At Netroots Nation with a Panel Thursday

Jun 7, 2012Mike Konczal

I'll be at Netroots Nation for the next several days. If you are here and want to say hi, shoot me an email or a twitter message.
 
Today, Thursday at 4:30pm in room 552, I'll moderating a panel on progressives and the Federal Reserve with Matt Yglesias of Moneybox, Karl Smith of Modeled Behavior, and Lisa Donner of Americans for Financial Reform. If you are there you should check it out.
 
I believe it will stream online, so you can watch it even if you weren't able to make it. Hopefully it'll be viewable in the box below.

 
After the fact it should be viewable online. You can stream other panels at this webpage.
 

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What Constrains the Federal Reserve? An Interview with Joseph Gagnon

Jun 4, 2012Mike Konczal

There's a growing consensus right now that the Federal Reserve could be doing more to bring about a stronger recovery given its current powers. It's even more relevant in light of the recent weakening of the recovery, as shown in the poor job numbers that came out last Friday. But there's a lot of disagreement and confusion about the constraints that prevent the Federal Reserve from taking more action.

There's a growing consensus right now that the Federal Reserve could be doing more to bring about a stronger recovery given its current powers. It's even more relevant in light of the recent weakening of the recovery, as shown in the poor job numbers that came out last Friday. But there's a lot of disagreement and confusion about the constraints that prevent the Federal Reserve from taking more action. It's even more confusing given Federal Reserve Chairman Ben Bernanke's past research, where he described the Bank of Japan falling into “self-induced paralysis.” Some believe the constraints are political, others believe they are related to fighting among the various governors, and there are those that believe Bernanke is comfortable with monetary policy as it is.

In order to make sense of the various constraints the Federal Reserve faces, I spoke with Joseph Gagnon, senior fellow at the Peterson Institute for International Economics, over the weekend. Gagnon was an associate director for the Federal Reserve’s Division of Monetary Affairs and Division of International Finance, where he was involved with the execution of QE1. I last spoke with Gagnon on the issue of QE3 last summer.

Mike Konczal: Let's start with the basics. Does a random person -- not at the highest levels, but among those who make up most of the researchers and workers -- at the Federal Reserve think that the Fed is "out of ammo"? What are their opinions on how well previous expansionary monetary policy at the zero bound, like QE2 and Operation Twist, have worked to bolster the economy?

Joseph Gagnon: Let me start by linking to a blog post from a former classmate at his new blog, Miles Kimball’s Balance Sheet Monetary Policy: A Primer, that spells out what the Fed could do and why it would work. However, he ignores some of the legal restrictions on what the Fed can do. (See below.)

My sense is that most Fed economists believe that the Fed does have substantial, though not unlimited, ammo. They also believe QE1, QE2, Operation Twist, and the language concerning future policy intentions (staying near zero interest rates through late 2014) had significant positive economic effects, but not apparently large enough to achieve the rapid recovery that is desired.

Basically, the Fed has run out of ammo in terms of language about future policy intentions because it cannot credibly signal its intentions for more than two to three years ahead. It can extend the “late 2014” horizon into 2015, but that is fairly minor.

In terms of the asset purchases, the Fed is limited by law to the Treasury, agency, and agency MBS markets plus foreign exchange. Buying foreign exchange would be viewed as economic warfare by many countries, so it is probably ruled out even though it reflects rank hypocrisy on the part of foreign governments that are massively buying dollars. In the Treasury market, yields on three-year notes are only 0.3 percent, so the Fed must buy five-year to 30-year bonds to have any effect. With the 10-year yield at 1.5 percent, the scope for further effects is modest. Even if the Fed bought every 10-year Treasury, it would be hard to get the yield much below 1 percent, because the risks on such a bond become tremendously skewed toward future losses. There is more scope to buy agency MBS to lower the mortgage rate, but already mortgage rates are at a record low of 3.75 percent. At some point between 2 and 3 percent we are likely to reach the limit. So, the Fed has quite a bit of ammo left, but we can see that it is not inexhaustible.  

Research I am doing suggests that it would be much more attractive for the Fed to buy a broad basket of U.S. equities to support the stock market than to try to push down bond yields from these already low levels. Sadly, the Fed is not authorized to buy equities, even though other central banks are allowed to do so.

MK: A story is circulating that there has been a lot of internal disagreements among the members of the Federal Open Market Committee (FOMC), and this has prevented Bernanke, who wants to have consensus on the votes, from expanding further. You see this idea in the series of three dissenting votes against more action throughout much of 2011 and the lack of dissenting votes for more action until Charles Evans' in late 2011. Is it your sense that the FOMC composition has held the Federal Reserve in check on expansion?

JG: The hawks will never get more than three votes. This year only one hawk has a vote. Chairman Bernanke and his close allies (Yellen, Dudley, Pianalto, Williams, Tarullo, Stein, and Raskin) have a comfortable majority.

MK: A lot of economics writers assume that Bernanke is uncomfortable with non-unanimous votes and just the presence of vocal, hawkish votes has constrained how far he is willing to go with expansionary actions. Have those divisions held expansion in check in the past, even if there are fewer hawks now? And would more doves on vacant FOMC seats have made a difference in 2009?

JG: I think Bernanke had some preference for unanimous decisions, but not a strong preference. I expect there will be dissents all year. I don’t think mere voting support would have made much difference in 2009 because Bernanke knew he could get whatever he wanted. But a strong discussion leader in favor of greater ease might have made some difference if he was persuasive enough. I believe Bernanke is intellectually much closer to the doves than the hawks, but he and some of the other doves are more cautious than the hawks.

MK: What's your sense of how the economics profession broadly reacts to the idea that the Federal Reserve could be doing more? Do you think a generic economist thinks the Fed could be doing more and isn't, or that the Fed is "out of ammo" in how it can expand the economy?

JG: I think the average economist outside the Fed thinks the Fed has less ammo than the average economist inside the Fed. I frequently hear people say the Fed has done all it can do. I do not agree, but I do see a limit approaching. Note that that limit arises from legal restrictions on the Fed. If the Fed were empowered to buy all assets, it would never run out of ammo.

