on August15, 1971, the U.S. President Richard Nixon decided to shut down the GoldWindow and severed the Bretton Woods Agreement. As a result, paper

ROUND TABLE ON

DEBT AND FISCAL PROBLEMS IN THE NORTH1

COSIMA BARONE2

1 Round-table integrated by Cosima Barone, Philip Suttle and Julio de Brun and organized bythe Central Bank of Uruguay during XXVI Jornadas Anuales de Economa that were held inMontevideo, on 18th and 19th of August 2011.

2 Cosima F.Barone is Chairman of FINARC S.A. Geneva, which provides unbiased nancialservices to institutions and individuals worldwide.

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CRISIS DE DEUDA EUROPEA6

money became the common medium of exchange to measure equalityand consequences of economic development. Paper money, not to beconfused with wealth, has value on two predominant accounts: 1) becausethe government in power says so, and 2) because people are willing toaccept it as payment. However, governments and central banks retain littlecontrol over the actions and reactions of paper money holders throughoutthe globe.

Fast-forward to 1975, when the global nancial world was hit by amajor event that no one seems to remember any more. It had the effect of

a tsunami, which marked the beginning of a multi-decade period whenglobal nance interests were, more and more each day, distancing them-selves from the real economy. On May 1st of 1975, modern nancewas energized when NYSE xed commissions charged on nancialtransactions were abandoned at the altar of negotiated commissions. Theaim was to encourage a larger public participation in Wall Street, so thatliquidity would be enhanced and risk be spread throughout all investors,institutions and individuals.

As a result, nancial engineers multiplied their efforts, withintelligence and innovation, to create sophisticated nancial instruments forinvestors. The nancial industry made larger use of debt, securitization and

proprietary trading. Incidentally, High Frequency Trading has alreadyclaimed the ash crash of May 6, 2010! In plain English, the messagegiven out to the world by the 1975 shift in the NYSE commission systemwas that ...ever American and worlds citien had the riht to own apiece of the national and lobal econom. The untold message, however,

truly was that ...upstairs tradin needed a larer tradin base on whichto build successfull its creative investment strateies!

Financial sophistication is not privy of major consequences.The individual investor is not in a position to effectively compete withalgorithm-based nancial trading systems, which remain only available tothe happy few, who command a large and growing share of the overalltrading volume. As a consequence, human traders are becoming a raritywhile supercomputers continue to trade with each other! But, for howlong? And, how big is the resulting systemic risk of modern day nance?In a nutshell, since the 1970s and under the complacent eyes of governingauthorities (government, central banks and nancial regulators) the bearing

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REVISTA DE ECONOMA 7

of nancial risk has consistently and systemically slipped from the hands ofthe global nancial institutions onto the shoulders of individuals, less ableto cope with it!

1971 and 1975 were also the years when the global liquidityspigots were left wide open ad innitum! All subsequent events justlled the pages of a nancial history book that was already in the workssince August 1971.

It is important, therefore, to understand that todays nancial messis part of a systemic debasement of the global nancial system that starteddecades ago. Along the years and decades, capital was displaced from underthe control of central banks and governments into private individual andinstitutional hands, often in foreign countries, and in the shadow bankingsystem. Governments and central banks, as a result do not have adequatecontrol of the economy and nancial markets.

It is disappointing, indeed, to witness the immense lack of knowledgeof leading policy makers around the globe about how the economy andnance are intimately intertwined and about the ever evolving technicalintricacies of sophisticated modern nance. This ignorance inexorably leadsto miscalculation of risk exposure and to systemic risks day of reckoning.

When this well oiled system stops working, it is the policy makersand central banks that are called to rescue the nancial system. How canthey rescue effectively a nancial system of which they simply ignore theincreasingly fast evolving sophistication? Yet, the Sovereign State isovertaking the Sovereign Individual!

2. Currenc Unions and the Euro Experiment

A brief glance at history reveals that, before the U.S. Dollars reignas a reserve currency began in earnest in 1920, there have been ve welldened cycles, each lasting approximately a century, when a superpower

of the world imposed its currency supremacy over other countries:Portuguese (1450-1530), Spanish (1530-1640), Dutch (1640-1720), French(1720-1815) and British (1815-1920).

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Currency Unions too have a long history. They tend to come and go.Currency Unions have a good chance to be successful and stand the test oftime only when:

a) based on economic inter-relationships and acceptable powerstructures among union members, as well as between the unionand other currency zones and currencies;

b) rampant arbitrage is not allowed;

c) there is also a political union (i.e., in USA, USSR, UK andGermany);

d) there is a single scal policy;e) there is a central monetary management;

f) wage and price exibility are a sine qua non;

g) there are clear convergence criteria; and...

h) there are clear monetary convergence targets.

Ever since the fall of the Roman Empire, a dream of Europeanunity and of a dominant European political structure has long animated

the continent. After two World Wars, Europe was nally liberated fromNazism in 1945. In November 1989, with the tearing down of the BerlinWall, the Eastern-half of the European continent was able to overcome 40years of communism. Finally, European political division started healing.The healing process culminated with the historic milestone of May 1, 2004,when barriers created by the Cold War were nally removed.

With the accession of Bulgaria and Romania in 2007, the EUROPEANUNION (EU) counts 27 Member States, with a total population of almost503 million inhabitants -- 23 ofcial languages. Despite all the agonisingabout whether or not it would work, the European Union has effectivelycreated the worlds largest trade bloc stretching from the Atlantic to the

borders of Russia, with a nominal GDP over 12 trillion (in 2010) -- or,approximately $16 trillion, larger than the $14.7 trillion of the United States.With 7% of the world population, the EUs trade accounts for about 20% ofglobal exports and imports, only second to the U.S.A.

Within this larger Community exists a separate currency union, theEUROZONE, made of 17 member states which have adopted the EUROas a common currency. The EUROZONE represents a total population ofalmost 332 million inhabitants, and 9.2 trillion GDP (2010).

CRISIS DE DEUDA EUROPEA

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The adoption of the EURO was expected to lead to economicconvergence, but that has not happened. The European Union failed

badly by not creating rst a political union, which would have been theindispensable solid foundation for the economic, monetary and scal

blocs survival.

In principle, the European dream was extraordinary: nations wouldbe combined into a single economic regime, which in turn would evolveinto a single united political entity! The idea was impressively imaginativeand a great gamble! The trouble is that it has not worked.

The European project was to endorse unity in all respects: social,political, economic and strategic including security and defense. BeingEuropean would have to translate into sharing a single fate and common

burdens. With hindsight, Europeans only shared interests, but not a singlefate! Furthermore, the European Monetary Union, erily trumpeted at thefour corners of the planet as a smashing success, is turning out already tohave been a monumental failure.

To be successful, a single-currency union must involve a central orfederal government, with tax and public expenditure authority, based ona national or federal GDP, also able to run signicant decits whennecessary. The absurdity in the EURO currency union turns around thefact that, within the OECD, member states in the EURO union are the onlygovernments issuing sovereign debt in a currency -- the EURO -- that theycannot print at will!

Moreover, the EU has no provisions for monetary divorce! Duringthe decades leading to the EU and the single currency launch, the possibilitywas not even remotely contemplated of a member state willing to exit thesingle currency system. As a consequence, no institutional and legal frame-work is available to allow a member state to quit the currency union.

Recently, the EURO has come under ferocious attacks in globalnancial markets as the European nancial, economic and sovereign debtcrises moved to a new level. The cruel reality is that debtor nations arelending to borrower nations! Furthermore, the European Union and theCentral Bank, even with the benevolent help of the International MonetaryFund, could fail in their efforts to contain the crises.

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European politics are in great turmoil nowadays. At stake are notonly the very survival of the EURO and the EUROZONE, but also whichcountry within the EUROPEAN UNION is truly able to take the EUsleadership to the next level. Emerging trends point to Germany using itseconomic power to reshape EUs institutions to its own liking, while Franceleads the Continent on foreign and military affairs.

The notion of unity as in sharing a single fate in Europe becamesuddenly energized when Greece run into nancial trouble. The Greek crisisunveiled the profound paradox embedded in the European Experiment.

Being member of the EU and the EUROZONE, Greeks believed thatGreeces problems would be EUs problems! In contrast, Berlin believedthat Greeks problems were neither Germanys, nor EUs problems! Peoplein other European countries had the same reaction and felt that Greeks wereforeigners.

