SECRETARIA DE ESTADO DE ECONOMÍA,

MINISTERIO SECRETARÍA GENERAL DE POLÍTICA ECONÓMICA DE ECONOMÍA Y ECONOMÍA INTERNACIONAL Y HACIENDA SUBDIRECCIÓN GENERAL DE ECONOMÍA INTERNACIONAL

CUADERNO DE DOCUMENTACION

Número 87-2º (alcance)

Alvaro Espina Vocal Asesor 20 Abril de 2009

CD 87-2º de alcance 20 de Abril de 2009 "Nuestro sistema ha fallado en cuestiones fundamentales. Corregirlo requerirá una reforma en profundidad. No modestas reparaciones marginales, sino nuevas reglas de juego." Timothy F. Geithner, Secretario del Tesoro

“La madre de Nicholas Hughes, como la de Sylvia Plath y la mía, Anne Sexton, sucumbieron al agotamiento de la implacable depresión. Se autodestruyeron. Habiendo crecido entre los restos de la catástrofe, yo sé como se debió sentir. Linda Gray Sexton Fenomenología de la crisis: ¿Dónde está Wally? William H. Gross (alias Bill Gross, rey de los bonos, según Money Masters), es el fundador y director de inversiones de Pacific Investment Management Company (PIMCO), el mayor fondo de inversiones en renta fija del mundo (que opera básicamente en el mercado de derivados), participado mayoritariamente por el Grupo Allianz, de Munich. Hace veinte meses, el 24 de agosto de 2007, Gross publicó un celebrado artículo en WP en el que señalaba que el problema del momento podía sintetizarse en el juego ¿Dónde está Wally?,1 en el que Waldo eran las hipotecas subprime y los préstamos fallidos escondidos en las carteras de los inversores institucionales: las mejores estimaciones indicaban que habría entre 200.000 y 300.000 millones de dólares en fallidos, pero, dada la huelga regulatoria y de supervisión practicada previamente por la Fed y las administraciones, nadie sabía dónde se encontraban ni cuánto valían realmente, ya que generalmente estaban contabilizados a precio de coste en los vehículos de inversión derivados de las hipotecas subprime, aunque, tras el cambio de tendencia del mercado inmobiliario, los impagados y los procesos

1 de desahucio arrojaban resultados y valor de recuperación final muy inciertos, y se daba por supuesto que su número aumentaría. En aquella estimación, Gross pensaba que se producirían más de dos millones de hipotecas fallidas antes de que el mercado se estabilizara y, como consecuencia de ello, descendería el precio de la vivienda, reduciendo el patrimonio del 70% de los norteamericanos propietarios de sus casas en un 10%, cosa nunca vista desde la depresión de los años treinta. Éste era el argumento sensible, pero no es que Bill Gross tratara de emular en 2007 al Longfellow Deeps de 1936, en “El Secreto de Vivir”2. Porque, además de las consecuencias para la riqueza inmobiliaria del americano medio —con el consiguiente “efecto-riqueza” sobre el consumo — el dilatado proceso de búsqueda para encontrar a Waldo iba a tener consecuencias particularmente graves para el sistema de crédito, por razones obvias:

“Las instituciones financieras se prestan unas a otras billones de dólares, euros, libras y yenes; la Fed presta a los bancos comerciales; éstos prestan a los principales bancos de inversión (prime brokers), como Goldman Sachs y Morgan Stanley, quienes prestan, a su vez, a los fondos de inversión (hedge funds). La cadena de alimentos no consiste en que un depredador devore a cada presa, sino en una multiplicación de crédito simbiótica, impulsada por la búsqueda de beneficio, que se interrumpe si desaparece la confianza de que el dinero será reembolsado en los términos del contrato...... [Cuando esto ocurre, como sucede ahora] estas estructuras experimentan las consecuencias del pánico entre sus depositantes y sus prestamistas, que se ven expuestos a descensos de precios de dimensiones inesperadas. En tal entorno el mercado se hace increíblemente volátil, a medida que un número creciente de instituciones financieras supera simultáneamente sus respectivos límites de riesgo.”

“Durante las últimas semanas ha aparecido una grieta gigantesca en la moderna arquitectura financiera, que fue creada por jóvenes magos y se había considerado hasta ahora por los

2 banqueros centrales como una forma positiva de diversificación de riesgos. Lo que sucede es que los productos derivados todavía se encuentran en la infancia y solo son capaces de cubrir el riesgo individual, institucional y sectorial; lo que no pueden hacer es cubrir el riesgo de liquidez. Por el contrario, el apalancamiento inherente al proceso de creación de derivados puede multiplicar el riesgo sistémico cuando no hay información disponible o ésta llega con retraso. Sólo los bancos centrales pueden solucionar esto, inyectando liquidez...” ...... “A comienzos de los años noventa el gobierno absorbió los préstamos fallidos de las cajas de ahorro. Si fue posible rescatar a los corruptos bucaneros de las cajas de ahorro, ¿vamos a echar ahora a los lobos a dos millones de propietarios de viviendas? Si podemos rescatar a Chrysler, ¿por qué no podemos apoyar a los americanos que han comprado su propia casa?”.

Bill Gross proporcionaba así una explicación abiertamente cínica de la gran crisis de 2007-2009. Los productos derivados fueron creados por los “jóvenes magos” a los que se refiere el fundador de PIMCO para cubrir riesgos, no para producirlos. Las instituciones especializadas en originarlos y comercializarlos — como PIMCO — se denominaron hedge funds porque se suponía que proporcionaban a sus clientes vehículos capaces de acotar o limitar el riesgo, poniéndole un seto (hedge)3. En palabras de la academia sueca, a través de ellos “los agentes que prevén ingresos o pagos futuros pueden asegurar un beneficio o asegurarse contra una pérdida por encima de un cierto nivel”. Bajo tales premisas, disponiendo de herramientas matemáticas adecuadas para estimar el precio de los correspondientes productos derivados, este mercado creció rápidamente, recibiendo los parabienes de algunos banqueros centrales, como Alan Greenspan —que fueron utilizadas como certificado de caución por todo el sector4—. Todo ello operaba bajo la premisa de que los gestores del negocio se comportarían de manera profesional, respetando los límites prudenciales adecuados para no incurrir ellos mismos en riesgos desproporcionados, por problemas de solvencia, susceptibles de anular la cobertura que decían proporcionar. Esta fue la

3 responsabilidad asumida como propia por los money managers. A instancias suyas, los banqueros centrales consideraron que no era preciso regular el sector, bajo el supuesto de que ellos mismos se autorregularían. Pero, en la formulación más reciente del propio Alan Greenspan, ....:

“... en Agosto de 2007 la estructura de gestión del riesgo (risk- management) quebró. Toda la magia computacional y las sofisticadas matemáticas descansaban esencialmente sobre una premisa central: que el propio interés de los propietarios y de los gestores de las instituciones financieras, convenientemente informados, les induciría a mantener amortiguadores adecuados contra la insolvencia, controlando activamente el capital de sus empresas y sus posiciones de riesgo”5

Pero esa autocontención o autorregulación no se produjo, lo que no quiere decir que el apalancamiento excesivo, causa de la acumulación de riesgo sistémico, sea algo inherente al negocio financiero, como afirma Gross. No. En su afán exculpatorio Greenspan no encuentra ninguna relación entre el desorden financiero y su propia política monetaria, ignorando intencionadamente toda la teoría del crédito, como le recuerda Doug Noland, acusándole de haber sido el causante directo de la “plétora global de ahorros” (que indujo al desbordamiento del consumo y de los déficits gemelos, junto a otros desequilibrios ), y de proporcionar al mundo de los hedge funds la falsa expectativa de que, llegado el caso, la Fed, saldría a rescatarlos.6 Se trata solo de un movimiento de diversión, buscando la complicidad de todo el sector de la “banca en la sombra”. Pero, aunque lo intenta, Greenspan no ratifica la coartada de sus captores. Más bien, el apalancamiento temerario es el signo evidente de que no se ha llevado a cabo una gestión responsable, acorde con la diligencia exigible a los profesionales del negocio financiero, que resulta completamente independiente de los fallos del banco central7. Y eso, por mucho que Greenspan apele a la “naturaleza humana” y a la recurrencia histórica8 para apoyar aquella coartada y mantenerse firme en una actitud cooperativa, propia

4 de un buen conocedor del dilema del prisionero. La temeridad financiera es pura y simplemente una traición a la confianza depositada en los gestores. Con razón dice Gross que esto es lo mismo que hicieron los dirigentes de las cajas de ahorro en los años noventa, pero les llama bucaneros y les califica de corruptos. El que entonces se rescatara a aquellas instituciones no puede aducirse como precedente, porque se trataba de entidades de depósito reguladas, y, como contrapartida, el Gobierno federal había asumido la responsabilidad del rescate y la Fed la de actuar como supervisor y prestamista de última instancia. Pero en este caso no es así. La responsabilidad recae directamente sobre los gestores, y es perfectamente exigible, aunque en este ámbito la prueba resulte siempre extremadamente difícil.9 Independientemente de su vertiente jurídica, sobre el fondo de la cuestión de responsabilidad no es posible a estas alturas llamarse a engaño, ya que acerca de ello viene tratándose desde tiempo inmemorial, a partir de la doctrina establecida por la escuela de Salamanca, que fijó los preceptos prudenciales básicos para evitar la bancarrota de los prestamistas (y para no caer en pecado, que es como calificaban ellos la traición a la confianza del prójimo). En su Suma de Tratos y Contratos, de 1571, Fray Tomás de Mercado recomendaba controlar dos parámetros: el coeficiente de reserva fraccionaria —o el nivel de apalancamiento— (“no despojar tanto el banco que no puedan pagar luego los libramientos”), y el nivel de riesgo derivado de la calidad de la cartera de créditos (“no se metan en negocios peligrosos”), además de la prohibición de que los banqueros tuvieran sus propios negocios particulares y de que se les exigiera una fianza bastante antes de ejercer, como hacía la Nueva Recopilación castellana, de 1554. Y en su Tratado de los Cambios, de 1597, Luís de Molina llegó a pergeñar un mecanismo de medición del riesgo y de imputación del consumo de capital: “Pecan mortalmente, por ejemplo, si envían tantas mercancías a ultramar que en caso de naufragar la nave, o de que sea apresada por piratas, no les sea posible pagar los depósitos ni aún vendiendo su patrimonio”.10 Por lo tanto, debían disponer de reservas de recursos propios

5 suficientes para hacer frente incluso a algo que hoy sería considerado probablemente como riesgo catastrófico Pues bien, Gross llamaba a rebato y vaticinaba el Armagedón financiero por causa de un problema de liquidez en un mercado que, en su propia evaluación, acabaría estabilizándose con un simple descenso del 10% en el valor de la vivienda (o sea, del activo de respaldo de las hipotecas), algo por debajo del aumento anual registrado a lo largo de 2005, tras haberse duplicado en un decenio, con crecimientos medios del 7% anual. En este contexto, una caída del 10% no podía considerarse ni mucho menos un “naufragio de la nave” ni su “apresamiento por los piratas”. Parece más bien un tipo de oscilaciones perfectamente previsibles por profesionales de la gestión del riesgo, cuyas instituciones deberían disponer de reservas suficientes para hacer frente a tal eventualidad. Y eso, sin necesidad de que ninguna ley especial se lo exija, porque entra dentro de las condiciones generales de los contratos en ese negocio, que consiste en observar la “conducta que socialmente se considera exigible (o, diligencia debida)” en el desempeño de la función “de un ordenado empresario y de un representante leal”, como indica la Ley española de Sociedades Anónimas. Si no tenían tales reservas sería más bien, en palabras de Mercado, porque “habían despojado tanto al ‘banco’ que no podían pagar luego los libramientos”. En palabras de Stiglitz:

“Los bancos americanos se metieron — y metieron a nuestra economía— en dificultades debido al apalancamiento; o sea, usando poco capital propio y tomando mucho dinero prestado para comprar activos inmobiliarios extremadamente arriesgados...... [Y cometieron] todos estos errores sin que nadie lo supiera, en parte porque casi todo esto eran operaciones financieras ‘fuera del balance’.11”

La inundación de crédito derivada del apalancamiento excesivo protagonizado por Bill Gross y los suyos —aunque no solo por ellos — había sido precisamente la causa de la escalada del precio de la vivienda durante la etapa expansiva, hasta la formación de una burbuja descomunal —que Bill Gross pretendía mantener

6 prácticamente incólume, con un simple recorte marginal —. Esto no es nuevo; es algo que se conoce también desde hace tiempo. En la Instrucción de Mercaderes escrita por Luís Saravia de la Calle en 1544 ya se afirmaba que la causa de la inflación de entonces había sido la fácil creación de dinero por parte de los banqueros sevillanos (a los que llamaba logreros), ya que en ausencia de su actuación temeraria, “cada uno habría tratado con su dinero en lo que pudiese y no en más, y así valdrían las cosas en el justo precio y no se cargarían más de lo que valen al contado”. Nada nuevo bajo el sol: a través del blog de Paul Krugman se puede acceder a un texto de L.M. Holt (escrito en 1902)12 que describe la secuencia de hinchazones y pinchazos de las burbujas del siglo XIX en Norteamérica, a propósito de la burbuja que ya empezaba a formarse en 1897, después del pinchazo de 1893, y que condujo a un nuevo pánico bancario en 1907 (aunque la secuencia apuntaba más bien hacia 1910 e, implícitamente, hacia 1927-1930):

“Una persona que dispone de 5.000 dólares puede comprar cuatro veces esa cantidad empleando su crédito, y a veces hasta más de diez veces aquella cantidad. Mientras los precios crezcan, no sólo obtendrá beneficios por el aumento de precio de la parte de su propiedad adquirida con la cantidad de capital aportada, sino también de la parte adquirida con el capital aportado por sus acreedores.”

“En cambio, cuando los precios caen, durante el período de depresión del ciclo de negocios, la disminución no afecta al conjunto de la propiedad, sino sólo a aquella parte de la misma representada por la capital en efectivo invertido en ella. La deuda nunca se reduce, hasta consumir toda la inversión.” ...... “ De modo que quienes habían comprado a crédito se encuestan sometidos a pesadas pérdidas al verse obligados a soportar la depreciación de bienes que no son suyos –o sea, bienes comprados a crédito–. Y por causa de esta

7 depreciación tienen que ahorrar, para ajustar sus gastos al nuevo orden de cosas, viéndose obligados a devolver el endeudamiento acumulado, con ingresos mucho menores...... “Echemos un vistazo panorámico a la historia financiera del siglo XIX y veamos cual ha sido la condición del país: En 1837 nos encontramos en medio de un pánico financiero. En 1857 –20 años más tarde- el país experimentó un nuevo pánico. En 1837 una crisis financiera golpeó a los estados orientales y la víctima principal de la oleada de quiebras de esa zona del país fue el gran banco Jay Cook & Co. En 1875 ese mismo pánico alcanzó a la costa del Pacífico, cerrando el Banco de California en San Francisco, junto a muchas otras instituciones bancarias, entre ellas el banco Temple and Workman de Los Ángeles —que quebró con un pasivo de un millón de dólares y no llegó a pagar ni un solo céntimo a sus muchos e infortunados depositantes —. En 1893 un nuevo pánico golpeó a los Estados Unidos, tras haber destruido tantas y tantas instituciones bancarias en Sudamérica, Australia y otras partes del mundo.

La burbuja especulativa local de 1886-87 estalló mucho antes de lo que podía preverse, pero el pánico universal, que barrió todo el mundo civilizado no apareció hasta el momento que era previsible: 1893. Porque bajo las condiciones económicas actuales parece que hacen falta entre dieciocho y veinte años para que el país atraviese un ciclo completo, entre una depresión y la siguiente.”

Eso mismo ha ocurrido ahora: el crecimiento del valor de mercado de la vivienda, anterior al verano de 2007 —ahora a punto de esfumarse —, sirvió como garantía para la inundación de crédito que condujo a la situación actual, y viceversa, el hundimiento de precios y la contracción del mercado inmobiliario ha producido consecuencias graves sobre todo el sistema de crédito, por causa de las pérdidas de los tenedores de títulos respaldados por aquellos activos —en muchos casos, instituciones

8 financieras —, que endurecieron con carácter general las condiciones del mercado crediticio, para provisionar tales pérdidas, como se observaba claramente ya en el otoño de 2007. La brusca desaceleración del crecimiento de los precios de la vivienda registrada a finales de 2005 había desencadenado el inicio de la escalada en las tasas de morosidad de las hipotecas subprime, al mismo tiempo que se degradaban las condiciones de concesión y se elevaba de forma temeraria la ratio préstamo/valor (LTV), refinanciando las hipotecas antiguas a cuenta de la revalorización. En dos años, la morosidad se duplicó (pasando del 6% al 13,5% entre los meses de junio de 2005 y de 2007). Como consecuencia de ello, en la primavera de 2007 se registró la huída de los inversores, que dejaron de financiar estas hipotecas; en agosto de ese año las instituciones financieras modificaron radicalmente su política de hipotecas suprime a tipo variable, restringiéndolas drásticamente; en octubre, los inversores dejaron ya de adquirir productos estructurados, incluso los respaldados por hipotecas de mejor calidad crediticia que las subprime (los Alt-A mortgage pools), y todo el crédito hipotecario se enrareció.13 Puede decirse, pues, que el juego “¿dónde está Wally?” —en el tono jocoso de Gras — había comenzado. O, más bien, como dice Taylor en tono más severo, había aparecido el problema de la engañosa Reina de espadas —del Tarot, que en el cuento de Pushkin parece un as, y hace que el jugador apueste y pierda —, de modo que ya nadie quería jugar a ese juego (porque se difundió la sospecha de que las cartas podían estar trucadas, podríamos decir). Y si esas cartas estaban trucadas, ¿por qué no iban a estarlo también las otras, barajadas y repartidas por los mismos croupiers? Así es como se produjo la huída de los bonos corporativos en agosto de 2007 y se dispararon los diferenciales, tanto de estos bonos como los de los productos derivados. En los términos del lenguaje macroeconómico de los últimos decenios estos problemas se habían venido estudiando, a contrario, como los efectos de transmisión de la política monetaria sobre la vivienda, desdibujando el papel del crédito. En concreto, el modelo FRB/US empleado por la Fed contempla solo el efecto directo de los tipos de interés sobre la actividad del mercado de la

9 vivienda a través del efecto “coste del capital” para el usuario (uc),14 y del efecto riqueza (considerado idéntico al efecto de la riqueza financiera, con propensión marginal al consumo del 3,75%). Esto es, empleando la notación y la secuencia del CD 87 (con los subíndices R y A significando “residencial” y “agregada”): p) M↓ → i↑ → uc↑ → (DR ↓ + IR↓) → DA↓ → Y↓ q) M↑ → i↓ → WR↑ → C↑ → Y↑ A partir del verano de 2007 no pudo seguir minusvalorándose el impacto del hundimiento del mercado de la vivienda sobre todo el sistema de crédito, a través del efecto balances, y sobre el consumo, pero a través de un potente efecto riqueza diferencial (WR). No tendría que haberse esperado tanto para anticipar ninguno de estos aspectos, ya que sobre ambos se disponía desde hace tiempo de análisis teóricos y evidencia empírica suficiente. De hecho, Ben Bernanke es el mejor conocedor de los resultados profundamente depresivos sobre la demanda agregada que tuvieron las perturbaciones financieras de 1930-1933, que aumentaron exponencialmente el precio y enrarecieron la disponibilidad del crédito, al tiempo que el sistema crediticio perdía toda su capacidad de asignación eficiente de recursos, prolongando la duración de la recesión.15 Además, en trabajos muy anteriores a 1999 el propio Ben Bernanke y su equipo habían sintetizado el bagaje teórico y recogido abundante evidencia empírica mucho más reciente acerca del carácter potencialmente desestabilizador del canal de crédito en contextos de rápido crecimiento del precio de los activos —a través del acelerador financiero — y, viceversa, de las consecuencias especialmente dañinas para el tejido de pequeñas empresas —que suponen mayores costes de agencia para el canal — del enrarecimiento del crédito en contextos de choques adversos, que provocan “huidas hacia la calidad” (pudiendo llegar a la situación de credit crunch).16 También se disponía de amplia evidencia acerca de las diferencias entre los efectos sobre el consumo de la riqueza en vivienda y la riqueza financiera, al menos desde 2001, proporcionada por el bien conocido estudio de Case, Quigley y Shiller, respondiendo a

10 la pregunta sobre esta cuestión hecha en público por Greenspan en 1999. Estos autores evaluaron el efecto riqueza real de la vivienda sobre el consumo utilizando cifras del período 1982-1999 —en que la riqueza norteamericana en vivienda ocupada por sus propietarios pasó de 2,8 a 7,2 billones de dólares —, corregidas con el deflactor del PIB, para una muestra de 14 países de la OCDE y de todos los Estados norteamericanos. Su principal conclusión econométrica consistía precisamente en la existencia de tal efecto diferencial, ya que en la muestra internacional el efecto riqueza real de la vivienda se situaba entre un 11% y un 17% —frente a un 2% para la riqueza financiera—, y en los estados de EEUU esta última era mayor (entre el 3% y el 6%), pero venía a suponer en torno al 60% del efecto riqueza de la vivienda (entre el 5% y el 9%)17, lo que se explicaba en parte por el mayor peso de la primera (18 billones de dólares en 1999, equivalente a 2,5 veces la riqueza en vivienda propia), en relación con la situación europea. En suma, lo que la situación actual y los estudios disponibles ponen de manifiesto es que la deflación de precios del sector inmobiliario tiene efectos macroeconómicos letales. O sea: 18 r) PR↓→(WR↓+eb↓) →(S↑+CF↓+Bl↓)→ (IA↓+ C↓) → DA↓↓→ Y↓↓ La política monetaria y el plan anticrisis de Bill Gross Lo que no explica el trabajo de Mishkin es que la preocupación actual por las consecuencias catastróficas de la reversión del proceso —unida a toda la evidencia previamente disponible — obligan, sensu contrario, a reconsiderar los efectos del canal de crédito sobre la demanda de vivienda registrados en el período anterior. En 2007 Mishkin19 concluía que este análisis tiene un carácter simétrico —lo que es tanto como decir que la Fed debería haberlo aplicado también para cortar el ascenso de ésta y de otras burbujas a su debido tiempo —, aunque sus conclusiones políticas se separaban de esa lógica, “por razones prácticas”. Por su parte, en 2001 Bernanke y Gertler20 se habían ocupado de “demostrar” que los bancos centrales no deben responder a los movimientos de precios de los activos, acatando la doctrina exculpatoria de Greenspan sobre el papel de la Fed en la burbuja

11 de los nuevos mercados. Trataban de desmontar con ello el argumento impecable de Cechetti et alia —que postulaba la introducción de los precios de los mercados de acciones en la regla de política económica a seguir por los bancos centrales21 y una fuerte intervención preventiva contra las burbujas, no dejándolas durar más de cinco años22—. Bernanke y Gertler aducían como justificación “que las burbujas pueden tener un carácter probabilístico exógeno” (y no una pauta derivada de comportamientos “irracionales”, aunque sistemáticos), o deberse a un cambio tecnológico en los fundamentos económicos (o sea, al “nuevo paradigma”). Su modelo incorporaba un acelerador financiero, debido al aumento de la imperfección de los mercados de crédito en contextos de rápido crecimiento de la riqueza en activos (además del efecto balances), que eleva los costes de agencia para los prestamistas por causa de la mayor autonomía financiera de los prestatarios. Sin embargo, los supuestos fundamentales seguían siendo la estacionariedad a largo plazo de los mercados de activos, la “reversión hacia la media” y la racionalidad de los agentes, “que conocen el proceso estadístico impulsor de las burbujas”. Como corolario se asumía que las burbujas se pinchan por sí solas, como mucho, en el sexto período de duración. En suma, Bernanke y Gertler —como Greenspan— hacían descansar toda su prognosis sobre la confianza en la hipótesis de los mercados eficientes, que resultaba ya insostenible, después de la burbuja de los nuevos mercados y del asunto Enron, como enfatizaba por aquellas fechas The Economist.23 La réplica de Cechetty et alia,24 reforzada con la evidencia recogida en el informe anual del BIS de 2001, desmontaba lo especioso del argumento, según el cual el mercado ya había recogido y procesado toda la información disponible, por lo que los bancos centrales no debían interferir. Los resultados de esta política de brazos caídos resultaban notorios en octubre de 2007. Pues bien, ya que no se había actuado de forma preventiva, ¿qué política monetaria había que aplicar para minimizar los daños de su propia inacción? Empleando el modelo FRB/US, aunque simulando impactos reforzados de los dos principales efectos (para compensar la impresentable ausencia

12 del canal del crédito en todo el modelo), Mishkin estimó que, de aplicarse estrictamente la regla de Taylor (que implica responder con políticas expansivas cuando el PIB real ya ha experimentado el efecto de la caída del mercado inmobiliario, dejando un cierto margen para el ajuste real), un descenso del 20% en el precio de la vivienda durante el bienio 2007-2008 podría llegar a producir una caída de entre medio punto y punto y medio del PIB en 2010, antes de iniciar la recuperación. Alternativamente, la simulación de una política monetaria “óptima” (anticipando preventivamente la regla, al estilo de lo reclamado por Gross) le permitía prever una reducción máxima del PIB del 0,6% y la compresión del proceso recesivo a un año, con lo que la recuperación podría iniciarse a finales de 2009. En realidad, todo esto era no era más que una chapuza, porque las carencias fundamentales del modelo impedían observar los efectos colaterales de tal anticipación sobre el conjunto de la economía —y especialmente sus efectos sobre la economía global, con su retroacción sobre la propia economía norteamericana —, como observaría Taylor25. Hoy sabemos que las estimaciones de Mishkin —y, con mucho mayor motivo, las de Gross — se quedaban considerablemente cortas (como casi todos los augurios interesados a lo largo de esta crisis): en diciembre de 2008 el índice Standard & Poor's/Case- Shiller de valor de la vivienda registraba una caída anual del 18,2%. No obstante, en términos reales, deflactando el índice con el IPC, en diciembre pasado el valor real se situaba todavía a la altura del primer trimestre de 2001 y un 20% por encima del de 1997. El ritmo de variación anual de valores nominales, que ha venido cayendo desde el segundo trimestre de 2008 (-15%), siguió cayendo en enero (-19%), acumulando un descenso del 30% desde su techo, situado en el segundo trimestre de 2007. RGE Monitor sitúa el suelo final entre el 30 y el 40% desde ese mismo techo.26 Las peores previsiones vaticinan que la caída acumulada puede llegar al 42%, hasta situar el índice de precios en línea con la evolución de las rentas. En ese contexto, se teme que la cifra de nuevos desahucios durante el próximo trienio pueda llegar hasta seis millones.27 Eso sí que empieza a parecerse a un Armagedón.

13 Según el índice I.A.S, en enero de 2009 el ritmo de pérdida mensual de riqueza del stock de viviendas se situó en 610.000 millones de dólares y el descenso de valor de la vivienda acumulado desde la aceleración de la crisis de septiembre de 2007 —cuando Gross hacía su vaticinio —, se estimaba en 2,4 billones de dólares.28 En marzo, la caída anual del precio prevista por la encuesta de Reuters y la Universidad de Michigan era del 2,2%, pero esto solo superaba ligeramente a la caída mensual del índice S&P Case-Shiller registrada en el mes de febrero, del 1,9%. Gráfico XVII

Lo que cambió de orientación fue el número de propietarios cuya vivienda bajó de precio, que pasó del 63% en febrero al 56% en marzo.29 Además, las cifras de ventas de casas nuevas experimentaron un ligerísimo repunte en el mes de febrero (327.000), por primera vez, tras haber alcanzado su mínimo histórico en enero (322.000), menos de la cuarta parte de la cifra alcanzada en su momento máximo, a mediados de 2005. Sin embargo, en ausencia de medidas firmes no cabía hacerse muchas ilusiones, puesto que el fondo de este mercado no se alcanzará hasta que las ventas de vivienda nueva sean equiparables a las de

14 segunda mano, ya que en tiempos normales la mayoría de las casas nuevas es adquirida por antiguos propietarios, tras vender sus casas (mientras los nuevos entrantes acceden principalmente a viviendas antiguas). En cambio, en tiempos de crisis abundan las ventas procedentes de desahucios, contra las que las ventas de casas nuevas no pueden competir. Pues bien, la diferencia entre ambas cifras alcanzó su nivel máximo precisamente en febrero de 2009, como señala el gráfico XVII, elaborado por Calculated Risk, lo que podría indicar que el suelo se acerca.30 Hay que tener en cuenta, además, que en EEUU el mercado regular de la vivienda se financia en un 85% con hipotecas a tipo fijo (y el 15% restante con tipos mixtos), mientras que en el mercado subprime el peso de los tipos variables es importante (por lo que este mercado es mucho más volátil y sensible a las variaciones de los tipos de interés a corto plazo practicadas por la política monetaria convencional)31. Gráfico XVIII

15 De ahí que Gross estimase en enero de 2008 que el mercado sólo empezaría a estabilizarse —deteniendo el proceso de deflación de la vivienda—, cuando el tipo fijo de las hipotecas a 30 años se redujese, al menos, en un punto.32 A comienzos de abril de 2009 este tipo se sitúa ya por debajo de 4,8%, habiendo caído más de un 1% en los últimos doce meses, hasta situarse en su mínimo histórico,33 tras la decisión de la Fed, en la reunión del FOMC del 18 de marzo, de practicar una política monetaria no convencional de adquisición de MBS suficientemente intensa como para situar esos tipos en el 4,5% (que es donde se encuentran ya las hipotecas a tipo fijo a quince años). Como, a mayor abundamiento, el tipo fijo es la opción preferida por los demandantes de refinanciación, las óptimas condiciones de este segmento de los créditos pueden consolidar el repunte de las ventas de vivienda nueva que se registró en febrero, reflejado también en el primer repunte de las cifras de inicio de construcción de casas nuevas (que se situaba ya en el nivel mínimo desde 1968, como se observa en el gráfico XVIII34). En septiembre de 2008 Bill Gross había hecho una oferta tramposa de asumir a título no oneroso35 la gestión por parte de PIMCO de una especie de Resolution Trust Corporation (RTC), de 1989,36 financiada y realizada por cuenta del Tesoro, que se encargaría de aplicar un plan de liquidación de hipotecas tóxicas (legacy assets, en la nueva denominación) que, en su opinión, no solo no producirían la más mínima carga para el contribuyente norteamericano, sino que producirían una rentabilidad de entre el 10% y el 15 %:

“Yo estimo que el precio medio de las hipotecas dañadas que pasarían desde las ‘instituciones financieras con problemas’ a la RTC del Tesoro mediante el procedimiento de subasta sería de 65 centavos por dólar, lo que significa una pérdida de un tercio del precio de compra original para el vendedor, y un rendimiento futuro del 10 a 15 por ciento para el Tesoro. Si esto se financia con bonos del tesoro al 3 o al 4 por ciento, el rendimiento diferencial resultante para el Tesoro sería, al menos, del 7 al 8 por ciento. Están más que justificadas las advertencias de que

16 este proceso de subasta debería ser adecuadamente supervisado. Pero existen empresas desinteresadas, no necesariamente residenciadas en Wall Street, con capacidad para evaluar estos vehículos complejos, estructurados a base de mezclar hipotecas con otras clases de activos, para garantizar que el dinero de los contribuyentes se invierta de manera juiciosa. Mi estimación de un rendimiento de dos dígitos se basa en que estos activos se mantendrían en la RTC por largo tiempo, aunque este plazo dependerá de la evolución de los desahucios. Como, a su vez, este programa iría dirigido a minimizar el ritmo de desahucios, éstos probablemente entrarían en una espiral descendente [acortando aquel plazo]. 37”

¿Era la propuesta de Gross un cuento de la lechera más, de esos a los que nos tienen acostumbrados los hedge funds? ¿Se trataba de una propuesta sincera y desinteresada por su parte (renunciando a obtener beneficios), aunque impulsada por el vértigo de unas instituciones abocadas al cierre si no se ponía coto al proceso de desapalancamiento y de deflación de deuda, que amenazaba con vaciar las cuentas de sus depositantes y obligarles a vender sus activos a unos precios de liquidación cada vez más irrisorios; 38 esto es, a incurrir en pérdidas mostruosas y a verse sometidos a reclamaciones de responsabilidad por daños, de resultado personal incierto, en un clima de animadversión pública creciente hacia los money managers? La cosa se les complicaba todavía más si se piensa que desde el mes de enero anterior había venido subiendo la marea de opiniones documentadas que encontraban materia penal en el comportamiento de muchos “originadores” de aquellos vehículos complejos (muchos de los cuales habían sido diseñados ex profeso para que los previsibles impagos se produjesen a plazo diferido, y, por lo tanto, su comercialización ofrecía la apariencia de una estafa). Además, la investigación del FBI seguía su curso,39 aunque era un verdadero laberinto legal40. Obsérvese también la sincronización entre la oferta de Gross y las previsiones de Mishkin. Éste había duplicado en 2007 la estimación inicial de caída del valor de la vivienda avanzada por

17 el fundador de PIMCO, elevándola hasta el 20%. Sobre esta base evaluaba Gross su negocio de la lechera en septiembre de 2008: como el mercado ya estaba valorando los productos hipotecarios con un 35% de descuento, si finalmente el mercado se estabilizaba con una simple caída del 20% —como preveía el modelo de la Fed—, el rendimiento bruto para el Tesoro podría estar entre el 10% y el 15% (dejando cinco puntos como margen de seguridad). Lo que Gross no contaba entonces es que el mercado de la vivienda estaba en lo cierto al descontar caídas adicionales, y que la adquisición de los MBS con un 35% de descuento probablemente iba a arrojar pérdidas para su proyectada RTC, porque los costes de la operación y de la financiación correrían a cargo del Tesoro —a no ser que contara con ello, pero esperase la formación de una nueva burbuja en el futuro —. Esta ha sido la tónica general en el comportamiento engañoso del sector financiero durante el último decenio, antes y después de la crisis: por eso casi nadie se fía de ninguno de sus representantes (aunque alguna gente “entendida” tampoco les culpa, todavía, ya que se suponía que actuaban como meros agentes de un principal muy extendido, representado por el colectivo de sus inversores41). Hemos visto que actualmente las estimaciones independientes menos optimistas vaticinan una caída máxima del mercado de la vivienda del 42% desde su techo, situado en la primavera de 2007, y que RGE Monitor se inclina por una horquilla de caída entre el 30% y el 40% (o sea, un promedio del 35%). Pero el problema no se encuentra solo en las garantías hipotecarias, ya que a partir del mes de marzo de 2009 el problema de la “reina de espadas” se generalizó, afectando en primer lugar a las tarjetas de crédito y a otras modalidades de créditos al consumo (que los observadores estiman experimentarán unas quitas de entre un 6% y un 38% de su saldo en 2009).42 Y afectó enseguida también al papel comercial respaldado por las actividades de promoción inmobiliaria (commercial real estate), que, de acuerdo con las estimaciones de Soros, experimentarán una pérdida de valor a lo largo de la crisis del orden del 30%, arrastrando tras de si a más de 700 bancos.43

18 Si el caso de las subprime era genuinamente americano — contagiado a todos los que adquirieron aquellos vehículos— esto es algo que afecta directamente a otros países, y entre ellos a España, como pone de manifiesto la intervención de CCM y la prognosis acerca de una reestructuración profunda de todo ese sector hecha por el Banco de España.44 Los gráficos XIX-XXII sintetizan la evidencia disponible sobre la diseminación internacional de estas actividades, a través de la emisión de bonos y otros títulos, de modo que la intervención y el saneamiento de las instituciones financieras afectadas constituirán la principal contribución española a la estabilidad financiera global —como lo fue el rescate de AIG por el gobierno federal —. Esto es, en el momento actual conocemos —con razonable grado de consenso entre los analistas no interesados — el nivel al que previsiblemente se estabilizarán los precios en el mercado inmobiliario de EEUU, que viene a ser el que les corresponde, de acuerdo con los fundamentos de su valor, una vez eliminada la burbuja, por lo que su suelo resultará sostenible: la vivienda, en torno a un 40% por debajo de su nivel máximo, y el papel comercial asociado a la misma en torno a un 30%. No sucede lo mismo en países, como España, cuyos mercados funcionan con inercias muy superiores, pero podemos aplicarles supuestos bastante parecidos, dadas las estimaciones profesionales y las de los interventores concursales de las grandes empresas inmobiliarias. La intervención del Banco de España en las cajas que no cumplen sus exigencias regulatorias —y su eventual entrada en el capital de las cajas y en sus órganos de dirección45 — le permitirá conocer mejor el tipo de prácticas a las que se han venido librando algunas de ellas y los desequilibrios de este mercado. Sin embargo, pese a la insuficiencia del sistema estadístico en materia de precios de la vivienda, comienzan a observarse también aquí indicios de que algo está cambiando: el director del Master en Consultoría Inmobiliaria de la Universidad de Barcelona, Gonzalo Bernardos, estima que la caída efectiva de precios ya es del 20% —como ocurre en el reciente acuerdo de algunos grandes bancos con las promotoras para financiar al

19 100% las ventas que se realicen con ese descuento46 —, lo que, unido a la reducción de los tipos de las hipotecas en tres puntos (hasta situarse en el 3,25%), supone una reducción de las cuotas de éstas en torno al 40%, de modo que el cambio de contexto está produciendo ya una inversión de la preferencia hacia el alquiler registrada durante 200847. Todo ello indica que el suelo del mercado podrá preverse de forma razonable en el inmediato futuro.48 En EEUU este es precisamente el cambio fundamental registrado durante los quince meses transcurridos desde la propuesta “altruista” de Bill Gross. El trasfondo de la misma —aunque no su operativa práctica — fue trasladado al Troubled Asset Relief Program (TARP), del mes de octubre pasado, aplicado por el secretario del Tesoro de entonces, Henry Paulson, que fue descalificado desde el momento mismo de su anuncio por toda la opinión ilustrada.49 Pues bien, el plan (Public-Private Investment Program: PPIP), anunciado por el nuevo Secretario del Tesoro, Tim Geithner, que recoge con mucha mayor fidelidad las ideas de Gross, ¿debería ser descalificado con igual contundencia y por los mismos motivos que el de Paulson, como ha hecho ya una parte de la intelligentsia crítica norteamericana?50 Luigi Zingales, por ejemplo, afirma que el PIPP es todavía más arriesgado, opaco e inútil que el TARP (y con mayor riesgo de rechazo político por parte de la ciudadanía).51 Sin embargo, hay algo que no casa en su análisis: por un lado, acepta las estimaciones según las cuales los activos dañados del sistema pueden acabar necesitando quitas de entre el 30 y el 40% de su valor durante la etapa de máximo esplendor, pero por otro lado considera que el valor de mercado de los títulos respaldados por esos activos —que ha llegado en algunos casos a situarse en el 30% de su valor al vencimiento— no está experimentando una convulsión temporal, motivada precisamente por la deflación de deuda, como estima el BIS. La contradicción es importante porque de ella depende que las instituciones que contabilizan esos títulos al 60% se encuentren actualmente en situación de iliquidez o de insolvencia (y la validez del PPIP). De hecho, la diferencia entre una y otra situación es mucho menos nítida de lo que parece,

20 incluso en circunstancias normales, como el propio Zingales conoce bien, ya que ese es el problema no resuelto de los procedimientos concursales. Pero en un contexto de deflación de deuda, el deslizamiento entre la iliquidez y la insolvencia — causado por la sobre-reacción de los mercados frente a la saturación de ventas, precipitadas por la espiral de desapalancamiento — es un riesgo evidente. La teoría y la práctica de la macroeconomía clásica y de la acción colectiva avalan este enfoque.52 Nouriel Roubini y Elisa Parisi-Caponem, de RGE Monitor, realizaron en enero de 2009 una contabilización precisa y ampliamente documentada de las pérdidas en las que han incurrido hasta ahora los bancos, basándose en la estimación del IMF para el mes de octubre y combinándola con estimaciones de futuras pérdidas imputables a la evolución prevista de los precios de mercado de los activos que sirven como respaldo a los préstamos bancarios y como activos subyacentes a la titulización de los distintos productos financieros —hasta alcanzar un precio acorde con los fundamentos de su valor, según las estimaciones de consenso: con una caída adicional del 20% en el valor de la vivienda y una tasa de desempleo entre el 9% y el 10% —.53 El ejercicio arroja los resultados que aparecen en el cuadro 4. Cuadro 4.- Estimación de pérdidas totales del sistema bancario norteamericano (descontadas a fecha 31/diciembre/2008) Saldo total % pérdidas Total pérdidas % BB. EEUU Pérdidas EEUU Prestamos no asegurados (en billones de dólares y %) 12,4 13,1% 1,6 65% 1,1 Titulización (en billones de dólares y %) 10,8 17,6% 1,9 35% 0,7 Pérdidas totales 23,2 15,5 3,6 50% 1,8 Como la capitalización total del sistema bancario ascendía en el tercer trimestre de 2008 a 1,4 billones de dólares, de haberse contabilizado esas futuras pérdidas se habría registrado un desequilibrio patrimonial de 0,4 billones, que se suplió con

21 aportaciones de 0,23 billones del programa TARP y con ampliaciones de capital de 0,2 billones, lo que implica que el sistema disponía a comienzos de 2009 de un capital inferior a 0,1 billones de dólares. Para recomponer la dotación de capital anterior a la crisis harían falta inyecciones adicionales del orden de 1,4 billones de dólares, aunque, obviamente, ese no es el escenario previsible, tras la inevitable reestructuración 54. El 20 de marzo Greenspan pensaba que serían necesarios al menos 0,85 billones55. Estos cálculos indican que los bancos norteamericanos sólo soportarán la mitad de las pérdidas totales, mientras que el resto del mundo deberá asumir el resto, lo que, unido a las pérdidas originadas en otras zonas, permite a RGE distribuir la última estimación de pérdidas bancarias realizada por el IMF en el mes de abril (que asciende a 4 billones de dólares) imputando 1,8 billones a EEUU; 2 billones a Europa, y 200.000 millones de dólares a Asia.56 Todo ello proporciona una base suficientemente firme para afrontar las medidas políticas que permitan hacer frente a la situación y corregirla, en la medida de lo posible, mientras que en un momento anterior del proceso el activismo político intempestivo habría impedido que los mercados recuperasen niveles de precios acordes con sus fundamentos, dificultando el proceso de recuperación, o haciéndolo más frágil y menos sostenible. Obsérvese que, aunque el epicentro de este tsunami financiero sea EEUU —en donde la corrección realizada por los diferentes mercados marca la pauta anticipativa para contextos similares, dada la proverbial flexibilidad de aquéllos — hacer frente al problema global requerirá que el resto del mundo actúe simultáneamente, ya que la salida de la crisis será más fácil y rápida si se aprovecha el reforzamiento mutuo derivado de la cooperación. Los gráficos XXIII a XXV, extraídos del informe de marzo del 2009 del BIS57, recogen la posición bruta y neta internacional de los principales sistemas bancarios. En ellos puede observarse que, aunque en términos brutos el peso internacional del sistema bancario español resulta comparativamente limitado (por debajo del de Bélgica), la posición internacional neta en

22 dólares es la más dependiente (puesto que, por contraposición a los otros grandes sistemas bancarios europeos, el español se endeudó en dólares fuera para prestar en Euros dentro), siendo así que el dólar es la moneda que ha resultado más escasa a lo largo de la crisis, de modo que objetivamente España es el país europeo más interesado en la resolución del problema del crédito, en la holgura monetaria en EEUU y en la eventual depreciación del dólar para corregir el desequilibrio exterior (puesto que tiene que devolver relativamente mayor cantidad de dólares). En cambio, la mayor parte de la banca internacional europea, que ha prestado y adquirido valores en dólares (como le sucede a China), está interesada más bien en que se mantengan los valores de los activos americanos y la sobreapreciación del dólar y en que continúe un desequilibrio comercial insostenible: ésa ha sido la apuesta recalcitrante de Angela Merkel a lo largo de toda esta crisis. Pero va a contracorriente, y la economía alemana decrece ya a una tasa del 11% anual en el primer trimestre de 2009, mientras el comercio exterior norteamericano se contrae actualmente a una tasa anual del orden del 20% (y sus importaciones desde Europa, excluido el petróleo, a una tasa del 30%, algo por encima de sus exportaciones)58. No es así como saldremos de la crisis, sino cooperando: del mismo modo que el rescate de AIG salvó a muchos bancos europeos, el rescate de éstos puede aliviar la carga de los mercados de activos norteamericanos, que volverían a hundirse si este continente — por no hablar de China — vaciasen sobre ellos los ocho billones de activos denominados en dólares que tienen invertidos allí —sólo una cuarta parte menos que la inversión de los propios bancos norteamericanos, según el BIS — para reducir apalancamiento y hacer frente a la corrección de sus balances. Según Brad Setser, el avance de la globalización requeriría que este tipo de reciprocidades se regulase de cara al futuro, para evitar que la resolución de las crisis quede sometida a la voluntad más o menos caprichosa de los gobernantes de turno (como Merkel), pero su vaticinio es que no se avanzará en la regulación y que habrá menos globalización.59 En el ámbito europeo, además, las tímidas expectativas regulatorias que despertó el informe Larosiere se han

23 visto frustradas por el Bundesbank, que se opone a la asimetría de un órgano de coordinación de la regulación financiera a nivel de la Unión mientras las competencias, responsabilidades y financiación dependan de las autoridades y de los presupuestos nacionales.60 En todo caso la crisis actual obligará a un replanteamiento de toda la actividad transfronteriza de los bancos (y del alcance de la acción de sus supervisores nacionales), ya que los contribuyentes de un país no están dispuestos a rescatar a las sucursales de bancos extranjeros que actúan en su territorio (lo que devuelve la supervisión, la garantía de depósitos y la condición de prestamista de última instancia al banco central de origen, obligándole a controlar de cerca estas actividades, que prácticamente desaparecerán). De modo que toda la actividad bancaria trasnacional pasará a realizarse a través de entidades sometidas íntegramente a la regulación del país anfitrión (como sucede con Abbey), independientemente de la composición de su accionariado (en este caso, el Banco Santander).61 Finalmente, hay que observar que, aunque la corrección del problema bancario y el restablecimiento de un sistema viable de crédito sea el prerrequisito para que la crisis toque fondo, sus consecuencias sobre la contracción de la economía real serán mucho más duraderas, como observa Willem Buiter,62 por lo que resulta imprescindible aplicar medidas de reforma institucional para impulsar sendas de crecimiento sostenible en cada país, aprovechando la crisis para corregir desequilibrios estructurales. Qué hacer ahora: el Plan Geithner-Summers-PIMCO Sobre la base de ese horizonte previsible, la resolución de la crisis exige, en primer lugar, evitar que la espiral liquidatoria empeore la valoración de los activos financieros más allá del descenso de cotización imputable a la minusvaloración de los activos reales que les sirven de respaldo. Una regulación razonable de las ventas en corto que impida su utilización flagrantemente especulatativa —aunque solo sea otorgando al regulador la facultad de impedirlo con carácter temporal, en momentos de turbulencia —,

24 resultaría de gran ayuda para preservar el funcionamiento de los mercados.63 Otra medida de acompañamiento apreciable es la adopción el 7 de abril de criterios comunes para toda la industria norteamericana de permutas de crédito (CDS) y el establecimiento de una caja central de compensación (clearinghouse) para las mismas, ya que clarificar la situación de estos mercados resulta fundamental para recuperar su función de orientación en la búsqueda de precios del conjunto de productos financieros. El grado de desorden al que había llegado este mercado se comprueba al observar que el dos de febrero los servicios de “compresión de carteras” de TriOptima —una firma que gestiona la casación de este tipo de derivados a través de Internet — habían logrado reducir el valor nocional del mercado de CDS en 30,2 billones de dólares, dejándolo reducido a 28,8 billones, eliminando la doble contabilización de los CDS que se compensan entre sí (lo que significa menor complejidad de gestión, pero no necesariamente menor riesgo, aunque sí mayor concentración del mismo)64. Al mismo tiempo, la industria trata de mantener la flexibilidad de los derivados “hechos a medida” (OTC), para lo cual se establecerá un comité conjunto de corredores e inversores con atribuciones para adoptar decisiones vinculantes (mediante mayoría del 80% de los 15 miembros del comité, en ausencia de la cual se establece el arbitraje obligatorio), competente en materia de declaración del “hecho de crédito causante”, los plazos y las cantidades de liquidación. La medida homogeneizadora más importante consiste en establecer una nueva comisión de entrada (como filtro de solvencia y de disuasión antiespeculativa), a abonar por todos los compradores de protección (relacionada con los precios del mercado), y primas anuales de entre 100.000 y 500.000 dólares por cada 10 millones de dólares asegurados. Todo ello viene a anticipar, con autorregulación, algunas de las medidas anunciadas en el plan que están diseñando conjuntamente el Tesoro y la Fed, que contará además con autoridades de supervisión. 65 La medida adoptada el 2 de abril por la Federal Accounting Standards Board (FASB) de relajar los criterios de aplicación del

25 valor de mercado (mark to market) en la contabilización de estos activos financieros, “mientras los mercados se encuentren inactivos”, puede significar un gran alivio para la presión liquidatoria, aunque, obviamente, podría ser utilizada también para ocultar las pérdidas ya incurridas y para mantener artificialmente vivos a bancos “zombies”, como teme Willem Buiter,66 ya que algunos bancos pueden preferir seguir supervalorando sus activos en el balance antes que participar en el plan de venta de activos tóxicos del gobierno, precisamente porque la participación en este último es voluntaria, lo que constituye el aspecto más vulnerable del mismo.67 Pero debe observarse que los criterios de la FASB (y los de la IASB, a escala global) afectan a todo tipo de tenedores, no solo a los bancos, por lo que la aplicación de criterios estrictos de contabilidad en mercados muy volátiles o inactivos contribuye a acelerar las espirales liquidatorias en múltiples instituciones y fondos, de modo que actualmente la medida resulta recomendable temporalmente, por razones prudenciales (y probablemente a medio plazo debería adoptarse un criterio menos procíclico). Lo que no quiere decir que haya que actuar con lenidad en la evaluación de la solvencia de los bancos, pero para eso se dispone de otros instrumentos, que sí están obligados a utilizar los criterios de contabilización más estrictos en orden a simular la viabilidad o inviabilidad futura de las instituciones bancarias. En general, esta es la tarea que llevan a cabo de oficio las autoridades supervisoras, allí donde funcionan regularmente (como hace el Banco de España), lo que no ha sido el caso en EEUU, al menos durante el pasado decenio. De ahí que el Plan Geithner haya establecido una “prueba de resistencia” (stress test) a la que se someten los bancos con carácter previo a su participación en el PPIP. El filtro para la prueba de resistencia consiste en disponer de una ratio del 6% en el primer tramo del capital (Tier 1: acciones comunes o preferentes y obligaciones convertibles), y una ratio total de recursos propios del 3%. Aunque se ha anticipado que algunos de los grandes bancos disponen de holgura suficiente en la primera de estas ratios (como Citigroup, que dice disponer del 11,8%), se encuentran muy por debajo en la segunda (1,5%,

26 en ese caso). ¿Es esta evaluación razonable, o se trata más bien de una autoevaluación engañosa? Gráfico XXVI

Muchos observadores se han mostrado abiertamente escépticos acerca del rigor y la fiabilidad del stress test, ya que el Tesoro no dispone más que de 200 inspectores para los 19 grandes bancos (mientras que fueron necesarios 190 para evaluar la crisis de Citi Corp. a comienzos de los noventa). No se trata de una verdadera auditoria bancaria —capaz de valorar lo que hay detrás de los préstamos, a través de un muestreo significativo — sino más bien de una simulación del comportamiento de las principales ratios bajo condiciones de una crisis no extrema, hasta el punto de que los parámetros del test no han soportado su propio “test de resistencia”,68 al verse superado por los acontecimientos. Como se observa en el gráfico XXVI, las pérdidas de crédito netas (NCL) de Citi imputables a tarjetas de crédito empeoraron rápidamente en el primer trimestre, a medida que la situación de desempleo se

27 situaba en el 8,5% (frente al “peor escenario” previsto en el test, del 7,9%)69. Además, la simulación se lleva a cabo por los propios interesados con ayuda de los mismos modelos de evaluación del riesgo que condujeron al desastre actual (del tipo autorizado para estas instituciones por Basilea II, que prácticamente nadie ha verificado desde el exterior).70 Willem Buiter señala que esto viene a ser una restricción insuperable, por cuanto la información en la que se basa la evaluación es información privativa de los bancos, que no puede obtenerse de forma independiente. De ser esto legalmente exacto, denotaría una carencia regulatoria fundamental, ya que sin la capacidad para acceder directamente a esa información no es posible una actividad supervisora del banco central como la que se realiza en el continente europeo (o, al menos, como la que realiza el Banco de España, con inspectores que actúan desde dentro de las entidades). Finalmente, el test solo se preocupa del 40% de los balances de los bancos invertido en títulos-valores (que es donde se sitúa la mayor parte del “peso del pasado”) y no en el 60% de préstamos, que son los que soportan el peso de la contracción actual y futura, como se observa en el gráfico XXVI. De ahí que Buiter piense que todo esto es una pura pérdida de tiempo y que los “resultados” del Test serán empleados por la banca al modo de un “certificado de buena salud”, otorgado por el gobierno, para beneficiarse de la operación de rescate. En opinión de este analista, más valdría reconocer ya el estado deplorable de los balances de los bancos realizando un test con escenarios verosímiles y, en lugar de utilizar el PPIP para crear una especie de gran “banco malo” en el que aparcar los activos dañados, obligar a los bancos que presumiblemente no vayan a cumplir los requisitos prudenciales a final de 2009 a desdoblarse en un “banco bueno” (con los activos sanos, los depósitos y el resto de créditos garantizados) y un “banco malo”, con el resto del balance, en el que los acreedores no garantizados conservarían los derechos de propiedad residual sobre el banco bueno —lo que implica la conversión obligatoria de deuda en acciones preferentes—. Como, previsiblemente, la recapitalización del banco malo requeriría recursos públicos adicionales, ésta solo se

28 llevaría a cabo tras agotarse los recursos de capital propios del banco, tras hacer recaer en primer lugar el coste del saneamiento sobre los inversores no garantizados, de acuerdo con las condiciones inherentes al contrato de capital de riesgo. De otro modo, piensa Buiter, los recursos públicos disponibles se agotarán antes de disponer de bancos saneados, mientras que la propuesta alternativa permitiría que los bancos buenos funcionasen al término de un fin de semana de pasar por la FDIC.71 En cualquier caso, los resultados finales de la evaluación de la banca norteamericana solo se encontrarán disponibles a comienzos del mes de mayo. Si de la prueba de resistencia resulta que un banco particular debe ser recapitalizado, el supervisor le concederá un plazo de seis meses (aunque previsiblemente lo hará de manera confidencial, ya que en público no se esperan grandes sorpresas). Durante ese período está previsto que funcione en paralelo el PPIP, aliviando los balances, para estimular la recapitalización a través del mercado. Ésta cuenta, a su vez, con el estímulo de que la prevista desaparición de los eslabones más débiles de la cadena bancaria dejará un confortable espacio abierto para los que superen la prueba, como ya se está observando a través de la comunicación de resultados del primer trimestre de algunos grandes bancos, como Wells Fargo o Goldman & Sachs.72 Únicamente en caso de que no se consiga la recapitalización privada y que la desaparición del banco produzca riesgo sistémico (lo que se predica automáticamente de los 19 grandes bancos), el Tesoro lo recapitalizará mediante la suscripción de acciones preferentes (adquiridas por la Fed), que solo en caso extremo se convertirán en ordinarias, con plenos derechos políticos. El PPIP comienza a operar a partir del 24 de abril, fecha en que expira el plazo para solicitar participar en las dos vertientes del plan.73 El sistema de adquisición de activos tóxicos (“legacy assets”, en la nueva terminología eufemística que a todo el mundo parece empezar a convenir) consiste en dos programas o tramos de inversión: el de préstamos (Legacy Loans Program: ILLP) y el de títulos (Legacy Securities Program: ILSP):

29 —El primero (ILLP) consiste en la cesión de prestamos de promoción inmobiliaria (pools of residential mortgages) en poder de los bancos para su adquisición por fondos de inversión público-pivados (PPIF), promovidos por el Fondo de Garantía de depósitos (FDIC), en los que participarán a la par el Tesoro y los inversores privados, a condición de encontrar partícipes privados—a través de subasta al mejor postor— que pujen para aportar el cincuenta por ciento del capital necesario para la adquisición. Ésta se realizará con una ratio 6 de apalancamiento, con crédito avalado por el FDIC. Esto es, para adquirir en la subasta un préstamo con valor nominal de 100 dólares al 70% de ese valor, el Tesoro y el inversor privado aportarían cinco dólares cada uno de capital y se tomarían prestados los otros 60 dólares (avalados por el FDIC). A su vez, en caso necesario estos préstamos podrían ser redescontados en la Fed, de acuerdo con el programa de expansión cuantitativa recientemente aprobado. Sería el inversor privado quien gestionaría la vida del préstamo y el tiempo de su realización, en términos de un “negocio en funcionamiento” (ongoing concern)74, sometido a la supervisión de la FDIC. —El segundo programa (ILSP) arranca con el proceso de selección para precalificar a las sociedades gestoras del programa, a las que se les faculta para recibir participaciones de capital privado interesadas en la inversión, aportando el Tesoro un 50% del capital total desembolsado y realizando un préstamo por un monto igual a su aportación de capital (o doble, en ciertos casos). Esto es, sobre la base de una aportación privada de cien dólares, el Tesoro aportaría cien de capital y otros cien de préstamo (o doscientos), constituyendo un fondo operativo de trescientos (o cuatrocientos) dólares, que se destinará a la adquisición de títulos dañados por parte de la sociedad. Ésta actuará con plenas facultades operativas, aunque exigiéndosele que desarrolle una estrategia de tenencia a largo plazo.75

Varias son las objeciones que se han hecho a este plan, la más contundente de las cuales es la de prestarse al fraude generalizado, ya que, dado el escaso nivel relativo de capital

30 exigido y la garantía pública o la aportación directa de préstamos por el Tesoro, a su propio riesgo y ventura y sin otra garantía que el activo adquirido (al tratarse de loans on a non-recourse basis), los bancos pueden participar en la puja —por sí mismos, o mediante intermediarios —76 con el exclusivo propósito de elevar el valor de sus propios activos en la subasta, a sabiendas de que, incluso en caso de pérdida total del valor del activo adquirido por el fondo, en el programa ILLP ellos sólo perderían el 7,1% de la inversión total, y en el programa ILSP entre el 33% y el 25%. Las estimaciones sobre la subvención del Tesoro a los balances de los bancos implícita en cada uno de estos programas varían: desde un 30%, para Krugman, hasta ocho veces el capital invertido, para Kotlikoff y Sachs, quienes computan el beneficio obtenido por la revalorización del balance de los bancos que participen en el plan pujando descaradamente al alza por sus propios activos.77 ¿Funcionará el PPIP y restablecerá el sistema y el flujo de crédito, o será solo un paso más, antes de adoptar soluciones más drásticas? ¿Existen alternativas económica y políticamente viables? Si no funciona, ¿habrá recursos adicionales para acometer la reestructuración bancaria inaplazable? ¿Y, lo que es más grave, quedaría después del eventual fracaso capital político y liderazgo creíble para acometer las tareas pendientes? ¿O el fracaso de este plan, de producirse, es un prerrequisito imprescindible para acometer eventualmente la solución final? En sexto lugar —y solo en sexto lugar— ¿es equitativo el plan Geithner-Summers-PIMCO? E, incluso si el plan tiene éxito y recompone el sistema, ¿qué problemas de moral hazard planteará en el futuro? ¿Hay que elegir entre los intereses de los contribuyentes y los de los inversores, o estos últimos se encuentran tan diseminados como para ser calificados de encompassing interests (en palabras de Mancur Olson), al constituir una muestra de los primeros, que podría considerarse representativa del interés general? Y, finalmente, evaluando el proceso en términos evolucionistas, ¿qué problemas plantea a largo plazo este programa para la selección eficiente de agentes económicos por el sistema capitalista?

31 Nadie puede asegurar que el PPIP va a ser un éxito o un fracaso. En la encuesta de urgencia planteada por New York Times78 el mismo día del anuncio del Plan entre los economistas con blog propio y mejor reputación radical se produce división de opiniones, auque solo Krugman piensa que va a ser un rotundo fracaso. Dos de ellos (Simon Johnson y Mark Thoma) manifiestan dudas, contemplando el plan solo como parte de la solución, aunque Thoma cree que tiene cierta probabilidad de éxito. Solo Brad DeLong apuesta abiertamente a su favor, pero más que nada porque piensa que es imperioso actuar y que el plan es lo único que se puede hacer en estos momentos, ya que para la nacionalización propuesta por Krugman —y apoyada por Walter Muchau, desde FT Alemania, y por Willem Buiter, desde FT RU — haría falta disponer de 60 votos adicionales en el Senado y de unas capacidades de gestión que el Tesoro no posee actualmente79; y los procedimientos especiales de quiebra bancaria —a la inglesa, como propone Johnson, o a la americana, con procedimiento de subasta, como desearía DeLong —,80 no están disponibles y habrá que prepararlos para la próxima crisis. En síntesis, DeLong piensa que el argumentario a emplear por la administración Obama para defender el plan tendría que combinar —u optar entre — tres mensajes:

1. Los bancos nos tienen pillados por las pelotas (The banks have us by the plums), porque para salir de la crisis y volver a crecer, primero hay que disponer de un sistema de crédito. 2. Nos vamos a forrar (The government has a chance to make a fortune), aprovechando que el mercado se ve invadido por una ola de pesimismo irracional, que remitirá pronto. 3. Antes de dar paso a un New Deal, estamos obligados a jugar las cartas que nos han tocado (We have to play out the hand before we ask for a New Deal), porque existen dudas razonables acerca de si los bancos pueden salir del atolladero con una simple ayudita, y, mientras no se demuestre lo contrario, el Senado no aceptará que nos embarquemos en la aventura de la nacionalización, porque

32 eso son palabras mayores, que no se pueden pronunciar sin haber probado antes todas las alternativas ordinarias.81

La principal incertidumbre a la hora de elegir entre los tres mensajes proviene de la ignorancia acerca de si existe un problema de iliquidez o de insolvencia, pero eso depende, como vimos, del comportamiento futuro de los mercados. De ahí que para quienes piensan que la estabilización de éstos ya está próxima, o que su nivel de medio plazo, acorde con los fundamentos de su valor, ya es previsible de manera objetiva — como es el caso de Roubini, ya mencionado —, la evaluación resulta menos negativa, porque el “descubrimiento del precio” no se fía exclusivamente a la operación de subasta, que comporta un grave riesgo de manipulación. En tal circunstancia los problemas surgen a la hora de garantizar que el diseño del plan no se preste al fraude, cosa que Jeffrey Sachs no duda ocurrirá, y que también preocupa a Roubini. Sorprende, sin embargo, este temor, porque para ello tendrían que burlar la supervisión de la FDIC, que cuenta ya con estimaciones bastante razonables de los precios de los títulos a medio plazo (que, al estar fundamentado por las previsiones de estabilización de los valores de mercado de los activos colaterales, pueden establecerse como umbrales máximos del precio de subasta). Además, parece claro que si los gestores de los bancos y de los fondos se confabularan para estafar al Tesoro, la reacción política, legislativa y popular sería de tal calibre que acabarían todos en la cárcel. Claro que si la opinión radical —y el Panel que monitoriza estas políticas en el Congreso — se limitan a rechazar frontalmente el programa —y no se ocupan de exigir garantías de juego limpio —, los amantes de la discrecionalidad absoluta lo tendrán más fácil y, en caso de fracaso, no será posible exigir responsabilidades con carácter retroactivo. Porque de lo que sí se tiene certeza es de que algunos de los principales operadores que ya han anunciado su participación en la operación —como PIMCO, que fue el primero en sumarse a un plan que se parece mucho al que Gross venía proponiendo desde 200782 — conocen perfectamente lo que hay detrás de los paquetes de títulos y de los grandes préstamos que circulan por el mercado

33 (porque en muchos casos los originadores fueron ellos mismos), como el propio Bill Gross se encargó de anunciar a bombo y platillo al ofrecer su gestión desinteresada. De hecho, en la versión actual de su propuesta, frente a la posición de los inversores —que desearían comprar los activos tóxicos a un precio actual de mercado que oscila entre 20 y 30 centavos por dólar — y las de los bancos —que desearían venderlos a 70 u 80 céntimos, con estimaciones propias de cuento de la lechera — Gross plantea que un buen negocio para ambos sería cederlos a 60 céntimos (que es el umbral de precios máximo que debería establecerse para la subasta, siempre que los bancos ofrezcan todos los activos de las clases afectadas, y no una selección in peius de los valores que pudren sus balances). Según Gras, con préstamos del Tesoro a un interés del 2%, la rentabilidad del negocio podría llegar al 15%.83 Esto podría resultar otro cuento de la lechera, pero, aunque se quedase en la mitad —o en la tercera parte, si se compran los activos a 55 céntimos/dólar y la inversión ha de mantenerse en cartera varios años —, no estaría mal para los tiempos que corren, dado lo limitado del riesgo en que se incurre y la escasez de alternativas viables de inversión. Pero para que esto funcione habría que exigir a las entidades gestoras responsabilidades a medio plazo. Y el problema es que nadie está diseñando el tipo de contrato ex ante necesario para hacerlo. La otra gran incertidumbre proviene de la evaluación del histerismo y la aversión patológica hacia el riesgo que domina actualmente los mercados. Para Christopher D. Carroll,84 esa es la principal diferencia entre los economistas académicos y los que conocen mejor el funcionamiento de los mercados y el comportamiento de sus agentes, además de la mayor inclinación de aquéllos a poner por delante el restablecimiento del orden y la corrección punitiva de tales comportamientos —dos cosas que no se deben confundir, según Brad DeLong —. A esta confusión podríamos denominarla el “síndrome de Sansón” que, para castigar a los filisteos, prefirió sucumbir con ellos, derribando las columnas del templo, desde dentro: de modo que el síndrome de Sansón viene a ser la denominación judeo-cristiana de su argumento sobre las pelotas.

34 Tampoco existe la más mínima certeza de que el PPIP vaya a servir para restablecer el sistema y el flujo de crédito, ya que en última instancia eso dependerá también de que resuelva el problema de la Reina de Espadas y de la angustiosa necesidad en que se ven los bancos para hacer frente a lo que no se ve, que son las múltiples operaciones acometidas fuera de sus balances. Y eso, sin dar por buena la antigua hipótesis de Caballero-Giavazzi, según la cual detrás de la renuencia de los bancos a prestarse dinero entre sí podrían esconderse objetivos estratégicos tendentes a acelerar la reestructuración del sector, manteniéndose los bancos mejor saneados en posición de máxima liquidez para hacer frente a eventuales adquisiciones de los bancos que haya que liquidar.85 De ahí que, en la medida en que se vayan despejando incertidumbres sobre la reestructuración bancaria, estos comportamientos estratégicos cederán (o, alternativamente, en la medida en que la crisis se prolongue, la preocupación por la supervivencia desplazará a la ambición por reforzarse de cara al futuro, y entonces el New Deal bancario, al que se refiere DeLong, caerá por su propio peso). Qué hacer ahora: el Panel del Congreso y el Informe Warren First thinks first: El plan Geithner-PIMCO es una continuación del plan TARP de Henry Paulson (y hereda sus fondos residuales, del orden de 100.000 millones de dólares). Para anticipar los resultados de esta nueva variante conviene evaluar previamente los del proceso anterior que, de una u otra manera, ya ha comprometido los recursos siguientes: 0,6 billones del Tesoro; 1,5 billones provenientes de la expansión del balance de la Fed — destinados principalmente a absorber los valores de las agencias hipotecarias con aval federal (GSE) —, y otros 0,9 billones mediante avales y garantías del fondo de garántía de depósitos (FDIC). En total, el riesgo asumido por las autoridades federales durante la crisis asciende ya al increíble monto de cuatro billones de dólares. Seis meses después de la aprobación del TARP por la Emergency Economic Stabilization Act, de 3 de octubre de 2008 (EESA), el Comité de Supervisión del Congreso adoptó el 7 de abril, por una estrecha votación (3/2), un Informe propuesto por

35 el Panel presidido por Elizabeth Warren, (Profesora de Derecho de la Harvard Law School).86 El Informe se realiza bajo la advocación de cuatro criterios de evaluación: el de Transparencia en la valoración de los activos bancarios y en el test de solvencia de los bancos; el de Asertividad en la actuación proactiva para recapitalizar los bancos saneables y cerrar los ineficientes; el de la Responsabilidad (Accountability) exigida a todos los actores, sustituyendo rápidamente a los incompetentes y persiguiendo a los delincuentes, y, finalmente, el de máxima Claridad y transparencia informativa en la medición de la intensidad de la asistencia proporcionada a los bancos y en los criterios de utilización de los fondos públicos. Porque el problema fundamental no resuelto, constatado también en el Informe Warren, consiste en determinar si la situación actual de los mercados refleja el verdadero valor de los activos o es resultado de la depresión artificial derivada de la espiral de desapalancamiento y deflación de deuda. El Tesoro apuesta de forma absoluta por la primera opción (que es la única manera de hacer estas cosas, como reza el argumento nº 2 (“vamos a forrarnos”) de Brad DeLong, pero, obviamente, puede equivocarse. Para resolver el rompecabezas, el Panel contrasta los dos indicadores estratégicos aducidos por el Tesoro en orden a avalar la contribución positiva del TARP al restablecimiento paulatino del sistema y el flujo de crédito (el repliegue de los diferenciales de tipos de interés en el préstamo interbancario y del diferencial LIBOR/OIS) con otras series de indicadores. Esta comparación arroja los siguientes resultados:

Tres indicadores de crédito muestran tendencia hacia un cierto repunte de las dificultades que ya se daban por superadas: los diferenciales de los CDS, aunque más reducidos que en octubre, resultan muy volátiles; eso mismo ocurre con el diferencial TED, del LIBOR respecto a la rentabilidad de los bonos del Tesoro, y, además, el diferencial LIBOR/OIS repuntó a comienzos de 2009.

36 Once indicadores siguen siendo negativos: los desahucios; los diferenciales de bonos corporativos; los precios de la vivienda y los inicios de promoción inmobiliaria; los saldos de papel comercial a descuento; los pactos de recompra en el mercado de valores; el crecimiento de la deuda de empresas y familias; los indicadores generales de crédito (nuevas concesiones y balance total), y los indicadores hipotecarios (diferenciales de tipos y nuevas concesiones).

Tres indicadores resultan indeterminados: los diferenciales interbancarios del papel comercial; el endeudamiento a través de las tarjetas de crédito, y la percepción de los directores sobre las prácticas bancarias (tanto en lo que se refiere a endurecimiento de las condiciones crediticias como en la demanda de crédito).

En síntesis, el Panel establece que, aunque la crisis sistémica parece haberse evitado, la crisis financiera subyacente no ha desaparecido sino que parece más bien haberse enraizado en la economía. El problema principal del PPIP consiste en que el Tesoro no ha hecho explícitos los indicadores que piensa utilizar para monitorizar los resultados del programa, lo que dificulta la evaluación futura de los mismos e impide pronunciarse acerca de si se han examinado las diferentes alternativas para alcanzar tales resultados: liquidación (mediante venta o desmembramiento), reestructuración, o subvenciones a los bancos que atraviesan dificultades. La evaluación de estas alternativas depende:

a) De la “dirección del viento” del ciclo: si éste se dirige hacia la salida de la crisis, una mayor inversión destinada al mantenimiento de la actividad puede ser rentable, mientras que si se trata de una depresión en L, la liquidación rápida serviría para minimizar pérdidas. b) De las clases a proteger mediante la acción pública (depositantes, inversores, accionistas) y de las estrategias

37 de salida del programa, que determinan el riesgo contraído en nombre del contribuyente. c) De la capacidad de intervención y la experiencia de gestión disponible por parte de la administración: con recursos propios, o contratando recursos humanos, en un mercado saturado de personal redundante. d) Del impacto que pueda tener el programa sobre la competitividad futura de las instituciones, que es máximo en el caso de la subsidiación (al adulterar la competencia con los bancos que han tenido un comportamiento prudente), e incurre en efectos moral hazard, consolidando la idea de que el tamaño es lo que importa (porque el banco “es demasiado grande para quebrar”). Estas distorsiones solo podrían paliarse o evitarse elevando los requisitos de funcionamiento futuro mediante una regulación más estricta. e) Del impacto de la medida sobre los inversores y los mercados de capitales. Algunos de ellos se confunden con el público en general, como los fondos de pensiones o los Ayuntamientos, lo que aumenta el coste social de la alternativa de liquidación. Bien es verdad que estos problemas sociales pueden paliarse directamente, sin necesidad de mantener estructuras bancarias ineficientes, que arrastran un “peso muerto” muy superior. Sin embargo, la propiedad de las acciones y ciertas formas de inversión, como los bonos basura (junk bonds), son con mayor frecuencia la forma de riqueza preferida por las familias ricas, que pueden soportar mejor el impacto de la quiebra. Ciertamente, ésta ahuyentaría por un tiempo a los inversores futuros, mientras que la alternativa de reestructuración a través de la FDIC es más propensa a atraer dinero fresco (pero la experiencia de la intervención del banco Continental Illinois, en 1984, indica que su permanencia puede ser duradera y costosa). f) Finalmente, como ya se dijo, la evaluación de cada medida depende profundamente de la transparencia en la

38 formación del precio de los activos y en la fiabilidad de la información disponible sobre la solvencia de los bancos.

Hasta aquí la síntesis del dictamen mayoritario del Panel del congreso. Uno de los votos en contra —el del senador Senunu— rechazó el texto precisamente por centrarse, más que en la evaluación de lo ya actuado —de acuerdo con el mandato del propio Congreso —, en la búsqueda de alternativas al PPIP mediante la comparación del TARP con experiencias pasadas, tanto en Norteamérica (como el pánico del banco Continental Illinois, o la crisis de las cajas de ahorro, a comienzos de los años ochenta), como en otros países (especialmente, Suecia y Japón durante los años noventa). La síntesis de esta comparación figura en el cuadro 5. Lo que sucede, según Senunu, es que, al referirse todas estas experiencias a crisis aisladas (de instituciones o de países), no resultan comparables con la situación actual en la que nos enfrentamos al colapso generalizado de los mercados de activos y del sistema bancario y financiero mundiales, dentro de un contexto de recesión generalizada a escala global. El Senador disidente critica que el Panel no haya evaluado los resultados del TARP en materia de restablecimiento de la actividad crediticia de las entidades beneficiarias del programa de capitalización de bancos (CPP), ni las causas de la interrupción temprana del mismo; ni la experiencia disponible derivada de las subastas de compra de activos del programa TALF87 (que podrían servir ahora como aprendizaje para las que debe realizar el PPIP), o los efectos de las medidas contra la remuneración de los ejecutivos bancarios sobre la participación de los bancos en el CAP, el TARP y, previsiblemente, también en el PPIP88. Además, el voto particular, firmado conjuntamente por Senunu y el superintendente de los bancos de Nueva York, R. H. Neiman, critica la escasa relevancia que concede el Panel al hecho de que los precios actuales de todos los activos se encuentren profundamente afectados por el factor de liquidación, como si ésta fuera una cuestión meramente opinable y no la causa fundamental de la profundidad de esta crisis y del riesgo de

39 convertirse en una larga depresión. Un factor que se vería multiplicado por la eventual iniciativa generalizada de nacionalización, que conllevaría el consiguiente deterioro de valor de todos los activos (dañados o saludables) de las entidades afectadas. En opinión de los disidentes, la principal prioridad actual consiste en restablecer la estabilidad financiera y el flujo de crédito, para lo cual es imperioso descongelar el mercado secundario de activos de titulización, derivados del mismo (hacia los que se dirige el programa TALF). En cambio, el Panel no analiza ni hace la menor sugerencia sobre los problemas de operatividad práctica del PPIP, como los límites a poner en el número, las características y los criterios de elegibilidad de las entidades gestoras participantes (para evitar que los vendedores de activos se posicionen a los dos lados del mostrador, falseando el proceso de determinación de precios), así como los problemas concretos derivados de los criterios aplicados para la medición y la calidad de la metodología de evaluación de la salud del sistema de crédito. En suma, el voto particular concluye señalando que el Panel se posiciona a priori en la falsa tesis de que restablecer la prosperidad es un objetivo de suma cero y que lo que gane una parte de la sociedad debe ser desembolsado por la otra parte, sin dar cabida a la hipótesis alternativa, en que la salida de la crisis y el rápido restablecimiento del crédito y los mercados pueden arrojar suma positiva y resultar beneficiosas para todos, evitando o limitando el daño experimentado por el conjunto de la sociedad. Además, conviene tener presente que —aun suponiendo que no todo fuera suma positiva, y que una parte del coste de las medidas debiera ser sufragada por el contribuyente a fondo perdido — la asimetría entre el universo de beneficiarios de las medidas (y especialmente de la eventual protección derivada del rescate de los bancos por los inversores no asegurados) y los contribuyentes convendría analizarla con detenimiento, ya que, aunque esta forma de riqueza es más propia de la gente rica —como dice el informe Warren — no se debe olvidar que el 25% de la población con mayor nivel de renta paga actualmente casi el 87% de los

40 impuestos sobre la renta de familias y empresas (gráfico XXVII89): Gráfico XXVII.A Gráfico XXVII.B

Fuente: Tomado de Stephen Moore, “Guess Who Really Pays the Taxes”, disponible en: http://www.american.com/archive/2007/november-december-magazine-contents/guess-who- really-pays-the-taxes La lectura del informe da pie a admitir que a los votos disidentes no les falta cierta razón, y que en la disyuntiva entre apostar por maximizar las probabilidades de estabilización y ulterior recuperación o por minimizar los riesgos derivados de una eventual crisis en forma de L —con depresión de larga duración, de estilo japonés —, el Panel opta por la segunda. Es bien conocido que en el tipo de problemas que plantean los modelos de toma de decisiones bajo condiciones de incertidumbre —o en la programación lineal — no es posible optimizar los dos objetivos al mismo tiempo. Al igual que sucede en la decisión estadística acerca de si una muestra es una selección aleatoria de una población, podemos incurrir en dos tipos de errores: el de tipo I, cuando rechazamos la hipótesis nula, siendo verdadera, y el de tipo II, cuando la aceptamos, siendo falsa. Al primer tipo de error se le denomina “falso positivo” o “exceso de credulidad”, y al segundo, “falso negativo” o “exceso de escepticismo”. En general, salvo que podamos ampliar la información disponible para mejorar el grado de certeza (como trata de hacer Roubini), no es posible disminuir la probabilidad de un tipo de error sin aumentar la del error de signo contrario, de modo que, bajo determinadas condiciones, las decisiones adoptadas tratando de evitar el exceso de credulidad —y de optimismo — conducen también a aumentar la probabilidad de resultados negativos, de

41 modo que quienes son proclives a ponerse en lo peor provocan a veces el resultado más pesimista, y viceversa. 90 El problema se plantea con especial agudeza en los procesos de decisión acerca del hecho causante de las quiebras. Michel White explica de esta forma la existencia de dos procedimientos alternativos para afrontar las crisis de empresas:

“Existe una razón de eficiencia para la existencia de dos procedimientos de bancarrota: el procedimiento de liquidación, para las empresas que son económicamente ineficientes y no son viables desde la perspectiva financiera, y el procedimiento de reestructuración, para la empresa que son económicamente eficientes pero atraviesan por dificultades financieras. Sin embargo, mientras que las dificultades financieras son fácilmente observables, la eficiencia económica depende de aspectos inobservables, como los ingresos que pueden obtenerse de un mejor uso alternativo de los activos. A la hora de abordar la resolución de las crisis de empresas que atraviesan por dificultades financieras, el tipo I de error ocurre cuando se liquidan empresas que son económicamente eficientes y el tipo II cuando se salvan empresas económicamente ineficientes. El coste del error de tipo I es la pérdida de capital humano específico de la empresa y la elevación de los costes de transacción (puesto que probablemente estas empresas volverán a funcionar), mientras que el coste del error de tipo II consiste en emplear los activos de forma ineficiente y atrasada. El error de filtración ocurre cuando el procedimiento de quiebra produce uno u otro tipo de error. Los países utilizan diferentes medios para dirigir a las empresas con problemas financieros hacia los procedimientos de liquidación o reorganización, como consecuencia de lo cual incurren en diferentes niveles de error de tipo I y de tipo II”91

Los países que priman la opción liquidacionista corren el riesgo de incurrir en infrainversión para evitar el error de tipo II, con el resultado de una pérdida de eficacia económica y competitividad.

42 Los que priman la opción conservacionista, por miedo a soportar liquidaciones prematuras, están abocados a incurrir en una sobreinversión innecesaria, no justificada por los resultados económicos ulteriores. Y, si esto es así en todos los ámbitos empresariales, los riesgos de uno u otro tipo de error resultan especialmente graves en el caso de crisis bancarias, debido al efecto multiplicador del sistema de crédito, ya que la posición extrema adoptada por Willem Buiter —negando de forma absoluta la existencia de economías de escala y de alcance en el sector bancario, y minimizando la evaluación del riesgo de error de tipo I — no se corresponde con la experiencia económica moderna, sino tan solo con la del tipo de banca desregulada, inserta en el sistema financiero anglosajón, que emergió a mediados de los años setenta del siglo pasado y ha arrastrado a las finanzas globales. Pero nada obliga a continuar con este modelo, que ha quedado amortizado ya a lo largo de la crisis. Sin embargo, en la Norteamérica actual —y en el debate económico global — parecen haber desaparecido los matices. Unos optan por el pesimismo absoluto, o criterio maximin, que trata de minimizar los riesgos en caso de fracaso, aun a costa de minimizar las probabilidades de éxito. Frente a ello, los defensores del programa Geithner se posicionan en el polo opuesto: el del optimismo absoluto, o criterio maximax, apostando todo a una sola carta, evitando tomar precauciones por miedo a que constituyen obstáculos, lo que obliga al sector público a asumir todos los riesgos. La opción del senador Sununu —como la de Nouriel Roubini, basada en una simulación del valor sostenible de los activos — parecen apuntar más bien hacia una opción que en los modelos de incertidumbre se conoce como regla minimax (o regret matrix, de L. J. Savage), que implica evaluar el “coste condicional de oportunidad” de cada alternativa, o sea la diferencia entre el resultado de aplicarla si no se cumple la hipótesis por la que se apuesta y el que se hubiera podido conseguir en caso de haber elegido la hipótesis alternativa. Desgraciadamente este tipo de análisis no se encuentra disponible ni parece que vaya a haber tiempo para realizarla, por lo que la

43 apuesta parece echada en los términos definidos por Brad DeLong. Conclusion La resolución de la crisis bancaria se presenta como la condición sine qua non para la salida de la crisis: una condicion necesaria, aunque no suficiente, porque hará falta también una política monetaria global de verdadera emergencia. Aunque muchos indicadores parecen señalar que la segunda derivada de la curva mundial de crecimiento puede estar pasando a la zona positiva (esto es, que la pendiente de la caída se está desacelerando), nadie espera que la recuperación sea vigorosa porque, en palabras del FMI, las crisis internacionalmente sincronizadas, acompañadas de crisis financieras, suelen ser más duraderas y su salida menos brillante que la de otros tipos de crisis. En el BCE parece que empieza a abrirse paso la idea de que, en lugar de una crisis en V, la forma de esta crisis será la de una J “mirada a través de un espejo”, también en Europa (lejos ya de la idea de una Europa “desacoplada” con respecto a EEUU). La asociación de ambas ideas permite pensar en una actuación más “coordinada” (aunque solo sea “por simpatía”) a ambos lados del Atlántico. Saneamiento de los balances de los bancos y relajación cuantitativa de la política monetaria serán los dos leit motivs de las políticas económicas globales al final de esta primavera. El miedo a la recesión profunda y duradera —a la japonesa — empieza a surtir efecto, incluso en Alemania (que acaba de iniciar su campaña electoral). La descalificación sin paliativos con que se acogió el Plan Geithner en los medios de la intelligentsia radical está dando paso a una consideración más cautelosa. La heroicidad de Brad DeLong — que dio la bienvenida al plan desde el primer día, aunque para acercarse a él hubiera que taparse la nariz (por no repetir la frase casi obscena dirigida a los bancos) — ya no se considera tan excepcional. Sigue pensándose que el plan es temerario e imprudente y que se presta al fraude, pero la atención se dirige ahora, no hacia el fondo de la cuestión, sino hacia las medidas (alternativas o complementarias) que minimicen el riesgo para el

44 contribuyente, aunque asumiendo que el consumo de fondos públicos resultará inevitable. La alternativa del banco bueno, planteada por Jeremy Bulow y Paul Klemperer (asumida como propia por Buiter y recomendada por DeLong y Krugman) se considera hoy como la alternativa óptima, pero requiere la conversión obligatoria de deuda en acciones preferentes y nadie piensa que el Senado vaya a aceptar eso —por el momento —. Sin embargo, en Alemania ya se piensa en cambiar los activos tóxicos de los bancos por deuda pública especial, a largo plazo y no negociable en el mercado secundario (o, alternativamente, la creación de un banco malo). En la medida que esta discusión avance, la cuestión central acabará siendo cómo valorar adecuadamente los activos tóxicos y qué condiciones poner a la aportación de fondos públicos para recapitalizar la banca después de contabilizar las pérdidas, y una vez reestructurada. Bien es verdad que los criterios más tolerantes de contabilidad de la FASB vienen a mejorar aproximadamente en un 20% el desequilibrio de los balances. La idea que se va imponiendo viene a ser: aunque a nadie le guste ni resulte equitativo, hay que hacerse a la idea de sanear los bancos con dinero público. Si es posible, los deudores no garantizados —y, en primer lugar, los accionistas — deben sacrificarse en primer lugar, aunque sin causar pánico ni ahuyentar a los inversores. Porque si el intento del Secretario del Tesoro no funcionase, el ingente consumo de recursos empleados en el mismo dejaría muy malparado el crédito público (financiero, y político) para acometer una iniciativa de última instancia. Bien es verdad que, llegados a ese extremo, no parece probable que el Senado siguiera oponiéndose a una reestructuración bancaria en profundidad (con visos de nacionalización). El giro espectacular dado el lunes 20 de abril por el Tesoro, al filtrar al NYT la posibilidad de convertir los créditos ya otorgados a los bancos en acciones comunes, significa un vuelco en la actitud mostrada hasta ahora, hasta el punto de que, si saliese adelante, resolvería al mismo tiempo el problema del veto del Congreso a la nacionalización y el del bloqueo de nuevos fondos para los bancos. Bien es verdad que ello se haría a costa de aumentar el riesgo para

45 el contribuyente, ya que si no se diferencian las dos clases de acciones, el Tesoro correría el mismo riesgo que el de los accionistas ordinarios, muy elevado en cualquier caso.92 La contrapartida es que el contribuyente se beneficiría de la eventual recuperación de las cotizaciones bancarias tras la crisis, reforzando la idea de que lo que es bueno para la banca es bueno para EEUU. Ahora bien, lo fundamental consiste en restablecer pronto un sistema de crédito sano, aunque de menor dimensión que el de antes de la crisis, haciendo las cosas lo mejor posible. Esto implica limar las asperezas que permitieron calificar al plan Geithner de “saqueo descarado del dinero de los contribuyentes” y de “latrocinio a la rusa”, con socialización de pérdidas y privatización de ganancias, debido al problema de selección adversa, que llevará a los bancos a desprenderse exclusivamente de los activos más dañados, con escaso valor en el mercado (Stiglitz).93 Tanto para Krugman94 como para Martin Wolf, por mucha que sea la urgencia, es imprescindible preservar la credibilidad política, ya que sin ella no volverá la confianza. En cambio, incluso si el plan tiene éxito y recompone el sistema bancario, surgirán inevitablemente problemas de moral hazar para el futuro, a los que solo se podrá hacer frente con una regulación y una supervisión tan estrictas o más que las derivadas del New Deal (lo que resulta fácilmente predecible, dado el clima que prevalece en el Congreso, a la luz del Informe Warren). Evitar ese riesgo futuro resulta imprescindible para que la selección adversa inducida por los rescates generalizados no tenga un efecto antievolucionista general a largo plazo para la selección eficiente de los agentes económicos por el mercado.