MK: Others point to political pressure, especially from the right. There have been rhetorical moves, such as Rick Perry saying he’d treat the Federal Reserve "pretty ugly." There is the blocking of nominees, such as Peter Diamond being blocked because “[h]e supports QE2.” And it also has to do with conservative political infrastructure. The Club for Growth put whether or not Republicans supported Peter Diamond for the FOMC on their checklists for proper Republican behavior.

How much does political pressure place a constraint on the Federal Reserve's ability to do more expansion?

JG: Chairman Bernanke would deny that political pressure influences his vote, and he even went out of his way to make a public appearance in Texas after Rick Perry made his threat. But FOMC members all read the papers. They see the virulent opposition to their policies on the right and the silence on the left. (Paul Krugman is a big exception, but he is not a politician.) They want to avoid any Congressional action that would reduce their independence in the future, in part because they think this might lead to even worse economic outcomes than we are currently experiencing.  I think they should stick to achieving their current mandate and not fail to achieve it out of fear of what a future Congress might do. In my view, Congress and the president are solely responsible for making laws and the Fed is solely responsible for achieving its mandate. But I am pretty sure some FOMC members either consciously or unconsciously disagree with me and shade their actions out of this concern.  

MK: Is it a question of balance? I've noticed that there is little political pressure from liberals on the Fed for more expansionary policy. Is it a matter of there being little countervailing pressure?

JG: I think it would help if politicians on the left criticized the Fed more strongly for failing to achieve its employment mandate.

MK: A very popular theory in the financial blogosphere is that the inflation target functions as a ceiling, not an actual target. Ryan Avent has argued that the Fed goes into action to prevent deflation, but once inflation expectations approach 2 percent it pulls back. Matthew O'Brien at the Atlantic Monthly has referred to a 2 percent ceiling as the new cross of gold. And Greg Mankiw has written, “If Chairman Bernanke ever suggested increasing inflation to, say, 4 percent, he would quickly return to being Professor Bernanke.”

Is the 2 percent "ceiling" a serious constraint, and why?

JG: The Fed has said 2 percent is the target, not the ceiling, but I agree that their actions over the past three years are not consistent with their statements. I think we should be willing to accept temporarily higher inflation if that would help to reduce unemployment faster. Indeed, combining actions like QE with an announced willingness to accept temporarily higher inflation could create a synergy that would increase the potency of QE (by reducing the real interest rate). But I fear that announcing a goal of higher inflation, either temporary or permanent, will not actually do anything unless it is backed by actions.

Also, I do not think we should permanently raise the inflation target. It is not necessary to do that to get more monetary stimulus and it would jeopardize the hard-won war on inflation of the past two decades.

MK: There’s the idea that, in the past, economists believed a lack of explicit inflation target gave central banks flexibility, but it doesn't seem that we've seen this flexibility.

JG: The general view is that you do not make up periods of being above or below target, you simply always strive to get back to the target. The problem is that the Fed is not taking this approach equally to unemployment and inflation.

Some have argued for a price path target or a nominal GDP path target. In that case you do make up for past deviations in inflation. But I think it is difficult to explain to the public how the specific path is chosen. Why should the CPI be 105 in 2013, 107 in 2014, 109 in 2015, and so on indefinitely? People care about the inflation rate not, some arbitrary price level. And it means that after booms you must have deflation. Indeed, if one had started the path in the early 1990s, the late 1990s boom would have put us way above it. Then the Fed would have had to make the 2001 recession much more severe to get us back on the path. That would have been a tough sell politically.

MK: There are those that think Bernanke should be much more explicit in declaring expectations. This became a big idea recently after an article by Paul Krugman said that Ben Bernanke has abandoned the insights of Professor Bernanke. Bernanke is essentially doing things that the Fed can't fail at instead of the things he proposed Japan should do in a similar downturn. What's your take on this disagreement?

JG: I think it is sensible for the Fed to stick to statements about things it is confident it can achieve, provided that it feels it is doing enough to achieve its objectives. For example, it can talk about purchasing MBS and pushing down the mortgage rate, thus stimulating the economy. The problem is that it has not achieved its objectives over the past three years and its own forecast shows it does not expect to achieve its objectives over the next three years. My advice is to take stronger actions of the type already taken. But if the scope for doing that runs out, then the Fed has to try riskier actions, including those of the type Paul Krugman described. Among those actions, I would tend to favor those for which the Fed has direct tools, such as buying foreign exchange to push down the dollar, rather than trying to raise inflation expectations by verbal jawboning.

MK: Finally, there are those who think that Bernanke is pretty happy with the rate of recovery and is mostly focused on downside risks. As Bernanke said at his recent press conference, "the question is does it make sense to actively seek a higher inflation rate in order to achieve a slightly increased pace of reduction in the unemployment rate? The view of the committee is that that would be very reckless." Is this, by itself, a significant barrier to future monetary expansion?

JG: Yes, this is a significant barrier. I think it reflects ill-defined concerns about the costs of taking more action to reduce unemployment faster. Some Wall Street economists fear that more aggressive Fed action now will give rise to more inflation in the future, but no Fed economist I know agrees with that. The Fed knows how to fight inflation and there is no reason that policy actions now need to cause excess inflation later. Another concern might be that expanding the Fed’s balance sheet will expose it to greater losses in the future when interest rates eventually rise (because higher interest rates will reduce the value of the bonds the Fed holds).

But the Fed’s mandate does not include maximizing profits. From the point of view of the United States, what matters is the consolidated government balance sheet (Fed + Treasury), and there is no way that QE can do anything but reduce our national debt burden. Any future losses by the Fed would be more than matched by gains to the Treasury.

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Federal Reserve image via Shutterstock.

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Toward More Market-Oriented Financial Reforms

May 29, 2012Mike Konczal

In Joe Nocera's editorial today, "The Simplicity Solution," he calls for financial reforms to be more focused on solutions that are both simple and market-based. He draws on recent writing by Sallie Krawcheck who "lays out a handful of market-oriented ideas that would almost surely pare back the complexity risk posed by banks." Nocera goes through Krawcheck's reforms, which are focused on corporate boards and dividend policy for financial institutions.

In Joe Nocera's editorial today, "The Simplicity Solution," he calls for financial reforms to be more focused on solutions that are both simple and market-based. He draws on recent writing by Sallie Krawcheck who "lays out a handful of market-oriented ideas that would almost surely pare back the complexity risk posed by banks." Nocera goes through Krawcheck's reforms, which are focused on corporate boards and dividend policy for financial institutions.