The EURO might not be allowed to disintegrate yet, although the riskof disintegration will exist as long as European nations remain obsessedwith nationalism. Individual regional powers not sharing a common vision,

with fragmented military and defense policies, with no united foreignpolicy, with diverse economic policies and scal systems, could lead todisintegration of the EU bloc and common currency. If disintegration isavoided, the EU could remain an alliance of states, nothing more than asystem of relationships and interests between sovereign nations. Hence,the EURO would have trouble gaining serious and predominant reservecurrency and store of value status.

The whole European Experiment was built on a dream that

economic convergence -- without mandatory scal convergence -- wouldeventually lead to a politically united Europe. Economic convergence neverfully happened. Even the introduction of a common currency did not setinto motion, as hoped, economic convergence within member states.

Worse, the EU is left battling every day with the many res inamingits member nations. And, how the EU remen deal with the spreading reinfers a highly troublesome trend ...that EUs member states are now able

to unload risks inherent in national dwindling public nances and economicpolicy mistakes to the entire EU collectivity. Yet, the basic foundation ofthe common currency was reliance on the scal self-responsibility ofeach nation adhering to the EURO bloc Not only Europe is violating its


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own founding treaty -- no countr is liable for the debts of an other-- but the European Central Bank overcame the explicit ban, within its ownconstitution, not to be involved in state nancing. Widely considered a fatalviolation of its own charter, the European Central Bank purchases memberstates sovereign debt in the secondary market and accepts sovereignsecurities as collateral even when they have been downgraded by ratingagencies. Incidentally, the ECB bought Greek, Irish, Portuguese, Spanishand Italian sovereign bonds. As a result, the ECB holds a substantial amountof questionable sovereign debt.

The EU is quite resourceful too at times. On one hand, the EU showscommitment to established legal issues, rules and regulations, but on theother, when confronted with existential threats to the Eurozone, the UNIONis able to work on the margins of its treaties -- i.e., the setup of the EuropeanFinancial Stability Facility (EFSF) and subsequently the European FinancialStabilization Mechanism (EFSM) as an independent bank, headquarteredin Luxembourg, which has nothing to do directly with either the EU orthe EU bureaucracy. Both funds are truly at the very extreme margin oflegality, based on applicable EU treaties. These bailout mechanisms do,indeed, infer how quickly the EU and the EUROZONE ofcials, out ofnecessity, sweep under the rug existing pacts if considered suicidal duringcrisis times.

History is in the making, as Europe tries to survive its crises withbailout and hope strategies! Meanwhile, the European Union hasopened the door to the International Monetary Fund (IMF). This event is,indeed, a resounding precedent, which could most probably entail future

consequences as this international institution could actually reign sovereignacross the continent.

I believe that cracks are appearing in the sacrosanct nationalsovereignty of individual member states, even though in a stealth way.If a country resorting to an EU-IMF bailout is de-facto relinquishing itsnational sovereignty, and if several countries would have to face such adramatic reality, then Brussels could strategically centralize the Europeansovereignty power.

Embedded into the EU-IMF bailout remains the fact that Germany,which funded the lions share of the EU bailout, is effectively dictating

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the bailed-out nations retirement age, welfare benets and pensions.Undoubtedly, this is the logic of a common currency, but it has importantrepercussions in terms of sovereignty!

In my view, it is possible that, out of necessity, a centralizationprocess could emerge in Europe, where the people would not be asked fortheir opinion through risky national referendums. This scenario has everychance of becoming reality provided that European politicians design a sim-

ple founding Constitutional Treaty to truly unite the people of Europe!

The recent convulsion spreading across global nancial marketsmight be, indeed, putting heavy pressure on the EU to rethink and toredesign the UNION. Hence, threats to social stability could suddenlyemerge, as mounting populist angst spreads not only in the countries being

bailed out, but also in the countries doing the bailing.

3. Is an International Reserve Fund the Solution?

The world is indeed facing many economic challenges, namely thedeleveraging across the West, while Japan remains stuck in deationarydoldrums, China resists a total de-peg of the Chinese Renminbi from theU.S. Dollar, and ination picks up in emerging markets.

As the world is thorn with liquidity and/or solvency issuesaffecting an increasing number of countries, a call for global cooperationand coordination to address the debt problems in the United States andEurope is becoming louder by the day.

Investors, are consistently getting out of the U.S. Dollar and theEURO to literally stampede into the perceived-safety of the Japanese Yenand the Swiss Franc. Amid growing concerns over a global slowdown,Japan and Switzerland are, as a result, worried that economic problems inthe U.S. and the EUROZONE are driving up the value of their currencies toabsurd levels and hurting domestic exports.

Emerging countries, with the economy ring on all cylinders, arealso attracting strong inows of foreign capital pushing their currenciesto alarming levels, threatening the vitality of their export sectors andraising ination worries. Money ees low interest rates in the U.S., Japan


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and Europe, to reach out to plumper returns in the currency of Australia,New Zealand, Brazil, Canada, South Korea, Israel, South Africa and...Uruguay.

Currency Wars began to spread across the globe as Brazil, Japanand Switzerland tried to calm currency waters, but to little avail, if any, sofar. Are there viable solutions at hand?

From the ashes of the 2007-2009 crisis, the G-20 came to life asglobal comprehension, cooperation and coordination was deemed to bethe cure to the nancial and economic agony spreading across the planet.Beyond the G-20, other ideas have emerged.

The World Bank sees a multipolar global economy developing by2025, to which emerging economies -- Brazil, China, India, Indonesia andthe Russian Federation -- would contribute the largest share of total growth.Concurrently, the international monetary system should cease to bedominated by a single currency. The World Bank identied the U.S., theEUROZONE and China as the major growth poles driving the world to itsnew order. Based on this unfolding reality, the World Bank envisions amulticurrency system in which the U.S. Dollar, the EURO and the ChineseRenminbi, would each serve as full-edged international currencies.However, such a system would herald a return to a xed exchange ratearrangement between major countries providing the reserve currencies ina world of free capital mobility. Moreover, a multipolar currency system,as suggested by the World Bank, would be a daunting task requiring policycoordination and loss of national monetary policy sovereignty. As we haveobserved, such a system has not worked in Europe!

The IMF proposed to adopt its SDRs unit (Special Drawing Rights,created in 1969 to support the Bretton Woods xed exchange rate system)as a global reserve currency. Hence, China seems to favour this idea.Incidentally, Madame Christine Lagarde, Managing Director of the IMF,nominated Mr. Zhu Min, the rst Chinese Vice-President Special Advisorat the IMF. Are these two events related? Do they infer future intense workfor a bancor type supranational currency (idea fathered by John MaynardKeynes)? Will a supranational currency be the solution?

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In 2008, even the United Nations gathered global experts in view ofdesigning reforms of the international monetary and nancial system. TheUN-mandated Commission of Experts published in September 2009 a

plethora of prescriptions aimed at global coordination of monetary policyand scal policy, a more balanced size of the nancial sector as a share ofGDP, a restructuring of the nancial system, the role of central banks, more

balanced allocation of capital to productive use, etc. The UN too, alongwith the IMF and China, seems in favour of a Global Reserve Bank andan international reserve currency, not linked to the external position ofany particular national economy and designed to regulate the creation of

global liquidity and maintain global stability.All represent great ideas for the future!

4. A New World standin on Values

The world is indeed at a crossroad. The world will have to choosebetween an ever evolving nancial sector mostly disconnected from theeconomy made of real human beings, living in a real world, working in areal economy and deserving fair compensation for hard labour.

Some global leaders have strongly called for moral values to beput back into the management of planet Earth. It is imperative, indeed!However, their call sounds so much like populist political prescriptionduring the global nancial and economic crises.

Yet, people need their leaders to be visionary and to have the politicalcourage for setting into motion progressive economic, political strategies inadvance for future generations. Unfortunately, politicians only worry aboutthe next election! In the meantime, the world of nance never sleeps! Itconstantly moves forward with very innovative nancial engineering.

Then, how to reconcile fairness and harmony, including innovation, inthis unsettled world? I strongly believe that fair compromise must replacenonexistent perfection. Politics, economics and nance have rarely, ifever, in history been in equilibrium during this most needed and essentialcompromising exercise. The world is facing exactly this imbalance at the

present time. The imbalance is so stretched that it will take political courageand large efforts for many years, from all involved actors, in order to attainsome sort of equilibrium between political, economic and nancial forcesfor the good of people.


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Major reforms on Earth are always a product of necessity, not ofmere ideological vision. I am convinced that a new vision will at some

point emerge from the ashes of the current global crises.

However, instead of fantasizing on a new global currency and anew global central bank, both of which might take decades to develop, I

believe that there is an impending need for immediate action. The citizensof world are already on the streets of their capitals wanting to work and toearn a fair price for it, to have transparent and accountable government andscal structures, as well as peace and harmony.