46

Cuadro 5.-

Fuente: Assessing Treasury’s Strategy: Six Months of TARP (Fig 3, p. 59), disponible en: http://cop.senate.gov/reports/library/report-040709-cop.cfm

47

Gráfico XIX Gráfico XX España: POSICIÓN DE INVERSIÓN España: POSICIÓN DE INVERSIÓN INTERNACIONAL NETA INTERNACIONAL NETA POR SECTORES POR INSTRUMENTOS

Fuente: BDE (2007), gráfico 4.1 Fuente: BDE (2007), gráfico 4.4

Gráfico XXI Gráfico XXII INVERSIÓN NETA EN CARTERA: OTROS INVERSIÓN NETA EN CARTERA POR SECTORES RESIDENTES INSTRUMENTOS (% pib) (millones de euros)

Fuente: BICE nº 2920, gráfico 12

IfnM: Instituciones financieras no monetarias SnF: Sociedades no financieras Fuente: BICE nº 2920, gráfico 6 HISFL; Hogares e inst. sin fines de luclo

48 Gráfico XXIII

Fuente: http://www.bis.org/publ/qtrpdf/r_qt0903f.pdf?noframes=1

49 Gráfico XXIV

Fuente: http://www.bis.org/publ/qtrpdf/r_qt0903f.pdf?noframes=1

50 Gráfico XXV

Fuente: http://www.bis.org/publ/qtrpdf/r_qt0903f.pdf?noframes=1

51 Notas finales

1 En su versión más popular, la americana Where's Waldo?: http://en.wikipedia.org/wiki/Where's_Waldo%3F. El artículo de Groos se titulaba: “Por qué necesitamos salvar la vivienda”: http://www.washingtonpost.com/wp- dyn/content/article/2007/08/23/AR2007082301834.html 2 Mr. Deeps es acusado de loco e incapaz por emplear veinte millones de dólares heredados impremeditadamente en facilitar la recuperación de la propiedad de sus granjas a un buen número de granjeros desahuciados durante la depresión. Véase Frank Capra (director) y Robert Riskin (guionista), Mr Deeds goes to Town, protagonizada por Gary Cooper y Jean Arthur, Columbia Pictures, 1936. 3 Aunque la ambivalencia del término proporciona la pista del porqué de esta elección de nombre, ya que hedge significa también rodeo (para evadir algo), escondrijo, etc. Y en realidad, enseguida serían utilizados para evadir la regulación en orden a obtener “elevados rendimientos”, que es la otra acepción de los hedge funds. 4 Que utilizó sus declaraciones públicas como el mejor aval para vender esquemas piramidales de financiación en todos los ámbitos. En el caso de los pequeños ayuntamientos el colapso ulterior del mercado ha tenido efectos devastadores. Véase Don Van Natta Jr., “Firm Acted as Tutor in Selling Towns Risky Deals”, NYT, 8, abril, 2009, disponible en: http://www.nytimes.com/2009/04/08/us/08bond.html?th&emc=th 5 Alan Greenspan, “We need a better cushion against risk”, Financial Times, 27/III/2009, disponible en: http://www.ft.com/cms/s/0/9b108250-1a6e-11de-9f91-0000779fd2ac.html 6 Para Noland, Greenspan es un “maestro consumado en ofuscar las facetas clave de algunos de los análisis más críticos de nuestro tiempo.” Véase su “Revisiting the Global Savings Glut Thesis”, 27/III/2009, disponible en: http://www.safehaven.com/article-12948.htm 7 De hecho, la capacidad de engañar al cliente ha sido una de las notas distintivas para los profesionales más reputados en Wall Street. Véase Steven Pearlstein, “Not Quite a Confession, But a Good Start”, WP, 8/IV/2009: http://www.washingtonpost.com/wp-dyn/content/article/2009/04/07/AR2009040703675.html?wpisrc=newsletter 8 “Once a bubble emerges out of an exceptionally positive economic environment, an inbred propensity of human nature fosters speculative fever that builds on itself, seeking new unexplored, leveraged areas of profit”, FT, 27/III/2009, artículo citado. 9 Para el caso de la ordenación jurídica española, véase el artículo de Roberto García González, “La Responsabilidad civil y penal de los administradores sociales”, Noticias Jurídicas, febrero de 2008, disponible en: http://noticias.juridicas.com/articulos/50-Derecho%20Mercantil/200802-25897463154623.html 10 Véase mi: “Finanzas, deuda pública y confianza en el gobierno de España bajo los Austrias”, en: http://biblioteca.minhac.es/CIC/BASIS/tlpesp/www/cat2/DDW?W%3DAUTH%3D%27Espina%2C+%C1lvaro %27%26M%3D37%26K%3D48077%26R%3DN%26U%3D1. Las citas están tomadas de Jesús Huerta de Soto, Dinero, Crédito Bancario y Ciclos Económicos), Unión Editorial, Madrid, 1998. 11 Véase “Obama’s Ersatz Capitalism”, 31/marzo/2009, disponible en: http://www.nytimes.com/2009/04/01/opinion/01stiglitz.html?_r=1&th&emc=th 12 El comentario (16) a la entrada del Blog (6/IV) dice: “There’s a fascinating little article from 1897 (!) explains exactly that: http://optionarmageddon.ml-implode.com/2009/03/11/panics-and-booms-1897/ — G. Nolin 13 Véase Frederic S. Mishkin, Housing and the Monetary Transmission Mechanism, NBER Working Paper Nº 13518, Octubre, 2007. Especialmente, Parte II: “Financial Stability and the Monetary Transmission Mechanism”, pp. 23-29, disponible en: http://www.nber.org/papers/w13518 14 e Definido como: uc = ph [(1-t) i – π h + δ], siendo ph el coste relativo de adquisición de la vivienda nueva (que incluye tanto coste del suelo como construcción), i el tipo de interés hipotecario, t el tipo impositivo marginal, e πh la tasa esperada de apreciación de la vivienda, y δ la tasa de depreciación. Ibid., p. 5. 15 Véase su trabajo clásico: “Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression”, NBER WP nº 1054, enero 1983, http://www.nber.org/papers/w1054.pdf?new_window=1 16 Véase Ben Bernanke, Mark Gertler y Simon Gilchrist, “The Financial Accelerator and the Flight to Quality”, Review of Economics & Statistics, vol. 78, nº 1, (febrero1996), junto a otros papeles presentados al simposio Economic Fluctuations research meeting de la NBER el 22 y 23 de octubre de 1993. Versión WP, del año 1994, disponible en: http://www.nber.org/papers/w4789.pdf?new_window=1

52

17 Véase Case, Karl E., Shiller, Robert J. and Quigley, John M., “Comparing Wealth Effects: The Stock Market Versus the Housing Market”, NBER Working Paper No. W8606, Noviembre 2001, disponible en: http://www.nber.org/papers/w8606.pdf?new_window=1. En el citado estudio de Mishkin se toma la versión final de este trabajo, publicada en 2005, con ligeros retoques que no cambian las conclusiones: Advances in Macroeconomics: Vol. 5, nº 1, en: http://www.bepress.com/bejm/advances/vol5/iss1/art1 18 Donde: P son los precios, W es la riqueza; eb es el efecto balances; S es el ahorro; CF es el cash flow; Bl es el crédito bancario; I es la inversión; C es el consumo, e Y es el PIB. 19 Véase Frederic S. Mishkin, Housing and the Monetary Transmission Mechanism, citado, pp. 11-20. 20 Véase Ben Bernanke y Mark. Gertler, “Should Central Banks Respond to Movements in Asset Prices?”, American Economic Review, Vol. 91, nº 2, Mayo 2001, pp. 253-257, disponible en: http://www.nyu.edu/econ/user/gertlerm/assets.pdf , 21 Algo que The Economist ya había señalado en mayo de 1998 ( “Price Bubble creation debate”), haciéndose eco del índice de J. Carson para el Deutsche Morgan Grenfell de Nueva York. 22 Véase Cecchetti, Stephen, Hans Genberg, John Lipsky, y Sushil Wadhwani (2000). Asset Prices and Central Bank Policy. Geneva Report on the World Economy 2. CEPR e ICMB. Una síntesis y una actualización de sus principales argumentos fue presentada por Hans Genberg en Frankfort el 5 de septiembre de 2008. Puede verse en: http://www.info.gov.hk/hkma/eng/speeches/speechs/hans/20080905e1.htm 23 En “Bubble trouble”, The Economist 16/V/2002: http://profesores.utdt.edu/~fsturzen/Bubble%20trouble.pdf 24 Véase Cecchetti, Stephen, Hans Genberg y Sushil Wadhwani, “Asset Prices in a Flexible Inflation Targeting Framework”, presentado en la conferencia “Asset Price Bubbles: Implications for Monetary, Regulatory, and International Policies”, organizado conjuntamente por el FRB de Chicago y el Banco Mundial, Chicago, Abril 22-24, 2002: http://people.brandeis.edu/~cecchett/pdf/cecchetti%20genberg%20wadhwani%202002.pdf 25 Aunque parece que no era una chapuza inocente, sino una estimación amañada para responder a las presiones financieras de Wall Street y a las presiones políticas, ya que, en palabras de Allan H. Meltzer (el principal discípulo de Karl Brunner) “el Congreso y la administración necesitan mostrar ‘preocupación’ haciendo algo en un año electoral, aunque esas no deberían ser preocupaciones susceptibles de influenciar a un banco central independiente”. Véase “That '70s Show, The Wall Street Journal, 28 febrero, 2008, p. A 16, disponible en: http://online.wsj.com/article/SB120416213296398435.html?mod=opinion_main_commentaries. Stephen S. Roach, pensaba que la política monetaria precipitada conduciría a retrasar el inevitable ajuste de las burbujas: “Double Bubble Trouble”, NYT, 5, marzo 2008: http://www.nytimes.com/2008/03/05/opinion/05roach.html 26 Véase “How Much Will U.S. Housing Prices Fall And How Long Will The Downturn Last?”, 1-abril-2009, en: http://www.rgemonitor.com/80/Housing_Bubble_and_Bust?cluster_id=6077 27 Véase “U.S. home prices drop at record pace in December: S&P”, 24/II/2009, http://www.reuters.com/article/businessNews/idUSTRE51N2VV20090224 28 Véase “U.S. home prices fell 3.5 pct in January: IAS”, 10/III/2009: http://www.reuters.com/article/GCA- Housing/idUSTRE5230YD20090310 29 Véase “Americans fear home price drop accelerating”, 20/III/2009: http://www.reuters.com/article/domesticNews/idUSTRE52J3GA20090320 30 Véase: http://www.calculatedriskblog.com/2009/03/new-home-sales-is-this-bottom.html , y http://www.calculatedriskblog.com/2009/03/march-economic-summary-in-graphs.html 31 Véase Frederic S. Mishkin, Housing and the Monetary Transmission Mechanism, citado, pp. 19. 32 Véase William H. Groos “It's the Housing Market Deflation”, WP, 31 enero 2008, disponible en: http://www.washingtonpost.com/wp-dyn/content/article/2008/01/30/AR2008013003211_pf.html 33 Véase “Long-term mortgage rates at record low”, UPI, 2 de abril de 2009, disponible en: http://www.upi.com/Business_News/2009/04/02/Long-term_mortgage_rates_at_record_low/UPI- 21821238692861/ 34 Tomado de: http://www.calculatedriskblog.com/2009/04/housing-starts-near-record-low.html 35 Véase Edward Wyatt, “Managing the Bailout: He’d Do It for Nothing”, disponible en: http://www.nytimes.com/2008/09/25/business/economy/25pimco.html

53

36 Creada en 1989 para resolver la crisis de las Cajas de ahorro. Entre 1989 y 1995 la RTC cerró o reestructuró 747 instituciones, con 394.000 millones de activos: http://en.wikipedia.org/wiki/Resolution_Trust_Corporation 37 Véase William H. Gross, “How Main Street Will Profit”, WP, 24, Septiembre, 2008; A23, disponible enn http://www.washingtonpost.com/wp-dyn/content/article/2008/09/23/AR2008092302322.html 38 En su Global Central Bank Focus de April 2009 Paul McCulley describe plásticamente la situación: Los hedge funds estan jugando al solitario con 51 cartas y la fed tiene la carta 52. Disponible en: http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2009/Global+Central+Bank+Focus+April+ 2009+Money+Marketeers+Solitaire+McCulley.htm 39 Véase Vikas Bajaj, “F.B.I. Opens Subprime Inquiry”, NYT, 30/I/2008, disponible en: http://www.nytimes.com/2008/01/30/business/30fbi.html 40 Véase Carrie Johnson, “A Labyrinthine Path to Justice. FBI, SEC Join Complex Probe of Housing Crisis”, WP, 14/II/2008 http://www.washingtonpost.com/wp-dyn/content/story/2008/02/13/ST2008021303869.html 41 Si bien la opinión y la evidencia acumulada estaban cambiando rápidamente. Véase: “The fund-management industry has done very well—but mainly for itself, says Philip Coggan”, The Economist, 28, febrero, 2008, en: http://www2.gsu.edu/~fncitt/files/Economist%20Fund%20Management.pdf 42 Véase “U.S. Credit Card Delinquencies At Record Highs: Same Dynamics As Mortgages?” RGE, 1/Abr/2009 http://www.rgemonitor.com/index.php?kwd=Search+Articles%2C+Blogs%2C+Archives+and+more...&option= com_search&task=search La Estimación del 38% es de Citigroup. Meredith Whitney considera que a la altura de 2010 las quitas totales superarán los 2,7 billones de dólares. Véase “Credit Card Crunch: Creating a New Generation of Subprime”, en http://seekingalpha.com/article/127937-credit-card-crunch-creating-a-new- generation-of-subprime. 43 Véase “Commercial Real Estate Bust Has Started: Access to TALF Just In Time?”, RGE Monitor 26/Marzo/2009, disponible en: http://www.rgemonitor.com/687 44 Véase “España tiene sus propios activos tóxicos. Entrevista: Dominique Strauss-Kahn Director gerente del Fondo Monetario Internacional”, El País, 01/04/2009, disponible en: http://www.elpais.com/articulo/economia/Espana/tiene/propios/activos/toxicos/elpepieco/20090401elpepieco_9/ Tes 45 Si prospera la creación del “fondo de reestructuración y organización de mercados” (de 30.000 millones) del que habla la noticia de la cadena Cuatro: El “Banco de España diseña un plan de rescate de cajas de ahorro afectadas por la crisis”, disponible en: http://www.cuatro.com/noticias/noticias/banco-espana-disena-plan- rescate-cajas-ahorro-afectadas-crisis/20090415ctoultpro_23/ 46 La publicidad inmobiliaria de estos días sigue esa línea para viviendas de primera residencia: en los alredeores de Madrid, por ejemplo, Pryconsa anuncia en la prensa gratuita cinco promociones con ofertas que suponen un descuento medio del 22% (QUÉ, 16, abril, 2009, p. 15). 47 Véase B. Muñoz, “Síntomas de recuperación”, Suplemento Su vivienda, El Mundo, nº 581, 10-abril, 2009 48 Para la segunda residencia la reducción de precios oscila ya entre el 20% y el 30%, dependiendo de los stocks sin vender (que es el máximo que pueden reducir las promotoras, para no quedar por debajo del crédito concedido por la banca). Pero CB Richard Ellis subasta online lotes de inmuebles con precios de salida que suponen descuentos de hasta el 38% respecto a su máximo, situado en el verano de 2007 (QUÉ, 16, abril, 2009, p. 13). El acuerdo entre Metrovacesa y Buyvip para venta de pisos por internet fija descuentos en torno al 30%: http://loogic.com/buyvip-vendera-por-internet-pisos-de-metrovacesa/ (9 Marzo 2009). 49 Una síntesis rápida puede verse en “Why You Should Hate the Treasury Bailout Proposal”, 21 de Septiembre de 2008, en: http://www.nakedcapitalism.com/2008/09/why-you-should-hate-treasury-bailout.html. Véase especialmente Luigi Zingales, “Why Paulson is wrong”, 21 de Septiembre de 2008, disponible en. http://www.voxeu.org/index.php?q=node/1670. El 24 de septiembre lo más granado de la profesión se dirigió al Congreso pidiendo el rechazo del plan por injusto, por ambiguo y por sus efectos económicos a largo plazo: http://faculty.chicagobooth.edu/luigi.zingales/research/papers/mortgage_protest.pdf 50 Krugman reaccionó al plan con una entrada de su blog en la que partía de una evaluación de los activos inmobiliarios estrictamente aleatoria (“lo mismo pueden valer 150 que 50, luego su valor esperado es 100”). La conclusión es que el PPIP es sustancialmente idéntico al plan de Paulson y encubre un subsidio del 30%. Véase: “Geithner plan arithmetic” (23/III/2009) http://krugman.blogs.nytimes.com/2009/03/23/geithner-plan-arithmetic/ Sin embargo, esta vez las posiciones intelectuales fueron mucho más matizadas y surgieron desencuentros

54 notables: véase la encuesta de urgencia realizada por los editores de NYT (24/III/2009): “Will the Geithner Plan Work?”, en la que sintetizan sus posiciones el propio Krugman, Simon Johnson, Brad DeLong, y Mark Thoma, en: http://roomfordebate.blogs.nytimes.com/2009/03/24/will-the-geithner-plan-work/. Probablemente la posición más contundente haya sido la de Joseph E. Stiglitz, en “Obama’s Ersatz Capitalism”, NYT, 1 abril, 2009: http://www.nytimes.com/2009/04/01/opinion/01stiglitz.html?_r=1&th&emc=th. Adam S. Posen critica el PPIP con base en su parecido con el que se aplicó en Japón entre 1995 y 1998, que fracasó precisamente porque la participación de los bancos era voluntaria. Solo cuando el ministro Heizo Takenaka obligó en 2002 a los bancos a provisionar los activos dañados antes de recapitalizarlos, el nuevo plan funcionó. Véase “Does Obama Have a Plan B?” (29/III/200), en: http://www.petersoninstitute.org/publications/opeds/oped.cfm?ResearchID=1170. En cambio, la entrada “Reading Krugman” (31/III/2009), del Blog The Incidental Economist, hace una revisión de todas estas posiciones , y aun siendo opuesta y profundamente crítica de la suya, el propio Krugman la considera equilibrada (véase la entrada “’The banks’ versus ‘some banks’”, en el blog de Krugman de 2 de abril). Para una narración del enfrentamiento entre Krugman y la administración Obama, véanse “Obama’s Nobel Headache” (Newsweek , 6/IV/2009), y Ryan Lizza , “The Gatekeeper. Rahm Emanuel on the job”, The New Yorker. Letter from Washington, 2/III/2009, disponible en: http://www.newyorker.com/reporting/2009/03/02/090302fa_fact_lizza?currentPage=all 51 Véase “The new Geithner plan is a flop”, New York Daily News, 25 Marzo, 2009, disponible en: http://faculty.chicagobooth.edu/luigi.zingales/research/papers/geithner_plan_flop.pdf 52 Véase Paul de Grauwe, “ Keynes' savings paradox, Fisher's debt deflation and the banking crisis”, http://www.eurointelligence.com/article.581+M5a44f3fb3ec.0.html 53 Véase “Total $3.6 Trillion Projected Loan and Securities Losses in the U.S., $1.8 Trillion of Which Borne by U.S. Banks/Brokers: Specter of Technical Insolvency for the Banking System Calls for Comprehensive Solution”, RGE Monitor, I/2009, http://media.rgemonitor.com/papers/0/RGECreditLossesEPCNRJan09.pdf 54 Que debería significar la vuelta a un sistema de crédito estructurado en torno a una red de bancos de tipo clásico, al menudeo, apegado a la realidad circundante y en estrecho contacto con la clientela: véase Bhidé, Amar (febrero 2009) "In Praise of More Primitive Finance," The Economists' Voice: Vol. 6 : Iss. 3, Article 8. DOI: 10.2202/1553-3832.1534, disponible en: http://www.bepress.com/ev/vol6/iss3/art8. Eso no quiere decir necesariamente que haya que aceptar la propuesta de Laurence J. Kotlikoff —que coincide con la tesis defendida habitualmente por la escuela austriaca—, según la cual “los servicios de liquidez, suministrados ahora por los bancos, deberían proporcionarlos instituciones sometidas a la obligación de mantener coeficientes de reserva del 100%, para hacerlas inmunes a pánicos, manías y juegos de casino” (Véase su Limited Purpose Banking). Pero sí que hay que volver a los tiempos de los “bancos aburridos”, con una función financiera claramente ancillar, en donde los negocios excitantes se encuentran en la economía real: Véase Paul Krugman, “Making Banking Boring”, NYT, 9/IV/2009, en: http://www.nytimes.com/2009/04/10/opinion/10krugman.html?_r=1. Como indica Gillian Tett (FT, 9/IV/2009), este tiempo proporciona “A chance for bankers to refocus their talents” , como ocurrió entre 1930 y 1980, cuando las remuneraciones del sector no eran sustancialmente más elevadas que las de la economía real. Eso es lo que documentan Thomas Philippon y Ariell Reshef en “Wages and Human Capital in the U.S. Financial Industry: 1909-2006”, Enero 2009, disponible en: www.nber.org/papers/w14644.pdf. El tono de la entrada de Bill Gross, en su Investment Outlook de abril de 2009 (“The Future of Investing: Evolution or Revolution?”) parece anunciar esos tiempos. 55 “We need a better cushion against risk”, FT, 27, Marzo, 2009: http://www.ft.com/cms/s/0/9b108250-1a6e- 11de-9f91-0000779fd2ac.html 56 Véase RGE MOnitor, “IMF Boosts Global Loss Estimate To $4 Trillion: RGE Estimates $1.8T Fall On U.S. Banks/Brokers, Up To $2T On European Banks, Remainder On Asia” 7/IV/2009: http://www.rgemonitor.com/10006/Finance_and_Banking?cluster_id=13434, 57 Véase Patrick McGuire y Goetz von Peter, “The US dollar shortage in global banking”, BIS Quarterly Review, Marzo 2009, disponible en: http://www.bis.org/publ/qtrpdf/r_qt0903f.pdf?noframes=1 58 Véase Brad Setser, “The US is exporting its recession (by not importing)”, 9 , abril, 2009, disponible en: http://blogs.cfr.org/setser/2009/04/09/the-us-is-exporting-its-recession-by-not-importing-the-february-trade- data/#more-5128 59 Véase “The Large Dollar Balance Sheet of Europe’s Banks”, 14 abril, 2009, disponible en: http://blogs.cfr.org/setser/2009/04/14/the-large-dollar-balance-sheet-of-europe%e2%80%99s-banks/.

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60 Véase “Bundesbank chief rejects De Larosiere Report”, Eurointelligence, 16/04/2009, disponible en: http://www.eurointelligence.com/article.581+M5a4c029f0d7.0.html 61 Véase Willem Buiter, “Ruminations on banking” (part 3: The repratriation of cross-border banking), disponible en: http://blogs.ft.com/maverecon/2009/04/ruminations-on-banking/ (15/04/2009). La propuesta de Buiter se complementa con un plan de lucha contra el criterio “demasiado grande para quebrar”, consistente en penalizar el tamaño de la banca por encima de un perímetro de balance superior a 100.000 millones de dólares, estableciendo requerimientos de capital crecientes a partir de ese umbral (que, a título ilustrativo, supone solo una cuarta parte de los recursos de clientes gestionados por el Banco Santander en Europa continental; además, Abbey Bank multiplica esa cifra por más de 2,75). La propuesta resulta excesivamente grosera, ya que existen otros mecanismos regulatorios y de supervisión susceptibles de controlar el riesgo sin neutralizar las economías de escala y alcance. 62 Véase “The green shoots are weeds growing through the rubble in the ruins of the global economy”, disponible en: http://blogs.ft.com/maverecon/2009/04/the-green-shoots-are-weeds-growing-through-the-rubble- in-the-ruins-of-the-global-economy/ 63 Véase Zachary A. Goldfarb “SEC to Pursue Limits On Stock Short Sales”, Washington Post, April 8, 2009, disponible en: http://www.washingtonpost.com/wp-dyn/content/article/2009/04/07/AR2009040704012_pf.html 64 Véase “Compressing the $54 Trillion CDS Market to $28T: Does It Ensure a Reduction in Counterparty Risk?”, en: http://www.rgemonitor.com/175/Risk_of_Systemic_Crises_and_Asset_Bubbles?cluster_id=6543. 65 Véase RGE Monitor, “'Big Bang' In the CDS Market: Private Sector Adopts Standardized Rules”, en: http://www.rgemonitor.com/16/Banks_and_Risk_Management?cluster_id=13698, 8, Abril, 2009. 66 Véase su “How the FASB aids and abets obfuscation by wonky zombie banks”, disponible en: http://blogs.ft.com/maverecon/2009/04/how-the-fasb-aids-and-abets-obfuscation-by-wonky-zombie-banks/ 67 Véase “FASB Eases Mark-To-Market Rules For Toxic Assets: Will Banks Prefer To Keep Them Now?”, 2, abril, 2009, en: http://www.rgemonitor.com/16/Banks_and_Risk_Management?cluster_id=13006 68 Como reza el titular de Nouriel Roubini: “Stress Testing the Stress Test Scenarios: Actual Macro Data Are Already Worse than the More Adverse Scenario for 2009 in the Stress Tests. So the Stress Tests Fail the Basic Criterion of Reality Check Even Before They Are Concluded”, 13, Abril, 2009, disponible en: http://www.rgemonitor.com/blog/roubini/256382/stress_testing_the_stress_test_scenarios_actual_macro_data_ar e_already_worse_than_the_more_adverse_scenario_for_2009_in_the_stress_tests_so_the_stress_tests_fail_the_ basic_criterion_of_reality_check_even_before_they_are_concluded. Calculated risk ha llevado la comparación en un gráfico. Véase: http://www.calculatedriskblog.com/2009/04/roubini-and-stress-test-scenarios.html 69 Véase “Citi: Net Credit Losses Rising Rapidly” , 17 abril 2009, disponible en: http://www.calculatedriskblog.com/2009/04/citi-net-credit-losses-rising-rapidly.html 70 Un comentario corrosivo puede verse en Naked capitalism: “Quelle Surprise! Bank Stress Tests Producing Expected Results!”, en: http://www.nakedcapitalism.com/2009/04/quelle-surprise-bank-stress-tests.html 71 Veáse Willem Buiter, “Ruminations on banking”, http://blogs.ft.com/maverecon/2009/04/ruminations-on- banking/ (15/04/2009). El plan es el propuesto por Jeremy Bulow y Paul Klemperer en “Reorganising the banks: Focus on the liabilities, not the assets”, disponible en: http://www.voxeu.org/index.php?q=node/3320 72 Aunque el caso de Goldman & Sachs resulta escandaloso, dada la utilización casi abusiva que a venido haciendo de su condición de “banco de inversión del gobierno” (Government & Sachs), aprovechando la desaparición más o menos discrecional de sus competidores (sobre todo, Lehman) y medidas fiscales hechas casi a medida para beneficiarle. Véase William D. Cohan, “Big Profits, Big Questions”, 15, abril, 2009, disponible en: http://www.nytimes.com/2009/04/15/opinion/15cohan.html?_r=1&th&emc=th 73 Véase “Stress Tests Underway: Analysts Predict Depression Scenario For Banks”, RGE Monitor, 7, abril 2009.disponible en: http://www.rgemonitor.com/ 74 En el derecho de quiebras esta expresión se contrapone a la de “en proceso de liquidación”, que implica la depreciación automática de los activos así calificados. De esta calificación suele depender que una entidad se considere en situación de iliquidez o de insolvencia. No se conoce un procedimiento fiable para resolver este tipo de dilemas. El derecho concursal lo deja a la decisión de los acreedores, en un procedimiento deliberativo reglado en el que participan todas las partes. Véase mi trabajo Crisis de empresas y sistema concursal. La reforma española y la experiencia comparada, CES, Colección estudios, nº 70, Madrid, 1999,

56 http://biblioteca.meh.es/DocsPublicaciones/LITERATURAGRIS/CRISIS%20DE%20EMPRESAS%20Y%20SI STEMA%20CONCURSAL.pdf 75 Véase http://www.rgemonitor.com/: “Details Of Geithner's Public-Private Partnership: Large Taxpayer Subsidies For Toxic Asset Investors”, 25, Marzo, 2009; “Will The Fed's PPPIP Get Credit Flowing Again?”, 6, Marzo, 2009. 76 Véase: http://www.rgemonitor.com/10006/Finance_and_Banking?cluster_id=13682 : “Are Banks To Buy Toxic Assets From Each Other?”, 6 abril, 2009. 77 Véase Laurence J Kotlikoff y Jeffrey Sachs, “The Geithner-Summers plan is worse than you think”, ft.com/economistsforum, 6, abril, 2009, disponible en: Lawrence Kotlikoff and Jeffrey Sachs 78 Véase “Will The Geithner Plan Work?”, Marzo, 2009,10:33 AM, citado. 79 Véase: David Cho, “Key Treasury Posts Remain Vacant”, WP, 10/III/2009, disponible en: http://www.washingtonpost.com/wp-dyn/content/article/2009/03/10/AR2009031001009.html 80 Del tipo estudiado por J. Bulow y P. Klemperer, “Why Do Sellers (Usually) Prefer Auctions?”, Febr., 2009, (American Economic Review), disponible en: http://www.nuff.ox.ac.uk/users/klemperer/whysellersprefer.pdf 81 Véase Brad DeLong, “Three Possible Financial Narratives for the Obama Administration”, 13/04/2009, en: http://delong.typepad.com/sdj/2009/04/three-possible-financial-narratives-for-the-obama-administration.html 82 Reuters lo anunciaba así: el mismo día 23 de marzo: “Exclusive: PIMCO to participate in U.S. toxic asset plan”. Y reproducía las palabras de Gross: “De todas las medidas políticas puestas sobre la mesa, esta es quizás la primera en la que todas las partes pueden ganar, y hay que darle la bienvenida de forma entusiasta”. 83 Véase Jane Sasseen, “Can Geithner's Toxic-A+sset Plan Work?”, BusinessWeek, 26-Marzo, 2009 84 Véase su comentario “Treasury rewards waiting”, en: ft.com/economistsforum, 24 Marzo, 2009 11:56am 85 Véasen las entradas de RGE Monitor: “Will The Fed's PPPIP Get Credit Flowing Again?, disponible en: , y “What Is Driving The Interbank Liquidity Hoarding at the Core of the Credit Crisis?”, (13/IV/2009), disponible en: http://www.rgemonitor.com/175?cluster_id=9411. La hipótesis Caballero-Giavazzi en: http://www.voxeu.org/index.php?q=node/1188. El comportamiento “tiburón” de Goldman & Sachs a lo largo de la crisis es un modelo de “capitalismo de amiguetes a la rusa”, como afirma W. D. Cohan en “Big profits, Big questions”, citado. Por su parte, Simon Johnnson considera que el “corredor” entre Wall Street y Washington hace que el capitalismo norteamericano se asemeje cada día más al de una república bananera. Sin embargo, Martin Wolf considera que para ello haría falta que en América la cosa funcionase solo a base de corrupción, pero no es exactamente así. Es algo más complejo. No es corrupción “egregia y flagrante”, “porque se ve acompañada de un sistema de creencias”. Véase Simon Jonnson “The Quiet Coup”, The Atlantic Monthly, Mayo, 2009 http://www.theatlantic.com/doc/200905/imf-advice, y Martin Wolf, “Is America the new Russia?”, http://www.ft.com/cms/s/0/09f8c996-2930-11de-bc5e-00144feabdc0.html 86 Véase Congress Oversight Panel, April Oversight Report. Assessing Treasury’s Strategy: Six Months of TARP, 7 abril, 2009, disponible en: http://cop.senate.gov/reports/library/report-040709-cop.cfm 87 Troubled Asset-Backed Securities Loan Facility (TALF). Programa de adquisiciones de activos iniciado por la Fed en noviembre pasado, dentro del TARP, y retomado por el Plan de Estabilidad Financiera de la nueva administración, con una dotación de 100.000 millones de dólares de capital del Tesoro y 900.000 en préstamos de la Fed. Su objetivo consiste en restablecer el crédito al consumo. Véase “Start Of The $1 Trillion TALF For Consumer Asset-Backed Securities (ABS): Eligible Collateral Includes Legacy RMBS and CMBS”, 24/III/2009, disponible en: http://www.rgemonitor.com/10006?cluster_id=12783 88 Según el mecionado artículo de William D. Cohan, una de las ventajas de que se vale Goldman & Sachs, es precisamente la de utilizar los recursos derivados de las “oportunas” normas fiscales, dictadas a su favor por Henry Paulson, para devolver las ayudas públicas y quedar libre así de las restricciones al pago de sus ejecutivos, con la consiguiente ventaja competitiva para contratar los mejores recursos humanos de la profesión. Esto sería achatarrar toda la doctrina de defensa de la competencia de un plumazo. Naked Capitalism se escandaliza con toda razón : “Don’t set Goldman free, Mr Geithner”, http://www.nakedcapitalism.com/2009/04/john-gapper.html 89 Nada impide, además, reforzar esa cifra, deshaciendo las reducciones de impuestos asimétricas realizadas por George W. Bush, como prevé hacer el Presidente Obama. La cifra corresponde a 2006 y es el promedio de la aportación del cuartil superior al impuesto individual sobre al renta (86,3%) y al impuesto de sociedades (87,2%). Las cifras correspondientes para la última decila son 72,8% y 80,5%, y para el último percentil 37,1% y

57

57,1%. Véase: Congressional Budget Office, Historical Effective Federal Tax Rates: 1979 to 2006, Abril 2009, disponible en: http://www.cbo.gov/ftpdocs/100xx/doc10068/effective_tax_rates_2006.pdf 90 Véase una síntesis en: http://en.wikipedia.org/wiki/Type_I_and_type_II_errors 91 Véase Michelle J. White “Corporate Bankruptcy,” en The New Palgrave Dictionary of Economics and the Law, P. Newman, ed. Macmillan Press, 1998, disponible en: http://weber.ucsd.edu/~miwhite/palgrav2.pdf, p. 11 92 Véase Edmund L. Andrews, “U.S. May Convert Banks’ Bailouts to Equity Share”, NYT, 20/04/2009, disponible en: http://www.nytimes.com/2009/04/20/business/20bailout.html?th&emc=th 93 En “Obama’s Ersatz Capitalism”, NYT, 1 abril, 2009, ya citado. Sin embargo, aquí también aparece un argumento circular, ya que si el plan cumple el objetivo de resolver la deflación de balances y tiene éxito en restablecer el crédito (aunque no sea equitativo y exonere de forma vergonzante las graves irregularidades cometidas en el pasado) no habrá expolio del contribuyente porque los mercados se recompondrán en un tiempo prudencial. Esa es la apuesta de todo el sector de los fondos de inversión, a través de la red, en su página oficial. Véase: “RTC All Over Again”, 27/III/2009: http://www.hedgefund.net/publicnews/default.aspx?story=9895# 94 En “Erin Go Broke” (NYT, 20/04/2009), Krugman hace el vaticinio más lúgubre sobre el “peor escenario posible para América” y para el sistema económico global. Disponible en: http://www.nytimes.com/2009/04/20/opinion/20krugman.html?th&emc=th

58 BACKGROUND PAPERS: 1. German government ponders bank resolution, Eurointelligence... 66 2. U.S. May Convert Banks’ Bailouts to Equity Share, by Edmund L. Andrews... 69 3. Erin go Broke, by Paul Krugman.... 72 4. Housing Data Could Signal If Bust Is Over, WP... 74 5. Is the Second Derivative of Growth Turning Positive? What Might the Recovery Look Like?, RGE Monitor... 75 6. When the Real Estate Game Cost $9.95, by Julie Creswell... 77 7. Nadie sabe los tiempos que me tocó vivir, por Norman Birbaum... 83 8. U.S. Bank Earnings In Q1: Take With A Pinch Of Salt?, RGE Monitor... 85 9. Green Shoots and Glimmers, by Paul Krugman... 87 10. Eurozone shows few signs of recovery, by Ralph Atkins... 91 11. Bank Test Results May Strain Limits Of Bailout Funding. Much Rides on Size of Capital Needs, by David Cho... 92 12. "Don’t set Goldman free, Mr Geithner", Naked Capitalism... 94 13. Bundesbank chief rejects De Larosiere Report, Eurointelligence... 97 14. Ruminations on banking, by Willem Buiter... 99 15. Deals Help China Expand Its Sway in Latin America, by Simon Romero and Alexei Barrionuevo... 104 16. The Battle Over Student Lending, NYT Editorial... 106 17. Could German GDP have declined by 11.5% annualised during Q1?, Eurointelligence... 107 18. The large dollar balance sheet of Europe’s banks, by Brad Setser... 109 19. “Is America the New Russia?”, by Martin Wolf... 111 20. “The Quiet Coup”, by Simon Johnson... 114 21. Goldman Revamp Puts Dec. Losses Off Books, by David S. Hilzenrath... 124 22. Big Profits, Big Questions, by William D. Cohan... 125 23. Three Possible Financial Narratives for the Obama Administration by Brad DeLong... 127

59 24. Stress Testing the Stress Test Scenarios: Actual Macro Data Are Already Worse than the More Adverse Scenario for 2009 in the Stress Tests. So the Stress Tests Fail the Basic Criterion of Reality Check Even Before They Are Concluded, by Nouriel Roubini… 130 25. What Is Driving The Interbank Liquidity Hoarding at the Core of the Credit Crisis?, RGE Monitor... 135 26. Ireland Is the First Eurozone Country to Set Up A Swedish-Inspired 'Bad Bank': Will Others Follow Suit?, RGE Monitor...136 27. Making Banking Boring, by Paul Krugman… 138 28. How Bernanke Staged a Revolution, by Neil Irwin... 140 29. Quelle Surprise! Bank Stress Tests Producing Expected Results!, Naked Capitalism… 145 30. Who pays taxes? Who should?, by Howard Gleckman... 147 31. Charting the current US downturn, by Brad Setser... 149 32. SEC to Pursue Limits On Stock Short Sales, by Zachary A. Goldfarb… 151 33. Bids Pour In for State Construction Jobs, by Eric M. Weiss… 153 34. Not Quite a Confession, But a Good Start, by Steven Pearlstein…. 155 35. Firm Acted as Tutor in Selling Towns Risky Deals, by Don Van Natta Jr…. 157 36. 'Big Bang' In The CDS Market: Private Sector Adopts Standardized Rules, RGE Monitor… 161 37. The green shoots are weeds growing through the rubble in the ruins of the global economy, by Willem Buiter… 162 38. Putting a Price on Social Connections, by Stephen Baker... 167 39. IMF Boosts Global Loss Estimate To $4 Trillion: RGE Estimates $1.8T Fall On U.S. Banks/Brokers, Up To $2T On European Banks, Remainder On Asia, RGE Monitor… 169 40. Ireland unveils emergency budget, by John Murray Brown in Dublin… 171 41. Economy Falling Years Behind Full Speed, by Louis Uchitelle… 173 42. Poll Finds New Optimism on Economy Since Inauguration, by Adam Nagourney and Megan Thee-Brenan… 176 43. The End of Philosophy, by David Brooks… 179 44. How the Internet Got Its Rules, by Stephen D. Crocker… 181

60 45. IMF to warn about $4 trillion write-offs, Eurointelligence… 183 46. Blog The conscience of a liberal: The financial factor an other entries, by Paul Krugman… 186 47. The Geithner-Summers Plan is Even Worse Than We Thought, by Jeffrey Sachs… 198 48. The Geithner-Summers plan is worse than you think, by Laurence J Kotlikoff and Jeffrey Sachs… 199 49. Stress Tests Underway: Analysts Predict Depression Scenario For Banks, RGE Monitor… 201 50. Keynes' savings paradox, Fisher's debt deflation and the banking crisis, by Paul de Grauwe…204 51. The consequence of global co-ordination failure, by Wolfgang Münchau… 211 52. Are Banks To Buy Toxic Assets From Each Other? , RGE Monitor… 213 53. A chance for bankers to refocus their talents, by Gillian Tett… 214 54. Deutsche Analyst: High Yield Defaults to Reach 53% Over Next Five Years, Naked Capitalism …216 55. How Will Active Credit Easing or Quantitative Easing by the ECB Look?, Naked Capitalism …217 56. How the ECB will implement a policy of quantitative easing, by Aurelio Macario… 218 57. Greenspan's Bogus Defense, by Robert P. Murphy… 220 58. IMF tells CEE countries to adopt euro now, Eurointelligence… 224 59. Summits surprises, Eurointelligence… 226 60. China’s Dollar Trap, by Paul Krugman… 230 61. The Economic Summit, NYT Editorial… 233 62. A Rare Triumph of Substance at the Summit, by Steven Pearlstein… 234 63. A Tortured Inheritance, by Linda Gray Sexton… 236 64. G20 Closes $1.1 Trillion Deal For World Economy, Agrees On Regulatory Crackdown, G20 Leaders Statement summary…238 65. Credibility is key to policy success, by Martin Wolf… 240 66. The Gatekeeper. Rahm Emanuel on the job, by Ryan Lizza… 242 67. FASB Eases Mark-To-Market Rules For Toxic Assets: Will Banks Prefer To Keep Them Now?, RGE Monitor… 249

61 68. U.S. Credit Card Delinquencies At Record Highs: Same Dynamics As Mortgages?, RGE Monitor… 251 69. Obama’s Ersatz Capitalism, by Joseph E. Stiglitz… 253 70. How Much Will U.S. Housing Prices Fall And How Long Will The Downturn Last?, RGE Monitor… 255 71. U.S. Housing Starts and New Home Sales Improve, Permits Still Weak: Is the Sector Stabilizing?, RGE Monitor… 256 72. A task fit for Herculean policymakers, by Gillian Tett… 258 73. Japan PM attacks Merkel’s complacency, Eurointelligence… 260 74. The Future of Investing: Evolution or Revolution?, by Bill Gross… 263 75. Playing Solitaire with a Deck of 51, with Number 52 on Offer, by Paul McCulley… 267 76. Reading Krugman, thefinancebuff.com… 272 77. Are ABX Derivatives Prices An Accurate Measure of Subprime RMBS and CDO Valuations?, RGE Monitor…274 78. America the Tarnished, by Paul Krugman… 276 79. Obama’s Nobel Headache, by Evan Thomas… 278 80. The G20: expect nothing, hope for the best and prepare for the worst, by Willem Buiter… 283 81. Does Obama Have a Plan B?, by Adam S. Posen… 289 82. New home sales is this bottom?, calculatedrisk… 292 83. The Mega-Bear Quartet, calculatedrisk… 293 84. Forecast: Two-thirds of California banks to face Regulatory Action, Calculatedrisk…294 85. Q1 GDP will be Ugly, Calculatedrisk… 294 86. February PCE and Personal Saving Rate, Calculatedrisk… 296 87. Revisiting the Global Savings Glut Thesis, by Doug Noland… 298 88. We need a better cushion against risk, by Alan Greenspan… 302 89. Zapatero favours a new round of stimulus spending, Eurointelligence… 305 90. Battles Over Reform Plan Lie Ahead, by Edmund L. Andrews…307 91. As Oversight Plan Is Unveiled, Turf Battle Begins to Unfold Rival Regulators Argue for Right to Expanded Authority, by Zachary A. Goldfarb, Binyamin Appelbaum and Tomoeh Murakami Tse… 309

62 92. RTC All Over Again, Hedgefundnet... 311 93. Geithner to Propose Vast Expansion Of U.S. Oversight of Financial System, by Binyamin Appelbaum and David Cho… 312 94. Time For A New Insolvency Regime For Non-Banks And Bank Holding Companies?, RGE Monitor… 315 95. Blueprint for Regulatory Reform: Regulation By Activity For Everybody Rather Than By Institution?, RGE Monitor… 316 96. Will The Fed's PPPIP Get Credit Flowing Again?, RGE Monitor... 317 97. Details Of Geithner's Public-Private Partnership: Large Taxpayer Subsidies For Toxic Asset Investors, RGE Monitor… 319 98. Can Geithner's Toxic-A+sset Plan Work?. The Treasury Secretary's plan to rid banks of bad loans faces plenty of roadblocks. Only time will tell if it can succeed, by Jane Sasseen… 322 99. Commercial Real Estate Bust Has Started: Access To TALF Just In Time?, RGE Monitor… 324 100. Is the EU run by a madman?, Eurointelligence… 326 101. Geithner Affirms Dollar After Remarks Send It Tumbling, by Anahad O’Connor... 330 102. Las turbulencias de la economía hacen caer a tres gobiernos de Europa del Este, por Cristina Galindo… 332 103. En medio de la crisis: la sequía de crédito, por Miguel Boyer Salvador… 334 104. Economists React: ‘Has Housing Hit Bottom?’, Posted by Phil Izzo… 337 105. New Home Sales: Is this the bottom?, Calculatedrisk… 339 106. Los hedge funds vuelven al punto de mira de los reguladores Universia-Knowledge@Wharton... 342 107. Is it back to the Fifties?, by John Authers… 347 108. Regional Banks Are the Future, por Meredith Whitney… 352 109. Dissecting Bank Plan for a Way to Profit, by Graham Bowley and Mary Williams Walsh… 353 110. Chris Carroll Reassures Me that I Am Not Crazy..., by Brad Delong… 356 111. Treasury rewards waiting, By Christopher D. Carroll… 356 112. Geithner’s plan, FT Lex… 358

63 113. Will the Geithner Plan Work?, NYT Editors (4 opinions: Paul Krugman, Simon Johnson, Brad DeLong and Mark Thoma)… 359 114. Dear A.I.G., I Quit!, by Jake DeSantis… 365 115. China Proposes a Shift to the SDR: Is it ready for A Global Role?, RGE Monitor… 368 116. Funding the Fed: Precedents and Purposes for Issuing Federal Reserve Bills, RGE Monitor… 369 117. U.S. Plan Seeking Expanded Power in Seizing Firms, by Edmund L. Andrews and Eric Dash… 371 118. U.S. Seeks Expanded Power to Seize Firms Goal Is to Limit Risk to Broader Economy, by Binyamin Appelbaum and David Cho… 373 119. Reactions to the Geithner Plan, by Adam Posen… 375 120. Fiscal dimensions of central banking: The fiscal vacuum at the heart of the Eurosystem and the fiscal abuse by and of the Fed, by Willem Buiter… 376 121. The Treasury’s Financial Stability Plan: Solution or Stopgap?, by Adam S. Posen... 389 122. Geithner’s trillion dollar gamble, Eurointelligence… 391 123. Geithner plan arithmetic, by Paul Krugman… 393 124. Prices of most-traded risky loans recover, by Anousha Sakoui… 395 125. The threat posed by ballooning Federal reserves, by John Taylor… 396 126. Financial de-globalization, illustrated, by Brad Setser…398 127. Reorganising the banks: Focus on the liabilities, not the assets, by Jeremy Bulow and Paul Klemperer… 402 128. Global imbalances and the crisis: A solution in search of a problem, by Michael Dooley and Peter Garber… 407 129. Mistakes Beget Greater Mistakes, by Doug Noland… 411 130. A Proven Framework to End the US Banking Crisis Including Some Temporary Nationalizations, by Adam S. Posen… 414 131. The new Geithner plan is a flop, by Luigi Zingales… 426 132. Exclusive: PIMCO to participate in U.S. toxic asset plan, Reuters… 428 133. Saving Capitalistic Banking From Itself , by Paul McCulley… 430

64 134. Managing the Bailout: He’d Do It for Nothing, by Edward Wyatt… 435 135. How Main Street Will Profit, by William H. Gross… 438 136. It's the Housing Market Deflation, by William H. Gross… 439 137. Why We Need a Housing Rescue, by William H. Gross… 440 138. William H. Gross — The King: “If Any One Man has put Bonds on the Map, it's Bill”, by Money Masters… 443 139. Guess Who Really Pays the Taxes, by Stephen Moore... 445

65 20.04.2009 GERMAN GOVERNMENT PONDERS BANK RESOLUTION

There is some movement in the debate on bank resolution policies in Germany. FT Deutschland has the details, according to which the government is currently favouring a model proposed by investment bank Lazard. According to one variant of this model, the government takes the toxic assets from the banks, in return for government debt obligtation, which carry ultra-low interest rates, and which the banks promise to keep on their books for a long time. The idea is that such a construction prevents spillovers into the general bond market. Another construction is a bad bank, which holds the bad assets, and which issues government-guranteed debt obligations to the good bank. German election campaign has started German newspapers are full of reports on the official start of the campaign for the September election, which kicked off yesterday with the party congress of the SPD in which Frank- Walter Steinmeier, foreign minister, gave a solid and far from exciting performance to the rank and file of his party. Der Spiegel has a nice commentary about it, saying that Steinmeier managed to quell the internal disputes within the party, but this had totally failed to improve the SPD’s dismal opinion poll ratings. Few see him as the successor to Angela Merkel. French social security system in trouble The deficit of the French social security system is cause a major political debate this year, writes Les Echos. Latest forecasts show the deficit for 2009 to pass 18bn, while the wage mass of the private sector, the basis for contributions, is expected to decline by 1% in the third quarter, an evolution never seen before. Refinancing solutions are already on the table. Eduard Ballardur suggested to set up a special crisis fund, Bernard Accoyer proposed a large government bond issue. Tax and contribution hikes are excluded so far. The parliament is likely to heat up in this debate. Dominique Seux comments that while the decisions on the refinancing of the social security deficit are still awaited it would be economically bizarre to replace private debt by public

66 debt. Public debt is already approaching 80% of GDP. The exploding debt of the public sector is the next crisis to be solved. Either by inflation, tax rises or expenditure cuts.

Spanish government attacks central bank chief The FT reports from Madrid of an open disagreement between the Spanish government and the central bank chief, after he questioned whether the Spanish pension system was sustainable. The Spanish deputy prime minister accused him of being alarmist about the pension system, and reiterated the “official” position that Spanish pensions are safe. The FT also quoted from a closed-door meeting in which Jose Luis Zapatero accused the central bank of hypocrisy, and to base its policy recommendations on superficial analysis. Bini Smaghi says potential output growth likely to be lower In an interview with FT Deutschland, Lorenzo Bini Smaghi of the ECB forecast a recovery that would follow the mirror image of a J – a shallow recovery after the fall. He predicted a persistent and significant fall in potential growth rates, which will have significant implications for economic policy. He appeared to suggest that non- conventional monetary policy policy action would be likely soon, without giving any details. De Grauwe on QE Paul de Grauwe said in an Interview with Der Standard that the ECB should intervene directly in the market for government bonds, and specifically buy Treasuries from countries with high yields, to reduce the speculative yield gap. He said this would aalso help support governments who take on toxic assets from the banking sector. Greg Mankiw on negative interest rates Grew Mankiw argues in his blog that it is possible after all for a central bank to have negative interest rates. He quotes an idea from one of his students who proposed the central bank should announce that it would randomly pick a single digit from 0 to 9 in one year’s time, after which all banknotes with serial numbers ending in that digit would be worthless. This would either induce people to spend the cash, or to lend it, but not to hoard it.. He concluded that negative interest rates could be to central bank what negative numbers were to mathematics: difficult to contemplate at first, but indispensable later. A long recession, a shallow recovery The IMF has prereleased chapters 3 and 4 of its WEO. This is from the introduction of chapter 3 “…recessions associated with financial crises tend to be unusually severe and their recoveries typically slow. Similarly, globally synchronized recessions are often long and deep, and recoveries from these recessions are generally weak. Countercyclical monetary policy can help shorten recessions, but its effectiveness is limited in financial crises. By contrast, expansionary fiscal policy seems particularly effective in shortening recessions associated with financial crises and boosting recoveries. However, its effectiveness is a decreasing function of the level of public debt. These findings suggest the current recession is likely to be unusually long and severe and the recovery sluggish.”

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Martin Feldstein on inflation Writing in the FT, Martin Feldstein says that inflation is clearly not a problem now, but will be a problem later on, and he says he does not understand why long term bond prices are not reflecting this concern. He says the reason for the rise in inflationary pressures is the combination of a rising fiscal deficit, and a loose monetary policy (unlike in the 1980s, when monetary policy was tight). The Fed will have great difficulty, mopping up the excess money they create through the sale of private-sector bonds.

Mansoor Mohi-uddin on euro vs dollar Writing in the FT Mansoor Mohi-uddin says the dollar is very likely to remain the world’s leading reserve currency for the foreseeable future. He cites a number of reasons, including lethargy, the need to keep strong reserve portfolios as insurance against devaluation, and the superiority of the US treasury market relative to the eurozone bond markets. He says fears that the euro might not be sustainable would prevent large portfolio shifts from dollars into euros. http://www.eurointelligence.com/article.581+M54358fb6843.0.html#

68 Business April 20, 2009 U.S. May Convert Banks’ Bailouts to Equity Share By EDMUND L. ANDREWS WASHINGTON — President Obama’s top economic advisers have determined that they can shore up the nation’s banking system without having to ask Congress for more money any time soon, according to administration officials. In a significant shift, White House and Treasury Department officials now say they can stretch what is left of the $700 billion financial bailout fund further than they had expected a few months ago, simply by converting the government’s existing loans to the nation’s 19 biggest banks into common stock. Converting those loans to common shares would turn the federal aid into available capital for a bank — and give the government a large ownership stake in return. While the option appears to be a quick and easy way to avoid a confrontation with Congressional leaders wary of putting more money into the banks, some critics would consider it a back door to nationalization, since the government could become the largest shareholder in several banks. The Treasury has already negotiated this kind of conversion with Citigroup and has said it would consider doing the same with other banks, as needed. But now the administration seems convinced that this maneuver can be used to make up for any shortfall in capital that the big banks confront in the near term. Each conversion of this type would force the administration to decide how to handle its considerable voting rights on a bank’s board. Taxpayers would also be taking on more risk, because there is no way to know what the common shares might be worth when it comes time for the government to sell them. Treasury officials estimate that they will have about $135 billion left after they follow through on all the loans that have already been announced. But the nation’s banks are believed to need far more than that to maintain enough capital to absorb all their losses from soured mortgages and other loan defaults. In his budget proposal for next year, Mr. Obama included $250 billion in additional spending to prop up the financial system. Because of the way the government accounts for such spending, the budget actually indicated that Mr. Obama might ask Congress for as much as $750 billion. The most immediate expense will come in the next several weeks, when federal bank regulators complete “stress tests” on the nation’s 19 biggest banks. The tests are expected to show that at least several major institutions, probably including Bank of America, need to increase their capital cushions by billions of dollars each. The change to common stock would not require the government to contribute any additional cash, but it could increase the capital of big banks by more than $100 billion.

69 The White House chief of staff, Rahm Emanuel, alluded to the strategy on Sunday in an interview on the ABC program “This Week.” Mr. Emanuel asserted that the government had enough money to shore up the 19 banks without asking for more. “We believe we have those resources available in the government as the final backstop to make sure that the 19 are financially viable and effective,” Mr. Emanuel said. “If they need capital, we have that capacity.” If that calculation is correct, Mr. Obama would gain important political maneuvering room because Democratic leaders in Congress have warned that they cannot possibly muster enough votes any time soon in support of spending more money to bail out some of the same financial institutions whose aggressive lending precipitated the financial crisis. The administration said in January that it would alter its arrangement with Citigroup by converting up to $25 billion of preferred stock, which is like a loan, to common stock, which represents equity. After the conversion, the Treasury would end up with about 36 percent of Citigroup’s common shares, which come with full voting rights. That would make the government Citigroup’s biggest shareholder, effectively nudging the government one step closer to nationalizing a major bank. Nationalization, or even just the hint of nationalization, is a politically explosive step that White House and Treasury officials have fought hard to avoid. Administration officials acknowledged that they might still have to ask Congress for extra money. Beyond the 19 big banks, which are defined as those with more than $100 billion in assets, the Treasury has also injected capital into hundreds of regional and community banks and may need to provide more money before the financial crisis is over. Treasury officials say they have more money left in the rescue fund than might be apparent. Officials estimate that the fund will have about $134.5 billion left after the Treasury completes its $100 billion plan to buy toxic assets from banks and after it uses $50 billion to help homeowners avoid foreclosure. In practice, the toxic-asset programs are not expected to start for another few months, and it could be more than a year before the Treasury uses up the entire $100 billion. Likewise, it will be at least a year before the Treasury uses up all the money budgeted for homeowners. But the biggest way to stretch funds could be to convert preferred shares to common stock, a strategy that the government seems prepared to use on a case-by-case basis. Ever since the Treasury agreed to restructure Citigroup’s loans, officials have made it clear that other banks could follow suit and convert their government loans to voting shares of common stock as well. In the stress tests now under way, regulators are examining whether the big banks would have enough capital to withstand an economic downturn in which unemployment climbs to 10 percent and housing prices fall much further than they already have. As their yardstick, regulators are expected to examine a measure of bank capital called “tangible common equity.” By that measure of capital, every dollar a bank converts from preferred to common shares becomes an additional dollar of capital. The 19 big banks have received more than $140 billion from the Treasury’s financial rescue fund, and all of that has been in exchange for nonvoting preferred shares that pay an annual interest rate of about 5 percent.

70 If all the banks that are found to have a capital shortfall fill that gap by converting their shares, rather than by obtaining more cash, the Treasury could stretch its dwindling rescue fund by more than $100 billion. The Treasury would also become a major shareholder, and perhaps even the controlling shareholder, in some financial institutions. That could lead to increasingly difficult conflicts of interest for the government, as policy makers juggle broad economic objectives with the narrower responsibility to maximize the value of their bank shares on behalf of taxpayers. Those are exactly the kinds of conflicts that Treasury and Fed officials were trying to avoid when they first began injecting capital into banks last fall. http://www.nytimes.com/2009/04/20/business/20bailout.html?th&emc=th

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Opinion

April 20, 2009 OP-ED COLUMNIST Erin Go Broke By PAUL KRUGMAN “What,” asked my interlocutor, “is the worst-case outlook for the world economy?” It wasn’t until the next day that I came up with the right answer: America could turn Irish. What’s so bad about that? Well, the Irish government now predicts that this year G.D.P. will fall more than 10 percent from its peak, crossing the line that is sometimes used to distinguish between a recession and a depression. But there’s more to it than that: to satisfy nervous lenders, Ireland is being forced to raise taxes and slash government spending in the face of an economic slump — policies that will further deepen the slump. And it’s that closing off of policy options that I’m afraid might happen to the rest of us. The slogan “Erin go bragh,” usually translated as “Ireland forever,” is traditionally used as a declaration of Irish identity. But it could also, I fear, be read as a prediction for the world economy. How did Ireland get into its current bind? By being just like us, only more so. Like its near- namesake Iceland, Ireland jumped with both feet into the brave new world of unsupervised global markets. Last year the Heritage Foundation declared Ireland the third freest economy in the world, behind only Hong Kong and Singapore. One part of the Irish economy that became especially free was the banking sector, which used its freedom to finance a monstrous housing bubble. Ireland became in effect a cool, snake-free version of coastal Florida. Then the bubble burst. The collapse of construction sent the economy into a tailspin, while plunging home prices left many people owing more than their houses were worth. The result, as in the United States, has been a rising tide of defaults and heavy losses for the banks. And the troubles of the banks are largely responsible for putting the Irish government in a policy straitjacket. On the eve of the crisis Ireland seemed to be in good shape, fiscally speaking, with a balanced budget and a low level of public debt. But the government’s revenue — which had become strongly dependent on the housing boom — collapsed along with the bubble. Even more important, the Irish government found itself having to take responsibility for the mistakes of private bankers. Last September Ireland moved to shore up confidence in its banks by offering a government guarantee on their liabilities — thereby putting taxpayers on the hook for potential losses of more than twice the country’s G.D.P., equivalent to $30 trillion for the United States.

72 The combination of deficits and exposure to bank losses raised doubts about Ireland’s long- run solvency, reflected in a rising risk premium on Irish debt and warnings about possible downgrades from ratings agencies. Hence the harsh new policies. Earlier this month the Irish government simultaneously announced a plan to purchase many of the banks’ bad assets — putting taxpayers even further on the hook — while raising taxes and cutting spending, to reassure lenders. Is Ireland’s government doing the right thing? As I read the debate among Irish experts, there’s widespread criticism of the bank plan, with many of the country’s leading economists calling for temporary nationalization instead. (Ireland has already nationalized one major bank.) The arguments of these Irish economists are very similar to those of a number of American economists, myself included, about how to deal with our own banking mess. But there isn’t much disagreement about the need for fiscal austerity. As far as responding to the recession goes, Ireland appears to be really, truly without options, other than to hope for an export-led recovery if and when the rest of the world bounces back. So what does all this say about those of us who aren’t Irish? For now, the United States isn’t confined by an Irish-type fiscal straitjacket: the financial markets still consider U.S. government debt safer than anything else. But we can’t assume that this will always be true. Unfortunately, we didn’t save for a rainy day: thanks to tax cuts and the war in Iraq, America came out of the “Bush boom” with a higher ratio of government debt to G.D.P. than it had going in. And if we push that ratio another 30 or 40 points higher — not out of the question if economic policy is mishandled over the next few years — we might start facing our own problems with the bond market. Not to put too fine a point on it, that’s one reason I’m so concerned about the Obama administration’s bank plan. If, as some of us fear, taxpayer funds end up providing windfalls to financial operators instead of fixing what needs to be fixed, we might not have the money to go back and do it right. And the lesson of Ireland is that you really, really don’t want to put yourself in a position where you have to punish your economy in order to save your banks. http://www.nytimes.com/2009/04/20/opinion/20krugman.html?th&emc=th

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Housing Data Could Signal If Bust Is Over This Week: THURSDAY Monday, April 20, 2009 Economy-watchers are searching for evidence that the housing market is starting to hit bottom. And in recent months, there has been some evidence that the end of the great housing bust may be near. This week offers a reality check, with three key pieces of housing-related data coming out. But to interpret the data, it helps to realize that the end of the housing bust means different things, and could come at different times, depending on what data you consider. Home sales will likely hit a bottom first -- and may have already done so. Data on existing home sales in March is scheduled to come out Thursday and new home sales on Friday. Both measures of housing activity picked up in February, a sign that between cheap foreclosed-on houses and low mortgage rates, the volume of sales may finally have stopped falling. This week's data will be a test of that thesis. Analysts are expecting a mixed bag, with new-home sales rising modestly but existing home sales falling a bit. Whatever the March numbers say, there are good reasons to think that home sales will improve as the spring selling season gets underway. Anecdotal reports suggest that low mortgage rates and an $8,000 first-time home-buyer tax credit are coaxing buyers back into the market. And while foreclosures are set to rise as banks begin to move on delinquent homeowners, that actually could boost home sales as banks auction homes for whatever the market will bear. The prospects are less promising for home prices, a report on which is set to come out Wednesday. Analysts expect the Federal Housing Finance Agency's price index to have fallen 0.6 percent. The new wave of foreclosures may help home sales activity but is likely to keep driving home prices down. Time lags are another issue. Even if low rates and tax credits bring buyers back into the market, it could take months for that increased demand to meaningfully affect prices, simply because of the time it takes a person to go from deciding it's time to shop again to actually closing on a house. NEIL IRWIN'S MUST-READS include lessons learned from the CEO of Goldman Sachs and 10 principles from professor Nassim Nicholas Taleb, author of "The Black Swan," for addressing the global economic crisis. For more, go to http://washingtonpost.com/economywatch.

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Apr 19, 2009 Is the Second Derivative of Growth Turning Positive? What Might the Recovery Look Like? o Some analysts suggest that the second derivative of growth is turning positive, that means that although the economy is spiraling down, it is doing so more slowly, the first step towards stabilization (Economist). However even if it does so, the recovery may well be very sluggish in part because synchronized global recessions and those accompanied by financial crisis tend to be severe and forestall quick recoveries (IMF) o The weakness in private demand tends to persist in upswings that follow recessions associated with financial crises. Private consumption typically grows more slowly than during other recoveries, signalling the usefulness of coordinated responses. (IMF) o The OECD composite leading indicators (CLIs) for February 2009 continue to point to a weakening outlook for all the major seven economies. Some tentative signs of improvement in the rate of deterioration in the outlook are appearing in some countries, (Italy, France and in some of the smaller OECD countries). The picture for all countries remains weak with the outlook in the United States, Canada, Japan and the major non- OECD member economies (BRICs) further deteriorating (OECD) o The second derivative of growth has likely already turned positive in Q1 09 in the G10, implying that further contractions in output will be smaller. any hopes of a strong bounce off the bottom should be put to rest. Growth in 2009 will likely be a very poor -3.5% while growth in 2010 in the G10 will likely clock in at just 1.1%. (MS) o Most indicators suggest that the second derivative of economic activity is still sharply negative in Europe and Japan and close to negative in the U.S. with China on the verge of positive territory: some signals that the second derivative was turning positive for US and China (a stabilizing ISM and PMI, credit growing in January in China, commodity prices stabilizing, retail sales up in the US in January) turned out to be fake starts.(Roubini) o Although Global PMI has been increasing from the low 30s to mid 30s, it still reflects a major contraction. In China where the Manufacturing PMI reached mid-40s by March 2009 there is a sign that the second derivative might be turning positive in the sector, however in the absence of end-user demand, the verge of expansion in Chinese markets may not be sustainable and might reflect the building of new capacity. o Should the pace of decline in final sales even moderate, inventories will be pared significantly, setting the stage for a stabilization in manufacturing and the economy toward midyear. While global consumer spending has firmed, other components of final demand have continued to weaken (JP Morgan) o Gross: for now, every piece of good news—every green shoot—bears caveats. We'll know the recovery is real when some of the measurable activity begins to match the rhetoric, when giant banks write checks to the Treasury to repay the cash they took last fall instead

75 of simply promising to do so, when the rising expressions of consumer confidence begin to ring up at the nation's malls, when the stock market rally is ratified by growth in companies' underlying earnings. o BoA/ML (not online): diffusion indices such as the ISM and Empire Manufacturing can be rather limited in terms of the information they provide. As they indices climb, they suggesting only that conditions are improving but most remain in contraction territory o BNP: PMIs and some of the consumer confidence surveys will improve in coming months. That would not herald the start of the recovery process, but merely a slower rate of fall. A slower pace of fall in PMIs, payrolls and GDP will not mean positive growth is just round the corner.It took years for the excesses to build up and it will take years to unwind them. There can be no economic stability until there is financial stability. On a q/q basis the worst falls in output may be in Q408 or Q109. o Danske:Manufacturing surveys have improved for most countries since January . PMI levels still suggest contraction for most countries although the official Chinese PMI breaking the important 50-level indicating renewed expansion. Asian trade data suggest foreign trade globally has rebounded somewhat from the very depressed levels seen in early 2009. With new orders apparently running ahead of production, industrial activity could increase in the coming months. However a significant share may reflect a temporary impact from restocking and fiscal easing. o In the US despite a potential bottoming of the ISM,a sustainable growth base might require stabilization of the housing market. o Economic data for China in Q1 are mixed so far. The rebound in investment in Jan/Feb) and deepening slump in exports (down 26% in Feb and 17.5% in January) reveal a country spending huge sums at home to offset steadily weakening demand overseas — with no conclusive signal whether the stimulus program will succeed. (Bradsher) Private consumption is decelerating slightly and there is a risk that stimulus may wear off before a sustained global recovery begin. However signs suggest that economic output has strengthened o BNP: A worse outcome for Germany in Q1 is more or less already baked in given the weak industrial production and exports. Moreover, orders data suggest production is likely to fall further in the coming months. o Daiwa: It would take a stimulus measures of the Chinese and U.S. governments and the the acceleration of industrial restructuring as Japanese companies to create a sustained upswing in the Japanese economy http://www.rgemonitor.com/10002/Global_Macroeconomic_Issues?cluster_id=13639

76 Business April 19, 2009 When the Real Estate Game Cost $9.95 By JULIE CRESWELL IN the alternate universe of late-night TV infomercials, Carleton H. Sheets once reigned supreme. Standing against a backdrop of tropical seas and gently swaying palm trees, he promised that viewers, no matter how down on their luck, could soar into the ranks of the super-rich by investing in that most bubblicious of assets: real estate.

Photo illustration by The New York Times Carleton Sheets was a staple of late-night TV, encouraging viewers to go into debt investing in real estate. Since the market soured, he has had a lower profile. “Even if you have no money, no credit and no experience in real estate,” you, too, could achieve financial freedom, he advised in a sonorous baritone that, after mesmerizing insomniacs for several years, gained even greater purchase with viewers during the recent housing boom. All you needed was Mr. Sheets’s real estate course, available for the low, low price of $9.95. Only five minutes left for this trial offer. Call now. “Why not make this the moment you stop dreaming?” he intoned. The dream that Mr. Sheets dangled in front of average Joes and Janes was a hand in the game, a piece of the action. When property values began soaring in the late 1990s, so did the frequency of Mr. Sheets’s infomercials. For millions of real estate wannabes sitting in their living rooms, he embodied the bubble as much as Citigroup or Merrill Lynch did. “He was the king of the real estate infomercial,” says Sam Catanese, chief executive of Infomercial Monitoring Service, a research firm in Philadelphia.

77 Today, Mr. Sheets presides over some holdings of his own that appear to be troubled, his late-night profile has greatly dimmed, and the world that he so avidly promoted — easy real estate riches — is in shambles. Even so, he retains a loyal flock of true believers. “If you write the truth about Carleton Sheets, you’ll make a lot of people mad,” says David L. Hancock of Burlington, N.C., a Sheets devotee who credits his mentor’s training course for his start in real estate investing. “The truth is, some people take the information and use it and some people are simply lazy,” says Mr. Hancock, who has also appeared in Mr. Sheets’s infomercials. “It’s just like any diet or exercise book out there. They probably work, but how many people are willing to stick to them?” Some people say it’s a little more complicated than that. “These guys all said, ‘I’m going to teach you how to get rich in real estate, even if you have no cash, no credit, no common sense, are unwilling to make any effort or take any risk.’ That’s literally their pitch,” says John T. Reed, who has written books about real estate investing and rates real estate gurus on his Web site, www.johntreed.com. On his site, Mr. Reed has made a sport of ripping apart Mr. Sheets’s advice and techniques. “Sheets targets beginners. The curriculum he devised for those novices is not what I think beginners need to know,” he writes on his site. “In fact, it appears to me that the topics he chose to write about were selected to maximize Carleton Sheets’ income, not to increase the incomes of his customers. The customers that most real estate gurus go after are relatively uneducated, inexperienced and poor.” Mr. Sheets, after a brief telephone conversation from his home in Stuart, Fla., declined to be interviewed. “I’m proud of the life that I’ve led and what I’ve helped accomplish for a lot of people,” he says. “I keep telling people that I gave them the cloth but they were the ones who made the clothes.” The Professional Education Institute, the Burr Ridge, Ill., company that is Mr. Sheets’s longtime partner, says its offerings have always provided value. “P.E.I. and Carleton Sheets have received thousands of letters from satisfied customers praising Carleton Sheets’s programs. Last year alone, we received over 3,000 such letters,” the company said in a statement. “All P.E.I./Carleton Sheets products/programs meet the highest standards to ensure they provide tangible benefits to their students.” Nor, says P.E.I., is it significant that portions of Mr. Sheets’s personal portfolio may be distressed. “It is neither surprising nor noteworthy that some of the properties owned or partially owned by Carleton Sheets may have, at least temporarily, lost some value,” the company says. “Nearly every property owner in the U.S. today has experienced at least some — if not significant — depreciation in property values.” And it may be that Mr. Sheets, who titled his 1998 book “The World’s Greatest Wealth Builder,” remains a true believer — as he was in early 2007, when, at the peak of the housing boom, he offered wisdom to real estate novices. “I’ve been a successful real estate investor for 35 years,” he said in an infomercial that was shown that year. “History shows real estate is the most stable and consistently profitable investment people can make.”

78 INFOMERCIAL-LAND has always been populated by colorful characters, who pitched real estate techniques while wearing Technicolor shirts or, offered nuggets of advice while posing on yachts, surrounded by bikini-clad women. Mr. Sheets, 69, entered the business more quietly. Having grown up in Delaware, Ohio — his father worked for Procter & Gamble — he marketed soft-drink bottle caps in one of his early jobs, and was later director of marketing for a Florida company that was a major processor of orange juice. In the 1970s, he started investing in property, and in the early 1980s he slogged away as a pitchman for a company that represented the real estate authority Robert G. Allen, an early advocate of the “no-money-down” path to financial success. (There are different definitions of no-money-down strategies, but they all involve someone borrowing money — from a bank or a partner — rather than using his own funds to purchase a property.) A few decades ago, before late-night cable infomercials burst onto the scene, real estate experts ran seminars early in the morning and at night so that aspiring millionaires could attend before or after their day jobs. The opportunity to sign up for more seminars was offered at tables in the back of the room, and Mr. Sheets proved to be an avid and dedicated seminar leader. “We traveled 47 weeks of the year,” recalls Mr. Sheets’s third wife, Sue Blair. (Mr. Sheets is now married to his fifth wife.) “We would go in and do a 90-minute talk, a 90-minute preview, where we taught investors two or three techniques out of like 40. It was a teaser session to get them to sign up for more seminars.” Ms. Blair says Mr. Sheets was broke when she first met him and had taken up teaching real estate courses in Miami after losses on Florida property investments. Things were so bad, Ms. Blair says, that she had to lend Mr. Sheets $500 for a mortgage payment. All of that changed in the early 1980s, when two businessmen from Chicago — Mark S. Holecek and Donald R. Strumillo — were on the lookout for a real-estate pitchman to help market products. They teamed up with Mr. Sheets, and their venture, eventually named the Professional Education Institute, grew at a decent clip, according to Ms. Blair. But when property values began to climb in the mid- to late 1990s, demand for Mr. Sheets’s investment programs soared. And he and his partners had found the perfect avenue for courting the masses, one more potent than road shows and seminars: television. Mr. Sheets’s backers spent an estimated $280 million running ads on cable and network television between 1993 and 2007, according to Infomercial Monitoring Service, and his infomercials were among the most frequently shown of all infomercials during the frenzied real estate boom. The industry rule of thumb is to bring in at least twice in revenue what you spend on advertising. P.E.I., which is privately held, raked in cash. In the three years ended in August 2005, the company’s revenue totaled at least $441.3 million, according to data P.E.I. provided to the research firm Gnames Media Group. The firm said that was its most recent data available because it stopped working with P.E.I. in early 2007. P.E.I. had commissioned sales representatives working from a Salt Lake City call center to encourage people who had already bought DVDs to cough up an additional $995 to $5,000 for phone sessions with a real estate coach. In theory, these coaches had years of experience buying and selling properties. In practice, according to a former employee, that wasn’t always the case.

79 “When things got really busy during the boom, I’m sure there were people hired that were not the company’s ideal candidates,” said that former employee, Bill Cox, who worked as a real estate coach for Mr. Sheets from 2004 to 2006 and says he personally does have years of real estate investment experience. “One of the criteria was that you had to have made at least one real estate purchase. That could have been their own home. That was O.K. because many of the students were first-time home buyers themselves.” A spokeswoman for P.E.I. said that the coaches have, on average, 15 years’ experience in real estate and that they must complete 100 hours of training each year. When Mr. Sheets signed on with Mr. Holecek and Mr. Strumillo, he received a fairly small stake in their company, maybe as little as 10 percent initially, Ms. Blair recalls. And in the infomercial world — filled with sizzle and va-va-voom sex appeal — Mr. Sheets, who came across in demeanor as a Mr. Rogers of real estate, was an unlikely star. Tall and slightly paunchy, Mr. Sheets typically appeared on air wearing button-down shirts (often checkered), sweaters and khaki pants. He would furrow his brows and nod sagely as he interacted with others on his infomercials, an Everyman who generously courted his viewers. “He’s a fatherly-looking type,” says Cliff Rose, who worked at P.E.I. in the early 1990s. An infomercial producer, Timothy R. Hawthorne, puts his finger on part of the Sheets mojo: “He was kind of like someone’s favorite uncle.” Like nearly all gurus, Mr. Sheets embroidered his infomercials with the requisite rags-to- riches tale. In one installment, as black-and-white photographs of a young Mr. Sheets flit by on the screen, he describes in a voiceover how he was fired from his Florida marketing job in the 1970s. With no money, no credit and a young family to support, he started investing in real estate. Today — ta-da! — he is a success. That tale ended, the screen fills with attractive individuals and couples who say they were scraping by but now, thanks to Mr. Sheets, are making money hand over fist. It’s easy. If we can do it, so can you! For some, Mr. Sheets’s inspirational and motivational message became a ticket to a better life. “I saw him on TV one Sunday morning,” recalls Mr. Hancock, who was working in newspaper advertising sales at the time. “I had seen his commercials before, but this time I ordered the program, some CDs and a manual. I was interested in the financial freedom that real estate could afford.” Soon, Mr. Hancock was hooked. Using some of the techniques he says he learned from Mr. Sheets’s course, he bought his first property in 1996. Today, he says he owns all or part of about $25 million worth of property, much of which he bought during the real estate bubble. Which means Mr. Hancock is in debt up to his eyeballs. “When I say I have $25 million worth of property, I’m $21 million in debt,” he says, adding that rental rates are holding up O.K. “Do I ever sleep uneasy? No, actually, I don’t.” Mr. Sheets’s programs are geared toward novices, but his advice sometimes veers into very sophisticated territory. (One DVD spends 11 minutes explaining cash flow analysis.) Other suggestions and information are so basic they come across as almost comical. In his book, Mr. Sheets offers negotiation techniques (“teach yourself to ask for and remember the other party’s name”); discussions of mortgages and how to use leverage (“leverage is the very nucleus of creating wealth out of thin air”); as well as definitions of real estate terms (“puffery: exaggerated praise of a product or property”).

80 His students were obviously willing to leap into the frenzied real estate market, but some were likely to have found themselves in way over their heads. “In one of the exercises I would do with students, I’d say, ‘Show me that you know how to use the financial calculator and calculate mortgage payments,’ ” recalls Mr. Cox. “With some people, it was like, boom, they could do it. With others, I’d spend 30 minutes with them, telling them how to, like, push the buttons. You would feel bad for those people.” AFTER agreeing to meet for an interview, Mr. Sheets called a few days later and rescinded the offer. “I don’t want to subject myself to a highly critical article,” he said. “I feel good about my reputation.” He later mailed an autographed copy of his book. (“You’re a great writer and sound like a very nice person! All the best! Carleton.”) Most of his partners aren’t eager to chat, either. When Russell J. Knowles of Port St. Lucie, Fla., who runs a medical equipment service company, was asked how he met Mr. Sheets, with whom he has invested in commercial property in Florida, he responded: “I’ve known him a long time. He’s a great guy. You keep pounding the pavement and you’ll get that story.” Then he hung up. A call to Mr. Holecek of the Professional Education Institute went unreturned. A spokesman said he declined to be interviewed. “You won’t hear from them,” predicts Mr. Reed, the guru-rating author. “People have been complaining about the firm for years — how they signed up for a $9.95 offer and somehow their credit card got charged $36 a month.” The Better Business Bureau has reported hundreds of complaints like those over the years from customers of Mr. Sheets and P.E.I., many of them contending that they were overbilled and had difficulties securing refunds. A few state attorney general offices say they have received a handful of similar complaints over the years. A spokesman for Mr. Sheets and P.E.I. says that only a tiny proportion of its customers — an average of 9 out of every 10,000 — filed complaints with the bureau or authorities over the years. “Virtually 100 percent” of the cases were successfully resolved, he added. APPARENTLY a more nagging problem for Mr. Sheets is that he, too, seems to have been caught in the real estate implosion. In the late 1990s, Mr. Sheets and a partner, Michael Maslak, began buying numerous condos and duplexes in and around Stuart, the Florida city where Mr. Sheets has a home in a luxurious gated community. But the homes that the partnership bought during the real estate frenzy were considerably more down-market than Mr. Sheets’s own, according to county property records and interviews. The homes have declined in value in the real estate downturn, causing Mr. Sheets to lose “a considerable amount of money” in the partnership, according to his spokesman. Mr. Maslak said that the partnership with Mr. Sheets was being dissolved, but he declined to speak about losses it had sustained on several properties it holds. When the days of easy money in the real estate market disappeared sometime last year, so, essentially, did Mr. Sheets. His once-ubiquitous infomercials stopped running, according to Infomercial Monitoring Service, and Mr. Sheets now maintains a much lower profile on his Web site. Still, he says that now is a great time for individuals to invest in real estate. In a recent videocast on his Web site, he suggests that lawmakers should extend tax credits for first-

81 time homebuyers to real estate investors, “encouraging them to become more active in the market again.” (In another, he advises viewers to make property offers in “uneven numbers to make the seller feel like you’ve really done a lot of work.”) But with some real estate investors being blamed as having played a significant role in the housing boom and bust, it’s going to be a little harder for Mr. Sheets to woo new students. “The infomercials are off the air completely now, and that’s strictly due to the times,” says Mike Summey, author of the “Weekend Millionaire” book series and a longtime friend of Mr. Sheets. “Real estate has been tarnished so badly in the press and so many people have lost their shirts out there buying stupidly, it just doesn’t have the luster to it that it once did.”

82

TRIBUNA: NORMAN BIRBAUM Nadie sabe los tiempos que me tocó vivir NORMAN BIRBAUM 18/04/2009 No sabe nadie las dificultades que me tocó vivir" es uno de esos himnos afro-americanos que inmortalizaron el valor de los oprimidos. Hoy, la nación entera estadounidense se enfrenta a unas dificultades que la mayoría de la generación actual no ha conocido, ni siquiera parecidas. Gran parte de nuestros argumentos políticos se han vuelto ciertamente históricos. ¿Cómo vamos a hacer frente a una crisis económica que supone un rechazo obvio de la idea del modelo americano, cuando hasta hace muy poco ese modelo se proclamaba triunfante? ¿Qué lugar ocupará Estados Unidos en un mundo que está cambiando mucho más rápidamente que nuestra capacidad para controlarlo o siquiera comprenderlo? Especialmente perturbador es el problema de una posible vía histórica nacional, pues ni en la alta cultura ni en la cultura popular parece haber un acuerdo con respecto al pasado. Se produjo un interés renovado en el New Deal, pero ese interés se ha transformado en un acalorado debate sobre las relaciones entre el mercado y el Estado, y las opiniones sobre las políticas llevadas a cabo por Franklin Roosevelt están hoy tan divididas como recuerdo que lo estaban en los años 1930. Las mayorías estadounidenses están dispuestas a aceptar la intervención estatal en la economía a fin de alcanzar unos mínimos considerables de igualdad en educación y sanidad, en pensiones y en oportunidades vitales en general. Los demócratas se enfrentan a un Partido Republicano que repite los mismos ensalmos económicos que lleva pronunciando desde 1920. Los republicanos se muestran igualmente retrógrados en el ámbito cultural, represivos en el sexual, indiferentes u hostiles a la ciencia y displicentes con respecto al medio ambiente, además de insistir obsesivamente en unos valores patriarcales periclitados. En política exterior y militar, quienes defienden el unilateralismo estadounidense han acusado a Obama de prestar demasiada atención a las opiniones e intereses de otras naciones. Un número importante de líderes demócratas comparten este punto de vista, en el que la arrogancia nacional de creerse moralmente superior se fusiona con una sobreestimación del poder estadounidense: piensen en la lista interminable de nuestras catástrofes. Con todo, el presidente Obama goza de un gran respaldo popular. La ciudadanía considera que su viaje ha sido un éxito y ahora sólo espera que actúe con firmeza en el terreno económico. La resistencia a sus medidas económicas es el resultado de la manipulación de la ansiedad y del interés que ejercen aquellos grupos que, detentando poder y riqueza, tienen mucho que perder. Los demócratas, como si di-jéramos, han tenido que dar marcha atrás: han vuelto a defender el New Deal (a excepción de una minoría vociferante) después de que bajo el mandato de Bill Clinton se convirtieran en un partido del mercado. La era de una militancia numerosa y bien formada en los partidos socialistas y socialdemócratas europeos ha terminado. Nosotros casi nunca tuvimos algo así, y los defensores del cambio en Estados Unidos están divididos en grupos definidos por un objetivo político monotemático o por unas reivindicaciones puntuales, sin un proyecto común. En este repaso de la situación, bien conocido para los progresistas, falta algo esencial. En su furibunda polémica con Marx, Max Weber afirmaba que los intereses por sí solos no determinan las ideologías: las visiones del mundo dictaron los cambios de agujas en las vías de la historia. Una fuente del excepcionalismo estadounidense es nuestro perenne conflicto de ideas sobre el tiempo histórico. El Sur blanco vivió durante un siglo como si la Guerra Civil

83 acabara de terminar. Las oleadas encadenadas de grupos de inmigrantes se sumaron a las lecturas etnocéntricas que proponían una misma suerte para unas experiencias muy diferentes en la nueva nación. Los descendientes de los puritanos de Nueva Inglaterra y de los grandes hacendados sureños, visto que sus esfuerzos eran cada vez más infructuosos, se han cansado de reivindicar sus derechos de propiedad sobre nuestro modelo de sociedad y se han convertido por voluntad propia en objetos de anticuario. Los hispanos que originariamente se asentaron en el suroeste se benefician tan poco de su largo arraigo en suelo estadounidense como los indios, que ya estaban aquí cuando llegaron todos los demás. Mientras tanto, los progresistas y los tradicionalistas se enfrentan en las iglesias. En Estados Unidos, las fronteras entre la sociedad secular y la sociedad religiosa cambian continuamente. La fluctuación en el número de quienes se consideran creyentes es menos importante cuando las creencias no acaban de fijarse. A todas estas diferencias hay que añadir unas limitaciones culturales de clase y generación semejantes a las que se dan en Europa. Se critica a Obama de estar en continuo movimiento ideológico, de pasar de un problema a otro sin atenerse a un plan determinado. Nuestro presidente es muy inteligente y sabe lo que hace. Considera que su elección fue el resultado de la voluntad del electorado de sustituir a un Gobierno cuya ideología superficial e intereses inflexibles no reflejaban el nuevo perfil de la nación. Y está luchando por redefinir la historia estadounidense, dándole un sentido nuevo y más incluyente a sus contenidos. Pese a su reserva con respecto a sus orígenes mixtos, su recorrido vital y social es tan importante para su sentido de la misión que tiene por delante como su confianza en los tecnócratas que ha nombrado para su Gobierno. Ciertamente, algunos de ellos (y, tal vez, Hillary Clinton) han vuelto a ver una fuente de inspiración para sus políticas en aquellas nuevas fronteras que exploraron de jóvenes. Junto a los veteranos de la política rutinaria, hoy han empezado a ocupar los rangos intermedios del Gobierno bastantes técnicos que se forjaron profesionalmente en movimientos sociales antes marginados. Y lo que traen con ellos es una convicción profunda, semejante a la de un joven Obama, de que existe la posibilidad histórica. No creen que se trate tan sólo de una idea de la historia, de nuestra historia, contrapuesta a otras, sino que reconocen en ella una nueva época. El planteamiento del propio Obama se basa en la alusión, el gesto y el símbolo, como si no consultara con un equipo de estrategas electorales, sino con historiadores de la cultura. "No sabe nadie los tiempos que me tocó vivir" es, sin embargo, un lema tan bueno como cualquier otro para la refundación de nuestra historia; tal vez, mejor que la mayoría.

84 Apr 17, 2009 U.S. Bank Earnings In Q1: Take With A Pinch Of Salt? Overview: (Patterson, WSJ): Large banks report Q1 earnings in week of April 13. J.P. Morgan, Citigroup and Bank of America said they posted a profit in January and February. Wells Fargo gave better than expected earnings guidance. Goldman posts profit and plans to raise $5bn in stock sale. Banking stocks have rallied nearly 30% since early March while awaiting official stress test results by the end of April. o FASB easing of mark-to-market rules is effective starting Q1--> Robert Willens (former Lehman): rule change could boost capital balances by 20 percent and earnings by as much as 15 percent. Edward Jones: Under the new rules banks will also be allowed to exclude from net income any losses they deem “temporary,” making it easier to provide a flattering earnings picture (via Bloomberg)--> see also: Use and Abuse of Fair Value Accounting: Watch Inflated Trading Revenues o Patterson (WSJ): In Q4, publicly traded banks posted combined losses of $52 billion, according to Moody's Economy.com. First-quarter losses are expected to total $34 billion. --> U.S. Banks' Q4 Results: First Aggregate Net Loss Since Q4 1990, Number Of Failed Banks Increases o Oppenheimer&Co (via WSJ)): While the tentative recovery in interbank spreads shows that banks are starting to lend to one another again, there is little sign they are lending much to consumers or businesses. That isn't good for commercial banks such as J.P. Morgan, whose lifeblood is lending. It is why firms with large investment-banking operations should recover before commercial banks.--> Will The PPIP Get Credit Flowing Again? Watch Interbank and Credit Spreads o Patterson (WSJ): Growth in loans and leases through the first two months of the year was the slowest since September 2002, according to Federal Reserve data. Delinquencies on credit-card debt continue to rise. Revolving consumer credit, which includes credit cards, fell 9.7% in February from a year ago, the biggest decline since 1978--> see U.S. Credit Card Delinquencies At Record Highs: Same Dynamics As Mortgages? and Bank Lending Continues To Fall: Lack of Credit Demand of Supply? o April 17, Bloomberg (Keoun): Citigroup, the U.S. bank rescued by $45 billion in U.S. taxpayer funds, ended a five- quarter losing streak with a $1.6 billion profit on trading gains and an accounting benefit for companies in distress. o April 16 DealBook: JPMorgan Chase reported a $2.1 billion profit in the first quarter, besting forecasts. o April 13 MarketWatch/Bloomberg: Goldman Sachs earned $1.81 billion, or $3.39 a share, in the first quarter as a surge in trading revenue outweighed asset writedowns. The results beat the $1.64 a share estimate of 16 analysts surveyed by Bloomberg but exclude the

85 month of December ('orphaned month' due to earnings calendar change: pre-tax loss was $1.3 billion, and the after-tax loss was $780 million).--> Raises $5bn in stock sale in oder to pay back TARP funds. Says that it plans to keep issuing FDIC guaranteed debt in the future. o HousingWire: Wells Fargo on April 9 said it expects to post a record net income of $3 billion — or 55 cents per share — in its first-quarter earnings statement, which is due out April 22. As part of the gain, Wells said it expects $20 billion in total revenue, offset by combined net charge-offs of $3.3 billion for both Wells and Wachovia (from $6.1 billion in the fourth quarter). Wells built its credit reserve by $1.3 billion, bringing the total credit loss allowance to $23 billion, the company said. o Whitney Tilson of hedge fund manager T2 Partners (via MarketPipeline): “The shocker was that they only had only $3.3 billion [in] charge offs. It’s weird, because in Q4 Wachovia and Wells Fargo together had $6.1 billion in charge-offs, and then in a quarter in which things were terrible, those charge offs fell by 50 percent … They’re going to have a lot of losses over the next couple of years, [and] anyone baselining at $3.3 billion in charge offs per quarter is crazy.” --> Wachovia's large OptionARM book is excluded from earnings guidance according to Jackson (HouseWire). o March 15: NYT: Financial companies that received multibillion-dollar payments owed by A.I.G. include Goldman Sachs ($12.9 billion), Merrill Lynch ($6.8 billion), Bank of America ($5.2 billion), Citigroup ($2.3 billion) and Wachovia ($1.5 billion). Big foreign banks also received large sums from the rescue, including Société Générale of France and Deutsche Bank of Germany, which each received nearly $12 billion; Barclays of Britain ($8.5 billion); and UBS of Switzerland ($5 billion)--> GAO suggests that Treasury should require that AIG seek additional concessions from employees and existing derivatives counterparties. o April 10 Nouriel Roubini: In brief: banks are benefitting from close to zero borrowing costs; they are benefitting from a massive transfer of wealth from savers to borrowers given a dozen different government bailout and subsidy programs for the financial system; they are not properly provisioning/reserving for massive future loan losses; they are not properly marking down current losses from loans in delinquency; they are using the recent changes by FASB to mark to market to inflate the value of many assets; they are using a number of accounting tricks to minimize reported losses and maximize reported earnings; the Treasury is using a stress scenario for the stress tests that is rather a benchmark of what the economy is likely to look like in 2009 and 2010; a true stress scenario would have considered a much more serious economic downturn--> IMF boosts its global loss estimate to $4T http://www.rgemonitor.com/10006/Finance_and_Banking?cluster_id=13703

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OP-ED COLUMNIST

April 17, 2009 Green Shoots and Glimmers By PAUL KRUGMAN Ben Bernanke, the Federal Reserve chairman, sees “green shoots.” President Obama sees “glimmers of hope.” And the stock market has been on a tear. So is it time to sound the all clear? Here are four reasons to be cautious about the economic outlook. 1. Things are still getting worse. Industrial production just hit a 10-year low. Housing starts remain incredibly weak. Foreclosures, which dipped as mortgage companies waited for details of the Obama administration’s housing plans, are surging again. The most you can say is that there are scattered signs that things are getting worse more slowly — that the economy isn’t plunging quite as fast as it was. And I do mean scattered: the latest edition of the Beige Book, the Fed’s periodic survey of business conditions, reports that “five of the twelve Districts noted a moderation in the pace of decline.” Whoopee. 2. Some of the good news isn’t convincing. The biggest positive news in recent days has come from banks, which have been announcing surprisingly good earnings. But some of those earnings reports look a little ... funny. Wells Fargo, for example, announced its best quarterly earnings ever. But a bank’s reported earnings aren’t a hard number, like sales; for example, they depend a lot on the amount the bank sets aside to cover expected future losses on its loans. And some analysts expressed considerable doubt about Wells Fargo’s assumptions, as well as other accounting issues. Meanwhile, Goldman Sachs announced a huge jump in profits from fourth-quarter 2008 to first-quarter 2009. But as analysts quickly noticed, Goldman changed its definition of “quarter” (in response to a change in its legal status), so that — I kid you not — the month of December, which happened to be a bad one for the bank, disappeared from this comparison. I don’t want to go overboard here. Maybe the banks really have swung from deep losses to hefty profits in record time. But skepticism comes naturally in this age of Madoff. Oh, and for those expecting the Treasury Department’s “stress tests” to make everything clear: the White House spokesman, Robert Gibbs, says that “you will see in a systematic and coordinated way the transparency of determining and showing to all involved some of the results of these stress tests.” No, I don’t know what that means, either. 3. There may be other shoes yet to drop. Even in the Great Depression, things didn’t head straight down. There was, in particular, a pause in the plunge about a year and a half in — roughly where we are now. But then came a series of bank failures on both sides of the Atlantic, combined with some disastrous policy moves as countries tried to defend the dying gold standard, and the world economy fell off another cliff.