I think people have a good sense of the arguments for simple rules in financial regulation. The clearer the lines are drawn, the less likely they are to be gamed, financially engineered-around, or ignored by regulators. As Elizabeth Warren noted in an interview with Ezra Klein, financial institutions "want layers and layers of complexity because it’s in complexity that there are loopholes. That’s where it’s possible to back up regulators who are not quite certain about the ground they stand on. And it’s a larger problem with our regulatory structure: Complexity favors those who can hire armies of lobbyists and lawyers." This is part of the big battle over the Volcker Rule.

But what about market-oriented reforms? What about reforms designed to make financial markets work better, more transparently, and in a way that prevents both cronyism and instability? The Roosevelt Institute's big financial reform program was named Make Markets Be Markets because we think that a focus on markets will be essential to the future of financial reform. There are two things worth noting: first is that the best parts of Dodd-Frank build on this insight, and secondly the first wave of battles brought by financial institutions were over smaller parts of Dodd-Frank, but parts that embraced market-based reforms.

If you look at the derivatives component of Dodd-Frank, it builds on the core essentials of New Deal financial reform for traded instruments: transparency, disclosure, clearing, capital adequacy, the regulation of intermediaries, anti-fraud and anti-manipulation authority, and private enforcement. The insight and practice is to set up the financial markets so that private entities regulate each other through transparent prices and adequate capital. Regulators need a gentler touch because they empower other parties to regulate the financial institutions in question. Clearing institutions make sure that counterparties are properly capitalized, something that was missing in the financial crisis; exchanges make sure that price information gets into the market broadly.

The same happens with the Consumer Financial Protection Bereau. The idea is to provide simple, clear rules across all firms for consumer financial products, regardless of banking charter, and let them compete against each other on price and product. Rather than racing to the bottom in terms of fees and mangled contracts, standardization of terms allows real market competition to take place. This extends across large parts of Dodd-Frank.

What's interesting is that, as I read it, the first two major battles over Dodd-Frank were precisely over these types of reforms. The first major lawsuit against Dodd-Frank, from September 2010, run by the Chamber of Commerce and the Business Roundtable, was against proxy access. Proxy access allows "[a]ny investor, or a group of investors, with at least 3 percent of a firm's shares for three years...to nominate directors." It re-balances the relationship between dispersed shareholders and boards: it allows shareholders to hold ineffectual boards accountable for everything from business practices to executive pay.

Notice that no regulator is necessary here. Shareholders are granted the power to take these actions on their own, which they'll use their their advantage as necessary. Indeed, just the threat forces boards into action, even if no proxy access is formally held. And shareholders, representing their own money and interests, are going to be more forceful as de facto regulators than a handful of actual regulators staring at and trying to regulate board composition.

The other big initial fight was over "interchange fees." On the urgent lobbying of financial firms, Congress came very close to repealing the part of Dodd-Frank that dealt with these fees in 2011, but that ultimately failed. Interchange balances the relationship between vendors and financial firms in regard to the fees charged on credit cards. It allows vendors to price discriminate between credit and debit cards, and it moves debit cards to clear at par so that people's money actually reflects their transactions. Again, no regulator is needed here. Every small business owner who feels squeezed by financial firms' fees becomes a regulator in this case. Their ability to price discriminate helps keep interchange on credit cards from spiraling out of control in a way a handful of regulators sitting in Washington DC could never pull off.

Going forward, we need Dodd-Frank implimented in the simplest, clearest regulatory way. But we also need to make sure that it makes financial markets work the way they are supposed to and allows the market itself to be the best regulator. Financial lobbyists know this, and will respond accordingly.

 

Wall Street image via Shutterstock.

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The Insane Idea Hidden in the Debate Over Obama's Spending

May 24, 2012Mike Konczal

Instead of debating whether Obama is responsible for a spending surge, we should ask why anyone expects the ratio of spending to GDP to remain constant in a recession.

Instead of debating whether Obama is responsible for a spending surge, we should ask why anyone expects the ratio of spending to GDP to remain constant in a recession.

There's a recent debate about whether or not a federal government spending boom has happened on President Obama's watch. This was kicked off two days ago by Rex Nutting's post at MarketWatch, "Obama spending binge never happened." Nutting notes that "federal spending is rising at the slowest pace since Dwight Eisenhower brought the Korean War to an end in the 1950s." He argues that the 2009 fiscal year, outside the stimulus spending, belongs to President Bush, as it was four months into that budget when Obama entered the presidency. He draws on OMB's numbers, which you can access here.

As you can imagine, the right wing has gone into action. Here's "Actually, the Obama spending binge really did happen" by AEI's James Pethokoukis, which argues that you must look at the government spending as a percentage of GDP to see the increase. Now there's a technical debate about how to approach the numbers in the 2009 fiscal year, and there's a fair debate on how to understand the increase in automatic stabilizers, such as unemployment insurance. Do they "belong" to Obama, given that they were already starting up due to a recession that started in December 2007? And then there's the economic debate: shouldn't the proper response have been to run a much larger federal government spending program?

But underneath it is an insane debate about an insane idea -- that the government should keep a consistent ratio of government spending to GDP in a recession. The attack on Obama is focused on this number without acknowledging the crazy part of what this number actually does in a recession.

Let's run through a quick example to show why I think this is insane. Imagine a government spends 20 percent of GDP this year, there is no expected GDP growth in the next year, and the government will spend the same exact amount of money next year. And then imagine that GDP drops 2.7 percent for the year, as it did from 2008-2009, for this hypothetical economy.

Now even though there is no additional money spent, government spending as a share of GDP will go up. The number goes up if the numerator increases (governments spend more) or the denominator decreases (GDP falls in a recession). It goes up to 20.6 percent in this hypothetical example. If the government wanted to keep the 20 percent ratio consistent, it would have to cut spending. But in a weak economy, in the middle of a recession, the last thing you want to do is cut government spending -- that will make the recession worse, which will decrease GDP further. Then you have to cut government spending even further, which creates a nasty loop.