I have identied simple and straightforward actions that everygovernment, if truly willing to work for the good of people, should considerat the national level, possibly also coordinate it internationally, without anyfurther delay. These actions are:

Reconsider the 1. size of the government and cut down all excessesand all inefciencies;

Simplify the 2. scal system, eliminate all niches -- only able tocapture votes at election time -- and build a scal system more justand totally cleaned up of all complexities mostly incomprehensible to the

people;

Reconsider the nancial 3. derivatives market structure in order toallow the use of derivatives only for hedging purposes of real transactionsin the real economy.

Cut entirely the unnecessary 4. sophistication of nancial marketsacross the globe.

Forbid the 5. making money with money strategies and blackpools activities (computers trading with computers) and let the people bepart again of the nancial market.

In other words, the nancial market should stick primarily to itsessential role of being the intermediary between savings and the use ofthese savings in the real economy. Banks should return to their main roleof nancing the real economy.

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I believe that these measures, although requiring real politicalcommitment and daunting efforts, could be discussed, negotiated andimplemented in a much easier and rapid way than any other visionaryinternational new structure at the moment. The people around the lobewould understand, appreciate and support such efforts.

Admittedly, these measures might sound retrograde at the presenttime. But, when the machine is broken as it is now, the clock must bestopped for a while and even turned back. A dose of common sense isnecessary in order to consider each economic and strategic issue in the

proper perspective. Then, global economies can rebound in a stronger andsustainable way in a NEW WORLD standin on VALUES!

Undoubtedly, as the world economy goes through major transformativechange in its growth dynamics and industrial landscape, there will be timeto design appropriate mechanisms for the global governance of economies,international liquidity and reserves, and the creation of global liquidity forspecic global issues (famine and water, for instance), aiming at globalgrowth and nancial stability.

The current monetary system most probably needs to be totallyoverhauled in order to accommodate the new realities of globally intertwinedeconomies.

Therefore, I strongly believe that the above-mentioned rst stepsmust imperatively be considered in each country. Indeed, a solid buildingrequires serious architectural work at its foundations rst. Otherwise, the

outcome could only be a monumental ruin standing on multiple ruins!

Allow me to conclude this presentation with some recommendationsfor your beautiful country. Uruguay should particularly focus on economicstrategies that would engineer internally generated growth, able to ensuresolid employment perspectives to all citizens, especially to its youth. Uru-guay should reduce its dependence on foreign capital and be particularlyvigilant to prevent foreign speculative capital from gaining substantialcontrol of domestic strategic economic sectors and corporations. Political,economic and scal stability, are essential to attract foreign investments.But, above all foreign investors scrutinize the level of security provided bythe government of Uruguay.


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ANNEX

A.1 Historical Transitions

A.2 Market capitaliation

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A.3 CURRENCy UNIONS

...TEND TO COME AND gO...... ONLy THE U.S. DOLLAR WAS TRULy SUCCESSFUL ...... WILL THE EURO SURVIVE THE CURRENT CRISIS?


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A.4 Is the EURO a Reserve Currenc? InternationalCondencemustbeearned!

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A.5 EUROPEs Milestones -- 1948 to present


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A.5 EUROPEs Milestones -- 1948 to present ...cont.d from previous page

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PHILIP SUTTLE1

I think I should actually congratulate Uruguay for organizing thisvery interesting looking conference. Also, in light of what is going on andwhat the previous speaker said, for showing the world that there is lifeafter selective default. It must be said that there are many people in Europelooking at the experience of Uruguay, what happened earlier, during the

past decade, and the lessons learned. Well done.

I am going to focus my comments on ve areas. My comments willfocus much more on shorter-term economic issues, so I think it ts verynicely with the previous presentation; they are both very different but Ithink they both provide interesting angles. First, I will spend some timetalking about where we are, particularly how to interpret the most recentglobal dip. The second topic I want to spend some time on is what comesnext. Third, how will the Euro crisis play out weve heard some of thatin the last presentation so I will not spend too much time there but I thinkwe agree that there is a mess ahead for Europe, it is a very challengingsituation. The fourth topic is actually whether S&P was right to downgradethe United States Ill leave my answer until I get to that, I will keep youon tenterhooks. Finally, I will conclude on how emerging economies will

perform against this backdrop.

Chart 1 shows a lot of numbers, and that tells a very clear story whichis that the global economy has slowed quite uniformly in recent months. Inthe second quarter about three quarters of the data are in so far it looks

as though global growth has slowed to about a 2 % pace. In what we liketo call mature economies (the OECD or what used to be high-incomecountries) growth is slowing to about 1 % in the rst half of the year, withJapan in particular going into recession as well see in a moment caused

by the earthquake and the tsunami. What is equally noticeable, however,is that the emerging economies have held up pretty well. Through the rstquarter of the year they showed some slowing which was most pronouncedin East Asia, the Asia Pacic region.

1 Deputy Managing Director and Chief Economist, Institute of International Finance.


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* Includes IIF estimates

Chart 2 actually highlights the United States. Across the worldwe have seen consumer-led weakening in recent months. You can seethe United States the dark line. This axis shows the total consumerspending and the grey line at durable goods spending. You can see that,as always, durables spending had led total spending down. Obviously

part of that is also consumption. A signicant part of that, we think, isrelated to disruptions with Japan.


All of this just underlines the fact that global slowing has been prettyuniform and I think we are not quite at the point where we are worriedabout recession risks but we are clearly irting with a period of sustainedsub-par growth, with the manufacturing sector, as youd expect, being onthe weak side of average. But I think that it is quite important to know thatit is not just inventories and manufacturing volatility that is giving us thisslowdown: weve had a crossover.

Chart 1 - Interpretin the most recent lobal dip.

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Chart 2 - A Consumer-led Weakenin

Real Private ConsumptionPercentae 3m/3msaar (both scales)

So, when you take a step back and ask yourself what are the driversof what I like to call a mini-cycle, I think there are ve essential featureswhich have given us this weakening. In some sense, looking at those vefeatures is useful when thinking about where to go next. They are:

Fiscal tightening in Mature Economies

Monetary tightening in Emerging Markets

Oil price surge Japan earthquake disruptions

Debt crisis worries?

The rst is basically scal tightening in the mature economies which,although I think well all agree theres still a lot of that ahead, I believe itsimportant to recognize that weve already entered a phase of signicantscal tightening.


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The second factor, which I think has highlighted its importance thesedays, is that weve had a signicant round of monetary tightening in emergingmarkets, specially in countries like China and India, Brazil included as well,obviously. Both got a little concerned about ination tensions at the end oflast year and this year they have tightened their monetary policy. Maybeit is too early to expect all of that tightening to have had its effect, butcertainly I think the rst wave of impact has spread.

The third factor which I think we all recognize as very important isthe surge in oil prices, some of it triggered by global demand but a lot of it

triggered by the instability coming out of the Middle East.

The fourth factor which I think is very important but hopefully willbe short-lived is the disruptions resulting from the Japanese earthquake, andthat it is true specially in the auto sector. I think weve all been remindedonce again how powerful the auto sector is.

And the fth factor which I think is a lot more recent and thereforeprobably its premature to think that this factor is fully played out in any

sense or maybe even partially played out are all of the worries relatingto the debt crisis in Europe, the renewed worries there. Also, we can includethe worries that we had in the United States.

But I think that as we look at these ve factors and consider, lookingahead, how they will play out, it is fair to say that some of them are stillclearly going to be with us.

What I think is important to know here is that it is pretty reasonableto expect the second half of the year to be a bit stronger. I guess one canalways hope, but I think that there is more than just hope here thereare a number of factors playing out, some of which I just outlined, and,as they get a bit reversed here, they could produce a better second halfreadout, most notably with Japan producing a snap back, and that will helpother economies. Weve already seen in the United States, for example,some of the June/July (specially July) indicators looking better, includingin the manufacturing sector, in part because of the normalization of auto

production as well as auto sales. I dont want to make too much of the autosector, but I think it is very important to recognize that its been a pretty

powerful inuence.

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Chart 3 - 2011 REAL gDP

Q1-Q2 averaePercent, q/q saar

Q3-Q4 averaePercent, q/q saar

And I think on top of that you have to argue that, while there are somereasons for a temporary rebound, the outlook across the major economiesfor the second half of the year does not actually look that bright. You cansee on the right hand chart on Chart 3, the dark bars show that weve gota very spectacular outlook in Japan but elsewhere the growth rates forthe U.S., the Euro area (the United Kingdom, for example) are all prettymeager, in fact in the U.S. it is expected that growth will be about 2.5 % in

the second half of the year, capping off the 1 % increase in the rst half. So,over the year as a whole thats not too impressive and certainly underlinesa disappointing picture.