87 Can this happen again? Well, commercial real estate is coming apart at the seams, credit card losses are surging and nobody knows yet just how bad things will get in Japan or Eastern Europe. We probably won’t repeat the disaster of 1931, but it’s far from certain that the worst is over. 4. Even when it’s over, it won’t be over. The 2001 recession officially lasted only eight months, ending in November of that year. But unemployment kept rising for another year and a half. The same thing happened after the 1990-91 recession. And there’s every reason to believe that it will happen this time too. Don’t be surprised if unemployment keeps rising right through 2010. Why? “V-shaped” recoveries, in which employment comes roaring back, take place only when there’s a lot of pent-up demand. In 1982, for example, housing was crushed by high interest rates, so when the Fed eased up, home sales surged. That’s not what’s going on this time: today, the economy is depressed, loosely speaking, because we ran up too much debt and built too many shopping malls, and nobody is in the mood for a new burst of spending. Employment will eventually recover — it always does. But it probably won’t happen fast. So now that I’ve got everyone depressed, what’s the answer? Persistence. History shows that one of the great policy dangers, in the face of a severe economic slump, is premature optimism. F.D.R. responded to signs of recovery by cutting the Works Progress Administration in half and raising taxes; the Great Depression promptly returned in full force. Japan slackened its efforts halfway through its lost decade, ensuring another five years of stagnation. The Obama administration’s economists understand this. They say all the right things about staying the course. But there’s a real risk that all the talk of green shoots and glimmers will breed a dangerous complacency. So here’s my advice, to the public and policy makers alike: Don’t count your recoveries before they’re hatched. http://www.nytimes.com/2009/04/17/opinion/17krugman.html?_r=1&th&emc=th

April 16, 2009, 4:28 pm Reconsidering a miracle In preparation for some recent teaching, I went back to something that was a hot topic not long ago, and will be again if and when the crisis ends: the apparent lag of European productivity since 1995. One recent, seemingly authoritative study is van Ark et al; and I noticed something that gave me pause. In their paper, van Ark etc. identify the service sector as the main source of America’s pullaway — which is the standard argument. Within services, roughly half they attribute to distribution — roughly speaking, the Wal- Mart effect. OK. But the other half is a surge in US productivity in financial and business services, not matched in Europe. And all I can say is, whoa! First of all, how do we even measure output of financial services? If I read this BEA paper correctly, we more or less use “checks cashed” — or, more broadly, the number of transactions undertaken. This may be the best we can do, but it’s a pretty weak measure of actual work done by the financial system. And given recent events, are we even sure that the expansion of the financial system was doing anything productive at all?

88 In short, how much of the apparent US productivity miracle, a miracle not shared by Europe, was a statistical illusion created by our bloated finance industry? Dean Baker has argued for some time that, properly measured, the productivity gap between America and Europe never happened. I’m becoming more sympathetic to his point of view. April 14, 2009, 10:05 am Bush budgeting lives — at Goldman Sachs Wow. Just wow. Floyd Norris, via Barry Ritholtz, tells us that Goldman’s good numbers have a lot to do with a magic trick: they made December disappear! It’s an “orphan” month! This is Bush-style budgeting, with sunsets and all that which made the true costs of policies disappear, but this time applied to the private sector. Add to this the questions about reported profits at other financial institutions, and you get the feeling that what we’re seeing isn’t so much green shoots as smoke and mirrors.

The Productivity Gap between Europe and the United States: Trends and Causes By Bart van Ark, Mary O’Mahony, and Marcel P. Timmer Measurement of Market Services Output It has been suggested that part of the productivity growth gap between European countries and the United States could be due to differences in the measurement of services output. The measurement of output is in general much more challenging in services than in goods-producing industries. Indeed, Griliches (1994) classified a large part of the services sector as “unmeasurable.” Most measurement problems boil down to the fact that service activities are intangible, more heterogeneous than goods, and often dependent on the actions of the consumer as well as the producer. While the measurement of nominal output in market services A2 Journal of Economic Perspectives is generally straightforward, being mostly a matter of accurately registering total revenue, the main bottleneck is the measurement of output volumes, which requires accurate price measurement adjusted for changes in the quality of services output. A prominent exception is the measurement of banking output, which still needs a suitable conceptual framework (Wang, Basu, and Fernald, 2004).

There is no doubt that problems in measuring services output still exist, but the data situation is much better than say two decades ago. In recent years, many statistical offices have made great strides forward in measuring the nominal value and prices of services output; for examples, see the general overview for the United States by Abraham (2005) and in-depth industry studies in Triplett and Bosworth (2004). Inklaar, Timmer, and van Ark (2008) provide an assessment of statistical practices in European countries and conclude that measurement problems are most severe in finance and business services. However, the scope of measurement problems should not be overstated: on average only about a quarter of output is deflated using inappropriate (and thus potentially misleading) deflators, while for the remainder at least acceptable methods are used, as defined by Eurostat, the Statistical Office of the European Union. Thus, there is no evidence that differences in measurement practices bias international comparisons of productivity growth rates across countries.

U.S. Productivity Growth Still Trails Europe For Immediate Release: June 12, 2007 Contact: Dan Beeton, 202-293-5380 x 104

89 Washington, D.C.: A report by the Center for Economic and Policy Research shows that U.S. productivity growth has lagged behind Europe -- even during the IT boom from 1995-2005 -- when adjusted to measure rises in living standards. The paper, "'Usable Productivity' Growth in the United States: An International Comparison, 1980-2005," by Dean Baker and David Rosnick, also finds that the U.S. economy's sustainable rate of usable productivity growth over the 1995-2005 period was 0.4 percentage points lower than the average of other OECD countries. These calculations suggest that even with the 1995 productivity upturn that accompanied the IT boom, the U.S. has not been able to sustain the same rate of increase in living standards as other wealthy countries. The performance of the United States also appeared relatively worse in the 1980 - 1995 period. "The U.S.' failure to keep up has been hidden, in part, by the huge increase in the current account deficit and the decline in net investment over the last decade," Dean Baker, Co-Director of the Center for Economic and Policy Research, and co-author of the study, explained. "But when the current account deficit stabilizes or shrinks in the coming years ahead, the rate of increase in living standards in the U.S. is likely to be slower than in other wealthy countries." Since productivity growth cannot be directly translated into improvements in living standards, the authors made two technical adjustments to measured productivity growth to assess the rate at which the economy is allowing for rises in living standards: 1) A net measure of output (removing changes in the share of output that go to replace depreciated capital), and 2) A consumption deflator instead of an output deflator to assess the rate at which the economy can provide for increases in living standards. "It is important to understand how well the U.S. has really fared," Baker said. "Rapidly increasing productivity growth can result in rapid increases in income, or leisure time, or some combination of both. And if these benefits are broadly shared, then the whole of society can benefit."

"Usable Productivity" Growth in the U.S.: An International Comparison, 1980-2005

June 2007, Dean Baker and David Rosnick This paper examines the U.S. economy’s sustainable rate of “usable productivity” growth over the 1995-2005 period with that of other OECD countries. Since productivity growth cannot be directly translated into improvements in living standards, the authors made two technical adjustments to measured productivity growth to assess the rate at which the economy is allowing for rises in living standards: 1) A net measure of output (removing changes in the share of output that go to replace depreciated capital) and 2) A consumption deflator instead of an output deflator to assess the rate at which the economy can provide for increases in living standards. When these two adjustments are made to measured productivity growth in the United States and other wealthy countries, the performance of the United States looks relatively worse in both the period from 1980 to 1995 and also in the period from 1995 to 2005. In fact, these adjustments make the rate of “usable productivity” growth slightly slower in the United States than in other wealthy countries over the period from 1995 to 2005. This report was republished by the International Productivity Monitor, a division of the Centre for the Study of Living Standards (CSLS), in their Fall 2007 issue (No. 15). View here in English, or here, en Français. Report

90 EUROZONE SHOWS FEW SIGNS OF RECOVERY Eurozone shows few signs of recovery By Ralph Atkins in Frankfurt Last updated: April 16 2009 21:32 The rapid pace of the eurozone’s economic contraction shows few signs of slowing, with industrial production down almost 20 per cent year-on-year in February and inflation dissipating, official data showed on Thursday. The 18.4 per cent fall in output in the 16-country region – the largest since records began in 1990 – highlighted the severity of the global slowdown. Monthly comparisons offered little sign of stabilisation, with the 2.3 per cent drop in February compared with January only slightly lower than the 2.4 per cent fall reported the month earlier. Monthly comparisons offered little sign of stabilisation, with the 2.3 per cent drop compared with January only slightly lower than the 2.4 per cent fall reported for the previous month. January’s industrial production figures were revised higher by Eurostat, the European Union’s statistical unit, to show a slightly less-catastrophic decline at the start of the year. But “the shocking fact is that almost a fifth of eurozone production has now been wiped out in the past year,” said Colin Ellis, European economist at Daiwa Securities SMBC Compared with the US or UK, the “glimmers of hope are less prevalent in the eurozone”, said Colin Ellis, European economist at Daiwa Securities SMBC. In the US, there was evidence that the inventory cycle was turning more positive for growth, but in the eurozone higher levels of stocks could act as a brake on activity until the second half of the year, Mr Ellis said. The data suggested that the rate of contraction in the eurozone might even have accelerated. First-quarter gross domestic product could have declined faster than the 1.6 per cent fall reported in the last three months of 2008, economists said. With eurozone economic trends typically following those in the US after a few months’ lag, the only signs of improvement so far have been confidence and activity surveys for March pointing to, at best, a slightly slower rate of contraction. The decline in industrial production came in spite of government incentives to boost car sales, which suggested automotive companies were still de-stocking, said Peter Vanden Houte, eurozone economist at ING. Germany, the eurozone’s largest economy, has been particularly affected because of its reliance on exports. German industrial output was more than 20 per cent lower in February than a year ago – as it was in Spain and Italy. France saw a less steep fall of 16.3 per cent. The slowdown in economic activity continues to feed through into lower price pressures. Eurostat said on Thursday the annual eurozone inflation rate fell from 1.2 per cent in February to 0.6 per cent in March – the lowest since records began in the early 1990s. That suggested an undershooting of the European Central Bank’s target of a rate “below but close” to 2 per cent annually. Much of the decline has been due to lower energy prices. But core inflation, excluding energy and other prices, is also slowing, from an annual rate of 1.7 per cent in February to 1.5 per cent in March – the lowest for six years. Eurozone inflation is widely expected to turn negative in future, increasing the pressure on the ECB to follow the Bank of England and US Federal Reserve in embarking on “quantitative easing”.

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Bank Test Results May Strain Limits Of Bailout Funding Much Rides on Size of Capital Needs By David Cho Washington Post Staff Writer Thursday, April 16, 2009 As the Obama administration works to complete its stress tests for gauging the health of major banks, it could confront another problem: how to pay for shoring up any weaknesses the tests reveal. No one yet knows the extent of the banks' needs. But a senior administration official said yesterday this will be clear once tests on the nation's 19 major banks are done and the results are released early next month. The administration would be hard-pressed to ask Congress for more rescue funds to plug the holes. Anger on Capitol Hill is high, especially after the furor over bonuses paid to employees at American International Group. The troubled insurer had earlier received more than $170 billion in bailout funds. But if the capital requirements of banks prove large, the government may need billions of dollars in federal aid back from strong financial firms, which have received that money within the past few months. The administration may even have to carve money from other rescue programs being funded from the $700 billion bailout program. The task of coming up with money underscores the difficulties posed by the next phase of the government's immense effort to stabilize the financial markets. Some senior officials say they worry that allowing strong banks to return their bailout funds would stigmatize the firms that couldn't, scaring off their investors. Treasury officials overseeing the rescue effort are willing to take that chance, believing that the risk of such bank runs has receded in recent months as the financial system has become more stable, a senior administration official said. The official noted that while Wall Street executives have expressed worries about what the government will reveal about their internal conditions in the stress test, the markets have reacted positively as the date of the stress test results has approached. For instance, shares of banks both weak and strong have risen in recent weeks. The official added that some banks will be able to convert federal aid received last year into common stock, providing these firms the most important kind of capital they need. For that reason, some may not require new government investments. Still, the stress tests could show that the needs of the 19 banks are substantial, requiring administration officials to rely on bailout money being returned or even scale back other federal programs, government sources said on condition of anonymity because the stress tests are still in their early phases. Over the past few months, administration officials have outlined ambitious plans that leave them with $32 billion unallocated from the $700 billion financial rescue package -- far less than what officials expect to need for a new round of bank aid, the government sources said. Treasury officials say they may have as much as $110 billion left over because some of the initiatives are not drawing as much as participation as expected. Many firms have grown wary

92 of taking federal aid, which requires them to cede a measure of control to the government and limit executive pay. In particular, a program to revive consumer lending, initially projected to soak up $100 billion in bailout funds, may only require $55 billion. The first round of direct government investments into banks, an initiative developed by the Bush administration, was projected to cost $250 billion, but may reach only $218 billion, even after including upcoming help anticipated for some ailing insurance companies. The Treasury Department also has a contingency plan in case a major financial firm collapses or the shortfall at the large banks proves far greater than anyone in the government now expects. In an emergency, the Treasury can move money out of previously announced programs. Currently, only $303 billion out of the $700 billion bailout program has been disbursed, officials said. Treasury officials say they conservatively project that at least $25 billion will be returned by recipients of government aid after the stress tests' results are unveiled. In recent weeks, several big firms have said they will pay back their money. Among them are Goldman Sachs, which received $10 billion, and J.P. Morgan Chase, which accepted $25 billion. Some analysts and officials worry that as strong banks return their government aid, other banks will feel pressured to overextend themselves in order to follow suit. Meanwhile, the weakest banks would be left behind and tarnished. A senior administration official said no firm will be allowed to pay back money without regulators ensuring that the bank is healthy and able to continue making loans to support economic recovery. Even if companies begin returning taxpayer money, some analysts and officials say the government may not have enough firepower to accomplish all the goals of the bailout effort, which include buying banks' toxic assets, stabilizing the banking system, reviving consumer lending and helping struggling homeowners and small businesses. Senior administration officials have said it is likely they may need to ask Congress for more money, but they say such a request probably wouldn't come anytime soon. In addition, a firestorm over $165 million in bonuses paid to a troubled division of AIG has made the task of asking for more money extremely difficult, officials said. The senior administration official said fears over another firm melting down like AIG -- whose near collapse last fall threatened the entire financial system -- has significantly diminished. The government demonstrated it will prevent any of the nation's most important banks from failing, spending a total of more than $90 billion to prop up Citigroup and Bank of America. The stress tests will also help assure the markets that no other major bank will face a fate similar to AIG. The tests aim to identify the precise areas of need within the banks and provide targeted capital to heal those businesses, the senior official said. They also will provide a clear view of the firms' problems, helping to dispel the uncertainty hanging over the financial system. "The penalty for opacity or lack of clarity is almost always worse than the truth," the official said. http://www.washingtonpost.com/wp- dyn/content/article/2009/04/15/AR2009041503943_pf.html

93 NAKED CAPITALISM THURSDAY, APRIL 16, 2009 "Don’t set Goldman free, Mr Geithner"

John Gapper makes a fundamentally important point in his Financial Times comment today, that Goldman should not be permitted to wriggle free of TARP strictures by repaying the emergency backing of last November, at least not until Treasury has imposed structural reforms. Why? Whether Goldman formally has government funding or not, it has been designated as one of the "too big to fail" banks. Thus it can operate as if it has government backing and play closer to the line than it otherwise would. Since Glass Steagall, the Depression era regulation mandating the separation of commercial and investment banking was passed in 1933, brokerage firms enjoyed higher profits than their government guaranteed brethren and were permitted to fail. But then the line got blurred, and finally erased, as banks pressed to get into more lucrative businesses. And as the brokerage firms became more bank-like (as in bigger users of capital and more active traders) in response to the bank incursion, they became bank-like risks to the system too. Goldman has been very clever at having its cake and eating it too, and that has to come to an end. However, despite the logic of Gapper's argument, I doubt any serious structural reform is in the offing for the financial services industry unless conditions decay to the point where Treasury's hand is forced. Geithner and Summers are clearly true believers in the what-ought- to-be-discredited model of finance-driven capitalism. They have been consistent enablers of the industry, taking tough stands only in the face of public outcry, and then on token issues (and the industry has dutifully played its part in this Kabuki drama, howling at how simply dreadful those requirements are). From the Financial Times: Should Tim Geithner let Lloyd Blankfein escape? Mr Blankfein, the chairman and chief executive of Goldman Sachs, is eager for his institution to become the first big bank to shake off the stifling embrace of the US government. Mr Geithner, the US Treasury secretary, must decide whether to let him. Mr Blankfein’s argument is seductive: it is Goldman’s “duty” to pay back the $10bn in taxpayer money it took last autumn when its future – and that of the global financial system – looked dicey. Goldman seems to be doing fine now: this week, it reported unexpectedly robust first-quarter earnings of $1.8bn. It has spent recent weeks attempting to turn its repayment into a fait accompli. First, Mr Blankfein made a contrite speech assuring investors – to the irritation of its rivals – that Goldman was sadder and wiser and would buckle down to pay reform. Then he raised $5bn in capital from those investors to wave in front of the Treasury secretary. But Mr Geithner should take his time. Not only is the future of Goldman and other taxpayer-backed banks unclear, given the unstable US economy, but Goldman wants to escape the burdens of political control while retaining the benefits of public backing. That does not seem like a good deal for the taxpayer.

94 There are obvious political risks in letting Goldman roam free while other banks remain bound by the troubled asset relief programme (Tarp). It would exacerbate suspicions that Goldman, with its long history of producing Treasury secretaries, gets special treatment. These were not soothed by the decision to pay off all Goldman’s credit default swaps with American International Group, now controlled by the state. The bigger danger is the long-term precedent it would set. Goldman wants to bolt before Congress or Mr Geithner, who still operates as a one-man band while the nomination process for his senior staff meanders along, has the chance to change fundamentally how it operates.

Yves here. This is not a given. Regulatory measures could still be imposed on Goldman, TARP or not. Goldman is an integrated firm. Many of its businesses are regulated, and there is no reason to think rules devised for broker dealers, large credit market players, or "too big to fail firms" would exclude Goldman, whether or not it is on the dole. Back to the article: So far, it has faced mildly irritating limits on how much it can pay staff but nothing on the scale of the 1933 Glass-Steagall Act, which imposed structural reforms on Wall Street after the excesses of the Jazz Age. It would never acknowledge it, but its political campaign is going just fine... Mr Blankfein criticised Wall Street’s past pay practices as “self-serving and greedy” but Goldman is still putting aside 50 per cent of revenues – $4.7bn in the first quarter – for the bonus pool. Inside, it may feel “humbled”, as Mr Blankfein said, but it looks like the same old bank. The same, that is, except for one thing – Goldman is now backed by the US government... Once it has repaid the $10bn, Goldman hopes to go back to paying employees what it wants, buying and selling more or less what it fancies and operating as before. He is peddling an illusion. Even if Goldman repays the equity, the world has changed irrevocably because it is a government-backed enterprise. That will formally be true for a year at least. As well as the preferred shares it took from the Tarp, it has raised another $28bn in bonds backed by the Federal Deposit Insurance Corporation and intends to carry on using the FDIC’s balance sheet. More fundamentally, we now know unambiguously that Goldman is a “systemically important financial firm”. In other words, Goldman is too big to fail and would be bailed out by the US government if its balance sheet failed. That privilege should come with weighty conditions. Note that Goldman’s status is a choice, not a tag it has unwillingly been given. It could avoid this by shrinking itself into an institution like a private equity group or a merchant bank, which can take all the risks it desires because its partners lose everything if it fails. Goldman does not want to do that because it likes having the engine of its capital markets division and equities operations alongside its advisory and fund management arms. It calculates, probably correctly, that the pay-obsessed Congress is not sufficiently serious to put a new Glass-Steagall Act in its way. But there is no clarity yet that Goldman or other Wall Street banks will be forced to pay an appropriate levy for government backing. Unless it is high, they have no incentive to be truly independent.

95 There is no need to look back far to observe how pernicious a combination of private ownership, implicit public backing and inadequate regulation can be. This produced the Fannie Mae and Freddie Mac fiascos. If Mr Geithner cannot think of a sound structural reform to limit the size of Wall Street banks, he must at least make regulatory restrictions bite. He has talked of capping their leverage and their latitude to indulge in proprietary trading but not defined what this means in practice. He ought to keep Goldman on the leash until he has set out the price it must pay for its newfound privileges. If he lets Mr Blankfein dash straight back to business as usual, Goldman will have won again. http://www.nakedcapitalism.com/2009/04/john-gapper.html

96 16.04.2009 BUNDESBANK CHIEF REJECTS DE LAROSIERE REPORT

The opposition to the De Larosiere Report is growing. Bundesbank chief Axel Weber rejected the proposal by the De Larosiere committee to upgrade the European co-ordinating bodies for banking, insurance and securities supervision, and to give them more powers. Weber said this would create an asymmetry, where national agencies have all the responsibilities, while the European co-ordinating bodies have too much power. This was the first official statement by the Bundesbank to the report, and it highlights growing concern among Germany’s policy establishment to let go of national controls. The Bundesbank’s position will almost certainly carry great weight in determining the German government’s own position. Weber said he was in favour of more European co-operation, but this was excessive. FT Deutschland quotes him as saying that if there is a banking crisis, it is the national fiscal authorities who will put up the money, not the EU. Weber on interest rates The FT Deutschland article also quotes Weber as saying that he favoured one more interest rate cut – to 1% - but regards this as the lower limit. The argument is not economic, but purely institutional. Money market funds would otherwise be threatened in their existence, if money market rates were to go down towards zero.

US industrial production continues to fall in March Anyone who thinks that this recession is already levelling off should take a look at the latest US data on industrial production. The Fed reported yesterday that IP fell 1.5% in March after a similar decrease in February. For the first quarter as a whole, output dropped at an annual rate of 20%. It is now at the lowest level since December 1998. Capacity utilisation has also hit an alarmingly new low. Here is the chart from the Calculated Risk blog.

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Guess who is France’s most popular political figure today? Jacques Chirac. This is how bad it has got. According to the latest popularity ranking in Paris Match, the former president has continued his spectacular popularity revival, followed by Rama Yade, state secretary in the foreign ministry. Les Echos has the story, and says that M Chirac’s assent reflects unease about Nicholas Sarkozy’s style of governance. Austria vs Paul Krugman Paul Krugman states the obvious, and got a furious reaction. Speaking in New York, he said Austria could become the third European country, after Iceland, and Ireland, to suffer a state bankruptcy because of its banks’ massive exposures to eastern Europe. This produced a furious reaction in the Alpine republic, both from finance minister Josef Proll, and central bank chief Ewald Nowotny, who insisted that there is no question about the health of Austrian banks (who is he kidding), and the probabily of a state bankruptcy was equal to zero.

April 15, 2009, 11:51 am Austria http://flutethoughts.blogspot.com Aha. It seems that I have reached the stage where I create a stir by saying the obvious. On Monday I held a Princeton-sponsored event at the Foreign Press Club, and was asked about Austria’s Eastern European exposure. I responded by saying what everyone knows: Austrian

98 lending to Eastern Europe is off the charts compared with anyone else’s, and that means some serious risk given that emerging Europe is experiencing the mother of all currency crises. Is Austria doomed? Of course not. It’s not as outrageously leveraged as Iceland, or even Ireland. But it may need a bank bailout that will seriously strain the country’s resources. So what I said at the event — that after those two, it’s probably the advanced country at most risk from the financial crisis — shouldn’t even be controversial. De Grauwe on the Maastricht convergence criteria Writing in Vox, Paul de Grauwe argues that the Maastricht convergence criteria are political instruments, not economically vital measures. They were ignored in 1998 so as to facilitate the Eurozone’s creation, and now they are stringently applied so as to slow its enlargement. There is now a large majority in the euro area against a hasty entry of the new member states. This is not based on any economic analysis showing that the new member states are less fit than the original member states to be part of the euro area. The motivation is political. Thus, the Maastricht convergence criteria are instruments that are used in arbitrary ways to pursue political objectives.

Willem Buiter on US bank rescue and stress tests Willem Buiter writes that the task to rescue the US banking system is getting bigger, while the political willingness to rescue banks is getting smaller. He is particularly dismissive of the stress tests with which the US treasury is assessing the health of the banking system. He identifies three problems. First, the economy is already doing worse than the negative baseline scenario in the stress tests. Second, the tests only focus on old bad assets, not on the banks’ loan books, which went sour during the recession. And third, the information is impossible to verify, as the information is based on private sources. Buiter also discusses the question of who should be responsible for the bank rescue of foreign-owned subsidiaries.

ft.com/maverecon Ruminations on banking By Willem Buiter APRIL 15, 2009 4:41PM (1) The autodafé of the unsecured creditors is coming to a US bank near you A binding budget constraint sure concentrates the mind, even for the US Treasury. There is just one way to make the US government’s policy towards the banks work. That is for the Congress to vote another $1.5 trillion worth of additional TARP money for the banks - $1 trillion to buy the remaining toxic assets off their balance sheets, and $0.5 trillion worth of additional capital. The likelihood of the US Congress voting even a nickel in additional financial support for the banks is zero. There is no real money left in the original $700 bn TARP facility - somewhere between $ 100 bn and 150 bn - to do more than stabilise a couple of pawn shops. The Treasury has been playing for time by raiding the resources of the FDIC (which, apart from the meagre insurance premiums it collects, has no resources other than what the Treasury grants it) and of

99 the Fed. The Fed has taken an open position in private credit risk to the tune of many hundreds of billions of dollars. Before this crisis is over, its exposure to private sector default risk could be counted in trillions of dollars. In addition to looking for money in off-budget and off-balance sheet places (and out of sight of Congress), the US Treasury has also tried to hide true extent of the problems of the US banks. I addition to supporting the FASB’s recent proposals for increasing managerial discretion as to the way illiquid assets are accounted for (that is, condoning the issuance of another license to lie), the Treasury appears to be using the ‘Stress Tests’ announced as part of the Financial Stability Plan, as a mechanism to play for time and gamble for resurrection.[1] I base this on what I have been picking up about the reality of these Stress Tests. 1. The actual decline of the real economy thus far is already steeper and deeper than assumed in the Stress Tests. 2. The Stress Tests focus on the 40% of the banks’ balance sheets consisting of securities, rather than on the 60% consisting of conventional loans. The securities (including the toxic waste) is where most of the old problems of the banking sector are concentrated, that is the problems incurred as a result of the pre-August 2007 speculative frenzy. The loan book contains the stuff that will go bad as a result of the steep and deep contraction in real economic activity the US has been in since Q4, but that will not show up in the banks’ reports until this summer at the earliest. 3. The bulk of the information provided to the authorities by the banks is private information to the banks that is virtually impossible to verify independently. Too many banks have lied about their exposure too many times for me to feel confident about the quality of the information the banks have been providing as part of these Stress Tests. As a result I now expect a clean bill of health for the banks from the Stress Tests. For most banks this will turn out to be incorrect before the end of the year. At that point, the de facto insolvency of much of the US border-crossing banking system will become so self-evident, that even the joint and several obfuscation of banks and Treasury will be unable to deny the obvious. There still will be no fiscal resources available to sanitise the banks’ balance sheets by purchasing or guaranteeing the old toxic assets and new bad assets. At that point, only the ‘good bank solution’, which requires either a serious hair cut for unsecured creditors or a mandatory conversion of debt into equity will be viable, simply because the bad bank solution requires additional public money which isn’t there. (You creating a new good bank out of the assets of the old bank and the insured deposits and counterparty claims on the old bank, leaving the unsecured creditors of the old bank with a claim on the equity in the new good bank; a bad bank requires funds to buy the toxic and bad assets from the old bank and addition resources to capitalise the bad bank). We will have wasted a lot of time - the good bank solution and the slaughter of the unsecured creditors should have been pursued actively as soon as it became clear that most of the US border-crossing banking system was insolvent, but for past, present and anticipated future tax payer support. If the Treasury can be pushed into a pro-active policy by declaring, just before the beginning of the weekend, that most of the banks undergoing the Stress Test have failed them and moving these wonky institutions straight into the FDIC’s special resolution regime where they can be restructured according to the good bank model, we could have well- capitalised banks capable of new lending and borrowing by the beginning of next week. The same policy should be pursued wherever banks have failed: it never makes sense to put the interests of the unsecured creditors before those of the tax payers. It is bad economics in

100 the short run and in the long run. And it is political poison. I fear, however, that only in those countries where there is no fiscal spare capacity (as in the US, for political reasons or in Iceland, for economic reasons), the right solution to bank restructuring will be adopted. Elsewhere the unsecured creditors will continue to feed off the carcases of the tax payers and the beneficiaries of public spending programs that will have to be sacrificed to foot the bill. (2) Too big to fail means too big No country should ever find itself in position of Iceland, with systemically important banks or other financial institutions that are too large to save. The fiscal spare capacity of the government (its ability to raise future primary (non-interest) surpluses has to be sufficient to take care of any possible solvency gap in the systemically important part of their financial institutions. If the too big to save problem can be resolved rather easily, the too big to fail issue has been with us for so long that one assumes there must be powerful forces sustaining large and complex financial institutions. The assumption is correct, but these forces are political, not economic or efficiency-related. Economies of scale for banks are exhausted well before a balance sheet size of $100 bn is achieved. Synergies between commercial banking and investment banking activities are essentially non-existent. The multiplication of products and services offered and of roles played by a financial institution can be privately profitable, because it allows the exploitation of the gains from conflicts of interest. Chinese walls, the industry’s answer to potential conflicts of interests, are aptly named. The Great Wall of China never kept the barbarians out or the Chinese in. Chinese Walls in banks, auditing companies, rating agencies and other financial enterprises don’t stop any information that is commercially profitable from getting across the boundaries. Financial supermarkets lose focus and ultimately become Citigroup - a conglomeration of worst-practice from across the financial spectrum. There is no ‘too interconnected-to-fail’ problem separate from the ‘too-big-to-fail’ problem. I can be infinitely interconnected. If I operate on a small scale, I and my interconnections are immaterial from a systemic stability perspective. Banks and other financial supermarkets want to be large for two reasons. The first is monopoly power. This causes banks to want to be large in any specific activity. It’s common to every industry and to all human activity. That’s what we ought to have anti-trust or pro- competition policies for. The second reason is that financial supermarkets can shelter non- systemically important profitable operations under the heavily subsidised public umbrella provided by the state to a few systemically important operations (deposit taking, payment, clearing and settlement systems, counterparty and custodial services) though lender-of-last- resort support (provided by the central bank) and through recapitaliser-of-last-resort support (provided by the Treasury). There is no economic reason for large banks. Therefore banks should be kept small. An obvious mechanism (apart from aggressive anti-trust policy) is to tax bank size. One way to do this is through making regulatory capital requirements increasing in the size of the bank’s activities. For instance, tier one capital as a share of (unweighted) assets could be made an increasing function of the value of the assets. Gary Becker has made a similar proposal. Governments everywhere should be focusing on breaking up banks and keeping them small. If some banking activity (or indeed any other economic activity) is deemed to have a minimum optimum scale that is makes it too large to fail, it should be publicly owned. Small is beautiful for banks.

101 (3) The repatriation of cross-border banking Even if we agree that a particular bank or other financial institution is too large to fail, as soon as there are multiple fiscal authorities and border-crossing banks, there remains the unanswered question as to who should bail it out. The host country fiscal authority? The home country fiscal authority? Both together through some ex-ante or ex-post negotiated sharing rule? A dedicated supranational fiscal authority? Recent events have made it clear that, as my colleague Charles Goodhart puts it, international financial institutions are international in life, but national in death. Any systemically important financial institution has to be backed by a central bank (for short-term liquidity support) and by a Treasury or ministry of finance (for recapitalisation and other long-term financial support when insolvency is the issue). If both your liquidity and your solvency are publicly insured or guaranteed (at highly subsidised rates), you need to be regulated and supervised, lest you be tempted to take insane risks. This means that conventional border-crossing banks and other systemically important financial institutions will become a thing of the past. We will not see the kind of cross-border branch banks that we have seen during the past decades for very much longer. These foreign branches are not independently capitalised, have no independent, ring-fenced sources of liquidity, are often effectively managed from the home country (the country of the parent bank), are regulated and supervised by the home country regulator and supervisor, with lender-of-last-resort support (if any) from the home country central bank and fiscal support (if any) from the home country Treasury. In the European Union, the relevant sections of the financial services action plan are now dead and need to be replaced unless we (a) get a single European supervisor and regulator for border-crossing banks and other systemically important financial institutions and (5) create a supranational fiscal Europe capable of dealing with insolvency threats to border-crossing systemically important financial institutions. Without a single regulator-supervisor and a sufficiently developed ‘fiscal Europe’, the principles of mutual recognition and the “single passport”, a system which allows financial services operators legally established in one Member State to establish/provide their services in the other Member States without further authorisation requirements, will not be permitted to operate in the field of banking and other systemically important border-crossing financial institutions and products. Need I say Icesave? (for a further discussion of the issues involved see the paper by Charles Goodhart and Dirk Schoenmaker (2009), “Fiscal Burden Sharing in Cross-Border Banking Crises” International Journal of Central Banking, Vol. 5, No. 1, 141-165, There will no doubt continue to be cross-border banking subsidiaries. These will, however, be independently capitalised. Their liquidity will not be pooled between parent and subsidiaries, but will have to be ring-fenced for each subsidiary. They will be regulated and supervised by the host country (as they often are today). Lender-of-last-resort support, if any, will be provided by the host country central bank (as it often is today) and fiscal support when insolvency threatens will be provided by the host country fiscal authority. The reason for host country supervision and regulation is simple: the pain is local, so the control will have to be local. The reason for host-country bail-outs is even simpler: tax payers are national. They will not accept the use of their taxes in bail-outs of foreign shareholders, unsecured creditors and counterparties. The US authorities have been able to channel somewhere between $40 bn and $50 bn of US tax payers’ money to foreign counterparties of AIG, but that is unlikely to be the new status quo. They got away with it, thus far, because the foreign bail-outs by the US tax payer was hidden in obscure, indeed barely comprehensible financial transactions.

102 But we should not expect the US taxpayer to stand behind foreign subsidiaries of US banks and other systemically important US financial institutions, unless a convincing case can be made that there is a material direct US financial exposure. If all the parent has at stake in its foreign subsidiary is its equity in the subsidiary, the US tax payer will not bail out the foreign subsidiary. If the parent has further exposure, through parent-to-daughter loans, through the parent having invested in securities issued by the subsidiary or as a counterparty, there may come a point at which the financial exposure of the parent becomes sufficiently large to induce a response by the US tax payer. But given the current mood of the tax payer, I don’t expect to see rescues of foreign subsidiaries anytime soon. The same applies to the UK and to other European countries with banks that have large foreign subsidiaries. I don’t expect the British government to bail out the foreign subsidiaries of RBS, Lloyd’s Group, Barclays or HSBC. I would expect the British government to look seriously at bailing out UK subsidiaries of foreign banks, should these be threatened with insolvency, especially if most of the substantive economic activity of these banks is in the UK. For instance (what follows is a pure hypothetical - I know of nothing that would lead me to question the financial soundness of Abbey), I would not expect the Spanish government ever to bail out Abbey (owned by the Spanish bank Santander), but I would expect the UK Treasury to show an active interest. Individual parent banks may decide to try to rescue their foreign subsidiaries, even when the subsidiaries in question appear to have gone belly-up by normal commercial standards. An extreme example of this is HSBC - reported to have incurred losses estimated to be somewhere between $30 bn and $62 bn (accounting does not appear to be an exact science) on its US credit card issuer and subprime lender, Household Finance Corporation (HFC), now renamed HSBC Finance, which it acquired at the end of 2002. Even though HSBC announced, in March 2009, that it would shut down the branch network of its HSBC Finance subsidiary in the U.S, it is continuing to operate the HSBC Finance credit card arm. HSBC could, in the opinion of many observers, have saved itself a bundle by cutting its losses and walking away from HFC when the scale of the subprime debacle became apparent late in 2007. There is a clear clash here between reputation and goodwill considerations on the one hand and throwing good money after bad on the other. This, however, is a matter for the shareholders and other stakeholders of HSBC and its management. It is a corporate governance problem. It is not a matter for the UK tax payers, unless HSBC’s HFC-related losses come to haunt it in the future and drive the parent into the arms of the UK tax payer after all. Should that happen, I hope the British authorities will take to heart all three of these ruminations.

[1] From the Treasury’s web site: Forward Looking Assessment - Stress Test: A key component of the Capital Assistance Program is a forward looking comprehensive “stress test” that requires an assessment of whether major financial institutions have the capital necessary to continue lending and to absorb the potential losses that could result from a more severe decline in the economy than projected. Requirement for $100 Billion-Plus Banks: All banking institutions with assets in excess of $100 billion will be required to participate in the coordinated supervisory review process and comprehensive stress test. “

103 World

April 16, 2009 Deals Help China Expand Its Sway in Latin America By SIMON ROMERO and ALEXEI BARRIONUEVO CARACAS, Venezuela — As Washington tries to rebuild its strained relationships in Latin America, China is stepping in vigorously, offering countries across the region large amounts of money while they struggle with sharply slowing economies, a plunge in commodity prices and restricted access to credit. In recent weeks, China has been negotiating deals to double a development fund in Venezuela to $12 billion, lend Ecuador at least $1 billion to build a hydroelectric plant, provide Argentina with access to more than $10 billion in Chinese currency and lend Brazil’s national oil company $10 billion. The deals largely focus on China locking in natural resources like oil for years to come. China’s trade with Latin America has grown quickly this decade, making it the region’s second largest trading partner after the United States. But the size and scope of these loans point to a deeper engagement with Latin America at a time when the Obama administration is starting to address the erosion of Washington’s influence in the hemisphere. “This is how the balance of power shifts quietly during times of crisis,” said David Rothkopf, a former Commerce Department official in the Clinton administration. “The loans are an example of the checkbook power in the world moving to new places, with the Chinese becoming more active.” Mr. Obama will meet with leaders from the region this weekend. They will discuss the economic crisis, including a plan to replenish the Inter-American Development Bank, a Washington-based pillar of clout that has suffered losses from the financial crisis. Leaders at the summit meeting are also expected to push Mr. Obama to further loosen the United States policy toward Cuba. Meanwhile, China is rapidly increasing its lending in Latin America as it pursues not only long-term access to commodities like soybeans and iron ore, but also an alternative to investing in United States Treasury notes. One of China’s new deals in Latin America, the $10 billion arrangement with Argentina, would allow Argentina reliable access to Chinese currency to help pay for imports from China. It may also help lead the way to China’s currency to eventually be used as an alternate reserve currency. The deal follows similar ones China has struck with countries like South Korea, Indonesia and Belarus. As the financial crisis began to whipsaw international markets last year, the Federal Reserve made its own currency arrangements with central banks around the world, allocating $30 billion each to Brazil and Mexico. (Brazil has opted not to tap it for now.) But smaller economies in the region, including Argentina, which has been trying to dispel

104 doubts about its ability to meet its international debt payments, were left out of those agreements. Details of the Chinese deal with Argentina are still being ironed out, but an official at Argentina’s central bank said it would allow Argentina to avoid using scarce dollars for all its international transactions. The takeover of billions of dollars in private pension funds, among other moves, led Argentines to pull the equivalent of nearly $23 billion, much of it in dollars, out of the country last year. Dante Sica, the lead economist at Abeceb, a consulting firm in Buenos Aires, said the Chinese overtures in the region were made possible by the “lack of attention that the United States showed to Latin America during the entire Bush administration.” China is also seizing opportunities in Latin America when traditional lenders over which the United States holds some sway, like the Inter-American Development Bank, are pushing up against their limits. Just one of China’s planned loans, the $10 billion for Brazil’s national oil company, is almost as much as the $11.2 billion in all approved financing by the Inter-American Bank in 2008. Brazil is expected to use the loan for offshore exploration, while agreeing to export as much as 100,000 barrels of oil a day to China, according to the oil company. The Inter-American bank, in which the United States has de facto veto power in some matters, is trying to triple its capital and increase lending to $18 billion this year. But the replenishment involves delicate negotiations among member nations, made all the more difficult after the bank lost almost $1 billion last year. China will also have a role in these talks, having become a member of the bank this year. China has also pushed into Latin American countries where the United States has negligible influence, like Venezuela. In February, China’s vice president, Xi Jinping, traveled to Caracas to meet with President Hugo Chávez. The two men announced that a Chinese-backed development fund based here would grow to $12 billion from $6 billion, giving Venezuela access to hard currency while agreeing to increase oil shipments to China to one million barrels a day from a level of about 380,000 barrels. Mr. Chávez’s government contends the Chinese aid differs from other multilateral loans because it comes without strings attached, like scrutiny of internal finances. But the Chinese fund has generated criticism among his opponents, who view it as an affront to Venezuela’s sovereignty. “The fund is a swindle to the nation,” said Luis Díaz, a lawmaker who claims that China locked in low prices for the oil Venezuela is using as repayment. Despite forging ties to Venezuela and extending loans to other nations that have chafed at Washington’s clout, Beijing has bolstered its presence without bombast, perhaps out of an awareness that its relationship with the United States is still of paramount importance. But this deference may not last. “This is China playing the long game,” said Gregory Chin, a political scientist at York University in Toronto. “If this ultimately translates into political influence, then that is how the game is played.” Simon Romero reported from Caracas, and Alexei Barrionuevo from Rio de Janeiro.

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Editorial April 16, 2009 The Battle Over Student Lending Private companies that reap undeserved profits from the federal student-loan program are gearing up to kill a White House plan that would get them off the dole and redirect the savings to federal scholarships for the needy. Instead of knuckling under to the powerful lending lobby, as it has so often done in the past, Congress needs to finally put the taxpayers’ interests first. That means embracing President Obama’s plan. The proposal takes the long-overdue step of phasing out the portion of the student-loan program that relies on private lenders. At the same time, it expands the more efficient and less expensive portion of the program that allows students to borrow directly from the federal government through their colleges. About three-quarters of this country’s college lending is carried out through the private program, known as the Federal Family Education Loan Program. Under this galling arrangement, lenders are paid handsome subsidies to make student loans that are virtually risk-free, since they are guaranteed by the government. The subsidy was created at a time when lenders weren’t interested in the student business and was intended to keep loan money flowing through tough economic times. But that did not happen during the credit crunch, when the federal government had to inject liquidity into the system by buying outstanding loans. The direct-loan program suffered no such disruption. In addition to being more reliable, direct lending is also less expensive. Equally important, according to the Congressional Budget Office, the country would save $94 billion over the next decade by switching completely to direct lending. This would not in fact “grow government,” as conservatives in Congress have already begun to charge. The loans would be handled through colleges, just the way Pell Grants are now. The loans would then be serviced and collected by private companies that are already competing for this lucrative business. Forcing service companies to compete permits the government to get the best possible deal for the taxpayers. The service contracts would be periodically re-evaluated, based on how well the companies treated their customers and how successful they were at preventing borrowers from defaulting. The new program would, of course, trim the bottom lines of some corporations, but it would not create enormous job losses, as some critics are suggesting. The work force needed to service, say, $100 billion in student loans must surely be comparable in size to the work force needed to lend the same amount. Beyond that, government rules forbidding foreign nationals from handling federal assets would ensure that the servicing jobs were not shipped abroad. The direct-lending proposal is clearly in the country’s best interest. But it will have a tough time in a Congress that has been historically more interested in pleasing the lending lobby than in looking out for families struggling to educate their children.

106 15.04.2009 COULD GERMAN GDP HAVE DECLINED BY 11.5% ANNUALISED DURING Q1?

The German blog Herdentrief extrapolated from some recent data to conclude that German GDP could have fallen by some 11.5% annualised during Q1. This estimate is based on the available data for January and February, and the data for employment and inflation for February, which he explains in a very detailed calcuation. Q2 will start with a huge inventory overhang. The recession, he concludes, is on the verge of turning into a depression. Angel Merkel calls crisis summit When economic crisis hits, German chancellors convene roundtables of industrialists and trade unionists to obtain intelligence how serious the situation is. It will now happen again, as Angela Merkel has convened one such summit for next week. The idea is to get a sense how the stimulus is working (the best guess now is that the car wreckage premium is working well, but the large infrastructure projections are not doing well at all). The FT reports on the policy options that are now available, including another stimulus package, and corporate tax reform. The article also says that Merkel is concerned about the rise in unemployment. UBS to cut 9000 jobs Der Spiegel reports this morning that UBS will cut 9000 jobs during this year, about 10% of its staff, as the bank reported losses of €1.3bn during the first quarter. The reason for the large loss is an increase in general provisions, illiquid risk positions, and falling asset prices. Also, the report notes a rise in redemptions from asset management clients, who have pulled out Sfr 23bn.

Obama, Bernanke now try recovery rethoric Despite the latest depression economic news from the US – March retail sales were down 1.1% from Feburary – President Barrack Obama and Fed chief Ben Bernanke are hailing the green shoots of recovery, forecasting some leveling out, and pretending that the existing measures are bearing fruit. According to the FT, Obama defended his administration’s approach to bank rescue by ruling out bank nationalisation. He said the stress test approach was the right one. See also Nouriel Roubini’s comment that the actual situation today is already worse than the negative scenario assumed in the stress test

Some signs of a rebound in global trade The first indicators of a reboud in global trade would be traffic volumes in ports, and there has been some encouraging news from the US, according to the Calculated Risk

107 blog, which monitors those data regularly. Inbound traffic in LA durding March was 35% above February, and outbound traffic was 25% higher, but both were still below last year’s level. There are some calander adjustment issues, so this single data set should not be overemphasised. Brad Setser on the balance sheets of European banks Brad Setser says that the total dollar liabilities of US banks are $12 trillion, and that of European banks $8 trillion. That means by bailing out European banks, European governments indirectly supported the US debt market, for otherwise those European banks would have had to dump dollar assets on the market. He says there has been a lot of cross-border bailouts during this crisis, but concludes that this will not end up in more globalisation of regulation, rather the opposite.

Martin Wolf on US vs Russia In his latest FT column Martin Wolf discusses an article by Simon Johnson in which he drew parallels between the US and Russia, as both societies suffer from crony capitalism – except that the situation is now worse for the US due to the country’s exorbitant privilege,which allows the US to paper over the cracks, and prolong the crisis. Wolf is slightly more optimistic about the US, arguing that policy is driven by beliefs more than corruption, but he acknowledges that the problem of a too powerful financial sector will have to be addressed to resolve this crisis. Don’t worry about US inflation Robert E. Hall and Susan Woodward, writing in Vox, provide an optimistic outlook about the Federal Reserve’s ability to constrain future inflation and its ability to find an exit strategy from current policy. The authors argue that the Fed can control inflation by varying the interest rate it pays (or charges) banks on their reserve holding. Consequently, the Fed’s exit strategy need not be constrained by concerns about inflation – reserve interest-rate policy can take care of inflation, but the Fed should publically announce this policy.

Wolfgang Munchau on global governance In his third and final column in a short series on global economic governance, Wolfgang Munchau says that our new form of globalisation, which involves more than just trade flows, but also large human and capital flows, requires different governance structures than inter-governmental co-ordination among the G20, or some other self-appointed group. In the absense of some form of global democracy, we should expect the anti- globalisation sentiment to increase, which will find its expression in protectionism, and a rise in public anger against global finance in general. Eric Chaney on the G20 Writing in Telos, Eric Chaney says if one had expected the G20 to solve the crisis, one would rightly be disappointed. But that would be asking too much of this group. By focusing on the Bretton Woods institutions, and global trade finance, they did what they could to help get the global economy out of recession within the next twelve months.

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THE LARGE DOLLAR BALANCE SHEET OF EUROPE’S BANKS Posted on Tuesday, April 14th, 2009 By bsetser Tyler Durden/ Zero Hedge’s analysis of the aggregate balance sheet of the US commercial banks attracted a lot of attention last week, for good reason (h/t Felix Salmon). American taxpayers are – in various ways – stabilized the US financial system by putting equity into a host of troubled banks, lending liquidity constrained banks a lot of money and guaranteeing a decent fraction of the banking system’s liabilities. And there is still a lot of uncertainly about the ultimate cost to the taxpayer of all these policies, as the “true” state of the banks’ balance sheet isn’t yet known – and in some sense cannot be known, as the cash flows underlying a host of financial assets themselves are a function of the economy.* I though was struck my something else. Data on the US banks seems to miss a large chunk of the US banking system. Total liabilities of US banks, according to Zero hedge, are close to $12 trillion. The dollar liabilities of Europe’s banks are – according to the BIS — about $8 trillion. UK banks alone had a gross dollar balance sheet of close to $2 trillion. For details, see the charts on p. 2 and p. 51 of the latest BIS quarterly. There may be some double counting. And European banks make dollar loans to non-US borrowers, so they aren’t just lending in dollars to the US. But the data – on face value, without any adjustment – suggests that US banks might only account for only about 60% of the aggregate dollar balance sheet of the world’s commercial banks. But the Fed’s flow of funds data suggests that there isn’t a lot of double counting. The liabilities of US-charted banks at the end of q4 totaled $9.9 trillion, with US bank holding companies accounting for an additional trillion dollars of debt. Foreign banking offices in the US had by contrast $1.6 trillion in liabilities (see tables L 110-112), far less than the $8 trillion in dollar balance sheet of the European banks.** There is little doubt that many of the world’s large dollar balance sheets aren’t regulated by the US – and aren’t going to be bailed out by the US taxpayer. At least not directly. The US did, though the Fed’s swap lines, provide Europe’s banks with dollar liquidity. But it did so by providing Europe’s central banks with dollars, dollars that were then onlent to European banks. US provided the dollar liquidity, but all the downside risk resided with European governments. And the US also indirectly bailed out some European banks by bailing out AIG, and thus assuring that AIG would be able to honor the insurance it sold to the world’s banks. But European governments have also bailed out a host of European banks that made bad bets on “toxic” US assets. Absent those bailouts, European banks would have had to dump a lot of US debt – driving the price of that debt down and threatening the health of a host of US

109 financial institutions that hold similar stuff on their balance sheets. Europeans taxpayers have indirectly helped to bail out American banks too. The FT – more than most – has recognized the challenges created by a global banking system and national regulation. A recent leader argued: “The current mismatch of globalised finance and national governance is unsustainable. Either governance becomes more globalised or finance less globalised.“ My guess is that finance will necessarily become a bit more national. The current crisis has shown than highly leveraged intermediaries require a government backstop, and for now there is no global taxpayer willing to bailout global banks that go bad.

* Gillian Tett’s analysis of the difficulties (a Sisyphean task ) of removing “toxic’ assets from banks’ balance sheets is worth reading.

** The BIS data is through q3, while the Fed’s flow of funds data is through q4. At the end of q3 foreign banking offices in the US only had $1.24 trillion in US liabilities. They clearly dramatically increased their “onshore” borrowing during the crisis, as they lost access to “offshore” dollar liquidity. I haven’t spent enough time with the BIS data to know whether the $1.24 trillion in onshore liabilities should be subtracted from the $8 trillion (or if the $1.17 trillion in onshore assets of foreign banking offices should be subtracted from the $8 trillion) to avoid double counting. Help on this would be appreciated. http://blogs.cfr.org/setser/2009/04/14/the-large-dollar-balance-sheet-of-europe%e2%80%99s- banks/

110 IS AMERICA THE NEW RUSSIA?

COLUMNISTS: Martin Wolf Is America the new Russia? By Martin Wolf Published: April 14 2009 21:47 | Last updated: April 14 2009 21:47 Is the US Russia? The question seems provocative, if not outrageous. Yet the person asking it is Simon Johnson, former chief economist at the International Monetary Fund and a professor at the Sloan School of Management at the Massachusetts Institute of Technology. In an article in the May issue of the Atlantic Monthly, Prof Johnson compares the hold of the “financial oligarchy” over US policy with that of business elites in emerging countries. Do such comparisons make sense? The answer is Yes, but only up to a point. “In its depth and suddenness,” argues Prof Johnson, “the US economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets.” The similarity is evident: large inflows of foreign capital; torrid credit growth; excessive leverage; bubbles in asset prices, particularly property; and, finally, asset-price collapses and financial catastrophe. “But,” adds Prof Johnson, “there’s a deeper and more disturbing similarity: elite business interests – financiers, in the case of the US – played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse.” Moreover, “the great wealth that the financial sector created and concentrated gave bankers enormous political weight.” Now, argues Prof Johnson, the weight of the financial sector is preventing resolution of the crisis. Banks “do not want to recognise the full extent of their losses, because that would likely expose them as insolvent ... This behaviour is corrosive: unhealthy banks either do not lend (hoarding money to shore up reserves) or they make desperate gambles on high-risk loans and investments that could pay off big, but probably won’t pay off at all. In either case, the economy suffers further, and, as it does, bank assets themselves continue to deteriorate – creating a highly destructive cycle.” Does such an analysis make sense? This is a question I thought about during my recent three- month stay in New York and visits to Washington, DC, now capital of global finance. They are why Prof Johnson’s analysis is so important. Unquestionably, we have witnessed a massive rise in the significance of the financial sector. In 2002, the sector generated an astonishing 41 per cent of US domestic corporate profits (see chart). In 2008, US private indebtedness reached 295 per cent of gross domestic product, a record, up from 112 per cent in 1976, while financial sector debt reached 121 per cent of GDP in 2008. Average pay in the sector rose from close to the average for all industries between 1948 and 1982 to 181 per cent of it in 2007. In recent research, Thomas Philippon of New York University’s Stern School of Business and Ariell Reshef of the University of Virginia conclude that the financial sector was a high-skill, high-wage industry between 1909 and 1933. It then went into relative decline until 1980, whereupon it again started to be a high-skill, high-wage sector.* They conclude that the prime

111 cause was deregulation, which “unleashes creativity and innovation and increases demand for skilled workers”. Deregulation also generates growth of credit, the raw stuff the financial sector creates and on which it feeds. Transmutation of credit into income is why the profitability of the financial system can be illusory. Equally, the expansion of the financial sector will reverse, at least within the US: credit growth and leverage masked low or even non-existent profitability of much activity, which will disappear, and part of the debt must also be liquidated. The golden age of Wall Street is over: the return of regulation is cause and consequence of this shift. Yet Prof Johnson makes a stronger point than this. He argues that the refusal of powerful institutions to admit losses – aided and abetted by a government in thrall to the “money- changers” – may make it impossible to escape from the crisis. Moreover, since the US enjoys the privilege of being able to borrow in its own currency it is far easier for it than for mere emerging economies to paper over cracks, turning crisis into long-term economic malaise. So we have witnessed a series of improvisations or “deals” whose underlying aim is to rescue as much of the financial system as possible in as generous a way as policymakers think they can get away with. I agree with the critique of the policies adopted so far. In the debate on the Financial Times’s economists’ forum on Treasury secretary Tim Geithner’s “public/private investment partnership”, the critics are right: if it works, it is because it is a non-transparent way of transferring taxpayer wealth to banks. But it is unlikely to fill the capital hole that the markets are, at present, ignoring, as Michael Pomerleano argues. Nor am I persuaded that the “stress tests” of bank capital under way will lead to action that fills the capital hole. Yet do these weaknesses make the US into Russia? No. In many emerging economies corruption is egregious and overt. In the US, influence comes as much from a system of beliefs as from lobbying (although the latter was not absent). What was good for Wall Street was deemed good for the world. The result was a bipartisan programme of ill-designed deregulation for the US and, given its influence, the world. Moreover, the belief that Wall Street needs to be preserved largely as it is now is mainly a consequence of fear. The view that large and complex financial institutions are too big to fail may be wrong. But it is easy to understand why intelligent policymakers shrink from testing it. At the same time, politicians fear a public backlash against large infusions of public capital. So, like Japan, the US is caught between the elite’s fear of bankruptcy and the public’s loathing of bail-outs. This is a more complex phenomenon than the “quiet coup” Prof Johnson describes. Yet decisive restructuring is indeed necessary. This is not because returning the economy to the debt-fuelled growth of recent years is either feasible or desirable. But two things must be achieved: first, the core financial institutions must become credibly solvent; and, second, no profit-seeking private institution can remain too big to fail. That is not capitalism, but socialism. That is one of the points on which the right and the left agree. They are right. Bankruptcy – and so losses for unsecured creditors – must be a part of any durable solution. Without that change, the resolution of this crisis can only be the harbinger of the next. *Wages and Human Capital in the US Financial Industry 1909-2006, January 2009, www.nber.org

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Martin Wolf, “Is America the new Russia?”, http://www.ft.com/cms/s/0/09f8c996-2930- 11de-bc5e-00144feabdc0.html Simon Jonnson “The Quiet Coup”, The Atlantic Monthly, Mayo, 2009 http://www.theatlantic.com/doc/200905/imf-advice

113 The Atlantic Monthly ECONOMY MAY 2009

IMAGE CREDIT: JIM BOURG/REUTERS/CORBIS The Quiet Coup

The crash has laid bare many unpleasant truths about the United States. One of the most alarming, says a former chief economist of the International Monetary Fund, is that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time. by Simon Johnson

ONE THING YOU learn rather quickly when working at the International Monetary Fund is that no one is ever very happy to see you. Typically, your “clients” come in only after private capital has abandoned them, after regional trading-bloc partners have been unable to throw a strong enough lifeline, after last-ditch attempts to borrow from powerful friends like China or the European Union have fallen through. You’re never at the top of anyone’s dance card. The reason, of course, is that the IMF specializes in telling its clients what they don’t want to hear. I should know; I pressed painful changes on many foreign officials during my time there as chief economist in 2007 and 2008. And I felt the effects of IMF pressure, at least indirectly, when I worked with governments in Eastern Europe as they struggled after 1989, and with the private sector in Asia and Latin America during the crises of the late 1990s and early 2000s. Over that time, from every vantage point, I saw firsthand the steady flow of officials—from Ukraine, Russia, Thailand, Indonesia, South Korea, and elsewhere—trudging to the fund when circumstances were dire and all else had failed.

114 Every crisis is different, of course. Ukraine faced hyperinflation in 1994; Russia desperately needed help when its short-term-debt rollover scheme exploded in the summer of 1998; the Indonesian rupiah plunged in 1997, nearly leveling the corporate economy; that same year, South Korea’s 30-year economic miracle ground to a halt when foreign banks suddenly refused to extend new credit. But I must tell you, to IMF officials, all of these crises looked depressingly similar. Each country, of course, needed a loan, but more than that, each needed to make big changes so that the loan could really work. Almost always, countries in crisis need to learn to live within their means after a period of excess—exports must be increased, and imports cut—and the goal is to do this without the most horrible of recessions. Naturally, the fund’s economists spend time figuring out the policies—budget, money supply, and the like—that make sense in this context. Yet the economic solution is seldom very hard to work out. No, the real concern of the fund’s senior staff, and the biggest obstacle to recovery, is almost invariably the politics of countries in crisis. Typically, these countries are in a desperate economic situation for one simple reason—the powerful elites within them overreached in good times and took too many risks. Emerging-market governments and their private-sector allies commonly form a tight-knit—and, most of the time, genteel—oligarchy, running the country rather like a profit-seeking company in which they are the controlling shareholders. When a country like Indonesia or South Korea or Russia grows, so do the ambitions of its captains of industry. As masters of their mini-universe, these people make some investments that clearly benefit the broader economy, but they also start making bigger and riskier bets. They reckon—correctly, in most cases—that their political connections will allow them to push onto the government any substantial problems that arise. In Russia, for instance, the private sector is now in serious trouble because, over the past five years or so, it borrowed at least $490 billion from global banks and investors on the assumption that the country’s energy sector could support a permanent increase in consumption throughout the economy. As Russia’s oligarchs spent this capital, acquiring other companies and embarking on ambitious investment plans that generated jobs, their importance to the political elite increased. Growing political support meant better access to lucrative contracts, tax breaks, and subsidies. And foreign investors could not have been more pleased; all other things being equal, they prefer to lend money to people who have the implicit backing of their national governments, even if that backing gives off the faint whiff of corruption. But inevitably, emerging-market oligarchs get carried away; they waste money and build massive business empires on a mountain of debt. Local banks, sometimes pressured by the government, become too willing to extend credit to the elite and to those who depend on them. Overborrowing always ends badly, whether for an individual, a company, or a country. Sooner or later, credit conditions become tighter and no one will lend you money on anything close to affordable terms. The downward spiral that follows is remarkably steep. Enormous companies teeter on the brink of default, and the local banks that have lent to them collapse. Yesterday’s “public-private partnerships” are relabeled “crony capitalism.” With credit unavailable, economic paralysis ensues, and conditions just get worse and worse. The government is forced to draw down its foreign- currency reserves to pay for imports, service debt, and cover private losses. But these reserves will eventually run out. If the country cannot right itself before that happens, it will default on its sovereign debt and become an economic pariah. The government, in its race to stop the bleeding, will typically need to wipe out some of the national champions—now hemorrhaging cash—and usually restructure a banking system that’s gone badly out of balance. It will, in other words, need to squeeze at least some of its oligarchs. Squeezing the oligarchs, though, is seldom the strategy of choice among emerging-market governments. Quite the contrary: at the outset of the crisis, the oligarchs are usually among the first to get extra help from the government, such as preferential access to foreign currency, or maybe a nice tax break, or—here’s a classic Kremlin bailout technique—the assumption of private debt obligations by the government. Under duress, generosity toward old friends takes many innovative

115 forms. Meanwhile, needing to squeeze someone, most emerging-market governments look first to ordinary working folk—at least until the riots grow too large. Eventually, as the oligarchs in Putin’s Russia now realize, some within the elite have to lose out before recovery can begin. It’s a game of musical chairs: there just aren’t enough currency reserves to take care of everyone, and the government cannot afford to take over private-sector debt completely. So the IMF staff looks into the eyes of the minister of finance and decides whether the government is serious yet. The fund will give even a country like Russia a loan eventually, but first it wants to make sure Prime Minister Putin is ready, willing, and able to be tough on some of his friends. If he is not ready to throw former pals to the wolves, the fund can wait. And when he is ready, the fund is happy to make helpful suggestions—particularly with regard to wresting control of the banking system from the hands of the most incompetent and avaricious “entrepreneurs.” Of course, Putin’s ex-friends will fight back. They’ll mobilize allies, work the system, and put pressure on other parts of the government to get additional subsidies. In extreme cases, they’ll even try subversion—including calling up their contacts in the American foreign-policy establishment, as the Ukrainians did with some success in the late 1990s. Many IMF programs “go off track” (a euphemism) precisely because the government can’t stay tough on erstwhile cronies, and the consequences are massive inflation or other disasters. A program “goes back on track” once the government prevails or powerful oligarchs sort out among themselves who will govern—and thus win or lose—under the IMF-supported plan. The real fight in Thailand and Indonesia in 1997 was about which powerful families would lose their banks. In Thailand, it was handled relatively smoothly. In Indonesia, it led to the fall of President Suharto and economic chaos. From long years of experience, the IMF staff knows its program will succeed—stabilizing the economy and enabling growth—only if at least some of the powerful oligarchs who did so much to create the underlying problems take a hit. This is the problem of all emerging markets. BECOMING A BANANA REPUBLIC In its depth and suddenness, the U.S. economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (and only in emerging markets): South Korea (1997), Malaysia (1998), Russia and Argentina (time and again). In each of those cases, global investors, afraid that the country or its financial sector wouldn’t be able to pay off mountainous debt, suddenly stopped lending. And in each case, that fear became self-fulfilling, as banks that couldn’t roll over their debt did, in fact, become unable to pay. This is precisely what drove Lehman Brothers into bankruptcy on September 15, causing all sources of funding to the U.S. financial sector to dry up overnight. Just as in emerging-market crises, the weakness in the banking system has quickly rippled out into the rest of the economy, causing a severe economic contraction and hardship for millions of people. But there’s a deeper and more disturbing similarity: elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them. Top investment bankers and government officials like to lay the blame for the current crisis on the lowering of U.S. interest rates after the dotcom bust or, even better—in a “buck stops somewhere else” sort of way—on the flow of savings out of China. Some on the right like to complain about Fannie Mae or Freddie Mac, or even about longer-standing efforts to promote broader homeownership. And, of course, it is axiomatic to everyone that the regulators responsible for “safety and soundness” were fast asleep at the wheel. But these various policies—lightweight regulation, cheap money, the unwritten Chinese-American economic alliance, the promotion of homeownership—had something in common. Even though

116 some are traditionally associated with Democrats and some with Republicans, they all benefited the financial sector. Policy changes that might have forestalled the crisis but would have limited the financial sector’s profits—such as Brooksley Born’s now-famous attempts to regulate credit- default swaps at the Commodity Futures Trading Commission, in 1998—were ignored or swept aside.

The financial industry has not always enjoyed such favored treatment. But for the past 25 years or so, finance has boomed, becoming ever more powerful. The boom began with the Reagan years,

117 and it only gained strength with the deregulatory policies of the Clinton and George W. Bush administrations. Several other factors helped fuel the financial industry’s ascent. Paul Volcker’s monetary policy in the 1980s, and the increased volatility in interest rates that accompanied it, made bond trading much more lucrative. The invention of securitization, interest-rate swaps, and credit-default swaps greatly increased the volume of transactions that bankers could make money on. And an aging and increasingly wealthy population invested more and more money in securities, helped by the invention of the IRA and the 401(k) plan. Together, these developments vastly increased the profit opportunities in financial services. Not surprisingly, Wall Street ran with these opportunities. From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007. The great wealth that the financial sector created and concentrated gave bankers enormous political weight—a weight not seen in the U.S. since the era of J.P. Morgan (the man). In that period, the banking panic of 1907 could be stopped only by coordination among private-sector bankers: no government entity was able to offer an effective response. But that first age of banking oligarchs came to an end with the passage of significant banking regulation in response to the Great Depression; the reemergence of an American financial oligarchy is quite recent. THE WALL STREET–WASHINGTON CORRIDOR Of course, the U.S. is unique. And just as we have the world’s most advanced economy, military, and technology, we also have its most advanced oligarchy. In a primitive political system, power is transmitted through violence, or the threat of violence: military coups, private militias, and so on. In a less primitive system more typical of emerging markets, power is transmitted via money: bribes, kickbacks, and offshore bank accounts. Although lobbying and campaign contributions certainly play major roles in the American political system, old-fashioned corruption—envelopes stuffed with $100 bills—is probably a sideshow today, Jack Abramoff notwithstanding. Instead, the American financial industry gained political power by amassing a kind of cultural capital—a belief system. Once, perhaps, what was good for General Motors was good for the country. Over the past decade, the attitude took hold that what was good for Wall Street was good for the country. The banking-and-securities industry has become one of the top contributors to political campaigns, but at the peak of its influence, it did not have to buy favors the way, for example, the tobacco companies or military contractors might have to. Instead, it benefited from the fact that Washington insiders already believed that large financial institutions and free-flowing capital markets were crucial to America’s position in the world. One channel of influence was, of course, the flow of individuals between Wall Street and Washington. Robert Rubin, once the co-chairman of Goldman Sachs, served in Washington as Treasury secretary under Clinton, and later became chairman of Citigroup’s executive committee. Henry Paulson, CEO of Goldman Sachs during the long boom, became Treasury secretary under George W.Bush. John Snow, Paulson’s predecessor, left to become chairman of Cerberus Capital Management, a large private-equity firm that also counts Dan Quayle among its executives. Alan Greenspan, after leaving the Federal Reserve, became a consultant to Pimco, perhaps the biggest player in international bond markets. These personal connections were multiplied many times over at the lower levels of the past three presidential administrations, strengthening the ties between Washington and Wall Street. It has become something of a tradition for Goldman Sachs employees to go into public service after they leave the firm. The flow of Goldman alumni—including Jon Corzine, now the governor of New Jersey, along with Rubin and Paulson—not only placed people with Wall Street’s worldview in the

118 halls of power; it also helped create an image of Goldman (inside the Beltway, at least) as an institution that was itself almost a form of public service. Wall Street is a very seductive place, imbued with an air of power. Its executives truly believe that they control the levers that make the world go round. A civil servant from Washington invited into their conference rooms, even if just for a meeting, could be forgiven for falling under their sway. Throughout my time at the IMF, I was struck by the easy access of leading financiers to the highest U.S. government officials, and the interweaving of the two career tracks. I vividly remember a meeting in early 2008—attended by top policy makers from a handful of rich countries—at which the chair casually proclaimed, to the room’s general approval, that the best preparation for becoming a central-bank governor was to work first as an investment banker. A whole generation of policy makers has been mesmerized by Wall Street, always and utterly convinced that whatever the banks said was true. Alan Greenspan’s pronouncements in favor of unregulated financial markets are well known. Yet Greenspan was hardly alone. This is what Ben Bernanke, the man who succeeded him, said in 2006: “The management of market risk and credit risk has become increasingly sophisticated. … Banking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks.” Of course, this was mostly an illusion. Regulators, legislators, and academics almost all assumed that the managers of these banks knew what they were doing. In retrospect, they didn’t. AIG’s Financial Products division, for instance, made $2.5 billion in pretax profits in 2005, largely by selling underpriced insurance on complex, poorly understood securities. Often described as “picking up nickels in front of a steamroller,” this strategy is profitable in ordinary years, and catastrophic in bad ones. As of last fall, AIG had outstanding insurance on more than $400 billion in securities. To date, the U.S. government, in an effort to rescue the company, has committed about $180 billion in investments and loans to cover losses that AIG’s sophisticated risk modeling had said were virtually impossible. Wall Street’s seductive power extended even (or especially) to finance and economics professors, historically confined to the cramped offices of universities and the pursuit of Nobel Prizes. As mathematical finance became more and more essential to practical finance, professors increasingly took positions as consultants or partners at financial institutions. Myron Scholes and Robert Merton, Nobel laureates both, were perhaps the most famous; they took board seats at the hedge fund Long-Term Capital Management in 1994, before the fund famously flamed out at the end of the decade. But many others beat similar paths. This migration gave the stamp of academic legitimacy (and the intimidating aura of intellectual rigor) to the burgeoning world of high finance. As more and more of the rich made their money in finance, the cult of finance seeped into the culture at large. Works like Barbarians at the Gate, Wall Street, and Bonfire of the Vanities—all intended as cautionary tales—served only to increase Wall Street’s mystique. Michael Lewis noted in Portfolio last year that when he wrote Liar’s Poker, an insider’s account of the financial industry, in 1989, he had hoped the book might provoke outrage at Wall Street’s hubris and excess. Instead, he found himself “knee-deep in letters from students at Ohio State who wanted to know if I had any other secrets to share. … They’d read my book as a how-to manual.” Even Wall Street’s criminals, like Michael Milken and Ivan Boesky, became larger than life. In a society that celebrates the idea of making money, it was easy to infer that the interests of the financial sector were the same as the interests of the country—and that the winners in the financial sector knew better what was good for America than did the career civil servants in Washington. Faith in free financial markets grew into conventional wisdom—trumpeted on the editorial pages of The Wall Street Journal and on the floor of Congress. From this confluence of campaign finance, personal connections, and ideology there flowed, in just the past decade, a river of deregulatory policies that is, in hindsight, astonishing: • insistence on free movement of capital across borders; • the repeal of Depression-era regulations separating commercial and investment banking; • a congressional ban on the regulation of credit-default swaps;

119 • major increases in the amount of leverage allowed to investment banks; • a light (dare I say invisible?) hand at the Securities and Exchange Commission in its regulatory enforcement; • an international agreement to allow banks to measure their own riskiness; • and an intentional failure to update regulations so as to keep up with the tremendous pace of financial innovation. The mood that accompanied these measures in Washington seemed to swing between nonchalance and outright celebration: finance unleashed, it was thought, would continue to propel the economy to greater heights. AMERICA’S OLIGARCHS AND THE FINANCIAL CRISIS The oligarchy and the government policies that aided it did not alone cause the financial crisis that exploded last year. Many other factors contributed, including excessive borrowing by households and lax lending standards out on the fringes of the financial world. But major commercial and investment banks—and the hedge funds that ran alongside them—were the big beneficiaries of the twin housing and equity-market bubbles of this decade, their profits fed by an ever-increasing volume of transactions founded on a relatively small base of actual physical assets. Each time a loan was sold, packaged, securitized, and resold, banks took their transaction fees, and the hedge funds buying those securities reaped ever-larger fees as their holdings grew. Because everyone was getting richer, and the health of the national economy depended so heavily on growth in real estate and finance, no one in Washington had any incentive to question what was going on. Instead, Fed Chairman Greenspan and President Bush insisted metronomically that the economy was fundamentally sound and that the tremendous growth in complex securities and credit-default swaps was evidence of a healthy economy where risk was distributed safely. In the summer of 2007, signs of strain started appearing. The boom had produced so much debt that even a small economic stumble could cause major problems, and rising delinquencies in subprime mortgages proved the stumbling block. Ever since, the financial sector and the federal government have been behaving exactly the way one would expect them to, in light of past emerging-market crises. By now, the princes of the financial world have of course been stripped naked as leaders and strategists—at least in the eyes of most Americans. But as the months have rolled by, financial elites have continued to assume that their position as the economy’s favored children is safe, despite the wreckage they have caused. Stanley O’Neal, the CEO of Merrill Lynch, pushed his firm heavily into the mortgage-backed- securities market at its peak in 2005 and 2006; in October 2007, he acknowledged, “The bottom line is, we—I—got it wrong by being overexposed to subprime, and we suffered as a result of impaired liquidity in that market. No one is more disappointed than I am in that result.” O’Neal took home a $14 million bonus in 2006; in 2007, he walked away from Merrill with a severance package worth $162 million, although it is presumably worth much less today. In October, John Thain, Merrill Lynch’s final CEO, reportedly lobbied his board of directors for a bonus of $30 million or more, eventually reducing his demand to $10 million in December; he withdrew the request, under a firestorm of protest, only after it was leaked to The Wall Street Journal. Merrill Lynch as a whole was no better: it moved its bonus payments, $4 billion in total, forward to December, presumably to avoid the possibility that they would be reduced by Bank of America, which would own Merrill beginning on January 1. Wall Street paid out $18 billion in year-end bonuses last year to its New York City employees, after the government disbursed $243 billion in emergency assistance to the financial sector. In a financial panic, the government must respond with both speed and overwhelming force. The root problem is uncertainty—in our case, uncertainty about whether the major banks have sufficient assets to cover their liabilities. Half measures combined with wishful thinking and a

120 wait-and-see attitude cannot overcome this uncertainty. And the longer the response takes, the longer the uncertainty will stymie the flow of credit, sap consumer confidence, and cripple the economy—ultimately making the problem much harder to solve. Yet the principal characteristics of the government’s response to the financial crisis have been delay, lack of transparency, and an unwillingness to upset the financial sector. The response so far is perhaps best described as “policy by deal”: when a major financial institution gets into trouble, the Treasury Department and the Federal Reserve engineer a bailout over the weekend and announce on Monday that everything is fine. In March 2008, Bear Stearns was sold to JP Morgan Chase in what looked to many like a gift to JP Morgan. (Jamie Dimon, JP Morgan’s CEO, sits on the board of directors of the Federal Reserve Bank of New York, which, along with the Treasury Department, brokered the deal.) In September, we saw the sale of Merrill Lynch to Bank of America, the first bailout of AIG, and the takeover and immediate sale of Washington Mutual to JP Morgan—all of which were brokered by the government. In October, nine large banks were recapitalized on the same day behind closed doors in Washington. This, in turn, was followed by additional bailouts for Citigroup, AIG, Bank of America, Citigroup (again), and AIG (again). Some of these deals may have been reasonable responses to the immediate situation. But it was never clear (and still isn’t) what combination of interests was being served, and how. Treasury and the Fed did not act according to any publicly articulated principles, but just worked out a transaction and claimed it was the best that could be done under the circumstances. This was late- night, backroom dealing, pure and simple. Throughout the crisis, the government has taken extreme care not to upset the interests of the financial institutions, or to question the basic outlines of the system that got us here. In September 2008, Henry Paulson asked Congress for $700 billion to buy toxic assets from banks, with no strings attached and no judicial review of his purchase decisions. Many observers suspected that the purpose was to overpay for those assets and thereby take the problem off the banks’ hands— indeed, that is the only way that buying toxic assets would have helped anything. Perhaps because there was no way to make such a blatant subsidy politically acceptable, that plan was shelved. Instead, the money was used to recapitalize banks, buying shares in them on terms that were grossly favorable to the banks themselves. As the crisis has deepened and financial institutions have needed more help, the government has gotten more and more creative in figuring out ways to provide banks with subsidies that are too complex for the general public to understand. The first AIG bailout, which was on relatively good terms for the taxpayer, was supplemented by three further bailouts whose terms were more AIG-friendly. The second Citigroup bailout and the Bank of America bailout included complex asset guarantees that provided the banks with insurance at below-market rates. The third Citigroup bailout, in late February, converted government-owned preferred stock to common stock at a price significantly higher than the market price—a subsidy that probably even most Wall Street Journal readers would miss on first reading. And the convertible preferred shares that the Treasury will buy under the new Financial Stability Plan give the conversion option (and thus the upside) to the banks, not the government. This latest plan—which is likely to provide cheap loans to hedge funds and others so that they can buy distressed bank assets at relatively high prices—has been heavily influenced by the financial sector, and Treasury has made no secret of that. As Neel Kashkari, a senior Treasury official under both Henry Paulson and Tim Geithner (and a Goldman alum) told Congress in March, “We had received inbound unsolicited proposals from people in the private sector saying, ‘We have capital on the sidelines; we want to go after [distressed bank] assets.’” And the plan lets them do just that: “By marrying government capital—taxpayer capital—with private-sector capital and providing financing, you can enable those investors to then go after those assets at a price that makes sense for the investors and at a price that makes sense for the banks.” Kashkari didn’t mention anything about what makes sense for the third group involved: the taxpayers. Even leaving aside fairness to taxpayers, the government’s velvet-glove approach with the banks is deeply troubling, for one simple reason: it is inadequate to change the behavior of a financial sector

121 accustomed to doing business on its own terms, at a time when that behavior must change. As an unnamed senior bank official said to The New York Times last fall, “It doesn’t matter how much Hank Paulson gives us, no one is going to lend a nickel until the economy turns.” But there’s the rub: the economy can’t recover until the banks are healthy and willing to lend. THE WAY OUT Looking just at the financial crisis (and leaving aside some problems of the larger economy), we face at least two major, interrelated problems. The first is a desperately ill banking sector that threatens to choke off any incipient recovery that the fiscal stimulus might generate. The second is a political balance of power that gives the financial sector a veto over public policy, even as that sector loses popular support. Big banks, it seems, have only gained political strength since the crisis began. And this is not surprising. With the financial system so fragile, the damage that a major bank failure could cause— Lehman was small relative to Citigroup or Bank of America—is much greater than it would be during ordinary times. The banks have been exploiting this fear as they wring favorable deals out of Washington. Bank of America obtained its second bailout package (in January) after warning the government that it might not be able to go through with the acquisition of Merrill Lynch, a prospect that Treasury did not want to consider. The challenges the United States faces are familiar territory to the people at the IMF. If you hid the name of the country and just showed them the numbers, there is no doubt what old IMF hands would say: nationalize troubled banks and break them up as necessary. In some ways, of course, the government has already taken control of the banking system. It has essentially guaranteed the liabilities of the biggest banks, and it is their only plausible source of capital today. Meanwhile, the Federal Reserve has taken on a major role in providing credit to the economy—the function that the private banking sector is supposed to be performing, but isn’t. Yet there are limits to what the Fed can do on its own; consumers and businesses are still dependent on banks that lack the balance sheets and the incentives to make the loans the economy needs, and the government has no real control over who runs the banks, or over what they do. At the root of the banks’ problems are the large losses they have undoubtedly taken on their securities and loan portfolios. But they don’t want to recognize the full extent of their losses, because that would likely expose them as insolvent. So they talk down the problem, and ask for handouts that aren’t enough to make them healthy (again, they can’t reveal the size of the handouts that would be necessary for that), but are enough to keep them upright a little longer. This behavior is corrosive: unhealthy banks either don’t lend (hoarding money to shore up reserves) or they make desperate gambles on high-risk loans and investments that could pay off big, but probably won’t pay off at all. In either case, the economy suffers further, and as it does, bank assets themselves continue to deteriorate—creating a highly destructive vicious cycle. To break this cycle, the government must force the banks to acknowledge the scale of their problems. As the IMF understands (and as the U.S. government itself has insisted to multiple emerging-market countries in the past), the most direct way to do this is nationalization. Instead, Treasury is trying to negotiate bailouts bank by bank, and behaving as if the banks hold all the cards—contorting the terms of each deal to minimize government ownership while forswearing government influence over bank strategy or operations. Under these conditions, cleaning up bank balance sheets is impossible. Nationalization would not imply permanent state ownership. The IMF’s advice would be, essentially: scale up the standard Federal Deposit Insurance Corporation process. An FDIC “intervention” is basically a government-managed bankruptcy procedure for banks. It would allow the government to wipe out bank shareholders, replace failed management, clean up the balance sheets, and then sell the banks back to the private sector. The main advantage is immediate recognition of the problem so that it can be solved before it grows worse. The government needs to inspect the balance sheets and identify the banks that cannot survive a severe recession. These banks should face a choice: write down your assets to their true value and

122 raise private capital within 30 days, or be taken over by the government. The government would write down the toxic assets of banks taken into receivership—recognizing reality—and transfer those assets to a separate government entity, which would attempt to salvage whatever value is possible for the taxpayer (as the Resolution Trust Corporation did after the savings-and-loan debacle of the 1980s). The rump banks—cleansed and able to lend safely, and hence trusted again by other lenders and investors—could then be sold off. Cleaning up the megabanks will be complex. And it will be expensive for the taxpayer; according to the latest IMF numbers, the cleanup of the banking system would probably cost close to $1.5 trillion (or 10 percent of our GDP) in the long term. But only decisive government action— exposing the full extent of the financial rot and restoring some set of banks to publicly verifiable health—can cure the financial sector as a whole. This may seem like strong medicine. But in fact, while necessary, it is insufficient. The second problem the U.S. faces—the power of the oligarchy—is just as important as the immediate crisis of lending. And the advice from the IMF on this front would again be simple: break the oligarchy. Oversize institutions disproportionately influence public policy; the major banks we have today draw much of their power from being too big to fail. Nationalization and re-privatization would not change that; while the replacement of the bank executives who got us into this crisis would be just and sensible, ultimately, the swapping-out of one set of powerful managers for another would change only the names of the oligarchs. Ideally, big banks should be sold in medium-size pieces, divided regionally or by type of business. Where this proves impractical—since we’ll want to sell the banks quickly—they could be sold whole, but with the requirement of being broken up within a short time. Banks that remain in private hands should also be subject to size limitations. This may seem like a crude and arbitrary step, but it is the best way to limit the power of individual institutions in a sector that is essential to the economy as a whole. Of course, some people will complain about the “efficiency costs” of a more fragmented banking system, and these costs are real. But so are the costs when a bank that is too big to fail—a financial weapon of mass self- destruction—explodes. Anything that is too big to fail is too big to exist. To ensure systematic bank breakup, and to prevent the eventual reemergence of dangerous behemoths, we also need to overhaul our antitrust legislation. Laws put in place more than 100 years ago to combat industrial monopolies were not designed to address the problem we now face. The problem in the financial sector today is not that a given firm might have enough market share to influence prices; it is that one firm or a small set of interconnected firms, by failing, can bring down the economy. The Obama administration’s fiscal stimulus evokes FDR, but what we need to imitate here is Teddy Roosevelt’s trust-busting. Caps on executive compensation, while redolent of populism, might help restore the political balance of power and deter the emergence of a new oligarchy. Wall Street’s main attraction—to the people who work there and to the government officials who were only too happy to bask in its reflected glory—has been the astounding amount of money that could be made. Limiting that money would reduce the allure of the financial sector and make it more like any other industry. Still, outright pay caps are clumsy, especially in the long run. And most money is now made in largely unregulated private hedge funds and private-equity firms, so lowering pay would be complicated. Regulation and taxation should be part of the solution. Over time, though, the largest part may involve more transparency and competition, which would bring financial-industry fees down. To those who say this would drive financial activities to other countries, we can now safely say: fine. TWO PATHS To paraphrase Joseph Schumpeter, the early-20th-century economist, everyone has elites; the important thing is to change them from time to time. If the U.S. were just another country, coming to the IMF with hat in hand, I might be fairly optimistic about its future. Most of the emerging-

123 market crises that I’ve mentioned ended relatively quickly, and gave way, for the most part, to relatively strong recoveries. But this, alas, brings us to the limit of the analogy between the U.S. and emerging markets. Emerging-market countries have only a precarious hold on wealth, and are weaklings globally. When they get into trouble, they quite literally run out of money—or at least out of foreign currency, without which they cannot survive. They must make difficult decisions; ultimately, aggressive action is baked into the cake. But the U.S., of course, is the world’s most powerful nation, rich beyond measure, and blessed with the exorbitant privilege of paying its foreign debts in its own currency, which it can print. As a result, it could very well stumble along for years—as Japan did during its lost decade—never summoning the courage to do what it needs to do, and never really recovering. A clean break with the past—involving the takeover and cleanup of major banks—hardly looks like a sure thing right now. Certainly no one at the IMF can force it. In my view, the U.S. faces two plausible scenarios. The first involves complicated bank-by-bank deals and a continual drumbeat of (repeated) bailouts, like the ones we saw in February with Citigroup and AIG. The administration will try to muddle through, and confusion will reign. Boris Fyodorov, the late finance minister of Russia, struggled for much of the past 20 years against oligarchs, corruption, and abuse of authority in all its forms. He liked to say that confusion and chaos were very much in the interests of the powerful—letting them take things, legally and illegally, with impunity. When inflation is high, who can say what a piece of property is really worth? When the credit system is supported by byzantine government arrangements and backroom deals, how do you know that you aren’t being fleeced? Our future could be one in which continued tumult feeds the looting of the financial system, and we talk more and more about exactly how our oligarchs became bandits and how the economy just can’t seem to get into gear. The second scenario begins more bleakly, and might end that way too. But it does provide at least some hope that we’ll be shaken out of our torpor. It goes like this: the global economy continues to deteriorate, the banking system in east-central Europe collapses, and—because eastern Europe’s banks are mostly owned by western European banks—justifiable fears of government insolvency spread throughout the Continent. Creditors take further hits and confidence falls further. The Asian economies that export manufactured goods are devastated, and the commodity producers in Latin America and Africa are not much better off. A dramatic worsening of the global environment forces the U.S. economy, already staggering, down onto both knees. The baseline growth rates used in the administration’s current budget are increasingly seen as unrealistic, and the rosy “stress scenario” that the U.S. Treasury is currently using to evaluate banks’ balance sheets becomes a source of great embarrassment. Under this kind of pressure, and faced with the prospect of a national and global collapse, minds may become more concentrated. The conventional wisdom among the elite is still that the current slump “cannot be as bad as the Great Depression.” This view is wrong. What we face now could, in fact, be worse than the Great Depression—because the world is now so much more interconnected and because the banking sector is now so big. We face a synchronized downturn in almost all countries, a weakening of confidence among individuals and firms, and major problems for government finances. If our leadership wakes up to the potential consequences, we may yet see dramatic action on the banking system and a breaking of the old elite. Let us hope it is not then too late. Simon Jonnson “The Quiet Coup”, The Atlantic Monthly, Mayo, 2009 http://www.theatlantic.com/doc/200905/imf-advice

124

Goldman Revamp Puts Dec. Losses Off Books Calendar Shift Left 1 Month Unreported By David S. Hilzenrath Washington Post Staff Writer Wednesday, April 15, 2009; A15 December was a disastrous month for Goldman Sachs, producing a loss of $780 million, but you wouldn't know it from looking at the company's bottom line for the last quarter of 2008 -- or the first quarter of 2009. December fell through the cracks as the big investment-banking firm moved from a fiscal year ending in November to a fiscal year beginning in January. Billions of dollars of write- downs in the value of commercial real estate loans and other assets showed up in neither period. The result was that Goldman was able to report a first-quarter profit of $1.81 billion Monday, just as it was gearing up to raise $5 billion from investors yesterday through a new stock offering. The $1.81 billion profit, in turn, helped Lloyd C. Blankfein, Goldman's chairman and chief executive, offer a positive view of the company's performance in a Monday news release. "Given the difficult market conditions, we are pleased with this quarter's performance," Blankfein said as the company disclosed results for the three-month period that ended March 27. "Our results reflect the strength and diversity of our client franchise, the resilience of our business model and the dedication and focus of our people," he said. Goldman spokesman Lucas van Praag said the firm was required to shift to a calendar year as a result of its decision in September to become a bank holding company. "We didn't make the rules," he said. The company included a page of charts in its Monday news release showing its December results, but it didn't include a narrative description of those results as it did for the January- through-March period. In a conference call with analysts yesterday, Chief Financial Officer David A. Viniar said the firm incurred $2.7 billion in "fair value losses" in December, meaning losses related to declines in the value of assets it holds. Among those write-downs were $1 billion for "non-investment grade loans," Viniar said, according to a transcript. Viniar told analysts that the company faced "a difficult market environment" in December. Michael Williams, director of research at Gradient Analytics, which specializes in examining corporate accounting, said companies have a lot of discretion in deciding when to recognize gains and losses. "It does seem rather remarkable that they ended up with such a large amount of losses in December itself, just in that four-week period," Williams said. "You're just left scratching your head to a large extent about what's underlying the numbers for the month," he said.

