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Financial precariousness not ebbing

What has  happened to the big bubble in risky, nonsovereign-currency debt–most emerging market bonds, domestic junk bonds, etc? What has not defaulted appears to be continuing to inflate, with buyers piling into these markets.

Some articles in the press have in fact been observing that relative calm has lulled investors in some types of securities, including US stocks and risky types of bonds, leading to stock market tranquility and falling bond yields. Prices for many types of emerging market bonds have risen after a post-US-election decline, while junk bonds have rallied in the United States. The New York Times‘s Dealbook notes that US equities are richly priced according to some standard valuation tools. Moreover, yields for risky debt have again fallen, providing strong returns to those holding these issues. The Times‘s analytically inclined Upshot points to reduced stock-market volatility, actual and anticipated: 1) markets seem less jumpy in response to policy news, and 2) the prices of derivatives that amount to bets on future volatility imply reduced expectations of future turmoil. What accounts for the markets’ calmness in the face of political tumult and risks that do not appear to have abated?

Incentives to hold risky investments seem adequate to market participants, until central banks take action to raise interest rates paid on sovereign debt—promises to pay by a central government in its own currency. Moreover, the market seems to be speculating against a renewal of financial turmoil.

Influencing the columnists’ thinking is a Keynesian analysis in which a convention holds sway among market participants—a belief that the current situation will more or less continue—which eventually must turn out to be wrong. In terms of statistical analysis, negative tail events from the past may in essence be out of the sample period in Wall Street models or their frequency underestimated. In U.S. equity markets, a similar situation holds: securities are optimistically priced by some standard measures used in stock analysis, including P-E ratios.

The figure at the top of this post shows some evidence that complacency may not be warranted, at least in the case of US corporate debt. Continuing weakness in this sector’s balance sheets was apparent in last month’s IMF (International Monetary Fund) Global Financial Stability Report, which featured the series depicted in the chart, which measures the ratio of cash flow (earnings before interest and taxes) to interest payments.

The IMF report indicated that the decline in the coverage ratio was most pronounced among the smallest firms, but that it was pervasive across industries and size classes. The organization projects another decline this year.

Among the inauspicious leading indicators are many policy developments, including imposed fiscal austerity in places where it is inappropriate at this time. Policymakers either lack appropriate policy space or believe fiscal conservatism is the appropriate reaction to slowness in domestic growth. One example would be spending cuts taking place in Puerto Rico following its declaration of a form of bankruptcy. Puerto Rico’s debt is of course not in sovereign currency, meaning a currency issued by a central bank of the debtor. Along with fiscal austerity, a second worldwide trend leading to increased fragility risks is ongoing financial deregulation.

Overall financial turmoil thus seems likely to continue. Moreover, weak debtors are an influence pointing in the direction of weaker growth and slower job creation around the world–another reason to be careful about post-crisis policy tightening. This applies in my view to talk that increases in the deficit are likely to set off inflation, that vigilance is no longer needed about unemployment, that there is no benefit whatsoever from quantitative easing measures, that crowding out will inevitably impose costs on firms and other investors, etc. It is all macroeconomically perverse, even leaving aside worthy expenditures and programs that might be stopped.

US policymakers must keep all of this in mind more than many seem to know. There is greater capacity around the world to push growth higher in the US in part because of weakness around the world as reflected in financial risk.  It adds to the case against strong-dollar or tight-money macro policies, both of which increase the burden of dollar-denominated debt.  On the other hand, the Fed will eventually raise interest rates on government debt, in part to give it room to loosen monetary policy in a future recession. Such a move must be offset by some domestically expansionary move in another arena, given the weak situation I have described for growth, debt repayment, and employment.

Given a need–and the Fed’s intention–to raise interest rates somewhat, one is led to fiscal policy or to policies that directly devalue the currency, other things equal. Such moves—in moderation and with good timing–also help the domestic manufacturing sector of a country, often a center of productivity growth. The historic decline of manufacturing has contributed to an unhealthy intersectoral imbalance. In contrast to dollar devaluation, tax changes that act on import and export prices only would not be effective as a way of easing the burden of debts denominated in US currency.

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