The other point I would like to emphasize and this is perhapsmost relevant to the emerging world because this is the good news aboutthis short-term cyclical story is that we should see receding ination

pressures. All the signs are there, in the pipeline: whether were looking atoil prices, food prices or simply more general demand trends, all signs pointto a moderation of ination.


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Chart4InationPressuresReceding

Emerin EconomiesMature economies

How will the Euro crisis play out? I will make two basic points.One, I do not really know, but what I do know is that its not going tolook good, its not going to be pretty. I think the previous speaker did awonderful job of setting the backdrop to the Euro crisis and emphasizedthat this is really as much a political struggle or a political set of issuesas it is an economic set of issues. That is part of the reason that I, aneconomist, have no idea how all those issues work and think and interactwith one another. But we have to say that the precedents so far, in thelast year and a half of the crisis, have not been good. As we like to say innancial markets, the politicians have not typically got out ahead of the

curve; instead, they have typically responded to problems. So, I think itis reasonable to expect difculties ahead.

I am not a monetarist, but I do like to show that if you look at therelationship between M1 growth in Europe and the leading indicator oneyear ahead, real GDP growth, it does seem to work quite well and it doesnot augur particularly well for the year ahead (Chart 5).

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Chart 5 - Real gDP and M1 Real growth

Percent chane over a ear ao (both scales)

In a very tough nancial environment, specially in the banking sectorin Europe, the ECB is likely to play a continued role as the lender of lastresort, in a sense, as the de facto scal authority, because the ECB is reallylending to the banks so that they can maintain or in some cases increasetheir sovereign debt holdings and if the ECB was not able to do that then

banks would be forced to sell their sovereign debt holdings more aggres-sively than they have been doing then the problem would calm down a lotquicker than it is likely to do. My sense here is the Euro crisis is just going

to play out as a bad story for the next year or year and a half.


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Chart 6 - The European Central Bank is the lender of last resort, for now

Lendin to Monetar Financial InstitutionsPercent of bankin sector assets

But I think what were painfully learning is that really the Euro areaofcials face a choice between seeing the system fragment in some fashion I do not think wed want to choose that option and the other option,which is some degree of accelerated scal integration. We essentially thinkthat the latter is the approach that is likely to be followed, not a preemptivemeasure, but the increasing widening of scal integration in the form ofmore and more centralization of debt and debt guarantees.

One more reason for that, which I think is highlighted by Chart 7, is

that the credit environment at the sovereign level within Europe is reallyvery serious. If we compare the deterioration of the credit worthiness ofwhat we like to call the EFSF-3 (which is basically Greece, Ireland andPortugal), if you line that up against the deterioration of credit in East Asiain the Asian crisis in 1997-98, you can see that already were not doing sowell. Frankly, a year and a half into their crisis in East Asia theyd alreadyfound a possible beginning to improve and I think were nowhere near thatin Europe. So, I think this is really looking to be quite a serious global creditevent which I think will require the choice of either euro fragmentation or,

more likely, some degree of accelerated euro scal integration.

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Chart 7 - Europe`s choice: EMU survival requires Fiscal Interation

Soverein credit ratins on lon-term debtAverae of Mood`s, S&P, and Fitch lon-term ratins

Finally, that takes me to my fourth set of topics, which is Was S&Pright to downgrade the United States? We can all debate the validity andworth of sovereign credit worthiness indicators and sovereign ratings, but I

think my answer would be, clearly, yes. Just to be fair to countries aroundthe world, and I would refer to that point by saying that among the matureeconomies its not just the U.S. that needs to be downgraded. I think wherewe are fundamentally in the world is that we are seeing a signicant rota -tion in creditworthiness, in a sense away from high creditworthiness in themature economies and low creditworthiness in the emerging economies tosomething of a convergence.


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Chart 8 - Was S&P riht to downrade the US?

Soverein term ratins on lon-term debtAverae of Mood`s, S&P, and Fitch lon-term ratins

In Chart 8 you can see the indicators. The bold line represents themature economies, the grey line represents the emerging economies. Mysense here is that in ve or ten years time we are going to be converging ona sort of A+, AA type range; Uruguay will be on the way up and the UnitedStates and another set of countries will be on the way down. Frankly, thisreects all these fundamental developments that we have been looking atfor the past 15-20 years. Latin America has managed to get its house in

order, specially on the scal side, and the mature economies have done theopposite, so sovereign ratings should be expected to respond to that.

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Chart 9 - Domestic vulnerabilit

Real gDP forecast for 2011Q4/Q4 (as published in IIF monthl global Economic Monitor)

One of the features of the United States is that we are struggling togrow and we are struggling to establish credible recovery. In that sense,from a sovereign creditworthiness perspective, there are problems on

both sides of the calculation. The numerators of the debt ratio keep goingup, debt levels keep going up because in a low-growth environment itis very hard to get the budget decit under control we have seen thatvery recently in Washington, all this rhetoric about doing something

while very little gets done and in a low-growth environment this isdoubly bad because the denominator of the debt calculation just doesnot go anywhere. So, the numerator is going up and the denominator isat to down. Thats very much the environment that Japan has founditself caught in recently and, I hate to say it, but the United States islooking as if it could get there as well.


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Chart 10 External Vulnerabilit

Fed custod holdins on behalf of forein insitutinons

On Chart 10 we point to the external vulnerability of the United

States. It is not just bad that we have domestic debt which is high and rising,but a huge amount is owed to foreigners. In fact, if you look at the left hand-side you can see that just the Fed itself has custody holdings on behalf offoreign central banks that now total about 3.5 trillion dollars, and you cansee that in recent years foreign central banks maybe the Central Bank ofUruguay would be proud of that have been sellers of agency securitiesand buyers of treasury securities.

How will the emerging economies perform in this environment? Ithink one point to make is that it is going to remain a very challengingexternal environment for emerging economies. But I guess what we feel isquite important is that the domestic demand environment in many emergingeconomies remains quite favorable. You can see for Latin America, forexample, we project around 4 % growth for this year and next slowerthan 2010 but 2010 was a year of unusually strong recovery. We continueto project East Asian growth at a 7 to 8 % rate, obviously much of that led

by India and China. I must confess there are probably more down-side risks

in some of these numbers than up-side risks at the current time. It mustbe emphasized that with a very permissive monetary environment in theemerging world the prospects for domestic demand are quite good.

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Chart 11 How will the emerin economiesperform in this environment?

gDP growth b reion

So far, what people in Uruguay, Brazil, Argentina, China, India,Turkey, what people across the emerging world need to worry about is rstof all the U.S., Japan and Europe, thats a problem. But the key challenge is

having to live with global monetary policy of zero inertest rates.

Chart 12 - The ke challene

Real polic rates

Percent,deatedbyheadlineination


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And I think if there is one point I would take exception with theprevious speaker is that she put a lot of blame, in a sense, on the globalnancial system, on the global banking system, but I think you have got toworry a little bit about the policy makers and their responsibility here, insetting interest rates at these levels and keeping them there. We just heardthe Feds say that they are going to keep them there until the middle of2013 that produces a very dangerous backdrop against which I thinknancial markets have to operate. In a sense, you cannot think of globalnancial players as innocent bystanders as that would not be the case they are certainly not innocent and they are not bystanders but there is

a system in which they have to play and operate to maximize prots, etc.And I think the picture I am showing here is a very toxic system, this is nota good environment got nancial markets to operate in.

Chart 13 Diverent credit conditions

One thing Id like to draw your attention to is that we do a survey ofthe Institutes bank members essentially among emerging market banks and what we are doing is asking them about credit conditions as well asdemand conditions. On Chart 13, on the left had side you have a pictureof whether banks are tightening or easing conditions. I think for us thegood news is that in the emerging world banks are actually tightening or

being quite cautious on their supply side conditions the credit. In the lefthand chart, the bars that are below 50 mean that they are tightening credit

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conditions, above 50 it means net easing. You can see on the supply sidehow banking members are actually being quite cautious, but if you turnto the right-hand picture what you see is some very dramatic news on thedemand side. And that just goes back to highlight what I was emphasizingearlier: that the conditions here in the emerging world are very, very buoyantin terms of domestic credit and domestic demand.