125 Given the scale of the December losses, and considering that March was so strong for the financial markets, it seems possible that Goldman's first-quarter profit would have been a loss if it were still reporting on the old schedule, Williams said. The change in Goldman's financial reporting schedule made it more difficult for investors to track the company's performance over time, and it would have been helpful if the firm provided more information, analyst Steve Stelmach of FBR Capital Markets said. The Goldman spokesman rejected the notion that the firm shifted losses into December. Goldman did not supplement its latest earnings release by showing past results on a comparable basis because its business isn't seasonal "and we didn't think it was material or significant," Van Praag said. Goldman raised $5 billion yesterday by selling new stock at $123 per share. The firm has said it plans to use the money to repay the government for public funds it received under the Troubled Assets Relief Program.

Opinion April 15, 2009 OP-ED CONTRIBUTOR Big Profits, Big Questions By WILLIAM D. COHAN AT its nadir last November, Goldman Sachs’s share price closed at $52, nearly 80 percent below its high of around $250. By then, many of its chief competitors — Bear Stearns, Lehman Brothers, Merrill Lynch and UBS — were dead or shadows of their former selves. Even Morgan Stanley, long considered Goldman’s archrival, had nearly died. But somehow, less than five months later, on the heels of a surprisingly profitable first quarter of fiscal 2009, Goldman Sachs is once again riding high, with its stock closing Tuesday at $115 a share. The question many Wall Streeters are asking is just how Goldman once again snatched victory from the jaws of defeat. Many point to Goldman’s expert manipulation of the levers of power in Washington. Since Robert Rubin, its former chairman, joined the Clinton administration in 1993, first as the director of the National Economic Council and then as Treasury secretary, the firm has come to be known, as a headline in this newspaper last October put it, as “Government Sachs.” How can one ignore, the conspiracy-minded say, the crucial role that Henry Paulson, who followed Mr. Rubin to the top at both Goldman and Treasury, played in the decisions to shutter Bear Stearns, to force Lehman Brothers to file for bankruptcy and to insist that Bank of America buy Merrill Lynch at an inflated price? David Viniar, Goldman’s chief financial officer, acknowledged in a conference call yesterday the important role the changed competitive landscape had on Goldman’s unexpected first-quarter profit of $1.8 billion: “Many of our traditional competitors have retreated from the marketplace, either due to financial distress, mergers or shift in strategic priorities.” But he was largely mum on American International Group, which, Goldman’s critics insist, is the canvas upon which the bank and its alumni have painted their great masterpiece of self-interest. A few days after Mr. Paulson refused to save Lehman

126 Brothers last September — at a cost of a mere $45 billion or so — he came to A.I.G.’s rescue, to the tune of $170 billion and rising. Then he decided to install Edward Liddy — a former Goldman Sachs board member — as A.I.G.’s chief executive. Goldman has since received some $13 billion in cash, collateral and other payouts from A.I.G. — that is, from taxpayers. Why kill Lehman and save A.I.G.? The theory, we now know, was that the government felt it needed to save the firms, including Goldman Sachs, that had insured many of their risky ventures through the insurer. Indeed, had Mr. Paulson decided not to save A.I.G., its counterparties would have suffered serious losses. Lehman’s creditors will be lucky to get back pennies on the dollar. In a conference call he held last month, Mr. Viniar made the shocking claim that Goldman “had no material exposure to A.I.G.” because the firm had “collateral and market hedges in order to protect ourselves.” If so, then why did Goldman need the government’s help in the first place? During yesterday’s conference call, Guy Moszkowski, an analyst from Merrill Lynch, asked Mr. Viniar what role the $13 billion Goldman has collected from A.I.G. had on its first-quarter showing. But Mr. Viniar would have none of it: Profits “related to A.I.G. in the first quarter rounded to zero.” Hmm, how then did Goldman make so much money if that multibillion-dollar gift from you and me had nothing to do with it? Part of the answer lies in a little sleight of hand. One consequence of Goldman’s becoming a bank holding company last year was that it had to switch its fiscal year to the calendar year. Previously, Goldman’s fiscal year had ended on Nov. 30. Now it ends Dec. 31. As a result, December 2008 was not included in Goldman’s rosy first-quarter 2009 numbers. In that month, Goldman lost a little more than $1 billion, after a $1 billion writedown related to “non-investment-grade credit origination activities” and a further $625 million related to commercial real estate loans and securities. All told, in the last seven months, Goldman has lost $1.5 billion. But that number didn’t come up on Monday. How convenient. Which leaves us with the real reason Goldman has cleaned up this year: the huge misfortunes of its major competitors. Those other firms have disappeared or have become severely wounded, and as a result have more or less been sitting on their collective hands since the collapse of Lehman last September. As part of its busy day on Monday, Goldman also announced it was raising $5 billion of equity capital and that it intended to pay back the $10 billion from the Treasury’s Troubled Asset Relief Program that Mr. Paulson forced on the bank last October. Being free of the TARP yoke will give Goldman yet another competitive advantage: the ability to pay its own top talent and new recruits whatever it wants without government scrutiny. This is significant, since it is unlikely any of Goldman’s remaining competitors will be able to make a similar move anytime soon. There is a reason Bill Gates once said Microsoft’s biggest competitor was Goldman Sachs. “It’s all about I.Q.,” Mr. Gates said. “You win with I.Q. Our only competition for I.Q. is the top investment banks.” And then there was one. William D. Cohan, a contributing editor at Fortune, is the author of “House of Cards: A Tale of Hubris and Wretched Excess on Wall Street.”

127 Grasping Reality with Both Hands:The Semi-Daily Journal of Economist Brad DeLong Three Possible Financial Narratives for the Obama Administration "So we are settled," said the convenor of the meeting. "Our story is: the truth!" "At least it is easy to remember," someone muttered under their breath as we gathered up our papers. It seems to me that the Obama administration can go with any of three different truths as it tries to explain its banking programs to the world: 1. The banks have us by the plums: Keeping the economy near full employment requires pushing asset prices back up to values at which businesses selling stocks and bonds can obtain financing that makes it profitable for them to expand. But pushing asset prices back up enriches the bankers whose overleverage got us into this mess, and prevents them from suffering their just punishment. There is no way out of this dilemma, but the Obama administration is trying as hard as it can given the limited authority congress has granted it to maximize the gain to employment and minimize the support provided to financial princes. 2. The government has a chance to make a fortune: Just as in 1999 and 2005 financial markets were ruled by irrational exuberance, now they are ruled by irrational pessimism. Because of this irrational pessimism, businesses selling stocks and bonds cannot obtain financing that makes it profitable for them to expand--and so unemployment is high. But the government is not irrationally pessimistic, and is "patient capital": the government can buy up financial assets and so raise their price, boost employment, and then hold the assets until maturity and very likely make a fortune. It can do good for the economy and the country and do well by its own finances at the same time. It is true that financiers who ride-alongside, front-run, and manage the government's portfolio are very likely to make fortunes too, but much smaller fortunes than the government. 3. We have to play out the hand before we ask for a New Deal: Perhaps the situation can be cured with relatively minor support for the banks. Perhaps the situation will require full-fledged bank nationalization. Bank nationalization could not pass the Senate now. Come this fall, it may be needed--but it will only be clear that it is needed if the Obama administration has done its best to rescue the banking situation with the powers it has at its current disposal. You cannot ask for a New Deal until you have played out your hand. If the Obama administration were selling any of these three lines of narrative--or were selling all of them--it seems likely to me that it would be having more success is building support for its strategy. But I do not think that it is selling any of these narrative lines to make sense of its policies. Indeed, I do not know what the narrative story it wants to tell about the current situation is. http://delong.typepad.com/sdj/2009/04/three-possible-financial-narratives-for-the-obama- administration.html

128 Possible Narratives About the Geithner Plan

By Matthew Yglesias, Apr 15th, 2009 at 11:42 am

Brad DeLong had a good post a couple of days ago outlining three different narratives about bank rescue policy that he thought might explain what the Obama administration is doing with the banks, followed by the observation that “I do not think that it is selling any of these narrative lines to make sense of its policies. Indeed, I do not know what the narrative story it wants to tell about the current situation is.”

Yesterday, it seemed to me that Barack Obama was making a fourth and tougher claim, namely that the PPIP approach would save money relative to nationalization. I share D-Day’s skepticism that this will actually be true when all is said and done. Arguably, though, what Obama was saying amounts to a kind of blend of number two and number three.

Meanwhile, I’m beginning to get the sense, based on some things I’ve heard from people who’ve had more contact with the key players, that there’s disagreement between high-level policymakers about whether (2) is true or (3) is true. The administration has hit on a policy approach that can be agnostic between (2) and (3) but that agnosticism makes it difficult to articulate a clear theory of the case. It also might lead to some hidden ambiguities in terms of the details of implementation. http://yglesias.thinkprogress.org/archives/2009/04/possible_narratives_about_the_geithner_pl an.php

129 Stress Testing the Stress Test Scenarios: Actual Macro Data Are Already Worse than the More Adverse Scenario for 2009 in the Stress Tests. So the Stress Tests Fail the Basic Criterion of Reality Check Even Before They Are Concluded Nouriel Roubini | Apr 13, 2009 The spin machine about the banks’ stress test is already in full motion; some banking regulators have already leaked to the New York Times the spin that all 19 banks who are subject to the stress test will pass it, i.e. none of them will fail it. But if you look at the actual data today macro data for Q1 on the three variables used in the stress tests – growth rate, unemployment rate, and home price depreciation – are already worse than those in FDIC baseline scenario for 2009 AND even worse than those for the more adverse stressed scenario for 2009. Thus, the stress test results are meaningless as actual data are already running worse than the worst case scenario. The FDIC and Treasury used assumptions for the macro variables in 2009 and 2010 both the baseline and more adverse scenarios that are so optimistic that actual data for 2009 are already worse than the adverse scenario. And for some crucial variables such as the unemployment rate – that is key to proper estimates of default rates and recovery rates (given default) for residential mortgages, commercial mortgages, credit cards, auto loans, student loans and other banks loans – current trend show that by the end of 2009 the unemployment rate will be higher than the average unemployment rate assumed in the more adverse scenario for 2010, not for 2009! In other terms, the results of the stress test – even before they are published – are not worth the paper they are written on as they make assumptions on the economy that are much more optimistic –even in the worst scenarios that the FDIC has designed - than the actual figures for Q1 of 2009. Description of the FDIC stress tests baseline and more adverse scenarios To see why actual 2009 are already even worse than the more adverse scenario of the FDIC let us first look at how the stress tests are done: According to the FDIC there are two scenarios, one a more optimistic “baseline scenario” for 2009 and 2010 for the three macro variables (GDP, unemployment, and home prices) and one more pessimistic one - the “alternative more adverse scenario”. The baseline scenario assumes – based on the average of the forecasts by the consensus of macro forecasters at the time when the stress tests were announced – that GDP growth (percentage change in annual average) will be -2.1% in 2009 and +2.0 % in 2010, that the unemployment rate will average 8.4% in 2009 and 8.8% in 2010, and that home prices will fall 14% in 2009 and 4% in 2010 (percentage change fourth quarter of the previous year to fourth quarter of the indicated year based on the Case-Shiller, 10-City Composite index). In the alternative adverse scenarios GDP growth is assumed to be -3.3% in 2009 and 0.5% in 2010, the unemployment rate is assumed to average

130 8.9% in 2009 and 10.3% in 2010 while home prices are assumed to fall 20% in 2009 and 7% in 2010. The description provided by the FDIC of the stress test also shows graphs – but not actual figures – for the quarterly behavior of the three macro variables in 2009 and 2010 for both scenarios. Based on these quarterly graphs in Q1 of 2009 the unemployment rate would approximately average for the quarter 7.7% in the baseline scenario and 7.8% in the adverse scenario; the GDP growth rate (4-quarter % change) would be -1.9% in the baseline scenario and -2.1 in the adverse scenario; while home prices would fall in Q1 relative to Q4 of 2008 by 4% in the baseline scenario and by 7% in the adverse scenario. How do these scenarios actually stack with actual figures for Q1 2009, with current consensus forecasts and with current likely paths for these macro variables? Unemployment rate Take the unemployment rate: in March of this year the actual unemployment rate was already – at 8.5% much higher than the baseline scenario for Q1 (7.7%) and even higher than the adverse scenario 7.8%. Even if you were to take the average unemployment rate in Q1 that was 8.1% this figure is already well above both the baseline and adverse scenario. If one has to look ahead the likely evolution of the unemployment rate in 2009 and 2010 will lead to actual data that are much worse than the baseline and more adverse scenarios. For example, based on current trends in employment and initial claims Ted Wieseman, US fixed income economist for Morgan Stanley and a very mainstream analyst, has recently argued that the unemployment rate could reach 10% by June of 2009; as he put it: The key round of early March economic news was weak, with another disastrous employment report again standing out. Non-farm payrolls plunged 663,000 in March, bringing the average drop over the past five months to 667,000, an unprecedented run of job losses in absolute terms and the worst in percentage terms over such a period since the 1973-75 recession… The past week’s jobless claims report showed substantial deterioration as we move towards the survey period for the April employment report, so at this point there is no reason to expect the extremely weak recent trend in the jobs report to show any improvement next month. Indeed, at the rate jobs are disappearing, the unemployment rate could be into double-digits as early as June (bold added). Indeed with per month job losses well above 600K for several months in a row and with initial claims still averaging 650k per week for the last few weeks there is no chance that job losses will be any less than 600K for the next two months. Even if the economy were to turn to positive growth by Q3 – as the consensus forecasts expects – the unemployment rate would rise for at least another 12 months as job market data are lagging indicators of economic activity. For example, in 2001 the recession was short and shallow – only 8 months – and over by November but job losses continued for another 19 months until August of 2003. So based on current trends – and even generously assuming that the economy recovers positive growth by Q3 of 2009 (quite an heroic assumption) it is almost certain that the unemployment rate will be 10.5% by December of this year (and would thus average about 9.5% for the year); in a more adverse – but more realistic scenario – the unemployment rate would reach 11% by December of 2009 and average 9.8% for the year. So in summary, based on current actual data the unemployment rate is already well above the values that the FDIC had for them in Q1 of 2009 in both the baseline and stress scenarios. And given current trends in the unemployment rate and initial claims for unemployment

131 benefits – even assuming that the economy behaves like the consensus forecasts and recovers positive growth in H2 of 2009 – the average unemployment rate in 2009 would be 9.5% that is not only well above the baseline scenario of 8.4% for 2009 but also well above the average unemployment rate for 2010 in that baseline scenario. Worse, 9.5% would be even worse than the average unemployment rate that is assumed by the FDIC for 2009 in the adverse scenario, i.e. 8.9%. Actually based on current data for initial claims it is highly likely that by April 2009 (this month) the unemployment rate will reach 9.0% and thus be higher already at this early part of 2009 than the average of 8.9% that the FDIC assumes it will be for the average of 2009. Since based on current and likely trends the unemployment rate will be – at best over 10% by year end – and more likely closer to 11% by year end (and average 9.8% for the year) 2009 data are already worse than the adverse scenario and will for sure be worse than the adverse scenario. But more importantly by year end 2009 the actual unemployment rate – even with a growth recovery in H2 – will be higher at 10.5% - than the average unemployment rate assumed by the FDIC in the adverse scenario for 2010, not 2009! GDP growth A similar analysis suggests that the FDIC assumptions for GDP growth and home prices are already worse than the adverse scenario – let alone the baseline scenario – for Q1 of 2009. A first estimate of Q1 2009 GDP growth will be out only at the end of April 2009 but the current consensus is that the figure will be around -5% for the SAAR figure in Q1 (i.e. the growth rate of the economy in Q1 2009 relative to Q4 of 2008 seasonally adjusted at annual rate) with a number of respected and reputable forecasters putting that figure at -6% or even worse. Now, based on the FDIC graphs the GDP growth rate (4-quarter % change in Q1 2009 relative to Q1 2008) would be -1.9% in the baseline scenario and -2.1 in the adverse scenario. If we plug the current consensus estimate of Q1 GDP growth and then compute the y-o-y 4- quarter % change we get a figure of -2.3%. Thus, based on consensus estimates of GDP for Q1 2009 the 4-quarter contraction of GDP will be – in Q1 of this year – already worse than both the baseline scenario figure (-1.9%) and the more adverse scenario figure (-2.1%). If, as possible, the GDP contraction in Q1 is -6% (SAAR) the Q1 2009 vs Q1 2008 percentage change in GDP will be -2.5%, a figure even worse than the previous one compared to the baseline and more adverse scenarios for Q1 of this year. So by Q1 of this year both the unemployment rate and the GDP growth rate are (or will likely be once the Q1 GDP first estimates are out) worse than the FDIC figures for both the baseline and more adverse scenarios. Moreover, relative to the time in December when the consensus forecasts for 2009 were used by the FDIC to derive its baseline scenario for 2009 such consensus forecasts have significantly worsened. Based on the latest March figures the consensus is now projecting that 2009 GDP growth will be -3.2 rather than the -2.0% in the original FDIC baseline. And a number of high profile mainstream sell-side research such as Goldman Sachs, Merrill Lynch, Morgan Stanley - houses – that have had a better than average track record in forecasting the current downturn – are now forecasting a 2009 GDP contraction of about 3.5% on average (the current RGE Monitor forecast is even worse at 3.7%). Thus, the current consensus forecast for 2009 GDP growth is – at 3.2% - practically identical to the adverse scenario GDP growth for 2009; and most reputable research institutions are forecasting for 2009 a figure that is actually worse than the consensus scenario. Also, while the current consensus forecast for 2010 growth (2.0%) is practically identical to the baseline scenario for 20010 GDP growth (2.1%) a number of more accurate than consensus source are predicting a much weaker scenario for 2010: for example Goldman Sachs has a current forecast of 1.2% for 2010 GDP

132 growth as opposed to the baseline scenario figure of 2.0%. So, in all likelihood even the current consensus forecasts is close – or worse – than the more adverse scenario while the baseline scenario is already out of the window both for Q1 and the year overall. Home prices Let us now consider the outlook for home prices. Unfortunately the Case-Shiller 10-City Composite figures are available – for now – up to January 2009 with the February figures due to be published at the end of April. The FDIC baseline assumes that home prices will fall – December 2009 vs December 2008 – by 14% while its more adverse scenario sees home prices falling by 22% during 2009. The fall in home prices in January 2009 relative to December 2008 was 1.9% that – if continuing at this rate for all of 2009 – it compounds to an annual rate of 25.3% that is well above the 14% of the baseline scenario and also above the adverse scenario of 22%. One month does not make a trend and the 12-month % change in home prices was a negative 19% in January 2009, December and November 2008, up from the 18% drop in August-September-October 2008 and the 17% drop in the May-June-July 2008 period. So, in the last year the rate of home price depreciation has accelerated from 17% to 18% to 19% and most recently to 25%. It is possible that the rate at which home prices will fall for the rest of 2009 will be smaller than the latest 25% rate. But even the more recent optimistic data for the housing sector – a possible stabilization of housing starts, building permits, new home sales and existing home sales – do not imply that the rate of fall of home prices will be significantly lower in the months to come. The reason is that, while home sales and housing starts/completion are now showing signs of stabilization – after falling from their peak by more than 70% - the excess supply of new and existing homes is still huge – both in absolute terms and as a ratio of sales – and thus a significant downward pressure on prices. Even if housing starts/completions were to go to zero – from their current 500K level – it would take about 11 months until the current supply of new homes is depleted by the current demands. And since a recovery of both supply and demand from current depressed levels would reduce the excess inventory only if new home sales are well above new completions, there is no reason to believe that home prices will fall at a much slower rate for the rest of 2009. In other terms, even if quantities in housing were to stabilize and then recover in the next few months prices will keep on falling for all of 2009 and for all of 20010 at a very rapid rate. Also, research done by RGE suggests that – based on a variety of criteria such as real home prices, home price to rental ratios, home price to income ratios, price affordability measures of homes in 2009 and 2010 home prices will fall much more than the baseline scenarios of the FDIC – that sees a cumulative fall in home prices in 2009-2010 of 18.5%. These criteria suggest that home prices will cumulatively fall by a figure very close – if not higher – than the one assumed in the more adverse scenario, i.e. 30.5%. In summary, home prices have been falling in recent months at a rate that is much higher than the 14% assumed in the FDIC baseline for 2009. They are also running currently at an annual rate that is higher than the 22% in the more adverse scenario of the FDIC; and even considering actual figures for the last few months – that show an accelerated rate of fall in homes prices between the spring of 2008 and the most recent data – home prices have been falling in the last few months at rates – average of y-o-y and m-o-m figures – of about 20% with an upward trend in the data. So the actual and trend figures are well above the baseline figure of 14% and closer to the 22% of more adverse scenario.

133 Conclusion: Actual macro data for 2009 are already worse than the more adverse scenario in the stress tests. These are not stress tests but rather fudge tests In conclusion, recent data and trends for the unemployment rate, GDP growth and home prices show that, as of Q1 of 2009, actual macro data are much worse than the baseline scenario of the stress tests and even worse than the more adverse scenario of the stress tests. Under the most reasonable scenario the unemployment rate by the end of this year will be worse than not just the baseline and more adverse scenarios for 2009 but it will also be even worse than the average unemployment rate for all of 2010 in the more adverse scenario. Similarly GDP growth figures are running – in Q1 2009 – at likely rates that are already worse than both the baseline and the more adverse scenarios. While home prices are currently falling at rates that are much higher than the baseline scenario and close to those of the more adverse scenario. And for some crucial variables such as the unemployment rate – that is key to the proper estimation of default rates and recovery rates for every type of bank loans – current trend show that by the end of 2009 the unemployment rate will be higher than the average unemployment rate assumed in the more adverse scenario for 2010, not for 2009! In other terms, the results of the stress tests – even before they are published – are not worth the paper they are written on. The stress test exercise was already flawed from the start as it took as its baseline scenario the consensus forecast for the economy for 2009 and 2010, a consensus that, for the last two years, had totally gotten wrong not only the growth rate of the economy but even the sign of the growth rate as the recession started in December 2007. And the more adverse scenario of the stress test was not really a truly adverse scenario as it assumed positive growth for 2010 (rather than an additional negative growth for 2010) and assumed an average unemployment rate for 2010 in the more adverse scenario that, based on current data and trends, is likely to be reached at the earliest by Q3 of 2009 and at the latest by Q4 of 2009. So how can anyone take seriously stress tests that are blatantly rigged from the outset with scenarios that make little economic sense and that, based on actual current data, are already obsolete as their worst case scenario is already more optimistic than actual current data for Q1? This financial crisis was one due to opacity and lack of transparency in financial markets and due to regulators that were asleep at the wheel. But now the administration officials and regulators have decided to add to the fog of opacity by adding to the lack of transparency in financial markets: regulatory forbearance that allows banks such as Well Fargo to declare charge-off rates and to set aside reserves for loan losses that make no sense relative to the state of the economy and relative to their loan book; partial suspension of mark-to-market accounting that allows – starting with Wells Fargo – to hide losses and reduce the amount of write-downs on securities; likely reinstatements of some variant of the uptick rule that will restrict shorting of stock and will artificially boost equity prices (a form of legalized manipulation of the stock market by regulators that are trying to prevent short-sellers to do their job, i.e. make stock prices reflect fundamentals and prevent bubbles in stock prices); and now stress tests that fail the basic test of a reality check by making assumptions – that even in the worst case scenario that is designed from start to be too mild to be a sensible realistic stress test scenario – that are obsolete based on actual data for the economy as of Q1 of 2009. Call it a generalized “fudge test” rather than a true “stress test”. http://www.rgemonitor.com/blog/roubini/256382/stress_testing_the_stress_test_scenarios_actual_macro_data_ar e_already_worse_than_the_more_adverse_scenario_for_2009_in_the_stress_tests_so_the_stress_tests_fail_the_ basic_criterion_of_reality_check_even_before_they_are_concluded

134 Mar 13, 2009 http://www.rgemonitor.com/175?cluster_id=9411 What Is Driving The Interbank Liquidity Hoarding at the Core of the Credit Crisis? • Overview: One view holds that whatever policymakers do to shore up the housing market will help money markets by increasing confidence and stop the asset value deterioration. Alternative view holds that policymakers cannot solve households' overindebtedness, nor make the housing oversupply go away, and therefore neither stop housing prices from falling. As house prices fall, re-intermediation of off-balance sheet vehicles will continue thus putting renewed stress on banks balance sheets. The fundamental problem is not uncertainty about toxic assets; banks know all too well what they have on and off their balance sheets which makes them hoard any cash they receive. o Sep 9 MorganStanley argues that as the housing market is central to the credit crisis, any relief in the housing market is likely to have positive repercussions on broader credit markets, starting from interbank lending. o August 25: After agency spreads (=stress leading indicator according to Brunnermeier) and LIBOR-OIS spreads, Ted spread -which is also a measure of financing conditions in repo markets- is back above 114bp. o August 15 McCormick: Extension of central banks' lending facilities earlier this month fail to ease money market tensions: 3m USD LIBOR-OIS spread widened to 77bp, 3m EUR spread to 64bp. Forward rates signal further stress ahead. o BNP August 5: Extension of Fed policy arsenal, incl. TSLF options for quarter-end tensions, reiterates severity and persistence of banks' stress situation. Banks in U.S., EU and Switzerland bid heavily for 3-month funds at just below LIBOR. Questions arise again if LIBOR is actually too low as there's barely a difference between secured and unsecured lending rates. o July 31, Reuters: Banks borrowed a record amount of funds from the Federal Reserve in July, while the commercial paper market continued to contract; ECB lent record $49bn Euro to Spanish banks. o Sarkar/Wang/McAndrews (NY Fed), July: The empirical results suggest that the TAF has helped to ease strains in intebank market. o Dudley (NY Fed Vice): Balance sheet constraints due to reintermediation and deleveraging are the main culprits rather than outright counterparty risk or less term funding provided by money market funds. o Taylor/Williams: LIBOR-OIS spread is driven by increased counterparty risk between banks --> no empirical evidence that the TAF has reduced spreads. As unsecured loans to companies and households are priced off LIBOR, the hike in interbank spreads interferes with monetary policy and the real economy. o Giavazzi, Caballero (Vox): hypotheses for persistently high interbank spreads includes possibility that banks aren’t lending in order to bankrupt acquisition targets.

135 Apr 11, 2009: Ireland Is the First Eurozone Country to Set Up A Swedish-Inspired 'Bad Bank': Will Others Follow Suit? Overview: April 8 Brown (FT): The Irish 'bad bank' plan involves a government-controlled agency taking legacy property assets and loans to developers off the banks’ books in return for government bonds. Mr Lenihan said the agency would take over loans with a book value of €80bn-€90bn (=about 45% of GDP) , although actual value is much lower--> Finance Minister Lenihan emphasized “this is not something the banks especially want because we’re insisting on the banks taking their losses up-front for the sake of the economy”. --> see 'Bad Bank' Proposals in EMU o cont.: minister Lenihan: the issuance of bonds would result in a “significant” increase in national debt levels, but “the cost of servicing this debt will be offset, as far as practical, from income accruing from the assets of the new agency.” Any shortfall would be met by a levy on the banks’ assets. o cont.: opposition critique: “We don’t know what price the taxpayer will have to pay. We don’t know if the working out of this leaves a huge deficit. Will the bankers pay up?”--> the value of assets being assumed by the new agency was “equivalent to more than 50 per cent of GDP, the equivalent of 12 years of income tax”. It might be 10 years before the full cost would be clear--> Irish government bond spreads rise on April 8. o Irish banking sector has grown rapidly both at home and abroad since the start of the EMU in January 1999: Bank assets are now at around 940% of GDP of which the share of Irish-owned banks, total €575bn, or 309% of GDP. o Standard & Poor’s recently estimated the banks’ gross problematic assets at around 11-33% of domestic credit, which is equivalent to around 23-69% of GDP. According to their calculations, the government may face re-capitalisation costs of around 4% (8%) of GDP in a base case (stress case) scenario (DB) o Solution akin to Jeffrey Sachs proposal: The bank can be recapitalized at fair value to taxpayers and without inducing a squeeze on bank capital and lending. The government can swap 20 in government bonds for the 20 in toxic assets plus contingent warrants on bank capital, the value of which depends on the eventual sale price of the toxic assets. The government would then dispose of the 20 in toxic assets at a market price over the course of the next year or two and exercise its contingent warrants at that time. During the period of liquidating the toxic assets, the government would exercise a kind of receivership over the banks in order to prevent asset stripping or 'Hail- Mary' incentives on the part of managers --> In this process, there are no taxpayer bailouts, and there is also no squeeze on bank capital resulting from the exchange of toxic assets at less than face value. o Compare also with Luigi Spaventa's Brady Bond proposal. o Question: Is Irish sovereign a credible backstop with deficit expected to reach 13% and public debt to nearly triple in 2 years (from 25% to exp. 75% of GDP)--> see Celtic Tiger No More: Ireland In Crisis Loses AAA Rating

136 Could situation of Irish banks impact solvency of the government? o Markets have begun to see a risk to the solvency of the Irish government and are questioning whether it has the financial muscle to back up the bank guarantees it made in September 2008- Klawitter of Dresdner Kleinwort (via Telegraph) o Costs of bailing out the financial system are rising: a sum of €5.5bn announced in Dec-08 was increased to €7bn in Feb-09 and will probably have to be raised again (EIU) o Yield spreads on Irish government bonds against German government bonds continue to balloon, reaching 282 bps in early Mar-09, from 20 bps at beginning of 2008. This is causing debt- servicing costs to rise rapidly (EIU) Timeline o Feb 22: Up to €10 billion (roughly 5.6% of Irish GDP) in corporate and individual deposits is believed to have left Ireland following a PwC report on Anglo Irish Bank with significant omissions (Independent) o Feb 23: Anger among Irish citizens is exacerbated by the realization that the EUR7bn that the government plans to inject to recapitalize Allied irish Banks and Bank of Ireland is being provided by the National Pensions Reserve Fund, a SWF originally set up to prefinance the pensions bill of public servants retiring after 2025 (FT) o Feb 12: In its second round of capitalization, government will provide EUR3.5bn in core tier 1 capital for each of the 2 largest banks in return for preference shares with a fixed dividend of 8% payable in cash or ordinary shares o BNP: As of Feb 12, the Irish capital injections plus pledged guarantees amount to EUR412.5bn or 216.4% of GDP o Jan 16: Government moved to nationalize Anglo Irish Bank, country’s third-largest lender. Fends off rumor about potential IMF loan talks o Dec 22: Irish government announced a capital injection totaling €5.5bn ($7.6bn) into the country’s three main banks; investment is in the form of perpetual preference shares Details of Capital Injections o Irish government will put EUR2bn into each of Bank of Ireland and Allied Irish Bank in return for an 8% dividend. Government will have 25% of the voting rights on ‘key issues’ such as change of control and capital structure. A further EUR1.5bn will go to Anglo Irish Bank in return for preference shares with a 10% dividend and 75% of voting rights (BNP) o In exchange for the money, the banks have agreed to increase lending to small and mid-size businesses by at least 10% in 2009. Banks also agreed to increase lending to first-time house buyers by 30% in 2009, subject to demand, and to wait at least six months after a homeowner first defaults on a mortgage before taking legal action or repossessing the home (WSJ) o The systemic recapitalization is aimed at strengthening banks' balance sheets and restoring investor confidence in bank shares, which have fallen sharply of late o Government plans to use money from the National Pension Reserve Fund, a sovereign wealth fund with assets under management of €18bn which was established to part fund the future public service pensions Background o Due to relatively high leverage and strong reliance on external funding, the global credit crisis has delivered a major external shock to Ireland and forced the government to support its ailing banking sector o Irish banks have been bleeding money as a property bust set off a chain of defaults http://www.rgemonitor.com/10009/Europe?cluster_id=13016

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Opinion April 10, 2009 OP-ED COLUMNIST Making Banking Boring By PAUL KRUGMAN Thirty-plus years ago, when I was a graduate student in economics, only the least ambitious of my classmates sought careers in the financial world. Even then, investment banks paid more than teaching or public service — but not that much more, and anyway, everyone knew that banking was, well, boring. In the years that followed, of course, banking became anything but boring. Wheeling and dealing flourished, and pay scales in finance shot up, drawing in many of the nation’s best and brightest young people (O.K., I’m not so sure about the “best” part). And we were assured that our supersized financial sector was the key to prosperity. Instead, however, finance turned into the monster that ate the world economy. Recently, the economists Thomas Philippon and Ariell Reshef circulated a paper that could have been titled “The Rise and Fall of Boring Banking” (it’s actually titled “Wages and Human Capital in the U.S. Financial Industry, 1909-2006”). They show that banking in America has gone through three eras over the past century. Before 1930, banking was an exciting industry featuring a number of larger-than-life figures, who built giant financial empires (some of which later turned out to have been based on fraud). This highflying finance sector presided over a rapid increase in debt: Household debt as a percentage of G.D.P. almost doubled between World War I and 1929. During this first era of high finance, bankers were, on average, paid much more than their counterparts in other industries. But finance lost its glamour when the banking system collapsed during the Great Depression. The banking industry that emerged from that collapse was tightly regulated, far less colorful than it had been before the Depression, and far less lucrative for those who ran it. Banking became boring, partly because bankers were so conservative about lending: Household debt, which had fallen sharply as a percentage of G.D.P. during the Depression and World War II, stayed far below pre-1930s levels. Strange to say, this era of boring banking was also an era of spectacular economic progress for most Americans. After 1980, however, as the political winds shifted, many of the regulations on banks were lifted — and banking became exciting again. Debt began rising rapidly, eventually reaching just about the same level relative to G.D.P. as in 1929. And the financial industry exploded in size. By the middle of this decade, it accounted for a third of corporate profits. As these changes took place, finance again became a high-paying career — spectacularly high-paying for those who built new financial empires. Indeed, soaring incomes in finance played a large role in creating America’s second Gilded Age. Needless to say, the new superstars believed that they had earned their wealth. “I think that the results our company had, which is where the great majority of my wealth

138 came from, justified what I got,” said Sanford Weill in 2007, a year after he had retired from Citigroup. And many economists agreed. Only a few people warned that this supercharged financial system might come to a bad end. Perhaps the most notable Cassandra was Raghuram Rajan of the University of Chicago, a former chief economist at the International Monetary Fund, who argued at a 2005 conference that the rapid growth of finance had increased the risk of a “catastrophic meltdown.” But other participants in the conference, including Lawrence Summers, now the head of the National Economic Council, ridiculed Mr. Rajan’s concerns. And the meltdown came. Much of the seeming success of the financial industry has now been revealed as an illusion. (Citigroup stock has lost more than 90 percent of its value since Mr. Weill congratulated himself.) Worse yet, the collapse of the financial house of cards has wreaked havoc with the rest of the economy, with world trade and industrial output actually falling faster than they did in the Great Depression. And the catastrophe has led to calls for much more regulation of the financial industry. But my sense is that policy makers are still thinking mainly about rearranging the boxes on the bank supervisory organization chart. They’re not at all ready to do what needs to be done — which is to make banking boring again. Part of the problem is that boring banking would mean poorer bankers, and the financial industry still has a lot of friends in high places. But it’s also a matter of ideology: Despite everything that has happened, most people in positions of power still associate fancy finance with economic progress. Can they be persuaded otherwise? Will we find the will to pursue serious financial reform? If not, the current crisis won’t be a one-time event; it will be the shape of things to come. David Brooks is off today. http://www.nytimes.com/2009/04/10/opinion/10krugman.html?_r=1

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How Bernanke Staged a Revolution This chairman set out to lead as a civil servant rather than a celebrity economist. Facing a thundering financial collapse, he has reinvented the Federal Reserve. By Neil Irwin Washington Post Staff Writer Thursday, April 9, 2009; A01 Every six weeks or so, around a giant mahogany table in an ornate room overlooking the National Mall, 16 people, one after another, give their take on how the U.S. economy is doing and what they, the leaders of the Federal Reserve, want to do about it. Then there's a coffee break. While most of the policymakers make small talk in the hallway, their chairman, Ben S. Bernanke, pops into his office next-door and types out a few lines on his computer. When the Federal Open Market Committee reconvenes, Bernanke speaks from the notes he printed moments earlier. "Here's what I think I heard," he'll say, before running through the range of views. He sometimes articulates the views of dissenters more persuasively than they did. "Did I get it right?" he says. The answer, in recent months, has been a resounding yes. And Bernanke's ability to understand and synthesize the views of his colleagues goes a long way toward explaining how he has revolutionized the Federal Reserve, which under his leadership has deployed trillions of dollars to try to contain the worst economic downturn in 80 years. Famously soft-spoken, Bernanke is an unlikely revolutionary. He is, after all, a career economics professor who lacks the charisma of a skilled politician. He also happens to run an organization designed for inertia: Decision-making authority is shared with four other governors in Washington appointed by the president; the heads of regional Fed banks in 12 cities who answer to their own boards of directors; and a staff of 2,000 that is led by economists who spent decades working their way through a rigid hierarchy. Yet in the past 18 months, Bernanke has transformed that stodgy organization, invoking rarely used emergency authorities. His decision to do so has drawn criticism -- he has transcended traditional limits on the role of a central bank, stretched the Fed's legal authority and to some, usurped the responsibility of political authorities in committing vast sums of taxpayer dollars. The Fed's actions put the economy on a "perilous" course, said James Grant, editor of Grant's Interest Rate Observer. "The real risk is that he will wind up instigating rampant inflation" once the recession has passed, he said. "A related possibility is that the Fed has created incentives to overdo it in borrowing and lending . . . which is what got us into this mess in the first place." What strikes many who have worked with Bernanke, though, is that he has pulled it all off without grand speeches, arm-twisting or Machiavellian games. Rather, according to interviews with more than a dozen current and former Fed officials and others familiar with the workings of the central bank, he has enacted bold policy moves through measured,

140 intellectual debates and by making even those who are resistant to some of the new actions feel that their concerns are understood. To many Fed veterans, his leadership style is a stark contrast with that of his predecessor, Alan Greenspan, whose tenure was characterized by tightly controlled decision-making with only rare open disagreement. "It's not Ben's personality to pound the table and scream and say you're going to agree with me or else," said Alan Blinder, a former Fed vice chairman and longtime colleague of Bernanke's at Princeton University. "It's not his way. I've known him for 25 years. He succeeds at persuading people by respecting their points of view and through the force of his own intellect. He doesn't say you're a jerk for disagreeing." In other words, Bernanke has remade the Federal Reserve not in spite of his low-key style and proclivity for consensus-building. He has been able to remake the Fed because of it. Looking High and Low More than a few times over the past year, senior Fed staff members have logged into their e- mail accounts to find an unusual message. Subject: Blue Sky. Sender: Ben S. Bernanke. The point of the e-mails has been to encourage them to think of creative ways that the Fed can guard the economy from the downdraft of a financial collapse. This is an institution that not long ago could spend the better part of a two-day policymaking meeting deciding whether its target for short-term interest rates should be 5.25 percent or 5 percent. But in this crisis, rate cuts, the most common tool for helping the economy, have lacked their usual punch. The Fed already has dropped the rate it controls essentially to zero, meaning there is no room left to cut. That's why Bernanke's Fed has been trying to dream up ideas out of the clear blue sky. The result has been 15 Fed lending programs, many with four-letter acronyms, most of them unthinkable before the current crisis. Under one unconventional program, the Fed is providing money for auto loans and credit card loans. Under another, it is making money available for home mortgages. Many of the programs have required legal and financial gymnastics to enact, with the central bank being forced to invoke an emergency authority that allows it to lend to most any institution in "unusual and exigent circumstances." In the end, though, they have allowed the Fed to effectively create money to keep lending going. Bernanke, 55, has said his academic research, especially about the Great Depression, convinced him that the Fed has no choice but to move forcefully during a financial crisis, even if doing so means it crosses conventional boundaries. "Everyone is encouraged to come up with ideas that are a little bit out of the ordinary, to try to encourage creative approaches and to think outside of the box, which is not the usual central bank approach," Bernanke said in an interview. "But in the current climate I think it is necessary." Dozens of staff members have been involved in figuring out how to execute the programs, but for many, Bernanke has been the catalyst. In November, for instance, the Fed moved to push down mortgage rates by buying $600 billion in mortgage-related securities; in March, it increased that number by another $850 billion.

141 But sources said Bernanke raised the possibility internally more than a year ago, and he pushed to make sure the Fed was prepared to act. "For many months, the chairman was asking 'how can we escalate?' " said William C. Dudley, president of the New York Fed. "There was a general consensus that we were getting to the point where traditional monetary policy tools might not be sufficient." Into the Mortgage Market The decision to flood money into the mortgage market was not Bernanke's alone; the power to do so belonged to the Federal Open Market Committee, which he leads. The four other governors serve on it, as does a rotating group of five of the 12 presidents of regional Fed banks. In November, Bernanke called individual committee members to see whether they would be open to the Fed inserting itself into the mortgage market. At the time, some committee members viewed the purchase of mortgage securities as a way to lower mortgage rates, encourage home sales and thus find a bottom for the housing market. Others said that buyers were irrationally avoiding even safe mortgage assets and that the Fed needed to act to make the markets to function more normally. Still others wanted the Fed to boost confidence in Fannie Mae and Freddie Mac by making more explicit the idea that the U.S. government stood behind the mortgage finance giants. There were worries, too, that buying mortgage-related securities could make it hard for the Fed to suck money out of the economy once it began to recover, which could lead to inflation, or that doing so could put the government in the role of favoring housing over other sectors. Bernanke guided the group toward a conclusion. Even though members had differences, most agreed that the economy was in bad shape and that the Fed's purchase of mortgage debt would likely help matters. "The chair of any committee can respond to comments that challenge his view in ways that essentially inform the committee that the issue isn't worth discussing. This chairman doesn't do that," said Jeffrey M. Lacker, president of the Richmond Fed, who worried that the Fed was putting itself in the uncomfortable position of allocating capital in the economy. "He takes other views seriously." 'Some Thoughts of My Own' At the Federal Open Market Committee meetings, after reading from his notes that synthesize the views of participants around the table, he turns to a second sheet of paper. "Having heard that," he might say, "let me add some thoughts of my own." In December, Bernanke came into the meeting looking to take steps to indicate to the world that the basic framework of policy had changed. Cut the interest rate the Fed controls to roughly zero, he argued. And lay out publicly the options the Fed could exercise to support the economy further, such as buying long-term Treasury bonds. He also promised to involve the Fed leaders broadly in future decisions. Given the Fed's peculiar structure, some decisions involving its emergency efforts to expand credit are made by the full FOMC while others are made by the Board of Governors in Washington. When the Fed decided to bail out Bear Stearns last spring and American International Group in the fall, presidents of regional Fed banks found out not long before the public did.

142 Bernanke essentially promised to engage senior officials across the Fed in that decision- making process, even in areas where they have no official say. In recent months, sources said, he has conducted a videoconference every couple of weeks with members of the FOMC, briefing them on the latest Fed programs. Bernanke has also adjusted the schedule to make all FOMC meetings last two days, instead of alternating between one- and two-day meetings. One-day meetings follow a rigid schedule, leaving little time for more open-ended discussion. "He tries to bring as much input as possible," said Kansas City Fed President Thomas Hoenig. "He's always been willing to ask questions, accept input and be responsive to that input." That strategy has paid dividends. At the December meeting, Dallas Fed President Richard Fisher didn't want to cut rates and initially dissented from the decision, sources said. At the last minute, in the spirit of public unanimity, he changed his vote. A Common Conversation Leaders of regional Fed banks aren't the only constituency Bernanke has rallied around a set of bold actions. Staff members at the Fed in Washington are known for their high-octane intellects and spirit of political independence. But they also tend to be insular and disinclined to rush into decisions. One midlevel staffer working on financial rescue issues said recently, "I've been here 20 years, and before the last few months never really dealt with anyone outside this building." One Fed governor, when he began, was expected to go through layers of bureaucracy just to get a daily update on the Treasury bond market; now he calls directly the lower-level staff who monitor those markets. From the day he became chairman three years ago, Bernanke has tried to make the culture less hierarchical. Senior staff members now commonly refer to governors by first names, instead of addressing them with the title "Governor," as they did previously. (The big boss is still Chairman Bernanke.) And whereas Greenspan once was briefed before policymaking meetings in ritualistic sessions with staff, Bernanke presides over sessions with more debate and discussion, often involving anyone on the staff with expertise on an issue rather than just top-level directors. A decade ago, when the Fed wanted to know how it might deal with technical issues created by the government's need for fewer Treasury bonds, a study of the issue took 18 months and involved 73 economists across the Fed system. The result was a 165-page report. This year, the Fed has made decisions of similar complexity and importance over a single weekend. The pressure to act fast has, by all accounts, come from Bernanke himself. His relationships with staff members are warm, dating to his days as a Fed governor when he ran the equivalent of faculty seminars to help young economists develop their research. But sources who have been in contact with Fed staffers also say that he has prodded economists and lawyers to move faster and think more creatively to execute new programs being enacted. The Fed's actions have not gone unquestioned -- its inspector general is reviewing all the programs it has launched under its emergency lending authority, and members of Congress have become increasingly skeptical toward the central bank.

143 "In a crisis, the task a chairman assigns is 'Find a way to do this.' It's not a question of 'Can we do this?' " said Vincent Reinhart, who was a senior Fed staffer until 2007 and is now a resident scholar at the American Enterprise Institute. In developing responses to the crisis, Bernanke collaborated extensively with the Bush administration, and has done so under the Obama administration, even though the Fed traditionally maintains its distance from political authorities. His inclination to build consensus has extended internationally as well. In October, he played a leading role in engineering a joint global interest rate cut with the European Central Bank and the central banks of Britain, Canada, Switzerland and Sweden. He is particularly close with Bank of England Governor Mervyn King, who shares his academic background, and has quietly urged European Central Bank President Jean-Claude Trichet to move more aggressively to stimulate the economies of Europe. The Bureaucrat Steps Forth Bernanke came into office aiming to depersonalize the role of Fed chairman. As Greenspan's successor, he aspired to be more anonymous bureaucrat than celebrity economist. But people who have worked with him say he has become more politically savvy over the past 18 months, developing a better sense for what's palatable to Congress. In the early days of the crisis, sources said, he suggested solutions to the foreclosure problem that would have been more expensive than lawmakers would have ever considered. He has also learned how to make his case publicly. In a first for a Fed chairman, he appeared at a de facto news conference, responding to questions from reporters at the National Press Club after a speech. Then, in another first, he sat for an interview with "60 Minutes," arguing that the biggest risk to the economy would be a lack of "political will" to solve the financial crisis. Fisher, the president of the Dallas Fed, said the television interview was important. It gave Americans some reassurance about the economy, and Bernanke came across as thoughtful and deliberate. "We all know Ben is not a publicity seeker," Fisher said. "All of us, in the world of central bankers, are meant to be felt but not seen. But these are unusual times."

144 naked capitalism Thursday, April 9, 2009 Quelle Surprise! Bank Stress Tests Producing Expected Results! Should this even qualify as news? From the New York Times: For the last eight weeks, nearly 200 federal examiners have labored inside some of the nation’s biggest banks to determine how those institutions would hold up if the recession deepened. What they are discovering may come as a relief to both the financial industry and the public: the banking industry, broadly speaking, seems to be in better shape than many people think, officials involved in the examinations say. That is the good news. The bad news is that many of the largest American lenders, despite all those bailouts, probably need to be bailed out again, either by private investors or, more likely, the federal government. After receiving many millions, and in some cases, many billions of taxpayer dollars, banks still need more capital, these officials say. The whole point of this charade exercise was to show the big banks weren't terminal but still needed dough, and I am sure it will prove to be lots of dough before we are done. But they now have the Good Housekeeping seal, so the chump taxpayer can breathe easy that the authorities are taking prudent measures to make sure his money is being shepherded wisely.

If you believe that, I have a bridge I'd like to sell you. We said from the beginning the stress tests were a complete sham. Just look at the numbers. 200 examiners for 19 banks? When Citi nearly went under in the early 1990s, it took 160 examiners to go over its US commercial real estate portfolio (and even then then the bodies were deployed against dodgy deals in Texas and the Southwest). This is a garbage in, garbage out exercise. The banks used their own risk models to make the assessment, for instance, the very same risk models that caused this mess. And there was no examination of the underlying loan files. The Times story does slip in some shreds of doubt, but a casual reader is likely to read past them. Consider these statements: Regulators say all 19 banks undergoing the exams will pass them. Indeed, they say this is a test that a bank simply will not fail: if the examiners determine that a bank needs “exceptional assistance,” the government, that is, taxpayers, will provide it... Regulators recognize that for the tests to be credible, not all of the banks can be winners. And it is becoming increasingly clear, industry insiders say, that the government will use its findings to press certain banks to sell troubled assets. The hope is that by cleansing their balance sheets, banks will be able to lure private capital, stabilizing the entire industry. Yves here. So did you get that? They all will be declared to pass in some form, no matter how dreadful they really are (if the remedy is putting in more Federal dollars, rather than a receivership, then the fiction that the money is not being wasted must be preserved). But so as to look sufficiently tough, some banks will be treated harshly. If it winds up being, say, Fifth Third (which I am told by John Hempton is a very well run bank, publishes much more honest financials than its peers, but is in simply terrible geographies, Michigan, Ohio. Florida) and not Citi, then we know the process is not just hopelessly politicized, but shamelessly so. Back to the article:

145 The state of the industry will come into sharper focus next week, when big banks like Citigroup and JPMorgan Chase start reporting first-quarter results. Many analysts predict the reports will show banks are on the mend, with help from low interest rates, fat lending margins, dwindling competition and profits from trading in the financial markets in January and February. In the last six weeks, financial shares have soared on hopes that the worst for the industry is over. But some analysts say investors’ hopes are misplaced. With the recession, banks are likely to record further large losses on credit cards, corporate loans and real estate. “Nothing has changed with the fundamentals,” said Meredith A. Whitney, a prominent banking analyst who has been bearish on most financial institutions. Yves here, Note the failure to point out that Whitney has been the most accurate in calling bank performance during this downturn. No, she is instead a mere bear. And the article also fails to mention that Leon Black, a distressed investor who has long been active in the real estate industry, is forecasting $2 trillion in real estate losses. I doubt the stress tests have that factored in. Consider the worst case scenario: The tests, led by the Federal Reserve, rely on a series of computer-generated “what-if” projections in the event the economy deteriorates. Those include unemployment rising to 10.3 percent by next year, home prices falling an additional 22 percent this year, and the economy contracting by 3.3 percent this year and staying flat in 2010. Based on the work of Carmen Reinhart and Kenneth Rogoff on financial crises, the expected trajectory for this crisis is for unemployment to peak in the 11-12% range, a fall in GDP of 5%, with it taking three years after the bottom for growth to return to normal levels, and housing takes over five years to bottom. And that is the typical trajectory for crisis countries, none of whom faced a backdrop of a global contraction. Whitney is calling for real estate prices to fall another 30%. So the worst case falls short of even likely outcomes, let alone a real disaster. And the theater continues: At a recent breakfast with a dozen or so corporate and banking executives in New York, Treasury Secretary Timothy F. Geithner warned he would take a tough stance. Many banks, he suggested, believe the investments and loans on their books are worth far more than they really are, according to a person who attended the meeting. Mr. Geithner said that was unacceptable. The banks, he said, will have to sell these assets at prices investors are willing to pay, and so must be prepared to take further write-downs. How does one parse tripe like this? First, the public private partnership program, aka cash for trash, is voluntary. Banks are not being compelled to sell. The idea that the banks "have to sell" is a canard. Second, the gaming of the program has already started (notice no lecture from Geithner about that?), so there is pretty much no risk that anyone will take a loss on the values they have in their books. The best summation of how bad this will get is from Rortybomb, who expects all the old Enron tricks to be employed (notice the terms of the PPIP prohibit the fund managers from gaming the process, not the banks trading among themselves. You can drive a truck through this oversight. And the Treasury has remained silent as the banks themselves have been loading up their balance sheets with toxic sludge, paying more than private investors are willing to bid). I'm sure all the bankers understand full well the massive disconnect between talk and action, and are dutifully following Treasury's lead in maintaining appearances. http://www.nakedcapitalism.com/2009/04/quelle-surprise-bank-stress-tests.html

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Who pays taxes? Who should? by Howard Gleckman on Thu 09 Apr 2009 05:34 PM EDT | Permanent Link At a fascinating TPC panel this afternoon, TPC’s Bob Williams, former CBO director (and McCain economic adviser) Doug Holtz-Eakin, former top Ronald Reagan tax adviser John (Buck) Chapoton, and Center on Budget & Policy Priorities executive director Bob Greenstein all wrestled with the nature—and future--of our progressive tax system. It is more than an academic question. President Obama wants to extend the 2001 and 2003 tax cuts for all but the highest earners. He wants to cut taxes for those making $200,000 or less, and raise them for those making $250,000 or more. Is this demarcation class warfare as Republicans would have it? Or a matter of simple fairness as Democrats suggest. And whoever is right, is this strategy a fiscal dead-end? Start thinking about this by ignoring the fevered rhetoric of the Left and the Right. The distribution of federal taxes is torn by crosscurrents that are much more complex than politicians claim. On one hand, it is true that after-tax income of the highest earners has been rising at a remarkable pace. And it is also true that one reason for this good fortune is that their effective federal tax rates have been plunging. New CBO estimates show that between 1979 and 2006, average pre-tax income of the top one percent of earners more than tripled, even after accounting for inflation. Their average income went from half a million dollars to $1.7 million even as incomes were basically flat for all households. At the same time, effective federal tax rates for the rich plunged from 37 percent to 31 percent while they barely budged for taxpayers as a whole. Bottom line: after- tax income at the very top increased from $330,000 to $1.2 million But it's also true that the top one percent have been paying an ever-larger share of the nation’s total tax bill. In 2006, these lucky duckies—to borrow a phrase from The Wall Street Journal—paid 28 percent of all federal taxes. The top 10 percent paid more than half, while the bottom 20 percent effectively contributed nothing. While many of those low-earners did pay payroll taxes, they paid negative income tax rates thanks to refundable income tax credits. So do the rich pay their fair share or not? Buck Chapoton may have it about right. His conclusions: Given both massive deficits and the huge increase in incomes for the very rich, there is a strong equity argument for raising taxes at the top. There is little credibility to the claim that boosting their tax liability will further damage an already-weak economy. However, by proposing to raise rates rather than broadening the tax base, Obama is practically begging the wealthy to seek out new sheltering opportunities. Finally, Buck raises another important issue that has little to do with economics (at least directly) and a lot to do with the nature of our democracy. Is it healthy to have a nation where a few pay most of the costs while millions pay no taxes at all, even as they enjoy the benefits of those programs largely financed by the wealthy. It brings to mind Obama’s plan to cover the uninsured by raising taxes only on those making more than $250,000. That’s a kind of class warfare that really does trouble me. http://taxvox.taxpolicycenter.org/blog/_archives/2009/4/9/4148788.html

147 http://www.cbo.gov/ftpdocs/100xx/doc10068/effective_tax_rates_2006.pdf

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CHARTING THE CURRENT US DOWNTURN Posted on Wednesday, April 8th, 2009 By bsetser My colleague at the Council’s Center for Geoeconomic Studies — Paul Swartz — has been tracking how the current US downturn stacks up against the typical post-War War 2 downturn. The answer isn’t pretty. The fall in US industrial production for example already exceeds the typical fall in a recent downturn, and looks set to exceed the the worst fall in the post Word War 2 data. The dotted lines in the following graph are defined by the best and worst data points at this stage in the economic cycle in the post war data, and right now the fall in industrial production is very close to setting a new low.*

The scale of the fall isn’t a surprise to Dr. Eichengreen and Dr. O’Rourke. Paul also plotted the current downturn against the trajectory in the 20s and the 30s. That also doesn’t make for pretty picture. But best as Paul can tell, the fall in US industrial production now isn’t quite as bad as in the 1930s. Is there any good news? Yes. The US isn’t making the same macroeconomic errors as is it made in the downturn than became the Great Depression. The US, for example, has implemented a large fiscal expansion to support demand far faster now than back then. But make no mistake, Paul’s charts leave little doubt that the current downturn is — on nearly every measure — as bad as any downturn since the Depression. That is the fundamental case why governments need to be taking bold actions now to slow the fall in global activity.

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Do check out his updated charts, and let me know what you think. — * I asked Paul to plot the drawdown in industrial production now v the drawdowns in industrial production over time. The current drawdown isn’t (yet) quite as large as the large as the drawdown in the mid-70s (the first oil shock). But it is also isn’t over.

His chart also clearly illustrates how, until recently, volatility in industrial production seemed to be falling over time. The great moderation, alas, is now clearly over. http://blogs.cfr.org/setser/2009/04/08/charting-the-current-us-downturn/#more-5121

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SEC to Pursue Limits On Stock Short Sales By Zachary A. Goldfarb Agency Is Under Political Pressure to Act By Zachary A. Goldfarb Washington Post Staff Writer Wednesday, April 8, 2009; A13 The Securities and Exchange Commission today holds its first policymaking session of the year, and under political pressure plans to introduce several proposals to restrict the short- selling of stock that many economists, including those inside the agency, say are likely to have little effect. A number of financial firm executives, investors and lawmakers have blamed aggressive short-selling for collapsing the stocks of banks and other Wall Street companies last fall. In a short sale, traders make money when a firm's shares decline in value. Today's meeting, the first held under new SEC Chairman Mary L. Schapiro, will examine several proposals to curb short sales. The commission is expected to formalize the proposals, allowing for 60 days of comment before deciding to vote on whether to implement them. The proposals would try to make it more difficult for short sellers to push down a stock's price when it is already declining. One way to do so would be to allow speculators to bet against a stock only when it moves at a higher price than its last trade. On any given day, a stock may trade more than tens of thousands of times. A more dramatic proposal would ban short-selling in a stock if it has declined by a set percentage in a day. The SEC has been here before. In 2007, after intense study by the commission's staff and economists, the SEC decided to end the uptick rule, a Depression-era regulation that allowed people to bet against a stock only when it was "ticking" up. Last fall, in the market crisis, the SEC temporarily banned short-selling in financial stocks -- a move then-SEC Chairman Christopher Cox said he regretted as a hasty response to political pressure. In recent weeks, the SEC's economists have circulated an outside study that found that the removal of the uptick rule in 2007 had no effect of the price of stocks. Charles M. Jones, a professor at Columbia Business School who co-authored the study, said he was skeptical about proposals to regulate short-selling. "It's really being done because there's this perception that there are bear raiders, or people pushing the price around, and there is concern that there are short sellers doing that," he said. "Call them manipulative or abusive. But we haven't been able to find them in the data." SEC officials say they are proposing the rules simply to give investors confidence that the commission is evaluating whether abusive techniques are unfairly driving down share prices. They say that it is not a foregone conclusion that the new rules will take effect; rather, they are hoping for a period of study.

151 "This is an issue that has both strong supporters and detractors, and we will be very deliberative in our effort to determine what is in the best interest of investors," Schapiro said Monday. The SEC's two Democratic commissioners, Elisse B. Walter and Luis A. Aguilar, said they welcomed the chance to take a fresh look at short-selling rules, but had no position yet on whether new rules were necessary. Republican commissioner Troy A. Paredes declined to comment, and Republican commissioner Kathleen L. Casey could not be reached for comment. People familiar with the Republican commissioners' thinking said they had major doubts about whether the new rules are necessary. "Some are very passionate about bringing back the uptick rule, and some just are equally passionate about the adverse impact it may have on price discovery," Aguilar said yesterday. "I welcome a more structured discussion." Walter said the commission would look in particular for any empirical studies documenting the impact of short-selling on last fall's market meltdown. "There is a very serious concern about investor confidence in the market, and a lot of the input we have gotten thus far suggests a link between that and the issue of short-selling," she said. The SEC began drafting new short-selling rules at the behest of Schapiro after she took office in late January. Since then, a number of prominent lawmakers have hounded her on the issue. Six senators, including Ted Kaufman (D-Del.) and Johnny Isakson (R-Ga.), recently wrote Schapiro urging her to institute new rules. "As the new leader at the SEC, you have an opportunity to clarify the commission's commitment to end abusive short-selling," the senators wrote. http://www.washingtonpost.com/wp- dyn/content/article/2009/04/07/AR2009040704012_pf.html

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Bids Pour In for State Construction Jobs More Bang for the Stimulus Buck as Firms Clamber for Contracts By Eric M. Weiss Washington Post Staff Writer Wednesday, April 8, 2009; A01 Construction firms are so eager for work in the sagging economy that project bids are coming in much lower than expected, allowing state and local governments to stretch their federal stimulus dollars further. At Baltimore-Washington International Marshall Airport, a recent project to reconstruct the area around Piers C and D received six bids instead of the usual two or three. The result: The estimated $50 million project will be built for $8 million less than was budgeted, and the savings will be allocated to other projects. There were 21 bidders for a $200,000 drainage project in Carroll County, more than anyone could remember. "Our bottom line is more bidders and better prices," said Maryland Transportation Secretary John Porcari. "This we like." After years of rapidly escalating construction costs on highway and other projects due to skyrocketing prices of fuel, asphalt and steel, transportation departments are getting a break as the economy slows and construction firms that once built subdivisions and strip malls bid for government work. In Virginia, state officials are receiving bids from companies as far away as the Ohio Valley. Projects that typically would have drawn four or five bids are receiving 10, said Byron Coburn, state construction engineer. C.J. Mahan Construction, based in Grove City, Ohio, for example, is bidding on a $100 million highway contract for the Virginia Department of Transportation. "Anytime you have more competition, it drives prices down," Coburn said. "You can't do but so much with the cost of materials, but firms have cut their margins or found a better mousetrap, and that reflects in pricing." That could mean using new technology that would make their bids cheaper or saving on payments to subcontractors, he said. Coburn said the falling cost of petroleum, which not only fuels large construction vehicles but is also a key ingredient in asphalt, has helped lower prices. Less competition from China and India for concrete and other materials has helped, too. Rick Williams, chief financial officer of Beaver Excavating in Canton, Ohio, said the company is bidding on jobs in Virginia, Indiana and Pennsylvania to keep work rolling in. "We've branched out further on some jobs. And there are a lot more bidders everywhere," Williams said. He said that Beaver is bidding on jobs deeper into Pennsylvania than it has in the past and that the company had never bid a job in Indiana in the eight years he has been there. "We're bidding a lot more work because we need the backlog to keep our people employed," Williams said. "We're probably half of where we want to be for backlog." Construction firms' hunger for work means that the $787 billion stimulus package passed by Congress could result in more paving for the buck. The stimulus is supposed to pay for

153 "shovel-ready" projects to stimulate the economy, put people back to work and get needed projects done. "What it's going to do is giving us value for the dollar," said John Horsley, executive director of the American Association of State Highway and Transportation Officials. "The two winners are the public, which gets more improvements, and a net gain in jobs creation. It's a win across the board." Virginia, Maryland and the District are using their stimulus funds for repairing and maintaining infrastructure instead of building large new projects. Metro will use its share to fix crumbling platforms and for a new railcar testing facility. Maryland is slated to receive $365 million, Metro will get $230 million and the District, $160 million. Virginia will receive $695 for statewide projects and $208 million for urban areas, including Northern Virginia. Kenneth Simonson, chief economist for the Associated General Contractors of America, said he is seeing the bidding trend across the nation. In Connecticut, a project on the Merritt Parkway was budgeted at $75 million. The final bid amount: $66.6 million. In North Carolina, Pennsylvania and Rhode Island, bids are coming in 19 percent, 15 percent and 10 percent lower, respectively, according to data provided by the American Association of State Highway and Transportation Officials. "Wherever I go, I hear of projects that used to attract two to three bids just a couple of years ago, now it's 20 or 30," Simonson said. "Many [contractors] are coming down on the minimum size of projects they will bid on, and ones who didn't do schools now are bidding on schools. Others are coming from out of state to a new region just to keep busy. And they are essentially giving away their services just to keep their key employees busy."

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Not Quite a Confession, But a Good Start By Steven Pearlstein Wednesday, April 8, 2009; A11 For the past year, as the nation has engaged in a heated debate about how we got into the current financial mess and how we're going to get out of it, there's been one group noticeably missing from the conversation: leaders of the big Wall Street firms. With the exception of the occasional public floggings organized by congressional committees and the quiet off-the-record lunches with newspaper editorial boards, the titans of finance have remained hunkered down in their bunkers. In public, at least, they have declined to accept personal and institutional responsibility for what went wrong, to explain more fully how and why it happened or even to express a simple thank you for the government's extraordinary rescue efforts. At a time when it was most needed, industry leadership has been nonexistent. Until now. In a speech yesterday in Washington to the Council of Institutional Investors, Lloyd Blankfein, the chairman of Goldman Sachs, took the first trip through the public confessional, acknowledging that "the past year has been deeply humbling" for an industry that held itself out as expert but disappointed customers and shareholders by taking actions that "look self-serving and greedy in hindsight." "We collectively neglected to raise enough questions about whether some of the trends and practices that became commonplace really served the public's long-term interests," said Blankfein, whose unflashy, straightforward style is more Mr. Whipple than Gordon Gekko. Explaining why the industry failed to understand the risks it was taking, Blankfein identified the kinds of rationalizations that people latched on to: the growing strength of emerging markets, the plentiful supply of liquidity and the availability of new risk-hedging instruments. "We rationalized because our self-interest in preserving and growing our market share, as competitors, sometimes blinds us -- especially when exuberance is at its peak," Blankfein said. He also acknowledged that too much faith was put in risk models that turned out to be badly flawed and that the size of the firms and the complexity of the financial instruments had been allowed to grow faster than the "operational capacity to manage them." To make sure it doesn't happen again, Blankfein called for stepped-up regulation of banks and even hedge funds. He also laid out a spot-on set of guidelines for industry bonuses that would give greater weight to the performance of the entire firm than just individual performance and reflect long-term risks as well as the short-term gains. Okay, so it's not exactly up there with the confessions of St. Augustine, but it's a start. There are some glaring factors, however, that Blankfein, like other Wall Street leaders, tends to overlook. The most important is culture -- in the case of Wall Street, a culture that not only tolerates but almost celebrates taking advantage of customers. Here is an industry in which brokers traditionally get their start making cold calls to strangers, offering bogus stock tips, and investment bankers cut their teeth peddling bad merger and acquisition

155 ideas to corporate clients. It is an industry in which the majority of money managers consistently underperform the broad market averages, analysts and strategists are almost always bullish, and firms rarely run into a security that can't be brought to market. These days, Wall Street is a place where the trading culture has supplanted the investment culture and score is kept on the basis of how many securities a banker or a firm underwrites rather than whether those securities actually turn out as good investments. It's hard for anyone who grows up in an industry to see fundamental problems in its culture. But until Wall Street deals with this blind spot, it is likely to careen from one crisis to another. Blankfein also makes the common mistake to think that the problem with compensation has only to do with how the pay is structured and not with the overall level of pay, which on Wall Street got to be ridiculously out of line with that of similarly skilled and equally successful people in other industries. No matter how it is structured, pay at such astronomical levels has a tendency to swell heads, inflate egos and tempt people to take undue risks of all sorts, ethical as well as financial. The answer to that problem isn't for Congress to use the tax code to effectively legislate pay caps for Wall Street. In the current climate, however, the only way to beat back such bad ideas is to find some other ways of stopping and reversing the Wall Street arms race on pay. Of course, an industry that earns so much profit that it can afford to pay multimillion-dollar bonuses to 26-year-old traders also has too much money to lavish on the political process in ways that undermine those who would regulate it. I wouldn't go as far as MIT economist Simon Johnson, who argues in the May Atlantic magazine that the United States has effectively become a banana republic with the Wall Street oligarchy running the show. What is undeniable, however, is that there are regulators here in Washington who have been reluctant to rein in the industry out of fear that they would be thwarted by the White House, the Treasury and key members of Congress acting under pressure from the industry. It's all well and good for the Goldman Sachs chairman to call for better regulation of the financial industry. But regulators are unlikely to do much better during the next bubble unless we can find better ways to insulate them from Wall Street's outsize political influence. http://www.washingtonpost.com/wp- dyn/content/article/2009/04/07/AR2009040703675.html?wpisrc=newsletter

156 U.S.

April 8, 2009 Firm Acted as Tutor in Selling Towns Risky Deals By DON VAN NATTA Jr. LEWISBURG, Tenn. — Five years ago, this small factory town was struggling to pay the interest on a bond for new sewers. Bob Phillips, Lewisburg’s part-time mayor and full-time pharmacist, was urged by the town’s financial adviser, an investment bank named Morgan Keegan & Company, to engage in a complex financial transaction to lower interest rates. When a Lewisburg official attended a state-sponsored seminar intended to lay out the transaction’s benefits and risks, he was taught by investment bankers from Morgan Keegan. And when Lewisburg decided to go ahead with the transaction, who was there to make the deal? Morgan Keegan. In January, local officials were shocked to discover that annual interest payments on the bond had quadrupled to $1 million. Morgan Keegan, they said, did not serve them well in any of its roles. “We’re little,” Mr. Phillips said, “and we depend on people wiser than us in financial ways to keep us informed, tell us what things mean, and I really didn’t think we got that.” Lewisburg is one of hundreds of small cities and counties across America reeling from their reliance in recent years on risky municipal bond derivatives that went bad. Municipalities that bought the derivatives were like homeowners with fixed-rate mortgages who refinanced by taking out lower-interest, variable-rate mortgages. But some local officials say they were not told, or did not understand, that interest rates could go much higher if economic conditions worsened — which, of course, they did. The municipal bond marketplace was so lightly regulated that in Tennessee Morgan Keegan was able to dominate almost every phase of the business. The firm, which is based in Memphis, sold $2 billion worth of municipal bond derivatives to 38 cities and counties since 2001, according to data compiled by the state comptroller’s office. After The New York Times made inquiries, the Tennessee comptroller, Justin P. Wilson, ordered a statewide freeze on bond derivatives and a review of the seminar taught by Morgan Keegan and others. Representatives of Morgan Keegan pointed out that they saved cities and counties money for years by delivering lower interest rates, and that the economic decline that created the turmoil in the bond market was beyond their control. Moody’s credit rating agency on Tuesday issued a negative outlook for the fiscal health of municipal governments. In Washington, federal regulators are now considering ways to restrict the use of municipal bond derivatives. Regulators and some in the industry are challenging whether it is appropriate for large investment banks to engage small cities and counties in transactions that lower interest rates but carry higher risks. “When these sophisticated things were created, most people didn’t think they’d ever be used by the smallest issuers, who had the least amount of resources and knowledge and

157 experience to understand the risks,” said Thomas G. Doe, the chief executive of Municipal Market Advisors, a bond strategy company in Concord, Mass. In Lewisburg, the fallout from the bad bonds confronted the city of 11,000 people at an inopportune moment. Unemployment just nudged past 10 percent, businesses like Penny’s Home Cooking are shuttered, and a sprawling new corporate park sits mostly empty. A nearby employer, Sanford Pencil, the maker of Sharpie pens, is preparing to move to Mexico. Unlike most states, Tennessee was one of the few where the legislature passed a law intended to regulate the sale of these complicated municipal bond derivatives to local governments. But the profusion of those deals and the various roles of Morgan Keegan have left leaders of those cities and counties furious at both the firm and the state. In Claiborne County, north of Knoxville, officials said they were recently told by Morgan Keegan bankers that extracting themselves from a municipal bond derivative would cost $3 million, a sum the poor county cannot afford. “I told the Morgan Keegan man here in my office, ‘It seems to me, you are all trying to slip paperwork by us like a small, shady loan company,’ ” said Joe Duncan, the mayor of Claiborne County. An Unpleasant Surprise In Mount Juliet, a suburb east of Nashville, city leaders were surprised to discover that the payments on its bonds had increased by 500 percent to $478,000. Morgan Keegan offered to refinance the bonds, but the city hired a new financial adviser and another investment bank. “We decided we needed advice from someone who was not trying to sell us something,” Mayor Linda Elam said. Mr. Wilson, the state comptroller, told a State Senate finance committee two weeks ago that his office was examining the guidelines on municipal bond derivatives, including the “swap school” taught by Morgan Keegan and the Nashville law firm of Bass, Berry & Sims, which often served as the bond counsel. An investment bank makes more in fees and annual income from derivatives than from fixed-rate bonds. Morgan Keegan has made millions of dollars in fees in Tennessee since 2001, but the precise number is not public. “I think the multiple roles of a single firm is something we should look at, and there well may be limitations or prohibitions,” Mr. Wilson, who became comptroller in January, said in an interview. In hindsight, he said, it “may not have been the best idea.” Municipal bond experts say they know of no other state where a firm was allowed to wear three hats; several states prohibit a single firm from acting as both adviser and underwriter. In Pennsylvania, which has such a prohibition, federal prosecutors are investigating accusations that investment banks and financial advisers conspired to sell bonds with inflated fees to school districts. “It’s like the lion being hired to protect the gazelle,” Robert E. Brooks, a municipal bonds expert and a professor of financial management at the University of Alabama, said of the situation in Tennessee. “Who was looking after these little towns?” Morgan Keegan said local officials were unfairly blaming them for the economic downturn. “People are upset; we’re upset, too,” said Joseph K. Ayres, the firm’s managing director. “We’ve been very successful helping a lot of communities try to weather this storm. Obviously, there are going to be a few disappointments. People are going to look to find a scapegoat. We’re big boys and girls. We understand that.”

158 Mr. Ayres denied that the firm had a conflict in advising municipalities and underwriting bond derivatives. He said that Morgan Keegan had taught the seminar at the request of the state and that they had offered unbiased descriptions of municipal bond options. He added that the firm had not marketed products during the sessions. “I don’t think the course was skewed at all,” Mr. Ayres said. “It was designed to deal equally with risk and reward. The course was approved by the state comptroller’s office.” Karen S. Neal, a lawyer at Bass, Berry & Sims, said the comptroller’s office had strictly monitored the seminars. “There was certainly no intent that they be biased one way or the other,” Ms. Neal said. “The intent was purely to educate people on the process, the mechanics, the legal requirements, the risks and the benefits.” Increasing Risk For decades, the tax-exempt municipal bond was considered as safe a way to raise money as it was to invest money. If a city wanted to build a bridge, a hospital or a school, it raised the money by issuing a bond and repaid investors over decades. Bonds were considered conservative and dependable. Beginning in the late 1970s, big states like California began to use variable rate bonds as a way to save money. By the late 1990s, some rural counties and small towns jumped on board as a way to avoid raising taxes. Not long afterward, interest rate swaps were introduced. A swap allowed a municipality to keep a portion of its debt at a fixed interest rate and a portion at a variable rate. The municipality was, in effect, betting that interest rates would move in its favor. Investors protected themselves by taking out insurance that guaranteed they would be paid. But as the nationwide credit market collapsed, most of the bond insurers’ credit ratings were downgraded, including the Ambac Financial Group, the primary insurer of Tennessee bonds. That allowed the investors to accelerate the retirement of the debt, usually from 20 years to 7, leading to a steep increase in the interest rate. Although such a provision was in the swap contract, several local officials said that possibility had not been explained to them. The risks of the transactions were, in fact, on the minds of members of the Tennessee legislature in 1999, when they passed a law requiring a municipality to follow several procedures before receiving authorization from the comptroller to enter a swap agreement. Even with those regulations, the comptroller approved all 215 swap applications submitted in the state since 2001. “Tennessee was an unwitting conspirator in this whole mess,” said Emily Evans, a Nashville City Council member and former bond trader who was a critic of her city’s swap deal on the bond for the Tennessee Titans’ stadium. One of the most important provisions of Tennessee’s law was education. In 2000, the state comptroller at the time, John G. Morgan, appointed nine government and industry representatives to establish guidelines for derivatives and devise a curriculum for the swap school. The panel included two lawyers from Bass, Berry & Sims and a Morgan Keegan banker. Mr. Morgan said he had asked business professors to teach the course, but they had declined. “So the job was left for the people who know the most about these intricate transactions — the people in the business,” he said. “I didn’t think there was a problem.” State records show that the comptroller’s office approved course material submitted by Morgan Keegan and Bass, Berry & Sims. In 2007, the comptroller approved a 300-page course book in two days, the records show.

159 In a 177-page book used in 2003 and reviewed by several bond experts for The Times, there was far more about rewards than risks. On a page titled “Interest Rate Swap Risks” for example, there is no mention of the consequences of a downgrade in the bond insurer’s rating. Ms. Evans said the daylong seminars, held in Memphis, Nashville and Knoxville, amounted to “nothing more than an infomercial.” The first page of a manual used at a 2007 seminar quotes the former Fed chairman Alan Greenspan extolling the virtues of derivatives in 1999. Peter Shapiro, the managing director of Swap Financial Group of South Orange, N.J., said the material “certainly doesn’t have what we would consider the requisite amount of detail going through the risks, how they materialize and how you might attempt to mitigate them.” Sheila Luckett, the city recorder in Mount Juliet, attended the swap school twice. “It was way over my head,” she said. “I’m not a bonds person. People with Morgan Keegan told me, ‘Don’t worry if you don’t understand it.’ ” A ‘Good Thing’ Goes Bad In many corners of Tennessee, the first anyone heard of interest-rate swaps was from C. L. Overman, a vice president of Morgan Keegan who assured officials that the deals carried little risk, city and county officials said. “He told us it would be a good thing and there wasn’t much downside,” said Mayor Duncan of Claiborne County. He then laughed, adding, “When everything went belly up, of course, they told us it wasn’t their fault.” Earlier this year, Claiborne County officials were told by Mr. Overman that they had only a few weeks to refinance an $18 million bond or pay a quadrupled quarterly payment of $700,000. Mr. Overman declined to comment for this article. In Lewisburg, after Mr. Overman pitched the swap idea for the sewer project, Kenneth E. Carr, a city official, attended the class. “The seminar was dull and boring,” said Mr. Carr, who still has a copy of the book, stamped with the state seal of Tennessee on every page. “I thought, ‘Well, this is approved by the state because they put their seal of approval on it. This must be something they think is good for us.’ ” Mr. Carr said he had not known the course would be taught by the bank and the law firm involved in Lewisburg’s deal. “It would have been better if someone neutral had taught the course,” he said. Even so, he said the officials making the decision never asked his opinion after the session. Connie W. Edde, Lewisburg’s finance director, said she had assumed the city would reject the proposal because “it was a big risk.” But hours before the City Council was to meet on the plan, Ms. Edde said, she saw the city’s superintendent for water and sewage return from lunch with Mr. Overman. The superintendent “announced that he decided this was now a good idea.” That evening, the plan passed. Mr. Ayres, the Morgan Keegan managing director, pointed out that Lewisburg had benefited from a relatively low interest rate of 2.5 percent, a rate that did not include the firm’s fees. This year, with residents facing a 33 percent increase in water and sewer rates, the city decided to refinance the bond, dropping Morgan Keegan and hiring another financial adviser. Mayor Phillips said the city would use fixed rate debt on its new bonds. “Nothing that says derivative, nothing that says swap,” he said. “We learned our lesson.” http://www.nytimes.com/2009/04/08/us/08bond.html?th&emc=th

160 Apr 8, 2009 'Big Bang' In The CDS Market: Private Sector Adopts Standardized Rules Apr 8, 2009 Overview: SIFMA and ISDA industry groups agree to central clearinghouse but don't want to lose flexibility and fees from OTC derivatives trading. Solution: "Big Bang" strategy: Faced with tougher regulation dealers plan to overhaul CDS trading by March 2009: 1) For the first time, the market will have a committee of dealers and investors making binding decisions that determine when buyers of the insurance-like derivatives can demand payment and could influence how much they get by e.g. deciding which bonds can be delivered in settlement; 2) In one of the most noticeable changes for traders, those who buy protection will pay an upfront fee depending on current market prices, and then a fixed $100,000 or $500,000 annual payment for every $10 million of protection purchased. (Now, upfront payments are only required for riskier companies) (Harrington, Jan 30) o April 8 Harrington: "Big Bang" underway: 2,023 entities have signed up as of late April 7 in New York, as measured by the ISDA, and agree to abide by the committee’s decisions and auctions that determine the value of underlying securities. These hardwiring rules are necessary for the establishment of a central clearinghouse and for the implementation of the Geithner/NY Fed plan (see below) o cont.: Rules of the new committee will require an 80 percent majority among the 15 members before a credit event can be declared. Credit events allow a firm that bought protection against default to demand payment from its counterparty. Matters failing to get an 80 percent agreement would be sent to a panel of arbitrators. o cont.: The International Swaps and Derivatives Association, or ISDA, will serve as secretary of the committee and will be required to publish each matter brought before the committee on its Web site, including information on the firm that brought it and how each member of the committee voted. o March 26 Geithner / NY Fed regulator plan: - Regulating Credit Default Swaps and Over-the-Counter Derivatives for the First Time; - Instituting a Strong Regulatory and Supervisory Regime; - Clearing All Contracts Through Designated Central Counterparties; - Requiring Non-Standardized Derivatives to Be Subject to Robust Standards; - Making Aggregate Data on Trading Volumes and Positions Available; - Applying Robust Eligibility Requirements to All Market Participants o February 1 RiskMagazine: Tri-Optima has reported that its portfolio compression service, triReduce, eliminated $30.2 trillion in notional principal from the credit default swap (CDS) market in 2008. Note: The new net notional outstanding is therefore reduced from 57.8T to 28.8 trillion. The compression process does not necessarily reduce counterparty risk if it increases concentration among fewer counterparties. o Lex: As in almost every other class of assets, the withdrawal of hedge funds has hurt CDS liquidity: perhaps two-thirds of market-makers by number, and one-third by capacity, have pulled out.

161 ft.com/maverecon The green shoots are weeds growing through the rubble in the ruins of the global economy By Willem Buiter APRIL 8, 2009 3:20AM The Great Contraction will last a while longer This financial crisis will end. The Great Contraction of the Noughties also will come to an end. But neither the financial crisis nor the contraction of the global real economy are over yet. As regards the financial sector, we are not too far - probably less than a year - from the beginning of the end. The impact of the collapse of real economic activity and of the associated dramatic increase in defaults and insolvencies by non-financial enterprises and households on the loan book of what is left of the banking sector will begin to show up in the banks’ financial reports at the end of the summer and in the autumn. By the end of the year - early 2010 at the latest - we will know which banks will survive and which ones are headed for the scrap heap. With the resolution of the current pervasive uncertainty about the true state of the banks’ balance sheets and about their off-balance-sheet exposures, normal financial intermediation will be able to resume later in 2010. Governments everywhere are doing the best they can to delay or prevent the lifting of the veil of uncertainty and disinformation that most banks have cast over their battered balance sheets. The banking establishment and the financial establishment representing the beneficial owners of the institutions exposed to the banks as unsecured creditors - pension funds, insurance companies, other banks, foreign investors including sovereign wealth funds - have captured the key governments, their central banks, their regulators, supervisors and accounting standard setters to a degree never seen before. I used to believe this state capture took the form of cognitive capture, rather than financial capture. I still believe this to be the case for many, perhaps even most of the policy makers and officials involved, but it is becoming increasingly hard to deny the possibility that the extraordinary reluctance of our governments to force the unsecured creditors (and any remaining non-government shareholders) of the zombie banks to absorb the losses made by these banks, may be due to rather more primal forms of state capture. History teaches us that systemic financial crises are protracted affairs. A most interesting paper by Carmen M. Reinhart and Kenneth S. Rogoff, “The Aftermath of Financial Crises”, using data on 10 systemic banking crises (the “big five” developed economy crises (Spain 1977, Norway 1987, Finland, 1991, Sweden, 1991, and Japan, 1992), three famous emerging market crises (the 1997–1998 Asian crisis (Hong Kong, Indonesia, Malaysia, the Philippines, and Thailand); Colombia, 1998; and Argentina 2001)), and two earlier crises (Norway 1899 and the United States 1929) reaches the following conclusions (the next paragraph paraphrases Reinhart and Rogoff). First, asset market collapses are deep and prolonged. Real housing price declines average 35 percent over six years; real equity price declines average 55 percent over a downturn of about

162 3.5 years. Second, the aftermath of banking crises is associated with large declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, but the duration of the downturn averages around 2 years. Nothing more can be expected as regards a global fiscal stimulus. Indeed, the G20 delivered nothing in this regard. It would have been preferable to maintain the overall size of the planned (or rather, expected) global fiscal stimulus but to redistribute the aggregate (about $5 trillion over 2 years, as measured by the aggregated changes in the national fiscal deficits) in accordance with national fiscal spare capacity (I believe the World Bank calls this ‘fiscal space’). This would mean a smaller fiscal stimulus for countries with weak fiscal fundamentals, including the US, Japan and the UK, and a larger fiscal stimulus for countries with strong fiscal fundamentals, including China, Germany, Brazil and, to a lesser degree, France. The effect of the Great Contraction on potential output growth Furthermore, a likely consequence of the fiscal stimuli we have already seen or are about to experience is a negative impact on the medium- and long-term growth potential of the global economy. The reason is that, if fiscal solvency is to be maintained, there will have to be some combination of an increase in the tax burden and a reduction in non-interest public spending in most countries when this contraction is over. The inevitable effect of the crisis and the contraction is a higher public debt burden and therefore a larger future required primary government surplus (as a share of GDP). Almost any increase in the tax burden will hurt potential output - just the level of the path of potential output if you are a classical growth groupie, both the level and the growth rate of the path of potential output if you are an adept of the endogenous growth school. In the study of Reinhart and Rogoff cited earlier, the authors conclude that the real value of government debt tends to explode following a systemic financial crisis, rising an average of 86 percent in major post–World War II episodes. The principal cause of these public debt explosions is not the costs of “bailing out” and recapitalizing banking system. The big drivers of these public debt burden increases are rather the collapse in tax revenues that comes with deep and prolonged output contractions (the operation of the automatic stabilisers) and discretionary counter-cyclical fiscal policies. For political expediency reasons, cuts in public spending are likely to fall first on maintenance, public sector capital formation and other forms of productive public expenditure, including spending on education, health and research. Welfare spending in cash or in kind is likely to be the last to be cut. The result is again likely to be a lower level (or level and growth rate) of the path of potential output. The risk of ’sudden stops’ in the overdeveloped world In a number of systemically important countries, notably the US and the UK, there is a material risk of a ’sudden stop’ - an emerging-market style interruption of capital inflows to both the public and private sectors - prompted by financial market concerns about the sustainability of the fiscal-financial-monetary programmes proposed and implemented by the fiscal and monetary authorities in these countries. For both countries there is a material risk that the mind-boggling general government deficits (14% of GDP or over for the US and 12 % of GDP or over for the UK for the coming year) will either have to be monetised permanently, implying high inflation as soon as the real economy recovers, the output gap

163 closes and the extraordinary fear-induced liquidity preference of the past year subsides, or lead to sovereign default. Pointing to a non-negligible risk of sovereign default in the US and the UK does not, I fear, qualify me as a madman. The last time things got serious, during the Great Depression of the 1930s, both the US and the UK defaulted de facto, and possibly even de jure, on their sovereign debt. In the case of the US, the sovereign default took the form of the abrogation of the gold clause when the US went off the gold standard (except for foreign exchange) in 1933. In 1933, Congress passed a joint resolution canceling all gold clauses in public and private contracts (including existing contracts). The Gold Reserve Act of 1934 abrogated the gold clause in government and private contracts and changed the value of the dollar in gold from $20.67 to $35 per ounce. These actions were upheld (by a 5 to 4 majority) by the Supreme Court in 1935. In the case of the UK, the de facto sovereign default took the form of the conversion in 1932 of Britain’s 5% War Loan Bonds (callable 1929-1947) into new 3½ % bonds (callable from 1952) on terms that were unambiguously unfavourable to the bond holders. Out of a total of £2,086,000,000 outstanding, £1,500,000,000, or something over 70%, was converted voluntarily by the end of 1932, thanks both to the government’s ability to appeal to patriotism and joint burden sharing in the face of economic adversity and to ferocious arm-twisting and ‘moral suasion’. I believe both defaults were eminently justified. There is no case for letting the interests of the holders of sovereign debt override the interests of the rest of the community, regardless of the financial, economic, social and political costs involved. But to say that these were justifiable sovereign defaults does not mean that they were not sovereign defaults. Similar circumstances could arise again. While I consider an inflationary solution to the public debt overhang problem (and indeed to the private debt overhang problem) to be more likely in the US and even in the UK than a sovereign default (or ‘restructuring’, ‘conversion’ or ‘consolidation’, as it would undoubtedly be referred to by the defaulting government), neither can be dismissed as out of the question, or even as extremely unlikely. Central banks: a mixed bag Central banks, with the notable exception of the procrastinating ECB, are doing as much as they can through quantitative easing and credit easing to deal with the immediate crisis. Unfortunately, some of them, notably the Fed, are providing these short-term financial stimuli in the worst possible way from the point of view of medium- and longer-term economic performance, by surrendering central bank independence to the fiscal authorities. When the Fed lends on a non-recourse basis to the private sector with only a $100 bn Treasury guarantee for a possible $1 trillion dollar Fed exposure (as with the TALF), when the Fed purchases private securities outright with just a similar 10-cents-on-the-dollar Treasury guarantee or when the Fed is party to an arrangement that transfers tens of billions of dollars to AIG counterparties - money that is likely to be extracted ultimately from the beneficiaries of other public spending programmes or from the tax payer, either through explicit taxes or through the inflation tax - the Fed is acting like an off-balance sheet and off- budget special purpose vehicle of the US Treasury. When the Chairman of the Fed stands shoulder-to-shoulder or sits side-by-side with the US Treasury Secretary to urge the passing of various budgetary proposals - involving matters

164 both beyond the Fed’s mandate and remit and beyond its competence - the Fed is politicised irretrievably. It becomes a partisan political player. This is likely to impair its ability to pursue its monetary policy mandate in the medium and long term. The G20 wind egg The global stimulus associated with the increase in IMF resources agreed at the G20 meeting earlier this month will be negligible unless and until these resources actually materialise. The statements, declarations and communiqués of the G20, including the most recent ones highlight the gaps between dreams and deeds. Even the promise of an immediate increase in bilateral financing from members of $250 bn is not funded yet. Only $200 have been promised firmly - $100 bn by Japan and $100 bn by the EU. Prime Minister Brown announced that the PRC had committed another $40 bn, but apparently he had forgotten to clear this with the Chinese. As regards the plan to incorporate in the near term, the immediate financing from members into an expanded and more flexible New Arrangements to Borrow would be increased by up to $500 billion (that is by another $250 bn). Unfortunately, nobody has volunteered any money yet. It therefore has no more substance than past commitments by the international community to fund the achievement of the Millenium Development Goals. Then there is the promise that the G20 will consider market borrowing by the IMF to be used if necessary in conjunction with other sources of financing, to raise resources to the level needed to meet demands. That is classic official prittle-prattle - suggesting the IMF borrow without providing it with the resources (capital) to engage in such borrowing. There is also $6 bn for the poorest countries, to be paid for by IMF gold sales and profits. Nice, but chicken feed. Finally there is the decision to support a general allocation of SDRs equivalent to $250 billion to increase global liquidity, $100 billion of which will go directly to emerging market and developing countries. The problem is that this requires the approval of the US Congress, which is deeply hostile to any additional money for any of the Bretton Woods institutions. A special allocation of SDRs is also out of the question, because the US has not yet ratified the fourth amendment to the IMF’s articles (approved by the IMF’s Board of Governors in 1997!). So apart from the $240 bn (or perhaps only $200 bn) already flagged well before the G20 meeting, the only hard commitment to additional resources (or to resources that have any chance of being available for lending and spending during the current contraction) is the $6 bn worth of alms for the poor from the sale of IMF gold. That’s what I call a bold approach! The Multilateral Development Banks may well be able to increase their lending by $100 bn as announced by the G20, even with existing capital resources. The increase in trade credit support announced at the G20 meeting is very modest indeed - $250 bn could be supported (mainly through guarantees, I suppose) over the next two years. As regards protectionism, we must be grateful for the vast difference between today’s relatively mild manifestations and the virulent protectionism of the 1930s. But again, the last few G20 meetings have yielded not a single concrete protectionism-reducing measure. Conclusion There are signs that the rate of contraction of real global economic activity may be slowing down. Straws in the wind in China, the UK and the US hint that things may be getting worse

165 at a slower rate. An inflection point for real activity (the second derivative turns positive) is not the same as a turning point (the first derivative turns positive), however. And even if decline were to end, there is no guarantee that whatever growth we get will be enough to keep up with the growth of potential. We could have a growing economy with rising unemployment and growing excess capacity for quite a while. The reason to fear a U-shaped recovery with a long, flat segment is that the financial system was effectively destroyed even before the Great Contraction started. By the time the negative feedback loops from declining activity to the balance sheet strenght of what’s left of the financial sector will have made themselves felt in full, financial intermediation is likely to be severely impaired. All contractions and recoveries are primarily investment-driven. High-frequency inventory decumulation causes activity to collapse rapidly. Since inventories cannot become negative, there is a strong self-correcting mechanism in an inventory disinvestment cycle. We may be getting to the stage in the UK and the US (possibly also in Japan) that inventories stop falling an begin to build up again. An end to inventory decumulation is a necessary but not a sufficient condition for sustained economic recovery. That requires fixed investment to pick up. This includes household fixed investment - residential construction, spending on home improvement and purchases of new automobiles and other consumer durables. It also includes public sector capital formation. Given the likely duration of the contraction and the subsequent period of excess capacity, even public sector infrastructure spending subject to long implementation lags is likely to come in handy. A healthy, sustained recovery also requires business fixed investment to pick up. At the moment, I can see not a single country where business fixed investment is likely to rise anytime soon. When the inventory investment accelerator goes into reverse and starts contributing to demand growth, and when the fiscal stimuli kick in, businesses wanting to invest will need access to external financing, since retained profits are, after a couple of years of declining output, likely to be few and far between. But with the banking system on its uppers and many key financial markets still disfunctional and out of commission, external financing will be scarce and costly. This is why sorting out the banks, or rather sorting out the substantive economic activities of new bank lending and funding, that is, sorting out banking , must be a top priority and a top claimant on scarce public resources. Until the authorities are ready to draw a clear line between the existing banks in western Europe and the USA, - many or even most of which are surplus to requirements and have become parasitic entities feeding off the tax payer - and the substantive economic activity of bank lending to non-financial enterprises and households, there will not be a robust, sustained recovery. D UNVEILS EMERGENCY BUDGET http://blogs.ft.com/maverecon/2009/04/the-green-shoots-are-weeds-growing-through-the- rubble-in-the-ruins-of-the-global-economy/

166

Putting a Price on Social Connections RESEARCHERS AT IBM AND MIT HAVE FOUND THAT CERTAIN E-MAIL CONNECTIONS AND PATTERNS AT WORK CORRELATE WITH HIGHER REVENUE PRODUCTION APRIL 8, 2009, 12:01AM EST By Stephen Baker (Editor's note: This is the first in a series, Value of Virtual Friends, exploring the ways our lives are affected—financially and otherwise—by the multiplicity of online social and professional contacts.) Messaging with the boss much? Maybe you ought to be. Workers who have strong communication ties with their managers tend to bring in more money than those who steer clear of the boss, according to a new analysis of social networks in the workplace by IBM (IBM) and Massachusetts Institute of Technology. The research, released this week, even assigns a dollar value to e-mail interaction with an employee's managers. Among the group studied, several thousand consultants at IBM, those with strong links to a manager produced an average of $588 of revenue per month over the norm. The results represent an early attempt to understand the value of the broadening variety of personal connections afforded by the Web. Users of social media rack up LinkedIn contacts, Facebook friends, and Twitter followers by the hundreds, if not thousands. But figuring out how big a difference all those contacts make in a person's life, financial or otherwise, is a far murkier matter. That's why leading tech companies, including IBM, Microsoft (MSFT), and Yahoo! (YHOO), are hiring economists, anthropologists, and other social scientists to map and classify new types of friendships—and put a value on them. Researchers at IBM Research and MIT's Sloan School of Management found that the average e-mail contact was worth $948 in revenue. To unearth that and other data, they used mathematical formulas to analyze the e-mail traffic, address books, and buddy lists of 2,600 IBM consultants over the course of a year. (Their identities were shielded from researchers, who viewed them only as encrypted numbers, known as hash codes.) They compared the communication patterns with performance, as measured by billable hours. Too Many Cooks? To be sure, not all networking yields dividends. The IBM-MIT study found that consultants with weak ties to a number of managers produced $98 per month less than average. Why? Those employees may move more slowly as they process "conflicting demands from different managers," the study's authors write. They suffer from "too many cooks in the kitchen." Findings like that may not be news to management consultants. But now, with the explosion of social media in the workplace, researchers have a chance to study office communication as never before. As they do, of course, workers can be expected to game the systems devised by researchers. This might mean taking steps to create strong links to managers—or efface signs of costly weak ties to higher-ups.