Federal government spending as a percentage of GDP went from 20.8 percent in 2008 to 25.2 percent in 2009. How much was GDP falling? If GDP had grown 3.4 percent as it had done the year before, instead of dropping 2.7 percent, spending as a percentage of GDP would have gone to 23.7 percent. That means a third of the rise in government spending as a percentage of GDP is a mechanical effect of GDP falling in the Great Recession. And if GDP didn't fall in the Great Recession, automatic stabilizers wouldn't have kicked in and there wouldn't have been the stimulus bill, meaning less spending.

It is worth noting that one reason why the Great Recession wasn't a Great Depression was likely because of the increased size of government spending in the economy compared to the 1920s.  Here's Josh Mason in a great post:

We always ask, why was the Great Recession so deep? But you could just as well turn the question around and ask why, despite initial appearances, did it turn out to be not nearly as deep as the Depression?
 
I can think of four families of answers....The second answer would be that the sheer size of government makes a Depression-scale collapse of demand impossible, regardless of policy. In 1929, with government final demand only a couple percent of GDP, autonomous spending basically was investment spending, especially if we think at the global level so exports wash out. Today, by contrast, G is significantly larger than I (about 20 vs 15 percent of GDP), so even if private investment had collapsed at the same scale as in 1929-1933, the percentage fall in autonomous demand would have been much less. (And of course that fact alone helped keep private investment from collapsing.) Interestingly, despite Hyman Minsky's association with stories about finance, this, and not anything to do with the financial system, was why his answer to the question Can "It" Happen Again was, No. Policy is secondary; big government itself is the ballast that stabilizes the economy.

And, for the record, it's a massive shame that government spending didn't go up more, reducing unemployment, getting the economy back on track, and ultimately really bringing down the debt-to-GDP ratio.

Mike Konczal is a Fellow at the Roosevelt Institute.

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What Theory is Animating Rajan's FT Mortgage-Debt Reduction Policy Recommendation?

May 23, 2012

Ok, I'm genuinely confused. There's two interesting things about this from Raghuram Rajan's Financial Times editorial, Sensible Keynesians see no easy way out, that we should unpack (my bold and numbering):

Ok, I'm genuinely confused. There's two interesting things about this from Raghuram Rajan's Financial Times editorial, Sensible Keynesians see no easy way out, that we should unpack (my bold and numbering):

The key question then is whether more government spending can make a real difference to the most severe employment problems. Here the case for a general stimulus becomes less compelling. [1] In the US, demand is weakest in communities where a boom and bust in house prices has left an overhang of household debt. Lower local demand has hit employment in industries such as retail and restaurants. A general increase in government spending may be too blunt – greater demand in New York is not going to help families eat out in Las Vegas (and hence create more restaurant jobs there). [2] Targeted household debt write-offs in Las Vegas could be a better use of stimulus dollars....
 
Targeted government spending, or reduced austerity, along the lines suggested by sensible Keynesians, might be feasible in some countries and helpful in speeding recovery. But we should examine each policy based on a country’s circumstances. We should be particularly wary of populist Keynesians, who parrot “in the long run we are dead” to justify any short-sighted government action. They do the world a disservice by suggesting there are easy ways out.
So Rajan is a sensible Keynesian who would push us towards targeted, household mortgage-debt write-offs. Meanwhile others, including presumably Paul Krugman, are a dangerous, populist variety of Keynesian who want fiscal or monetary stimulus.
 
The first numbered argument is true - places where housing prices collapsed the most are hardest hit by unemployment. But unemployment is still a nation-wide phenomenon, hitting places that didn't even have a housing bubble.  Let's chart the ratio of unemployment for April 2012 versus the unemployment for December 2007 state-by-state (source, click for larger image):

The average increase is 1.65. In New York, which Rajan singles out as being ok, unemployment has gone from 4.7 percent to 8.5 percent, which gives us an above-the-average ratio of 1.8. This is not a localized crisis.

Now Rajan is almost certainly alluding to a graph like this, which we put together a year and a half ago (sigh), of unemployment against the percentage of homes that are deeply underwater, or more than 50% underwater:

There's a lot of ways to visulize this relationship between housing bust and unemployment - Jared Bernstein had one recently. But let's examine this relationship in light of Rajan's suggestion that "Targeted household debt write-offs" could be "a better use of stimulus dollars."

There's three stories explaining this this relationship between unemployment and underwater housing. The first is a structural story. Can't turn housing construction workers into nurses, underwater homeowners can't move, etc. The mobility story turns out to be incorrect, and the "skills" story has problems we've discussed elsewhere. But notice that writing down mortgage debt doesn't make a construction worker into a nurse. So writing down mortgage debt doesn't help with this story.

There's a second story about this graph that describes a "wealth effect." People where housing values collapsed feel poorer, so they spend less. The latest Economic Report of the President argued that the "severity of losses experienced during the recession that began in December of 2007 in both national output and in labor markets makes these [wealth-effect] estimates appear too small." Also households are the net seller, but also net buyer, of housing - it's not clear, outside demographics, that housing shifts should make the macroeconomy feel poorer. But either way, writing down mortgage debt would not help with the wealth effect: if all the housing was paid in cash we'd still have the same recession under this second story.

Now there's a third story, a "balance-sheet" story of the recession. Here consumers are overleveraged and are cutting back on consumption until their balance-sheet, or their amount of debt, is repaired. In this story, reducing household mortgage debt can be a really great use of stimulus dollars. We walked through this story in this interview with Amir Sufi, who has done the leading empirical work on this. And the key, recent, theorectical work on this story, the best model of how this happens, was done by.....Paul Krugman. Specifically Eggertsson/Krugman's "Debt, Deleveraging, and the Liquidity Trap."

If the problem is household's balance-sheets, you can either make people richer or reduce their debts. Rajan thinks that taking money and writing down debt is a good idea. You could also take that money, give it to people in exchange for building useful public stuff; they can pay down debts, and then everyone has some stuff that helps the productive capabilities of the economy. You could also just give people money by not collecting taxes and mailing out checks, and they can efficiently choose whether or not to reduce debts. But under the three most common stories for the relationship between housing and debt, Rajan's policy recommendation only makes sense in the context of deleveraging, or a serious demand story, or the theory that is animating the so-called "populist" Keynesian wing.

This debate is frustratingly not new. Christina Romer was telling media in early 2009 that balance-sheet problems become worse if you let unemployment soar, even if you reduce debts. Romer: "Actually, you know, a crucial thing–when [FDR] did the bank holiday, it took the next two years to actually clean up the banks, that we actually did not get the things really cleaned up until 1935. And that a big part of that cleanup was he managed to turn around the real economy. We saw employment growing again, GDP growing again, and that inherently helps your financial system." Nothing messes up balance-sheets like mass unemployment and falling median wages.