Concluding thoughts: there are ve basic sets of issues to go backover. First, the global growth picture is not very good but, most importantof all, global conditions remain very divergent. I would say down-side risks

have intensied in recent months, although, having said that, we still thinkthat the second half of the year will be better, so we had a bad rst halfand will have a slightly better second half, and then 2012 will not be thatgood. The European situation is bad and it is going to get worse; we aregoing to have a lot more local Sarkozy summits and ad hoc meetings to xthe plumbing. The fourth point would be that the U.S. is facing formidablescal headwinds, leaving a lot of pressure on the Fed I would say placingexcessive pressure on the Fed. I think if you go back ten years in theemerging world and I asked you all what you would like youd all say more

credit, a better environment for credit, lets have more external nance. AllI can say is be careful what you wish for.


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JULIO DE BRUN1

Es difcil atar el montn de puntas que este tema genera en un intervalo tanbreve, por lo que aunque voy a dejar muchos cabos sueltos, preero con-centrarme en algunos aspectos, en benecio del tiempo y la posibilidad detener una ronda de preguntas posteriormente.

Cuando uno ve las noticias y analiza estos temas, ya sea en charlas p-blicas como sta o en reuniones entre amigos, tiene la tendencia a mirar

los problemas de Europa como miraba los de Latinoamrica hace quin-ce o veinte aos: de manera separada aun cuando estuvieran pasandosimultneamente.

En los aos ochenta uno vea como Argentina, Uruguay, Mxico o Brasilresolvan su deuda y sus problemas scales, de inacin y dems, comocasos separados. Y de la misma manera se trataron analticamente otrosepisodios posteriores.

En esta cuestin de Europa se tiende a hacer lo mismo; uno dice bueno,hoy los mercados atacaron a Francia; hoy los mercados atacaron a Italia;Grecia pas este paquete de medidas; ser posible o ser sostenible la deudade Grecia; ser sostenible la deuda de Portugal, de Irlanda, de Espaa... enn. Uno tiende a recibir noticias, analizarlas, procesarlas y discutirlas comosi estuviramos hablando de un conjunto de pases, tratndolos individual-mente. Me gustara centrar mi charla de estos minutos en si se es el en-

foque correcto, si deberamos estar mirando las cosas de esa manera. Creoque esto es relevante porque, adems, a nivel de lderes polticos tambinse tiende a abordar el problema de esa forma. Ciertamente ese sera el casocorrecto si estuviramos hablando de pases con ciertos vnculos comercia-les o nancieros entre ellos pero esencialmente separados y en ausencia deun proyecto poltico de unin por detrs de ello. En ese caso s dicindose

podra decir: veamos cmo cada uno de estos pases resuelve sus proble-mas scales y sus problemas nancieros y su respectivo sistema nancieroy, en denitiva, sus problemas de endeudamiento.

1 Presidente de la Asociacin de Bancos Privados del Uruguay.

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El punto es que hoy por hoy, y repitiendo expresiones de quien me precedien el uso de la palabra, estamos realmente en un cruce de caminos en cuantoa si debemos seguir discutiendo las cosas de esa manera. Viendo, por lotanto, cmo distintas instituciones de cooperacin nanciera internacionalexistentes ms las que se estn desarrollando en la propia Europa intentanresolver estos problemas soberanos en forma aislada o si, por el contrario,se decide nalmente a nivel poltico tomar sto como un nico problema,relacionado no slo con el euro como moneda sino con Europa como pro-yecto poltico. Yo creo que esa es la principal cuestin que se va a ventilaren los prximos meses o en los prximos aos: si de esto surge un proyecto

de una Europa polticamente unida y, como corolario de ello, una monedacomn, o simplemente tenemos un conjunto de pases con acuerdos comer-ciales, acuerdos nancieros y algn rgimen monetario de mayor o menoralcance, segn lo que pueda ser la situacin de cada uno de ellos.

Entonces, aqu surgen dos o tres cuestiones que hacen a la dicultad deeste asunto. Como ya haba las enumerado Cosima en su presentacin, haymuchas razones por las cuales no se puede pensar que Europa sea un reamonetaria comn o que tenga las caractersticas de un rea monetaria co-mn. En este momento, adems de todos los problemas polticos ya men-cionados, Europa est en una situacin con dos claras divergencias en ma-teria de tendencias de crecimiento en los ltimos aos: en lo que ha sido elrelativamente fuerte desempeo de algunos pases el caso de Alemania, elcaso de Francia y el verdaderamente dbil desempeo de otras economasfuertemente afectadas por problemas de competitividad y productividad,como el caso de Portugal, Grecia, la propia Italia y Espaa cuando uno dejade lado todo lo que fue el fenmeno asociado a la construccin. Esas dife-

rencias de productividad, esas diferencias en ciclo econmico, ciertamenteson puntos que en la literatura de reas econmicas se sealan en el sentidoque si hay shocks tan dispares y situaciones cclicas tan dispares no es con-veniente (o no es razonable) estar pensando en un rea monetaria.

Debo precisar que respecto de estos argumentos siempre pens que si hayun lugar en el mundo que tiene pocas de las caractersticas de rea mone-taria comn que se sealan en la literatura es el de los Estados Unidos deAmrica. Qu coincidencia de ciclos econmicos o de convergencia de

productividad puede haber entre Nebraska, Alaska, Florida, Louisiana, Ca-lifornia, Nueva York...? Entonces, en realidad, cuando uno mira los requi-sitos de una zona monetaria comn, ms que una cuestin normativa sobre


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qu lugares del mundo o qu regiones del mundo deberan constituir reasmonetarias y qu regiones no deberan serlo, , uno simplemente debera veresas condiciones como el tipo de obstculos que tiene que superar quiendesea llevar adelante un proyecto poltico de unicacin. En otros trminos,

para lo nico que deberamos mirar las condiciones de la constitucin deun rea monetaria es para preguntar: Usted, en su proyecto poltico, estdispuesto a sobrellevar todo esto y seguir adelante ms all, pase lo que

pase?. O no? Si no est dispuesto, bueno, vaya pensando en otra cosa,no se complique la vida con estos temas, pero si est dispuesto mire lo quetiene por delante.

Entonces, cuando uno mira lo que ha sido la diferencia de desempeos enEuropa, que en denitiva han ido llevando a esta situacin actual, en primerlugar uno observa un benecio evidente de lo que fue para algunos pasesintegrarse a la zona euro en trminos de reduccin de deuda, en trminosde compresin. Un poco relacionado con esta simbiosis que ha habido enlos ltimos treinta aos entre monedas, entre papel moneda o dinero -duciario y deuda de pases, la mera adhesin al euro por parte de algunos

pases, gener una compresin de los spread de deuda ms all de lo que sejusticaba por la propia dinmica de las nanzas pblicas en cada pas. In-dependientemente de que en un pas tuviera 4, 5 o 6 por ciento del productode dcit o tuviera un tamao de deuda de 50, 60, 70 o 100 por ciento del

producto, todos los spread en la zona euro se comprimieron simplementepor el hecho de que un pas entrara al euro y por lo tanto pasara a formarparte de este club, como si la moneda comn de alguna manera garantizarala solvencia de todas las deudas soberanas.

Lamentablemente, en muchos de estos pases el benecio de la reduccinde spread, el efecto ingreso favorable que result para las economas de lareduccin de spread, se tradujo en gran parte en gasto improductivo msque en contribuciones a la mejora de la productividad. As, observamosesta trayectoria de gastos ascendentes en todos estos pases, exacerbada

por la crisis de nes de la dcada pasada y con la recesin que estos pasestuvieron en los ltimos aos.

Entonces, hoy por hoy tenemos un problema de altos niveles de deuday elevado dcit scal en varios pases europeos, y uno podra dirigiruna charla de estas en dos sentidos. Uno, cmo cada uno de estos pa-ses eventualmente resuelve estos problemas: es sostenible la deuda de

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Grecia?; es suciente el esfuerzo scal que se est haciendo?; el ta-mao de la deuda de Espaa, es preocupante o es ms preocupante elnivel de su dcit scal?; es posible que en algn momento converjahacia niveles de resultados scales ms sostenibles en el tiempo? Unohara un anlisis de cada uno de estos pases y dira: bueno, Grecia noes sostenible; Italia capaz que s lo es; Espaa s lo es, pero necesitareducir su desequilibrio scal, y as por el estilo.

En esta oportunidad me gustara plantear las cosas de otra manera, dicien-do: A Carlomagno le hubiera preocupado esto? George Washington,

Adams, Hamilton, Jefferson, hubieran dejado que el estado de Nueva Yorknegociara sus problemas scales con sus acreedores holandeses en formaindependiente? O hubieran considerado (como lo hicieron) el problemananciero de cada Estado como una cuestin de la Unin que queran lle-var adelante y resolverlo conjuntamente? Ciertamente, a Carlomagno nole hubiera quitado el sueo el problema scal de un feudo y, ciertamente,si se hubiera procedido por parte de los fundadores de la Repblica norte-americana en la forma que hoy actan los gobiernos europeos con respectoa la situacin scal de cada uno de estos pases nunca se hubiera llegado a

formar el Estado de la Unin. Es ms, a tal punto esto es as, que EstadosUnidos en su momento tuvo que encarar diferencias de problemas scalesinternos, diferencias de productividad interna, con tensiones que eventual-mente llevaron a una guerra civil, y que justamente, en la propia visin deconservar la Unin, se estuvo dispuesto a ir a una guerra para mantenerla.