167 For IBM, research into the networked behavior of its employees promises insights about teamwork, innovation, and the transmission of knowledge and ideas within the company. This is especially important for global companies—say, where experts in New York might be unaware that colleagues in Singapore are untangling a similar problem. IBM researchers fine- tuned management of industrial supply chains a half-century ago; now their challenge is promoting the flow of knowledge throughout the workforce. A key laboratory for this research is the company's internal social network, Beehive. The 55,000 employees who choose to use it exchange everything from family photos to the algorithms they use to resolve complicated work-related problems. In another study to be released this week, an IBM team at the company's Cambridge (Mass.) labs analyzes methods to introduce employees to colleagues they haven't yet met. The idea, says researcher Werner Geyer, is to create new connections within the global workforce and to encourage employees to share knowledge. "We want to incent people to participate," Geyer says. He notes that participation in the network has doubled in the past year. Matchmaking Allies One key is to alert people to potential friends and allies at the company. Much the way companies like Netflix (NFLX) and Amazon (AMZN) study past Web-surfing patterns to recommend books and movies, Geyer and his team are digging for signs of shared interests and behaviors among their colleagues. In their matchmaking efforts, the IBM team tried a variety of approaches. One used a tool favored by Facebook, recommending friends of common friends. Others analyzed the subjects and themes of employees' postings on Beehive, words they use, and patents they've filed. As expected, some of the systems lined up workers with colleagues they already knew. Others were better at unearthing unknowns. But fewer of them turned out to be good matches. To the frustration of the researchers, some of the workers noted that recommendations looked good, yet they didn't bother contacting the people. "They put them aside for future reference," Geyer says. The research, he concedes, is at an early stage. But as the economy struggles, more companies are sure to study the company we keep—and even attempt to calculate how much each friendship is worth. http://www.businessweek.com/print/technology/content/apr2009/tc2009047_031301.htm

168 Apr 7, 2009 IMF Boosts Global Loss Estimate To $4 Trillion: RGE Estimates $1.8T Fall On U.S. Banks/Brokers, Up To $2T On European Banks, Remainder On Asia

Overview: Times, April 7: IMF to say that toxic debts racked up by banks and insurers around the world could spiral to $4 trillion. The IMF said in January that it expected the deterioration in US-originated assets to reach $2.2 trillion by the end of next year, but it is understood to be looking at raising losses on U.S. originated assets to $3.1 trillion (subject to further revision) in its next assessment of the global economy, due to be published on April 21. In addition, it is likely to boost that total by $900 billion for toxic assets originated in Europe and Asia. Banks and insurers have so far owned up to $1.29 trillion in writedowns (about $800bn in U.S., $400bn in Europe, remainder in Asia). RGE calculates that U.S. banks/brokers take a $1.8T writedown, EU banks $2T, and the remainder in Asia. Loss Estimates for U.S. Banks/Brokers: o IMF in January update raised total loan and security loss estimate on U.S. originated assets to $2.2 trillion, of which about half incurred abroad. Times reports that IMF plans to raise total loss estimate to $3.1T in April Stability Report, subject to further revision. o Jan 20 Roubini/Parisi (RGE): Assuming a further 20% fall in house prices and unemployment peaking at 9-10%, we project total loan and securities losses amount to $3.6T, half of which accrue to the U.S. banking system, or $1.8T (of which $1.1 T in loan losses/ $600-700bn in securities writedowns). o Capitalization of FDIC banks is $1.4T, that of investment banks as of Q3 $110bn. If projected loan and securities losses materialize, the U.S. banking system is close to insolvency despite TARP 1 of $230bn and private capital of $200bn. o Outstanding loans are $12.4T. Of these, RGE estimates $1.6T to turn bad. Of these, U.S banks and brokers are assumed to carry $1.1T o Mark-to-market prices as of December imply around $2T in writedowns on $10.8T U.S. originated securities outstanding. Flow of funds data show that 40% of U.S. originated securities are held abroad. U.S. banks' share of writedowns is about 30-35%, or $600- 700bn for U.S. banks/brokers according to weights in IMF GFSR October 2008, table 1.1 o Chris Whalen (IRA): The bad news is that estimates that put aggregate loan charge-offs for all US banks over the next 12-18 months above $1 trillion are probably in the right neighborhood. The entire banking industry only has $1.5 trillion in capital, so new equity must obviously be provided by Washington and/or private investors.

169 o Jan 25 Goldman (via Zero Hedge): Total loan losses will reach $2 trillion of which $1 trillion are carried by the U.S. banking system (50% mortgage losses and 50% other loan losses). Banks need a minimum of $300bn additional capital but most likely more. o Roubini: In order to restore healthy credit conditions, the banking system needs about $1- 1.5T in public or private capital. This calls for a comprehensive solution along the lines of a 'bad bank' or RTC. Loss Estimates For European Banks: o Fed Board: Flow of funds data show that 40% of U.S. originated securitizations are held abroad--> about $4.4T out of $10.8T securitizations held abroad, assume $4 T in Europe. Average writedown rate on securitization is 17% as calculated by RGE, so about $680bn writedowns apply for Europe. o Goldman Sachs: Total gross loan losses among European banks estimated at EUR 900bn, or $1.1 trillion. This figure includes EUR310bn in losses falling on foreign registered banks and EUR77 registered in CEE ($400bn/$100bn respectively). (Note: report says that given that EU banks were slow in writing securities up they are justified in writing securities down slowly in the downturn as well--> focus on loans only.) o The IMF puts expected losses on European/Asian loans at $900bn, rather than $1.1T estimated above. o Danske: European banks have $1.3T in claims on Central and Eastern European countries. Assuming that 20% of these loans turn bad, EU banks incur about $270bn in CEE-related losses, of which 70bn are already accounted for in Goldman loan loss estimate above. --> Adding all up, expected losses among European banks amount to about $650bn exposure to U.S. securities +$1100 domestic&foreign loan losses+200 CEE=$1950. -->Compare with RGE's expected losses amoung U.S. banks and brokers of $1.8T. --> Asia is expected to incur the remaining $200bn in writedowns for the total $4T expected by the IMF.

http://www.rgemonitor.com/26?cluster_id=5376

Ireland Ireland unveils emergency budget By John Murray Brown in Dublin Published: April 7 2009 20:33 | Last updated: April 7 2009 23:40 Ireland’s finance minister warned on Tuesday that the nation faced “the challenge of [its] life”, as he slapped higher taxes on the middle classes in an emergency budget aimed at tackling the spiralling economic crisis. Brian Lenihan outlined plans to set up a national asset management agency to take over an estimated €80bn-€90bn of bad loans extended by local domestic banks to developers and property companies that now look as if they will not be able to repay.

170 Bankers said Ireland would be the first European Union country to adopt a so-called “bad bank” model to clean up the balance sheets of its main banks in the hope this would restore lending to the real economy. Mr Lenihan acknowledged that the move “will result in a very significant increase in gross national debt”. But he said the cost of servicing the debt would be met “as far as possible from income accruing from the assets of the new agency”.

A levy of 4 per cent of gross income on anyone earning more than €75,000 – rising to 6 per cent for those earning above €175,000 – was at the heart of measures announced by Mr Lenihan that will hit the main beneficiaries of Ireland’s recent boom as the government tries to cut a ballooning public deficit and stave off economic collapse. Forecasting an 8 per cent fall in Ireland’s economic output this year, the finance minister said he had to tackle soaring government borrowing and called on political opponents to “set aside narrow sectional interests” and support the tax increases. Referring to the Irish electorate’s shock rejection of the European Union’s Lisbon treaty last June, he said “economic success had fostered a false sense of invincibility” and warned that the country was now facing “the challenge of this nation’s life”. Richard Bruton, finance spokesman for the opposition Fine Gael party, attacked the government for exposing the taxpayer to the risk of more losses. “The banks bailed out the developers, the government then bailed out the banks, today the taxpayer is being asked to bail out the government once again. The question I ask is who is going to bail out the taxpayer.” The tax-raising measures are aimed at restoring investor confidence in Ireland’s handling of its public finance crisis. The country faces a hole in its exchequer, with tax revenues from construction evaporating after the bursting of the property bubble. Revenues are set to fall to €34.5bn this year from €40.75bn last year and from €47.25bn in 2007. In an attempt to assuage public anger at the tax increases, the minister announced cuts in the remuneration, expenses and pensions of members of parliament and senior civil servants. The budget marked the third attempt in six months to address the crisis in the public finances after the main budget in October and additional savings measures in January. The European Commission described the January measures as “somewhat optimistic” and lacking in detail. Standard & Poor’s, the rating agency, last week downgraded Ireland’s sovereign debt. Even after Tuesday’s measures, Mr Lenihan forecast government borrowing would be the

171 equivalent of 10.75 per cent of gross domestic product – more than three times the limit on countries joining the euro.

172 Economy

April 7, 2009 Economy Falling Years Behind Full Speed By LOUIS UCHITELLE As the recession grinds on, more and more of the nation’s means of production — its workers, its factories, its retail outlets, its freight lines, its bank lending, even its new inventions — are being mothballed. This idled capacity, like baseball players after a winter off, takes time to bring back into robust use. So even if the recession miraculously ended tomorrow, economists estimate that at least three years would pass before full employment returned and output rose enough for the economy to operate at full throttle.

While stock market investors have embraced tentative signs of improvement in the mortgage market and elsewhere, even a sharp pickup in demand for products and services will take considerable time to play out. The mathematics are daunting. The shortfall is running at more than $1 trillion in annual sales and other transactions. Only once since the Great Depression has there been such a severe loss of output — in the 1981-82 recession — and after that downturn, it was seven years before the economy regained the lost production. Recovery from the current recession could be similarly sluggish. New occupants have to be found for empty stores. Factory owners who are hesitant to ramp up production will wait until they are sure of demand. Hiring the right people for an operation will take time. And imports, entering the country in ever greater quantities, will slow any expansion by siphoning sales from domestic producers. Then there is the growth rate itself. In the six years of recovery from the 2001 recession to the current one, the economy grew at an average annual rate of only 2.5 percent, adjusted for inflation. If that growth rate were to resume, just $350 billion a year would be added back, requiring three years to restore the $1 trillion in lost capacity. But getting the

173 economy to grow at all after so much output has been lost, and so many jobs, is no easy task. “Excess capacity, once entrenched, perpetuates itself, and that is what is happening now,” said James Crotty, an economist at the University of Massachusetts, Amherst. “Companies cannot hire workers to make more goods and provide more services until their sales go up. But people can’t buy goods and services until they are hired — so the excess capacity just sits there.” It shows up everywhere. Lawyers are booking fewer hours. Retail space goes begging. Tourism is down. So is cellphone use, airline bookings, freight traffic and household borrowing, which is less than half what it was on the eve of the recession, the Federal Reserve reports. With orders dwindling, manufacturers are using less than 68 percent of the nation’s factory capacity, the lowest level since records were first kept in 1948. And while entrepreneurs are as inventive as ever, they may not be able to get venture capitalists to bankroll their creations. “We and others are funding start-ups as slowly as possible, or not at all,” said Howard Anderson, a founding partner of Battery Ventures in Waltham, Mass., and a senior lecturer at the Massachusetts Institute of Technology. He cites as an example a hand-held device, similar in shape to an iPod, that restaurant diners would use to order food and drink electronically. Waiters would bring the orders, but not take them. “The prototype just sits there,” Mr. Anderson said, “and maybe the inventors will get funding to produce and market their device — and maybe their company never gets born.” If there is an upside, it is the absence of inflationary pressure. With so much excess capacity rattling around, shortages do not develop that would push up prices. Indeed, interest rates are kept low to encourage more borrowing and spending. Neither is happening. Instead, demand continues to shrink and idle capacity to build up. The Obama administration, like the Roosevelt administration 75 years ago, is trying to break this logjam through government spending, using it in effect as a substitute for consumers who are jobless or short of credit. The spending is also a substitute for companies that hesitate to extend themselves or see no profit in doing so. But the president’s solution, the recently enacted stimulus package, spreads $787 billion over two years. So even if every dollar of spending restored a dollar of output, President Obama would be nearing the end of his first term before output approached the level achieved just before the start of the recession in December 2007. Or so says Robert J. Gordon, an economist at Northwestern University who specializes in tracking the gap between actual output and potential output, a k a full capacity. The Roosevelt economy also languished well below full capacity, Mr. Gordon said, until the summer of 1940, when France fell to Hitler’s armies. From then until the attack on Pearl Harbor, 18 months later, a galvanized administration more than doubled federal outlays — soon accounting for $1 of every $4 spent in the country — and the United States entered the war with its economy operating almost at full capacity.

174 (Government currently accounts for $1 of every $5 spent, barely more than in 2007, and most of that spending is at the state and local levels, the opposite of 1940-41, when federal outlays shot up.) “What you had was a revolution in the labor force,” Mr. Gordon said. “Women poured into jobs in droves, often replacing men, and every factory went to three shifts.” By V-J Day in 1945, the economy, propelled by war spending, was operating beyond what the experts thought of as full capacity, demonstrating the “squishiness” of the concept, as Mr. Gordon put it. Just the swing from one to three shifts alters capacity, he said, and so does the more intensive use of floor space. Capacity stretched again in the 1950s and ’60s, to feed demand created by the wars in Korea and Vietnam, and then again in the late 1990s, propelled by the dot-com boom. And there were downdrafts as recessions sapped demand, but none as punishing as the current one. Sixteen months into this recession, the economy is operating at 7 percent below its potential capacity, the Congressional Budget Office reported last month. If that were to continue, today’s $14 trillion economy would be a $13 trillion economy by this time next year. Labor is contributing hugely to the shortfall. More than 24 million men and women, or 15.6 percent of the labor force, are either hunting for work or working fewer hours than they would like to work, or are too discouraged to seek work, although they would take jobs if offered them, the Bureau of Labor Statistics reports. The ranks of this “underutilized” group — the bureau’s label — are up by 10 million since early last year. Generating work for so many people would take several years, even if the nation’s employers stopped shedding more than 600,000 jobs a month, as they have done since December, and began hiring robustly. “We have rarely been in this deep a hole,” said Nigel Gault, chief domestic economist for IHS Global Insight. His concern is that nearly every nation — not just the United States — is suffering from idle capacity as the recession that started in America grips Europe and Asia. Struggling for sales in a marketplace swamped with goods and services, companies are cutting prices and shutting down operations, trying to keep supply in line with dwindling demand. The cutback is particularly severe in the auto industry, which had the capacity, going into the recession, to make nearly twice as many cars in the United States as are now being sold here. Indeed, some of the factories being closed are unlikely to ever reopen. “Eventually, once this recession is over, we will fill up capacity,” Mr. Gault said. “Not only that, capacity itself will inevitably expand as the labor force grows and innovation kicks in. But the new capacity won’t be as great as it would have been if we had not gone through this terrible experience.”

175 Politics April 7, 2009 Poll Finds New Optimism on Economy Since Inauguration By ADAM NAGOURNEY and MEGAN THEE-BRENAN Americans have grown more optimistic about the economy and the direction of the country in the 11 weeks since President Obama was inaugurated, suggesting that he is enjoying some success in his critical task of rebuilding the nation’s confidence, according to the latest New York Times/CBS News poll.

These sometimes turbulent weeks — marked by new initiatives by Mr. Obama, attacks by Republicans and more than a few missteps by the White House — do not appear to have hurt the president. Americans said they approved of Mr. Obama’s handling of the economy, foreign policy, Iraq and Afghanistan; fully two-thirds said they approved of his overall job performance. By contrast, just 31 percent of respondents said they had a favorable view of the Republican Party, the lowest in the 25 years the question has been asked in New York Times/CBS News polls.

176

It is not unusual for new presidents to enjoy a period of public support. Still, the durability of Mr. Obama’s support contrasts with that of some of his predecessors at the same point in their terms. It is also striking at a time when anxiety has gripped households across the country and Mr. Obama has alternately sought to rally Americans’ spirits and warn against economic collapse as he seeks Congressional support for his programs. The poll found that 70 percent of respondents were very or somewhat concerned that someone in their household would be out of work and looking for a job in the next 12 months. Forty percent said they had cut spending on luxuries, and 10 percent said they had cut back on necessities; 31 percent said they had cut both. For all that, the number of people who said they thought the country was headed in the right direction jumped from 15 percent in mid- January, just before Mr. Obama took office, to 39 percent today, while the number who said it was headed in the wrong direction dropped to 53 percent from 79 percent. That is the highest percentage of Americans who said the country was headed in the right direction since 42 percent said so in February 2005, the second month of President George W. Bush’s second term. The percentage of people who said the economy was getting worse has declined from 54 percent just before Mr. Obama took office to 34 percent today. And 20 percent now think the economy is getting better, compared with 7 percent in mid- January. “It’s psychology more than anything else,”Arthur Gilman, a Republican from Ridgewood, N.J., said in a follow-up interview to the poll. “President Obama has turned around the negative feeling in this country. He’s given everything an impetus because he’s very upbeat, like Roosevelt was. It’s too soon to tell if the spending stuff works, but some things have improved.” Frank Henwood, an independent from Amarillo, Tex., said: “Hopefully, the stock market has bottomed out and is on the rise. Once the stock market shapes up, I think the economy will come back, and then jobs will come back and people will start buying automobiles made in America.”

177 With the poll finding that an overwhelming number think the recession will last a year or more, Mr. Obama may find he has a deep well of patience to draw on. The poll found that he shoulders virtually none of the public blame for the economic crisis: 33 percent blame Mr. Bush, 21 percent blame financial institutions, and 11 percent blame Congress. By more than three to one, voters said they trusted Mr. Obama more than they trusted Congressional Republicans to make the right decisions about the economy. And by more than two to one, they said they trusted Mr. Obama to keep the nation safe, typically a Republican strong suit. Nearly one-quarter of Republicans said they trusted Mr. Obama more than Congressional Republicans to make the right decisions about the economy. “As far as acting like adults and getting things done, the Democrat Party has done better,” said Rachel Beeson, an independent from Wahiawa, Hawaii. “The Republican Party seems to have decided that they are going to turn down anything that comes out of the White House, and nothing will get done that way.” The poll showed signs of continued political division: 57 percent of people who said they voted for Senator John McCain in November said they disapproved of Mr. Obama’s performance. While Mr. Obama’s budget proposal enjoys the support of 56 percent of Americans over all, sentiments splinter along party lines: 79 percent of Democrats said his budget had the right priorities, compared with 27 percent of Republicans. The survey was conducted Wednesday through Sunday, while Mr. Obama was in Europe for the Group of 20 summit of the world’s largest economies. Two-thirds of respondents said leaders of other countries had respect for Mr. Obama; when a similar question was asked in July 2006, 30 percent of respondents said foreign leaders had respect for Mr. Bush. The national telephone poll was conducted with 998 adults. It has a margin of sampling error of plus or minus three percentage points. Even as Americans strongly support Mr. Obama, they do not necessarily support all of his initiatives. For example, 58 percent disapprove of his proposal to bail out banks. But the percentage of respondents who said they thought it would benefit all Americans, rather than only bankers, jumped from 29 percent in February to 47 percent now, signaling that the White House might be making progress in changing perceptions of the plan. And as Mr. Obama has proposed a vast expansion in spending and programs, 48 percent of Americans said they preferred a smaller government providing fewer services, while 41 percent preferred a bigger government with more services. Americans remain concerned about the growing national debt being passed on to future generations, but in the face of the current economic troubles, they are divided over whether it is necessary to increase debt. Forty-six percent said the government should not incur further debt, but 45 percent said the government should spend money to stimulate the economy even though it would increase the budget deficit. Amid evidence of a surge of populism in response to abuses on Wall Street, respondents said by more than two to one that Democrats cared more about the needs of people like themselves than Republicans did. Seventy-one percent of Americans said Mr. Obama cared more about the interests of ordinary people than about large corporations. Mr. Obama’s push to increase income taxes on people making over $250,000 a year was supported by 74 percent of respondents. When presented with the possibility that taxing those in the higher income bracket might hurt the economy, 39 percent of those polled still backed the plan.

178 Opinion

April 7, 2009 OP-ED COLUMNIST The End of Philosophy By DAVID BROOKS Socrates talked. The assumption behind his approach to philosophy, and the approaches of millions of people since, is that moral thinking is mostly a matter of reason and deliberation: Think through moral problems. Find a just principle. Apply it. One problem with this kind of approach to morality, as Michael Gazzaniga writes in his 2008 book, “Human,” is that “it has been hard to find any correlation between moral reasoning and proactive moral behavior, such as helping other people. In fact, in most studies, none has been found.” Today, many psychologists, cognitive scientists and even philosophers embrace a different view of morality. In this view, moral thinking is more like aesthetics. As we look around the world, we are constantly evaluating what we see. Seeing and evaluating are not two separate processes. They are linked and basically simultaneous. As Steven Quartz of the California Institute of Technology said during a recent discussion of ethics sponsored by the John Templeton Foundation, “Our brain is computing value at every fraction of a second. Everything that we look at, we form an implicit preference. Some of those make it into our awareness; some of them remain at the level of our unconscious, but ... what our brain is for, what our brain has evolved for, is to find what is of value in our environment.” Think of what happens when you put a new food into your mouth. You don’t have to decide if it’s disgusting. You just know. You don’t have to decide if a landscape is beautiful. You just know. Moral judgments are like that. They are rapid intuitive decisions and involve the emotion- processing parts of the brain. Most of us make snap moral judgments about what feels fair or not, or what feels good or not. We start doing this when we are babies, before we have language. And even as adults, we often can’t explain to ourselves why something feels wrong. In other words, reasoning comes later and is often guided by the emotions that preceded it. Or as Jonathan Haidt of the University of Virginia memorably wrote, “The emotions are, in fact, in charge of the temple of morality, and ... moral reasoning is really just a servant masquerading as a high priest.” The question then becomes: What shapes moral emotions in the first place? The answer has long been evolution, but in recent years there’s an increasing appreciation that evolution isn’t just about competition. It’s also about cooperation within groups. Like bees, humans have long lived or died based on their ability to divide labor, help each other and stand together in the face of common threats. Many of our moral emotions and intuitions reflect that history. We don’t just care about our individual rights, or even the rights of other individuals. We also care about loyalty, respect, traditions, religions. We are all the descendents of successful cooperators.

179 The first nice thing about this evolutionary approach to morality is that it emphasizes the social nature of moral intuition. People are not discrete units coolly formulating moral arguments. They link themselves together into communities and networks of mutual influence. The second nice thing is that it entails a warmer view of human nature. Evolution is always about competition, but for humans, as Darwin speculated, competition among groups has turned us into pretty cooperative, empathetic and altruistic creatures — at least within our families, groups and sometimes nations. The third nice thing is that it explains the haphazard way most of us lead our lives without destroying dignity and choice. Moral intuitions have primacy, Haidt argues, but they are not dictators. There are times, often the most important moments in our lives, when in fact we do use reason to override moral intuitions, and often those reasons — along with new intuitions — come from our friends. The rise and now dominance of this emotional approach to morality is an epochal change. It challenges all sorts of traditions. It challenges the bookish way philosophy is conceived by most people. It challenges the Talmudic tradition, with its hyper-rational scrutiny of texts. It challenges the new atheists, who see themselves involved in a war of reason against faith and who have an unwarranted faith in the power of pure reason and in the purity of their own reasoning. Finally, it should also challenge the very scientists who study morality. They’re good at explaining how people make judgments about harm and fairness, but they still struggle to explain the feelings of awe, transcendence, patriotism, joy and self-sacrifice, which are not ancillary to most people’s moral experiences, but central. The evolutionary approach also leads many scientists to neglect the concept of individual responsibility and makes it hard for them to appreciate that most people struggle toward goodness, not as a means, but as an end in itself. Bob Herbert is off today.

180 Opinion

April 7, 2009 OP-ED CONTRIBUTOR How the Internet Got Its Rules By STEPHEN D. CROCKER Bethesda, Md. TODAY is an important date in the history of the Internet: the 40th anniversary of what is known as the Request for Comments. Outside the technical community, not many people know about the R.F.C.’s, but these humble documents shape the Internet’s inner workings and have played a significant role in its success. When the R.F.C.’s were born, there wasn’t a World Wide Web. Even by the end of 1969, there was just a rudimentary network linking four computers at four research centers: the University of California, Los Angeles; the Stanford Research Institute; the University of California, Santa Barbara; and the University of Utah in Salt Lake City. The government financed the network and the hundred or fewer computer scientists who used it. It was such a small community that we all got to know one another. A great deal of deliberation and planning had gone into the network’s underlying technology, but no one had given a lot of thought to what we would actually do with it. So, in August 1968, a handful of graduate students and staff members from the four sites began meeting intermittently, in person, to try to figure it out. (I was lucky enough to be one of the U.C.L.A. students included in these wide-ranging discussions.) It wasn’t until the next spring that we realized we should start writing down our thoughts. We thought maybe we’d put together a few temporary, informal memos on network protocols, the rules by which computers exchange information. I offered to organize our early notes. What was supposed to be a simple chore turned out to be a nerve-racking project. Our intent was only to encourage others to chime in, but I worried we might sound as though we were making official decisions or asserting authority. In my mind, I was inciting the wrath of some prestigious professor at some phantom East Coast establishment. I was actually losing sleep over the whole thing, and when I finally tackled my first memo, which dealt with basic communication between two computers, it was in the wee hours of the morning. I had to work in a bathroom so as not to disturb the friends I was staying with, who were all asleep. Still fearful of sounding presumptuous, I labeled the note a “Request for Comments.” R.F.C. 1, written 40 years ago today, left many questions unanswered, and soon became obsolete. But the R.F.C.’s themselves took root and flourished. They became the formal method of publishing Internet protocol standards, and today there are more than 5,000, all readily available online. But we started writing these notes before we had e-mail, or even before the network was really working, so we wrote our visions for the future on paper and sent them around via the postal service. We’d mail each research group one printout and they’d have to photocopy more themselves.

181 The early R.F.C.’s ranged from grand visions to mundane details, although the latter quickly became the most common. Less important than the content of those first documents was that they were available free of charge and anyone could write one. Instead of authority-based decision-making, we relied on a process we called “rough consensus and running code.” Everyone was welcome to propose ideas, and if enough people liked it and used it, the design became a standard. After all, everyone understood there was a practical value in choosing to do the same task in the same way. For example, if we wanted to move a file from one machine to another, and if you were to design the process one way, and I was to design it another, then anyone who wanted to talk to both of us would have to employ two distinct ways of doing the same thing. So there was plenty of natural pressure to avoid such hassles. It probably helped that in those days we avoided patents and other restrictions; without any financial incentive to control the protocols, it was much easier to reach agreement. This was the ultimate in openness in technical design and that culture of open processes was essential in enabling the Internet to grow and evolve as spectacularly as it has. In fact, we probably wouldn’t have the Web without it. When CERN physicists wanted to publish a lot of information in a way that people could easily get to it and add to it, they simply built and tested their ideas. Because of the groundwork we’d laid in the R.F.C.’s, they did not have to ask permission, or make any changes to the core operations of the Internet. Others soon copied them — hundreds of thousands of computer users, then hundreds of millions, creating and sharing content and technology. That’s the Web. Put another way, we always tried to design each new protocol to be both useful in its own right and a building block available to others. We did not think of protocols as finished products, and we deliberately exposed the internal architecture to make it easy for others to gain a foothold. This was the antithesis of the attitude of the old telephone networks, which actively discouraged any additions or uses they had not sanctioned. Of course, the process for both publishing ideas and for choosing standards eventually became more formal. Our loose, unnamed meetings grew larger and semi-organized into what we called the Network Working Group. In the four decades since, that group evolved and transformed a couple of times and is now the Internet Engineering Task Force. It has some hierarchy and formality but not much, and it remains free and accessible to anyone. The R.F.C.’s have grown up, too. They really aren’t requests for comments anymore because they are published only after a lot of vetting. But the culture that was built up in the beginning has continued to play a strong role in keeping things more open than they might have been. Ideas are accepted and sorted on their merits, with as many ideas rejected by peers as are accepted. As we rebuild our economy, I do hope we keep in mind the value of openness, especially in industries that have rarely had it. Whether it’s in health care reform or energy innovation, the largest payoffs will come not from what the stimulus package pays for directly, but from the huge vistas we open up for others to explore. I was reminded of the power and vitality of the R.F.C.’s when I made my first trip to Bangalore, India, 15 years ago. I was invited to give a talk at the Indian Institute of Science, and as part of the visit I was introduced to a student who had built a fairly complex software system. Impressed, I asked where he had learned to do so much. He simply said, “I downloaded the R.F.C.’s and read them.” Stephen D. Crocker is the chief executive of a company that develops information-sharing technology.

182 07.04.2009 IMF TO WARN ABOUT $4 TRILLION WRITE-OFFS

This is how toxic assets can grow during a depression. The first IMF estimate about the size of toxic assets in the global banking system, made a year ago, was $1 trillion. It was shocking number then. Then the IMF upped this forecast to $2.2 trillion. Now, according to the Times of London (hat tip Calculated Risk), there will be a new estimate of $4 trillion, of which $3.1 trillion are originated in the US, and the remaining trillion, almost, in Europe and Asia. These estimates keep on rising because the depression is now affecting the prices of some of the more liquid assets, and turning them toxic (so in solving the bankings crisis you are trying to pin down a moving target)

Deutsche Bank: US junk bond default rate to rise to 53% If true, this forecast would have very serious implications for the financial sector, and could easily prolong our crisis signficantly. Bloomberg reports a Deutsche Bank projection that the default would rise above the level of the Great Depression, when it was “only” 45 per cent. The forecast assumes a recory rate of zero. Naked Capitalism makes the point that the latter was a pessimistic assumption, but the prevalence of so-called cov-light loans means that recovery is going to be more difficutl.

Kotlikoff and Sachs on Geithner-Summers: Even worse than you think In an article in Martin Wolf’s economists forum Lawrence Kotlikoff and Jeffrey Sachs argue that the Geithner Summers plan is even worse that they had thought – because it allows banks to abuse it. Sachs previous outlined that the plan is a massive transfer of wealth from the US taxpayer to Wall Street, as it encourages private investors to overbid. What they have now discovered is that banks can set up an off-balance sheet subsidiary that bids for the bank’s own toxic assets. The subsidiary would not profit, but the bank’s shareholders would get benefit that is directly proportional to the taxpayers’ money. So this is worse than the orginal TARP programme. Paul Krugman, who is truly alarmed by this prospect calls this an insider deal, which amounts to a straight transfer of funds from the taxpayer to the shareholders.

183 Worse than the Great Depression This is truly alarming stuff. Writing in Vox, Barry Eichengreen and Kevin O’Rourke take a look at industrial production, world trade and stocks markets and find that this recession, from a global perspective, is much worse than the Great Depression, at least so far. Most of the comparison are a US-centric only, and this suggests a milder development today (because the US is not as badly hit as other countries now, and it was worse hit than most countries then). Here are the two charts for industrial production and stock markets respectively.

184 Another striking picture Brad Setser has produced the following chart, showing the collapse of global trade as well as global capital flows, which have collapse even faster. The latter is not the result of protectionism, he concludes, but of the financial crisis directly. He says the scale of the collapse is amazing.

Euro area’s policy establishment opposed to IMF’s proposal of fast-track euro entry The reaction to the leaked IMF report about fast track euro entry by CEE countries were swift and predictable. The Europeans would rather spend hundreds of billions in firefighting balance of payment assistence than simply solving the problem. Jean-Claude Juncker says there are no short cuts for euro adoption. The ECB insisted that membership has rules, and these rules must be followed. The FT quotes analysts who say that this proposal is “not realistic”, and perhaps suited to small Baltic countries which already have fixed exchange rates.

Pisani-Ferry on the G20 Jean Pisani-Ferry has a fairly positive take on the G20 summit in London. Even though they did not solve the problem of the acute crisis, the G20 start a process of emerging global governance. He said the decision on international financial institutions were significant, in particular the $250bn increase in SDRs for the IMF, as this allows the IMF to deal far more effectively with capital outflows from emerging countries. He also welcomes the upgrading and extension of the Financial Stability Forum into a Financial Stability Board – which is another, albeit small step. He concludes that such decisions would have been regarded as unrealistic not too long ago, and they should be welcomed for that reason.

185 April 7, 2009, 1:43 pm THE FINANCIAL FACTOR One of my long-running interests/concerns has been the decline and rise of US inequality over the past century, which is closely tied to the fall and rise of intense partisanship; here’s one of the McCarty-Poole-Rosenthal pictures:

But what caused the fall and rise of inequality? A lot of very high incomes, both in the pre- 1930 world and now, have been in the finance sector. A recent paper by Phillipon and Reshef http://www.nber.org/papers/w14644.pdf (cited today by Gillian Tett in the FT) traces the path of relative compensation in finance, and ties it to regulation and deregulation. Here’s the key figure:

186 OK, correlation does not imply causation yada yada. The move to regulate in the 1930s was part of a broader crackdown on rampant capitalism, and the deregulation since 1980s was similarly part of a broader phenomenon. But it’s a good bet that finance is a key part of the story of how we got to where we are April 6, 2009, 12:01 pm BANK SCAMS By Paul Krugman Jeff Sachs comes down hard on the Geithner plan, and his worries need to be taken seriously. I was starting to come to the conclusion that the plan would simply fizzle — that even though participating players would get a large put along with their free toaster, it wouldn’t be enough to raise the price they’re willing to pay to a level banks would be willing to sell at, rather than keep assets on the books at far above their true value. But once you take into account the possibility of insider deals, that all changes. As Jeff says, a bank can create an off-balance- sheet entity that buys bad assets for far more than they’re worth, using money borrowed from taxpayers, then defaults — in effect a straight transfer from taxpayers to stockholders. If there’s a mechanism to police such deals, it isn’t clear. And the sense that the administration is just too close to Wall Street continues to grow. April 6, 2009, 12:23 pm BALANCE SHEETS AND THE TRADE CYCLE (SOMEWHAT WONKISH) Paul Kedrosky has the slides from a presentation by Nomura’s Richard Koo on “balance sheet recessions”, a meme that’s been gaining ground lately. I’m in the process of trying to think this stuff through more formally; here’s a quick note about where my thoughts are tending. As I see it, the balance sheet recession approach to the business cycle is a close cousin to a once-influential but largely forgotten literature: the “non-linear” theory of the business cycle. The original version, by John Hicks (”A contribution to the theory of the trade cycle”), set up the basics. The idea was that in the short run the economy is unstable: an economic boom causes rising investment spending, which further feeds the boom, and so on, while a slump depresses investment spending, deepening the slump, etc.. Hicks’s big contribution was to add limits to the boom and slump: a “ceiling” set by the economy’s capacity, a “floor” set by the fact that investment can’t go negative. The cycle then went like this: the economy races to the ceiling during a boom, and stays there for a while. Eventually, however, overcapacity builds up, investment starts to fade, and a self- reinforcing slump takes hold. This pushes the economy to the floor. The depressed economy eventually revives when a combination of depreciation and growth in sources of demand not tied to the business cycle starts to create a shortage of capacity, which leads to an upward trajectory, and the whole thing starts all over again. (Yes, we can do this with equations …) What Koo is arguing for is something similar, but with debt playing the role played by capacity in the old trade cycle. When the economy is growing, taking on more debt seems OK, and rising debt feeds rising spending, which feeds the boom. Eventually growth has to slow, however, and the debt starts to drag down spending, which reduces income, forcing more deleveraging, and so on to the floor. Then debt slowly gets paid down, until the cycle is ready to start again.

187 This suggests a prolonged slump. In particular, it tells us not to get too euphoric over “green shoots” and all that. Yes, we may — may — be approaching the “floor”, where the free fall ends. But it can take a long time, many years, before balance sheets are sufficiently repaired for the economy starts to climb off that floor. It also suggests a positive role for fiscal expansion — and an answer to the line that debt got us into this, so how can it get us out? What this style of modeling suggests is that over the course of the whole cycle, the problem isn’t so much excessive debt as the fact that everyone tries to increase or reduce debt at the same time. What deficit spending can do is stabilize things: you have one big player in the economy that is increasing debt when the economy is stuck in a paradox-of-thrift world, then pays that debt down when the private sector is happy to borrow. Much more when I have time to do a proper writeup. Comments (84) El comentario (16) a la entrada del Blog (6/IV) < http://krugman.blogs.nytimes.com/2009/04/06/balance-sheets- and-the-trade-cycle-somewhat-wonkish/ > dice: “There’s a fascinating little article from 1897 (!)explains exactly that: http://optionarmageddon.ml-implode.com/2009/03/11/panics-and-booms-1897/ — G. Nolin

Economics and Finance soufflé PANICS AND BOOMS, A LESSON FROM 1897 March 11, 2009 – 4:24 pm

Thanks to Patrick for an absolute gem. Earlier this week, he linked to a fantastic newspaper article written in 1902. That article actually reprinted a paper written five years previously, entitled “Panics and Booms” by L.M. Holt. When Holt wrote the paper, the economy was at the tail end of a depression. Holt argued that booms always follow busts, so folks should anticipate the return of flush times. Fast-forward five years, a new boom was in full swing, and the newspaper republished Holt’s paper as a warning that the next depression was due around 1910, give or take. The Bank Panic of 1907 arrived a bit ahead of schedule. It’s a great read, particularly now when most observers remain conflicted about what kind of economic funk we’re in. Mr. Holt described quite clearly the economic conditions we face today, a depression created by over-indebtedness. And he offers a prescription for how to dig ourselves out: pay back debt. It’s a prescription I endorse wholeheartedly. The paper is so good, for posterity’s sake, I have reproduced it here in full. Another reason: Irving Fisher generally gets credit for having created the “debt deflation theory of depressions,” but Holt beat him to it by 36 years. Enjoy! “Panics and Booms” L.M. Holt Ever since the establishment of the human race on this planet there has been a gradual increase of population and a more rapid consumption of wealth. Wealth is the result of labor, and without labor there can be no wealth. Men live and pass away, but as they cannot take their wealth with them a large percentage accumulates for the benefit of their successors. Hence the wealth of the

188 world today, per capita, is much greater than ever before, and it is continually on the increase. The transfer of wealth, or property, from one person to another creates business. Under favorable conditions, transfers are numerous and business is brisk. Under unfavorable conditions transfers are few and business is dull. During periods of business activity there is work for all, and this of itself makes greater business activity. During periods of business depression there is not work for all, and this of itself makes business dull and unprofitable. The existence of either one of these conditions leads necessarily to the other. It is an impossibility for either prosperous times or depressed times to continue permanently. This is where it starts to get good… During prosperous times, there being work for all, all are supplied with the means of accumulating wealth, and thus all are enabled to provide themselves, and families with all the necessaries, and many of the luxuries, of life; and hence, during the prosperous times the demand for goods and property increases and soon the demand exceeds supply, and then prices advance. This rule, which is applied to the laborer, is also applied to the business man. Prosperous times induce business men to branch out in their several lines of trade….The volume of trade being large, each gets a corresponding proportion of it. Many business men find that they can do more business than is allowed by their limited capital. They then buy on credit. Prices are continually advancing, therefore they are able to make margins of profit not only on the capital furnished by themselves, but on the capital furnished through their credit. This rule also applies to people dealing in real estate. The country is growing; money is easy; the times are good; business is prosperous and therefore speculation is favored. A man worth $5000 can buy four times that amount of property using his credit, and sometimes he buys ten times that amount or more. While prices are advancing he not only gets the benefits of the advance in the price of the property represented by the capital furnished by himself, but also on the capital furnished by his credit. When prices of property and goods during a period of business depression are falling, the loss does not come on the entire property, but only on that portion of it represented by the cash capital the man has invested in it. The debt never shrinks until the real investment is all gone. A fantastically simple description of leverage, that is, investing with borrowed money as a way to amplify potential gains at the risk of greater losses. How quaint that Holt seems impressed by “ten times” leverage. He would blush at the leverage ratios permissible today. A quick tutorial on leverage for the unfamiliar. The more money borrowed to buy an asset, the higher the buyer’s return on equity when times are flush. If you buy a $100,000 house with only $5,000 down and the price increases to $125,000, the return on your equity investment is 400%. ($25,000 increase in price / $5,000 initial investment = 400% return). A cash basis investor who pays the full price of the house up front has a much more meager return, 25%. ($125k / $100k = 25% return). The flip side is that when prices fall, the leveraged investor sees his equity wiped out quickly. The guy who paid cash has lots of cushion. All people in a given section of country use their credit at the same time because they are all governed by the same local conditions. Hence, there is a fictitious stimulation of prices which must come to an end. This end brings a financial depression which must necessarily follow a period of business activity. A “fictitious stimulation of prices.” We have our own word for that: “bubble.”

189 When the people arrive at a point where their credit limit is reached there is necessarily a decrease in the demand for goods and property, and soon the supply becomes greater than the demand and prices begin to decline. This stops speculation. Thousands of people engaged in manufacturing or producing articles of general use are thus thrown out of employment, and this causes a still further decrease in the demand for goods and hence a further decline in prices. Those who have purchased on credit find themselves subjected to heavy losses because they are compelled to sustain the depreciation on goods they do not own—that is, goods bought on credit. Because of this decrease in valuations all are compelled to economize in order to adjust their expenses to the new order of things, they being compelled to pay off the accumulated indebtedness with the decreased income. This economy of the masses still further decreases the demand for goods and property and this still further increases the supply over the demand, and decreases the prices, throwing more people out of employment and increasing the depressed condition of business. Fisher, eat your heart out! The business man feels the change in conditions as well as the laborer. Doing business largely on borrowed capital he loses all the capital employed in the business, not alone on the money furnished by himself. The value of the business shrinks, but the debt remains the same or increases. Bankruptcy stares the business world in the face. The weaker go under while the stronger pull through, and sometimes make fortunes at a little later date out of the misfortunes of others. Here is a condition of hard times. A large percentage of laboring people of the world are thrown out of employment. Every time a man stops work—stops producing—his purchasing ability is impaired, the demand for goods becomes less and prices are lowered. During the period of depression—the debt-paying period—the people at large are forced to economize. The earning capacity of all classes has been decreased. A large percentage of people are thrown out of steady employment and wages are reduced for those who do secure labor. Some earn enough to pay expenses of living economically, while others do not and are compelled to live in part on the limited accumulation of former more prosperous years. Holt notes that depression coincides with the period during which debt gets paid back. Economic expansion coincides with the expansion of debt, with the period during which debts are rolled over rather than paid back. [I made this point in my post on The Great American Ponzi.] The bigger the debt hole we dig for ourselves—via bailouts, stimulus, etc.,—the longer our payback period. More debt, in other words, will only exacerbate the depression. Many business men continue in business: some are able to meet running expenses, while others prefer to lose a little each month, awaiting a return of better times rather than to lose more heavily by retiring entirely from business. Many cannot stand the pressure and quite business, forced to lose the accumulation for years. During the years of depression, values of all kinds of property shrink. In the case of incumbered property this shrinkage falls entirely on the margin and not on the debt. Sometimes it wipes out the margin and a portion of the debt also. Sometimes the margin is so nearly wiped out that the alleged owner of the property transfers his interest in the property to the one who holds the claim against it, and another debt is paid. Sometimes the holder of the debt declines to thus take the property and releases the owner. More on leverage. Assets “incumbered” with debt leave their owners very vulnerable. What Holt refers to as “margin” we refer to as equity. Equity, “during the years of depression,” may be substantially “wiped out.”

190 A person who does business on a partial credit basis, on borrowed capital, makes larger profits during periods of prosperity when the prices are advancing than he who is on a cash basis, but he sustains larger losses during periods of depression when prices are dropping. If a man could change quickly from a credit system to a cash basis as soon as the period of prosperity closes he would be all right, but he is in debt, and the debt must be paid, and hence it is not usually practical to make the change. If it were he would not be in debt. Gradually the surplus debts of the country are paid and the people breathe easier again. People live within their incomes and temporarily learn economical habits. Men smoke fewer and cheaper cigars and ladies purchase fewer ribbons and occasionally fix over a bonnet and dress instead of getting new ones. A time is finally reached when people begin to get out of debt and they begin to live a little better, buy more of the necessities of life and some of the luxuries. As the number of people in such improved condition increases, trade begins to pick up, larger orders are sent to the factories, more wheels are set in motion, more operatives are employed and more people are placed in position to buy more goods, which in turn starts more mills and gives employment to still more men. Note how the pre-existing condition for healthy economic growth is first getting out of debt. Deficit spending won’t stimulate anything. It will just sow the seeds of an even deeper depression. The sooner we get out of debt, the better off we’ll be. Thus the business of the country is forced into an active condition, and thus business activity increases in geometrical progression until wages reach their maximum point, factories are running to their utmost capacity, prices of all kinds of goods and all kinds of property advance, and people begin to purchase again more than they have the money to pay for—some because they want profits on increasing valuations and others simply because of extravagant ideas of living. Money is plenty, credits are good, and the masses are good pay because all kinds of property are convertible into legal tender. Improvements, public and private, are pushed to their utmost extent, fancy prices are paid for real estate because it can be sold readily again at still more fancy prices. Individuals of limited capital hold thousands and hundreds of thousands of dollars worth of property on which only a small payment has been made. An advance of five per cent on the price of the property is an advance of 50 or 100 per cent or more on the cash investment. Another transfer is made and another soul is made happy. In short a speculative boom has struck the country again gradually but surely. This speculative boom is not the result of any movement on the part of the people or any portion of them to create a boom, but it is the result of natural laws of business and is just as certain to materialize as a good crop is sure to be the result of favorable climatic conditions. It is not, perhaps, in order here to discuss the millionaire question or inquire into the trust combinations which threaten to disturb so seriously the business interests of the country. It is, however, safe to say that those who think during a period of business activity that such activity will always continue are just as much mistaken as are those who believe during a period of business depression that such business depression will never come to an end. Good times will follow bad times and bad times will follow good times just as surely as darkness follows day and day follows darkness. Those periods always have followed each other and they always will. The seeds of prosperity are sown during the periods of financial depression and the seeds of hard times are just as surely down during the period of business activity and

191 speculative boom. There is not question as to the soundness of this conclusion. There is no question that these changes will come. The only question is—when? At the close of a speculative boom the change comes like a thief in the night. In fact a thief in the night would be a welcome visitor to many instead of the change which puts in an appearance, but the change from a financial depression to better times comes gradually—so gradually that for months there is a difference of opinion as to whether a change for the better has actually commenced or not. Glance for a moment over the financial history of the century just closing, and see what has been the condition of the country. During 1837 the country was in the midst of a financial panic. Again during the year 1857—twenty years later—there was another panic. In 1837 a financial crisis struck the eastern states and the great banking house of Jay Cook & Co. was found among the financial wrecks scattered throughout that section of the country. In 1875 that same panic reached the Pacific Coast, closing the doors of the Bank of California of San Francisco, together with many other banking institutions, including the then popular banking house of Temple and Workman in our own Los Angeles—a bank that failed for over a million dollars and never paid a cent on the dollar to the many unfortunate depositors. In 1893 the next panic struck the United States after having wrecked so many banking institutions in South America, Australia, and other parts of the world. During the year 1886, when the late speculative boom was getting under good headway in Southern California, Hon. D.C. Reed, now mayor of the City of San Diego, gave a banquet at the Horton House in that city, to which he invited business men from all points in Southern California. In response to the sentiment, “The Prosperity of Southern California,” the writer, among others, briefly reviewed many of the principles herein laid down and following the line of thought that waves of prosperity and depression follow each other with more or less regularity, predicted that somewhere between the years of 1892 and 1895 this country would again enter upon a period of business depression that would be very severe on the business activity of the country. The local speculative boom of 1886-7 broke long before this predicted period, but the universal panic which swept over the civilized world did not appear until the time predicted—1893. It appears to require, under present business conditions, from eighteen to twenty years for the country to pass through a complete cycle from one business depression to another. After the panic of 1875 it took the people of Southern California five years to get ready for business again in 1880. A similar period after the panic of 1893 ought to place this country again in line for business activity. The panic of 1893 was more widespread in its operations that that of 1875; but locally, it was not so severe, as comparatively little money was lost by depositors by falling banks in Southern California four years ago, whereas in 1875 the loss was heavy. Again so far as Southern California is concerned the past five years has dealt very kindly with our people. Southern California increased its population from 200,000 in 1890 to over 300,000 in 1896. Los Angeles city has increased in population from 50,000 in 1890 to 103,000 in 1897, more than doubled. In actual wealth, Southern California has kept pace with the increase of population, although on account of the business depression of the country and the decrease in valuation all over the world, this increase in wealth is not so apparent. With the extraordinary increase in population and wealth in Los Angeles city during the past seven years, nothing short of a financial depression all over the country could have prevented that city from experiencing a speculative boom of great magnitude.

192 If Southern California in general and Los Angeles city in particular can make such a showing during a period of financial depression, what will be the result when the clouds roll by and prosperous times are enjoyed again throughout the country at large? It is a difficult matter to make the people believe that our country is now entering upon another period of prosperity. Each one has a remedy for hard times. And each one sticks firmly to the proposition that better times cannot come again until his remedy has been applied. These remedies are mostly of a political nature. One man believes that a high protective tariff is all that is necessary to restore prosperity to the country, and another thinks the free coinage of silver and gold on a basis of 16 to 1 without making any suggestion to any other nation about the matter would bring good times. There is no question but the legislation on both these questions or either of them would affect the main proposition. Wise legislation will always assist in bringing prosperity, and unwise legislation will always retard the coming of better times, but no legislation, no matter what it be, can prevent the incoming tide any more than the little child on the sandy beach with its little shovel can, by piling up a ridge of sand, stay the incoming surf. “The statement that, except for the temporary depression in prices the volume of business transacted is now larger than it was in 1892—the year of the greatest prosperity—has been questions by some. But a comparison of prices this week in the leading branches of manufacture, not only confirms that view, but shows a remarkable similarity to the course of prices in the early months of 1879, when the most wonderful advance in production and prices ever known in this or any other country was close at hand. The key of the situation is the excessive production of some goods in advance of an expected increase in demand. So, in 1879, consumption gradually gained, month by month, until suddenly it was found that the demand was greater than the possible supply. All know how prices then advanced and the most marvelous progress in the history of any country resulted within two years. Reports from all parts of the country now show that retail distribution of products is unusually large and increasing.” This is a remarkably clear statement of the facts of the case, and is evidence from unquestionable authority that the position taken herein is correct. Local conditions in Southern California will affect the issue here, and they appear in our favor. The building of the breakwater at San Pedro by the government will insure another transcontinental railroad from the east to Los Angeles via Utah. Then a 1 cent a pound tariff on citrus fruits, the building or more beet-sugar factories and the improvement of the vast water power of the mountain streams, and the setting of that power to work building up and enriching the country—all these and more will help along the good work. Capitalists are now active, laying the foundations solidly for future operations in this, God’s corner of the universe; and while we would not advise people to stand still and see the salvation of the Lord, still it is pretty certain that those who stand will see it, although they will not be benefited thereby so much as they would be if they didn’t stand still. The coming boom is not here today and it will not be here tomorrow, but he who has no faith that a period of very busy business activity, accompanied by a speculative boom is close at hand, would do well to place himself under the fostering care of a good, reliable guardian. http://optionarmageddon.ml-implode.com/2009/03/11/panics-and-booms-1897/

193 38. April 6, 2009 5:54 pm Link We are currently in a crisis where many households feel they owe far more than they perceive they have the ability to pay. Current estimates suggest that the bank bailouts might cost around 4 trillion. (http://money.cnn.com/2009/01/27/news/bigger.bailout.fortune/) add in another 1 trillion stimulus plus various other costs you get close to 6 Trillion. The idea behind the bank bailout is that the banks will start lending again once the “toxic assets” are off the books. I question this seriously. Why? 9 million homes are currently behind on payments or are in foreclosure. Figure another 10-11 million are in trouble. So even if the Paulson plan opens up lending it will not get consumption moving. Those 20 million homes are at their credit limit. So the current plan is wasted money. Instead we do the following. We write a check to every man woman and child in the US for $20K. So if you, your wife and 2 kids were getting this money you would get a check for $80K. The total amount to pay for this whole bailout would be 300,000,0000 people * $20,000 = 6 trillion dollars. Now wait this may not be politically feasible. So here is what might have to happen. All of the money a household receives in this manner must FIRST go to paying off debt. So if that same household owed $120,000 on the mortgage they would have to put all 80k to the mortgage. If they owed less then the government payment they could do as they saw fit with the remainder. Now I was thinking about people asking “how would we pay for this?” and I realized something even more interesting. Suppose the government enforced the laws on the books that would put the banks that are illiquid into government receivership. We institute those laws before we began writing these checks. So now the US government owns a large number of these banks prior to this money going out to the households. The government then sends the checks out to the households and the households send the checks to the banks, which then give the money directly back to the government. A large chunk of the 6 trillion would come directly back to the government and the increase in debt might be significantly less than 6 trillion. The government could then sell off the banks to private investors to make back the money that would actually have to be paid out. To make it even more politically palatable the banks could be given back to the previous stock holders and the government could simply take on the debt it would generate. This would result in the following. Most households would have much smaller debt. The banks would now be in a situation of solvency where the debts still on the books could be managed by the people who owed the money. Many houses would have extra money they could use to consume. Thoughts. I know it sounds whacko but why not? — curious 52. April 6, 2009 9:54 pm Link It would have been more interesting to include Minsky’s financial instability hypothesis. Minsky recognized that, in a modern capitalist economy with complex, expensive, and long-lived assets, the method used to finance asset positions is of critical importance,

194 both for theory and for real-world outcomes—one reason his alternate approach has been embraced by Post Keynesian economists and Wall Street practitioners alike. This allowed Minsky to analyze the evolution, over time, of the modern capitalist economy toward fragility—what is well known as Minsky’s financial instability hypothesis. http://www.levy.org/pubs/wp_543.pdf http://www.levy.org/pubs/wp74.pdf Minsky, H.P. (1986) Stabilizing an Unstable Economy, New Haven, CT: Yale University Press. — Felipe 63. April 7, 2009 5:47 am Link You don’t need the non-linear model from Hicks. Hyman P. Minsky developed the same idea, with the balance sheet as the driving force of the cycle, in “A Linear Model of Cyclical Growth”, The Review of Economics and Statistics, Vol. 41.2, Part 1 (May, 1959). In Minsky’s view the problem with non linear models is that they work as a black box. With a linear model you can do the same think maintaining yourself always in direct relation with the economic variables — Álvaro Espina http://krugman.blogs.nytimes.com/2009/04/06/balance-sheets-and-the-trade-cycle-somewhat- wonkish/?apage=3#comments 68. April 7, 2009 12:25 pm Link Miskslam beat me to it. Maybe we should come up with a new law of economics, something like: “He has not read Minsky is doomed to rewrite him, badly.” — Jim 71. April 7, 2009 7:16 pm Link Minsky recognized that, in a modern capitalist economy with complex, expensive, and long-lived assets, the method used to finance asset positions is of critical importance, both for theory and for real-world outcomes—one reason his alternate approach has been embraced by Post Keynesian economists and Wall Street practitioners alike. This allowed Minsky to analyze the evolution, over time, of the modern capitalist economy toward fragility—what is well known as Minsky’s financial instability hypothesis. http://www.levy.org/vdoc.aspx?docid=1087 http://www.levy.org/vdoc.aspx?docid=392 Minsky, H.P.1986. Stabilizing an Unstable Economy. New Haven: Yale University Press. — Felipe 78. April 8, 2009 2:48 am Link Yes, it is Minsky’s debt-based arguments, which can be and have been used to produce non-linear trade cycle models. And it is also Kalecki’s “principle of

195 increasing risk.” See my forthcoming book, Kalecki’s Principle of Increasing Risk and Keynesian Economics, coming out from Routledge in August. Or, for a much cruder version, see my 1982 Stanford Ph.D. thesis on Kalecki’s principle of increasing risk. — Tracy Mott 79. April 8, 2009 4:52 am Link I agree with previous posters that this is very reminiscent of Minsky’s “Stabilizing an unstable economy”. What puzzles me is why is this stuff not taught in mainstream macro courses? Instead, the typical macro course teaches “consumption smoothing”, the idea that rational people save in good times and use their savings in bad times. Or, which is the same, borrow in bad times and repay their debts in good times. That’s great in theory, but what I see “through the window” is a world in which people borrow like crazy in good times and try to save (or “deleverage”) in bad times. The reasons why this happens seem very well explained in Minsky. Why is this not taught at school? Is it so hard to formalize his ideas using a modern modelling appoach? — Anton from Europe April 6, 2009, 7:08 pm IT’S 1930 TIME Barry Eichengreen and Kevin O’Rourke have an alarming paper in Vox EU, showing that if you take a global view, the world slump since early 2008 is as bad or worse than the slump from 1929-30. It’s full of pictures like this one, showing monthly volume of world trade:

What this says is that the world economy right now is more or less at the point Keynes described in his essay The Great Slump of 1930. What hasn’t happened — at least not yet — is any counterpart to the catastrophes of 1931: the wave of bank runs in the US, the failure of Credit Anstalt in Austria, and the great perverse response of central banks that was triggered by the death spasms of the gold standard. What Eichengreen-O’Rourke show, it seems to me, is that knowledge is the only thing standing between us and Great Depression 2.0. It’s only to the extent that we understand these things a bit better than our grandfathers — and that we act on that knowledge — that we have any real reason to think this time will be better.

196 April 6, 2009, 7:19 pm ONE MORE TIME Brad DeLong is, rightly, horrified at the great Ricardian equivalence misunderstanding. It’s one thing to have an argument about whether consumers are perfectly rational and have perfect access to the capital markets; it’s another to have the big advocates of all that perfection not understand the implications of their own model. So let me try this one more time. Here’s what we agree on: if consumers have perfect foresight, live forever, have perfect access to capital markets, etc., then they will take into account the expected future burden of taxes to pay for government spending. If the government introduces a new program that will spend $100 billion a year forever, then taxes must ultimately go up by the present-value equivalent of $100 billion forever. Assume that consumers want to reduce consumption by the same amount every year to offset this tax burden; then consumer spending will fall by $100 billion per year to compensate, wiping out any expansionary effect of the government spending. But suppose that the increase in government spending is temporary, not permanent — that it will increase spending by $100 billion per year for only 1 or 2 years, not forever. This clearly implies a lower future tax burden than $100 billion a year forever, and therefore implies a fall in consumer spending of less than $100 billion per year. So the spending program IS expansionary in this case, EVEN IF you have full Ricardian equivalence. Is that explanation clear enough to get through? Is there anybody out there?

197

JEFFREY SACHS Director of the Earth Institute, Economics Professor, Columbia University Posted April 6, 2009 | 12:38 PM (EST)

The Geithner-Summers Plan is Even Worse Than We Thought Two weeks ago, I posted an article showing how the Geithner-Summers banking plan could potentially and unnecessarily transfer hundreds of billions of dollars of wealth from taxpayers to banks. The same basic arithmetic was later described by Joseph Stiglitz in the New York Times (April 1) and by Peyton Young in the Financial Times (April 1). In fact, the situation is even potentially more disastrous than we wrote. Insiders can easily game the system created by Geithner and Summers to cost up to a trillion dollars or more to the taxpayers. Here's how. Consider a toxic asset held by Citibank with a face value of $1 million, but with zero probability of any payout and therefore with a zero market value. An outside bidder would not pay anything for such an asset. All of the previous articles consider the case of true outside bidders. Suppose, however, that Citibank itself sets up a Citibank Public-Private Investment Fund (CPPIF) under the Geithner-Summers plan. The CPPIF will bid the full face value of $1 million for the worthless asset, because it can borrow $850K from the FDIC, and get $75K from the Treasury, to make the purchase! Citibank will only have to put in $75K of the total. Citibank thereby receives $1 million for the worthless asset, while the CPPIF ends up with an utterly worthless asset against $850K in debt to the FDIC. The CPPIF therefore quietly declares bankruptcy, while Citibank walks away with a cool $1 million. Citibank's net profit on the transaction is $925K (remember that the bank invested $75K in the CPPIF) and the taxpayers lose $925K. Since the total of toxic assets in the banking system exceeds $1 trillion, and perhaps reaches $2-3 trillion, the amount of potential rip-off in the Geithner-Summers plan is unconscionably large. The earlier criticisms of the Geithner-Summers plan showed that even outside bidders generally have the incentive to bid far too much for the toxic assets, since they too get a free ride from the government loans. But once we acknowledge the insider-bidding route, the potential to game the plan at the cost of the taxpayers becomes extraordinary. And the gaming of the system doesn't have to be as crude as Citibank setting up its own CPPIF. There are lots of ways that it can do this indirectly, for example, buying assets of other banks which in turn buy Citi's assets. Or other stakeholders in Citi, such as groups of bondholders and shareholders, could do the same. Several news stories suggest some grounding for these fears. Both Business Week and the Financial Times report that the banks themselves might be invited to bid for the toxic assets, which would seem to set up just the scam outline above. What is incredible is that lack of the most minimal transparency so far about the rules, risks, and procedures of this trillion-dollar plan. Also incredible is the apparent lack of any oversight by Congress, reinforcing the sense that the fix is in or that at best we are all sitting ducks. The sad part of all this is that there are now several much better ideas circulating among experts, but none of these seems to get the time of day from the Treasury. The best ideas are

198 forms of corporate reorganization, in which a bank weighed down with toxic assets is divided into two banks -- a "good bank" and a "bad bank" -- with the bad bank left holding the toxic assets and the long-term debts, while owning the equity of the good bank. If the bad assets pay off better than is now feared, the bondholders get repaid and the current bank shares keep their value. If the bad assets in fact default heavily as is now expected, the bondholders and shareholders lose their investments. The key point of the good bank -- bad bank plans is an orderly process to restore healthy banking functions (in the good bank) while divvying up the losses in a fair way among the banks' existing claimants. The taxpayer is not needed for that, except to cover the insured part of the banks' existing liabilities, specifically the banks' deposits and perhaps other short-term liabilities that are key to financial market liquidity. Cynics believe that the Geithner-Summers Plan is exactly what it seems: a naked grab of taxpayer money for Wall Street interests. Geithner and Summers argue that it's the least bad approach to a messy situation, in which we need to restore banking functions but don't have any perfect ways to do that. If they are serious about their justification, let them come forward to confront their critics and to explain to the American people why the other proposals are not being pursued. Let them explain the hidden and not-so-hidden risks to the American taxpayer of the plan that they have put forward. Let them explain why they are so intent on saving the banks' bondholders, even the long-term unsecured creditors who clearly knew they were taking market risks in buying Citibank bonds. Let them work with their critics to fashion a less risky and less costly plan. So far Geithner and Summers tell us that their plan is the only option, but without a word of further explanation as to why. http://www.huffingtonpost.com/jeffrey-sachs/the-geithner-summers-plan_b_183499.html

ft.com/economistsforum April 6, 2009 12:18pm The Geithner-Summers plan is worse than you think By Laurence J Kotlikoff and Jeffrey Sachs The Geithner-And-Summers Plan (GASP) to buy toxic assets from the banks is rightly scorned as an unnecessary give-away by virtually every independent economist who has looked at it. Its only friends are the Wall Street firms it is designed to bail out. In an article last month, one of us (Sachs, FT, March 23) described the systematic overbidding entailed by the proposal. Others have since made similar calculations, including Joseph Stiglitz (NYT, April 1) and Peyton Young (FT, April 1). The situation is even worse that it looks, however, since the GASP can be gamed by the banks that own the toxic assets to boost the purchase prices for their bad assets even higher than has been suggested to date. Suppose that Citibank holds $1bn face value of toxic assets that will pay $1bn with 20 per cent probability and $200m with 80 per cent. The market value is $360m. The GASP calls on investors to establish a Public-Private Investment Fund (PPIF) to bid for the toxic assets. For each $1 that a private investor brings in equity to the PPIF, the Treasury will put in another $1, and then the FDIC will leverage the $2 in equity with $12 of non-recourse loans (6-to-1 leverage). It’s easy to show that a risk-neutral and arms-length PPIF will bid $636m, financed with an Federal Deposit Insurance Corporation loan of $545m, Treasury equity of $45m and private equity of $45m. (The expected profit to the private investor is one-half of 20 per cent of $1bn minus $545m, or $45m. The private investor therefore has a net expected profit of zero.) The

199 PPIF overpays by $276m, which equals the expected loss to the Treasury. The ultimate beneficiaries are Citibank’s shareholders and bondholders, whose net worth rises by $276m at the taxpayers’ expense. But the outcome could be even more outrageous than this. Citibank can arrange to receive even more than $636m for its assets by setting up its own Citibank PPIF (CPPIF) to bid for its bad assets. The CPPIF will bid the full $1bn in face value for its own toxic assets! To see this, note that on a bid of $1bn by the CPPIF, Citibank would finance $71m in equity of the CPPIF, the Treasury would add another $71m in equity, and the FDIC would add $857m in loans to the CPPIF. The CPPIF will either break even (20 per cent of the time), or go bankrupt (80 per cent of the time). The CPPIF is therefore a washout - with no chance of profits, yet also zero liability. On the other hand, Citibank gets a sure boost of $1bn minus $360m, or $640m in net worth, for which it pays $71m. Citibank’s gain from the CPPIF’s overbidding is $569m, which exactly equals the taxpayer’s expected loss that is incurred by the FDIC loan and Treasury equity. The real icing on the cake is that Citibank still ends up owning the toxic assets even after the assets are “auctioned,” but this time in an off-balance-sheet structured investment vehicle called the CPPIF. The toxic assets revert to the FDIC when the CPPIF goes bankrupt. It’s possible that some fine print of the GASP would try to preclude explicit hyper-self- dealing of the type just described. But when there is free money on the ground, Wall Street will figure out ways to pick it up. For example, Citibank could arrange to overpay Bank of America for some unrelated securities in exchange for having Bank of America do its bidding at the auction. Indeed, Citibank, Bank of America, and other toxic asset owners might join together in a consortium to finance an “arms-length” PPIF on favorable terms with the proviso that the PPIF bid for the toxic assets of the consortium. BusinessWeek has reported that “Administration officials confirm Treasury may allow such seller financing. The sad part of all of this is that there are excellent alternatives to the GASP that are vastly more transparent and cheaper for the taxpayers. The best of these involves separating a weak bank like Citibank into a “Good Citibank” that holds Citibank’s good assets and its deposits, and a “Bad Citibank” that holds the toxic assets, the bondholder debt, and the shares of the Good Citibank. The Good Citibank returns quickly to normal business, while the Bad Citibank is eventually liquidated under bankruptcy, with the bondholders and other uninsured claimants getting partial repayments depending on their priority under bankruptcy. The best description of this approach is by Jeremy Bulow and Paul Klemperer. Over time, we should consider more fundamental reforms, including the idea of establishing Limited Purpose Banking, in which the liquidity services provided by banks are undertaken by institutions with 100 per cent reserve requirements, and which, therefore, are immune from runs, panics, and reckless gambles. It would be absurd and self-defeating to bear the enormous social costs of the current financial crisis only to return to the same kind of flawed banking institutions that got us into this mess. The Geithner-and-Summers Plan should be scrapped. President Obama should ask his advisors to canvas the economics and legal community to hear the much better ideas that are in wide circulation. Laurence J. Kotlikoff is professor of economics at Boston University. Jeffrey Sachs is professor of economics at Columbia University and director of the Earth Institute.

200 Apr 7, 2009 Stress Tests Underway: Analysts Predict Depression Scenario For Banks

Overview: Stress test results are expected by the end of April. Banks then have six months to raise private capital if found to be undercapitalized. Meanwhile, Treasury plans to have the PPIP for toxic assets in place in order to facilitate the quest for private shareholder capital (application deadline extended to April 24) before government injects preferred shares. Critics of the stress tests say that the Treasury's stress scenario looks more like the unfolding baseline scenario. o Eichengreen/ O'Rourke (Vox): The world economy is now plummeting as it did in the Great Depression; indeed, world industrial production, trade and stock markets are diving faster now than during 1929-30. Fortunately, the policy response to date is much better. Wether this will be enough to make a difference we'll see. o April 6, Mike Mayo (via Bloomberg): Loan losses may exceed Great Depression levels and the government may be forced to take over large lenders. “New government actions might not help as much as expected, especially given that loans have been marked down to only 98 cents on the dollar, on average.”--> FASB Eases Mark-To-Market Rules For Toxic Assets: Will Banks Prefer To Keep Them? o cont.: Mayo said he expects loan losses to increase to 3.5 percent, and as high as 5.5 percent in a stress scenario, by the end of 2010. The highest level of loan losses in the Great Depression was 3.4 percent in 1934, according to the report. In the 3.5% loss rate scenario, Mr. Mayo said banks will lose between $600 billion and $1 trillion over the next three years, more than the roughly $400 billion in write-downs they've taken on risky investments. o cont.: Mortgage-related losses are about halfway to their peak, while credit-card and consumer losses are only a third of the way to their expected highest levels, according to Mayo--> IMF To Boost Loss Estimate On U.S. Originated Assets To $3.1 Trillion From $2.2 Trillion In January o Among the banks Mr. Mayo rates "underperform" are: Bank of America Corp., Citigroup Inc., Comerica Inc., J.P. Morgan Chase & Co., PNC Financial Services Inc. and Wells Fargo & Co. An "underperform" rating means the stock is expected to perform up to 10% worse than the broader market over the next year. o cont.: The U.S. government cannot provide much relief because its actions will lead to either banks having to raise new capital or toxic assets remaining on banks’ balance sheets. Solutions to the banking crisis will take time, as the increase in risk happened over a decade or more.

201 o cont.: "Nationalization of banks remains a possibility because government policy remains unclear." o cont.: The "seven deadly sins" of banking include greedy loan growth, gluttony of real estate, lust for high yields, sloth-like risk management, pride of low capital, envy of exotic fees, and anger of regulators. o April 6, Meredith Whitney: Banks will continue to write down their mortgage assets as home prices decline further than lenders expected. The unemployment rate also has exceeded banks’ projections and could lead to further loan losses o March 30: Bank stocks plunge as Geithner says that some banks will need “large amounts” of assistance o March 25 FT Guha/Guerrera: The government’s toxic assets plan will force banks such as Citigroup, Bank of America and Wells Fargo to take large writedowns on their loans, requiring them to raise more capital from taxpayers or investors, executives and analysts have warned--> see Geithner presents new insolvency regime for holding companies and non-banks o March 20 Greenspan (via Bloomberg): “Restoration of normal bank lending will require a very large capital infusion from private or public sources.” The need is “north of $750 billion” and can’t be met just from banks’ cash flows, he said. o March 13 IRA (Whalen): "Remember that the maximum probably loss ("MPL") shown in The IRA Bank Monitor for the top US banks with assets above $10 billion, also known as Economic Capital, is a cash number representing the amount of incremental capital the banks may require to absorb the losses from a 3-4 standard deviation economic slump, such as the one we have today. If you include the subsidy required for the GSEs and AIG, the US Treasury could face a collective funding requirement of $4 trillion through the cycle. Do Ben Bernanke and Tim Geithner really believe that they can sell such a program to the Congress? To put it in perspective, the $250 billion in the Obama Budget for additional TARP funds will not quite cover Citigroup" o Feb 25 DealBook: Stress Test specifics: the government appears to be aiming for banks to have a Tier 1 (=common stock, preferred stock and hybrid debt-equity instruments) capital ratio of 6% and a total common equity ratio of 3%. These are the baseline amounts and could be increased depending on how the financial markets react going forward. o Feb 22 WSJ: As part of those stress tests, the Federal Reserve is expected to dwell on the 'tangible common equity' (TCE) measurement as a gauge of bank health. Bankers and regulators generally prefer to use what is known as “Tier 1″ ratio of a bank’s capital adequacy. o cont.: By Tier 1 measurements, most big banks, including Citigroup, appear healthy. Citigroup’s Tier 1 ratio is 11.8%, well above the level needed to be classified as well- capitalized. By contrast, most banks’ TCE ratios indicate severe weakness. Citigroup’s TCE ratio stood at about 1.5% of assets at Dec. 31, well below the 3% level that investors regard as safe.--> see Hybrid Capital All But Discredited o DealBook: If Citigroup and Bank of America are forced to dole out common stock to get to the 3 percent level, the government could end up owning 59 percent of Citigroup and 19 percent of Bank of America, according to BreakingViews’ nationalization calculator. That is a whole lot more than the maximum 40 percent ownership stake of Citi that has been talked about in Washington.

202 o Feb 25 Treasury: Regulators set a six-month deadline for the biggest 19 U.S. banks to raise any new capital deemed necessary after a review of their balance sheets. The regulators will complete their so-called stress tests by the end of March (now April). Banks with less than $100 billion of assets will also be eligible to participate in the Treasury’s new capital-raising plan. o Feb 24 Ben Bernanke: The Treasury will buy convertible preferred stock in the 19 largest U.S. banks if stress tests determine they need more capital to weather a deeper-than- forecast recession. The shares would be converted to common equity stakes only as extraordinary losses materialize, stress tests are no pretext to nationalize banks. While the U.S. government may take “substantial” stakes in Citigroup Inc. and other banks, it doesn’t plan a full-scale nationalization that wipes out stockholders. o Feb 23: Joint statement: Stress Tests begin February 25. In case of undercapitalization try private capital first. Afterwards, "any government capital will be in the form of mandatory convertible preferred shares, which would be converted into common equity shares only as needed over time to keep banks in a well-capitalized position and can be retired under improved financial conditions before the conversion becomes mandatory." As details about the current legacy loan valuations on banks' books emerge, doubts increase about the viability of matching buyer and seller interest without a huge subsidy--> Sifting Through Past FDIC Troubled Asset Auctions: Average 56 Cents on Dollar Value Implies Additional $1 Trillion Writedowns. The public and Congress are increasingly concerned about too many incentives to private investors, whereas Treasury has only $50bn in TARP money left after PPIP and TALF to make it work without resorting to Congress or nationalization--> see Are Banks To Buy Toxic Assets From Each Other?

203 06.04.2009 KEYNES' SAVINGS PARADOX, FISHER'S DEBT DEFLATION AND THE BANKING CRISIS By: Paul de Grauwe

The world economy is experiencing a downward spiral in output and international trade that has not been seen since the Great Depression of the 1930s. The most striking feature of this downward spiral is the breathtaking speed at which industrial production, world trade and GDP is declining in the world since the end of 2008. How can such a rapid deceleration of economic activity be explained? The answer has to do with different deflationary spirals that feed on themselves and amplify each other. Four deflationary spirals There are four deflationary spirals presently at work in the world economy, i.e. the Keynesian savings paradox, Fisher’s debt deflation, the cost cutting deflation, and the bank credit deflation. Each of these deflationary spirals can be dealt with when they occur in isolation. They become lethal when they interact with each other. Keynesian savings paradox. When one individual desires to save more, and he is alone to do so, his decision to save more (consume less) will not affect aggregate output. He will succeed to save more, and once he has achieved his desired level of savings he stops trying to save more. When the desire to save more is the result of a collective lack of confidence (animal spirits) the individual tries to build up savings when all the others do the same. As a result, output and income decline and the individual fails in his attempt to increase savings. He will try again, thereby intensifying the decline in output, and failing again to build-up savings. There is thus a coordination failure: if the individuals could be convinced that their attempts to build up savings will not work when they all try to do it at the same time, they would stop trying, thereby stopping the downward spiral. Somebody must organize the collective action. An individual agent will not do this because the cost of collective action exceeds his private gain. Fisher’s debt deflation: When one individual tries to reduce his debt, and he is alone to do so, this attempt will generally succeed. The reason is that his sales of assets to reduce his debt will not be felt by the others, and therefore will not affect the solvency of others. The individual will succeed in reducing his debt. When the desire to reduce debt is driven by a collective movement of distrust, the simultaneous action of individuals to reduce their debt is self-defeating (Fisher(1933)).

204 They all sell assets at the same time, thereby reducing the value of these assets. This leads to a deterioration of the solvency of everybody else, thereby forcing everybody to increase their attempts at reducing their debt by selling assets. Here also there is a coordination failure. If individuals could be convinced that their attempts to reduce their debt will no work when they all try to do this at the same time, they would stop trying and the deflationary cycle would also stop. An individual, however, will have no incentive to organize such a collective action. Cost cutting deflation When one individual firm reduces its costs by reducing wages and firing workers in order to improve its profits, and this firm is alone to do so, it will generally succeed in improving its profits. The reason is that the cost cutting by an individual firm does not affect the other firms. The latter will not react by reducing their wages and firing their workers. When cost cutting is inspired by a collective movement of fear about future profitability the simultaneous cost cutting will not restore profitability. The reason is that the workers who earn lower wages and the unemployed workers who have less (or no) disposable income will reduce their consumption and thus the output of all firms. This reduces profits of all firms. They will then continue to cut costs leading to further reductions of output and profits. There is again a coordination failure. If firms could be convinced that the collective cost cutting will not improve profits they would stop cutting their costs. But individual firms have no incentives to do this. Bank credit deflation: When one individual bank wants to reduce the riskiness of its loan portfolio it will cut back on loans and accumulate liquid assets. When the bank is alone to do so (and provided it is not too big), it will succeed in reducing the riskiness of its loan portfolio. The reason is that the strategy of the bank will not be felt by the other banks, which will not react. Once the bank has succeeded in reducing the riskiness of its loan portfolio it will stop calling back loans. When banks are gripped by pessimism and extreme risk aversion the simultaneous reduction of bank loans by all banks will not reduce the risk of the banks’ loan portfolio. There are two reasons for this. First, banks lend to each other. As a result when banks reduce their lending they reduce the funding of other banks. The latter will be induced to reduce their lending, and thus the funding of other banks. Second, when one bank cuts back its loans, firms get into trouble. Some of these firms buy goods and services from other firms. As a result, these other firms also get into trouble and fail to repay their debt to other banks. The latter will see that their loan portfolio has become riskier. They will in turn reduce credit thereby increasing the riskiness of the loan portfolio of other banks. There is again a coordination failure. If banks could be convinced that the simultaneous loan cutting does not reduce the risk of their loan portfolio they would stop cutting back on their loans and the negative spiral would stop. They have no individual incentives, however, to engage in collective action. The four deflationary spirals that we described have the same structure. The actions by economic agents create a negative externality that makes these actions self-defeating. This spiral is triggered by a collective movement of fear, distrust or risk aversion (animal spirits; see Akerlof and Shiller(2009) for a fascinating analysis). Individuals (savers,

205 firms, banks) are unable to internalize these externalities because collective action is costly. There is thus a failure to coordinate individual actions to avoid a bad outcome. Cyclical movements in optimism and pessimism (animal spirits) have always existed. Why do these now lead to such a breakdown of coordination? The four deflationary spirals we identified, although similar in structure, are different in one particular dimension. The savings paradox and the cost deflation can be called “flow deflations”. They arise because consumers and firms want to change a flow (savings and profits). The other two involve the adjustment of stocks (the debt levels and the levels of credit). We call them “stock deflations”. Problems arise when the flow and stock deflations interact with each other. In “normal” recessions such as the ones we have experienced in the postwar period prior to the present crisis, only the flow deflations were in operation. There had not been a preceding period of excessive debt accumulation and unsustainable levels of bank loans. As a result, households, firms and banks were not trying to adjust their balance sheets. The pessimism of households and firms was related to expected shortfalls in income and profits, and led to increased savings and cost cutting. In such an environment in which the stock levels were perceived to be right, there were sufficient automatic equilibrating mechanisms that prevented these two flow deflations from leading to an unstoppable downward spiral. The most important equilibrating mechanism occurred through the banking system. When banks function normally they have a stabilizing force on the business cycle. The reason is that in a recession the central bank typically reduces the interest rate making it easier for banks to lend. In normal circumstances, when banks are not in the process of cleaning up their balance sheets, they will be willing to transmit this interest rate decline into a reduction of the loan rate. As a result, banks will engage in automatic “distress lending” to firms and households. Households will be less tempted to increase their savings. In addition, private investment by firms will be stimulated, i.e. firms will be willing to dissave, thereby mitigating the deflationary potential provoked by the savings paradox. (In De Grauwe(2009) I show this in the context of a simple IS-LM analysis). The interest rate decline will also mitigate the cost cutting dynamics. This is so because it improves the profit outlook for firms, giving them lower incentives to go on cutting costs. Thus when the banking system functions normally, there are self-equilibrating mechanisms that prevent the flow deflations from degenerating into uncontrollable downward spirals. The problem the world economy faces today is that flow and stock deflations interact and reinforce each other. The period prior to the crisis was one of excessive buildups of private debt and banks’ assets. The result of these excessive buildups of private debt and balance sheets is that the stock deflation processes described in the previous section operate with full force. As a result, the equilibrating mechanism that exists in normal recessions does not function. The lower interest rates engineered by central banks are not transmitted by the banking sector into lower loan rates for consumers and firms. In addition, we now are confronted by the interaction of the flow and stock deflations. This interaction amplifies these deflationary processes. This interaction, which is especially strong in the US, can be described as follows. Because of excessive debt accumulation of the past, households desire to reduce their debt levels. Thus they all attempt to save more. As argued earlier, these attempts are self-defeating. As a result, households fail to save more, and thus fail to reduce their debt. This leads them to increase their attempts to save more. The fact that the banks do not pass on the lower deposit rates into lower loan

206 rates makes things worse. There are no incentives for firms to increase their investments (no dissaving). Nothing stops the deflationary spiral. The interaction goes further. The deteriorating conditions in the “real economy” feed back on the banking system. Banks’ loan portfolios deteriorate further as a result of increasing default rates. Banks reduce their lending even further, etc. In De Grauwe(2009) it is shown that a banking sector that is in the grips of credit deflation and deleveraging can destabilize the economy and can push the economy into a true deflationary spiral. The irrelevance of modern macroeconomics Modern macroeconomics as embodied in Dynamic Stochastic General Equilibrium models (DSGE) is based on the paradigm of the utility maximizing individual agent who understands the full complexity of the world. Since all individuals understand the same “Truth”, modern macroeconomics has taken the view that it suffices to model one “representative individual” to fully represent reality. Thus as a consumer the agent continuously maximizes an intertemporal utility function and is capable of computing the implications of exogenous shocks on his optimal consumption plan, taking full account of what these shocks will do to the plans of the producers. Similarly, producers compute the implications of these shocks on their present and future production plans taking into account how consumers react to these shocks. Thus in such a model coordination failures cannot arise. The representative agent fully internalizes the external effects of all his actions. When shocks occur there can be only one equilibrium to which the system will converge, and agents perfectly understand this (Woodford(2009)). Deflationary spirals as we have described them in the previous sections cannot occur in the world of the DSGE-models. The latter is a world of stable equilibria. It will not come as a surprise that DSGE-models have not produced useful insight allowing us to understand the nature of the present economic crisis. Yet vast amounts of intellectual energies are still being spent on the further refining of DSGE-models. Collective action to stop the deflationary spirals The common characteristic of the different deflationary spirals is a coordination failure. The market fails to coordinate private actions towards an attractive collective outcome. This market failure can in principle be solved by collective action. Such a collective action can only be organized by the government. Let us analyze what this collective action must be to deal with the different forms of deflation. The key to economic recovery is the stabilization of the banking sector. As argued earlier, a banking sector that is in the grips of credit deflation and deleveraging can destabilize the economy and can push the economy into a true deflationary spiral. There is no secret about how the bank credit deflation can be stopped. Here are the principles (see Hall and Woodward(2009) for a more detailed analysis). First, bad loans should be separated from good loans, putting the former in separate entities (“bad banks”) to be managed by specialized management teams whose responsibility it is to dispose of these assets. Losses on these bad assets are inevitable, and so is the inevitability that the taxpayer will be asked to foot the bill. The good loans remain on the balance sheet of the “good bank”. The hope is that this good bank, freed as it is from the toxic assets, will feel liberated and will be willing to take more risk so that the credit flow can start again. One can doubt, however, that a privately run good bank will have sufficient incentives to start lending again. The reason

207 is that extreme risk aversion and a desire to “save the skin” of the shareholders will restrain the managers of the good bank in extending loans. If that is what the managers of the good bank do, the bank credit deflation process described earlier will not stop. This leads to the issue of whether it is not desirable to (temporarily) nationalize the good bank. Such nationalization would take away the paralyzing fear that new bank loans put the bank’s capital (and its shareholders) at risk. There is a second reason why the government may want to temporarily nationalize the good bank. The bad bank – good bank solution carries the risk of socializing the losses while privatizing the profits. Indeed, the losses of the bad bank will necessarily be borne by the taxpayers. If the good bank remains in private ownership the expected future profits will be handed out to the shareholders. But these profits will be realized only because the toxic assets have been separated and the losses on these assets have been borne by taxpayers. It is therefore more reasonable to make sure that these future profits are given back to the taxpayers. The resolution of the bank crisis along the lines discussed in the previous paragraphs is a necessary condition for the recovery. It will also make the use of other macroeconomic policies easier and more effective. These other macroeconomic policies must be geared towards resolving the other deflationary processes. Let us discuss these consecutively. The Keynesian savings paradox The collective action failure implicit in the Keynesian savings paradox calls for the government to do the opposite of what private agents do, i.e. to dissave. Dissaving by the government is a necessary condition for making it possible for private consumers to succeed in their attempts to save more. A well-functioning banking sector reduces the need for dissaving by the government. When the banking sector works well, the consumers’ attempts to save more leads to a lower interest rate and induces firms to invest more (they dissave). As a result, the required dissaving by the government is reduced correspondingly. Fisher’s debt deflation Government action is required to solve the coordination failure implicit in the debt deflation process. This can be done by taking over private debt and substituting it with government debt. In doing so, the government makes it possible for the private sector to reduce its debt level. The private sector will then stop attempting (unsuccessfully) to reduce its debt level. The debt deflation process can stop. The issue that arises here is whether the substitution of private by government debt will not lead to unsustainable government debt levels. There are two aspects to this issue. Let us first look at the debt levels of the public and private sectors in the eurozone. These are shown in figure 1. The most remarkable feature of this figure is how low the government debt is relative to private debt. In addition, the government debt is the only one that has declined (as a percent of GDP) during the last 10 years. This contrasts with the debt of households and especially the debt of financial institutions that has increased significantly and that stood at 250% of GDP in 2008. This is three times higher than the debt of the government which stood at approximately 70%. We conclude that more than the public debt, the private sector’s debt has become unsustainable. The process of substitution of private debt by public debt can go on for quite some time before it reaches the levels of unsustainability of the private debt. Figure 1

208

Source: European Commission The second dimension to the sustainability issue of government debt arises from the question of what will happen in the absence of a government takeover of the private debt. The answer is that in that case the debt deflation process is not likely to stop soon. As a result, output and income are likely to go down further. This will negatively affect tax revenues and will increase future budget deficits, forcing governments to increase their debt. Refusing to stop the debt deflation dynamics by issuing government debt today will not prevent the government debt from increasing in the future. The same problem of sustainability of the government debt will reappear. To conclude it is useful to formulate a methodological note. The effectiveness of fiscal policies has been very much analyzed by economists. It appears from the empirical evidence that fiscal policy is limited in its effect to boost the economy. This evidence, however, is typically obtained from equilibrium models estimated during “normal” business cycle movements (see e.g; Wieland(2009), Cogan, et al. (2009)). In the context of the flow and stock deflations that are disequilibrium phenomena and that at the core of the present economic downturn, fiscal policy becomes an instrument to stabilize an economy that otherwise can become unstable. This feature is absent from modern macroeconomic models that are intrinsically stable. The evidence obtained from these models may not be very relevant to gauge the effectiveness of fiscal policies in the present context. Paul de Grauwe is professor of economics, Catholic University of Leuven.