As we've seen, writing down mortgage debt is a viciously ugly, difficult, zero-sum battle. I think it makes good sense to consider, and will have some more formal writing on it, but the idea that it is the sensible ideal while everyone else pushing fiscal or monetary stimulus is behaving irresponsibly is wrong - they both are working from the same intellectual framework.

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Can Private Equity Firms Like Bain Do Whatever They Want With the Companies They Buy?

May 22, 2012Mike Konczal

Three critiques of the notion that private equity's actions are above public concern.

The question of Romney's tenure at private equity firm Bain Capital will stay in the headlines as the Obama team releases ads on the subject and Romney continues to run on that record. But what can we take away from this debate?

Three critiques of the notion that private equity's actions are above public concern.

The question of Romney's tenure at private equity firm Bain Capital will stay in the headlines as the Obama team releases ads on the subject and Romney continues to run on that record. But what can we take away from this debate?

Ezra Klein argues that running a leveraged buyout company ought to give one some sense of solidarity with those left behind. As LBO/private equity creates winners and losers, winners should be in favor of an expanded social safety net that helps those who lose in the layoffs get back on their feet with minimial disruptions. Since LBO overall creates more wealth, part of that wealth should be taxed for the benefit of those who need help adjusting to their new economic reality afterwards - such as providing continuous health care coverage, job training, etc.

One thing I'm noticing in these debates is an almost tautological idea that since shareholders own the firm, anything shareholders do with their firm is legitimate and outside the boundaries of public concern or critique. It was in the background of what Karl Smith was discussing on Sunday's "Up With Chris Hayes," and Josh Barro made it more explicit this morning on twitter.

A Stick

Let's imagine that I buy a stick. Under a idea of general, everyday libertarianism, since I own the stick I can do anything I want with it. I can break it in half, burn it in a fireplace, carve it into something else, turn it into woodchips, attach a kite to it, exclude people from using it, etc. I can't hit people with it, or use it to set their stuff on fire, or attach duct tape to it in order to steal their stuff - but that's a function of general prohibitions against force and fraud. Short of that, it would be weird to say that I shouldn't do whatever I want to my stick of wood - that something I do with it could be illegitimate - as long as I enjoy it.

But does a private equity firm own its portfolio businesses in the same exact way that I own my stick? Is it weird to even think, outside general prohibitions against force and fraud (which I'll treat as unproblematic as it relates to the question at hand), that their actions could be illegitimate? There are many references to increasing profits, or making firms more dynamic, or "creative destruction," but those are side effects of shareholders doing whatever they want with its portfolio. The core issue is that there could be nothing illegitimate in terms of how a private equity firm runs those businesses in the sense there's nothing illegitimate I could do with a stick I own.

Three Critiques

Starting from this baseline, the critiques as far as I read them (which will draw on two previous posts) break down along three lines:

1. Tax/regulatory loopholes. I did an interview with Josh Kosman, author of The Buyout of America, where he argued that the whole point of the enterprise is to game tax law loopholes. Private equity "saw that you could buy a company through a leveraged buyout and radically reduce its tax rate. The company then could use those savings to pay off the increase in its debt loads. For every dollar that the company paid off in debt, your equity value rises by that same dollar, as long as the value of the company remains the same."

A recent paper from the University of Chicago looking at private equity found that “a reasonable estimate of the value of lower taxes due to increased leverage for the 1980s might be 10 to 20 percent of firm value,” which is value that comes from taxpayers to private equity as a result of the tax code.

That's one thing in an industry with large and predictable cash flows. But after those low-hanging fruits were picked, as Kosman explained, "firms are taken over in very volatile industries. And they are taking on debts where they have to pay 15 times their cash flow over seven years — they are way over-levered."

This critique has power as far as it goes. But let's combine it with another issue.

2. Risk-shifting among parts of the firm. Traditional "creative destruction" is about putting rivals out of business with better products and techniques. Leveraged buyouts and private equity are about something different, something that exists within a single firm. This is often described as putting new techniques into place, firing people and divisions that are not performing, and generally making the firm more efficient.

The critique here is that, instead of making the firm more efficient, it often simply shifts the risks into different places. As Peter Róna, head of the IBJ Schroder Bank & Trust in New York, described it in 1989:

The very foundation of the LBO is the current actual distribution of hypothetical future cash flows. If the hypothesis (including the author’s net present value discounted at the relevant cost of capital) tums out to be wrong, the shareholders have the cash and everyone else is left with a carcass. “Creating shareholder value” and “unlocking billions” consists of shifting the risk of future uncertainty to others, namely, the corporation and its current creditors, customers, and employees…
 
The notion that underleveraging a corporation can cause problems is neither new nor unfounded. What is new is the assertion that shareholders shouid set the proper leverage because, motivated by maximizing the return on their investment, they will ensure efficiency of all factors of production. This hypothesis requires much more rigorous proof than Jensen’s episodic arguments… although Jensen denies it, the maximization of shareholder returns must take place, at least in part, at someone else’s expense.
Shareholders gain, but at the expense of other stakeholders in the firm. This isn't the normal winner/loser dynamic, where some suffer in the short-term to do what's best for the long-term. Here the long-term suffers to create short-term winners. Once again, this issue becomes problematic when combined with another critique.
 
3. Dividend looting. The theory behind private equity, as Róna caught above, is that it requires shareholders to be the proper and most efficient group to set the leverage ratio. But what if, instead of setting leverage for the long term to make the firm more efficient, shareholders simply use additional debt to pay themselves, regardless of the health of the firm? As Josh Kosman put it:
If you look at the dividends stuff that private equity firms do, and Bain is one of the worst offenders, if you increase the short-term earnings of a company you then use those new earnings to borrow more money. That money goes right back to the private equity firm in dividends, making it quite a quick profit. More importantly, most companies can’t handle that debt load twice. Just as they are in a position to reduce debt, they are getting hit with maximum leverage again. It’s very hard for companies to take that hit twice...
 