No quiero decir con esto que Europa termine en guerra; simplemente lo quequiero es marcar la diferencia de problemas que se tienen hoy en Europacon respecto a regiones del mundo que en su momento tuvieron un proyec-to de Unin y tomaron las medidas que fuera necesario tomar para llevar

adelante ese proyecto.

Las incgnitas que a uno se le plantean hacia el futuro son si Europa va aresolver esto como un problema de la Unin Europea, en cuyo caso: i) losajustes scales tendrn que producirse en cada uno de estos pases, y ii)sin ser tomados como consecuencia de una imposicin externa sino comoel compromiso que cada uno de estos pases o estas regiones tiene con laUnin, o si, alternativamente, hay que pensar que la solucin de este pro-

blema pone en juego la viabilidad del proyecto de Europa como Unin.

Mucho se ha hablado del efecto negativo que pueden tener en materia decrecimiento econmico los ajustes scales en Europa. Yo creo que ha sido


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tan mala la calidad del gasto pblico en Europa en los ltimos 15-20 aosque buena parte de los recortes scales que se estn planteando son excesosscales que, en todo caso, su eliminacin es promovedora del crecimientoeconmico ms que un shock negativo de demanda en el corto plazo. Eltema scal esencial en Europa a largo plazo es la viabilidad de sus sistemasde pensiones y esto es un problema independiente, relacionado con la crisisactual pero que tiene que abordarse bajo cualquier escenario, independien-temente de lo que se decida con el mantenimiento de la moneda.

Las consecuencias de las reformas o de la ausencia de stas en los pases

europeos en los prximos aos determinar no slo la sostenibilidad de sudeuda soberana sino tambin si hay un freno a posibles efectos de contagio,a nivel no solamente europeo sino tambin a nivel mundial. . Pero lo queuno ve hoy por hoy es un discurso dual y un conjunto de medidas dualesque apuntan a ambas cosas. Por un lado recordar a cada uno de los pasesque tienen un compromiso con la Unin Europea y por lo tanto deben llevaradelante ciertas medidas y aqu es muy importante lo que sealaba Cosi-ma, el tema es si democrticamente cada uno de estos pases est dispuestoa hacerlo: si no est dispuesto a hacerlo que no se tome la molestia de per-tenecer a la Unin, pero si quiere los benecios de la Unin deben hacerlo.Porque en denitiva, si cada pas miembro no est realmente dispuesto atomar las medidas necesarias, entonces no vale la pena seguir insistiendo enmantener a ese pas o esa regin dentro de la zona del euro. O la alternativa y algunas de las medidas que se han tomado en Europa tambin de algunamanera tienden un puente en ese sentido es aceptar que eventualmentealgunos de los pases involucrados no puedan completar la sostenibilidadscal que requieren a mediano plazo, y que en ese caso los efectos hacia el

resto sean lo ms leves posible, en particular en lo que tiene que ver con elsistema nanciero.

Quizs lo que uno debera pedir a las autoridades europeas en este trayectoes un poco ms de claridad y conviccin en lo que realmente quieren ha-cer. La preocupacin sobre el evento de default en este contexto creo queest sobrestimada. Lo que se hizo respecto de Grecia el anuncio respec-to del deseo de que los bancos contribuyan en un rollover de sus dbitoscon una especie de Brady pequeo con distintas alternativas de bonos amediano plazo y dems si se hubiera iniciado por el gobierno de Greciaunilateralmente, presentndolo como un anuncio frente a sus acreedores,seguramente hubiera implicado que las calicadoras de riesgo inmediata-


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mente pusieran a este pas en selective default hasta que se completara elproceso de aprobacin por parte de los bancos de su propuesta de reestruc-tura. Como no lo hizo Grecia sino que lo hicieron las autoridades europeas,incluso como mecanismo de presin frente a los distintos bancos, esto seviste de voluntariedad y por lo tanto por ahora las calicadoras no handicho nada, aunque lo que se hizo a ese respecto es exactamente lo mismo(aunque formalmente diferente debido a quien lo anuncia) que lo que hizoUruguay en marzo del 2003 cuando inici su proceso de dilogo con susacreedores. Entonces el selective default ya est planteado y el problema deesta falta de conviccin es que se ha planteado un selective default que lo

nico que hace a largo plazo es mantener la expectativa de deuda de Greciaestable, si sale todo bien, en 150 por ciento del producto. O sea, hacer todoeste esfuerzo para no resolver el problema de la deuda parece en todo casoun desperdicio.

La misma contradiccin y dudas aparecen con los anuncios del Banco Cen-tral Europeo respecto de su compra de bonos soberanos en el mercado so-

berano. Ms all de todos los problemas estatutarios que pueda tener parahacerlo, el tema es que si se ha decidido que el Banco Central Europeo va

salir a comprar deuda soberana en los mercados los recursos disponiblesdeberan concentrarse en comprar la que est sufriendo en el momento msataques especulativos, como la de Italia, resultando incomprensible quesalga (como sali) a comprar deuda de Portugal o de Irlanda cuando ya el

problema de deuda de esos pases estaba incorporado en los mercados y porlo tanto lo que hiciera el Banco Central a ese respecto era poco efectivo.

En n, repitiendo lo que deca hasta este momento yo creo que en los prxi-mos meses, ms que en el prximo ao, vamos a estar viendo cul es el fu-turo de Europa, si sigue siendo una Unin o simplemente un conglomeradode pases que funciona en forma ms o menos en coordinada.


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UNDERSTANDINg UNCONVENTIONAL

MONETARy POLICy:A NEW MONETARIST APPROACH

STEPHEN D. WILLIAMSON1

[email protected]

This version: October 2011

ABSTRACT:

This paper focuses on Federal Reserve policy in the United States afterthe nancial crisis. Three key interventions - QE1, QE2, and forwardguidance - are reviewed, and a model is outlined that can be used tohelp understand some of the consequences of the nancial crisis, andthe policy responses to the crisis. Liquidity traps play an importantrole in the analysis, and it is shown how the nancial crisis led toan unconventional liquidity shortage, requiring an unconventional

policy response.

Kewords: Money, microfoundations, monetarism, monetary policy.

JELClassications: E40, E50

INTRODUCTION

Before the nancial crisis in 2008-09 the academic economics

profession perhaps seemed a well-ordered place. Economists were goingabout our business writing and publishing papers, debating economic issuesat conferences and in the seminar room, and working with policymakers inan attempt to make the world a better place. There were disagreements ofcourse, and sometimes those disagreements were heated, but the systemseemed to be working. Mostly, good ideas appeared to be rising to the top,and academias structure of peer review and incentives, though of courseimperfect, seemed to be working to advance economic science.

Revista de Economa - Segunda Epoca Vol. 18 N 2 - Banco Central del Uruguay - Noviembre 2011

1 This paper was prepared for the Banco Central del Uruguay.2 Washington University in St. Louis and Federal Reserve Banks of Richmond and St. Louis.

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Since the nancial crisis, the world appears to have changed, thoughmaybe we are just seeing pieces of that world that we were unaware of.People who want to assign blame for the nancial crisis have targetedeconomists, and macroeconomists in particular, with accusations of neglect,if not corruption. Within the profession, some economists have criticized

particular economic research programs as being out of touch. Krugman(2009), for example, feels that much of the mainstream developments inmacroeconomics and nancial economics of the last 40 years are uselessand should be relegated to the trash heap. Caballero (2011) argues thatmacroeconomic research has been too focussed on minor perturbations of the

neoclassical growth model, and that there should be more experimentationin terms of research paths. A common complaint seems to be that there hasbeen a neglect of the study of the nancial sector and its role in aggregateeconomic activity.

Some macroeconomic researchers may indeed have been guilty ofignoring the details of nancial arrangements in their work. For example,the researchers whose work appears in Kehoe and Prescott (2007) seemdismissive of the role of monetary and nancial factors in depressiveeconomic episodes. Also Woodford (2003), an inuential handbook formonetary policy, focusses exclusively on the role of monetary policyin mitigating the frictions resulting from sticky prices, while ignoringmonetary exchange and nancial frictions. However, plenty of rigorousand well-respected research has been conducted over the last 40 years ormore that addresses the role of private information and limited commitmentin nancial contracts and incentive contracts, examines the functions ofnancial intermediaries, highlights the role of assets in exchange, and

integrates these ideas in macroeconomic frameworks that are amenable topolicy analysis. Indeed, we do not have to dig deeply or look far aeld tond top quality macroeconomic research on imperfect nancial marketsand to observe macroeconomists thinking outside the box.