209 References Akerlof, G., and Shiller, R., (2009), Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism, Princeton University Press, 264pp. Cogan, J, Tobias, C, Taylor, J, and Wieland, V., (2009), “New Keynesian versus Old Keynesian Government Spending Multipliers”, CEPR Discussion Paper 7236, March 2009. De Grauwe, P. (2009), Keynes’ Savings Paradox, Fisher’s Debt Deflation and the Banking Crisis, http://www.econ.kuleuven.be/ew/academic/intecon/Degrauwe/PDG- papers/Work_in_progress_Presentations/Flow-Stock%20Deflations.pdf Fisher, I, (1933), The Debt-Deflation Theory of Great Depressions, Econometrica, 1, October, pp. 337-57. Hall, R., and Woodward, S., (2009), The right way to create a good bank and a bad bank, www.voxeu.org/index.php Minsky, H., (1986), Stabilizing an Unstable Economy, McGraw Hill, 395pp. Wieland, V., (2009), The fiscal stimulus debate: “Bone-headed” and “Neanderthal”? http://www.voxeu.org/index.php?q=node/3373 Woodford, Michael (2009), “Convergence in Macroeconomics: Elements of the New Synthesis”, American Economic Journal: Macroeconomics, Vol. 1, No. 1, 267-279 http://www.eurointelligence.com/article.581+M5a44f3fb3ec.0.html

210 06.04.2009 THE CONSEQUENCE OF GLOBAL CO- ORDINATION FAILURE By: Wolfgang Münchau For the first time since the crisis erupted two years ago, global leaders went a few millimetres beyond what was expected of them. The decision by the Group of 20 developed and emerging nations to commit $1,100bn in new funds for international institutions is no doubt substantial. It will allow the International Monetary Fund to deal with the current and future torrent of balance of payment crises more effectively. But the London summit comprehensively failed to do what it set out to do. Not one of its resolutions will move the world a small step closer to resolving the global economic crisis. As world leaders return home, they will be confronted by the reality of the decisions they have not taken. They will return to economies in which bankruptcies and unemployment are about to rise to the highest levels since the Great Depression. They will face an outraged public that seeks to exact revenge on bankers and banks. The longer they wait, the harder it will be to take the needed decisions. Many of those decisions, such as the recapitalisation of the global banking system, will become a lot more expensive, and politically difficult, if we procrastinate while the economy deteriorates further. The forward looking indicators do not tell us the situation is getting better. US house prices are down 30 per cent, and have further to fall. Countries with large current account deficits are cutting consumption of imported goods. One of the results will be that the combined export surpluses of Japan, China, and Germany will shrink dramatically. World trade has been collapsing faster than during the Great Depression. The monetary indicators are also absolutely awful. In Europe, both real and nominal growth of M3http://www.ft.com/cms/s/0/819e1b8a-1572-11de-b9a9-0000779fd2ac.html, a broad measure of money, is falling on a month-by-month basis – with no turnround in sight. Whether you look at this as a Keynesian or a monetarist, you come to the same conclusion: the world economy is in serious trouble. The monetary authorities are close to having exhausted their ammunition. Money market interest rates are close to zero almost everywhere – and that includes the eurozone. We are now all moving towards what the Federal Reserve calls credit easing, a policy designed to alleviate bottlenecks in specific pockets of the credit market. The US and UK have adopted those policies, and the eurozone will follow suit with some delay. It will probably happen next month. And then what? Not much, actually. Governments are now in a wait-and-see mode – wait until those existing stimulus packages kick in, and see how the economy responds. The US administration will wait until the public-private partnership, proposed by Tim Geithner, the US Treasury secretary, takes off. It will see how fast and effective the programme to buy “legacy assets” from US banks turns out to be. Chances are that it will succeed on its

211 own limited terms, but it will not solve the problem of an undercapitalised banking sector. And US taxpayers may not like the idea that they are spending billions of dollars and have not saved the banks. I would expect that, as we return from the summer holidays, governments will start to discuss a new round of stimulus and bank rescue packages. The politics of bank rescue are toxic. A former European finance minister reminded me that, from a political perspective, there is nothing in it for a rational politician. Handing over hundreds of billions of euros to the banks is akin to political suicide, no matter how you do this. But this only makes the need for co-ordinated global policy action even stronger. If you undertake this gargantuan political act while others are not, you bear all the political costs and reap none of the benefits. Bank rescue is a task that will test even the most gifted political orator. The best way to do it is as part of a global effort. The public would only accept it if it believes there is a realistic chance that the aid will solve the problem and in return they will insist on a minimal degree of fairness. The real problem with the US bank rescue plan is that it may exhaust the public’s sense of fair play. The G20 summit has ducked the important question of bank rescue beyond a few meaningless and self-congratulatory statements. Instead, our leaders showed more interest in future crises than in the current one. But the probability that another crisis may break out soon, is inversely related to the length and depth of this one. The longer this crisis lasts, the more absurd the G20’s order of priorities will seem. If the crisis shows no sign of ending in the autumn, our great leaders may gather for another desperate summit, in another city, facing another set of protesters, producing yet another series of desperate but ineffective pledges to save the world economy, embedded in another pretentious communiqué. The London summit has shown us what “We, the leaders of the Group of Twenty” can do, and what they cannot. The G20 has shown that it can fix international institutions, but not the biggest economic crisis in our lifetime.

212 Apr 6, 2009 Are Banks To Buy Toxic Assets From Each Other? Overview: In order to persuade the private sector to participate in the PPIP, the government is engineering solutions that sidestep the strings attached to direct government aid, in particular executive pay restrictions. Moreover, reports show that banks are planning to bid on each other's assets to drive up the price and take advantage of the subsidies, wheile the FDIC is mulling to let banks share in any upside if they participate in the program as Treasury wants to keep participation voluntary. Increasingly, questions arise about the legality of this approach starting with AIG's full bailout of counterparties with taxpayer money. Given the limited TARP buffer left ($150bn before PPIP) and likely Congressional opposition to new TARP money, the administration is under pressure to restore the banking system with the help of private capital if it wants to avoid anything resembling nationalization. This puts Wall Street in a position to dictate the terms. o WaPo: Private investors said that they would not help the government buy toxic assets from banks if the congressional restrictions were applied to them. And every major provider of small-business loans has said that it will not participate in the government's program if it has to surrender ownership stakes to the government or submit to executive- pay limits--> administration plans to set up SPV to sidestep Congressional regulations. o FT: Banks plan to bid on each others assets in order to take advantage of favorable terms-- > Bebchuk: PPIP needs additional safeguards to protect the taxpayer from overpaying through the generous guarantees provided to the private sector. o Sachs, Stiglitz, Sinn: No wonder the stock market rallied upon the PPIP announcement. This is not the most efficient use of taxpayer money and it won't get lending flowing again. The proper approach is to put lenders unable to raise private capital for certain amount of time under conservatorship and then divest the toxic assets at market prices over time while reselling the good bank back to the markets in order to resume lending. o Lex: Cue the outrage. Kickstarting the market for these assets so that all banks benefit is not an unfortunate side-effect; it is the aim of the plan. A certain incestuousness is unavoidable. And rebuilding the financial system requires the active engagement of its component parts, even those that caused the trouble in the first place. o Simon Johnson: The big banks are essentially making themselves “too politically toxic to rescue,” and this has potentially bad macroeconomic consequences. So what will Bernanke do? As he sees the world, there is only one course of action remaining: Print money and hope for a moderate degree of inflation. However, if inflation depends on the output gap, just creating inflation might be a difficult thing to do. On the other hand, the oil price spike in early 2008 shows that inflationary spikes are certainly a possibility.

213 COLUMNISTS: GillianTett A CHANCE FOR BANKERS TO REFOCUS THEIR TALENTS By Gillian Tett Published: April 6 2009 19:52 | Last updated: April 6 2009 19:52 A few weeks ago, some science and engineering students at London University lobbed me a question. “Lots of people on our course used to go to work for banks, but now that seems a really bad idea, so where do you think the job opportunities will be in the future for graduates like us?” Where indeed? It is a question of great import right now – not just for current students but for policymakers across the western world. Until three years ago, smart, numerate students took it for granted that one of the fastest ways to become rich and successful was to dive into the world of complex finance, producing structures such as collateralised debt obligations (CDOs). Now, however, those CDO dreams have crumbled. By late last year, large western banks had shed more than 125,000 jobs. Thousands more have gone since then, many in high finance. The betting in the management consultancy industry (which is cutting back too) is that some 300,000 global jobs linked to banking could vanish before the crisis ends. That is striking, given that the City of London was thought to employ some 350,000 financial workers two years ago. An entire financial army, in other words, is being demobilised – of all ages and ranks. Some optimists (and students) hope the trend will be temporary in nature. History, however, suggests otherwise. Take a look, for example, at some fascinating recent research by Thomas Philippon and Ariell Reshef, two US-based economists, on human capital and wage trends in the 20th century banking and non-banking worlds. This analysis suggests that between the 1930s and early 1980s, pay and skill levels in finance were roughly comparable to those in the rest of the business and professional world. However, from the early 1990s, pay and skill levels soared until by 2006 bankers were earning 1.7 times what other comparable business employees took home. No wonder graduates flocked to finance. But – more interestingly – the research also shows that an almost identical rise in the wage and skill levels of finance workers relative to other business spheres was also seen in the 1920s. It was only in the late 1930s, or after the Wall Street crash, that banking pay and skills fell to levels comparable with other industries (where they stayed for almost five decades). That has two intriguing implications. First, it suggests that the ability of finance to attract smart graduates this decade had little to do with the inherent challenge of the technology of modern finance. After all, CDOs – and “rocket scientists” – did not exist in the 1920s. Instead, Philippon blames extreme deregulation, or a bubble. But second, the data also suggest that if history now repeats itself – i.e. banking becomes a tightly regulated, low-margin business – then the relative skills and pay of bankers could stay

214 low for years. The next decade, in other words, could look like the 1950s or 1960s, when bankers’ remuneration differed little from everyone else’s. That might horrify financiers. But it may also carry some seeds of hope. After all, if finance no longer keeps monopolising the brightest and best workers, some of that talent could be diverted into other, more productive, arenas – for the good of the economy. Some of those financiers now being “demobbed” – or sacked – have strong science or engineering backgrounds, and are sitting on spare capital. In an ideal world, they would be perfect candidates to support manufacturing, information technology or other high-tech start- ups of the kind that Europe in particular so desperately needs. America, for its part, is also short of engineers. The Society of Manufacturing Engineers, for example, calculates that while the country needs 100,000 engineering graduates a year, it is only producing some 70,000. The SME itself points out in a new advertising campaign aimed at students: “Engineers create real wealth by solving problems rather than creating ‘paper’ wealth by playing with the markets.” The public sector in both America and Europe could also benefit from an influx of highly skilled, financially astute managers. Expanding the talent base of the regulators, in particular, would seem one obvious place to start. The non-profit and educational sectors also need more smart, highly skilled workers, particularly (but not exclusively) in places such as the UK. Will these redeployments of talent actually happen? It is still far too early to tell. A few sectors of the economy are already trying to ride the wave. In the City of London, a campaign has been launched to persuade former bankers to become physics teachers. In New York, the mayor’s office is also developing programmes to retrain Wall Street workers. But thus far, such efforts remain disappointingly sporadic. Most policymakers remain keener to bash bankers than to consider how to use them in an economically rational way. Some shell-shocked bankers, for their part, seem to prefer to sit on the beach, hoping – foolishly – that the current cull is simply temporary in nature. But the science students who asked me that jobs question, at least, are already voting with their feet. One of them (bravely) says that he still hopes to be a banker. Most of his classmates, though, are looking for jobs in science or industry (working with “green technology” is apparently now ultra-hip, just as derivatives used to be). Fingers crossed that they succeed – not just for the sake of their own careers, but the health of the wider economy, too. * www.nber.org/papers/w14644.pdf

The writer is the FT’s capital markets editor

215 naked capitalism MONDAY, APRIL 6, 2009 Deutsche Analyst: High Yield Defaults to Reach 53% Over Next Five Years Note that the 53% cumulative default rate for junk bonds over the next five years foreseen by Deutsche Bank analyst Jim Reid is nearly twice the level forecast by Moodys of 29%, It is also well in excess of the rate during the S&L crisis, which produced a nasty but comparatively short recession. From Bloomberg: About 53 percent of U.S. companies that issued high-risk, high-yield bonds will default over the next five years, according to Jim Reid at Deutsche Bank AG.

The figure compares with a 31 percent five-year rate in the early 1990s and 2000s, and as much as 45 percent “in a very, very different market in the Great Depression,” Reid, the London-based head of fundamental credit strategy, wrote in a note to clients today. The estimate is based on the premium investors demand to hold the notes and assumes recoveries from the defaults will be zero, Reid wrote.

Yves here. No recoveries would seem to be an awfully aggressive assumption, but we have noted that the widespread use of "cov lite" loans means a much higher proportion of companies will enter bankruptcy in a much weaker condition than in past downturns (covenants enable lenders to force restructurings earlier in the process, when there is more to salvage). Thus a higher proportion will wind up liquidating. However, note that the recovery assumption is independent of the default rate estimate. Back to the article: “Given that this recession will easily outstrip the 90s and 00s, then 40 percent high-yield defaults over five years seems to be a minimum starting point for this default cycle,” he wrote. A 50 percent rate is “not unrealistic.”... According to Moody’s Investors Service, the 12-month default rate will rise to 22.5 percent in Europe and 13.8 percent in the U.S. by the end of the year, the New York-based firm said in a report last month. Moody’s expects the five-year default rate to be about 29 percent by February 2014, according to the report. “The main catalyst for this crisis, namely property, is still vulnerable around the world,” Reid wrote. U.S. real estate prices still have more than 16 percent to decline, while the figure is almost double that in the U.K., Reid wrote http://www.nakedcapitalism.com/2009/04/deutsche-analyst-high-yield-defaults-to.html

216 Apr 6, 2009 How Will Active Credit Easing or Quantitative Easing by the ECB Look? As the ECB's refi rate approaches its lower bound as the deposit rate approaches zero, continued credit tightness may drive the ECB to outright asset purchases. Private sector lending rates have yet to fall in line with lower ECB rates because 1) it seems banks are trying to widen their net interest margins to improve balance sheets and 2) the eurozone recession has raised corporate risk premia. Providing liquidity to the banks has not been enough to lower lending rates in the eurozone. However there are technical impediments to the implementation of outright asset purchases by the ECB, such as the lack of a centralized government. What Will Drive the ECB to Outright Asset Purchases?

o Goldman Sachs: The interest rate channel is not functioning as it should, and this is unlikely to change any time soon. This increases the pressure on the ECB to start buying debt and, in fact, ECB Trichet announced during the April press conference that the Governing Council will decide on more 'unconventional measures' in May.

o Maccario: In the euro area you cannot lower the cost of funding for the real economy without lowering the cost of funding for banks, which still face significant difficulty in raising medium-term financing What Will the ECB Buy?

o Government Debt? Purchases of government debt in the secondary market might interfere with the market's risk pricing mechanism, and might raise fears that the ECB is financing budget deficits; moreover, the impact on the real economy would be much more questionable than in the US, where many mortgage rates are linked to long-term Treasury yields. (Maccario)

o Corporate Debt? The ECB could buy commercial paper, but some key economies would be left out of this support. In the same vein, they could buy corporate bonds but in that case the backbone of the euro area corporate sector - small and medium enterprises with very limited or no access to capital markets - would not benefit (Maccario). Besides, debt securities account for just 8.4% of corporate sector debt in the euro area as of 3Q08, far lower than in the US (Williams)

o Bank Debt? The banking system plays by the far the dominant role in financing the eurozone's real economy and the banking system still faces significant difficulties in raising medium-term financing. What Are the Stumbling Blocks and Ways to Overcome Them?

o National allocation of purchases: ECB could provide capital to the Eurosystem central banks and let them decide which instruments to buy. The ECB would then announce the gross allotment, which could be divided among national central banks in proportion to

217 their shares in the ECB's capital (Maccario) or in eurozone GDP (BNP). Another idea is for the ECB to create a fund to buy bank assets (BNP).

o Shallowness and/or skew of corporate bond market towards some sectors in certain countries: One option to overcome these problems would be for the ECB also to accept ABS structures, which would allow banks to come up with a more representative bundle of financial assets. (Goldman Sachs)

03.04.2009 HOW THE ECB WILL IMPLEMENT A POLICY OF QUANTITATIVE EASING By: Aurelio Maccario

At the last Thursday meeting, the ECB cut the refi rate by 25bp and left the corridor unaltered with the depo and the lending rate now at 0.25% and 2.25%, respectively. The statement was very similar to the March one and did not add much new information. In the press conference, by saying that the 25 bp move was “measured” and that future rate decisions will be measured as well, Trichet already flagged a 25 bp rate cut that is likely to be the end of the easing campaign. Moreover, Trichet made it clear that 1.25% is not the lowest possible limit, and stated that the depo rate won’t go below 0.25%. However, I do not believe that they will go below that threshold unless they start seeing a much higher risk of deflation. Therefore, as the refi rate is approaching its lower bound, most of the attention has turned on those unconventional (“non-standard”, in Trichet’s words) measures that should complement the action on official rates and help unclog the interbank and the credit market. Asked about these measures, Trichet did not give specific details, but stated very definitely that next month the ECB will decide if and how to implement further non-standard measures. What are these “unconventional, non-standard” measures? Recall that the ECB has clear in mind that the role of the banking system makes eurozone “a different universe” from the US and the UK, where the relative importance of market-based financing is significantly higher. In the eurozone, the economy is heavily dependent on the ability of banks to extend loans to the non-financial sector (households and corporate), and to ensure that credit flows smoothly even at times of economic downturn. Therefore, the banking sector will be at the centre of the ECB strategy. Two issues are of relevance here: short term and medium-long term funding. Admittedly, on the first point, the ECB on Thursday disappointed expectations about a possible lengthening of the maturity of its liquidity operations to twelve months from six. This would have been a natural further step in line with the ECB’s strategy of working through the banking system rather than by-passing it. I believe that such a strategy will be launched

218 at the next meeting in May. Such a measure would help ease fears of liquidity shortages in the second half of 2009 and in 2010, and will go some ways towards easing the banking sector’s funding requirement beyond the very short term. In fact, the ECB acknowledges that flows in the interbank market remain scarce and although bank lending rates have been gradually falling, bank credit standards on new loans have been tightened and credit growth to the private sector has been decelerating. Bottom line: they will keep flooding the markets with liquidity as the deleveraging continues as long as banks face very stressed funding markets. The second point (medium-long term funding) was anticipated by Vice President Papademos last week at the 7th European Business Summit organized by the European Business Forum. Indeed, the key novelty of his speech was that one of the possible further measures consists of “purchases of private debt securities in the secondary market in order to improve its liquidity and reduce the cost of funding of the real economy, thus helping its recovery”. Two questions are in order here. First, what kind of assets would the central banks buy? Papademos talked of “private” debt securities, which rules out government debt—purchases of government debt in the secondary market might interfere with the market’s risk pricing mechanism, and might raise fears that the ECB is financing budget deficits; moreover, the impact on the real economy would be much more questionable than in the US, where many mortgage rates are linked to long-term UST yields. The ECB could buy commercial paper, but some key economies would be left out of this support. In the same vein, they could buy corporate bonds but in that case the backbone of the euro area corporate sector - small and medium enterprises with very limited or no access to capital markets - would not benefit. The ECB members know very well that in the euro area you cannot lower the cost of funding for the real economy without lowering the cost of funding for banks—indeed the ECB has been arguing consistently that the banking system plays by the far the dominant role in financing the eurozone’s real economy. And the banking system still faces significant difficulties in raising medium-term financing. Second, how would the strategy be implemented? My take here is that the ECB would provide capital to the Eurosystem central banks and let them decide which instruments to buy. The ECB would then announce the gross allotment, which could be divided among national central banks in proportion to their shares in the ECB’s capital. National central banks would then have the final decision on which specific assets to buy. Most of the hurdles mentioned before could thereby be overcome with a tailor-made differentiated strategy with much higher chances of success, given that credit and financing conditions vary among countries, as does the importance of commercial paper and corporate bond as a source of corporate sector financing. So far, the ECB has been reluctant to embark in direct asset purchases, probably because of the same desire to be able to tighten policy quickly enough once the time comes. Massive injections of liquidity via repos can be reversed easily and automatically once the repo comes to maturity. If the ECB buys assets, instead, it will face the more complicated issue of deciding when to sell them back onto the market. However, the dire growth outlook clearly calls for further action: with the eurozone now forecast to experience an even deeper recession than the US, it becomes much harder for the ECB to remain the only major central bank not to implement “orthodox” Quantitative Easing, that is outright asset purchases. http://www.eurointelligence.com/article.581+M5eb02d3c957.0.html

219

Greenspan's Bogus Defense Mises Daily by Robert P. Murphy | Posted on 4/6/2009 12:00:00 AM

In his March 11 Wall Street Journal op-ed, former Federal Reserve Chairman Alan Greenspan tried to exonerate himself from the housing boom and bust. Even though more and more analysts are realizing that Greenspan's low interest rates fueled the bubble, the ex- maestro himself uses statistics to defend his record. On these pages Frank Shostak has already taken on Greenspan's spurious arguments, but in the present article I'll touch on a few more points. GREENSPAN COULDN'T PUSH UP RATES? Greenspan's main argument is that the Fed lost control of the ability to move long-term interest rates, especially 30-year fixed mortgage rates. Since it is these longer rates that (at least in theory) ought to influence house prices much more than the overnight federal-funds rate, Greenspan can't possibly be held responsible for the housing bubble. In his words, The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier — in the wake of the emergence, beginning around the turn of this century, of a well arbitraged global market for long-term debt instruments. U.S. mortgage rates' linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance. Now this is extremely misleading. Judging from Greenspan's description, the reader would think that the federal-funds rate (which the Fed directly targets with its open-market operations) and the mortgage rate moved along in sync, when all of a sudden Greenspan tried to jack up short-term rates in 2004, and yet those pesky mortgage rates refused to move up. Hence, he did what he could to slow the housing bubble, but alas, it was precisely when he tried to help that the markets rendered him impotent.

220 On the other hand, Greenspan says (truthfully) that the correlation between the two series broke down earlier, in 2002. Let's look at the graph and see exactly what happened: Effective Federal Funds Rate vs. 30-Year Conventional Fixed Mortgage Rate (monthly data, source: St. Louis Fed)

So it's true, the red and blue lines in the chart above moved pretty much in lockstep up until 2002, as Greenspan claimed. But the disconnect occurred when Greenspan slashed short-term rates while mortgage rates held steady. Since the participants in the mortgage market wisely realized that rates wouldn't be held at 1% forever, they didn't foolishly drop their own yields down so far. Then in June 2004, when Greenspan began ratcheting the federal-funds rate back up, it is perfectly understandable that mortgage rates wouldn't rise with them. To repeat, Greenspan's defense of his policies made it sound as if he tried to push up mortgage rates, but that they wouldn't budge. Yet, as the chart above makes clear, Greenspan didn't really push up very hard on rates. After all, he stopped short of breaking through mortgage rates (the blue line) once the federal-funds rate (the red line) plateaued in June 2006 at 5.25%. If he really had wanted to push up mortgage rates, he could have pushed up the federal-funds rate more. Let's look at this issue a little more carefully. In the chart below, I've graphed the difference between the federal-funds and mortgage rates; i.e., I am plotting the gap between the blue and red lines from the first chart, above. In addition, I overlay the average value of this gap for the period 1971–2002: Gap Between Mortgage and Federal Funds Rate

The above chart takes a minute to digest, but if the reader masters it, he will see just how silly Greenspan's argument is. The great "divergence" between the two interest rate series that began in 2002 was nothing unusual by historical standards. And once Greenspan tried to slam

221 on the brakes by raising short rates (in 2004), a full year went by before the gap between the two had returned to its average over the 1971–2002 period — the very period that Greenspan says the two series moved "in lockstep." In terms of the graph itself, it is not until June 2005 that the blue line crosses below the red line. Only from that point onward was the gap between the mortgage and federal-funds rates even smaller than average. (And the gap even went negative several times during the 1970s, when the federal-funds rate exceeded mortgage rates.) Finally, just step back and look at the chart. Does it look as if something crazy and unprecedented happened from 2002–2005? Not at all: the whole housing boom period from 1998–2007 looks almost like a mirror image of 1988–1997. So to repeat, the reason that the correlation between the federal-funds rate and the 30-year mortgage rate broke down during the housing boom was that Greenspan whipsawed short rates waaaaaay down, then waaaaaay up, in a fairly narrow window. Mortgage rates (thank goodness) didn't move around in such a volatile manner. If one series goes from 6.5% down to 1%, then back up to 5.25%, while the other series stays roughly flat, then obviously the measured correlation is going to be low.[1] THOSE PESKY ASIAN SAVERS Greenspan repeats the claim that Asian savings were the real culprit. But there are two problems with this theory: first, global savings rates continued to rise throughout the housing boom and bust. So it's very difficult to explain the peak of the housing boom with reference to Asian saving. (In contrast, Greenspan's actions with short-term rates fit the fortunes of the housing market much more closely.) But a second major problem is that even on its own terms, the influx of blind Asian saving — to the extent it existed at all — was itself partially a product of Greenspan's monetary inflation. Remember that the Chinese central bank had maintained a rigid peg to the dollar until it was pressured to drop it — right around the time the housing boom faltered:

To put it somewhat simplistically, when Greenspan flooded the world with more dollars, the dollar fell sharply against most major currencies. But in order for the Chinese to keep the renminbi (yuan) from appreciating against the dollar as well, they had to load up on dollar-

222 denominated assets, such as US Treasuries. Thus, Greenspan's inflation in combination with the Chinese peg, on paper might have appeared as an irrational influx of Asian investment, which stubbornly refused to subside even as US indebtedness grew.

CONCLUSION It is bad enough that Alan Greenspan refuses to acknowledge what more and more people are realizing: his ultralow interest rates — which were in turn accomplished through injections of artificial credits into the banking system — fueled the housing boom. The Greenspan Fed was not a sufficient condition to cause the housing and stock bubbles, but it was almost certainly a necessary factor. If the Fed had let the post-9/11 recession run its course, there would have been no absurd boom (and now bust). But beyond Greenspan's refusal to admit his mistakes is the ludicrous accusation that high savings rates among the world's poorest people — coupled with growing incomes made possible by technological and legal advances — was cause for misery. What a warped view of how the market economy works, to think that savings and foreign investment can cripple an economy. Notes [1] In fact, the correlation is 0.015 over the period from 2002–2005. And for what it's worth, the correlation from 1974–1977 is a lowly 0.436, which is only about half of the correlation over the whole period 1971–2002. If you look at the first graph in the text, you can see why.

223

06.04.2009 IMF TELLS CEE COUNTRIES TO ADOPT EURO NOW

We have been proposing this as a solution to the CEE crisis all along (see, for example, our new briefing note on the future of the euro area). Now the IMF also recommends a policy of euroisation for CEE countries, who should adopt the single currency either as a full or quasi member. The IMF made this recommendations in a confidential report prepared a month ago, according to the FT. “For countries in the EU, euroisation offers the largest benefits in terms of resolving the foreign currency debt overhang [accumulation], removing uncertainty and restoring confidence. Without euroisation, addressing the foreign debt currency overhang would require massive domestic retrenchment in some countries, against growing political resistance.” The IMF has calculated that the region’s financing gap would be €186bn, of which €105bn would have to be financed from sources other than the IMF, mostly the EU.

EU plan to regulate hedge funds The Financial Times Deutschland leads the paper with a story from Brussels, giving details on a yet to be published EU directive on the regulation of hedge funds. According to the report, all hedge fund mangers who handle more than €250m of clients’ money should be registered and licenced. Hedge funds must pose collateral, and accept risk management procedures. The good news for hedge funds is that they will be able to operate from tax havens, and that once licenced, they will be able to operate in the entire EU. The directive is not finished, the report says. The European Parliament will probably want a tougher regulation.

Berlin to launch new retail bond Germany is developing a sovereign product aimed directly at retail investors, circumventing the capital market, in a sign that the government is getting increasingly desperate as it needs to raise €346bn over the next two years. It is a basket of sovereign bonds into which the general public can buy a direct stake. This follows last year’s introduction of the a day bond, which raised a total of €3.2bn in its first six months, the FT reports.

224 US bank recapitalisation is likely to be even slower after latest Geithner initiative Tim Geithner’s latest bright idea, popular no doubt, is to force bank board members, whose banks will receive government money, to step down. (which means that the decision-makers in banks have even less incentive to accept state recapitalisation than otherwise. The Germans did a similar thing by imposing a €500,000 salary cap). The FT has the story.

Wolfgang Munchau on the G20 Wolfgang Munchau disagrees with the consensus view about the G20 summit. He finds it difficult to accept that the summit should be seen as a success if it has failed to take steps that would alleviate, let alone end the crisis. The agreement on IFIs was indeed substantial, but the summit did nothing at all in terms of coordination on global macro responses and bank rescue policies. From the point of crisis resolution, the G20 is marginal. Avinash Persaud on the G20 Avinash Persaud, writing in Vox, is marginally optimistic about the outcome of the G20 summit. He argues that the G20 Summit is not the turning point, but it provides the strongest reason yet to be less pessimistic. The commitments may leave plenty of room for the devil to make mischief with, but it is hard to think what more the G20 could have done. Gordon Brown has pulled some large rabbits from his hat. Willem Buiter on the FASB Willem Buiter has a post on the decision by the Federal Accounting Standards Board in the US to relax the mark-to-market accounting rules. He says the entier US establishment is pandering to the vested interested of bank managers and their unsecured creditors. The decision constitutes another fig leave behind which banks can hide their losses. He writes this “continues and prolongs the zombification of most Wall Street banks.” It thus prolongs the crisis. Mario Monti proposes a deal Writing in the FT, Mario Monti says the gap between the countries with Anglo-Saxon economic models and those of Social Market economy models has been closing even more after this crisis, as the Anglo-Saxons are now questioning the benefit of their system. He proposes a deal for Europe, in which the Social Market countries accept a relaunch of the internal market, while the Anglo Saxons accept a degree of tax-coordination, stopping short of tax harmonisation, which is neither necessary nor desirable. Hans-Werner Sinn on bank recapitalisation Writing in Vox, Hans-Werner Sinn says banks’ balance sheets need to be fixed, but they cannot be allowed to shrink themselves back to health – instead of accepting government money – because that would severely harm the economy. This column proposes that any bank that cannot privately find at least 4% equity capital and a tier-one ratio of 8% must let the state supply the required capital and become a partner.

225 03.04.2009 SUMMITS SURPRISES

It was not what we hoped for, but it was more than we thought. The G20 summit did make a number of substantial agreements, most importantly new funds to international financial institutions, including the IMF. The best source is not a newspaper, but the actual summit communiqué itself – which is unusually well written. The main results are: On support for international institutions:

- trebling resources to the International Monetary Fund from $250bn to $750bn. - A new allocation of special drawing rights of $250bn; - More than $100bn in new funds to multilateral development banks; - $250bn in support for trade finance; - To use proceeds from IMF gold sales for help to the poorest countries; - To implement IMF reforms of April 2008 and to call on the IMF to complete the next review of quotas by January 2011. (that’s when the Europeans have to give some ground) - Make IMF MD appointment process more transparent and fair (i.e. no more Europeans to head the fund for the next 2000 years) On stimulus and growth: - The above add to $1.1 trillion – which is new money to support growth and lending. They claim that their total combined stimulus effort is $5 trillion, some 4% of GDP. (No we don’t believe that number) - “provide significant and comprehensive support to our banking systems to provide liquidity, recapitalise financial institutions, and address decisively the problem of impaired assets.” (which we don’t believe either). And they said it was the largest fiscal stimulus ever (which we are happy to believe, except this is not some virility contest.) - We know that leaders have to be optimistic, but the following is a bit much: “We are confident that the actions we have agreed today, and our unshakeable commitment to work

226 together to restore growth and jobs, while preserving long-term fiscal sustainability, will accelerate the return to trend growth.“ (it ain’t going to happen like this) On regulation: - to establish a Financial Stability Board (FSB) to replace the Financial Stability Forum (FSF). It will including all G20 countries, FSF members, Spain, and the European Commission; - FSB to collaborate with IMF on early warning system - FSB in charge of identifying macro-prudential risks; - Extend regulation to all systemically important financial institutions - implement the FSF’s principles on pay and compensation - to insure capital adequacy - to take action against tax havens. “The era of banking secrecy is over. We note that the OECD has today published a list of countries assessed by the Global Forum against the international standard for exchange of tax information” (Note: the word “note” is the compromise. Sarkozy wanted “endorses”, the Chinese wanted nothing. - To strive for better accounting and valuation standards - regulatory oversight and registration of Credit Rating Agencies. And some proclamations on protectionism that one should not take too seriously. The following photos represents the serious worklike mood at the meeting.

And this is what some of the commentators had to say Commentators were unusually reticent. Paul Krugman applauds the G20’s decision on international financial institution as more far-reaching that he had hoped for. He called it substantive and important. Mark Thoma of the Economists View blog, was more sceptical, saying the summit would have been a great opportunity for a coordinated response, but it did not happen. Philip Stephens of the FT called the summit a substantial success. He writes that it was never possible for this summit to fix the global economy. Politics should be seen as a process, not as an event.

227 Dominique Seux in Les Echos concludes that the G20 summit was not a failure, which is already a success in itself. But the measures agreed upon are insufficient to avoid a recession, the rise in unemployment or the halt in international trade. Heike Goebel warns in the FAZ that the IMF is transformed into a huge credit machine to support countries without the usual conditions attached. While this solution is much easier to sell politically in Germany it falls short addressing responsibility and liability in case the money proves to be inefficient. The markets liked it. The European shares were up 4-6%, the US was a little more guarded with the Dow rising some 2% to close a touch under 8000.

ECB to consider quantitative easing in May The big news in Frankfurt is that the European Central Bank will consider quantitative easing at its May meeting, according to the FT. This suggests that some policy of that nature is likely to be adopted. Both refinance rate and deposit rate were cut by a quarter points to 1.25 and 0.25% respectively, as the ECB gradually tries to shift money market rates further down. Another rate cut is now very likely in May. As the financial markets expected a half point rate cut, the euro rose to $1.35. Trichet said there was unease among some members that zero policy rates could produce distortions (though it is not clearly what exactly that means). FT Deutschland writes that the ECB’s first option under quantitative easing would be to buy corporate bonds from banks, to alleviate pressures in corporate lending. But there would be no direct commercial paper purchase from companies.

Thomas Fricke on Steinbruck In his FT Deutschland column, Thomas Fricke criticises finance minister Peer Steinbruck over his recent warning that the global policy response will all end in inflation. He said Steinbruck was clearly overwhelmed by the situation, as he simultaneously warns about rising inflation, and the likelohood of further belt-tightening in the future. Inflation is very unlikely to materialise in the present situation, given the overall lack of demand in the world economy, Fricke concludes. Dominique Moisi on parallels with the French revolution Writing in the FT, Dominique Moisi draws some interesting parallels between today’s situation in the US and France just before the revolution. There is much anger out there, combined with the possibility that something goes disastrously wrong. ”Revolution is not around the corner; at least, not in America. But there are lessons Mr Obama can learn from the French king’s failure to manage dissent. He must not fall prey to populism. His goal is to save the economy, not punish the bankers. At the same time, he must not be seen to have too much sympathy for the world of finance and its excesses or to cut himself off from the suffering of his people. If he fails, the corporate laws of today will face the same fate as the ancien régime rights of yesterday.” Keenan on the Irish structural deficit target In the Irish Independent Brendan Keenan comments on the Irish government’s decision to target the structural deficit (currently €16bn or 8% of GDP) rather than actual deficit (€20bn or 12% of GDP). Keenan warns that this is a nightmare all over. There is first the difficulty to calculate trend growth, the basis for calculating the structural deficit, in times that were

228 completely unexpected. The second nightmare is that given there is no hope for a return to 3.5% growth rate, the structural deficit can only shrink through higher taxes or lower benefits. It may even be impossible to close the structural deficit if the government costs are rising. With the economy shrinking public spending as a proportion of income could become the highest in the EU meaning that taxation would then also have to be the highest in the EU.

Greek government to cut car registration tax The Greek government is to present a bill to reduce registration taxes payable on purchases of new cars and motorcycles by 50%, reports Kathimerini. The tax cut will translate into savings of up to some €4400. It might be extended for second hand cars for a four month period. Plans for a wrecking primium, like the one is Germany, have been dropped as it was considered too costly.

Credit guarantees for the Austrian industry The Austrian finance minister Josef Proell is to present a guarantee scheme for industry credits reports Der Standard. These are no new budget commitments but a redirection of €10bn from the €75bn guarantee package for banks. The credits, once approved by a “control bank”, are to be handled by the commercial bank. Still under discussion are the conditions attached to such credits, such as restricted dividend and bonus payments.

229

Opinion

April 3, 2009 OP-ED COLUMNIST China’s Dollar Trap By PAUL KRUGMAN Back in the early stages of the financial crisis, wags joked that our trade with China had turned out to be fair and balanced after all: They sold us poison toys and tainted seafood; we sold them fraudulent securities. But these days, both sides of that deal are breaking down. On one side, the world’s appetite for Chinese goods has fallen off sharply. China’s exports have plunged in recent months and are now down 26 percent from a year ago. On the other side, the Chinese are evidently getting anxious about those securities. But China still seems to have unrealistic expectations. And that’s a problem for all of us. The big news last week was a speech by Zhou Xiaochuan, the governor of China’s central bank, calling for a new “super-sovereign reserve currency.” The paranoid wing of the Republican Party promptly warned of a dastardly plot to make America give up the dollar. But Mr. Zhou’s speech was actually an admission of weakness. In effect, he was saying that China had driven itself into a dollar trap, and that it can neither get itself out nor change the policies that put it in that trap in the first place. Some background: In the early years of this decade, China began running large trade surpluses and also began attracting substantial inflows of foreign capital. If China had had a floating exchange rate — like, say, Canada — this would have led to a rise in the value of its currency, which, in turn, would have slowed the growth of China’s exports. But China chose instead to keep the value of the yuan in terms of the dollar more or less fixed. To do this, it had to buy up dollars as they came flooding in. As the years went by, those trade surpluses just kept growing — and so did China’s hoard of foreign assets. Now the joke about fraudulent securities was actually unfair. Aside from a late, ill- considered plunge into equities (at the very top of the market), the Chinese mainly accumulated very safe assets, with U.S. Treasury bills“; T-bills, for short — making up a large part of the total. But while T-bills are as safe from default as anything on the planet, they yield a very low rate of return. Was there a deep strategy behind this vast accumulation of low-yielding assets? Probably not. China acquired its $2 trillion stash — turning the People’s Republic into the T-bills Republic — the same way Britain acquired its empire: in a fit of absence of mind. And just the other day, it seems, China’s leaders woke up and realized that they had a problem.

230 The low yield doesn’t seem to bother them much, even now. But they are, apparently, worried about the fact that around 70 percent of those assets are dollar-denominated, so any future fall in the dollar would mean a big capital loss for China. Hence Mr. Zhou’s proposal to move to a new reserve currency along the lines of the S.D.R.’s, or special drawing rights, in which the International Monetary Fund keeps its accounts. But there’s both less and more here than meets the eye. S.D.R.’s aren’t real money. They’re accounting units whose value is set by a basket of dollars, euros, Japanese yen and British pounds. And there’s nothing to keep China from diversifying its reserves away from the dollar, indeed from holding a reserve basket matching the composition of the S.D.R.’s — nothing, that is, except for the fact that China now owns so many dollars that it can’t sell them off without driving the dollar down and triggering the very capital loss its leaders fear. So what Mr. Zhou’s proposal actually amounts to is a plea that someone rescue China from the consequences of its own investment mistakes. That’s not going to happen. And the call for some magical solution to the problem of China’s excess of dollars suggests something else: that China’s leaders haven’t come to grips with the fact that the rules of the game have changed in a fundamental way. Two years ago, we lived in a world in which China could save much more than it invested and dispose of the excess savings in America. That world is gone. Yet the day after his new-reserve-currency speech, Mr. Zhou gave another speech in which he seemed to assert that China’s extremely high savings rate is immutable, a result of Confucianism, which values “anti-extravagance.” Meanwhile, “it is not the right time” for the United States to save more. In other words, let’s go on as we were. That’s also not going to happen. The bottom line is that China hasn’t yet faced up to the wrenching changes that will be needed to deal with this global crisis. The same could, of course, be said of the Japanese, the Europeans — and us. And that failure to face up to new realities is the main reason that, despite some glimmers of good news — the G-20 summit accomplished more than I thought it would — this crisis probably still has years to run. http://www.nytimes.com/2009/04/03/opinion/03krugman.html?_r=2

April 2, 2009, 8:58 am “The banks” versus “some banks” On the run: this critique of my views is interesting. But I think there’s a crucial assumption that isn’t right. The question isn’t whether “the banks” are insolvent; most surely aren’t. Instead, some banks are probably insolvent. So it’s not the case that the costs of the PPIP are costs we’d have to bear one way or another; there’s a lot of money going to institutions that would never otherwise arrive at the taxpayers’ door.

231 And that, in a broad sense, is what’s wrong with TARPish rescue schemes. They try to fix the banks by driving up the price of a whole asset class. Most of those assets are NOT held by the probably insolvent banks. So it’s a diffuse, inefficient way of tackling the problem — a taxpayer subsidy to basically anyone holding legacy assets, rather than a direct infusion of funds where needed. Contrast it with what the FDIC does when it moves in: it doesn’t shower money on banks in general, hoping that this will solve the problem; it seizes banks that are in trouble, and recapitalizes them. To justify the scheme as announced, you have to either assume that the toxic assets are wildly underpriced, or take as a given extreme political and legal constraints preventing you from doing anything close to the right thing. And about those legal constraints: it’s funny how GM is being treated as a ward of the state, even though it hasn’t formally declared bankruptcy, in a way that AIG — which is 80% government-owned! — is not. March 31, 2009, 10:01 am “Dow 36,000″ and your pension So in 2007 the Pension Benefit Guarantee Corporation — which stands behind corporate pensions — switched from bonds only to lots of stocks, buying in at, natch, the peak of the market. Oops. And this is big stuff: the Bush administration may have left us all a gratuitous loss of hundreds of billions. Why did this happen? I’m sure we’ll find some nasty stuff, but at least part of the reason was that the Bush administration, like many conservatives, was under the spell of the following pseudo-syllogism: 1. The stock market captures the essential spirit of capitalism. 2. Capitalism roolz! 3. Therefore, stocks will go up. The most influential disseminator of this fallacy is the Wall Street Journal, which as far as I can tell has cheered on every bubble since the 1920s, always dismissing the skeptics as fools and promoting the dumbest bull-market arguments available. I don’t have time to search for it right now, but I think there was an editorial circa 2000 saying precisely that anyone who questioned the bull market of the time was anti-capitalist. And now the cost for that attitude is falling on you and me.

232 EDITORIAL

April 3, 2009 The Economic Summit In normal times we don’t expect a lot from summit meetings. But with the global economy imploding, leaders at Thursday’s meeting of the world’s top 20 economic powers had an urgent responsibility to come up with concrete policies to fix the global financial system and restore growth. They fell short. The meeting certainly produced more than the usual photo ops and spin — and its participants did not go away yelling at one another as they have in the past. The leaders pledged to fight protectionism and to help badly battered developing countries and — putting their money where their mouths are — committed $1 trillion for loans and trade guarantees. The group also agreed to crack down on tax havens and, on a country-by-country basis, impose stricter financial regulations on hedge funds and rating agencies — necessary though insufficient steps to avoid a repeat of the current disaster. Where they fell dangerously short was their refusal to commit to spend the hundreds of billions of dollars in additional fiscal stimulus that the world economy needs to pull out of its frighteningly steep dive. With consumer spending and business investment collapsing around the world, rich countries are the only ones that have the resources to do what is needed. European leaders — most notably Germany’s chancellor, Angela Merkel — made clear going into the meeting that they were not going to give in on that issue. German politicians are historically afraid of touching off inflation with too much deficit spending. But inflation is not the danger Europe faces today, and German history should make them equally wary of the disastrous consequences of a new depression. President Obama has rightly warned the Europeans that they cannot count on American consumer spending alone to drive a global recovery. But he apparently decided that a battle would be too destructive. After years of watching former President George W. Bush hector and alienate this country’s closest friends, we were relieved to see Mr. Obama in full diplomatic mode. We fear, however, that this is not the time or the issue on which to hold back. If world growth continues to decline — and all signs suggest that it will — the president will have to take on this fight soon. Stimulus spending wasn’t the only area of fundamental disagreements. The Europeans came to the meeting stressing the need for comprehensive cross-border regulation of financial markets, participants and products. Mr. Obama and his team seem more committed to domestic regulation than their predecessors — but fiercely resistant to the idea of a global regulator. The group compromised with its call for more transparency and better early-warning systems for systemic risks. We suspect that it will take considerably more than that to reassure investors that markets are safe. The world’s wealthy nations must come to a common understanding of the causes of this crisis and a common vision of the future role of financial markets. From there, they need to write new rules and regulatory regimes that address the real dangers. In the end, necessary regulation will not be transnational enough for European tastes and too binding for American tastes. When both sides grumble about the result, rather than praise it, you will know that progress is being made. The British prime minister, Gordon Brown, declared at the meeting’s end that “this is the day the world came together to fight back against the global recession.” As host, he had to. To pull out of the current crisis, it will take a lot more than was done in London.

233

A Rare Triumph of Substance at the Summit By Steven Pearlstein Friday, April 3, 2009; A12 International economic summits deserve to be regarded with skepticism: The most important decision to come out of them is usually the call for yet another meeting. But yesterday's G-20 meeting in London was an exception. While President Obama may have overstated things a bit when he declared it a "turning point" for the now-shrinking global economy, the meeting did manage to boost the confidence of financial markets, inject another trillion dollars into the financial system and provide needed political cover for world leaders to take unpopular actions back home. Ever since this round of G-20 consultations was launched last year by an insistent President Nicolas Sarkozy, there's been a distinctly French accent to the process. Implicit in the agenda has been a critique of the Anglo-American economic model that, in the European imagination, was the root cause of the current economic crisis. Sarkozy's aim was nothing less than a rewrite of the rules for global capitalism to conform to the more civilized norms of the continental European model. At the same time, British Prime Minister Gordon Brown was keen on creating a new global financial architecture to replace the creaky Bretton Woods financial institutions that failed to prevent a series of international financial crises and now seem oddly out of sync with the global economy. To the American ear, much of this sounded overdone and overly ambitious. While the financial crisis revealed an urgent need to better coordinate regulation of global institutions and capital flows, nobody seriously thought that any country -- not the United States, and certainly not France -- would cede its sovereign powers to an international bureaucracy. After all, the most recent attempt at international regulatory coordination -- the Basel II standards on bank capital -- wound up leaving European banks woefully undercapitalized when the current crisis hit, requiring bank bailouts that in many cases were much larger, in relation to the size of the countries' economies, than in the United States. U.S. banks, by comparison, had relatively more capital, thanks to those worrywarts at the FDIC, who had fought the looser Basel II standards despite their strong support from the banks and their always-accommodating regulators at the Federal Reserve. The push for broader, tighter cross-border financial regulation, in fact, came largely in response to the light-touch approach of the Bush administration. But whatever transatlantic tension once existed over that issue pretty much melted away last week when Tim Geithner outlined the new administration's regulatory reform proposal, which could just as easily have been written at the French Finance Ministry as at the U.S. Treasury. In the end, yesterday's communique, with its promise of a global regulatory crackdown, was an easy win for all concerned. Sarkozy and German Chancellor Angela Merkel could declare victory over unfettered Anglo-American capitalism, while Obama now has added political ammunition for taking on the banks, hedge funds, rating agencies and private-equity firms

234 that will try to water down his proposals. While that may constitute a turning point for Anglo- American capitalism, it is hardly the death knell. Gordon Brown, meanwhile, emerged from yesterday's talks to declare an end to "the old Washington consensus," the now-derogatory description for the policy prescription of open borders, floating exchange rates and fiscal prudence long favored by the World Bank and the International Monetary Fund. What emerged yesterday from the G-20, however, amounts more to reform than to revolution. Member countries committed themselves to adding $850 billion to the resources available to the IMF and regional development banks to mount rescues of countries in financial distress, with instructions that the money be used not only for traditional purposes such as debt rollover, bank recapitalization and balance-of-payments support, but also for more "flexible" goals such as stimulus spending, infrastructure investment, trade finance and social support. And just as the old G-7 has given way to the enlarged G-20, the governance structure of the fund and the bank will be revised to give the bigger developing countries the authority they now deserve. It may suit the politics of Europe to portray all this as a blow to Washington's power and prestige, but the reality may be quite different. In fact, the shift is perfectly in keeping with the new emphasis on the developing world that Obama brings to international economic policy. And if any countries are likely to lose out in the restructuring, they are those of "old Europe" that, by dint of history, now wield power far in excess of their importance in the global economy. Indeed, while European leaders were crowing that they had successfully beat back calls to step up efforts to stimulate their economies, that's not exactly true. Yesterday's big boost in funding for the IMF could well translate into hundreds of billions of dollars in fresh financing for Eastern European countries that, for political reasons, leaders of Western Europe have been unwilling to offer directly. Yesterday's communique also contains a carefully worded commitment for all countries (read: France and Germany) to increase stimulus spending if the IMF finds that current policies prove insufficient to get their economies growing again. All in all, a pretty successful opening-night performance for President Obama on the international economic stage. He achieved most of what he wanted while allowing others to claim victory and allowing the United States to shed its Bush-era reputation for inflexibility and heavy-handedness. And by the standards of past summits, this one was full of accomplishment. By the way, in case you're wondering -- yes, they agreed to meet again in September, this time in New York.

235

Opinion

April 3, 2009 OP-ED CONTRIBUTOR A Tortured Inheritance By LINDA GRAY SEXTON Palomar Park, Calif. I HAVE been crying for Nicholas Hughes. I never met Dr. Hughes, yet I believe I know a great deal about him. He was the second child of the poet Sylvia Plath, who gassed herself in her oven when he was a toddler. I am the elder daughter of the poet Anne Sexton, who gassed herself in her car when I was 21. Nicholas Hughes hanged himself two weeks ago at the age of 47. And despite my insistence that I would never turn out like my mother, I tried to kill myself, too — three times — and would have succeeded once had it not been for the efforts of a determined police officer, who forced open the window of my car. Did it surprise me to read about his suicide? Not in the least. As my mother wrote in one of her most famous poems: “I have gone out, a possessed witch... lonely thing, twelve- fingered, out of mind./A woman like that is not a woman, quite./I have been her kind.” All of us who follow that depressing family path — from suffering to suicide — have known what it is like to be her kind. Nicholas Hughes’s mother, and mine, succumbed to the exhaustion of unrelenting depression. They self-destructed. And we grew up in the wreckage of their catastrophe. Their deaths took away from him and his sister, Frieda, and from me and my sister, Joyce, the solace of a mother’s love. And worse, all four of us, I imagine, had to live with the knowledge that our mothers had quite willfully abandoned us. Understanding and accepting this is heart-wrenching, but it is a necessary part of healing. I have wanted to kill myself, but I survived, and so can attest to what Dr. Hughes, like my mother, probably must have felt — that there was no other alternative. Studies show that some kinds of depression are hereditary, and suicides tend to run in families. But even if there isn’t an absolute genetic component, there certainly is an emotional one. When I turned 45, the age at which my mother killed herself, I too began to be drawn to suicide as a way to escape pain. This was my inheritance. My guess is that I wasn’t alone: hundreds of thousands die by suicide each year. And hundreds of thousands of families are damaged by that loss. Of course, not everyone reacts in the same way. My sister doesn’t like to speak publicly about our mother, and she doesn’t think she is “her kind.” Perhaps Frieda Hughes is more like Joyce, perhaps her brother once was as well. Or maybe they were more like me, trying to recover by talking about what happened. My mother always said, “Tell it true,” and I believe she thought, as I do, that it is important to share the experience of depression with others, who may be suffering in the same way.

236 Which is why we need to speak about these things, to help families deal with their depressed children, siblings and parents, and to intervene and alter the dark world of suicidal legacies. I continue to worry about myself — but I worry about my children more. Despite the dangerous inheritance my oldest son faces, and the depression he also fights, he urges me to keep writing about it, just as his grandmother did. Sadly, I’ll never get to know Nicholas Hughes. I know he was a fisheries biologist living in the forests of Alaska. I know he was more than a suicide. In a memorial, a friend wrote that he was the kind of man who “would seek out a larch tree in a forest of spruce.” I hope he’s succeeded in reaching it. Linda Gray Sexton is the author of “Searching for Mercy Street: My Journey Back to My Mother, Anne Sexton.”

237 Apr 2, 2009 G20 Closes $1.1 Trillion Deal For World Economy, Agrees On Regulatory Crackdown G20 Leaders Statement summary: 1) additional $1.1 trillion of support to the world economy: triple resources available to the IMF to $750 billion, to support a new SDR allocation of $250 billion, to support at least $100 billion of additional lending by the MDBs, to ensure $250 billion of support for trade finance, and to use the additional resources from agreed IMF gold sales for concessional finance for the poorest countries, 2) fiscal measures adopted amount to $5 trillion, raise output by 4 per cent, and accelerate the transition to a green economy. 3) Strengthening the Financial System Declaration: - establish a new Financial Stability Board (FSB) with a strengthened mandate, as a successor to the Financial Stability Forum (FSF), including all G20 countries, FSF members, Spain, and the European Commission, to collaborate as early warning system with IMF - extend regulation and oversight to all systemically important financial institutions, instruments and markets. This will include, for the first time, systemically important hedge funds; - implement the FSF’s tough new principles on pay and compensation; - improve the quality, quantity, and international consistency of capital in the banking system. - In future, regulation must prevent excessive leverage and require buffers of resources to be built up in good times; - The era of banking secrecy is over. See OECD list of countries on black list - call on the accounting standard setters to work urgently with supervisors and regulators to improve standards on valuation and provisioning and achieve a single set of high-quality global accounting standards - extend regulatory oversight and registration to Credit Rating Agencies 4) Strenghtening Global Financial Institutions: -enhance IMF's new $750bn available funds with Flexible Credit Line (FCL) and its reformed lending and conditionality framework. -complete the next review of quotas by January 2011 -new global consensus desirable on the key values and principles that will promote sustainable economic activity.

238 5) Resisting protectionism and promoting global trade and investment remain committed to reaching an ambitious and balanced conclusion to the Doha Development Round 6) Ensuring a fair and sustainable recovery for all current crisis has a disproportionate impact on the vulnerable in the poorest countries. additional resources from agreed sales of IMF gold will be used, together with surplus income, to provide $6 billion additional concessional and flexible finance for the poorest countries over the next 2 to 3 years. Run-Up o Martin Wolf March 31: Most important issue awaiting global solution are imbalances. So far everybody (incl. export-dependent China and Germany) is working to preserve the status quo ante instead of envisaging a structural change. o White House signals the most pressing issue should be economic stimulus but European ministers said they had no plans to add to recent fiscal stimulus packages-->EU Council position paper agreed on March 20 reads like German wish list: focus on financial market regulation, no additional stimulus (via Spiegel) o EurActiv: Joint European position paper calls for coordination on regulatory issues but rejects additional fiscal stimulus with a view to medium-term public finances. o One key difference between U.S. and EU are automatic stabilizers: In Europe's generous welfare states,when recession strikes, governments automatically start paying out more than in the U.S. in the form of welfare checks and other so-called automatic stabilizers (see details below) o G-20 will agree to require the registration of credit rating agencies, a step towards regulation but consensus on dealing with tax havens is stymied in part by China's concerns about how that will affect Hong Kong and Macao.(WSJ). Regulation of hedge funds and CDS instruments is also on the table. http://www.rgemonitor.com/707/Complete_Coverage_of_the_Global_Financial_Crisis?cluste r_id=13616

239 COLUMNISTS Credibility is key to policy success By Martin Wolf Published: April 2 2009 19:29 | Last updated: April 2 2009 19:29 The UK has followed the US and Japan into “unconventional monetary policy”. Meanwhile, Mervyn King, governor of the Bank of England warns the UK government of the dangers of further discretionary fiscal stimulus. Yet what are the implications of the policies followed by central banks? Are these not the big threat to monetary stability? According to forecasts from the International Monetary Fund, the UK’s general government deficit will be 9.5 per cent of gross domestic product this year and 11 per cent in 2010, the largest in the Group of 20. As I argued earlier this week (“Why G20 leaders will fail to deal with the big challenge”), the rise in the deficit, from 2.7 per cent of GDP in 2007, is the counterpart of the swing in the private balance, forecast at 8.9 per cent of GDP between 2007 and 2009. As my colleague, Samuel Brittan, asked last week, why should such a temporary increase in the fiscal deficit be terrifying? UK net public debt – forecast at 61 per cent of GDP this year – remains well below the average of advanced country members of the G20. At the end of the Napoleonic and second world wars, UK public debt was close to 2.7 times GDP. Yet even this triggered none of the hyperinflationary consequences now widely feared. As the IMF also notes, even a 100 percentage point increase in the debt ratio should require an offsetting shift in the primary fiscal balance (with interest payments removed from spending) of no more than 1 per cent of GDP, provided fiscal credibility is maintained. The condition for this is evident: in his Budget, the chancellor of the exchequer should lay out fiscal measures to go into effect, automatically, once the economy recovers. In short, what is needed is a far more credible fiscal regime. Yet it is very peculiar to be agitated about the inflationary impact of fiscal deficits, yet relaxed about monetary expansion by central banks. Is the latter not the true danger? Or are these not just two sides of one coin, the ultimate inflationary risk being the central bank financing of deficits? Yet, even before reaching that point, reliance on aggressive expansion of the balance sheet of the central bank has dangers, including for the fiscal position, as my colleague Willem Buiter has noted in his Maverecon column. Unconventional monetary policies work by expanding the money supply (“quantitative easing”), by easing credit constraints (“credit easing”) and by altering relative yields on assets, particularly through direct purchases of longer- term assets. The Bank of Japan focused on the first; the Federal Reserve has concentrated on the second; and the Bank of England has now initiated the last, with direct purchases of gilts. Carried out with sufficient single-mindedness, such programmes will “work”. At the limit, a modern central bank can drown an economy in infinite quantities of fiat (or man-made) money. The question is the obverse: it is whether the longer-term inflationary impact of monetary expansion can be reversed in time. To this, again, two answers exist: one concerns feasibility; and the other concerns credibility.

240 On the former, the broad answer is that a central bank’s unconventional monetary operations are reversible: if it buys bonds, it can resell them; if it buys short-dated paper, it can allow it to expire; if it directly finances government deficits, it can sell the public debt to the public; and even if it sends cheques directly to every citizen, which would be closest to a purely fiscal operation, the government can always sterilise the monetary effects by issuing new bonds. So, if and when economies and, as important, financial systems, recover, aggressive action by the authorities would unwind the inflationary impact of even these unconventional policies. So, as over fiscal policy, the fundamental question – as Spencer Dale, the Bank’s new chief economist, notes in an important recent speech – is the credibility of the commitment to stability.* If, for example, the central bank takes very large credit risk and the public doubts the willingness of the fiscal authorities to reimburse resulting losses, it will expect these losses to be monetised. Similarly, the public may well doubt whether the huge expansion in central bank balance sheets – as is evident in the US – would be reversed in time. Inflationary expectations may then gain a firm hold, driving inflation-risk premia up and the exchange rates down. This would greatly increase the costs of restoring credibility on the inflationary upside, thereby further undermining the central banks’ ability to do so when the time comes. The conclusion is straightforward: the ability to navigate through the crisis, using either fiscal or monetary measures effectively and at modest overall cost, depends in both of these cases on the credibility of the authorities’ commitment to long-term monetary stability. Neither huge fiscal deficits nor massive monetary expansions are themselves an unmanageable threat, provided the regime itself remains credible. This is crucial even for a country as indispensable to the global economy as the US. For the UK, it is close to a matter of economic life and death. * Tough times, unconventional measures, www.bankofengland.co.uk http://www.ft.com/cms/s/0/f945653c-1fb1-11de-a1df-00144feabdc0.html

241

Letter from Washington The Gatekeeper RAHM EMANUEL ON THE JOB. by Ryan Lizza March 2, 2009

Besides Obama himself, Emanuel did the most to get the stimulus bill passed. Rahm Emanuel’s office, which is no more than a three-second walk from the Oval Office, is as neat as a Marine barracks. On his desk, the files and documents, including leatherbound folders from the National Security Council, are precisely arranged, each one parallel with the desk’s edge. During a visit hours before Congress passed President Barack Obama’s stimulus package, on Friday, February 13th, I absently jostled one of Emanuel’s heavy wooden letter trays a few degrees off kilter. He glared at me disapprovingly. Next to his computer monitor is a smaller screen that looks like a handheld G.P.S. device and tells Emanuel where the President and senior White House officials are at all times. Over all, the office suggests the workspace of someone who, in a more psychologized realm than the West Wing of the White House and with a less exacting job than that of the President’s chief of staff, might be cited for “control issues.” Because the atmosphere of crisis is now so thick at the White House, any moment of triumph has a fleeting half-life, but the impending passage of the seven-hundred-and-eighty-seven-billion-dollar stimulus bill provided, at least for an afternoon, a sense of satisfaction. As Emanuel spoke about the complications of the legislation, he was quick to credit colleagues for shepherding the bill to victory— Peter Orszag, the budget director; Phil Schiliro, the legislative-affairs director; Jason Furman, the deputy director of the National Economic Council––but, in fact, nearly everyone in official Washington acknowledges that, besides Obama himself, Emanuel had done the most to coax and bully the bill out of Congress and onto the President’s desk for signing. That afternoon, Emanuel and his team were already concentrating on the next major project: the President’s budget, which will be released on February 26th. Emanuel had just come from a budget meeting in the Roosevelt Room with the President’s senior staff. (The President was downstairs in the Situation Room; coincidentally or not, hours later U.S. Predators attacked a Pakistani Taliban compound in South Waziristan.) After the budget meeting broke up, staffers hurried through the West

242 Wing reception area: Carol Browner, who is in charge of energy policy; Larry Summers, Obama’s top economic adviser; Gene Sperling, an adviser to the Treasury Secretary; Orszag; Furman. Like Emanuel, all had worked in the Clinton Administration, all are strong-willed, and all know how to navigate the White House bureaucracy to advance their views. Emanuel personally recruited several of them, and it is now his job to manage their competing egos. Hard copies of that morning’s issue of Politico were strewn across desks in the West Wing; the paper depicted Emanuel on its front page as a lordly giant ruling over the White House, Congress, and the rest of Washington’s political architecture. Not all the world’s commentators, however, were as awestruck by his achievements. In Granma, the Cuban government’s leading propaganda organ, Fidel Castro wrote of Emanuel, “Never in my life have I heard or read about any student or compatriot with that name, among tens of thousands.” After a rambling meditation on the similarities between the chief of staff and Immanuel Kant, the retired jefe concluded that “Obama, Emanuel and all of the brilliant politicians and economists who have come together would not suffice to solve the growing problems of U.S. capitalist society.” Emanuel, for his part, seemed indifferent both to the praise in Washington and to the oddball critique from Havana. In a few hours, he would be leaving for a ski trip with his family to Park City, Utah, and he was anxious to get out of the White House and start the weekend. Asked about Castro’s article, he said, “Well, you know, ever since I stopped sending him my holiday card he’s been ticked off. I don’t know what to think about it. Do you know what I’m thinking about? I’m going to finally get to see my kids after a month. So that’s all I give a fuck about.” Unlike recent chiefs of staff from the Bush and Clinton eras, who tended to be relatively quiet inside players, Emanuel is a former congressional leader, a Democratic Party power, and one of the more colorful Beltway celebrities. He is a political John McEnroe, known for both his mercurial temperament and his tactical brilliance. In the same conversation, he can be wonkish and thoughtful, blunt and profane. (When Emanuel was a teen-ager, he lost half of his right middle finger, after cutting it on a meat slicer—an accident, Obama once joked, that “rendered him practically mute.”) And, like McEnroe, Emanuel seems to employ his volcanic moments for effect, intimidating opponents and referees alike but never quite losing himself in the midst of battle. “I’ve seen Rahm scream at a candidate for office one moment and then quickly send him a cheesecake,” Chris Van Hollen, a Democratic representative from Maryland, and a friend of Emanuel’s, told me. Emanuel has long since learned to balance his outsized personality, which has made him a subject of intrigue in Washington, with a compulsion for order, which makes him an effective manager. As a child, he attended a Jewish day school in Chicago, where students received written evaluations, instead of A’s and B’s. “My first-grade teacher,” he told me, “said two things that were very interesting: ‘Rahm likes to clean up after cleanup time is over.’ ” He pointed to his desk. “I am fastidious about it. In fact, this is messy today.” The second point was about Emanuel’s “personality being larger than life.” In the first grade. By any measure, what Obama’s White House has achieved in passing the stimulus bill is historic. The last President to preside over a legislative victory of this magnitude so early in his Administration was Franklin Roosevelt, who on the sixth day of his Presidency persuaded Congress to enact a wholesale restructuring of the banking system. (That, too, is likely in the offing for the Obama team.) Yet praise for Obama was surprisingly grudging. Some liberal Democrats said that Emanuel and his team had made too many concessions to House Republicans, all of whom voted against the legislation. Meanwhile, conservatives complained that Obama had broken his pledge of bipartisan coöperation. Both arguments infuriated Emanuel, who spent hours on the Hill during the negotiations, arranged private meetings with Obama in the Oval Office for the Republican senators Susan Collins, Olympia Snowe, and Arlen Specter, whose votes were critical to the bill’s passage, and personally haggled over the smallest spending details during a crucial evening of bargaining that lasted until the early morning. “They have never worked the legislative process,” Emanuel said of critics like the Times columnist Paul Krugman, who argued that Obama’s concessions to Senate Republicans—in particular, the tax cuts, which will do little to stimulate the economy—produced a package that wasn’t large enough to respond to the magnitude of the recession. “How many bills has he passed?”

243 Emanuel has heard such complaints before. As a senior aide in the Clinton White House, he successfully fought a Republican Congress to pass the State Children’s Health Insurance Program (S- CHIP), which now provides health care for seven million kids. “I worked children’s health care,” he said. “President Clinton had pediatric care, eye, and dental, inside Medicaid. The Republicans had pediatric care, no eye and dental, outside of Medicaid. The deal Chris Jennings, Bruce Reed, and Rahm Emanuel cut for President Clinton was eye, dental, and pediatric, but the Republican way— outside of Medicaid. At that time, I was eviscerated by the left.” He slammed his fist on the desk, his voice rising. “I had sold out! Today, who are the greatest defenders of kids’ health care? The very people that opposed it when it passed,” Emanuel said. “Back then, you’d have thought I was a whore! How could we do this outside of Medicaid? They warned that it had to be in Medicaid—not that they gave a rat’s ass that the kid had eye or dental care. But, for getting it outside of Medicaid, we got kids’ eye and dental care. O.K.? That was the swap. Now, my view is that Krugman as an economist is not wrong. But in the art of the possible, of the deal, he is wrong. He couldn’t get his legislation.” The stimulus bill was essentially held hostage to the whims of Collins, Snowe, and Specter, but if Al Franken, the apparent winner of the disputed Minnesota Senate race, had been seated in Washington, and if Ted Kennedy, who is battling brain cancer, had been regularly available to vote, the White House would have needed only one Republican to pass the measure. “No disrespect to Paul Krugman,” Emanuel went on, “but has he figured out how to seat the Minnesota senator?” (Franken’s victory is the subject of an ongoing court challenge by his opponent, Norm Coleman, which the national Republican Party has been happy to help finance.) “Write a fucking column on how to seat the son of a bitch. I would be fascinated with that column. O.K.?” Emanuel stood up theatrically and gestured toward his seat with open palms. “Anytime they want, they can have it,” he said of those who are critical of his legislative strategies. “I give them my chair.” His task has been made no easier by Obama’s desire for bipartisanship, which Emanuel argues the press has misunderstood. “The public wants bipartisanship,” he said. “We just have to try. We don’t have to succeed.” Still, he insisted, they have been succeeding. All Obama’s other major accomplishments to date—winning approval for three hundred and fifty billion dollars in additional funding for the Troubled Asset Relief Program (TARP), passing the Lilly Ledbetter Fair Pay Act, expanding S-CHIP, signing an executive order to shutter the detention camp at Guantánamo Bay and a memorandum to increase the fuel efficiency of cars—were supported by at least some Republicans. The G.O.P., Emanuel said, decided that opposing the stimulus “was definitional, and I will make an argument to you, both on political and economic grounds: they will lose. I don’t think the onus is on us. We tried. The story is they failed.” When Emanuel said this, I noticed that over his left shoulder, on the credenza behind him, was an official-looking name plate, which he said was a birthday present from his two brothers. It read, “Undersecretary for Go Fuck Yourself.” The office of chief of staff was created by Dwight Eisenhower, who redesigned the working structure of the White House along the hierarchal staff system he had learned as supreme commander of Allied forces in the Second World War. His chief of staff—though he didn’t officially use the title, because Eisenhower worried that “politicians think it sounds too military”—was Sherman Adams, who accrued enormous influence, power, and enemies. Neither John F. Kennedy nor Lyndon Johnson had a chief of staff, and largely managed the White House themselves. Richard Nixon returned to Eisenhower’s system and delegated vast managerial authority to H. R. Haldeman, the Watergate conspirator whose ironfisted management of the White House abetted Nixon’s own self-destructive behavior in office. In reaction, both Gerald Ford and Jimmy Carter tried to operate without chiefs of staff, but both men reversed course when the flat management structure of their respective White Houses produced staff disarray. Since Carter, every President has acknowledged the need for a strong chief of staff. Over the years, some clear patterns about what kind of person succeeds in the job have emerged. James Pfiffner, a professor at George Mason University who has written extensively on the history of the office, cites four chiefs of staff as notable failures: Adams, Haldeman, Donald Regan, who was Ronald Reagan’s second chief of staff, and John Sununu, George H. W. Bush’s first chief of staff. “All

244 of them got power-hungry, they alienated members of Congress, they alienated members of their own Administration, they had reputations for a lack of common civility, and they had hostile relations with the press. And each one of them resigned in disgrace and hurt their Presidents,” Pfiffner said. “Being able to be firm and tough without being obnoxious and overbearing is crucial.” Emanuel’s début as chief of staff featured him on the Hill making deals with lawmakers—politely and with due deference, by all accounts—but a chief of staff’s primary job is to serve as the gatekeeper to the President, controlling the flow of information and people into the Oval Office. Constrict that flow too much and you deprive the President of opposing points of view; increase it too much and you drown him in extraneous detail and force him to arbitrate disputes better settled at a lower level. Emanuel saw both extremes in the Clinton White House. Clinton’s first chief of staff, Thomas (Mack) McLarty, a childhood friend from Arkansas, was known as Mack the Nice, and under his leadership the White House was chaotic. Leon Panetta, who is now Obama’s C.I.A. director and, like Emanuel, was a congressman, took over from McLarty. Arguably, he overcompensated for McLarty’s laxness, limiting access to the President so drastically that Clinton surreptitiously sought counsel outside the channels that Panetta controlled. “The President set up a parallel White House, led by Dick Morris, while Leon was chief of staff,” a former senior Clinton White House official told me. “If you clamp down too tight the principal says, ‘You’re not letting me have access to the people and the information I really want, so I’m just going to go build some other structure.’ ” Obama’s managerial instincts tend toward a looser operation, with lots of staff and outside input. The fact that he will keep a BlackBerry to stay in touch with friends outside the West Wing fishbowl is one sign of this. (Emanuel grimaced when I mentioned his boss’s devotion to the device.) But early in his Senate career Obama also learned the perils of not having one strong manager in charge. When he arrived in Washington, in 2005, he told one of his senior aides, “My vision of this is having six smart people sitting around the table batting ideas around.” A month and a half later, tensions erupted between Obama’s Chicago staff and his Washington staff, making it difficult for them to agree on his schedule. Obama was frustrated that no single person was able to make decisions. The aide reminded him, “Don’t you remember: ‘six smart people sitting around the table’?” Obama replied, “Oh, that was six weeks ago. I’m not on that now.” Emanuel’s task will be further complicated by what is a fairly top-heavy White House. David Axelrod, Obama’s longtime political strategist, Valerie Jarrett, a close friend and counsellor, and Pete Rouse, Obama’s Senate chief of staff, are “senior advisers,” a title that in the White House denotes a special place at the top of the hierarchy. Part of Emanuel’s job will be to stitch Obama’s old campaign hands together with powerful new figures on the policy side, such as Summers—“a dominating personality,” according to a senior White House official—and James L. Jones, a retired four-star general and Obama’s national-security adviser. In addition, Obama has created four new policy czars at the White House—for health care, energy, Native American affairs, and urban affairs—making the West Wing a more crowded place. Meanwhile, Vice-President Joseph Biden has been promised a high-level role in decision-making. Joshua Bolten, George W. Bush’s last chief of staff, told me that Emanuel has “the challenge of fitting a lot of large personalities and brains and portfolios into a relatively small space.” Perhaps Emanuel’s greatest challenge, however, will be making the adjustment from being a prominent elected official to being a staffer. Bolten, who hosted Emanuel and eleven former chiefs of staff for breakfast at the White House in December, said, “One of the interesting bits of advice that emerged from the breakfast was that you probably shouldn’t be a political principal yourself. You need to put aside your own personality and profile and adopt one that serves your boss. I’m not saying you necessarily have to have a low profile, but it can’t really be your own independent profile. It’s got to be the profile your boss wants reflected, and it has to be a profile that does not compete with the rest of the Cabinet.” Emanuel said that he has thought about that advice. “There’s no doubt” that this is an issue, he told me. “There are pluses to who I was and what I was and there are perils to who I was and what I was, and you’ve got to be conscious of them.” David Axelrod is one of Emanuel’s best friends. (When Emanuel got married, to Amy Rule, Axelrod signed the ketubah, the traditional Jewish marriage contract.) The two men met in 1982, when Emanuel was a spokesman for a Naderite group called the Illinois Public Action Council and Axelrod

245 was a reporter for the Chicago Tribune. Emanuel’s organization had just helped elect Lane Evans as the first Democratic representative from western Illinois in many years, and Emanuel was eager to get Axelrod to write about it. “He was just relentless,” Axelrod told me recently. “Rahm chased me down to the recovery room after my second child was born. He says, ‘What is it, a boy or a girl?’ I said, ‘It’s a boy.’ He said, ‘Mazel tov,’ and then a little pause. Then he says, ‘When do you think you’ll be back at work?’ ” Emanuel and Axelrod crossed paths again in 1984, when Axelrod left journalism to run Paul Simon’s Illinois Senate campaign and Emanuel worked as a junior fund-raiser and field organizer for Simon. By 1988, Emanuel was a top staffer at the Democratic Congressional Campaign Committee, or D.C.C.C. (the same organization that he ran as a congressman seventeen years later). “I did campaigns in ’86 and ’88 for him and with him,” Axelrod said. “Including the famous dead-fish race.” More than any other story about Emanuel’s tactics—and there are lots of them—the tale of the “dead- fish race” came to define his public persona as a Democratic operative. He and Axelrod were working for David Swarts, a Democratic official from Erie County, New York, running an underfunded campaign for a congressional seat long held by Republicans. “We were rolling the dice on the race, just spending the money we had as it came in to try and get these numbers up,” Axelrod said. Their plan was to take a poll at the end of the contest which they hoped would show a competitive race and then use the results to help raise last-minute funds and overtake their opponent. “The poll came back a week or two before the end, and it said we were down by seventeen,” Axelrod said. “And that was it.” According to Axelrod, Swarts’s campaign manager later studied the poll’s findings and concluded that the pollster had botched the analysis: the survey showed that Swarts was just five or six points behind. (The pollster says that the error was actually minor and quickly caught.) Axelrod added, “Had we gotten that correct poll then, we would have put our foot to the pedal. But it was too late. So Rahm, being as invested as he was in the thing, expressed himself as only Rahm can.” After the election, Emanuel and his colleagues hired a Massachusetts company called Enough Is Enough, which specialized in “creative revenge,” to send the pollster a box with a dead fish inside. Emanuel laughed mischievously when I asked him about the prank. “We had our choice of animals,” he said. When Emanuel is in Washington, he stays in the basement of the Capitol Hill home of Representative Rosa DeLauro, of Connecticut, and her husband, the pollster Stanley Greenberg, an old friend. (“It’s part of my workout room,” Greenberg said recently of the accommodations. “He walks out of his bedroom into where I work out.”) Greenberg argues that Emanuel’s antics have been integral to his success. “Understand that the caricature and the mythology have always been helpful,” Greenberg said. “Sending the fish to the pollster that he thought had failed sent a message about how public he can be about his displeasure, and showed that he’s willing to step beyond the normal bounds, that he’s willing to be outrageous and he doesn’t suffer fools. He doesn’t mind bad publicity. It’s part of his cachet, it’s part of why he’s able to be effective.” Emanuel has succeeded in almost every professional endeavor he has undertaken. In Chicago, in 1989 and 1991, he raised money for the successful mayoral campaigns of Richard M. Daley, and this caught the attention of Bill Clinton’s campaign, which hired him. Emanuel then raised a record amount of money for Clinton, which kept his Presidential campaign from collapsing during the darkest days of the primaries, when he was fighting allegations of adultery and draft-dodging. In the Clinton White House, after a brief setback—he was demoted after clashing with Hillary Clinton—Emanuel rose to become a top adviser to Bill Clinton, securing for himself the small but coveted office next to the President’s private study, the office that Axelrod now occupies. When Emanuel left the Clinton Administration, in 1998, he moved back to Chicago, took a job as an investment banker, and in less than three years earned nearly twenty million dollars. In 2002, he won a congressional seat in the city on his first attempt. Three years later, he took over the D.C.C.C., and, more than anyone else, was responsible for restoring Democrats to power the following year. (Not a single Democratic incumbent lost in the general election.) By the time Obama came calling for a chief of staff, Emanuel was the Democratic Caucus chair, making him fourth in the House leadership, and on a path to becoming Speaker.

246 Obama settled on Emanuel as early as last August. “It was months before the election when Barack said to me, ‘You know, Rahm would make a great chief of staff,’ ” Axelrod said. “He spent six years in the White House, knows this place inside and out, spent four or five years in Congress, and became a leader in a short period of time. He really understands the legislative process, he’s a friend who the President has known for a long time from Chicago, and whose loyalty is beyond question, and who thinks like a Chicagoan.” Emanuel did not want the job. A few months before Election Day, Obama sent him an e-mail, with a warning: “Heads up, I’m coming for you.” Emanuel was a key negotiator in moving the TARP legislation through Congress, in October. After the bill cleared Congress, Obama, who supported it, sent Emanuel another e-mail. “I told you we made a great team,” he said. Emanuel wrote back, “I look forward to being your floor leader in the House.” While Obama was wooing Rahm, Rahm’s older brother, Ezekiel, an oncologist and a bioethicist, served as a sounding board. “I probably spent half an hour every day being screamed at on the telephone by him,” he said. “ ‘I don’t want to do this. Why do I have to do this? Tell me I don’t have to do this.’ All of which said to me he knew he had to do it.” (Ezekiel told me that the rivalry among himself, Rahm, and their third brother, Ariel, a Hollywood agent who is the basis for the Ari Gold character on HBO’s “Entourage,” was so intense that they had to pursue careers in different cities. “We couldn’t possibly be within a thousand miles of each other, because the force fields just wouldn’t let it happen,” Ezekiel said. Rahm is now his boss; he works at the White House as an adviser to the budget director on health policy.) Over lunch two days before the Inauguration, Emanuel explained to me his decision to give up his congressional seat and return to the White House. We were in a brasserie in the lobby of a Washington hotel, and Emanuel, dressed in a black sweater over a white button-down, was frequently interrupted by people who wanted to wish him well or have their picture taken with him. “The main hesitation was family, because there’s no way you will convince me this is good for my family,” Emanuel, who has three children, ages eleven, ten, and eight, said. “No matter what every White House says—‘We’re going to be great, family-friendly’—well, the only family we’re going to be good for is the First Family. Everybody else is, like, really a distant second, O.K.?” Then there was the issue of his congressional ambition. In 2005, when Obama first arrived in Washington, he and Emanuel had dinner and discussed their futures. “He knew what I wanted to do, I knew what he wanted to do,” Emanuel told me. “He was going to be President one day, and I was going to run for Speaker. It was not that he was deciding on 2008 but his course was one day he was going to run for President.” For Emanuel, being chief of staff meant abandoning his goal. “I was putting together the pieces of my puzzle for Speaker,” he said. “I’d been to the White House—that was a dream, but I’d been there. Now I was on to another dream and professional goal and career. And so I had to give that up.” He added, “I had my own personal desire of being the first Jewish Speaker. That’s why I took on the D.C.C.C. job, that’s why I ran for Caucus chair, that’s why I stayed involved.” Emanuel grew up in a political family. His Israeli-born father, Benjamin, was a member of the Irgun, a militant Zionist group from which the modern Likud Party eventually emerged. His mother, Marsha, was a civil-rights activist who was arrested several times. “We were attacked because we were white Jews with African-Americans,” Ezekiel said. When Martin Luther King, Jr., marched in Chicago in 1966, and was pelted with eggs, Marsha and her children marched along with him. Ezekiel told me that he knew Rahm would take the job of chief of staff because of Marsha’s father, Herman Smulivitz, a boxer and a union organizer. It was Herman who instilled in Rahm a commitment to service, and Rahm was particularly close to him. When I asked Rahm about his grandfather, his eyes welled up with tears. “I’m a little too tired, a little too stressed,” he said. “It’s too emotional about Gramp.” He poured himself a glass of water and took a sip. Earlier, he had explained his decision in pragmatic terms: “If you got into public life to affect policy, and to affect the direction of the country, where could you do that on the most immediate basis? Everybody knows: chief of staff.”

247 Obama’s decision to hire Emanuel says two things about his Presidency. First, like his decision to make Biden, an expert in foreign policy, his running mate, it shows that he is honest enough about what he doesn’t know to try to fill in the gaps in his own experience. There are people working for Obama who know as much as Emanuel does about the legislative process, and others who know as much as he does about running the White House, but there isn’t anybody who knows as much about both. Obama’s choice also says a great deal about the ethos of his White House. He recently characterized his team as a group of “mechanics,” which suggests an emphasis not on ideology but on details and problem-solving. In the Clinton White House, Emanuel’s specialty was helping to pass legislation that required centrist coalitions, like NAFTA, a crime bill, and welfare reform. “He’s a partisan in the sense that he’s a strong Democrat, but he’s not an ideological Democrat,” Stanley Greenberg said. “He’s not ideologically liberal. He comes out of Chicago politics, which is more transactional.” During the Senate negotiations, Obama agreed to pare back his tax cut for workers, from five hundred dollars to four hundred dollars. It was Emanuel’s job to sell the decision to House Democrats. “Nancy was opposed to it,” he told me, referring to Nancy Pelosi, the Speaker of the House, who asked him why he would put the President’s tax cut on the table. “I said, ‘Because at the end of the day the President believes we have to get this done.’ ” Emanuel thinks that the stimulus bill speaks for itself: “It is the most progressive tax bill in the history of the United States, bar none, by a quotient of two.” Emanuel laughed as he recounted the final sticking point in the negotiations. It was not, as many people have thought, an argument between the five centrist senators—Ben Nelson, Joe Lieberman, Collins, Snowe, and Specter—and the House but a debate among the centrists themselves. The dispute was over a formula for how Medicaid funds in the bill would be allocated to the states. In the House version of the legislation, fifty per cent of the funds would go to all states and fifty per cent would go to states with high unemployment. In the Senate, where rural interests are more dominant, the formula was 80-20. A deal had been reached between the two chambers to split the difference and make the formula 65-35. “Everybody signed except for Ben Nelson,” Emanuel said. “He wants 72-28, or seventy-two and a half, and he says, ‘I’m not signing this deal.’ Specter says, ‘Well, I am not agreeing with you.’ ” Without Nelson, Collins wasn’t likely to vote for the deal, either. “Collins and Snowe are kind of like, at this point, looking at their shoes,” Emanuel went on, “because Specter says, ‘Well, why make it seventy-two? What do you mean? We all have it at sixty-five, in the middle.’ ” Emanuel politely declared that the formula would stay at 65-35. He then asked Nelson to step out of the room with him. After a brief conversation in the hallway, they returned, and Nelson agreed to the stimulus package. Emanuel stood up and removed his tie as he finished the story, making it clear that he was ready to leave for the airport. He seemed more cheerful, knowing that he was that much closer to seeing his family. I asked him what he promised Nelson to persuade him to drop his objections. Emanuel just smiled. “Everything is going to be O.K.,” he said, in a mock-soothing voice. “America is going to be a great place.” ♦ http://www.newyorker.com/reporting/2009/03/02/090302fa_fact_lizza?currentPage=all

248 Apr 2, 2009 FASB Eases Mark-To-Market Rules For Toxic Assets: Will Banks Prefer To Keep Them Now?

Overview: On April 2 FASB agrees to ease mtm accounting rules for illiquid assets with uncertain market value. Question arises if that undermines Geithner's PPPIP plan unless banks are forced to participate. If participation remains voluntary, banks might prefer to hold on to particularly toxic assets and in particular loans for which the auction price coulp potentially lead to large writedown at the sales price. o Key points (Reuters): 1) Rules effective Q1 2009; 2) FASB says the objective of mark-to- market accounting is to set a price that would be received by a bank in an "orderly" transaction in the current, inactive market. It says an "orderly" transaction for accounting purposes does not include the forced liquidation or a distressed sale of an asset. 3) FASB agrees to drop the presumption in mark-to-market accounting that all transactions in an inactive market are distressed unless proven otherwise. 4) FASB clarifies when banks are required to take write downs on impaired assets, letting them record smaller losses on their income statements --> see Theoretical Aspect of Fair Value and Mark-To-Market Accounting: Is There A Better Alternative? o March 30: Upon pressure from Congress at March 13 hearing and the industry back in September 2008 with explicit IIF request, FASB proposes a meaningful flexibilization of accounting rules to be voted upon on April 2. In particular, assets for which no active market exists would be assumed to be distressed. in this case the last transaction price is not the benchmark anymore. o April 2 Reuters: Investor groups opposed the change, saying it would let big banks conceal the real value of their toxic assets. o April 2: Fitch Ratings believes that should these proposals be adopted, disclosures by issuers should be expanded to allow for thorough and meaningful analysis, regardless of the minimum requirements o Robert Willens (former Lehman director) Fair value overhaul may improve profits at banks such as Citigroup by more than 20 percent. o March 19 Jonathan Weil: The banks demanded that the accountants give them leeway in how they report losses to investors. "The accountants [at FASB] responded by giving away their souls": Starting Q1 2009, U.S. companies would be allowed to report net- income figures that ignore severe, long-term price declines in securities they own. Not just debt securities but even common stocks and other equities, too. o cont.: Investors should ignore net income and start focusing on the real bottom line, a term called comprehensive income, which is found on a company’s statement of shareholder equity: this measure includes changes in the values of corporate pension plans, foreign currencies, certain derivative instruments, and securities classified as available for sale. That’s why investors should stop giving credence to net income.