The initial private equity model was that you would make money by reselling your company or taking it public, not by levering it a second time...Right after this goes on for a few years, you’ve starved your firm of human and operating capital. Five years later, when the private equity leaves, the company will collapse — you can’t starve a company for that long. This is what the history of private equity shows.

This runup in dividend payouts is feature of the post 1980 financial markets more broadly, one that LBO had a hand in creating:

The blue line is profits, the solid red line is payouts. As Josh Mason noted (my bold), "In the pre-neoliberal era, up until 1980 or so, nonfinancial businesses paid out about 40 percent of their profits to shareholders. But in most of the years since 1980, they’ve paid out more than all of them...It was a common trope in accounts of the housing bubble that greedy or shortsighted homeowners were extracting equity from their houses with second mortgages or cash-out refinancings to pay for extra consumption. What nobody mentioned was that the rentier class had been doing this longer, and on a much larger scale, to the country’s productive enterprises."

Versions of these three arguments form the core of the private equity critique. Instead of simply carving a figurine or starting a BBQ, private equity uses its stick to game tax law while cashing out short-term value, leaving others in the firm worse off and the firm itself more prone to collapse and less able to produce long-term value. Do you find this critique convincing? What else is missing?

Mike Konczal is a Fellow at the Roosevelt Institute.

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Cyclicalists/Structuralist Divide, Redux

May 18, 2012Mike Konczal

Karl Smith has had some great posts lately, both about Noah Smith and the cyclicalists/structuralist divide and about Rajan's Foreign Affairs article (I, II). I'm going to add my own thoughts on each topic here.

Karl Smith has had some great posts lately, both about Noah Smith and the cyclicalists/structuralist divide and about Rajan's Foreign Affairs article (I, II). I'm going to add my own thoughts on each topic here.

Noah Smith has a blog post arguing that cyclicalists should start talking about structural issues too. Using David Brooks' recent terms, he says "I do not mean that cyclicalists should stop recommending things like quantitative easing. I mean that they should start also throwing out ideas about how to improve our economic performance in the long run."

There's two issues here worth bringing up. The first is that Obama is in a ton of trouble, because all he's done in the past two years is talk about long-term problems (remember Winning the Future?) while dancing around the short-term unemployment crisis. His big achievement, health-care reform, wasn't about how in a rich, modern society like ours everyone has a right to health care. Instead it was explained as a way of "bending the cost curve." Bending the long-term cost curve is about as much of a "structuralist" way of pitching expanding health care as possible.

The second is that blurring these two items as an economic matter has been a major problem for both the Obama economics team and for a certain variety of centrist, deficit-hawks in their view of our economic situation. This is the "two deficits" problem. In this argument our short-term deficit isn't large enough, but our long-term deficit is too large. Fine as far as it goes. But in this theory, in order to fix the first you have to make progress on the second at the same time.

Maybe there are political reasons why this is the case, but the economic ones don't jump out. There are good short-term ideas and good long-term ideas. If they are each good ideas, why not do each on their own? Why do they have to move together? The explanation most give, as a Treasury official told Noam Scheiber, is that the government needs to show “some signal to US bondholders that it takes the deficit seriously” and that “spending more money now [on stimulus] could actually raise long-term [government] rates, thereby offsetting its stimulative effect.” I think this is dead wrong, and if Obama loses this argument will be one of the major reasons why. It is what kept him trying to kick Lucy's football negoitate with Republicans in 2011. If both need to move, they throwing a roadblock in front of one stops the other - and given that Republicans won't budge on tax increases, it takes away the case for more stimulus in the short-term. Meanwhile interest rates continue to stay at record lows.

As for the Rajan piece in Foreign Affairs, I think there are two big problems with it beyond what Karl mentions ("the piece had little to do with the recession and nothing to do with borrowing and spending for recovery"). The first is the crux of his argument, which is that 2007 featured "artificially inflated GDP numbers." It is no doubt impressive to people who haven't thought about it hard to state that we had a GDP bubble in 2007 alongside a housing bubble. But what does that even mean? What else would be true about the world if US GDP was unsustainably high in 2007?

Jim Bullard made this argument recently and even then the justification for the argument switched completely within days, once it came under the critical scrunity of the econoblogosphere. In one version the case was about how the collapse of the housing bubble represents a technology loss. In the second argument it was pure wealth effect: we feel poorer, and the only solution is to beg policymakers to “please reinflate the bubble."

The second issue is that the manitude of numbers are completely off. Subprime mortgages were about refinancing, not about new home construction. As Karl Smith noted, to the extent subprime encouraged single-family home construction, it came at the expense of multi-family home construction. Residential building construction is off about 400,000 workers - even if those jobs are gone completely, we have 5 million more workers unemployed right now than we did in 2007 (12.5m versus 7.5m). I'd be happy to say that the NAIRU is up 400,000 people if we can end these so-called structural arguments here.

[Also: Rajan's GSE argument has been debunked in several places. It is hard to argue that Congress is pro-consumer-debt and pro-debtor/easy credit policies in the past 30 years when it passed the 2005 bankruptcy reform act. It is not controversial to argue that the 2005 bill was significantly harder on debtors looking to file bankruptcy. Instead of Congress, the major thing that changed the consumer debt markets came from the Supreme Court. In 1978's Marquette Nat. Bank of Minneapolis v. First of Omaha Service Corp, the Supreme Court interpreted the word “located” in the National Bank Act of 1863 as meaning the location of the business and not the location of the customer, which completely changed how credit cards would work in the following decades.

Also, the conservatives' publically-stated calculus is off. There is a sense in which there are short-term things we can do, or long-term things we can do, and we have limited time and energy, so better to focus on the long-term things. But there's reason to believe that conservatives are purposely ignoring the short-term things, because weak economies are the perfect time to be able to achieve their preferred long-term agenda ideas.

We know from the explanations for dissenting votes on the Federal Reserve that those dissenting from more demand now believe that this higher demand through monetary policy gets in the way of making "hard choices" on entitlements and tax reform. The Wall Street Journal has Federal Reserve Bank of Dallas President Richard Fisher saying “The more we offer accommodative monetary policy, the less incentive they have to pull their socks up and do what’s right for the American people.” (This is also currently going on in Europe.)