In Williamson and Wright (2010, 2011), Randall Wright and I discussthe details of what we call New Monetarist Economics, which is the areaof macroeconomic research in which we work. We think of this research

program as having two branches, one dealing with monetary economics,and the other with nancial intermediation and banking, though in a senseour view is that this is all nancial economics - a unied whole. Keycontributions in the monetary economics research program are Kareken

STEPHEN D. WILLIAMSON

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and Wallace (1980), Kiyotaki and Wright (1989), and Lagos and Wright(2005), and key early contributions in the nancial intermediation research

program were Diamond and Dybvig (1983), Diamond (1984), Williamson(1986, 1987), and Bernanke and Gertler (1989), building on even earlierdevelopments in information economics.

The key New Monetarist ideas are the following:

1. To understand how nancial factors are important for aggregateeconomic activity, we need to delve into the particulars of private

information and limited commitment frictions. Private information andlimited commitment are at the foundation of the role for monetary exchange,and they are also key to understanding nancial contracts, nancialintermediation, and the nancial propagation of macroeconomic shocks.

2. To analyze monetary policy requires that we construct models thatexplain how and why central bank liabilities and other assets are used inexchange, and to think carefully about how the central bank functions asa nancial intermediary. Monetary policy works in part because of specialadvantages that a central bank has in intermediating assets - principallycoming from monopolies on the issue of hand-to-hand currency and on

payments systems arrangements among private nancial institutions.

3. Attempting to classify some subset of assets as money is a futileexercise. We are interested in liquidity - broadly, some notion of how assetsare used in exchange (retail exchange, wholesale exchange, exchangeamong nancial institutions). Liquidity comes in many different forms.

Some liquidity is supplied by the government, some by the private sector,and some assets are liquid in some circumstances but illiquid in others. Insome transactions, for example the purchase of food from a street vendor,currency is the only object accepted in exchange, i.e. currency is highlyliquid in this circumstance, but other assets are highly illiquid. However,in a large-value transaction involving nancial institutions such as Bankof America and JP Morgan Chase, currency is highly illiquid while otherassets such as US government Treasury bills and deposits with the FederalReserve System (reserves) are highly liquid.

These three ideas set us apart, from Old Monetarists and NewKeynesians in particular. Milton Friedman and the Old Monetarists thought

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it important to categorize some assets as money and other assets as not-money, and they did not appear very concerned with the role of nancialintermediaries in the economy, other than as suppliers of money. For

New Keynesians, monetary and nancial frictions are thought to be ofminor importance in conducting monetary policy, though that idea may bechanging (see for example Curdia and Woodford 2010) in response to thenancial crisis.

In this paper, I use a particular New Monetarist model to help makesense of some features of the nancial crisis, as well as to evaluate some of

the policy interventions undertaken by the Federal Reserve System in theUnited States after the nancial crisis. I will include only an outline of thespecic model used here, and refer readers to Williamson (2011) for thedetails.

One key feature that our model has, which is crucial for understandingsome features of the nancial crisis, is a distinction between different typesof liquid assets. In the model, currency is a liquid asset which is necessaryto engage in particular kinds of retail transactions. However, intermediatedloans and government bonds - interest-bearing assets - are also importantliquid assets that are used in other types of transactions. In the model, whenthe central bank conducts a one-time open market operation, this can actin an unconventional way. If interest-bearing assets are scarce - wherescarcity is dened in a precise way in the model - then a one-time openmarket purchase of interest-bearing assets by the central bank will lowerthe real interest rate permanently. This is an illiquidity effect, in that theopen market purchase essentially makes interest-bearing assets more scarce.

Typically, we would think of such an open market operation as an injectionof liquidity, but in this instance it actually reduces liquidity by reducing thequantity of interest-bearing assets used in transactions.

The Federal Reserve System had been granted the power by Congressto pay interest on reserve accounts at the Fed, prior to the nancial crisis.Beginning in October 2008, the Fed began paying interest on reserves at0.25%, and that policy continues to the present date. Further, since the fallof 2008 when the Fed began to intervene in nancial markets in a dramaticway, the quantity of excess reserves held by nancial institutions in theUnited States has been very large. In such an environment, monetary policyworks in a quite different way than in pre-nancial crisis times. Under


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current conditions, an extra unit of reserves in the nancial system will beheld overnight by nancial institutions, and will have no marginal value innancial transactions during the day. Thus, if the Fed exchanges reserves forshort-term government debt, that will be irrelevant, i.e. traditional central

bank actions will have no effect. This does not mean, however, that thereare no actions the Fed can take that will matter. Indeed, if the Fed changesthe interest rate on reserves, then that essentially has the same effect as anopen market purchase of short-term government securities would have hadin the pre-nancial crisis period.

The nancial crisis is sometimes viewed as a puzzling event, whichconventional economic theory cannot successfully confront. However,there is actually plenty of off-the-shelf economic theory that can be used tomake sense of what we observed during the nancial crisis. In particular,the model in Williamson (2011), which is used in this paper, uses nancialintermediation theory developed primarily in the 1980s, by Townsend(1978), Diamond (1984), and Williamson (1986, 1987), and by Diamondand Dybvig (1983). It also makes use of monetary theory developed overthe last 40 years or so. The costly state verication model of Townsend(1978) which gives rise to optimal debt contracts and can be used as anelement in nancial intermediary structures, is particular useful, as criticalcomponents of the nancial crisis were non-contingent contracts, default,and the costs of bankruptcy. In this paper, we show how aggregate shocksto asset returns, risk, and the costs of bankruptcy can reproduce some keyobservations related to the nancial crisis, in particular increases in interestrate spreads, declines in aggregate lending, and reductions in safe rates ofinterest.

These aggregate shocks work to explain features of the nancialcrisis, and also show how the scarcity of interest-bearing assets plays animportant role in the nancial crisis. Prior to the nancial crisis, asset-

backed securities played a key role in providing apparently safe liquidityin nancial exchange. However, perceptions about the safety of thosesecurities changed during the crisis so that, effectively, the private sectorscapacity for producing safe liquid assets for nancial exchange declineddramatically. This type of liquidity shortage is very different from theliquidity shortages that occurred during the Great Depression in the UnitedStates, or earlier, during the banking panics of the National Banking era(1863-1913). The Great Depression and National Banking era panics were


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essentially currency shortages - a very different kind of liquidity scarcity.A currency shortage can be cured through standard open market purchasesof interest-bearing assets, but such central bank actions will only aggravatethe liquidity scarcity that existed during the nancial crisis.

Once the Fed had lowered the interest rate on reserves to 0.25% inOctober 2008, there were essentially no conventional options open to thecentral bank to ease nancial conditions in the United States. In this paperI will focus on three unconventional monetary policy interventions carriedout by the Fed. The rst two interventions are both typically referred to

as quantitative easing. Quantitative easing is a misnomer, rst, asquantitative suggests that what makes this type of intervention differs byits quantitative nature, i.e. that asset quantities on the Feds balance sheetare being manipulated. Of course, any action by a central bank, other thanthe setting of administered interest rates (the central banks lending anddeposit rates) involves quantities. In normal times, for example, most central

banks intervene by targeting some overnight interest rate, and achievingthat target by buying and selling quantities of assets. Second, as we will seein the paper, quantitative easing may not be easing anything.

The particular quantitative easing programs that the Fed engaged inare typically called QE1 and QE2. QE1 was a program of purchasesof mortgage backed securities and agency securities by the Fed, while QE2involved purchases of long-maturity federal government bonds (Treasurydebt). These purchases were fundamentally different, as the rst involvedthe indirect purchases of private assets, while the second was closely relatedto conventional open market operations with the only difference being that

the asset purchases were long-maturity rather than short-maturity. In anycase, the argument made in the paper is that there are conditions underwhich neither QE1 nor QE2 would have matters for any quantities or prices.It is possible that QE1 mattered, but this would only happen if the Fed were

buying private assets on better terms than the private sector was offering. Inthat case QE1 would have altered the allocation of credit, and would havecaused a redistribution of wealth.