249 o cont.: General Electric Co., for example, reported $17.4 billion of net income for 2008 -- and a comprehensive loss of $12.8 billion. o Allen/Carletti/Poschman: .In crises when liquidity constraints affect market prices, model-based and historic cost valuations may provide helpful information. The rest of the time, and in particular when asset prices are low because expectations of future cash flows have fallen, mark-to-market accounting should be used instead o IMF: Mark-to-market has its issues that can be dealt with but it is still the best alternative available o March 12: OCC deputy Kevin Baily (via Reuters): in congressional hearing opposes to suspending mark-to-market accounting rules to value bank assets, but said some tweaks might be needed. o Ben Bernanke has proposed 'hold-to-maturity' purchase price instead of current market value described as 'fire-sale' price. o Daniel Gros shows that non-recourse feature of U.S. mortgages translates into put option for borrowers that gains value as house prices fall--> real value of RMBS might indeed be as low as is suggested by ABX subprime derivatives indices. o RGE: Merrill's CDO equity tranche sale to Lone Star was in line with TABX derivatives valuations--> derivatives indices provide good guidance to mark-to-market value of structured instruments. o Dealbreaker TARP bill text analysis: "Prevent unjust enrichment of financial institutions including by preventing the sale of a troubled asset to the Secretary at a higher price than what the seller paid to purchase the asset." o Accountants, auditors: If an asset is technically undervalued, this is called a buying opportunity. o Tett: valuation and pricing issues prevented the first Super-SIV from working, the same might happen again. If bad asset purchase price is too low, writedowns might be too large to bear; if price is too high, taxpayer overpays and has limited upside eventually

250 Apr 1, 2009 U.S. Credit Card Delinquencies At Record Highs: Same Dynamics As Mortgages? Overview: U.S. credit card defaults rise to 20 year-high. Analysts estimate credit card chargeoffs could climb to between 9 and 10% this year from 6 to 7% at the end of 2008. In that scenario, such losses could total $70 billion to $75 billion in 2009 (Reuters). Meanwhile, the $5trillion in outstanding credit card lines (of which $800bn is currently drawn upon) are being trimmed even for credit worthy borrowers with Meredith Whitney estimating that over $2 trillion of credit-card lines will be cut in 2009 and $2.7 trillion by the end of 2010. Research shows that unemployment is one of the most important drivers of credit card and auto loan loss rates. RGE (Kruettli) estimates that credit card charge-off rate could reach 13% (or $146bn) in the worst case scenario. o March 16 Reuters: losses particularly severe at American Express and Citigroup amid a deepening recession. AmEx, the largest U.S. charge card operator by sales volume, says net charge-off rate rose in February to 8.7% from 8.3% in January as job losses accelerated and the economy deteriorated. Citigroup -- one of the largest issuers of MasterCard cards -- default rate soared to 9.33 percent in February, from 6.95 percent a month earlier. o cont.: Positive surprises: JPMorgan Chase and Capital One reported higher credit card losses, but they were below analysts expectations. o BNP March 16: AAA ABS Benchmark Spreads Improve In View of $1000bn TALF liquidity program , Fixed Rated ABS Spreads Stay High. o Fitch March: In January, credit card delinquencies breached all-time highs for the second consecutive month according to the latest Fitch Credit Card Index results. At January month end, the 60 plus day delinquency rate was 4.04%. The results come amid an unending parade of troubling economic data from surging unemployment to steeper declines home and equity market values. o Moody's: January credit card charge-offs reached a record-high 7.74%, and with an increasing number of borrowers falling behind on their credit card payments charge-off rates will almost certainly increase in the coming months. The seasonal post-holiday rebound in payment rates did not materialize this January, leaving the payment rate index, which has been falling since early 2007, near a five-year low. The payment rate has been falling since early 2007. (research recap) o Meredith Whitney (via WSJ) March 10: Currently, there is roughly $5 trillion in credit-card lines outstanding in the U.S., and a little more than $800 billion is currently drawn upon. Just six months ago, I estimated that at least $2 trillion of available credit-card lines would be expunged from the system by the end of 2010. However, today, that estimate now looks optimistic, as available lines were reduced by nearly $500 billion in the fourth quarter of 2008 alone. My revised estimates are that

251 over $2 trillion of credit-card lines will be cut inside of 2009, and $2.7 trillion by the end of 2010.--> see Credit Card Reform: What Impact On Consumers? On Banks? On Investors? cont.: Currently five lenders dominate two thirds of the market. o SIFMA: Q4 2008 marked the first time ever that four of the major sectors (home equity, credit card, student loan, and equipment leases) had no issuance. o Graef (Deutsche Bank): Credit card debt grew strongly in absolute terms but was comparatively stable in relation to disposable income. In light of the virtually unchanged ratio of credit card debt to disposable incomes we cannot detect a credit card bubble-->we do not expect an above-average increase in credit card defaults, particularly in view of substantially lower credit card interest rates compared with earlier years. o White (NBER/UCSD): Ratio of consumer debt to median income increased to 4.5 in 2007 from 1 in 1980 compared to a ratio of 3 for mortgage debt/median income--> "high debt/misuse of credit cards" is the primary reason for increase in bankruptcy filings since the mid-1980s. o Wieting (Citigroup): Households shifted expensive credit card debt to less expensive, tax-deductible mortgage credit in the early/mid 2000s. Revolving credit grew at an average 4.3% year/year pace in 2002-2007 vs 12.4% for mortgage debt. As such, credit card delinquencies have been closer to “cyclical norms,” unlike housing. However, we believe the employment downturn will now drive cyclical delinquencies in cards too. Expect unemployment to rise to 8-10%. o Mathias Kruettli (RGE): Given that lending standards are being tightened across the board, a jump in the unemployment rate is likely to increase the default rate on credit card debt, which might lead to higher write-downs on the banks credit card portfolios. o cont.: The paper comes to the conclusion that write-downs in 2009 are likely to be significantly higher than in2008 (50 billion USD). In the worst case scenario the credit card receivable write-downs could be as high as 146billion USD in 2009. In the best case the write-downs will be around 64 billion USD. Currently, there are about $2.5T ABS receivables outstanding, incl. credit card, auto loan, HEL (SIFMA estim. of Q2 08) o Fitch, DBRS: report addresses the sensitivity of auto and credit card transactions to unemployment, one of the most important macroeconomic indicators for consumer finance. Results: - Changes in the unemployment rate are strongly correlated with changes in auto loan losses and credit card chargeoffs; - Auto loan and credit card ABS loss rates are expected to increase proportionately to the increases in unemployment rate; - Prime credit card chargeoffs are expected to increase on a 1:1 basis wrt unemployment. Accordingly, a 100% increase in the base unemployment rate, from 5% to 10%, would lead to a 100% increase in the prime credit card chargeoff index, from 6.18% (April 2008) to 12.36% over the next 12 months; - Subprime credit card chargeoffs and prime and subprime auto loan net losses are expected to increase at a rate closer to 1.2−1.3:1, meaning a 100% increase in unemployment could lead up to a 130% increase in losses; - Consumers are more likely to default on credit cards more immediately than they default on auto loans following shocks to the labor markets; - While, on average, the ‘BBB’ or ‘AAA’ bonds could withstand an unemployment rate of up to 11% or 20% respectively before a default occurs, downgrades during these stresses would be inevitable. http://www.rgemonitor.com/index.php?kwd=Search+Articles%2C+Blogs%2C+Archives+and+more...&option=com_search&task=search

252 Opinion

April 1, 2009 OP-ED CONTRIBUTOR Obama’s Ersatz Capitalism By JOSEPH E. STIGLITZ THE Obama administration’s $500 billion or more proposal to deal with America’s ailing banks has been described by some in the financial markets as a win-win-win proposal. Actually, it is a win-win-lose proposal: the banks win, investors win — and taxpayers lose. Treasury hopes to get us out of the mess by replicating the flawed system that the private sector used to bring the world crashing down, with a proposal marked by overleveraging in the public sector, excessive complexity, poor incentives and a lack of transparency. Let’s take a moment to remember what caused this mess in the first place. Banks got themselves, and our economy, into trouble by overleveraging — that is, using relatively little capital of their own, they borrowed heavily to buy extremely risky real estate assets. In the process, they used overly complex instruments like collateralized debt obligations. The prospect of high compensation gave managers incentives to be shortsighted and undertake excessive risk, rather than lend money prudently. Banks made all these mistakes without anyone knowing, partly because so much of what they were doing was “off balance sheet” financing. In theory, the administration’s plan is based on letting the market determine the prices of the banks’ “toxic assets” — including outstanding house loans and securities based on those loans. The reality, though, is that the market will not be pricing the toxic assets themselves, but options on those assets. The two have little to do with each other. The government plan in effect involves insuring almost all losses. Since the private investors are spared most losses, then they primarily “value” their potential gains. This is exactly the same as being given an option. Consider an asset that has a 50-50 chance of being worth either zero or $200 in a year’s time. The average “value” of the asset is $100. Ignoring interest, this is what the asset would sell for in a competitive market. It is what the asset is “worth.” Under the plan by Treasury Secretary Timothy Geithner, the government would provide about 92 percent of the money to buy the asset but would stand to receive only 50 percent of any gains, and would absorb almost all of the losses. Some partnership! Assume that one of the public-private partnerships the Treasury has promised to create is willing to pay $150 for the asset. That’s 50 percent more than its true value, and the bank is more than happy to sell. So the private partner puts up $12, and the government supplies the rest — $12 in “equity” plus $126 in the form of a guaranteed loan. If, in a year’s time, it turns out that the true value of the asset is zero, the private partner loses the $12, and the government loses $138. If the true value is $200, the government and the private partner split the $74 that’s left over after paying back the $126 loan. In that rosy

253 scenario, the private partner more than triples his $12 investment. But the taxpayer, having risked $138, gains a mere $37. Even in an imperfect market, one shouldn’t confuse the value of an asset with the value of the upside option on that asset. But Americans are likely to lose even more than these calculations suggest, because of an effect called adverse selection. The banks get to choose the loans and securities that they want to sell. They will want to sell the worst assets, and especially the assets that they think the market overestimates (and thus is willing to pay too much for). But the market is likely to recognize this, which will drive down the price that it is willing to pay. Only the government’s picking up enough of the losses overcomes this “adverse selection” effect. With the government absorbing the losses, the market doesn’t care if the banks are “cheating” them by selling their lousiest assets, because the government bears the cost. The main problem is not a lack of liquidity. If it were, then a far simpler program would work: just provide the funds without loan guarantees. The real issue is that the banks made bad loans in a bubble and were highly leveraged. They have lost their capital, and this capital has to be replaced. Paying fair market values for the assets will not work. Only by overpaying for the assets will the banks be adequately recapitalized. But overpaying for the assets simply shifts the losses to the government. In other words, the Geithner plan works only if and when the taxpayer loses big time. Some Americans are afraid that the government might temporarily “nationalize” the banks, but that option would be preferable to the Geithner plan. After all, the F.D.I.C. has taken control of failing banks before, and done it well. It has even nationalized large institutions like Continental Illinois (taken over in 1984, back in private hands a few years later), and Washington Mutual (seized last September, and immediately resold). What the Obama administration is doing is far worse than nationalization: it is ersatz capitalism, the privatizing of gains and the socializing of losses. It is a “partnership” in which one partner robs the other. And such partnerships — with the private sector in control — have perverse incentives, worse even than the ones that got us into the mess. So what is the appeal of a proposal like this? Perhaps it’s the kind of Rube Goldberg device that Wall Street loves — clever, complex and nontransparent, allowing huge transfers of wealth to the financial markets. It has allowed the administration to avoid going back to Congress to ask for the money needed to fix our banks, and it provided a way to avoid nationalization. But we are already suffering from a crisis of confidence. When the high costs of the administration’s plan become apparent, confidence will be eroded further. At that point the task of recreating a vibrant financial sector, and resuscitating the economy, will be even harder. Joseph E. Stiglitz, a professor of economics at Columbia who was chairman of the Council of Economic Advisers from 1995 to 1997, was awarded the Nobel prize in economics in 2001. http://www.nytimes.com/2009/04/01/opinion/01stiglitz.html?_r=1&th&emc=th

254 Apr 1, 2009 How Much Will U.S. Housing Prices Fall And How Long Will The Downturn Last? o The S&P/Case-Shiller 20-City Composite Index fell 19.0% y/y in January 2009, the fastest on record, as high inventories and foreclosures continued to drive down prices. All 20 cities covered in the survey showed a decrease in prices, with 9 of the 20 areas showing rates of annual decline of over 20% y/y.(S&P) o As of January 2009, average home prices are at similar levels to what they were in Q3 2003. From the peak in mid-2006, the 10-City Composite is down 30.2% and the 20-City Composite is down 29.1%.(S&P) o Q4 2008: The decline in the S&P/Case-Shiller U.S. National Home Price Index recorded an 18.2% decline in Q4 2008, largest in the series' history. This has increased from the annual declines of 16.6% and 15.1%, reported for the Q3 and Q2 2008, respectively. o Kiesel: U.S. housing prices, despite having fallen roughly 20% from their peak back in the second quarter of 2006, remain 10%–15% overvalued based on long-term historical measures such as price-to-income, price-to-rent and price-to-economic growth. In addition, total new and existing inventories of 4.7 million units are higher now than at the beginning of the year, and roughly 12 million homes are now in a negative equity position in which homeowners owe more on their mortgage than the home is worth. More challenging credit markets also mean fewer potential buyers. As a result, in terms of housing’s total peak-to-trough decline, a 30%–35% total decline from peak now looks possible o RGE Monitor: based on a range of indicators (real home price index by Shiller 2006, price rent ratio and price/income ratio) the fall in home prices from their peak will be in the 30- 40% range o CEPR: Nominal prices have now declined 19.5 percent from their peak two years ago, which implies a real decline of approximately 27 percent. This means that the bubble is approximately 60 percent deflated. This corresponds to a loss of more than $5 trillion in real housing wealth o OFHEO index fell 0.6% m/m in July and it is down 5.3% on a y/y basis. This is the sharpest decline for this cycle and on record o Fitch (via Calculated Risk): expecting home prices to decline by an average of 25 percent in real terms at the national level over the next five years, starting from the Q2 2008 o Wachovia:the S&P/Case-Shiller 10-city composite index will fall 28.6% on a peak-to- trough basis. OFHEO purchase only index will decline around 22% o IMF: the baseline scenario for the U.S. economy assumes a 14–22% drop in house prices during 2007–08

255 o PMI Group: U.S. home price declines will probably double to a national average of 20 percent by next year, with lower values most likely in metropolitan areas in California, Florida, Arizona and Nevada o Krugman: My preferred metric is the ratio of home prices to rental rates. By that measure, average home prices nationally got way too high. We'll probably basically retrace all that. So that's about a 25% decline in overall home prices (CNN) o Davis, Lehnert and Martin: prices would have to fall 15% over five years - assuming rents rose 4% a year - to bring rent/price ratio back to its long-term average o Goldman Sachs (Calculated Risk): Home prices to fall 15% w/o recession and 30% in case of a recession o Shiller: home prices to fall up to 50% in some areas

Apr 1, 2009 U.S. Housing Starts and New Home Sales Improve, Permits Still Weak: Is the Sector Stabilizing? Stabilization in the U.S. housing sector is not yet in sight: inventories and vacancies are still at a record high and continue to put downward pressure on home prices which continue to fall translating into trillions of real wealth losses for the engine of the economy: the U.S. consumer o Feb 2009: Starts rose unexpectedly by 22.2% m/m to an annual rate of 583,000, led by a surge in the multifamily component, but are down 47.3% y/y and 74% below their peak in January 2006. This first gain in eight months defies weak fundamentals and is likely to be due to seasonal factors. Building permits, a indicator of future construction rose slower at 3.0% m/m, indicating that starts might ease further in the future. Completions rose 2.3% m/m and were down 37.3% y/y. o Feb 2009: Existing home sales rose 5.1% to an annual rate of 4.72 million units in February from 4.49 million units in January, as cheaper credit and bargains on foreclosed properties attracted first time buyers. Distressed sales accounted for 45% of all sales, causing the national median home price to fall 15.5% y/y. The number of previously owned unsold homes on the market by the end of February represented 9.7 months’ worth supply at the current sales pace, up from 9.6 months in January. Resales of single-family homes rose 4.4% to an annual rate of 4.23 million in February. Sales of condos and co-ops rose 11.4% to an annual rate of 490,000 units. o Feb 2009: New home sales rose unexpectedly by 4.7%m/m in February to an annualized rate of 337,000. New sales are down 41.1% y/y and down 76.1% from the peak of July 2005. Lower mortgage rates and falling home prices caused the gain in sales in February.

256 The median sale price fell to $200,900, the lowest since December 2003 and is 17.7% below last February's level. o Feb 2009: Construction Spending fell 0.9% in February 2009 and by 10% y/y, led by declining residential construction. Housing construction fell faster in February by 4.3% from a 2.9% drop in January. Nonresidential spending rose marginally, up 0.3%, while government building projects rose by by 0.8% o NAHB builders’ sentiment index rose a single point to 9 in February – virtually unchanged from a record low of 8 in January o November new home sales plunge -35%; existing home sales -10.6%--> Ritholtz: Mortgage rates are the lowest in three years but tight lending standards mean that credit is hardly available for anyone but the best qualified buyers. o MBA: 1 in 10 Americans fell behind on mortgage payments or were in foreclosure in Q3 2008. The share of mortgages 30 days or more overdue and the share of loans already in foreclosure both jumped to all-time highs in a survey that goes back 29 years o Q3-08: Foreclosures boosted sales of single-family houses and condominiums to 5.04 mn at a seasonally adjusted annual rate, up 2.6% in Q2-08 o RealtyTrac: Foreclosure filings (incl. default notices, pending auctions, repossessions) rose 25% y/y to 279,561 in October o CBO: Under an optimistic scenario, starts will return to normal underlying levels by end of 2009; Under cyclical downturn scenario, return to underlying levels doesn't occur until early 2011; Under pessimistic scenario, return to underlying levels occurs in 2H 2012 o NAR: The Pending Home Sales Index a forward-looking indicator based on contracts signed in October 2008, slipped 0.7% to 88.9 from an upwardly revised reading of 89.5 in September, and is 1.0% below October 2007 when it was 89.8 o Toll Brothers cancellation rate running around 24.9% (CEPR) http://www.rgemonitor.com/80/Housing_Bubble_and_Bust?cluster_id=6077

257 A TASK FIT FOR HERCULEAN POLICYMAKERS

A task fit for Herculean policymakers By Gillian Tett in London Published: April 1 2009 22:49 | Last updated: April 1 2009 23:32 As global leaders gather in London on Thursday, they might be forgiven for feeling caught in a Sisyphean situation. Time and again over the past two years, bureaucrats and bankers have tried to halt the financial crisis by unveiling measures to write off toxic assets – and make the banks healthy again. Yet almost every time they have laboriously rolled the toxic asset boulder up the hill, it has come crashing down again. Never mind all those flashy forensic tests that bankers have promised, to measure the scale of the rot – or those trillions of dollars of taxpayers’ funds that have been spent to “clean up” the banks. As more toxic assets keep emerging, public confidence in the financial system keeps crumbling afresh. Little wonder. After all, the only thing more scary than the current scale of today’s banking woes is that, a full two years after subprime defaults got under way, policymakers and bankers alike remain confused about just how big the toxic rot really is, let alone when it might end. Will Thursday’s meeting provide any further clues? Don’t bet on it. After all, the issue of toxic assets – or “legacy assets”, as the Americans prefer to say – barely even features on the official agenda of the Group of 20 summit. Instead, the topics that are grabbing the limelight are initiatives on public spending, banking pay or regulatory reform, including an eye-catching row about tax havens. That is no accident. One dirty secret that hangs over Thursday’s meeting is that there is still precious little global consensus about how to tackle the toxic woes. Some countries (such as the US) are trying to persuade banks to sell their bad assets; others (such as the UK) are trying to “insure” the banks against losses instead. Meanwhile, several governments in continental Europe seem to be just holding their breath – and praying that the problem will magically disappear. “You won’t have a recovery until you cleanse the system [of toxic assets], but nobody wants to discuss it,” mutters one senior global policy official. “The Americans are hiding behind stimulus and the Europeans are hiding behind regulatory reform. But that misses the real issue.” To a certain extent, this reluctance to debate the issue reflects a desperate attempt to avoid telling taxpayers how much it might really cost to remove the toxic rot. The other big problem, though, is logistics. A decade ago, during Japan’s banking crisis, officials eventually managed to halt their woes by summoning senior bankers into a single (smoke-filled) room and imposing a common system to measure the rot.

258 It took them several attempts before they arrived at a credible number (and it was dramatically bigger than the first guess). But once they finally came up with a big sum, they recapitalised the banks – and rebuilt investor faith. However, the problem that now haunts western leaders is that it looks extremely hard to replicate the same smoke-filled room trick. After all, this is a global crisis involving banks in numerous different legal and accounting regimes that answer to different bosses. Moreover, the bad loan total is a moving target: as confidence crumbles in the banks, the economy is weakening – creating more bad loans. Even if global leaders could organise a single “count”, in other words, it would almost certainly be out of date by the time it was completed. Yet the rub is that until a credible number appears, it will be painfully hard to end the current banking mess. “The main thing we need now is to implement a sense of transparency where we can put a credible floor to the bank losses,” points out Mario Draghi, the Bank of Italy governor who chairs the influential Financial Stability Forum. Given that, Mr Draghi and others are now quietly hunting for fresh ideas. Thursday’s gathering will give the FSF an expanded role on the global stage – and Mr Draghi intends to use that wider mandate to push for more global consistency in measuring bad loans. More broadly, many policymakers hope – or pray – that if the meeting boosts investor confidence, it may eventually help to halt the slide in asset values, too. Yet the grim fact remains that, a full year after the International Monetary Fund first caused “shock” by predicting $1,000bn of credit losses, the IMF has now doubled that tally to $2,200bn. That is more than 20 times bigger than the US government’s first estimate of the likely credit losses, back in the summer of 2007. Yet the gossip is that the IMF estimate is poised to jump even higher soon. That is just one more reminder – if any were needed – that the G20 now needs to display some truly Herculean vision and strength. Copyright The Financial Times Limited 2009 http://www.ft.com/cms/s/0/b459b6a0-1f00-11de-a748-00144feabdc0.html

259 01.04.2009 JAPAN PM ATTACKS MERKEL’S COMPLACENCY

Japan’s PM Taro Aso said Angela Merkel did not understand the importance of fiscal policy duiring a slump. He made his pointed remarks in an interview with the FT. It is extremely unusual for a Japanese prime minister to criticise another head of government, which shows the scale of the irritation of the global community at Germany’s refusal to do more, considering that the country has been running extremely strong current account surpluses. Aso said: “the experience of the past 15 years, we know what is necessary, whilst countries like the US and European countries may be facing this sort of situation for the first time...I think there are countries that understand the importance of fiscal mobilisation and there are some other countries that do not – which is why, I believe, Germany has come up with their views.” Sarkozy threat to walk out of the meeting if there is no agreement is widely seen as a typical sign of Sarkozy grandstanding – especially so since the results are being negotiated well before the meeting starts. Le Monde politely calls it dramatising, while the FT makes the point that he is not going to walk out considering that the following day he will receive Nato leaders in Strasbourg. Martin Wolf says on current patterns, crisis will last forever In his FT column, Martin Wolf argues that the G20 will end up with some symbolic politics, but will not decide anything substantial to help the global economy now. He says Germany is behaving irresponsibly. He calculates that Germany, Japan and China have been running accumulated current account surplus of E629bn, which required off- setting deficits in other countries. But these deficits are coming down, and so are the surpluses. While the deficit countries are offsetting the fall in private sector through large deficits, the surplus countries, with the exception of Japan, refrain from massive fiscal boosts in the hope to be bailed out by a global recovery. Wolf concludes that this constellation means that there will be no exit from the crisis, since the deficit countries will not be able to deliver this recovery. He says at least part of the answer has to be changing the policies of surplus countries.

260 Adam Posen on Japan and the US In a brilliant comparative analysis, Adam Posen, writing in the Daily Beast, compares the experiences of various Japanese administrations in the 1990s with the present administration’s approach to bank rescue. The Geithner public-private partnership idea, too clever by half, has actually been tried in Japan, and failed. “I know that the very same self-limiting discussions took place at Okurasho, the Japanese Ministry of Finance circa 1995-1998. And they ended with the same result, a series of bank-recapitalization plans that tried to mobilize private-sector monies and overpay for distressed bank assets without forcing the banks to truly write off the losses. Even though the top Japanese technocrats at the ministry were even more insulated from a weak Diet than the congressionally unconfirmed advisers currently running economic policy for the Obama administration, they did worse. Whatever the political context, countries usually try to end banking crises on the cheap, with a limited public role at first, overpaying for distressed assets and failing to change banks’ behavior, only to have to go back in a couple of years later.” Wolfgang Munchau on the G20 In the first installment of a three part series on post-crisis global economic governance, Wolfgang Munchau says that the G-Groups were in the past useful to take ad hoc decisions – a stimulus in the 1970s, stabilisation of the dollar exchange rate in the 1980s –but the group is unsuited to the management of longer-term projects. The G20 is to large to be effective, too small to be representative, and too intergovernmental for the detailed work that is require to fix globalisation after the crisis. OECD calls on ECB to adopt quantitative easing Euro area inflation was down to 0.6% in March- now definitely undershooting the ECB’s price stability target. The FT reports that the OECD has warned that disinflationary pressures will continue, and has called on the ECB to cut interest rates, and adopt a policy of quantitative easing. German stimulus ineffective according to OECD The OECD has calculated what effect fiscal stimulus will have on GDP (not just how much their headline figure amounts to in GDP growth). For the 2009, the effect will be a meagre 0.5 % (on projections of a fall of GDP in the 5-7% range), which means there is effectively no meaning stimulus. The effect in the US is much better at 1.3% (and even better in relative terms considering that the US economy is not falling quite as fast. In our view, the discrepancy is almost entirely due to the lack of co-ordination in the euro area. The result is that stimulus is shifted towards long-term pork barrel projects, rather than short-term consumption). FT Deutschland writes that the stimulus effect for 2010 will remain small at 0.7%. German unemployment rises The jobs data in Germany are beginning to show the extent of the downturn. Unemployment in February rose even on even on a seasonally unadjustment basis, which means that companies are not hiring. The hardest hit are the young trainees, who are not taken over into full employment after the end of their traineeship, reports FT Deutschland. What seems to be happening is that companies remain massively overstaffed, due to the short-time working arrangement under which staff remain on the

261 payroll in exchange for government subsidies. Hence the complete collapse of new demand. Short-time work is hiding the underlying problem, and once those schemes run out, unemployment totals are likely to explode. More bank rescues likely in Spain El Pais leads its economic section with the story that more bank rescue packages are likely in Spain, follow the weekend rescue of Castille La Mancha, a savings bank. The governor of the Bank of Spain, Miguel Angel Ferandez said if the crisis extends (which it will), it would be necessary to reconstructure several more smaller or medium sized savings banks, and to divert more public funds into bank rescue operations. He said the large banks are ok under any circumstances. In a separate article, the paper quotes OECD chief economist Klaus Schmidt-Hebbel as saying that the Spanish banks are in a relatively strong position, much better than their counterparts in other EU countries. US house prices continue to fall The fall in US house continues, and has now reached a decline of about 30% from the peak. But perhaps more important, as this chart from Calculated Risk shows, it has still a long way to go. Without the support of a credit bubble, there is no reason to expect why house price should not return to the trend. Given or take a little, we are about half-way through – another year or two.

262 PIMCO Investment Outlook Bill Gross | April 2009 The Future of Investing: Evolution or

Revolution? The title of this Outlook, “The Future of Investing,” is a theme that will take the evolving years to resolve, let alone the next few days. Still, PIMCO is an organization that loves a challenge. All of us here today would agree that the answer to both questions will be highly dependent on the evolution of the global economy, and when it comes to those questions PIMCO has excelled because of its long-term secular outlook. It has paid dividends for our clients for over 30 years and it should do so now as well. The fact is, that the future of investing will depend on the long-term future of the global economy – its nominal growth rate and the distribution of that growth between public and private interests. And so we should start at the beginning, or perhaps at the top, of our top-down process – the future of the global economy. I. Future of the Global Economy The future of the global economy will likely be dominated by delevering, deglobalization, and reregulating, yet if so, it is important to state at the outset that we do not envision a mean reversion, cyclically oriented future, but instead a new world where players assume different roles, and models relying on bell-shaped/thin-tailed outcomes based on historical data are less relevant. Historical models look backward while modern- day finance is being fast forwarded and reconstituted almost as we speak. 1. Delevering – The prior half-century of leveraging and the development of the amorphous shadow banking system was growth positive. Major G-10 economies became dominated by asset prices and asset-backed lending most clearly evidenced in housing markets. Excess consumption was promoted, and investment based on that consumption followed in turn. Savings rates in many countries including Japan, the U.K., and the U.S. fell towards zero as the reliance on rainy day thrift faded. Deleveraging of business and household balance sheets now means those trends must reverse, and as they do, growth itself will slow, bolstered primarily by government spending as opposed to the animal spirits of the private sector.

This topic is one which literally could take hours to discuss, and at PIMCO forums and Investment Committee meetings, it does. There are those of us here as well as highly respected economists outside of PIMCO who would suggest destruction as opposed to slow growth, and they may have a minority, but not insignificant, case. Much depends on the effectiveness of policy responses and the simplistic answer to a simplistic question. Can global financial markets and the global economy heal by pouring lighter fluid on an already raging fire? Can too much debt be cured by the issuance of even more debt? Must the debt supercycle come to an end by crashing and burning or does the world keep breathing with a whimper instead of a bang? We shall see, but there is a near certain probability that the financially based global economy of the past half-century will not return, nor will we experience the steroid driven growth excesses that it facilitated. 2. Deglobalization – Lost in the wondrous descriptions of finance-dominated, Bretton

263 Woods-initiated, global growth has been the adrenaline push provided by global trade and indeed portfolio diversification into a multitude of markets – developed or developing. Yet historians point out that globalization is not an irreversible phenomenon – witness the aftermath of WWI and nearly three decades of implosion. Now the beginning signs of trade barriers – “Buy American” and “British jobs for British workers” among them – as well as government support of locally domiciled corporations (banks and autos) suggest an inward orientation that is less growth positive. Additionally, “financial mercantilism” is an added threat – a phenomenon that speaks to growing pressure on banks to retreat from international business and concentrate on domestic markets. 3. Reregulation – Academics, politicians, investors, central bankers and everyday citizens are questioning the economic philosophy that idolized free markets and their ability to self-regulate. The belief in uncapped and unregulated incentives producing unlimited upside but nearly always cushioned downside losses is fading. While Sarbanes-Oxley was a well publicized but relatively toothless response to the dot- com bust of nearly a decade past, today’s politicians have gained the upper hand, driven by a citizenry that has recognized the unbalanced, disproportionate distribution of incomes. The efficient market thesis, so prevalent in academic theory and market modeling is now in retreat, and perhaps rightly so. In its place, we will experience less efficient but hopefully less volatile economies and markets – monitored and controlled by government regulation. Executive compensation, of course, is just the poster child. Government ownership and control of vital financial and manufacturing institutions will politely be described as “industrial based” policy and “burden sharing,” but we should have no doubt that we will move significantly away from the free market model that has dominated capitalistic countries for the past 25 years. With the top-down framework for future global economic growth in place, let’s take a look at PIMCO’s outlook for the future of investing – evolution or revolution. II. The Future of Investing Whether evolution or revolution it is important to recognize that the aftermath of an economic and investment bubble transitioning from levering to delevering, globalization to deglobalization and lax regulation to reregulation leads to an across-the-board rise in risk premiums, higher volatility and therefore lower asset prices for a majority of asset classes. The journey to a new stasis is a destructive one insofar as it affects previously assumed wealth. Rough estimates suggest that as much as 40% of global wealth has been destroyed since the beginning of this delevering process. In essence, asset prices, which are really only the discounted future value of wealth creation, go down – not only because that wealth creation slows down but because it becomes more uncertain. In such an environment, equity interests in the form of stocks, real estate or even high yield bonds become re-rated. Those who believe that capitalism is and will remain a going concern and that risk taking – over the long run – will be rewarded, must recognize that those rewards spring from beginning prices and valuations that correctly anticipate the global economy’s future growth path and volatility. In terms of that old maxim “buy low – sell high,” this means at the minimum that an investor during this period of re-rating must “buy low.”

In turn, investor preferences towards risk taking, even when correctly calculated and modeled must be considered. Peter Bernstein has for several years counseled that policy portfolios structured for the long run and based on historical return statistics should be

264 reconsidered. The standard pension or foundation approaches to policy portfolios are being challenged, he asserts, and PIMCO agrees. Stocks for the long run? Home prices that cannot go down? The inevitable levering of asset structures to double or quadruple returns relative to risk-free assets? These historical axioms must now be questioned. In fact, as of March 2009, the superiority of risk-asset returns are not what many assume them to be. For the past 10, 25, and 40 years, for example, total returns from bonds have exceeded those for common stocks.1 Home prices have declined a staggering 30% since their peak in late 2006, and have barely kept up with inflation for the last century according to Case-Shiller statistics. Commercial real estate when ultimately mark-to-market over the next several years will likely show similar results. In short, our stereotyped conceptions of what makes money are being challenged. As Bernstein says, there is no predestined rate of return. And a PIMCO corollary would counsel that future rates of return will be dependent on the beginning price and future growth rates and risk preferences that cannot necessarily be derived from historical models. Government policies will also play an important role, especially insofar as they impact long-standing property rights and capital structures. What I have previously described as a CQ – a common sense quotient – may take precedence over IQ and quantitative analysis in future years. How much of a benefit, for instance, did the renowned risk modeling of some of our major competitors produce over the past several years in terms of their bond funds and derivative-related products as compared to PIMCO’s? We invite comparison, not only of our own risk models, but our collective common sense quotient. What then does common sense tell us about future asset returns? Let’s revisit our previous conclusions on the developing environment for some clues. They include: delevering, deglobalization, reregulation leading to slow global growth, a heightened risk aversion, a distrust of conventional investment model portfolios, and a greater emphasis on surviving as opposed to thriving. If valid, then an investor or an investment committee would likely stress the bird in the hand – as opposed to the one in the bush; stable and secure income – as opposed to uncertain capital gains; a government-regulated utility model – as opposed to innovative yet risky venture capital investments. At current price levels, to cite one example, the current income from corporate bonds is higher and certainly more secure than the dividend income from stocks.2 A return to an era reminiscent of the first half of the 20th century is not unimaginable where stocks were viewed as subordinated income producers with yields exceeding their senior bond companions on the liability ladder. But let me not go too far in suggesting that asset classes near the perimeter of risk have no future. They do if only because they eventually will be priced right. In fact, PIMCO intends to participate in the management of many of them, and as argued previously should be well and healthily positioned to do so. Our recent launch of a global multi-asset fund featuring tail-risk protection is just one example. The potential participation in TALF and other government-sponsored levered structures is another. Still, the tide seems to be going out and as Buffet suggests, all swimmers are being exposed, swimming suits or bare-bottomed naked.

There are a host of investment implications that one can subjectively conclude from this outgoing tide, although they have not been officially endorsed by our upcoming secular forum. It seems to me, though, that one has only to ask what investments were positively affected by the previous long-term cycle of levering, deregulation, and globalization in order to imagine which ones will do poorly as the trends reverse. A short list might read as follows: 1. The Dollar – As the center of structured finance and the shadow banking system, the

265 dollar was bolstered as it sold paper to the rest of the world. To date, its recent strength seems counterintuitive. Weakness may more accurately describe its future. 2. Credit – Lax regulation and increasing leverage squeezed risk premiums and spreads to historically overvalued levels. We are now moving in full reverse. 3. Equity – In addition to the previous conclusions, it is evident in retrospect that narrow risk premiums in credit markets facilitated narrow equity premiums in stocks if only because they seemed cheap by comparison and allowed corporations to borrow cheaply and buy back their own stock. 4. Emerging Market Globalization and lax lending standards re-rated emerging and developing country financial markets to unrealistic levels. Eastern Europe is likely the first to fall. Many of these trends, of course, have now reversed course, direction, and magnitude, and there will come a point where those low and lower prices, as well as the potential for successful policy healing, will favor what is now in disfavor. For now, however, let it be simplistically said that the trend is your friend and that the ad hoc, disjointed and anemic policy responses of government appear to be too little, too late. Investors should therefore favor stable income as opposed to speculative growth or the subordinate liability structures of most private market balance sheets. Shake hands with the government is and has been our motto although the contractual certainty of a government handshake may now be questioned in an increasingly number of marginal areas. Another way to summarize our caution would be to quote a recent comment by Barton Biggs. “I am a child of the bull market,” he said which upon further elaboration meant that he bought on cyclical dips with the expectation of riding mean reversion to an upward sloping trend line of prosperity and ultimately higher peaks. In a sense, we are all children of the bull market, although some of us are more mature than others – a bull market of free- enterprise productivity and innovation, yes, but one fostered by a bull market in leverage, deregulation and globalization that proved unsustainable in its excesses. We now must view ourselves as chastened adults, forced into acknowledging a new reality that is dependent upon bear-market delevering and debt liquidation to deliver us to our new and ultimate restructured destination – wherever it lies. Thus, while historians might describe these years as an evolution, for those of us living it day-by-day it most assuredly has the feel of a revolution. Much like Irving Fisher’s “permanently higher plateau” of prosperity that was quickly turned on its head in 1929, those who would forecast a “permanently lower valley” of despair might similarly be off the mark. Yet there should be no doubt that the bull markets as we’ve known them are over and that the revolution is on. Investing is no longer child’s play.

William H. Gross Managing Director

1 Source: Research Affiliates. 2 Source: Bloomberg. As of 3/30/09, the current yield on the Barclay’s investment-grade credit index is 7.11% and the current yield on the S&P 500 is 3.66%.

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2009/Investment+Outloo k+April+2009+Evolution+or+Revolution+Bill+Gross.htm

266 Playing Solitaire with a Deck of 51, with Number 52 on Offer Paul McCulley: Global Central Bank Focus April 2009 http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2009/Global+Central+Ba nk+Focus+April+2009+Money+Marketeers+Solitaire+McCulley.htm Thank you, Dana, for that wonderfully kind introduction. It is a deep honor to be speaking before this august club for the fourth time. When I look at the list of speakers over the last 50 years, I am very humbled. As I’ve mentioned before when here, this forum is one of the very few for which I actually write a speech. Not that I actually deliver it the way I write it – that might be congenitally impossible for me! – but because I want to be held accountable, to be forced to both own and eat my own words. And to re-read them again and again, before speaking yet again. Looking Backward In May 2004,1 just before the Fed embarked on a tightening process from 1% Fed funds, my axe to grind was that the conventional wisdom of a constant neutral real Fed funds rate was wrong. Put more wonkishly, as I’m wont to do, I challenged the notion of a constant constant in the Taylor Rule. As all in our profession know, John Taylor conveniently assumed that if the active cyclical terms in his Rule – (1) the gap between actual inflation and targeted inflation and (2) the gap between actual and potential GDP (Gross Domestic Product) – drop out, because inflation is at target and GDP is at potential,2 then the real Fed funds rate should approximate the potential real growth rate of the economy, determined by demographically-driven labor force growth and productivity growth. That’s the constant term in the Taylor Rule, and John assumed it to be constant. I took issue with this concept of the constant in Taylor being constant on two key fronts, one a matter of theory and the other a matter of practicality. On the theoretical front, I have always made a distinction between cash and capital or, in the words of today, the difference between capital and liquidity. I’ve always believed in the capitalist notion of no risk, no reward. Thus, I’ve always struggled with the notion that government-guaranteed cash, or liquidity, if you prefer, should pay a positive after-tax real rate of return. Yes, I believe nominal cash yields should be high enough to offset the inflation rate, which is an implicit tax. And since we tax nominal returns, I have also always believed that the nominal cash yield should be high enough to not only offset the implicit inflation tax, but also the explicit tax on the inflation tax. But I’ve never believed that cash should generate a real after-tax return. Again, no risk, no reward. Cash always trades at par, at least in nominal terms, and that’s a very precious attribute. You can have it if you want it. But if you do, you should not get paid for it, but rather pay for it, in the form of forgoing any after-tax real return. If you want a positive after-tax real return, you gotta take some risk, summarized best, perhaps, by the possibility of your investment trading south of par. Which means that I did and do believe that a positive neutral after-tax real rate of interest does exist, even if it is not constant. But for me, unlike John, it’s the after-tax real rate of interest on high grade, long-term, private sector debt obligations. Back in May 2004, I posited that we should use the long-term swap rates as a proxy – the credit risk of the AA global banking system. (Note I said system, not any individual bank.)

267 That after-tax real rate of return should, I argued, be consistent with John Taylor’s assumption – widely embraced in our profession – that there is a functional connection between potential real growth rates and real interest rates. Thus, John and I were actually in the same analytical church, but we were sitting in very different pews, singing from a different hymn book. We both wanted to tie the neutral real rate to the potential real growth rate of the economy. But he focused on the overnight risk-free rate, which the Fed directly controls, while I focused on the long-term private sector rate, determined by the market. Translated, John was and is a Fed funds man while I was and am a financial conditions man. Which brings me to my practical beef with John: I don’t believe that the neutral rate – whichever one you choose – is constant, but rather time-varying, a function of changes in broad financial conditions. With my colleague, and good friend, Ramin Toloui, I wrote a lengthy essay on this issue this past February.3 No need to replow that plowed ground again tonight, except to say that the financial crisis over the last year proves my point in spades. Be that as it may, most of you thought I was singing way off key back in 2004. And truth be told, I felt that at the margin too, as I recognized my theoretical construct implied a very steep yield curve, an open invitation for entrepreneurial financial operators to lever to the eyeballs into the carry trade. Thus, I openly acknowledged that if the Fed were to embrace my notion of a neutral zero after-tax real rate on cash, then it would be necessary to put regulatory limits on the use of leverage by financial intermediaries. At that time, policy makers were doing just that with the GSEs (Government Sponsored Enterprises), putting limits on growth of their balance sheets. I was encouraged by this. But falsely so, as the next several years demonstrated painfully, with unbridled growth in the Shadow Banking System, a term I coined in August 2007 at Jackson Hole. Recall, Shadow Banks are levered-up intermediaries without access to either FDIC deposit insurance or the Fed’s discount window to protect against runs or stop runs. But since they don’t have access to those governmental safety nets, Shadow Banks do not have to operate under meaningful regulatory constraints, notably for leverage, only the friendly eyes of the ratings agencies. The bottom line is that the Shadow Banking System created explosive growth in leverage and liquidity risk outside the purview of the Fed. Or, as I said here last time in November 2007, again playing the wonk, Shadow Banking both (1) shifted the IS Curve to the right and also (2) made it steeper, or less elastic, if you will. In such a world, Fed rate hikes had little tempering effect on the demand for credit, or if you prefer, little tightening effect on financial conditions. And so it came to pass with the Fed hiking the nominal Fed funds rate to 5¼%, double that which I had forecast in May 2004, as financial conditions refused to tighten in sympathy with the Fed’s desire. I was proven spectacularly wrong. It was the Forward Minsky Journey, as I lectured here last time. And it ended in the Minsky Moment, defined as the moment when bubbly asset prices – made so by the application of ever-greater leverage – crack, kicking off the imperative for deleveraging, notably by the Shadow Banking System. We can quibble about the precise month of the Moment. I pick August 2007, but would not argue strenuously with you about three months either side of that date. Whatever moment you pick for the Moment, we have, ever since, been traveling the Reverse Minsky Journey, violently shifting the IS Curve back to the left, with an even steeper slope. This prospect implied, I argued 16 months ago, that the Fed would inevitably cut the Fed

268 funds rate dramatically, in more-than-mirror image of the hiking process, as financial conditions would refuse to ease in sympathy with the Fed’s intentions. In turn, I forecast that by the next time you invited me here again, the Fed funds rate would likely be at or below the 2½% level that I had so petulantly forecast back in May 2004. I also forecast that I might be contemplating buying a second home, after never having owned more than one. Looking Forward Which brings us to today, with the nominal Fed funds rate pinched against zero. I simply wasn’t bold enough in my forecast last time here. And while I haven’t bought a second home, I am indeed contemplating buying one. I’d like for it to be in a certain city a few hundred miles south of here, but that’s a decision above my power grade, even if below my pay grade. But I digress. What I want to discuss with you tonight is just how simple the solution to our current global economic and financial crisis is on paper, contrasting that to just how difficult and complex the solution is in reality. The present crisis, in textbook terms, is a case of the dual, mutually reinforcing maladies of the Paradox of Thrift and the Paradox of Leverage. In many respects, they are the same disease: what is rational at the individual citizen or firm level, notably to increase savings out of income or to delever balance sheets, becomes irrational at the community level. If everybody seeks to increase their savings by consuming less of their incomes, they will collectively fail, because consumption drives production which drives income, the fountain from which savings flow. Likewise, if everybody seeks to delever by selling assets and paying down debt, or by selling equity in themselves, they can’t, as the market for both assets and equity will go offer-only, no bid. Both of these maladies require that the sovereign go the other way, (1) dis-saving with even more passion than the private sector is attempting to increase savings, thereby maintaining nominal aggregate demand and thus, nominal national income; and (2) becoming the bid side for the levered private sector’s offer-only markets for assets and equity. It really is that simple, at least on paper, as Keynes and Minsky wisely taught. The problem with the desirable textbook solution is that it suffers from constrained political feasibility. Actually, dealing with the Paradox of Thrift is practically much easier, even if less critically important, than dealing with the Paradox of Deleveraging. While Congress may belly-ache and wrangle incessantly about the precise size and composition of fiscal stimulus packages, it is safe to say that but for a few wing nuts, we are all Keynesians now in the matter of cracking the Paradox of Thrift. In contrast there is limited political consensus for using the sovereign’s balance sheet and good credit to break the Paradox of Deleveraging. Put differently, while we may all now be Keynesians, we are not all Minskyians. What is ineluctably needed involves socializing the losses of a banking system – both conventional banking and shadow banking – after the spectacular winnings of the Forward Minsky Journey were privatized. It simply doesn’t sit well politically. In fact, it stinks to high heaven. Thus, to quote my partner Mohamed El-Erian, we must contemplate a scenario in which the economically desirable solution is not politically feasible, while that which is politically feasible may not necessarily be economically desirable. Last Sunday, on 60 Minutes, Ben Bernanke addressed this nasty reality directly when he said that perhaps the most severe risk we face is the lack of political will.

269 I applaud him, both for doing the interview, speaking directly to the American people, and for speaking the truth. But that doesn’t necessarily mean that the truth will set us free. As Kris Kristofferson wrote long ago, and Janis Joplin made famous, we cannot dismiss out of hand the proposition that freedom is just another word for nothing left to lose. I trust not. But the honest answer is that we honestly don’t know. We are living in a world of hysteresis, in which outcomes become path-dependent, where multiple outcomes are possible, where both policy input and economic/financial outcomes become hostage to serial correlation. How’s that for talking wonkish? Concluding Comment Seriously, let me conclude by once and again quoting Mohamed, who observes that what we are experiencing is not a crisis within the market-driven, democratic capitalist system of most of our careers, but rather a crisis of the system itself. This is not a spat within a marriage, but rather a test of the sustainability of the marriage itself. It’s playing solitaire with a deck of 51. Fortunately, the 52nd card is now on offer, if only policy makers are willing to seize it and play it: Competitive Quantitative Easing (mixed with Credit Easing, in some cases). Usually, when we think of competitive global policies, we think of them in a negative way, as in competitive hiking of tariffs or competitive currency depreciation. While different in execution, these two forms of competition are economically very similar, a competitive attempt to secure a larger piece of a too-small global aggregate nominal demand pie. In contrast, Competitive Quantitative Easing (QE) offers scope for growing the global aggregate demand pie, with an endogenous enforcement mechanism. How so? First, let’s consider what QE is all about. In an oversimplified nutshell, it involves a central bank voluntarily surrendering for a time its independence from the fiscal authority, taking the short-term policy rate to the zero neighborhood, thereby obviating any need to control growth in its balance sheet. For those of us in the room old enough to remember the jargon — and there are more than a few! — QE obviates any need for the central bank to keep “pressure on bank reserve positions,” so as to hit a positive target for its policy rate. It’s not quite that simple, I recognize, for central banks that are allowed to pay interest on excess reserves, as is now the case with the Fed. Conceptually, with the ability to pay interest on excess reserves, a central bank could “go QE” and still peg a positive policy rate. But that’s a technicality without great substance at the moment, notably with the Fed, whose target range for the Fed funds rate is 0–.25%. Close enough to zero for me! Thus, the Fed is practically unconstrained in how big it can grow its balance sheet. Which, in turn, sets the stage for the Fed to voluntarily work corporately with the fiscal authority — Congress and the Treasury — to monetize longer-dated Treasury securities, facilitating a huge expansion in Treasury debt issues at exceedingly low interest rates. Ordinarily, we would be aghast at such a prospect, as every bone in our bodies would scream that such an operation would, in the long run, be inflationary. And our bones would be right. The very reason for central bank independence within the government – but not of the government – is precisely to prevent the central bank from being the handmaiden of the fiscal authority, who inherently wants to spend more than it taxes, running deficits, overheating the economy in an inflationary way. But if and when the dominant macroeconomic problem is a huge output gap, borne of deficient aggregate demand, fattening the fat tail of deflation risk, the argument for strict central bank independence goes into temporary submission. Note, I said temporary, not

270 permanent. There is no more sure way, in the proverbial long run, to destroy the purchasing power of a currency than to let vote-seeking politicians have the keys to the fiat-money printing press. But there can be extraordinary and exigent circumstances when it does make sense for a central bank to work cooperatively, if not subordinately, with the fiscal authority to break capitalism’s inherent debt-deflation pathologies. Indeed, none other than Chairman Bernanke made the case forcefully in May 2003, speaking in Japan about Japan (my emphasis, not his): The Bank of Japan became fully independent only in 1998, and it has guarded its independence carefully, as is appropriate. Economically, however, it is important to recognize that the role of an independent central bank is different in inflationary and deflationary environments. In the face of inflation, which is often associated with excessive monetization of government debt, the virtue of an independent central bank is its ability to say “no” to the government. With protracted deflation, however, excessive money creation is unlikely to be the problem, and a more cooperative stance on the part of the central bank may be called for. Under the current circumstances, greater cooperation for a time between the Bank of Japan and the fiscal authorities is in no way inconsistent with the independence of the central bank, any more than cooperation between two independent nations in pursuit of a common objective is inconsistent with the principle of national sovereignty. Thus, the Fed’s announcement just yesterday that the central bank would be buying up to $300 billion of Treasuries, primarily in the two- to ten-year maturity range, is fully consistent with both what Mr. Bernanke said six years ago and with evident debt-deflationary pathologies, both here in the United States and around the world. Indeed, what intrigues me the most right now is the concept of global Competitive QE, rather than competitive tariff hiking or competitive currency depreciation. If all countries, or most major countries anyway, “go QE,” then the global game changes from fighting for bigger slices of a too-small global nominal aggregate demand pie to actually correlated efforts to enlarge the nominal pie. Note I said “correlated” not “coordinated.” There need not necessarily be any explicit coordination between countries, because those that choose not to play will likely experience a rise in their real effective exchange rate, a deflationary impulse to their underutilized economies. Thus, there need not be an explicit enforcement mechanism to propel Competitive QE, merely individual countries acting in their own best interest. This is the best kind of cooperative behavior, explicitly because it need not be coordinated, but rather brought about by, you guessed it, Adam Smith’s invisible hand! To be sure, the ECB (European Central Bank) has difficulty with the concept of QE, in part because Euroland represents monetary union without political union and, thus, fiscal policy union. Put differently, if the ECB wants to be accommodative of more Keynesian fiscal policy stimulus, de facto monetizing it, what fiscal authority does the ECB call to cut the deal? It’s an open question, but my sense is that about ten big figures higher from here for the Euro, the ECB would find the answer! Thank you, again, for the great honor of being here tonight. Paul McCulley Managing Director [email protected]

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Reading Krugman March 31, 2009 by TIE I think Paul Krugman has a blind spot. Yes, the Nobel Prize winning, Princeton University economist, and NY Times columnist Paul Krugman. I saw evidence of it in last week’s debate among economists over Treasury Secretary Geithner’s bank rescue plan, the so-called Public- Private Investment Program (PPIP). In brief, under PPIP private investors would receive non-recourse federal loans to buy toxic assets from banks. The goal is to increase lending so as to reduce unemployment. (Was that too brief? If so, the dots are connected in Brad DeLong’s clever FAQ, and well-crafted numerical examples can be found here and here.) The cynical won’t be surprised that the plan is similar to one pitched to the Treasury Department by institutional investors, or that some banks may be gaming the system. The plan is also similar to one proposed by Harvard Law Professor Lucian Bebchuk. While the White House press corps was not terribly interested in PPIP, it lit up the economics blogosphere. MIT’s Ricardo Caballero thinks the plan “is well-conceived and deserves to be supported.” Johns Hopkins economics professor Christopher Carroll finds savvy the way it induces private investors to price assets. NYU’s Nouriel Roubini is cautiously optimistic. Many other sharp economists view the approach favorably, including Mark Thoma (Univ. of Oregon) and Brad DeLong (Berkeley). There is a list of equally impressive opponents. Jeffrey Sachs of Columbia University thinks PPIP provides a one-way bet: heads investors win, tails the government loses. Financial Times columnist Martin Wolf calls PPIP a “vulture fund relief scheme.” MIT Sloan School’s Simon Johnson worries in a well thought out LA Times opinion piece that without nationalization banks will not sell enough of their toxic assets. Finally, Paul Krugman is filled with despair over PPIP, calling it a “waste of taxpayer money.” He believes Obama is “squandering [the] credibility” he needs to win support for bank nationalization. (Krugman once worried that nationalization might be too expensive: Times change and opinions with them.) As the liberal economist of record, Krugman’s critique of PPIP received a lot of press much of it uncritical. I think a little more critical reading is warranted, that his cry for nationalization now misses something crucial. Namely, he has a blind spot for the political and implementation risks and challenges. As John Heilemann wrote in New York Magazine, “Getting the economics right may be devilishly difficult—but the politics are even trickier, and just as crucial.” One cannot be president and apolitical. Incentives and risks of governance compel Obama to think beyond economics even when considering economic issues. He is, no doubt, sensitive to his political capital, the issues over which to allocate it, and Congress’ appetite for alternatives to PPIP (like nationalization), among others. Brad DeLong points out that Obama does not easily achieve the 60 votes in the Senate he would need to take bolder action. (PPIP requires no additional congressional approval.) “Do we want to revive our economy, or do

272 we want to punish the bankers?” DeLong asks, “I don’t agree that we can do both.” Matthew Yglesias elaborates, “Doing something…without an additional vote makes it more likely that they can ask Congress to cast those tough votes on the budget and on health care rather than on bank bailouts.” According to Obama aides, “Krugman’s suggestion that the government could take over the banking system is deeply impractical.” (Newsweek) Impractical politically but also because nationalization would require expertise and staff the Treasury Department does not yet possess. Therefore, like it or not, Geithner needs the banking industry’s cooperation to increase lending. He nearly lost it during the uproar over the AIG bonuses. He’d lose it for sure with a nationalization plan. If nationalizing banks is a political non-starter then attempting to do so would destroy the credibility Krugman feels Obama is squandering with PPIP. Therefore, right now PPIP may be the only step forward. After all, a bank balance sheet has only two sides: assets and liabilities. Nationalization works the latter, PPIP the former. My critique of Krugman is brash. He has a Nobel Prize while I have a Certificate of Appreciation from my employer. Yet it is hardly ever wise to consider an expert’s opinion thoughtlessly. Even experts can be poor sources of expertise. Even Nobel laureates make mistakes (like this or this). Whether you’re reading Krugman or TIE, it is not wise to reflexively trust what you read. You can take that to the bank. © The Incidental Economist (TIE) http://thefinancebuff.com/2009/03/reading-krugman.html

273 Mar 31, 2009 Are ABX Derivatives Prices An Accurate Measure of Subprime RMBS and CDO Valuations? Issue: Generally speaking, the less repackaged a security, the higher is the degree of cash- flow pass-through from underlying credits (e.g. pro-rata pass-throughs where each tranche receives the same share of the underlying cash-flow). The further up the repackaging chain, and the more mixed the collateral in a structure, the more the value of a security depends on credit enhancement, implied leverage of junior tranches, and market risk than on pass-through from underlying credits (see also Adrian/Shin) Moreover, CDOs were overvalued to start with based on their large undiversifiable systemic risk component in senior tranches resulting from cash flow prioritization--> current low valuations are more realistic (Coval et al., Harvard) o BIS (Fender/Scheicher): Declining risk appetite and heightened concerns about market illiquidity - likely due in part to significant short positioning activity - have provided a sizeable contribution to the observed collapse in ABX prices since the summer of 2007--> PPIP/TARP is a good program in that it brings back liquidity. o RGE: Markit index shows that as of December 2008 mark-to-market (MTM) losses for the entire 1.4 trillion subprime RMBS universe from 2005-2007 implied by the ABX derivatives index are $700bn (i.e. 50%) which is roughly consistent with expected credit losses on 2006/07 vintages calculated from a further 17% fall in house prices (and high oil prices) as estimated by Sherlund (2008). Shin/Hatzius (2008) and Hatzius (2008) show similar comparability between ABX and other loss estimates. o cont.: Moreover, cash flow shortfall from subprime loans in foreclosure plus serious delinquencies is 19% as of December 2008 according to OCC data--> subprime RMBS residuals and mezzanine tranches are wiped out at these levels (ie. first 20% of notional) and ABS CDOs comprised of mezzanine RMBS tranches are worthless and expected to remain that way. o Bank of England Financial Stability report: "Credit losses from the turmoil are unlikely to ever rise to levels implied by current market prices [e.g. ABX index] unless there is a significant deterioration in fundamentals, well beyond the slowdown currently anticipated. That is because prices are likely to reflect substantial discounts for illiquidity and uncertainty that have emerged as markets have adjusted but which should ease over time.” o Tett, auditors: If AAA RMBS and CDO securities are so obviously underpriced, why don't bargain hunters step in? Or the Bank of England itself? o Nov 18, FT: John Paulson who made a fortune shorting the subprime ABX index in 2007, told his investors he started to buying troubled MBS that dropped to record low

274 values after Hank Paulson dropped plans to buy up troubled assets but focus on recapitalizing banks instead (see Geithner's Financial Stability Plan) o Parisi-Capone (RGE): Merrill sells first 5% loss on $30.6bn portfolio to Lone Star for $1.7bn or around 5 cents on the dollar while retaining any losses above $1.7bn--> This is reminiscent of CDO structure where Lone Star buys equity/low mezzanine tranche for 5 cents on the dollar--> ABX.HE.BBB- trades at 5.5 cents on the dollar; latest available TABX equity tranche price at 5.25 cents on the dollar (Markit)--> Current ABS CDO market values consistent with ABX pricing. Merrill actually gained from transaction so there is no fire sale involved. o Daniel Gros: The non-recourse feature of U.S. mortgages translates in a de facto long put option for the mortgage owner and short put option for the lender. As long as house prices rise, the option is worthless but the more house prices fall, and the higher indebted the borrower, the higher the borrower's incentive to walk away (i.e. exercise the put)--> when the payout costs of this put option are taken into account, U.S. private-label mortgage assets are indeed nearly worthless. o BIS Joint Forum: There is little upside to CDOs of ABS or CDO^2 as there were not even enough subprime deals in H2 2007 to create a new ABX.HE 08-1 index (each ABX index vintage refers to 20 subprime RMBS deals closed in the prior six months.)--> TABX derivatives index that tracks CDOs is worthless including the most senior tranches. o BIS: The credit risk (i.e. probability of default PD and expected loss EL mappings) of corporate bonds and tranched securities such as RMBS and CDOs are not directly comparable [this is the rating agencies' mistake]--> tranched securities are inherently leveraged and will therefore experience larger value losses with changes in either PD or EL of underlying assets. Correlation complicates the picture further. Structured and tranched securities need own PD/EL matrices and rating scale, as acknowledged in Congress hearings. http://www.rgemonitor.com/691/Securitization,_Structured_Finance,_and_Derivatives?cluste r_id=9804

275 Opinion March 30, 2009 America the Tarnished By PAUL KRUGMAN Ten years ago the cover of Time magazine featured Robert Rubin, then Treasury secretary, Alan Greenspan, then chairman of the Federal Reserve, and Lawrence Summers, then deputy Treasury secretary. Time dubbed the three “the committee to save the world,” crediting them with leading the global financial system through a crisis that seemed terrifying at the time, although it was a small blip compared with what we’re going through now. All the men on that cover were Americans, but nobody considered that odd. After all, in 1999 the United States was the unquestioned leader of the global crisis response. That leadership role was only partly based on American wealth; it also, to an important degree, reflected America’s stature as a role model. The United States, everyone thought, was the country that knew how to do finance right. How times have changed. Never mind the fact that two members of the committee have since succumbed to the magazine cover curse, the plunge in reputation that so often follows lionization in the media. (Mr. Summers, now the head of the National Economic Council, is still going strong.) Far more important is the extent to which our claims of financial soundness — claims often invoked as we lectured other countries on the need to change their ways — have proved hollow. Indeed, these days America is looking like the Bernie Madoff of economies: for many years it was held in respect, even awe, but it turns out to have been a fraud all along. It’s painful now to read a lecture that Mr. Summers gave in early 2000, as the economic crisis of the 1990s was winding down. Discussing the causes of that crisis, Mr. Summers pointed to things that the crisis countries lacked — and that, by implication, the United States had. These things included “well-capitalized and supervised banks” and reliable, transparent corporate accounting. Oh well. One of the analysts Mr. Summers cited in that lecture, by the way, was the economist Simon Johnson. In an article in the current issue of The Atlantic, Mr. Johnson, who served as the chief economist at the I.M.F. and is now a professor at M.I.T., declares that America’s current difficulties are “shockingly reminiscent” of crises in places like Russia and Argentina — including the key role played by crony capitalists. In America as in the third world, he writes, “elite business interests — financiers, in the case of the U.S. — played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive.” It’s no wonder, then, that an article in yesterday’s Times about the response President Obama will receive in Europe was titled “English-Speaking Capitalism on Trial.” Now, in fairness we have to say that the United States was far from being the only nation in which banks ran wild. Many European leaders are still in denial about the continent’s economic and financial troubles, which arguably run as deep as our own — although their

276 nations’ much stronger social safety nets mean that we’re likely to experience far more human suffering. Still, it’s a fact that the crisis has cost America much of its credibility, and with it much of its ability to lead. And that’s a very bad thing. Like many other economists, I’ve been revisiting the Great Depression, looking for lessons that might help us avoid a repeat performance. And one thing that stands out from the history of the early 1930s is the extent to which the world’s response to crisis was crippled by the inability of the world’s major economies to cooperate. The details of our current crisis are very different, but the need for cooperation is no less. President Obama got it exactly right last week when he declared: “All of us are going to have to take steps in order to lift the economy. We don’t want a situation in which some countries are making extraordinary efforts and other countries aren’t.” Yet that is exactly the situation we’re in. I don’t believe that even America’s economic efforts are adequate, but they’re far more than most other wealthy countries have been willing to undertake. And by rights this week’s G-20 summit ought to be an occasion for Mr. Obama to chide and chivy European leaders, in particular, into pulling their weight. But these days foreign leaders are in no mood to be lectured by American officials, even when — as in this case — the Americans are right. The financial crisis has had many costs. And one of those costs is the damage to America’s reputation, an asset we’ve lost just when we, and the world, need it most. http://www.nytimes.com/2009/03/30/opinion/30krugman.html?_r=1&th&emc=th

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From the magazine issue dated Apr 6, 2009 Obama’s Nobel Headache Paul Krugman has emerged as Obama's toughest liberal critic. He's deeply skeptical of the bank bailout and pessimistic about the economy. Why the establishment worries he may be right. Evan Thomas Traditionally, punditry in Washington has been a cozy business. To get the inside scoop, big-time columnists sometimes befriend top policymakers and offer informal advice over lunch or drinks. Naturally, lines can blur. The most noted pundit of mid- 20th-century Washington, Walter Lippmann, was known to help a president write a speech—and then to write a newspaper column praising the speech. Paul Krugman has all the credentials of a ranking member of the East Coast liberal establishment: a column in The New York Times, a professorship at Princeton, a Nobel Prize in economics. He is the type you might expect to find holding forth at a Georgetown cocktail party or chumming around in the White House Mess of a Democratic administration. But in his published opinions, and perhaps in his very being, he is anti- establishment. Though he was a scourge of the Bush administration, he has been critical, if not hostile, to the Obama White House. In his twice-a-week column and his blog, Conscience of a Liberal, he criticizes the Obamaites for trying to prop up a financial system that he regards as essentially a dead man walking. In conversation, he portrays Treasury Secretary Tim Geithner and other top officials as, in effect, tools of Wall Street (a ridiculous charge, say Geithner defenders). These men and women have "no venality," Krugman hastened to say in an interview with NEWSWEEK. But they are suffering from "osmosis," from simply spending too much time around investment bankers and the like. In his Times column the day Geithner announced the details of the administration's bank-rescue plan, Krugman described his "despair" that Obama "has apparently settled on a financial plan that, in essence, assumes that banks are fundamentally sound and that bankers know what they're doing. It's as if the president were determined to confirm the growing perception that he and his economic team are out of touch, that their economic vision is clouded by excessively close ties to Wall Street." If you are of the establishment persuasion (and I am), reading Krugman makes you uneasy. You hope he's wrong, and you sense he's being a little harsh (especially about Geithner), but you have a creeping feeling that he knows something that others cannot, or will not, see. By definition, establishments believe in propping up the existing order. Members of the ruling class have a vested interest in keeping things pretty much the way they are. Safeguarding the status quo, protecting traditional institutions, can be healthy and useful, stabilizing and reassuring. But sometimes, beneath the pleasant murmur and tinkle of cocktails, the old guard cannot hear the sound of ice cracking. The in crowd of any age can be deceived by self- confidence, as Liaquat Ahamed has shown in "Lords of Finance," his new book about the folly

278 of central bankers before the Great Depression, and David Halberstam revealed in his Vietnam War classic, "The Best and the Brightest." Krugman may be exaggerating the decay of the financial system or the devotion of Obama's team to preserving it. But what if he's right, or part right? What if President Obama is squandering his only chance to step in and nationalize—well, maybe not nationalize, that loaded word—but restructure the banks before they collapse altogether? The Obama White House is careful not to provoke the wrath of Krugman any more than necessary. Treasury officials go out of their way to praise him by name (while also decrying the bank-rescue prescriptions of him and his ilk as "deeply impractical"). But the administration does not seek to cultivate him. Obama aides have invited commentators of all persuasions to the White House for some off-the-record stroking; in February, after Krugman's fellow Times op-ed columnist David Brooks wrote a critical column accusing Obama of overreaching, Brooks, a moderate Republican, was cajoled by three different aides and by the president himself, who just happened to drop by. But, says Krugman, "the White House has done very little by way of serious outreach. I've never met Obama. He pronounced my name wrong"—when, at a press conference, the president, with a slight note of irritation in his voice, invited Krugman (pronounced with an "oo," not an "uh" sound) to offer a better plan for fixing the banking system. It's possible that Krugman is a little wounded by this high-level disregard, and he said he felt sorry about criticizing officials whom he regards as friends, like White House Council of Economic Advisers chair Christina Romer. But he didn't seem all that sorry. Krugman is having his 15 minutes and enjoying it, although at moments, as I followed him around last week, he seemed a little overwhelmed. He is an unusual mix, at once nervous, shy, sweet and fiercely sure of himself. He enjoys his outsider's power: "No one has as big a megaphone as I have," he says. "Aside from the world going to hell, it's great." He is in much demand on the talk-show circuit: PBS's "The NewsHour" and "Charlie Rose" on Monday last week, ABC's "This Week With George Stephanopoulos" this past Sunday. Someone has even cut a rock video on YouTube: "Hey, Paul Krugman, why aren't you in the administration?" A singer croons, "Hey, Paul Krugman, where the hell are you, man? We need you on the front lines, not just writing for The New York Times." (And the cruel chorus: "All we hear [from Geithner] is blah, blah, blah.") Krugman is not likely to show up in an administration job in part because he has a noble—but not government-career-enhancing—history of speaking truth to power. With dry humor, he once told a friend the story of attending an economic summit in Little Rock after Bill Clinton was elected president in 1992. As the friend recounted the story to NEWSWEEK, "Clinton asked Paul, 'Can we have a balanced budget and health-care reform?'—essentially, can we have it all? And Paul said, 'No, you have to be disciplined. You have to make choices.' Then Paul says to me (deadpan), 'That was the wrong answer.' Then Clinton turns to Laura Tyson and asks the same questions, and she says, 'Yes, it's all possible, you have your cake and eat it too.' And then [Paul] says, 'That was the right answer'." (Tyson became chairman of Clinton's Council of Economic Advisers; she did not respond to requests to comment.) Krugman confirmed the story to NEWSWEEK WITH a smile. "I'm more tolerant now," he says. But at the time, he was bitter that he was kept out of the Clinton administration. Krugman has a bit of a reputation for settling scores. "He doesn't suffer fools. He doesn't like hauteur in any shape or form. He doesn't like to be f––ked with," says his friend and colleague Princeton history professor Sean Wilentz. "He's not a Jim Baker; he's not that kind of Princeton," says Wilentz, referring to the ur-establishment operator who was Reagan's secretary of the Treasury and George H.W. Bush's secretary of state. But Wilentz went on to

279 say that Krugman is "not a prima donna, he wears his fame lightly," and that Krugman is not resented among his academic colleagues, who can be a jealous lot. Krugman's fellow geniuses sometimes tease him or intentionally provoke his wrath. At an economic conference in Tokyo in 1994, Krugman spent so much time berating others that his friends purposely started telling him things that they knew weren't true, just to see him get riled up. "He fell for it every time," said a journalist who was there but asked not to be identified so she could speak candidly. "You'd think that eventually, he would say, 'Oh, come on, you're just jerking my chain'." Krugman says he doesn't recall the incident, but says it's "possible." Born of poor Russian-immigrant stock, raised in a small suburban house on middle-class Long Island, Krugman, 56, has never pretended to be in the cool crowd. Taunted in school as a nerd, he came home one day with a bloody nose—but told his parents to stay out of it, he would take care of himself. "He was so shy as a child that I'm shocked at the way he turned out," says his mother, Anita. Krugman says he found himself in the science fiction of Isaac Asimov, especially the "Foundation" series—"It was nerds saving civilization, quants who had a theory of society, people writing equations on a blackboard, saying, 'See, unless you follow this formula, the empire will fail and be followed by a thousand years of barbarism'." His Yale was "not George Bush's Yale," he says—no boola-boola, no frats or secret societies, rather "drinking coffee in the Economics Department lounge." Social science, he says, offered the promise of what he dreamed of in science fiction—"the beauty of pushing a button to solve problems. Sometimes there really are simple solutions: you really can have a grand idea." Searching for his own grand idea (his model and hero is John Maynard Keynes) Krugman became one of the top economists in the country before he turned 30. He took a job on the Council of Economic Advisers in the Reagan administration at the age of 29. His colleague and rival was another brilliant young economist named Larry Summers. The two share a kind of edgy braininess, but they took different career paths—Summers as an inside player, working his way up to become Treasury secretary under Clinton and president of Harvard, then Obama's chief economic adviser. Krugman preferred to stay in the world of ideas, as an "irresponsible academic," he puts it, half jokingly, teaching at Yale, MIT, Stanford and Princeton. In 1999 he almost turned down the extraordinary opportunity to become the economic op-ed columnist for The New York Times. He was afraid that if he became a mere popularizer he'd blow his shot at a Nobel Prize. Last October, he won his Nobel. Most economists interviewed by NEWSWEEK agreed that he richly deserved it for his pathbreaking work on global trade—his discovery that traditional theories of comparative advantage between nations often do not work in practice. He was stepping into the shower at a hotel when his cell phone rang with the news that he had achieved his life's ambition. At first, he thought the call might be a hoax. His wife Robin's reaction, once the initial thrill wore off, was, "Paul, you don't have time for this." He is, to be sure, insanely busy, producing two columns a week, teaching two courses and still writing books (his latest is "The Return of Depression Economics and the Crisis of 2008"). He posts to his blog as many as six times a day. Last Thursday morning, he was gleeful because he was able to thump a blogger who insisted, wrongly, that Keynes did not use much math in his work. In class that day, discussing global currency exchange with a score of undergraduates, he was gentle, bemused, a little absent-minded, occasionally cracking mordant jokes (on trade with China: "They give us poisoned products, we give them worthless paper"). He says he plans to reduce his teaching load a little, and his colleagues say his best academic work is behind him. "His academic career culminated with him winning the prize," says his Princeton colleague

280 and friend Gene Grossman. "He's not that engaged anymore with academic research. He has a public career now. That's what he views as his main avocation now—as a public intellectual." He has made enemies in the economics community. "He's become more and more outspoken. A lot of what he says is wrong and not considered," says Daniel Klein, professor of economics at George Mason University. A longtime mentor, MIT Nobel laureate Robert Solow, who taught Krugman as a grad student, remembers him as "very unassertive, mild-mannered. One thing he still has is a smile that plays around his face when he's talking, almost like he's looking at himself and thinking, 'What am I doing here?' " But, Solow added, "when he started writing his column, his personality adapted to it." Academic life, bolstered by book and lecture fees, has been lucrative and comfortable. Krugman and Robin (his second wife; he has no children) live in a lovely custom-built wood, stone and glass house by a brook in bucolic Princeton. Krugman pointed out that unlike some earlier Nobel Prize winners, he has not asked for a better parking place on campus. (He was not kidding.) Arriving at the Times just before Bush's election in 2000, he was soon writing about politics and national security as well as economics, sharply attacking the Bush administration for invading Iraq. Someone at the Times—Krugman won't say who—told him to tone it down a bit and stick to what he knew. "I made them nervous," he says. In 2005, Times ombudsman Daniel Okrent wrote, "Op-Ed columnist Paul Krugman has the disturbing habit of shaping, slicing and selectively citing numbers in a fashion that pleases his acolytes but leaves him open to substantive assaults." Krugman says that Okrent "caved" to the criticism of conservative ideologues who were out to get him. ("I tried to be an honest broker," says Okrent. "But when someone challenged Krugman on the facts, he tended to question the motivation and ignore the substance.") It's true that during the Bush era Krugman was the target of cranks and kooks, but it is also true that in areas outside his expertise he sometimes gets his facts wrong (his record has improved lately). Krugman is unrepentant about his Bush bashing. "I was more right in 2001 than anyone in the pundit class," he says. Ideologically, Krugman is a European Social Democrat. Brought up to worship the New Deal, he says, "I am not overflowing with human compassion. It's more of an intellectual thing. I don't buy that selfishness is always good. That doesn't fit the way the world works." Krugman is particularly passionate about the growing gap between rich and poor. Last week he raced down to Washington to testify on the subject before the House Appropriations Committee. In the 2008 election, Krugman first leaned toward populist John Edwards, then Hillary Clinton. "Obama offered a weak health-care plan," he explains, "and he had a postpartisan shtik, which I thought was naive." Krugman generally applauds Obama's efforts to tax the rich in his budget and try for massive health-care reform. On the all-important questions of the financial system, he says he has not given up on the White House's seeing the merits of his argument—that the government must guarantee the liabilities of all the nation's banks and nationalize the big "zombie" banks—and do it fast. "The public wants to trust Obama," Krugman says. "This is still Bush's crisis. But if they wait, Obama will be blamed for a fair share of the problem." Obama administration officials are dismissive of Krugman's arguments, although not on the record. One official made the point that pundits can have a 60 percent chance of being right— and just go for it. They have nothing to lose but readers, and Krugman's many fans have routinely forgiven his wrong calls. The government does not have the luxury of guessing wrong. If Obama miscalculates, he could truly crash the stock market and drive the economy into depression. Krugman's suggestion that the government could take over the banking system is deeply impractical, Obama aides say. Krugman points to the example of Sweden,

281 which nationalized its banks in the 1990s. But Sweden is tiny. The United States, with 8,000 banks, has a vastly more complex financial system. What's more, the federal government does not have anywhere near the manpower or resources to take over the banking system. Krugman swats away these arguments, though he acknowledges he's not a "detail" man. He believes he is fighting a philosophical battle against the plutocrats and money-changers. Although he thinks Geithner has been captured by Wall Street, he has hope for Summers. "I have a strong suspicion that if Larry was on the outside and I was on the inside, we'd be reversing roles," he says, but adds, "Well, not entirely. Larry has more faith in markets. I'm more of an interventionist." Last week Krugman and Summers were "playing phone tag." ("It doesn't necessarily mean that much," says Krugman. "We've known each other all our adult lives." Summers initiated the call; Krugman suspects he wanted to talk him through the administration's plan.) In Friday's column, Krugman tweaked Summers directly for his faith in markets, though he grudgingly gave the Obamaites credit for calling for extensive regulation of the financial world. Krugman thinks that Obama needs some kind of "wise man" to advise him and mentions Paul Volcker, the former Fed chairman who tamed inflation for Reagan and now heads an advisory panel for Obama. How about Krugman himself for that role? "I'm not a backroom kind of guy," he says, schlumped over in his Princeton office, which overflows with unopened mail. He describes himself as a "born pessimist" and a "natural rebel." But he adds, "What I have is a voice." That he does. With Pat Wingert, Daniel Stone, Michael Hirsh and Dina Fine Maron

March 28, 2009, 4:43 pm THE MAGAZINE COVER EFFECT By Paul Krugman I’ve long been a believer in the magazine cover indicator: when you see a corporate chieftain on the cover of a glossy magazine, short the stock. Or as I once put it (I’d actually forgotten I’d said that), “Whom the Gods would destroy, they first put on the cover of Business Week.” There’s even empirical evidence supporting the proposition that celebrity ruins the performance of previously good chief executives. Presumably the same effect applies to, say, economists. You have been warned.

282 ft.com/maverecon Willem Buiter's The G20: expect nothing, hope for the best and prepare for the worst MARCH 29, 2009 8:11PM The Group of Twenty (G20) meetings that start on April 2, ought to have started on April 1 instead. That way, when nothing but hot air emanates from the Docklands venue, at least the organisers of the event will be able to claim it was all an April fool’s joke. In the unlikely event that the assembled dignitaries get serious and decide to negotiate as if the well-being of mankind hung in the balance - as it does - I have a short agenda to propose. (1) A true commitment to maintain an open global trading environment The summit of finance ministers and central bankers from the (G20) in the English town of Horsham on 13-14 March 2009, concluded with a statement that contained the following sentence: “We commit to fight all forms of protectionism and maintain open trade and investment”. Let’s just hope they are more successful that they were for the past year and a half, or even since their mid-November 2008 meeting. The hypocrisy and mendaciousness of the G20 when it comes to protectionism are breathtaking. The World Bank published a Report on March 2, 2009, which shows that seventeen of the 19 developing and industrial nations (plus the EU) have introduced restrictive trade practices since pledging (again!) in mid-November to avoid protectionism. The G20 includes the Group of Seven industrialised countries — Britain, Canada, France, Germany, Italy, Japan and the United States — and 12 developing countries and emerging markets — Argentina, Australia, Brazil, China, India, Indonesia, Mexico, Russia, South Africa, Saudi Arabia, South Korea and Turkey — as well as the European Union. Since the financial crisis started in August 2007, officials in the countries monitored by the World Bank (including but not restricted to the G20 members) have proposed and/or implemented roughly 78 trade measures. Of these 66 involved trade restrictions and 12 trade liberalising measures; 47 trade-restricting measures were implemented. Scanning the World Bank study (I did not have access to the raw data), it is clear that all the G7 countries (and the EU) imposed protectionist measures. So did Argentina, Australia, Brazil, China, India, Indonesia, Russia and South Korea. There must be two more among the four G20 countries not named in the Report (Mexico, South Africa, Saudi Arabia and Turkey) that did impose trade restrictions — my guess would be Mexico and Turkey. To avoid screwing up the world economy any further, it is not enough to abstain from actions that violate WTO rules. Many WTO-compliant actions are deeply protectionist. The Buy American provisions in the American Recovery and Reinvestment Act of 2009 (Recovery Act) are an example: “SEC. 1605. USE OF AMERICAN IRON, STEEL, AND MANUFACTURED GOODS. (a) None of the funds appropriated or otherwise made available by this Act may be used for a project for the construction, alteration, maintenance, or repair of a public building or public work unless all of the iron, steel, and manufactured goods used in the project are produced in the United States.”

283 This is protectionism of the most blatant kind. Another example of WTO-compliant protectionism is ‘bound tariffs’, which are the maximum tariff rates that WTO members agree to. These can be high for developing countries. Raising the actual tariff level does not breach any WTO obligations as long as the new higher tariff level does not exceed the bound level. For instance, India has actual tariff rates for manufactured goods in the 10 percent to 12 percent range, but has bound rates in the 40 percent to 60 percent range. Another potentially WTO-compliant set of protectionist measures fall in the Anti-Dumping category - used extensively by the advanced industrial countries and by India. Every country whose banking sector has got into trouble to the extent that financial support actions had to be mounted, underwritten ultimately by the Treasury and the tax payer, has indulged in financial protectionism. Governments have extracted promises of additional lending from banks suckling at the public teat (the UK and the Netherlands are examples). It is clear that the expectation is that this lending will be to domestic enterprises and households. It is therefore not surprising that cross-border leverage in the banking sector is declining much faster than overall leverage. Much of this financial protectionism is the politically unavoidable consequence of the use of national fiscal resources to bail out banks and shadow banks. In (2c) below, I propose that to avoid financial protectionism from spreading beyond what we will have to live with because of the absence of supranational fiscal authorities or international fiscal burden sharing rules, permissible restrictions on cross- border banking activity be explicitly regulated with reference to macro-prudential stability criteria. (2) A true commitment to tackle the fiscal stimulus and macro-prudential financial regulation issues as part of an integrated package There is no point in the US and UK authorities clamouring for a larger global fiscal stimulus until it is recognised that the global financial system that grew up since about 1980 has collapsed and cannot be patched up, let alone reconstructed to re-capture its 2006 state of glory, with just a light trimming of a few excesses. There is a huge problem in the US and in the UK particularly caused by the inability/unwillingness of the authorities to recognise that we have to re-think 39 years of financial sector de-regulation. In the US, Larry Summers and Tim Geithner were major players, during the Clinton Presidency, in creating the financial structures that have now collapsed. In the UK, distortions and excesses were allowed or even encouraged to develop on an unprecedented scale under the stewardship of Gordon Brown as Chancellor of the Exchequer. Clearly, these developments had started earlier, under the governments of Margaret Thatcher and John Major, but the cult of light-touch regulation or even no-touch regulation (or self-regulation) reached its most extreme form when Gordon Brown was Chancellor of the Exchequer. It is unlikely that those who put together the faulty design are the right persons to clean up the mess after the collapse of the system, and to lead the construction of a new banking and financial system, domestically and globally. The theory that only those who screwed it up can sort it out has no evidence to support it, but continues to exercise a powerful influence. In the case of Long Term Capital Management, the geniuses who brought the hedge fund to the edge of collapse were allowed to stay on (with an equity stake) to manage down the portfolio, something that could have been done by a handful of ABD graduate students in finance from any top university. Hank Paulson’s tenure at the US Treasury is widely judged to have been a failure.

284 It doesn’t really matter at this stage whether it is selective blindness (cognitive capture) or more conventional forms of capture that have made the officials in charge of the rescue of US financial intermediation as ineffective from the perspective of the macroeconomy and as attentive to the wishes and demands of the financial establishment as they have been since the crisis started. The result is a dysfunctional non-system that continues to enrich a few while failing to serve the many. Let me suggest the following as a minimal global regulatory reform agenda. (2a) All systemically important financial institutions and markets will have to be regulated according to the risks they pose to the financial system and the real economy. The legal form of these institutions is irrelevant. Failure to pursue the macro-prudential regulation of institutions, markets, trading platforms and other financial infrastructure according to the systemic risk they pose, and according to this risk alone, will result in another round of cross- legal-entity regulatory arbitrage, even within a given national regulatory jurisdiction. (2b) This regulation has to be done at the global level. Failure to do so will result in another round of cross-border regulatory arbitrage resulting in the kind of global soft-touch regulation that was at the root of many of the excesses that were allowed to sprout and propagate during the Great Financial Deregulation (1979-2007). (2c) There has to be an agreement to restrict the scope of systemically important cross-border banking and other financial activity to what can be effectively regulated and supervised, supported with central bank liquidity and bailed out fiscally. As an example, cross-border bank branches would be ruled out, except in a region like the Euro Area, where there is a supranational central bank, provided there is a single Euro-Area banking supervisor and regulator for cross-border banks and shadow banks, and provided the Euro Area creates either a supranational fiscal authority, a fund or a fiscal burden sharing rule for recapitalising cross-border banks (and the Eurosystem). There can be cross-border bank subsidiaries, but they would have to be independently capitalised, with independent, dedicated liquidity, managed at arm’s length from the parent and supervised and regulated by the host country. For centralised management by the parent and partial or full pooling of capital and liquidity of parent and subsidiaries, it is necessary that the parent and each of the subsidiaries (1) be regulated and supervised by the same regulator/supervisor; (2) have access to the lender-of-last-resort-and market-maker-of-last- resort-facilities of the same central bank; and (3) have the same fiscal authority, facility or arrangement as a back-stop source of capital and other financial support. (2d) There has to be international agreement on restricting the size and scope of financial institutions. Aggressive enforcement of anti-monopoly policy and the imposition of capital requirements that are increasing in the size of a bank (for given leverage and risk) would be two obvious tools for achieving this. (2e) Financial innovation (that is, the introduction of new instruments, services, products and institutions) should be regulated the way the FDA regulates pharmaceuticals. The required testing, evaluations, trials and pilot schemes should be regulated at the global level, to avoid innovation arbitrage. Economies of scale and scope in banking and shadow banking are limited. The reasons banks want to be huge and like to be involved in a wide range of financial services, products and activities are (1) the desire to exploit monopoly power; (2) the desire to shelter systemically unimportant but profitable activities under the umbrella of institutional support given to the

285 banks by the state because of their systemically important (narrow banking) activities; and (3) the attractions of exploiting conflict-of-interest situations. Once these financial regulatory issues are agreed, a global fiscal stimulus, modulated according to (1) national fiscal spare capacity and (2) the national sustainable current account imbalance. This means no further fiscal stimulus for the US, and preferably a reduction in what has already been announced. The US political system does not today permit a credible commitment to future tax increases or public spending cuts. The government deficits of 14 percent of GDP or more that are likely in the US even without any further discretionary stimulus are likely to be more than the markets are willing to tolerate and absorb, except at a much weaker external value of the US dollar and a much higher level of long-term Treasury bond rates. A country with fiscal credibility can promise virtue in the future in exchange for fiscal laxity now. That permits it to escape the painful consequences of the paradox of thrift: that an ex- ante desire to increase the national saving rate (say though fiscal tightening or a shift upwards in the private propensity to save) may, at least temporarily, depress economic activity to such an extent that ex-post savings will not rise very much if at all. For the US, I see no alternative to a painful restoration of external balance through a higher national saving rate. The UK’s position is not very different. On current policies, government deficits of more than 10 percent are likely for the next fiscal year. As with the US, such banana-Republic deficits are likely to spook the market. As with the US, the pro-cyclical behaviour of fiscal policy during the last boom will have done nothing to get the markets to believe that this time things will be different. China, Germany and even France, however can do more than they have so far indicated they will do. So can some other emerging markets, including Brazil. Only the virtuous can follow Keynesian policies. If they don’t, they not only are bad global citizens, they will also shoot themselves in the foot. Like all recessions, the current global recession is proximately an investment-driven recession. The recovery, when it comes, will be an investment-driven recovery. Those who point to large increases in private saving rates in the US and some other countries (including the UK) should recognise that household investment includes residential construction, spending on home-improvement and purchases of consumer durables, including cars, white goods, furniture and IT equipment. Investment can be internally financed, out of retained profits, as well as externally. When animal spirits re-awaken in the enterprise sector and firms want to invest again, retained profits will, after several years of deep recession, be low or negative. So external finance - its availability and cost - will be key to a sustained recovery. This holds even for the recovery of inventory investment and working capital investment. That is why reconstructing financial intermediation by creating a new banking system and a system of functional capital markets is so central. There will be no sustained recovery without it. 3. A true commitment to increase the resources of the IMF at least 10-fold and to change its governance to reflect the current distribution of economic power in the world. The IMF has approximately $250 billion worth of resources. With what it has already committed in Europe (Iceland, Latvia, Hungary, Ukraine and Romania, with Lithuania about to join the party), there is not enough left in the kitty to provide effective support to a couple

286 of large EMs. Doubling the resources to $500 billion would be a sad under-reaction to the severity of the crisis. To be a serious player in the global financial stability game, even if just in the EM and developing countries, the IMF needs an increase in its resources of about $2.25 trillion. Global capital markets are likely to remain impaired for years to come, not just for developing countries and emerging markets, but also for a large number of supposedly advance industrial countries. The need from IMF financing is BAAAAACK! It should be granted that increase through an increase in quotas (a massive new issue of SDRs) rather than through a series of bilateral loans from countries keen to buy influence. The increase in IMF resources should be accompanied by a revision in voting weights that reflects the current economic realities. That means a radical reduction in the shares of the European nations (ideally, they should be replaced by a single European Union Executive Director)), It also means a reduction in the voting weight of the US large enough to deprive it of its veto power in the organisation. It is clear that the US and the European nations have repeatedly muzzled the IMF when the organisation wanted to sound the alarm about financial in stability in the heartland of financial capitalism. That should no longer be possible. Tax havens and regulatory havens It is likely that the G20 will push further on the issue of tax havens. This certainly is the time. The aspect of tax havens that matters is not the tax rates on different sources of income or different kinds of wealth, but bank secrecy - the ability of natural and legal persons to hide assets and income from their domestic tax authorities. Bank secrecy serves tax avoidance, tax evasion and tax fraud. It assists tax evaders, tax frauds and other criminals to hide income, be it legitimate income or the proceeds from illegal activity, from the eyes of the authority. They should be closed down. The easiest way to achieve this is to make it illegal for any natural or legal person from a non-tax haven country to do business with or enter into transactions with any natural or legal person in a tax haven. That ought to do it. Tax haven, again, is defined not with respect to tax rates or tax bases, but with respect to bank secrecy, that is, with respect to the information shared by the country’s financial institutions with foreign tax authorities. That information sharing should be automatic and comprehensive. As regards regulatory havens, once common G20 standards for regulatory norms, rules and regulations has been set, countries that violate these standards would be black-listed. The obvious sanction is non-recognition of contracts drawn up in the regulatory haven jurisdiction and non-recognition of court decisions in these regulatory havens. That ought to do it. Bonuses Moral indignation is no substitute for thought. Structuring incentives to promote the long- term interests of all the stake holders in listed companies is both important and complicated. Where possible, the regulator should take into account the impact of internal incentive structures on the risk profile of the organisation when it comes to determine capital adequacy. Governance, however, is a matter in the first instance for shareholders and boards. Shareholders have been robbed blind. Now it is the turn of the tax payers. Boards have often been complicit or oblivious in these robberies. Corporate governance reform is obviously overdue. The insiders (agents), that is the management and employees, have had their day at the expense of the outsiders (principals), that is the shareholders and tax payers. In new corporate governance legislation, the same person should never combine the obviously conflicted responsibilities of Chairman of the Board and CEO. The fiduciary duties of the

287 Board to the shareholders and to the other stakeholders would be spelled out clearly. Civil and criminal law consequences should follow from wilful negligence. We clearly don’t want to have sectorally differentiated tax policies for bonuses or other forms of remuneration. Simple rules like taxing all income according to the same schedule, be it labour income, bonuses, interest, dividends or capital gains, would remove some obvious distortions. Further mitigation is likely to result from more progressive income taxation (including a higher top rate) in a much-changed political climate. Ceterum censeo Carthaginem esse delendam. http://blogs.ft.com/maverecon/2009/03/the-g20-expect-nothing-hope-for-the-best-and- prepare-for-the-worst/

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Does Obama Have a Plan B? by Adam S. Posen, Peterson Institute for International Economics Op-ed in the Daily Beast March 29, 2009 It is so much harder when the financial crisis is in your own country. Timothy Geithner, Larry Summers, and a host of other economists—myself among them— spent the late 1990s yelling at Japanese and other Asian officials to clean up their banking crises. A typical conversation would end with the American adviser bursting with frustration: "Don't you understand? The money is gone. If you just wish for the banks' asset values to come back, any recovery will be short-lived and you will only get more losses in the end. We all know this from long experience." Then we would go to conferences and discuss what it was about Japanese (or Korean or Indonesian) political economy that prevented resolute action. So it is with some irony if not humility that we should approach Treasury Secretary Geithner's Public Private Investment Plan presented on March 23. A number of major American banks have lost huge amounts of money, and clearly have insufficient capital if they are not literally insolvent. Why else would they be pushing so hard to change the accounting rules to avoid showing what they really have on their books instead of raising private capital? Why else is the US government taking so long to perform "stress tests" and trying to get expectations of overpayment for some of the bad assets on the banks' books before the test results are out? In short, the US government is looking to shovel capital into the banks without sufficient conditions, hiding rather than confronting the actual situation. That is just like the Japanese government in their lost decade, or the US officials during the 1980s before they really tackled the savings-and-loan crisis. In those cases, the delay simply made the problem worse over time and in the end the government had to put more money into the troubled banks directly, taking over or shutting down the weakest of them. Whatever the political culture, it would seem we have not learned from experience. Or perhaps we cannot act on our learning. The universal barrier would appear to be the political difficulty of recapitalizing banks. That seems obvious, but the constraint it puts on good policy is enormous. That is why the Geithner plan is so complex and jury-rigged, to avoid the need for public requests for more money for banks. Unfortunately, it is unlikely to succeed absent additional public money and more-intrusive government action. The plan will buy some time and certainly some appreciation in bank share prices. Current shareholders will be getting a new lease on life with subsidies from taxpayers. For that reason alone, the plan certainly will cost

289 the taxpayer more in the end than a more direct recapitalization with public control would have. A year or two down the road, we will know for certain whether it worked. By then the banks will either return to normal pre-crisis lending or they will be both too distrusted and too distrustful even to borrow from each other again. As we have seen over the last 18 months, the latter is what near-insolvent banks do. When I was working with the US Council of Economic Advisers and the Japanese business federation Keidanren in 2001–02 encouraging the Japanese government to do finally what was needed, it was the commitment of public money with tough conditions on the banks that we pushed for, and it was the normalization of the interbank market and then of lending behavior that showed success. In essence, the U.S. Treasury’s plan to subsidize private investors’ purchases of the banks’ toxic assets is a too-clever-by-half mechanism to fix the banks while avoiding going to Congress for more upfront on-budget expenditures. One can imagine the discussions at the White House: We have a budget to pass, and cannot give up those goals to give the bankers still more. Figure out some way to do this off-budget. And so the Geithner plan hugely bribes private investors with taxpayer money, as Simon Johnson, Paul Krugman, Jeffrey Sachs, and I have all described, with one-way government insured bets. Yet the bets are contingent, they only pay when the taxpayer loses—and those losses first appear on the Fed or FDIC balance sheet, not subject to congressional approval. I know that the very same self-limiting discussions took place at Okurasho, the Japanese Ministry of Finance circa 1995-1998. And they ended with the same result, a series of bank- recapitalization plans that tried to mobilize private-sector monies and overpay for distressed bank assets without forcing the banks to truly write off the losses. Even though the top Japanese technocrats at the ministry were even more insulated from a weak Diet than the congressionally unconfirmed advisers currently running economic policy for the Obama administration, they did worse. Whatever the political context, countries usually try to end banking crises on the cheap, with a limited public role at first, overpaying for distressed assets and failing to change banks’ behavior, only to have to go back in a couple of years later.