If you view the Great Society, the New Deal, and the whole regulatory/Keynesian/welfare state as a form of tyranny, well, destroying most forms of tryanny requires bloodshed. If a conservative revolution happens in the next Congress, and the only cost was 4 years of mass unemployment, wouldn't it be worth it to experience liberty in our lives? I fear this explanation drives more conservative commentary on economics than we realize.]

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Why a Strong Middle Class Is Necessary For Growth

May 18, 2012Mike Konczal

A new paper maps out the best progressive arguments about how inequality is hurting our economy.

It's great to get to watch the arguments against inequality in the United States being built in real time. On issues ranging from political corruption to a lack of a serious, sustained response to the economic crisis, people are telling sharper and more critical stories about why inequality should be a concern for the country. Which is important, as inequality is not going away.

A new paper maps out the best progressive arguments about how inequality is hurting our economy.

It's great to get to watch the arguments against inequality in the United States being built in real time. On issues ranging from political corruption to a lack of a serious, sustained response to the economic crisis, people are telling sharper and more critical stories about why inequality should be a concern for the country. Which is important, as inequality is not going away.

One of the issue areas where this has been lacking is long-term economic growth. The research has been substantial, but few have collected and curated it into a set of arguments for why inequality is bad for the health of our economy. This is one of the more important battles. The normal assumption is that inequality helps everyone by allowing the economic pie to grow as big and as quickly as it possibly can. The background thought animating this is that there's a serious tension between efficiency and equality -- to support equality is to necessarily sacrifice economic efficiency.

Heather Boushey and Adam S. Hersh from the Center for American Progress have a new paper out, "The American Middle Class, Income Inequality, and the Strength of Our Economy: New Evidence in Economics," that summarizes the case for why inequality can damage the economy. They start by reviewing the literature trying to link income inequality and growth, and find that the link is, if anything, in the other direction. "Roland Benabou of Princeton University surveyed 23 studies analyzing the relationship between inequality and growth. Benabou found that about half (11) of the studies showed inequality has a significant and strongly negative effect on growth; the other half (12) showed either a negative but inconsistently significant relationship or no relationship at all. None of the studies surveyed found a positive relationship between inequality and growth."

But why should this be? If the long-term health of the economy is driven by human capital, savings, and technology, what does inequality have to do with anything? Here is where they create a map of the arguments through which a strong middle class and a more egalitarian distribution of income can build long-term growth:

We have identified four areas where literature points to ways that the strength of the middle class and the level of inequality affect economic growth and stability:
 
A strong middle class promotes the development of human capital and a well educated population.
A strong middle class creates a stable source of demand for goods and services.
A strong middle class incubates the next generation of entrepreneurs.
A strong middle class supports inclusive political and economic institutions, which underpin economic growth.
They pull together the current research, as well as the range of supporting evidence, for each point. They focus on how educational attainment is becoming more tied to parents' income, the instability of growth and macroeconomic risks to weak middle-class demand, the fact that the Kauffman Foundation found that less than 1 percent of entrepreneurs come from extremely poor or extremely rich backgrounds, and the way inequality is involved with our polarized politics. All of these have consequences for our economy.
 
The research will continue to move forward here. There's a lot of fascinating work done on the relationship between inequality, balance-sheet recessions, and slow recoveries right now. I'm interested in the way the government creates and enforces property changes under massive, entrenched inequality. Do exclusive, 1%-dominated political and economic institutions produce property regimes -- high rents from patents, repressive creditor/debtor relationships, all labor income from finance viewed as capital income for tax/regulatory purposes, privatization of public goods, corporation structures predisposed for financialization -- that are terrible for growth?
 
This paper gives us the best up-to-date arguments that progressives discussing inequality should understand inside out. I thought I was fairly versed in these arguments, and I learned a ton from it. As they say, read the whole thing.
 

Mike Konczal is a Fellow at the Roosevelt Institute.

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JP Morgan Proves That Size Does Matter

May 15, 2012Mike Konczal

Breaking up the big banks might not be the whole solution, but it could make resolution authority more credible.

Breaking up the big banks might not be the whole solution, but it could make resolution authority more credible.

Before we start talking about the advantages and disadvantages of introducing size caps and restricting business lines through a new Glass-Steagall, it is important to understand how very big the five biggest banks are. If you need a sense of how big JP Morgan is and why it is hard for it to "hedge" without moving the market, the graph below gives you a sense. This is a graph I put together during Dodd-Frank based on data that was floating around at the time:

When bills restricting size of a large financial institution have been introduced they usually put size in the context of deposit liabilities (what we provide a backstop for and what reflects consumer savings, expressed as a percent of all deposits) and non-deposit liabilities (what reflects a blunt measure of size and potential for shadow banking runs, expressed as a percentage of GDP). The SAFE Banking Act, which has been reintroduced, mostly impacts the six firms listed above. The original SAFE Banking Act had a cap of 3 percent of GDP for non-deposit liabilities for financial firms (2 percent for actual banks) -- a space that ignores over 8,000 banks to just focus on the biggest six.

Yesterday Elizabeth Warren sent out an email with PCCC calling for a new Glass-Steagall. Let's back up: what kind of regulation do we have in the financial sector? First, there's the background regulation that structures and forms the financial markets. How are derivatives treated in bankruptcy? How is capital income and debt taxed? How are contracts and corporations set up and enforced? And so on.

The second level of regulation is "prudential" regulation. Prudential regulation of financial institutions is the various ways regulators regulate banks. Capital requirements are one example. So is prompt corrective action, restricting dividends for troubled firms, etc. One reason to do this for regular banks is to act as a coordinator for dispersed depositors who are unable or unwilling to perform these functions. Another is that financial firms have serious macroeconomic effects on the economy. And another is to intervene in issues of asymmetric information. The everyday libertarian case against regulating a restaurant is "who would want to poison their customers?" As we saw in the last 20 years, Wall Street is comfortable not only selling their customers poison at a high margin, but taking out life insurance on them through the credit swaps market.

The third level is blunter, and that's strict prohibitions, either on businesses or on size. What are the advantages and disadvantages of adding prohibitions? One factor is simplicity compared to other forms of prudential regulations, but what else is there?

Resolution

Adding prohibitions can help ensure the end of Too Big To Fail. In this sense it works to amplify, rather than replace, Dodd-Frank's resolution authority.