A third unconventional intervention is forward guidance. In recentyears, the Fed has been somewhat more forthcoming in its policy statementsconcerning the future path of monetary policy, though typically the FOMC(Federal Open Market Committee) policy statement has supplied only vague


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As of August 2011, in Table 1, the Feds liability structure hadchanged dramatically from the earlier period, with reserves accounting forthe majority of Fed liabilities. Though the August 2011 data do not showit, Treasury account balances with the Fed have been substantial since theonset of the nancial crisis - sometimes in excess of $300 billion - and have

been highly volatile.

Table 1: Federal Reserve Liabilities ($billions)

Source: Federal Reserve Bulletin

On the asset side of the Feds balance sheet, in Table 2, the Fedsassets in January 2008 consisted mainly of US government debt, both short-term (Treasury bills or T-bills) and long-term (Treasury bonds or T-bonds).T-bills were used in day-to-day open market operations (often involvingrepurchase agreements) conducted by the Fed, and T-bonds were typicallyrolled over as they matured, but were not bought and sold on a daily basis.

As of August 2011, in Table 2, the average maturity of the Fedsassets had lengthened considerably from what it was prior to the nancialcrisis. In August 2011, the Fed held almost no T-bills, and had expandedits holdings of T-bonds considerably. Further, in August 2011 the Fed heldabout $1 trillion in assets that were essentially backed by private mortgagedebt (and implicitly guaranteed by the federal government). In August2001 the Fed held almost $900 billion in mortgage-backed securities issued

by the government-sponsored enterprises or GSEs (actually now undergovernment conservatorship): FNMA (or Fannie Mae) and FHLMC (orFreddie Mac). The agency securities on the Feds balance sheet are theliabilities of these two GSEs.


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in T-bonds with remaining maturities of 3 years and less, in exchange forT-bonds with maturities of 6 to 30 years. The intervention will take place

between September 2011 and June 2012. The result of operation twist willbe to lengthen the average maturity of assets held by the Fed. While thismay appear to be different from either QE1 or QE2, will show that, undercurrent circumstances, Operation Twist is actually qualitatively identicalto QE2.

Forward guidance, as discussed in the Introduction, involvesstatements by the central bank about the future course of policy. Prior to the

nancial crisis, Fed policy decisions concerned the setting of a target ratefor the overnight fed funds rate, and communication with the public hadevolved to the point where the FOMC policy statement would include somelanguage which would signal the likely future path of the policy rate, andwhat that path might depend on. After the nancial crisis, the Fed began tomake more explicit statements about the future path for the policy rate, tothe point where, in August 2011, the Fed essentially xed the target policyrate for about two years.

How Does Fed Polic Work? Pre-Crisis and Post-Crisis

Most central bank intervention occurs roughly in the following way.If we focus just on overnight nancial markets, the central bank lends tonancial institutions overnight at a central bank lending rate, nancialinstitutions can deposit funds (reserves) with the central bank overnightat a central bank deposit rate, and nancial institutions can lend amongthemselves at a market overnight rate. There are basically three procedures

that central banks typically exercise monetary control in the very short run.First, through open market operations, a central bank can intervene so asto target the overnight rate within bounds determined by the central banklending rate (the upper bound) and the central bank deposit rate (the lower

bound). This is a channel system, whereby the channel determined by thecentral bank lending and deposit rates channels the overnight rate. TheBank of Canada, for example, conforms to a channel system, and Figure2 shows a forty-day period prior to early July 2011, illustrating the pathsfollowed by the central bank lending rate, the central bank deposit rate, andthe overnight market rate. In this case, the overnight rate was targeted at 1%over that period, and the Bank of Canadas deposit and lending rates wereset, respectively, at 0.75% and 1.25%. Further, note that the Bank of Canada


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In conclusion, there are three ways for a central bank to inuenceshort-term nominal interest rates, all working through the overnight marketon which nancial institutions trade. First, the central bank can intervenethrough open market operations to target the overnight rate such that it lies

between the central banks lending rate and the central banks deposit rate.Second, the central bank can operate so that there is a positive quantityof central bank deposits (in excess of reserve requirements, if those exist)held overnight, in which case the central bank deposit rate determines theovernight rate. Third, the central bank could set a lending rate, and offer tosatisfy all of the forthcoming demand at that rate and, further, set the rate

in such a way that forthcoming demand is strictly positive. In this case, thecentral banks lending rate determines the overnight rate.

Currently, the Fed operates according to the second regime. Thenancial system is awash in reserves, and the interest rate on reserves (thedeposit rate at the central bank) is the key policy rate. In later sections wewill explore how monetary policy works under these conditions.

A New Monetarist Model

This section contains an outline of the model. For more detailsreaders should consult Williamson (2011). The basic structure of the modelis similar to Rocheteau and Wright (2005), which in turn is derived fromLagos and Wright (2005). There is an innite horizon with time indexed

by t=0,1,2,3,..., with each period having two subperiods. We will refer tothe rst subperiod as the decentralized market or DM, and the second asthe centralized market or CM. The population consists of three types of

economic agents. First, there is a continuum of buyers, with unit mass, eachof whom has preferences

Here, 0 0, andwith the property that there exists somex > 0 such that u (x) x = 0. Denex* by u (x*) = 1. Second, there is also a continuum of sellers, with unitmass, each of whom has preferences


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where htdenotes labor supply in the DM and X

tis consumption in the

CM. When a buyer or seller can produce (the buyer in the CM, the sellerin the DM), one unit of labor input produces one unit of the perishableconsumption good.

Finally, the third group of agents are entrepreneurs. In each CM, amass of these agents is born, and they live until the next CM. An entrepreneur

has an indivisible investment project with payoffw and distributionF(w),and payoffs are independent across entrepreneurs. For an individualentrepreneur, the realized payoffw is private information, but another agentcan incur a verication cost to observe w. Entrepreneurs differ accordingto their observable verication cost, and G() describes the distributionof verication costs across entrepreneurs. Entrepreneurs do not consumein the CM when they are born, but consume in the subsequent CM, andare risk-neutral. Since he or she has no endowment, an entrepreneur must

borrow when he or she is born in order to fund his or her investment project,which is a necessary condition to consume in the next CM. This costlystate verication structure is very similar to what is built into the model inWilliamson (1987).

In the decentralized market, each buyer is matched at random witha seller, while in the CM everyone is in the same location. In addition tothe costly-state-verication information friction that will operate in theloan market, there are elements of imperfect information in the model that

inhibit other types of lending. In the DM, sellers do not know the histories(i.e. relevant credit records) of buyers, which makes credit arrangementsinfeasible in DM meetings between buyers and sellers. Further, market

participants in the CM can only observe prices.

In the model, there are three basic assets. First, there are loans toentrepreneurs. As is detailed in Williamson (1987, 2011), costly stateverication, under some restrictions, implies that intermediated debtcontracts with entrepreneurs are optimal, with perfectly-diversieddelegated-monitoring nancial intermediaries that hold portfoliosof loans to entrepreneurs. For convenience, call these nancialintermediaries banks. A loan to an entrepreneur with verication cost

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will in equilibrium pay a gross real loan interest rateR(), andR() will ingeneral reect a default premium that is increasing in . In equilibrium,the expected payoff to a bank from a loan to any entrepreneur will be r,the gross market real interest rate.

Further, some entrepreneurs will receive loans in equilibrium, whileothers do not. There is some critical value * for the verication cost, suchthat some entrepreneurs with * receive a loan, while those with >* do not. The gross real interest rate ris an endogenous variable. Ifrishigher, then this will imply that the cutoff * is smaller, so that there is less

lending. We can then write the aggregate loan quantity as L= L (r), whereL() is a decreasing function.

The other two assets are liabilities of the consolidated government(scal authority and central bank) - currency and one-period nominalgovernment bonds. Let M

tdenote the stock of money in period t, which

trades at t

price in the CM, and Bt

the stock of one-period nominalgovernment bonds, each of which sells in the period-t CM for one unit ofmoney, and pays offq units of money in the next CM in equilibrium. Banks

will be indifferent between government bonds and loans to entrepreneurs in

equilibrium, so in equilibrium we will have r = .

In the DM, in fraction of meetings - non-monitored meetings -between buyers and sellers, the information technology is not available totrade loans, government bonds (account balances with the scal authority),or the liabilities of intermediaries holding these objects as assets. Currencyis the only asset that is tradeable in non-monitored meetings. However, in

fraction 1 of meetings - monitored meetings - buyers and sellers haveaccess to an information technology that allows them to exchange claimson entrepreneurs, bonds, currency, or claims to a portfolio of those assets.In all DM meetings, goods produced by the seller can be acquired by the

buyer only through an exchange of assets. For convenience, we assume thatthe buyer makes a take-it-or-leave-it offer to the

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