A common response is that the problem with Too Big To Fail isn't that the firms are too big or too complex, but too interconnected. Matt Yglesias notes that in the context of resolution, prohibitions aren't that important: "we can't put investment banks through the bankruptcy process because it's too systemically chaotic. In that case, Glass-Steagall is irrelevant and what we really need is a new legislative mechanism for the resolution of investment banking enterprises. That's what Dodd-Frank is supposed to do. This all just backs in to the point that even though the phrase 'too big to fail' has caught the public imagination, it's never been clear that size is relevant."

But here's Martin J. Gruenberg, Acting Chairman of the FDIC, in a big speech last Thursday:

While there are numerous differences between a typical bank resolution and what the FDIC would face in resolving a SIFI, I want to focus on a few key differences...

In addition, the resolution of a large U.S. financial firm involves a more complex corporate structure than the resolution of a single insured bank. Large financial companies conduct business through multiple subsidiary legal entities with many interconnections owned by a parent holding company. A resolution of the individual subsidiaries of the financial company would increase the likelihood of disruption and loss of franchise value by disrupting the interrelationships among the subsidiary companies. A much more promising approach from the FDIC's point of view is to place into receivership only the parent holding company while maintaining the subsidiary interconnections.
 
Another difference arises from sheer size alone. In the typical bank failure, there are a number of banks capable of quickly handling the financial, managerial, and operational requirements of an acquisition. This is unlikely to be the case when a large financial firm fails. Even if it were the case, it may not be desirable to pursue a resolution that would result in an even larger, more complex institution. This suggests both the need to create a bridge financial institution and the means of returning control and ownership to private hands.
Resolution authority is an untested solution for a financial firm, particularly one as large and complex as JP Morgan. Size and complexity make a difference. If financial firms were smaller and more siloed, there is an argument that resolution authority, which is one of the core mechanisms of Dodd-Frank, would work more smoothly and be more credible.
 
Market Power and Competition
 
As Barry Ritholtz noted on the JP Morgan loss, "Simply stated, once you are the market, you are no longer a hedge." Size makes a difference in these markets, and by breaking up the largest firms you'd see reduced market power. In terms of size, Andrew Haldane argues that economics of scale in banking top out at around $100 billion, or signficantly less than a 3 percent GDP liabilities cap. Beyond market power, the largest banks represent a large amount of political power as well.
 
And in terms of business lines, Kevin J. Stiroh and Adrienne Rumble, in "The dark side of diversification," look at financial holding companies as they absorb different business lines in the late 1990s and 2000s. "The key finding that diversification gains are more than offset by the costs of increased exposure to volatile activities represents the dark side of the search for diversification benefits and has implications for supervisors, managers, investors, and borrowers." New business lines introduce new profits but also introduce new volatility. The more volatile a firm is, the harder it is for it to fail without bringing down the financial system.
 
Mike Konczal is a Fellow at the Roosevelt Institute.
 
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On Hysteresis Hysterics

May 14, 2012Mike Konczal

Dean Baker and Kevin Hassett have a great editorial in the weekend's New York Times, "The Human Disaster of Unemployment." They correctly identlfy the many long-term psychological and social problems of periods of mass unemployment for people, families, communities, and ultimately our nation.

Dean Baker and Kevin Hassett have a great editorial in the weekend's New York Times, "The Human Disaster of Unemployment." They correctly identlfy the many long-term psychological and social problems of periods of mass unemployment for people, families, communities, and ultimately our nation. As is the nature of editorials written by people with cross-ideological committments, the solutions are a bit off, but this weakness is also part of the issue with discussing the urgency of unemployment because of "hysteresis."

Imagine having a fever so bad that it permanently raised your body temperature. Now imagine a period of unemployment so bad that it permanently reduces our economy's ability to produce things and employ people. That's hysteresis -- the long-term scarring of our economy from periods of short-term unemployment. I've discussed this before, and I think the evidence is very convincing it is a major issue. Hysteresis is part of the engine in the recent Brad Delong/Larry Summers paper arguing for self-sustaining stimulus.

Crucially, hysteresis is an intellectual challenge to the so-called structuralists who would argue that we should ignore the short-term economy and just focus on the long-run health of the economy. Beyond us all being dead in the long run, the long run is just a series of short runs right after each other. And hysteresis shows that short-run problems can perpetuate themselves and become embedded in the long-run economy.

Where I become ambivalent about the focus on hysteresis is that it too quickly presumes that special policy is required to combat it. Instead of a weak economy and poor job growth, suddenly hysteresis calls for the assumption that jobs are available and that the long-term unemployed, for whatever individual reasons, can't take them. I think the easiest way to fight hysteresis is just to have a lot of jobs available through strong demand, and employers will be perfectly incentivized to train workers however they need to as they look to expand their workforce. But others would take their eye off the ball of full employment and try to focus on just the long-term unemployed policy-wise, through such things as special job training programs.

Is there data we can use to test this theory one way or the other? I was able to get the people in charge of the flows data at the BLS to send me an update of one of my favorite data sets, flows from unemployment to employment by duration of unemployment. We've talked about this data last year here and here, and now I have it updated through April 2012. The longer you've been unemployed, the less likely it is that you'll find a job over the course of a month.  But how has this changed during the Great Recession and the aftermath?

Thesis: if hysteresis is problematic in that the long-term unemployed have become detached from the labor force in such a way that it requires policy intervention beyond creating jobs - like special job training programs - then we'll see that people who have only been unemployed a short time (low duration) find jobs easiers than a year ago. But we will also see that those that have been unemployed a longer-time will not show any increase in their job finding rate, and maybe their rate of finding a job has even decreased. The unemployed parts of the economy will be bifurcating into a healthy short-term section and a dislodged long-term section.

I'm plotting the chance of the unemployed for the average of the first four months of 2007, 2011 and 2012 each (the data is seasonally unadjusted) by duration of unemployment. How did the last year look?

The purple line for 2012 is pulling away from 2011 across the entire unemployment spectrum. The chances of finding a job are increasing for all unemployment spell lengths, though they aren't anywhere near 2007 levels. Meanwhile, here's a graph of the six month moving average of each duration bucket going back 9 years:

The entire job market is weaker, even for those who have only been unemployed for a few weeks. Though the suffering the long-term unemployed are going through is real, the best policy for them is providing anti-poverty relief through cash and services while pushing on expansionary fiscal, monetary and debt-relief policies to get the economy back on track.

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