I hope the Geithner plan, combined with the other financial measures under way, proves to be an exception to the rule and succeeds in stabilizing the U.S. banking system. It could remove some of the bad assets from the banks’ balance sheets and put some capital into the banks. Even in that best case, though, it is clear that the avoidance of on-budget costs makes it penny- wise, pound-foolish, for the U.S. taxpayer. It will likely cost the taxpayer more on net, between the subsidies given and the transfer of most upside gains to the private investors, and the overpayments to current bank shareholders for toxic assets. If the U.S. government steps in more aggressively to take full ownership and pays a low price for these assets, the taxpayer would stand to get the full upside, even though it would require more cash up front. That would still be better than the Japanese experience. But the pattern of these crises—Japan in the 1990s or the U.S. in the 1980s, and elsewhere around the world—leads me to believe that this partial fix will be temporary at best. The banks will still have the worst toxic assets on their books; their managers and shareholders’ incentives will not have changed. The banks will be playing with a fresh stack of public money with insufficient strings and probably insufficient capital. Then, 18 months or so down the road, the U.S. government will still have to put capital into the banks, because credit markets will break down again, with many banks again under water. But in that case, the necessary recapitalization would have to take place after this round of money is squandered and the current fiscal stimulus will have run out.

290 Part of the problem is that some of these distressed assets are genuinely toxic. They cannot be consistently valued and priced by anyone because they are part of larger securitized packages and so purchasers cannot disentangle the underlying investments behind them. Under the Treasury plan, those toxic assets are not restructured, but sold as-is just because of the federal guarantee offered against losses. Restructuring these assets would require government supermajority ownership, which so far seems to be politically unpalatable. In which case, the FDIC will end up paying out on the insurance for overpriced assets. What the Obama team is proposing is disconcertingly similar to the actions of Japanese Prime Ministers Hashimoti, Obuchi, and Mori in 1995 and 1998: Rather than ask the legislature for straightforward recapitalization money, you have the political leadership preferring to risk overpaying current owners of toxic assets rather than forcing sales. For all of Japan’s supposed intervention in markets, its government still lacked the stomach for taking over banks, let alone closing them. In 1998, Japan did get a reformer, Hakuo Yanagisawa, the first financial-services minister independent of the Ministry of Finance. He got a bank recapitalization under way—but did so without putting enough conditions on the capital, hoping to mobilize private investment and limit the number of bank nationalizations. I remember a dinner with him in Tokyo shortly thereafter, where he spoke with conviction about the need to be tough with the irresponsible banks, and how he was politically independent enough to be tougher than the bureaucrats had been, since he was an elected official running a new agency. Three years later, the Japanese banking system failed again, imperiling the economy, while having accumulated billions more in non-performing loans. Only when Heizo Takenaka became the responsible minister in 2002 were Japanese banks forced to write down the value of the distressed assets before getting recapitalized. From that point forward, the Japanese economy began growing again, and within months, the worst of the Japanese banking crisis was resolved. In the meantime, a couple of Japanese governments had lost power, Yanagisawa had been replaced three times, and Japan suffered three more years of recession. Takenaka was a brave academic economist unafraid to cite lessons from the U.S. and abroad and took strength from the personal support of the new reformist Prime Minister Junichiro Koizumi. At least as importantly, though, the failure of the Japanese banking system had become so evident and imminent that politicians had no choice but to do the right thing with public capital injections and some bank closings. It is as easy to imagine the candidates for the Takenaka role in the U.S. today as it is tempting to hope that Geithner’s current plan will work, albeit at excessive taxpayer expense. But I fear that until Congress gets the message, a lasting resolution of the U.S. banking crisis will not occur—and it may take the failure of the current plan to get that message across, as it did in Japan and elsewhere. http://www.petersoninstitute.org/publications/opeds/oped.cfm?ResearchID=1170

291 http://www.calculatedriskblog.com/2009/03/new-home- sales-is-this-bottom.html WEDNESDAY, MARCH 29, 2009 From the Seattle Times: Washington's banks under stress (ht Lyle) Ailing financial giants such as Citigroup, Bank of America and AIG have drawn most of the attention as the worst banking crisis since the Great Depression grinds on. But several of Washington's community banks also are clearly straining under the weight of the crisis, a Seattle Times analysis shows. At least a dozen of the 52 Washington-based banks examined are carrying heavy loads of past-due loans, defaults and foreclosed properties relative to their financial resources. ... While banks big and small have been kneecapped by the collapse of the housing bubble, the crisis has played out differently for the big "money center" banks and the thousands of regional and community banks sprinkled across the country. The main problem for the big banks and investment firms has been exotic instruments such as collateralized mortgage obligations, structured investment vehicles and credit- default swaps — all tied, one way or another, to pools of residential mortgages that were bought, sold, sliced up and repackaged like so much salami. ... But at most community banks, residential mortgages were a relatively small part of their business. Instead, their troubles are tied directly to their heavy dependence on real-estate loans — mainly loans to local builders and developers. "Many community banks found that (construction and development loans) was an area in which they could compete effectively against the big banks," Frontier's Fahey said. At Frontier Bank, for example, construction and development loans made up 44.5 percent of all assets at year's end. City Bank had 53.3 percent of its assets in such loans, and at Seattle Bank (until recently Seattle Savings Bank), they constituted a full 54.2 percent of total assets.... Regulators can act to bring wobbly banks back into balance, short of seizing them outright. Four Washington banks — Horizon, Frontier, Westsound and Bank Reale of Pasco — are operating under FDIC "corrective action plans" that place tight restrictions on their lending practices, management and overall operations. But sometimes, such plans just delay the inevitable. Last year, for instance, the FDIC imposed corrective action plans on Pinnacle Bank and Silver Falls Bank, both of Oregon; in February, both were seized. This article makes a couple of key points that we've been discussing: many community and regional banks sidestepped the residential mortgage debacle, and focused on local commercial real estate (CRE) and construction & development (C&D) lending. Now, with rapidly increasing defaults on C&D and CRE loans, the high concentrations of CRE and C&D loans at these banks will lead to many bank failures. And unlike the "too big to fail" banks, these community banks will just be seized by the FDIC.

292 http://www.calculatedriskblog.com/2009/03/mega-bear-

quartet.html Saturday, March 28, 2009

The Mega-Bear Quartet

By popular request, here is a graph comparing four significant bear markets: the Dow during the Great Depression, the NASDAQ, the Nikkei, and the current S&P 500.

This graph is from Doug Short of dshort.com (financial planner): "The Mega-Bear Quartet and L-Shaped Recoveries". Note: updated today.

293 HTTP://WWW.CALCULATEDRISKBLOG.COM/20 09/03/FORECAST-TWO-THIRDS-OF- CALIFORNIA-BANKS.HTML Saturday, March 28, 2009

Forecast: Two-thirds of California banks to face Regulatory Action

From the LA Times: FDIC orders changes at six California banks [T]he Federal Deposit Insurance Corp. disclosed Friday that it had ordered six more California banks to clean up their acts in February after the agency examined their books and operations. ... The number of such regulatory actions has been increasing rapidly. ... By the end of 2009, two-thirds of the state's banks will be operating under cease-and- desist orders or other regulatory actions, Anaheim-based banking consultant Gary S. Findley predicts. ... Most banks targeted in such actions eventually tighten up operations and continue in business or merge with stronger institutions, but regulators are preparing for a major wave of failures. ... In addition to public cease-and-desist orders, banks are subject to a variety of regulatory sanctions, including so-called memorandums of understanding, which are informal directives to correct problems. Regulators don't release those memos, but banks sometimes disclose them to shareholders. So far 21 FDIC insured banks have failed this year, and 3 in California. There will probably be many more ... http://www.calculatedriskblog.com/2009/03/q1- gdp-will-be-ugly.html Friday, March 27, 2009

Q1 GDP will be Ugly

First, a quick market update ... This graph is from Doug Short of dshort.com (financial planner): "Four Bad Bears". Note that the Great Depression crash is based on the DOW; the three others are for the S&P 500. On Q1 GDP: Earlier today the BEA released the February Personal Income and Outlays report. This report suggests Personal Consumption Expenditures (PCE) will probably be slightly positive in Q1

294 (caveat: this is before the March releases and revisions). Since PCE is almost 70% of GDP, does this mean GDP will be OK in Q1? Nope.

I expect Q1 2009 GDP to be very negative, and possibly worse than in Q4 2008. Right now I'm looking at something like a 6% to 8% decline (annualized) in real GDP (there is significant uncertainty, especially with inventory and trade). The problem is the 30% of non-PCE GDP, especially private fixed investment. There will probably be a significant inventory correction too, and some decline in local and state government spending. But it is private fixed investment that will cliff dive. This includes residential investment, non-residential investment in structures, and investment in equipment and software. A little story ... Imagine ACME widget company with a steadily growing sales volume (say 5% per year). In the first half of 2008 their sales were running at 100 widgets per year, but in the 2nd half sales fell to a 95 widget per year rate. Not too bad. ACME's customers are telling the company that they expect to only buy 95 widgets this year, and 95 in 2010. Not good news, but still not too bad for ACME. But this is a disaster for companies that manufacturer widget making equipment. ACME was steadily buying new widget making equipment over the years, but now they have all the equipment they need for the next two years or longer. ACME sales fell 5%. But the widget equipment manufacturer's sales could fall to zero, except for replacements and repairs. And this is what we will see in Q1 2009. Real investment in equipment and software has declined for four straight quarters, including a 28.1% decline (annualized) in Q4. And I expect another huge decline in Q1. For non-residential investment in structures, the long awaited slump is here. I expect declining investment over a number of quarters (many of these projects are large and take a number of

295 quarters to complete, so the decline in investment could be spread out over a couple of years). And once again, residential investment has declined sharply in Q1 too. When you add it up, this looks like a significant investment slump in Q1. http://www.calculatedriskblog.com/2009/03/february-pce-and- personal-saving-rate.html Friday, March 27, 2009 February PCE and Personal Saving Rate The BEA released the Personal Income and Outlays report for February this morning. The report shows that PCE will probably make a positive contribution to GDP in Q1 2009. Each quarter I've been estimating PCE growth based on the Two Month method. This method is based on the first two months of each quarter and has provided a very close estimate for the actual quarterly PCE growth. Some background: The BEA releases Personal Consumption Expenditures monthly and quarterly, as part of the GDP report (also released separately quarterly). You can use the monthly series to exactly calculate the quarterly change in real PCE. The quarterly change is not calculated as the change from the last month of one quarter to the last month of the next. Instead, you have to average all three months of a quarter, and then take the change from the average of the three months of the preceding quarter. So, for Q1 2009, you would average real PCE for January, February, and March, then divide by the average for October, November and December. Of course you need to take this to the fourth power (for the annual rate) and subtract one. The March data isn't released until after the advance Q1 GDP report. But we can use the change from October to January, and the change from November to February (the Two Month Estimate) to approximate PCE growth for Q1. The two month method suggests real PCE growth in Q1 of 0.8% (annualized). Not much, but a significant improvement from the previous two quarters (declines of -3.8% and -4.3% in PCE). The following graph shows this calculation:

This graph shows real PCE for the last 12 months. The Y-axis doesn't start at zero to better show the change. The dashed red line shows the comparison between January and October. The dashed green line shows the comparison between February and November.

296 Since PCE was weak in December, the March to December comparison will probably be positive too. This graph also show the declines in PCE in Q3 and Q4. For Q3, compare July through September with April through June. Notice the sharp decline in PCE. The same was true in Q4.

This suggests that PCE will make a positive contribution to GDP in Q1. Also interesting: Personal saving -- DPI less personal outlays -- was $450.7 billion in February, compared with $478.1 billion in January. Personal saving as a percentage of disposable personal income was 4.2 percent in February, compared with 4.4 percent in January. This is substantially above the near zero percent saved of recent years.

This graph shows the saving rate starting in 1959 (using a three month centered average for smoothing). Although this data may be revised significantly, this does suggest households are saving substantially more than during the last few years (when they saving rate was close to zero). This is a necessary but painful step ... and a rising saving rate will repair balance sheets, but also keep downward pressure on personal consumption. It is not much, but this is definitely a positive report.

297 March 27, 2009 Revisiting the Global Savings Glut Thesis by Doug Noland "The extraordinary risk-management discipline that developed out of the writings of the University of Chicago's Harry Markowitz in the 1950s produced insights that won several Nobel prizes in economics. It was widely embraced not only by academia but also by a large majority of financial professionals and global regulators. But in August 2007, the risk- management structure cracked. All the sophisticated mathematics and computer wizardry essentially rested on one central premise: that the enlightened self-interest of owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency by actively monitoring their firms' capital and risk positions." Alan Greenspan, March 27, 2009, Financial Times Alan Greenspan remains the master of cleverly obfuscating key facets of some of the most critical analysis of our time. The fact of the matter is that "the sophisticated mathematics and computer wizardry" fundamental to contemporary derivatives and risk management essentially rested on one central premise: that the Federal Reserve (and, more generally speaking, global policymakers) was there to backstop marketplace liquidity in the event of market tumult. More specific to the mushrooming derivatives marketplace, participants came to believe that the Fed had essentially guaranteed liquid and continuous markets. And the Bigger the Credit Bubble inflated the greater the belief that it was Too Big for the Fed To ever let Fail. It was clearly in the "enlightened self-interest" of operators of "Wall Street finance" and throughout the system to fully exploit this market prevision. With unimaginable wealth there for the taking, along with the perception of a Federal Reserve "backstop," why would anyone have kidded themselves that there was incentive to ensure individual institutions "maintained a sufficient buffer against insolvency"? By the end of boom cycle, market incentives had been completely debauched. The Greespan Fed pegged the cost of short-term finance (fixing an artificially low cost for speculative borrowings), while repeatedly intervening to avert financial crisis ("coins in the fusebox"). There is absolutely no way that total system Credit would have doubled this decade to almost $53 TN had the Activist Federal Reserve not so aggressively and repeatedly intervened in the markets. To be sure, the explosion of derivatives and attendant speculative leveraging was central to the historic dimensions of the Credit Bubble. Mr. Greenspan today made it through yet another article without using the word "Credit." "Free-market capitalism has emerged from the battle of ideas as the most effective means to maximise material wellbeing, but it has also been periodically derailed by asset-price bubbles..." "Financial crises are defined by a sharp discontinuity of asset prices. But that requires that the crisis be largely unanticipated by market participants." "Once a bubble emerges out of an exceptionally positive economic environment, an inbred propensity of human nature fosters speculative fever that builds on itself..." He might cannily dodge the topic, but Mr. Greenspan recognizes all too well that Credit has and always will be central to the functioning - and misfunctions - of free-market Capitalistic systems.

298 With respect to the past, present and future analyses, I believe the spotlight should be taken off asset prices. Such focus is misplaced and greatly muddies key issues. Much superior is an analytical framework that examines the underlying Credit excesses that fuel asset inflation and myriad other distortions. Ensure us a stable Credit system and the risk of runaway asset booms and busts disappears. Today's financial crisis - and financial crises generally - are defined by a sharp discontinuity of the flow of Credit. Major fluctuations in asset markets - on the upside and downside - are typically driven by changes in the quantity and directional flow of Credit. Central bankers should focus on stable finance and resist the powerful tempation to monkey with asset prices and markets. As common sense as this is, today's flawed conventional thinkng leaves most oblivious and poised for Mistakes to Beget Greater Mistakes. When it comes to flawed conventional thinking, few things get my blood pressure rising more than the "global savings glut" thesis. Two weeks ago from Alan Greenspan, via The Wall Street Journal: "...The presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition. The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005. That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of, real-estate capitalization rates that declined and converged across the globe, resulting in the global housing price bubble. By 2006, long-term interest rates and the home mortgage rates driven by them, for all developed and the main developing economies, had declined to single digits -- I believe for the first time ever. I would have thought that the weight of such evidence would lead to wide support for this as a global explanation of the current crisis." It is difficult these days for me to accept that Greenspan, Bernanke and others are sticking to this misplaced view that a glut of global saving was predominantly responsible for the proliferation of U.S. and global Bubbles. The failure of our policymakers to understand and accept responsibility for the Bubble must not sit well internationally. Long-time readers might recall that I pilloried this analysis from day one. The issue was never some glut of "savings" but a historic glut of Credit and the resulting "global pool of speculative finance." In today's post-Bubble period, it should be indisputable that the acute financial and economic fragility exposed around the globe was the result of egregious lending, financial leveraging, and speculation. True savings would have worked to lessen fragility - instead of being the root cause of it. Unfortunately, there is somewhat of a chicken and egg issue that bedevils the debate. Greenspan and Bernanke have posited that China and others saved too much. This dynamic is said to have stoked excess demand for U.S. financial assets, pushing U.S. and global interest rates to artifically low levels. This, they expound, was the root cause of asset Bubbles at home and abroad. I take a quite opposing view, believing it is unequivocal that U.S. Credit excess and resulting over-consumption, trade deficits, and massive current account deficits were the underlying source of so-called global "savings." Again, if it had been "savings" driving the process, underlying system dynamics wouldn't have been so highly unstable and the end result would not have been unprecedented systemic fragility. Instead, the seemingly endless liquidity - so distorting of markets and economies round the world - was in

299 large part created through the process of unfettered speculative leveraging of securities and real estate. As is so often the case, we can look directly to the Fed's Z.1 "flow of funds" report for Credit Bubble clarification. Total (non-financial and financial) system Credit expanded $1.735 TN in 2000. As one would expect from aggessive monetary easing, total Credit growth accelerated to $2.016 TN in 2001, then to $2.385 TN in 2002, $2.786 TN in 2003, $3.126 TN in 2004, $3.553 TN in 2005, $4.025 TN in 2006 and finally to $4.395 TN in 2007. Recall that the Greenspan Fed had cut rates to an unprecedented 1.0% by mid-2003 (in the face of double-digit mortgage Credit growth and the rapid expansion of securitizations, hedge funds, and derivatives), where they remained until mid-2004. Fed funds didn't rise above 2% until December of 2004. Mr. Greenspan refers to Fed "tightening" in 2004, but Credit and financial conditions remained incredibly loose until the 2007 erruption of the Credit crisis. It is worth noting that our Current Account Deficit averaged about $120bn annually during the nineties. By 2003, it had surged more than four-fold to an unprecedented $523bn. Following the path of underlying Credit growth (and attendant home price inflation and consumption!), the Current Account Deficit inflated to $625bn in 2004, $729bn in 2005, $788bn in 2006, and $731bn in 2007. And examining the "Rest of World" (ROW) page from the Z.1 report, we see that ROW expanded U.S. financial asset holdings by $1.400 TN in 2004, $1.076 TN in 2005, $1.831 TN in 2006 and $1.686 TN in 2007. It is worth noting that ROW "net acquisition of financial assets" averaged $370bn during the nineties, or less than a quarter the level from the fateful years 2006 and 2007. The Z.1 details, on the one hand, the unprecedented underlying U.S. Credit growth behind our massive Current Account Deficits. ROW data, in particular, diagnoses the flooding of dollar balances to the rest of the world - and the "recycling" of these flows back to dollar instruments. This unmatched flow of finance devalued our currency, and in the process inflated commodities, foreign debt, equity and assets markets, and global Credit systems more generally. In somewhat simplistic terms, ultra-loose monetary conditions fed U.S. Credit excess, excessive financial leveraging and speculating, asset inflation, over-consumption, and enormous Current Account Deficits. And this unrelenting flow of dollar balances to the world inflated the value of many things priced in devalued dollars, thus exacerbating both global Credit and speculative excess. The path from the U.S. Credit Bubble to the Global Credit Bubble is even more evident in hindsight. Back in November of 2007 Mr. Greenspan made a particularly outrageous statement. "So long as the dollar weakness does not create inflation, which is a major concern around the globe for everyone who watches the exchange rate, then I think it's a market phenomenon, which aside from those who travel the world, has no real fundamental economic consequences." Similar to more recent comments on the "global savings glut," I can imagine such remarks really rankle our largest creditor, the Chinese. As we know, the Chinese were the major accumulator of U.S. financial assets during the Bubble years. They are these days sitting on an unfathomable $2.0 TN of foreign currency reserves and are increasingly outspoken when it comes to their concerns for the safety of their dollar holdings. There is obvious reason for the Chinese to question the reasonableness of continuing to trade goods for ever greater quantities of U.S. financial claims. Interestingly, Chinese policymakers are today comfortable making pointed comments. Policymakers around the world are likely in agreement on a key point but only the Chinese are willing to state it publicly: the chiefly dollar-based global monetary "system" is

300 dysfunctional and unsustainable. Mr. Greenpan may have actually convinced himself that dollar weakness has little relevance outside of inflation. And the inflationists may somehow believe that a massive inflation of government finance provides the solution to today's "deflationary" backdrop. Yet to much of the rest of the world - especially our legions of creditors - this must appear too close to lunacy. How can the dollar remain a respected store of value? Expect increasingly vocal calls for global monetary reform. "The desirable goal of reforming the international monetary system, therefore, is to create an international reserve currency that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies.' Zhou Xiaochuan, head of the People's Bank of China, March 23, 2009 http://www.safehaven.com/article-12948.htm

301

We need a better cushion against risk By Alan Greenspan Published: March 27 2009 02:00 | Last updated: March 27 2009 02:00 The extraordinary risk-management discipline that developed out of the writings of the University of Chicago's Harry Markowitz in the 1950s produced insights that won several Nobel prizes in economics. It was widely embraced not only by academia but also by a large majority of financial professionals and global regulators. But in August 2007, the risk-management structure cracked. All the sophisticated mathematics and computer wizardry essentially rested on one central premise: that the enlightened self-interest of owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency by actively monitoring their firms' capital and risk positions. For generations, that premise appeared incontestable but, in the summer of 2007, it failed. It is clear that the levels of complexity to which market practitioners, at the height of their euphoria, carried risk-management techniques and risk- product design were too much for even the most sophisticated market players to handle prudently. Even with the breakdown of selfregulation, the financial system would have held together had the second bulwark against crisis - our regulatory system - functioned effectively. But, under crisis pressure, it too failed. Only a year earlier, the Federal Deposit Insurance Corporation had noted that "more than 99 per cent of all insured institutions met or exceeded the requirements of the highest regulatory capital standards". US banks are extensively regulated and, even though our largest 10 to 15 banking institutions have had permanently assigned on-site examiners to oversee daily operations, many of these banks still took on toxic assets that brought them to their knees. The UK's heavily praised Financial Services Authority was unable to anticipate and prevent the bank run that threatened Northern Rock. The Basel Committee, representing regulatory authorities from the world's major financial systems, promulgated a set of capital rules that failed to foresee the need that arose in August 2007 for large capital buffers. The important lesson is that bank regulators cannot fully or accurately forecast whether, for example, subprime mortgages will turn toxic, or a particular tranche of a collateralised debt obligation will default, or even if the financial system will seize up. A large fraction of such difficult forecasts will invariably be proved wrong. What, in my experience, supervision and examination can do is set and enforce capital and collateral requirements and other rules that are preventative and do not require anticipating an uncertain future. It can, and has, put limits or prohibitions on certain types of bank lending, for example, in commercial real estate. But it is incumbent on advocates of new regulations that they improve the ability of financial institutions to direct a nation's savings into the most productive capital investments - those that enhance living standards. Much regulation fails that test and is often costly and counterproductive. Regulation should enhance the effectiveness of competitive markets, not impede them. Competition, not protectionism, is the source of capitalism's great success over the generations.

302 New regulatory challenges arise because of the recently proven fact that some financial institutions have become too big to fail as their failure would raise systemic concerns. This status gives them a highly marketdistorting special competitive advantage in pricing their debt and equities. The solution is to have graduated regulatory capital requirements to discourage them from becoming too big and to offset their competitive advantage. In any event, we need not rush to reform. Private markets are now imposing far greater restraint than would any of the current sets of regulatory proposals. Free-market capitalism has emerged from the battle of ideas as the most effective means to maximise material wellbeing, but it has also been periodically derailed by asset-price bubbles and rare but devastating economic collapse that engenders widespread misery. Bubbles seem to require prolonged periods of prosperity, damped inflation and low long-term interest rates. Euphoria-driven bubbles do not arise in inflation-racked or unsuccessful economies. I do not recall bubbles emerging in the former Soviet Union. History also demonstrates that underpriced risk - the hallmark of bubbles - can persist for years. I feared "irrational exuberance" in 1996, but the dotcom bubble proceeded to inflate for another four years. Similarly, I opined in a federal open market committee meeting in 2002 that "it's hard to escape the conclusion that . . . our extraordinary housing boom . . . finan-ced by very large increases in mortgage debt, cannot continue indefinitely into the future". The housing bubble did continue to inflate into 2006. It has rarely been a problem of judging when risk is historically underpriced. Credit spreads are reliable guides. Anticipating the onset of crisis, however, appears out of our forecasting reach. Financial crises are defined by a sharp discontinuity of asset prices. But that requires that the crisis be largely unanticipated by market participants. For, were it otherwise, financial arbitrage would have diverted it. Earlier this decade, for example, it was widely expected that the next crisis would be triggered by the large and persistent US current-account deficit precipitating a collapse of the US dollar. The dollar accordingly came under heavy selling pressure. The rise in the euro-dollar exchange rate from, say, 1.10 in the spring of 2003 to 1.30 at the end of 2004 appears to have arbitraged away the presumed dollar trigger of the "next" crisis. Instead, arguably, it was the excess securitisation of US subprime mortgages that unexpectedly set off the current solvency crisis. Once a bubble emerges out of an exceptionally positive economic environment, an inbred propensity of human nature fosters speculative fever that builds on itself, seeking new unexplored, leveraged areas of profit. Mortgage-backed securities were sliced into collateralised debt obligations and then into CDOs squared. Speculative fever creates new avenues of excess until the house of cards collapses. What causes it finally to fall? Reality. An event shocks markets when it contradicts conventional wisdom of how the financial world is supposed to work. The uncertainty leads to a dramatic disengagement by the financial community that almost always requires sales and, hence, lower prices of goods and assets. We can model the euphoria and the fear stage of the business cycle. Their parameters are quite different. We have never successfully modelled the transition from euphoria to fear. I do not question that central banks can defuse any bubble. But it has been my experience that unless monetary policy crushes economic activity and, for example, breaks the back of rising profits or rents, policy actions to abort bubbles will fail. I know of no instance where incremental monetary policy has defused a bubble. I believe that recent risk spreads suggest that markets require perhaps 13 or 14 per cent capital (up from 10 per cent) before US banks are likely to lend freely again. Thus,

303 before we probe too deeply into what type of new regulatory structure is appropriate, we have to find ways to restore our now-broken system of financial intermediation. Restoring the US banking system is a key requirement of global rebalancing. The US Treasury's purchase of $250bn (€185bn, £173bn) of preferred stock of US commercial banks under the troubled asset relief programme (subsequent to the Lehman Brothers default) was measurably successful in reducing the risk of US bank insolvency. But, starting in mid- January 2009, without further investments from the US Treasury, the improvement has stalled. The restoration of normal bank lending by banks will require a very large capital infusion from private or public sources. Analysis of the US consolidated bank balance sheet suggests a potential loss of at least $1,000bn out of the more than $12,000bn of US commercial bank assets at original book value. Through the end of 2008, approximately $500bn had been written off, leaving an additional $500bn yet to be recognised. But funding the latter $500bn will not be enough to foster normal lending if investors in the liabilities of banks require, as I suspect, an additional 3-4 percentage points of cushion in their equity capital-to-asset ratios. The overall need appears to be north of $850bn. Some is being replenished by increased bank cash flow. A turnround of global equity prices could deliver a far larger part of those needs. Still, a deep hole must be filled, probably with sovereign US Treasury credits. It is too soon to evaluate the US Treasury's most recent public-private initiatives. Hopefully, they will succeed in removing much of the heavy burden of illiquid bank assets. We need a better cushion against risk, By Alan Greenspan , Published: March 27 2009 http://www.ft.com/cms/s/0/9b108250-1a6e-11de-9f91-0000779fd2ac.html

304 27.03.2009 ZAPATERO FAVOURS A NEW ROUND OF STIMULUS SPENDING

In an interview with the FT and other newspapers, Jose Luis Zapatero said he favoured a new programme of government spending, should a stimulus be needed later this year. He said he would back a fresh round of spending on renewable energy and biotechnology (not clear to us why and how this is can be cyclical, fast-acting stimulus, rather than a structural expense). He said such a new stimulus round would have to be smaller than existing ones, but better co-ordinated within the EU. Samuel Brittan on debt Samuel Brittan, in his FT column, draws some interesting historical parallels of periods when UK debt rose very fast, only to come down later with relative ease. He says the current fiscal expansion is not nearly on the scale as during the second world war, and that one was financed and repaid in the post-war economic boom. In times of fiscal expansion, there are always those who warn that the country would face bankruptcy. Geithner’s plans for regulation and supervision Tim Geithner yesterday outlined his plans for a regulatory overhaul, by forcing large financial institutions, including investment banks and hedge funds, to hold more capital. Geithner was weak on details, including how to determine which institution is systemically relevant, according to the FT. Hedge funds would have to register with the SEC, and large parts of the CDS market would be pushed into central clearing. The FT also noted that this proposals close the transatlantic gap on this issue. Papademous warns about vicious circle in credit Lucas Papademous warned about a vicious circle in which the financial crisis and the recession led to higher defaults, which led to reduced lending, which in turns makes the recession worse. He made his comments after the second monthly fall in the volume of credit in the euro area. On annual basis credit growth was only 4.2%. M1 was slightly higher – which some analysts got excited about – but this probably indicates mainly a rise in demand for sight deposits from outside the eurozone, and portfolio effects. M3 growth is down at 5.9%. The following is an interesting chart from Rebecca Wilder in Economonitor about the real money supply growth, showing how much the euro area is lagging behind the others.

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Strauss Kahn sees growth recovery early 2010 if toxic assets are written off Dominique Strauss Kahn said on French television yesterday that he estimates economic growth to rebound in the first quarter of 2010 but only if the banking sector gets rid of its toxic assets (IMF estimates of remaining toxic assets to amount to $ 1.7 trillion), reports Le Monde. Stimulus packages alone will not do the trick and Europe as well the US are not doing enough. Prompted on French issues he said that the workers of the French production site of Continental had been deceived and called for pressure on Germany not to close the site. On rumours that he could become prime minister under Sarkozy DSK said “ce n’est pas serieux”. French bonus payments provoke fury E90m bonus payments to traders of Natixis provoke a row in France and make headlines in the newspapers, see e.g. Les Echos. The bank, a common subsidiary of Banques Populaires and Caisses d’Epargne, has cut 1250 jobs, lost E2.8bn in 2008 and is to receive E5bn government aid. Le Monde's article on Strauss Kahn mentions that the government is to announce a new regulation that excludes bonus payments to companies that received state aid. Solvency II takes final hurdle A committee by national governments and the European Parliament reached final agreement on the Solvency II regulation for the insurance industry, which includes some exemptions for France, where insurance companies will not have to use the strict capital adequacy rules for the valuation of equities in their pension investments. The French government had feared the loss of French companies as ankers of the French stock market, according to FT Deutschland

306 Economy

March 27, 2009 Battles Over Reform Plan Lie Ahead By EDMUND L. ANDREWS WASHINGTON — Outlining a far-reaching proposal on Thursday to rebuild the nation’s broken system of financial regulation, the Treasury secretary, Timothy F. Geithner, fired the opening salvo in what is likely to be a marathon battle. “Our system failed in fundamental ways,” Mr. Geithner told the House Financial Services Committee. “To address this will require comprehensive reform. Not modest repairs at the margin, but new rules of the game.” On the surface, both the lawmakers who listened to the Treasury secretary and the financial industry’s lobbying groups made it sound as if they completely agreed with Mr. Geithner’s call for what he described as “better, smarter tougher regulation.” But in fact industry groups are already mobilizing to block restrictions they oppose and win new protections they have wanted for years. Even though Mr. Geithner carefully avoided specific details, laying out mostly broad principles for overhauling the system, financial industry groups are identifying issues they plan to pursue and lining up well-connected lobbyists and publicists to help make their cases. If history is any guide, Mr. Geithner’s proposals will start an equally intense battle among the regulatory agencies themselves — including the alphabet soup of banking regulators, the Securities and Exchange Commission and the Federal Reserve — to stay in business and enhance their authority. It took years to complete past efforts to overhaul regulation of the financial industry — replacing the Depression-era laws that separated commercial banks from investment banks, for example, and knocking down barriers between the telephone and cable television industries. And those efforts were in some ways easier than the task confronting President Obama and Congress today. Many of the past overhauls were really about deregulation, knocking down legal barriers that had prevented different segments of an industry from competing with each other. By contrast, Mr. Geithner’s plan marks the first attempt in decades to drastically tighten the restrictions on industry. It would create a new still-unidentified “systemic risk regulator” that would have the authority to scrutinize and second-guess the operations of bank holding companies like Citigroup or JPMorgan Chase, insurance conglomerates like the American International Group and other financial institutions that are deemed too big to fail. Hedge funds and private equity funds, which have been almost entirely unregulated, would have to register with the S.E.C. and tell it about their risk-management practices. Many financial derivative instruments, like credit-default swaps, would come under supervision for the first time. Mr. Geithner’s most specific proposal, which Democratic lawmakers hope to pass in the next few weeks, would allow the federal government to seize control of troubled institutions whose collapse or bankruptcy might jeopardize the broader financial system.

307 In the months ahead, Mr. Geithner said, he will unveil more detailed proposals to set up a new regime for tighter regulation of most segments of the financial services industry. He has also said the government should more actively regulate executive compensation, not just at companies that are receiving federal bailout money, but at all companies that might be providing incentives for excessive risk-taking. “The days of light-touch regulation are over,” said Representative Barney Frank of Massachusetts, chairman of the House Financial Services Committee. Mr. Frank said the financial and economic catastrophes of the last 18 months had created a new political consensus in favor of tighter financial supervision. Mr. Frank said he hoped to pass a bill “very soon” to give the federal government “resolution authority” to seize control, restructure and shut down troubled financial institutions. And he said he hoped to pass a much broader bill along the lines of Mr. Geithner’s plan by the end of this summer. But administration officials acknowledged that enacting broad financial reforms would provoke political battles that are almost certain to drag on for months, if not years. President Obama and his economic team are already trying to navigate between the deep popular anger over reckless financial practices and the pragmatic need to coax support from the financial industry for regulations they almost reflexively oppose. On Friday, Mr. Obama will meet with executives from the nation’s biggest financial institutions. Bank executives said they expected Mr. Obama to try to sell them on his ideas, and perhaps to encourage them to keep participating in the Treasury Department’s Troubled Asset Relief Program, or TARP. Goldman Sachs has signaled that it wants to return the government’s money that the Treasury loaned it under that program. On Thursday, most industry lobbying groups held their fire and reacted to Mr. Geithner’s proposals as if they agreed with him entirely. The Securities Industry and Financial Markets Association said on Thursday that it “has been advocating for many of the same reforms” and that it “looks forward” to developing specific legislation. The Private Equity Council, which represents firms like Kohlberg Kravis Roberts and the Carlyle Group, praised the Obama administration for its “plan to comprehensively address systemic risk.” The American Insurance Association declared that “we agree with Secretary Geithner” that the new rules should “encourage high standards and a race to the top.” But industry lobbying groups are pushing their own agenda. Edward L. Yingling, president of the American Bankers Association, said he hoped to use the meeting with Mr. Obama to make the case for relaxing mark-to-market rules, which require financial institutions to value their investment securities at current market prices. Banks have argued that the rules are hurting their financial positions. Many insurance companies, for their part, are hoping to free themselves from the oversight of 50 separate state insurance regulators. Lobbyists for the retailing and restaurant industry, meanwhile, are hoping to use the banner of financial reform to persuade Congress help reduce the fees that credit card companies charge for processing customer transactions. Edmund L. Andrews reported from Washington, and Louise Story from New York. David Stout contributed reporting from Washington, and Michael de la Merced and Zachery Kouwe from New York.

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As Oversight Plan Is Unveiled, Turf Battle Begins to Unfold Rival Regulators Argue for Right to Expanded Authority By Zachary A. Goldfarb, Binyamin Appelbaum and Tomoeh Murakami Tse Washington Post Staff Writers Friday, March 27, 2009; D01 Even as Treasury Secretary Timothy F. Geithner yesterday was presenting to Congress his new blueprint for revamping financial oversight, federal regulators at the Securities and Exchange Commission and elsewhere were joining the battle over the creation and apportionment of any expanded powers. The Obama administration wants Congress to vastly expand federal oversight of previously unregulated financial markets such as trading in derivatives, and to impose more rigorous regulations and curbs on risk-taking by the largest financial companies, including major banks, insurers and hedge funds. SEC Chairman Mary L. Schapiro urged that her agency play a major role, telling the Senate Banking Committee that the SEC may soon ask for new authority to oversee financial firms and products, including hedge funds, derivatives and municipal bonds. At the same time, she warned that the administration's proposal to endow some federal agency with the authority to detect risks throughout the economy "could usurp" the work of the SEC and other regulators. Rival agencies -- including the Federal Reserve, Commodity Futures Trading Commission and banking regulators -- already are pushing similar arguments. Consumer advocates, meanwhile, say they are being ignored. Industry groups caution against a surfeit of new regulation. The administration is taking advantage of what Geithner described yesterday as an "opportunity" to enact regulations that before the financial crisis might have faced much more opposition. Notable by their absence, however, were proposals addressed at the causes of the crisis. There was no mention of increased regulation of the mortgage industry, for example, or of securitization, the process of bundling loans for sale to investors that funded much of the boom in lending. In part, the administration appears to be deferring to Congress. Rep. Brad Miller (D-N.C.) yesterday introduced legislation to create national regulations for mortgage lending. Rep. Barney Frank (D-Mass.), the chairman of the House Financial Services Committee, opened the Geithner hearing with a speech about the need for increased regulation of securitization. The administration, by contrast, is focused first on creating a system for regulating the largest financial companies, limiting the risks they take and granting the government new powers to seize large firms before they collapse. In her testimony, Schapiro said she could endorse in principal the proposal to assign a single agency to regulate systemic risk but was concerned this could harm the effectiveness of the SEC. For example, a regulator that worries primarily about risks that one firm poses to the entire financial system might favor relaxing accounting standards in periods of crisis or

309 oppose stiff penalties for an already struggling financial company. Enforcing accounting standards and securities laws are the SEC's bread and butter. "We have to have equal attention on investor protection, and an independent agency like the SEC focuses on that," Schapiro said in an interview yesterday. Another area already being contested is Geithner's proposal to regulate derivatives, the exotic financial instruments such as credit-default swaps that have exacerbated the crisis. The SEC and CFTC are both trying to lay claim to overseeing this market. Schapiro yesterday cited the SEC's experience in regulating similar forms of trading as "a pretty compelling reason to be involved in their regulation." The CFTC released a statement asserting its own expertise and saying that it looked forward to contributing to the overhaul of derivatives regulation. Industry executives, fearful of regulatory overreach, are gearing up for marathon discussions with the administration and key members of Congress. "We want to achieve meaningful regulatory reform to make sure these products remain widely available, in a way that is cost effective," said Robert Pickel, chief executive of the International Swaps and Derivatives Association. The turf battle between agencies is mirrored on Capitol Hill, where House and Senate agriculture committees with authority over the CFTC do not want to cede authority to the financial services and banking committees that have oversight over the SEC. Yet another conflict is brewing over regulation of hedge funds. Geithner wants larger funds to register with the SEC. Schapiro wants all hedge funds to register with the agency. Geithner has also suggested that venture capital and private-equity firms register with the SEC. Schapiro hasn't expressed opposition to this but said that such companies may need to be subject to different rules than hedge funds. James Chanos, an outspoken hedge fund manager, said yesterday that while the industry is willing to accept some new regulations, Congress shouldn't be quick to treat them the same way as banks and other financial firms. "Hedge funds and their investors have generally absorbed the painful losses of the past year without any government cushion; the same certainly cannot be said of the major investment and commercial banks, insurance companies, and [Fannie Mae and Freddie Mac] that have had to run to the taxpayer to cushion against the losses caused by poor investment decisions, faulty risk management or fraud," he said. "Private equity can make a cogent argument that the problem was not of its own making," said an executive at a major private-equity firm who spoke on condition of anonymity because he expects to be part of the discussions with government officials in formulating details of the plan. "It poses no systemic risk. . . . The worst that can happen is the fund goes to zero. It doesn't suddenly turn into this black hole threatening to suck in everything around it." Perhaps Geithner's friendliest reception came from the House Financial Services Committee, whose members earlier this week had slammed the Treasury secretary for his role in the payment of bonuses to employees at American International Group. Staff writer Amit R. Paley contributed to this report. Tse reported from New York.

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RTC All Over Again http://www.hedgefund.net/publicnews/default.aspx?story=9895# RTC All Over Again March 27, 2009 In September 2008, the Shadow predicted that a Resolution Trust Corp. (RTC)-type of entity would emerge to deal with the ill conceived, badly documented and unaffordable mortgages that are on the books of financial institutions. That day has arrived under Tim Geithner and the Obama Administration and has the potential, just as in the late 1980s and early 1990s, to generate enormous profits for entities that have the intestinal fortitude and work ethic to sift through the rubble to find properties that have value. The plan is intended to work something like this: A bank will auction a pool of mortgage assets to the highest private sector bidder, for which the FDIC will provide leverage directly to the buyer on a six to one debt-to-equity basis. So if a bidder wins a $100 million asset pool for say $84 million, the FDIC will provide guarantees of $72 million. Of the remaining $12 million of equity, the investor will provide $6 million and the U.S. Treasury will provide the balance of $6 million. Let us assume that the actual value of the assets after disposition is $50 million and that the total profit on the transaction is $2 million, which goes evenly to the equity holders. The investor made $1 million on a $6 million investment, or 16.7% return on capital. The assets are now off the banks’ books (making them stronger institutions) who actually sold $50 million worth of assets for $84 million (they gained $34 million), and the investor and the Treasury has turned a profit of $2 million. Who loses $36 million? The FDIC of course, who blindly will extend loans on assets worth perhaps far less than the debt used to acquire them. A friend of mine always recites a quote from Ronald Reagan during meetings when discussing mortgaged backed securities and it goes something like this: “What are the most feared words in America? ‘Hello, I’m from the Federal Government and I’m here to help.’” The point is well taken: if the government gets involved in any process that is normally handled by the private sector, you know that it will get screwed up somehow. No one seems to be accountable for any programs or behavior since it can be categorized as “the government.” How about using riot control tactics and singling out individuals. (“Mr. Geithner, you will be evaluated on this program” and perhaps have his pay tied to the success of the program.) Will this program of $1.2 trillion take enough of the impaired assets out of the mortgage marketplace to get the economy back on track and restore confidence with investors and consumers? Time will tell but it seems the government does not end up following through on a program before it becomes distracted and turns to some other issue. Experience tells us that fixing the underlying cause of a problem will alleviate the symptoms and not the other way around. As painful or as inequitable or as much of a boondoggle that this new program may turn out to be, it is at least an attempt to correct the problem. I am hoping against hope that the phrase “Hello, I’m from the Federal Government and I’m here to help” will take on new, positive meaning. The views expressed in this column do not necessarily reflect the views of Channel Capital Group. Inc.

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Geithner to Propose Vast Expansion Of U.S. Oversight of Financial System By Binyamin Appelbaum and David Cho Washington Post Staff Writers Thursday, March 26, 2009; A01 Treasury Secretary Timothy F. Geithner plans to propose today a sweeping expansion of federal authority over the financial system, breaking from an era in which the government stood back from financial markets and allowed participants to decide how much risk to take in the pursuit of profit. The Obama administration's plan, described by several sources, would extend federal regulation for the first time to all trading in financial derivatives and to companies including large hedge funds and major insurers such as American International Group. The administration also will seek to impose uniform standards on all large financial firms, including banks, an unprecedented step that would place significant limits on the scope and risk of their activities. Most of these initiatives would require legislation. Geithner plans to make the case for the regulatory reform agenda in testimony before Congress this morning, and he is expected to introduce proposals to regulate the largest financial firms. In coming months, the administration plans to detail its strategy in three other areas: protecting consumers, eliminating flaws in existing regulations and enhancing international coordination. The testimony will not call for any existing federal agencies to be eliminated or combined, according to the sources, who spoke on condition of anonymity. The plan focuses on setting standards first, leaving for later any reshaping of the government's administrative structure. The nation's financial regulations are largely an accumulation of responses to financial crises. Federal bank regulation was a product of the Civil War. The Federal Reserve was created early in the 20th century to mitigate a long series of monetary crises. The Great Depression delivered deposit insurance and a federally sponsored mortgage market. In the midst of a modern economic upheaval, the Obama administration is pitching the most significant regulatory expansion since that time. An administration official said the goal is to set new rules of the road to restore faith in the financial system. In essence, the plan is a rebuke of raw capitalism and a reassertion that regulation is critical to the healthy function of financial markets and the steady flow of money to borrowers. The government also plans to push companies to pay employees based on their long- term performance, curtailing big paydays for short-term victories. Long-simmering anger about Wall Street pay practices erupted last week when the Obama administration disclosed that AIG had paid $165 million in bonuses to employees of its most troubled division, despite losing so much money that the government stepped in with more than $170 billion in emergency aid.

312 The administration's signature proposal is to vest a single federal agency with the power to police risk across the entire financial system. The agency would regulate the largest financial firms, including hedge funds and insurers not currently subject to federal regulation. It also would monitor financial markets for emergent dangers. Geithner plans to call for legislation that would define which financial firms are sufficiently large and important to be subjected to this increased regulation. Those firms would be required to hold relatively more capital in their reserves against losses than smaller firms, to demonstrate that they have access to adequate funding to support their operations, and to maintain constantly updated assessments of their exposure to financial risk. The designated agency would not replace existing regulators but would be granted the power to compel firms to comply with its directives. Geithner's testimony will not identify which agency should hold those powers, but sources familiar with the matter said that the Federal Reserve, widely viewed as the most obvious choice, is the administration's favored candidate. Geithner and other officials have said in recent weeks that such powers could have kept in check the excesses of AIG and other large financial companies. "The framework will significantly raise the prudential requirements, once we get through the crisis, that our largest and most interconnected financial firms must meet in order to ensure they do not pose risks to the system," Geithner said yesterday in a speech before the Council on Foreign Relations in New York. Hand in glove with this expanded oversight, the administration also is seeking the authority to seize these large firms if they totter toward failure. Under current law, the government can seize only banks. The administration yesterday detailed its proposed process, under which the Federal Reserve Board, along with any agency overseeing the troubled company, would recommend the need for a takeover. The Treasury secretary, in consultation with the president, then would authorize the action. The firm would be placed under the control of the Federal Deposit Insurance Corp. The government also would have the power to take intermediate steps to stabilize a firm, such as taking an ownership stake or providing loans. "Destabilizing dangers can come from financial institutions besides banks, but our current regulatory system provides few ways to deal with these risks," Geithner said yesterday. "Our plan will give the government the tools to limit the risk-taking at firms that could set off cascading damage." The administration compared the proposed process with the existing system under which banking regulators can take over failed banks and place them under FDIC control. One important difference is that the decision to seize a bank is made by agencies that have considerable autonomy and are intentionally shielded from the political process. Some legislators have raised concerns about providing such powers to the Treasury secretary, a member of the president's Cabinet. The cost of bank failures is carried by the industry, which pays assessments to the FDIC. The Treasury said it has not yet determined how to pay for takeovers under the proposed system. Possibilities include dunning taxpayers or collecting fees from all institutions the government considers possible candidates for seizure.

313 FDIC chairman Sheila C. Bair issued a statement that expressed support for an expansion of her agency's responsibilities. "Due to the FDIC's extensive experience with resolving failed institutions and the cyclical nature of resolution work, it would make sense on many levels for the FDIC to be given this authority working in close cooperation with the Treasury and the Federal Reserve Board of Governors," Bair said. The administration also wants to expand oversight of a broad category of unregulated investment firms including hedge funds, private-equity funds and venture capital funds, by requiring larger companies to register with the Securities and Exchange Commission. Firms also would have to provide financial information to help determine whether they are large enough to warrant additional regulation. Hedge funds were designed to offer high-risk investment strategies to wealthy investors, but their role quickly grew from one on the fringe of the system to a place near the center. Some government officials have sought increased regulation of the industry since the 1998 collapse of Long-Term Capital Management threatened the stability of the financial system. Geithner also plans to call for the SEC to impose tougher standards on money-market mutual funds, investment accounts that appeal to investors by aping the features of checking accounts while offering higher interest rates. He will not make specific suggestions. SEC chairman Mary Schapiro plans to testify today that the SEC supports both proposals. The administration's broad determination to regulate the totality of the financial markets also includes a plan to regulate the vast trade in derivatives, complex financial instruments that take their value from the performance of some other asset. Derivatives have become a basic tool of the financial markets, but trading in many variants is not regulated. Credit-default swaps, a major category of unregulated derivatives, played a major role in the collapse of AIG. Geithner plans to call for the entire industry to be placed under strict regulation, including supervision of dealers in derivatives, mandatory use of central clearinghouses to process trades and uniform trading rules to ensure an orderly marketplace. The Fed already is moving to improve the plumbing of the financial system, including of the derivatives trade. The administration wants to expand and formalize these efforts. Senior government officials view these highly technical arrangements as critical to the restoration of a healthy financial system. Staff writer Zachary A. Goldfarb contributed to this report.

314 Mar 26, 2009 Time For A New Insolvency Regime For Non- Banks And Bank Holding Companies? Overview: While banks have a receivership regime based on the FDIC taking over insolvent banks and working them out in a orderly way, bank holding companies and non bank financial institutions do not have such conservatorship/receivership regime outside of Chapter 11 or Chapter 7 bankruptcy. That is why the government had to bail out the creditors of Bear Stearns and AIG and that is why the collapse of Lehman was disorderly. We need now an orderly system to wind down systemically important financial institutions and bank holding companies as many assets and CDS and bonds of banks are at the holding company level rather than the bank level (Roubini)--> see Blueprint for Regulatory Reform: Should There Be A Super-Fed? o March 25 Geithner (via WSJ, CFR): The Treasury Department revealed key details of a draft bill it plans to send to Congress that would give regulators unprecedented emergency powers to wind down faltering nonbank firms such as insurer AIG. o cont.: Treasury said the draft bill would enable the federal government to seize troubled bank- and thrift-holding companies as well as firms that control broker- dealers and futures commission merchants. Under the bill, the Treasury secretary would have to make "triggering determination" before invoking resolution authority (akin to the so-called systemic risk exception under the FDIA). The secretary would have to find that the firm is in danger of becoming insolvent, that its insolvency would have serious adverse effects on the economy and financial stability, and that taking emergency action would avoid those adverse effects. o cont.: An Obama administration official confirmed that the legislative proposal would also give the government authority to shut down troubled hedge funds, which currently face minimal oversight. The government could potentially use the new "resolution authority" on any non-bank financial firm that is deemed to pose systemic risk, the official added. o March 10 Bernanke: Models do exist for resolution procedures including the process currently in place under the Federal Deposit Insurance Act (FDIA) for dealing with failing insured depository institutions and the framework established for Fannie Mae and Freddie Mac under the Housing and Economic Recovery Act of 2008. o cont.: Any new regime must be structured to work as seamlessly as possible with other domestic or foreign insolvency regimes that might apply to one or more parts of the consolidated organization (see Financial Stability Forum report) o Bulow/Klemperer: Focus on liabilities of troubled institutions rather than on assets as with Geithner's pppip: 1. We cannot efficiently value or transfer “toxic” assets - so a good plan cannot depend upon this. 2. The UK’s Special Resolution Regime, or one similar to that of the US FDIC, can cleanly split off the key banking functions into a new "bridge"

315 bank, leaving liabilities behind in an "old” bank, thus also removing creditors’ bargaining power. 3. Creditors left behind in the old bank can be fairly compensated by giving them the equity in the new bank. 4. We can pick and choose which creditors we wish to “top up” beyond this level, but should not indiscriminately make all creditors completely whole as in recent bailouts. 5. Coordinating actions with other countries will reduce any risks. o Buiter: I propose that a special resolution regime for banks be designed in such a way that 1) it achieves any desired increase in the capital ratios of a bank entering the SRR (or any desired reduction in the leverage ratio) to the maximum possible exent through a mandatory debt-to-equity conversion. 2) Unsecured creditors would be first in line for a haircut (in reverse order of seniority). 3) Secured creditors would retain their claim to the collateral securing their loan or bond, but would share with the unsecured creditors the haircut in their claim on the bank. 4) New capital should only injected by the government if there either is not enough debt in the balance sheet or if the balance sheet of the bank is considered too small. 5) While it is conventional for existing equity holders to be wiped out before debt is converted into equity, I don’t consider this essential. Dilution may provide adequate punishment and incentives for future equity investment decisions. o cont.: The worst of all possible worlds would be the Irish (and now also Danish) approach where all creditors of the banks are guaranteed by the government (for a fee that undoubtedly will not cover the government’s opportunity cost) and the tax payer is left without any upside. Mar 26, 2009 Blueprint for Regulatory Reform: Regulation By Activity For Everybody Rather Than By Institution? o March 26 WaPo: Geithner will seek to impose uniform standards on all large financial firms, including banks, an unprecedented step that would place significant limits on the scope and risk of their activities. The administration also wants to extend federal regulation for the first time to all trading in financial derivatives and to companies including large hedge funds and major insurers such as AIG. o March 25: Roubini: Finally, Geithner and Bernanke (see respective testimonies at AIG hearing on March 24) have come to agree about the need for a new insolvency regime for systemically important financial institutions (bank holding companies and non bank financial institutions) in order to avoid another Lehman and expensive ad-hoc bailouts like AIG. A new conservatorship/receivership regime of insolvency could be similar to the one used to manage the orderly takeover of Fannie and Freddie. o March 10: Bernanke (via FTAlphaville): "Effectively identifying and addressing systemic risks would seem to require the involvement of the Federal Reserve in some capacity, even if not in the lead role." Bernanke's other suggestions for resolving systemic risk include: more supervision for financial institutions deemed ‘too big to fail’, tighter restrictions on the assets in which money market funds can invest, and, perhaps most significantly, modifying the accounting rules which cause pro-cyclicality for bank’s capital positions.

316 o March 6 Reuters: A top priority for lawmakers is to create a new regulator of systemic risk, a job that Barney Frank has previously said should go to the Federal Reserve. "Are any of you troubled with giving the Fed so much power?" asked Spencer Bachus, the top Republican on the full House Financial Services committee. Frank's Financial Services committee will explore legislation to prevent excessive leverage in the financial system, create a way for the government to unwind failed non-bank financial institutions, and prohibit 100 percent securitization of loans. o Baker/Wallison: Why expand the powers of an agency that sat idly by as the housing bubble took shape? o Gross (PIMCO): There seems no way that current reserve requirements for banks will not in some nearly uniform way be imposed on investment banks. o Lewitt (HCM): There is too little, not too much regulation. To do: impose absolute leverage limit on all financial institutions incl. hedge funds; outlaw off-balance sheet entities; reinstitute downtick rule against short-sellers immediately. o Larry Summers: Raise bank capital requirements. o Barney Frank: Single regulator/greater power to Fed good idea. Regulators should also re-examine capital reserves, risk-management practices and consumer protection without regard to whether companies were commercial banks, investment banks or nonbank mortgage lenders.

Will The Fed's PPPIP Get Credit Flowing Again? Mar 25, 2009 Overview: The Geithner plan rests on the premise that legacy assets that are being re- intermediated on banks' balance sheets thus clogging them up are fundamentally undervalued due to a liquidity premium rather than drastically reduced cash flow expectations. If such is the case, the substantial incentives and debt guarantees provided by the taxpayers to private asset managers should be enough to wake their interest in bidding for toxic assets at a reasonable value for sellers. Whether credit supply resumes depends on the true health of banks: fundamentally sound institutions will be able to take whatever writedown relative to the PPPIP established market price and get rid of the assets without the need of further recapitalization, others might need recapitalization in response to writedown (see i.e additional $750bn TARP 3 and 4 earmarked in Obama's budget subject to Congress approval as TARP 2 has only $150bn left), and weak banks won't have an incentive to sell at all in view of easing mark-to-market rules and if the writedown would wipe out their capital. o March 25 FT Guha/Guerrera: The government’s toxic assets plan will force banks such as Citigroup, Bank of America and Wells Fargo to take large writedowns on their loans, requiring them to raise more capital from taxpayers or investors, executives and analysts have warned. o March 25: ON Libor: 28bp - TED spread (3m LIBOR - T-bill): 104bp--> extreme flight to quality caused record repo fails; - 3m USD LIBOR - OIS: 98bp; - 3m EUR LIBOR - OIS: 82bp; - U.S. CDX IG spread: 184bp

317 - U.S. Crossover: 1673bp - EU iTraxx IG spread: 162bp; - EU iTraxx subfinancials: 904bp - CMBX, LCDX and ABX spreads/prices are all off their recent lows. o BNP March 24: We have seen equity, the iTraxx subordinated financials index and Tier 1 debt spreads all improve. But the rise in bank lower tier 2 debt spreads also appears to have been arrested in the last couple of days and iBoxx senior financials spreads have also been ticking slightly lower. Small improvements, but encouraging none-theless. o March 24 FT: The MBA revised its forecast for new loans upward by $800bn, predicting that aggressive Federal Reserve policies will drive the total loans originated to reach 2,780bn, the most since 2005. The revision was sparked by falling interest rates following last week’s Fed decision to purchase Treasury bonds and mortgage-backed securities which is expected to create a flurry of refinancing activity. o March 10 Bloomberg: “There is also a general concern over the demand for dollar-based funding in Europe,” said Meyrick Chapman, a fixed- income strategist in London at UBS AG. “Movement in cross- currency basis swaps signals that this demand has increased.” o Dec 19 WSJ: BBA made it clear that banks must not contribute LIBOR quotes for any government-guaranteed, or effectively secured, debt. The clarification is designed to help ensure the London interbank offered rates reflect the cost of unsecured borrowing between banks. o ECB via FT: ECB mulls an ECB-organized clearing house that would guarantee interbank lending, with the intention of overcoming mutual distrust between banks--> interbank guarantee would achieve in Europe what Credit Easing would do in U.S. with Fed buying non-financial debt because bank lending is relatively more important in Europe than market-based financing. o Dec 17 BNP analyst Jacq via Bloomberg: “There is no demand coming from the interbank market at all. Banks are borrowing straight from the Fed and hoarding that cash till they need some and then returning to the Fed. We don’t expect a return to normal conditions in the coming six months.” o Economist: Why isn't there any arbitrage between low funding cost and high lending revenue in term interbank market? One reason is that central banks require collateral against lending, and the type of assets that are suitable pledges are in short supply. o Mason: Reason for persistently high interbank spreads is not lack of confidence but forced re-intermediation of off-balance sheet items for which banks know all too well that there isn't enough capital (see: What is driving interbank spreads?) o Dec 6 RGE: The cost of protecting corporate bonds from default surged to records around the world as did corporate bond spreads themselves--> negative basis is back in AAA segment after Lehman's default, HY bond spreads in line with amount of low quality debt oustanding--> spreads are currently pricing in a default rate of 21%. Corporate downgrades are accelerating, real outlook worsens and deleveraging is likely to continue (see: Record Corporate Bond Spreads: A Buying Opportunity?) o Dec 19: George Magnus: 5 things to do after Minsky Moment: 1) European banks will need a further $100bn-$150bn of capital, while US banks, including regional banks, should quickly be allocated most of the unspent Tarp money of $350bn; 2) Equity-for- debt swaps will be required for companies with excessive debt; 3) British, German and

318 French programmes amount to a little over 1 per cent of their GDP, incl. much window- dressing. The forthcoming US programme, expected to be about $600-$700bn (or about 4 per cent of GDP), will compensate for much of the private sector’s withdrawal of spending and borrowing; 4) Quantitative easing helps to keep short-term rates near zero and could peg longer-term rates too--> risk of inflation can be dealt with later; 5) leadership. o Roubini: To make the Wall Street rescue sustainable Main Street must be helped as well. The US government will need to implement a clear plan to reduce the face value of mortgages for distressed home owners and avoid a tsunami of foreclosures (as in the Great Depression HOLC and in my HOME proposal). o cont.: A fiscal stimulus plan is essential to restore – on a sustained basis – the viability and solvency of many impaired financial institutions. If Main Street goes bust in the next six months rescuing in the short run Wall Street will still lead Wall Street to go bust again as the real economy implodes further. o cont.: To do: 1) the federal government should have a plan to immediately spend in infrastructures and in new green technologies; 2) also unemployment benefits should be sharply increased together with a 3) targeted tax rebates only for lower income households at risk; and 4) federal block grants should be given to state and local government to boost their infrastructure spending (roads, sewer systems, etc.). Details Of Geithner's Public-Private Partnership: Large Taxpayer Subsidies For Toxic Asset Investors Mar 25, 2009 Overview: Industry analysts estimate that the nation’s banks are holding at least $2 trillion in troubled assets mostly residential and commercial mortgages.(NYT) . Geithner's $500bn - $1 trillion Public-Private Partnership Investment Program plan in own words (WSJ): o “The Public-Private Investment Program will purchase real-estate related loans from banks and securities from the broader markets. Banks will have the ability to sell pools of loans to dedicated funds, and investors will compete to have the ability to participate in those funds and take advantage of the financing provided by the government." o "The funds established under this program will have three essential design features. First, they will use government resources in the form of capital from the Treasury, and financing from the FDIC and Federal Reserve, to mobilize capital from private investors. Second, the Public-Private Investment Program will ensure that private-sector participants share the risks alongside the taxpayer, and that the taxpayer shares in the profits from these investments. These funds will be open to investors of all types, such as pension funds, so that a broad range of Americans can participate." o "Third, private-sector purchasers will establish the value of the loans and securities purchased under the program through auctions, which will protect the government from overpaying for these assets." o Sample Investment Under the Legacy Loans Program: o Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.

319 o Step 2: The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio. o Step 3: The pool would then be auctioned by the FDIC, with several private sector bidders submitting bids. The highest bid from the private sector – in this example, $84 – would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages. o Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity. o Step 5: The Treasury would then provide 50% of the equity funding required on a side-by- side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6. o Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis – using asset managers approved and subject to oversight by the FDIC. o Sample Investment Under the Legacy Securities Program: o Step 1: Treasury will launch the application process for managers interested in the Legacy Securities Program. o Step 2: A fund manager submits a proposal and is pre-qualified to raise private capital to participate in joint investment programs with Treasury. o Step 3: The Government agrees to provide a one-for-one match for every dollar of private capital that the fund manager raises and to provide fund-level leverage for the proposed Public-Private Investment Fund. o Step 4: The fund manager commences the sales process for the investment fund and is able to raise $100 of private capital for the fund. Treasury provides $100 equity co- investment on a side-by-side basis with private capital and will provide a $100 loan to the Public-Private Investment Fund. Treasury will also consider requests from the fund manager for an additional loan of up to $100 to the fund. o Step 5: As a result, the fund manager has $300 (or, in some cases, up to $400) in total capital and commences a purchase program for targeted securities. o Step 6: The fund manager has full discretion in investment decisions, although it will predominately follow a long-term buy-and-hold strategy. The Public-Private Investment Fund, if the fund manager so determines, would also be eligible to take advantage of the expanded TALF program for legacy securities when it is launched. Reactions: o FT Alphaville: At the heart of this complex plan is liquidity, which Geithner has identified as both the problem and the answer. Increase liquidity and assets price will rise towards fair value, banks’ capital ratios will improve and they will start lending again. What if value of assets is low because of reduced cash flow expectations--> see also 'Fire- Sale' Vs. 'Hold-to-Maturity' Prices: Is The FASB Yielding To Pressure From The Industry? o Alea: The plan is good in theory as private investors have no incentive to overpay because they are in a first-loss position. However, there is likely to be a gap between the mtm value of the toxic assets and what a rational investor would pay, reducing or

320 eliminating the incentive for banks to participate. Only the truly cash-starved banks will jump. o Blog comments: private investors will take long positions in the selling banks’ stocks (or other long positions in derivatives) and will then have an incentive to grossly overpay for the securities in this program. They’ll gladly take some losses in this program to boost their other positions outside the program. o Krugman: Huge taxpayer subsidies to the private sector are involved: Suppose that there’s an asset with an uncertain value: there’s an equal chance that it will be worth either 150 or 50. So the expected value is 100. But suppose that I can buy this asset with a non- recourse loan equal to 85 percent of the purchase price. How much would I be willing to pay for the asset? The answer is, slightly over 130 [in a competitive auction.] Why? All I have to put up is 15 percent of the price — 19.5, if the asset costs 130. That’s the most I can lose. On the other hand, if the asset turns out to be worth 150, I gain 20. So it’s a good deal for me. o cont.: Another way to say this is that by financing a large part of the purchase with a non- recourse loan , the government is in effect giving investors a put option to sweeten the deal. o John Mauldin (via TechTicker): I'm in the hedge fund business myself but as a taxpayer I don't believe Treasury should subsidize hedge funds.

Rationale: o Lucian Bebchuk (Harvard, via Forbes): If the underlying problem is at least partly one of liquidity, an effective plan for a public-private partnership in buying troubled assets can be designed. The key is to have competition at two levels. First, at the level of buying troubled assets, the government’s program should focus on establishing many competing funds that are privately managed and partly funded with private capital--and not creating one, large "aggregator bank" funded with public and private capital and engaging in purchasing troubled assets. Second, at the level of allocating government capital among the competing private funds, potential fund managers should compete for government capital under a market mechanism resulting in maximum participation of private capital and minimum costs to taxpayers.

321 News March 26, 2009, 5:00PM EST Can Geithner's Toxic-A+sset Plan Work? THE TREASURY SECRETARY'S PLAN TO RID BANKS OF BAD LOANS FACES PLENTY OF ROADBLOCKS. ONLY TIME WILL TELL IF IT CAN SUCCEED By Jane Sasseen The stock market enjoyed an explosive rally on Mar. 23 after Treasury Secretary Timothy F. Geithner at long last unveiled a detailed plan to team up with private investors to rid the banks of troubled mortgage assets. No mystery here: Bolstering major banks so they can start lending again is essential if the economy is going to recover. Will it work? It might, but that may require some sizable bank asset sales to come together by early summer, followed by a steady flow of deals through yearend to get the program off the ground. Geithner thinks he has the right mix of incentives in place to quickly ramp up the program. But it will take a sustained flow of deals to establish attractive prices for all manner of home loans and mortgage-backed securities, which have been devilishly tough for banks to unload since the credit crisis began back in late 2007. The Treasury's Public-Private Investment Program aims to create investment partnerships that will combine government cash with equity capital from private investors. Uncle Sam will then lend those partnerships money at below-market rates so they have more funds to buy up the banks' bad assets. By providing much of the funding—and limiting private investors' potential losses—Geithner hopes to spur competitive bidding that will establish realistic prices for the toxic assets and get them off the banks' balance sheets. "The goal is to provide liquidity to the market on reasonable terms," says Larry Summers, head of President Obama's National Economic Council. So far, private equity giant Blackstone Group (BX), bond mavens Pimco, and other investors have expressed interest in participating. Investors expect Treasury to line up a few high- profile deals by late May or June. William H. Gross, Pimco's co-chief investment officer, argues that if the government lends to the partnership at rates as low as 2%—which the market expects—investors could pay close to 60 cents on the dollar for the devalued assets with returns of around 15%. Sellers would still have to make concessions, but far smaller ones than if forced to sell at today's fire-sale prices. "Geithner's plan closes the gap significantly, but we'll still have to see if anything crosses the market," says Gross. With Treasury aiming to buy up to $1 trillion in bank assets, Gross wants to see a monthly deal flow of $150 billion in the second half. It will take that kind of volume to get a sustained lift in prices. "If this is working, you'll start to see housing and mortgage securities prices stabilize, and maybe even go up," says Steven D. Persky, managing partner of Dalton Investments. Money pros say it will be a month or even two before enough is known about the terms of the deal to decide if it's worth participating. Also, the backlash against AIG's (AIG) bonuses makes a partnership with Uncle Sam risky. "Until we see how the pricing mechanism works, the rates the government is offering, and the expected returns, [we won't know] where the deals are," says Robert A. Eisenbeis, the chief monetary economist for Cumberland Advisors.

322 Another problem: Bankers are already complaining that they could be forced into big writeoffs if the prices for troubled assets remain too low. If the banks refuse to sign on, the Treasury program will tank. That's one reason why Obama plans to meet with the CEOs of JPMorgan Chase (JPM), Citigroup (C), and other banks on Mar. 27. So it will be critical that the bidding process narrows the gap between what buyers will pay for the assets and what banks will sell them for. The market is in a deep freeze now, in part, because the two sides don't agree on the value of the tainted mortgage assets. Investors, who don't want to overpay, think most mortgage assets are worth only around 20 cents to 30 cents on the dollar. But many banks argue that plenty of good mortgages have been knocked down to rock- bottom prices and they want 70 cents to 80 cents on the dollar; accepting less would lead to more ruinous write-offs. And if, as expected, U.S. accounting rulemakers meeting on Apr. 2 make it easier for the banks to avoid such write-downs, the banks may be even less willing to sell at a loss. Administration officials make clear they expect the banks to take the haircut given the economic stakes. Those that do poorly on the so-called stress tests currently under way may have little choice but to cooperate. If they don't, expect another market mood swing, this time to one of despair. With Theo Francis Business Exchange: Read, save, and add content on BW's new Web 2.0 topic network Preventing the Next Crisis The Obama Administration has proposed giving Treasury the authority to reorganize financial giants if their collapse threatens the economy, a more expedient approach than relying on bankruptcy courts. New York University economist Nouriel Roubini, credited with predicting the current crisis, says that such authority is long overdue. To read Roubini's blog post, go to http://bx.businessweek.com/bailout/reference/ Sasseen is Washington bureau chief for BusinessWeek.

323 Mar 26, 2009 Commercial Real Estate Bust Has Started: Access To TALF Just In Time? Overview: The delinquency rate on about $700 billion in securitized loans backed by office buildings, hotels, stores and other investment property has more than doubled since September to 1.8% in March 2009. Foresight Analytics in Oakland, Calif., estimates the U.S. banking sector could suffer as much as $250 billion in commercial-real-estate losses in this downturn. The research firm projects that more than 700 banks could fail as a result of their exposure to commercial real estate.(Calculated Risk) o March 26: Soros: U.S. commercial real estate will probably drop at least 30 percent in value, causing further strains on banks. o March 23: Under Geithner's new PPIP for toxic legacy assets, the government expands the $1 trillion TALF secured lending facility -initially created by the government to restart the market for new car loans, student loans and credit-card debt- to include legacy AAA CMBS o Feb 5: MIT "With the index already having fallen 22 percent in the current downturn, it now seems likely that this down market will be at least as severe as that of the early 1990s for commercial property," o Dec 22 WSJ: According to research firm Foresight Analytics LCC, $530 billion of commercial mortgages will be coming due for refinancing in the next three years with about $160 billion maturing in the next year. Credit is practically nonexistent and cash flows from commercial property are siphoning off--> industry lobbies to be included in TALF. o Dec 22 Bloomberg: U.S. commercial properties at risk of default could triple to around 7% if rental income from office, retail and apartment buildings drops by even 5 percent, a likely possibility given the recession, according to research by New York-based real estate analysts at Reis Inc. o FT Alphaville: With CMBS, as opposed to RMBS, when trouble does hit, it is much more sudden and sharp. The delinquency rate might not be expected to smoothly move higher, it should jump. And it will do so when the real pain begins to bite in the economy. o Banks' exposure to real estate: - At the end of Q2, Deutsche Bank held $25.1 billion worth of commercial loans. Morgan Stanley held $22.1 billion and Citigroup had $19.1 billion. Lehman held largest exposure with $40bn worth of commercial real estate assets--> A large part of its portfolio is a high-risk loan known as bridge equity made with Archstone, a metropolitan apartment developer, and most of the rest are floating-rate loans, which are riskier, according to a person who reviewed the offering.

324 - CRE and CMBS exposures will likely exacerbate credit problems at U.S. banks but not as much as RMBS (except those banks specializing in commercial real estate); - default rates on CMBS collateral could increase toward the historical average of 80bp, roughly double or triple the lowest point of the credit cycle; - lax underwriting standards could increase rates on bank CRE loans further; - recent valuation declines in the CMBS market imply near-catastrophic and rather - unrealistic credit conditions; - CMBS troubles should not reach the 1980s levels. (Fitch and Interest Rate Roundup) o Fitch August 1: 50% of CMBS outstanding are 2006/2007 vintages--> Borrowers would default on an average of 17.2% of securitized commercial mortgages over 10 years if U.S. economy dips into recession with 0.2% contraction in growth, compared with current very low default rates of 4% (i.e. +330%). o OCC Dugan, Feb 08: One third of regional banks have commercial real estate exposure of at least 300% of equity. So far, non-current loans have increased in the construction&development category to around 5%; non-residential buildings, multifamily buildings, and real estate loans not secured by property are set to follow suit. o Fitch: Since '05, interest-only loans and loans with high loan-to-value ratios implying unrealistic future rent expectations http://www.rgemonitor.com/687

325 26.03.2009 IS THE EU RUN BY A MADMAN?

Speaking in the European Parliament, a mentally unbalanced Topalanek accuses Obama of going down the road to hell. The Czech EU presidency is now turning into the disaster we have always expected. A day after losing a vote of no confidence in his national parliament, the Czech premier took the stage at the European Parliament in Strasbourg to launch a diplomatically disastrous attack on US president Barrack Obama over his stimulus programme. He said the attempt to borrow trillions would pave the road to hell. (While conservative economists inside and outside the US may agree with that view, it is nevertheless a different matter for the acting president of the EU to make such a statement, as one would expect it to reflect official EU position, which it is not.) FT Deutschland said in its news story that the comments underline doubt the Czech EU presidency, which runs until June, could be successfully completed. Wolfgang Proissl of FT Deutschland also produced a nice anecdote in a separate article. When Topolanek said the US had to finance its stimulus through the issue of bonds, a translation error produce the news headline that the US would finance its stimulus through the export of bombs. Flabberghasted Czech officials told everybody that he said “bonds, not bombs”. Global trade shrinks 20% since October – Speed of decline greater than during Great Depression The best authority on real time global trade data is the Netherlands CPB Institute, which yesterday published its January trade data. Global trade are now down 20% since October. This is not annualised but actual. In other words, global trade volumes are down by a fifth compared to pre-crisis levels. FT Deutschland quotes a CPB staffer as saying this is faster than during the Great Depression (the estimates there range from 25- 35% during 1929 and 1932).

326 This is only the beginning Says a warning from a group named “bank bosses are criminals” issued after claiming responsibility for vandalising the home of former RBS chief Fred Goodwin. Goodwin was publicly criticised for receiving £700000 annual pension after his bank had to be bailed out by the government with a £20bn capital injection. FT Deutschland also reports about other incidents, such as the French 3M chief Luc Rousselet, who is taken hostage by his own staff over dismissals. In France, uprising social frustration is used by trade unions to mobilise for protest actions and led some commentators to compare the situation with the French revolution. But a contagion throughout the Western World seems still considered as unlikely since welfare systems are capable of buffering intense social tensions. German tax presents German finance minister Peer Steinbrueck wants a temporary tax break for companies to support them through the crisis reports the FT Deutschland. Parts of the tax reform last year could be reversed as the finance ministry now works on provisions that allows a loosening the limits for tax deductibility of interest payments (which is currently limited to 1m and could be extended to 3m). Also strict rules for firms that acquire other companies to offset their losses against own tax liabilities could be relaxed. Industrial confederations and Christian Democrats called for relaxation of both rules for weeks but met resistance from Steinbrueck, who now explains his U-turn by saying that he does not want to appear bull-headed. EU should help CEE A Le Monde editorial argues that the EU has no option to be indifferent to what happens in Central and Eastern Europe. They are emerging countries that our economies were happy to invest and outsource our production to in the past. Today, as the crisis proceeds, money and production are repatriated from the CEEs, causing their currencies to depreciate and provoking a political crisis in some countries. The other EU states are economically so interlinked with the CEE that a crisis there has serious repercussions for the centre. Also politically, it is impossible to simply leave those countries to their own destiny in a crisis that was not of their own making. In the coming years the CEE will need money but also political consideration. DSK: Question about new reserve currency legitimate In a hearing of the parliamentary finance committee in Paris, IMF president Dominique Strauss Kahn said that it is absolutely legitimate to discuss the possibility of a new international currency (Le Monde). This is not a new question but the current crisis renews the interest in this question. He also said that he does not consider that the dollar ceases to be an international reserve currency. Even the Chinese don’t think that. A new chief of the Economic and Financial Committee Thomas Wieser, state secretary in the Austrian finance minister is to be become the next head of the Economic and Financial Committee, the influential committee that prepares the eurogroup and Ecofin meetings of finance ministers. FT Deutschland has this story, and points out that it is unusually for a non-G7 representation to fulfil this role, but Germany’s Jorg Assmussen was considered as too inexperience to be entrusted with this

327 role. Wieser replaces Xavier Muscat, who will return to Paris as Sarkozy’s economic adviser.

US New Home Sales Bankers are now talking about the green shoots of recovery because a few indicators have turned. When it comes to the US housing market, a critical element in the crisis, our favourite source Calculated Risk tells us that the February upturn in new home sales should not be exaggerated, nor confused with an upturn in prices. Also the upturn is so small that it is hardly visible on the chart – an eyetest as Calculated Risks puts it. Still the blogger expects new homes sales to bottom out this year, which suggest that prices could bottom out next year. Here is the eyetest chart.

In defence of the Geithner plan Yesterday, we summerised four highly negative comments about the Geithner plan. For balance, we thought it appropriate to highlight a few of the positive comments. Brad DeLong The most comprehensive defence of the plan comes from Brad DeLong. He makes the point companies cannot currently finance expansion because asset prices are excessively low due to higher risk and information discounts. The idea is to boost asset prices to the companies can expand once again. If the government buys up $1 trillion of financial assets, the private sector has to hold $1 trillion less of risky and information-impacted assets. He estimates that one would have to take $4 trillion out of the market to move asset prices to unfreeze credit markets. So the plan is not sufficient. “But the Fed is taking an additional $1 trillion of risky debt off the private sector's books and replacing it with cash through its program of quantitative easing. And there is the fiscal boost program. And there is a potential second-round stimulus in September. And there is still $200 billion more left in the TARP to be used in other ways.”

328 Nouriel Roubini Nouriel Roubini says he sees light at the end of the tunnel, except that he does not know whether it’s daylight, or the light of an oncoming train. But he was positive on the Geithner plan: He told the New York Times he liked that the government was finally stepping up to clear the toxic assets off the bank’s balance sheet and that private capital would come in to make a market for it. “Having five people bid on a toxic asset, rather than a clueless government, will ensure that the government doesn’t overpay… People say, ‘the government is putting in 95 cents on the dollar, so why not put 100,’ to do it all by itself. It’s because private-sector participants have the incentive to get the best price.” Jeff Frankel, too, believes that the Geithner plan should be given a chance for similar reasons, as those of Roubini and DeLong. In the end, the argument boils down to the question how to judge the importance of the private sector component. Without it, the plan is similar to the TARP programmes, which most of these commentators have condemned as being ineffective. (¿es también cuestión de tiempo?)

329

Economy March 26, 2009 Geithner Affirms Dollar After Remarks Send It Tumbling By ANAHAD O’CONNOR Treasury Secretary Timothy F. Geithner on Wednesday said that the dollar would remain the world’s dominant reserve currency for some time to come, clarifying earlier remarks that sent the dollar tumbling. “The dollar remains the world’s dominant reserve currency,” Mr. Geithner said after a speech in Midtown Manhattan to the Council on Foreign Relations. “I think that’s likely to continue for a long period of time. Mr. Geithner’s comments came in response to a question regarding a proposal by Zhou Xiaochuan, the governor of the People’s Bank of China, that suggested a possible replacement for the dollar as a global reserve currency. The proposal called on the International Monetary Fund to increase the use of "Special Drawing Rights" — a basket of currencies made up of the euro, yen, pound and dollar that has served as a reserve asset. The dollar plunged earlier in the morning after Mr. Geithner, in response to another question, said China’s suggestion “deserves some consideration,” though he added that he had not read the proposal. The dollar rebounded later on Mr. Geithner’s clarification. Still Mr. Geitner said that the “evolution of the dollar’s role in the system depends really primarily on how effective we are in the United States in getting not just recovery back on track, our financial system repaired, but we get our fiscal position back to the point where people will judge it as sustainable over time.” “As a country,” he added, “we will do what’s necessary to make sure we’re sustaining confidence in our financial markets and in — and in the productive capacity of this economy and our long-term fundamentals.” In his speech before the group, Mr. Geithner pressed the case for expanding the government’s ability to take over and restructure ailing institutions that threaten the broader financial system. Mr. Geithner said that the government needed the expanded powers in order “to help ensure that this country is never again confronted with the untenable choice between meltdown and massive taxpayer bailouts.” “One of the key lessons of the current crisis is that destabilizing dangers can come from financial institutions besides banks,” Mr. Geithner said in his remarks, “but our current regulatory system provides few ways to deal with these risks.” Mr. Geithner focused his remarks on the Obama administration’s plan to free the nation’s financial institutions from the toxic mortgage-related securities that have poisoned the economy.

330 On Tuesday, Mr. Geithner, testifying before the House Financial Services Committee, proposed expanding the government’s power to give it more control over financial institutions, like insurance companies, that are in trouble and big enough to destabilize the broader financial system. With such authority, the administration argued, rather than having to spend $170 billion to bailout the American International Group, the government could have put the insurance company into receivership or conservatorship and regulators would have been able to unwind it slowly. Atop A.I.G. insurance companies “is an almost entirely unregulated business unit that took extraordinary risks to generate extraordinary profits,” Mr. Geithner said Wednesday. “And when this unit’s derivative contract losses pushed A.I.G. to the brink of failure last fall, the entire financial system was endangered.” “The legislation that I believe we need would help us deal with a similar case in the future,” he said. The proposal would extend power the government has long had over banks to insurance companies like A.I.G., investment banks, hedge funds, private equity firms and any other kind of financial institution considered “systemically” important. That would let the government for the first time take control of private equity firms like Carlyle or industrial finance giants like GE Capital should they falter. If Congress approves such a measure, it would represent one of the biggest permanent expansions of federal regulatory power in decades. But scores of questions remained about how the authority would actually work, and industry experts cautioned that it would only be one step in a broad overhaul of financial regulation that President Obama and Congress were beginning to map out. Mr. Geithner’s speech on Wednesday is sandwiched between hearings before the House Financial Services Committee. On Thursday, Mr. Geithner is scheduled to return before the committee. “Tomorrow, I will lay out the administration’s broad framework for dealing with the kind of systemic risk that A.I.G. posed,” Mr. Geithner said. “The framework will significantly raise the prudential requirements, once we get through the crisis, that our largest and most interconnected financial firms must meet in order to ensure they do not pose risks to the system.” “In the coming weeks, we will take additional steps, among them, proposing new and stronger rules to protect American consumers and investors against financial fraud and abuse.” He ended with a plea for cooperation. “The world needs to see America come together with a commitment that is commensurate with the deep gravity of the problem,” Mr. Geithner said. “The American people need confidence that the resources they are providing will be used wisely and in ways that will benefit them.”

331

Las turbulencias de la economía hacen caer a tres gobiernos de Europa del Este Las primeras señales de alarma política por la crisis de los mercados se dejan notar en Rumania, Hungría y República Checa CRISTINA GALINDO | Enviada especial - Varsovia - 25/03/2009 Primero fue Letonia, después Hungría y, ahora, le toca el turno a República Checa. La crisis económica está provocando la caída de los Gobiernos del Este de la Unión Europea (UE), acorralados por las turbulencias financieras y las protestas populares. Los elevados déficit públicos y las abultadas deudas externas de muchos de los países de la región no dejan margen a sus Ejecutivos, ya de por sí bastante inestables políticamente, para elevar el gasto y las inversiones y contrarrestar los efectos de la crisis. Los analistas ya comparan lo que está pasando en el Este europeo, muy dependiente de las inversiones extranjeras y de las exportaciones al Oeste, con las crisis sufridas en América Latina en los ochenta y en Asia en los noventa, cuando el Fondo Monetario Internacional (FMI) tenía que salir al rescate de esas economías, mientras sus Gobiernos caían uno tras otro. Rumania se ha convertido hoy en el tercer país de la zona que recibe ayuda de urgencia del Fondo, en colaboración con la UE y el Banco Mundial, en forma de préstamos por 20.000 millones de euros. Hungría ha recibido ayudas por otros 25.000 millones y la pequeña Letonia, por otros 10.000 millones. En la cumbre europea celebrada la semana pasada, la UE duplicó el límite máximo del mecanismo comunitario de ayuda financiera a las economías del Este hasta llegar a los 50.000 millones. Mientras algunos Gobiernos piden ayuda, sus rivales políticos piden elecciones adelantadas. "Lo que ha derrumbado al Gobierno checo no ha sido en realidad la crisis económica, sino que la oposición quiere ahora perjudicar de forma especial al partido de (el primer ministro Mirek) Topolanek de cara a las elecciones europeas de junio", afirma Jiri Pehe, director de la Universidad de Nueva York en Praga, y uno de los analistas más reputados del país, que además preside este semestre la Unión Europea. La corona checa caía este miércoles, un día después de que el partido del primer ministro, Mirek Topolanek, que llevaba meses gobernando en minoría, perdiera una moción de censura presentada por la oposición socialdemócrata por su gestión de la situación económica. La República Checa se enfrenta a la crisis con mayor solidez, en principio, pero si algo está demostrado este tsunami financiero es que nadie está a salvo de la recesión. "Creo que un equipo de expertos gobernará el país hasta las próximas elecciones, previstas para 2010; adelantar las elecciones en complicado", añade Pehe. Otra víctima es el primer ministro húngaro , en el ojo del huracán desde mucho antes del inicio de esta crisis porque su gestión no consiguió que el país creciera al ritmo de sus vecinos, ni en los buenos tiempos. Ahora, Ferenc Gyurcsany ha decidido dimitir porque considera que puede ser un obstáculo para la recuperación económica. Su partido, el socialista, tiene la minoría en el Parlamento, y tendrá que buscar un sucesor que convenza a los dos principales partidos de la oposición. El presidente del país, Laszlo Solyom, ha pedido hoy que se adelanten las elecciones, previstas para la primavera de 2010, para intentar evitar la bancarrota del país.

332 Pero el récord de la inestabilidad está en manos de Letonia, que acaba de formar su 15º Gobierno (una coalición de seis partidos) desde principios de los noventa. El república báltica, que creció un 50% entre 2004 y 2007, es el país del Este más afectado por la crisis: su producto interior bruto caerá un 12% este año y el paro amenaza con llegar al 50% de la población activa. Son las primeras señales de alarma. El tsunami financiero arrasa el Este y sus ciudadanos parecen cada día más indignados. El director gerente del FMI, Dominique Strauss-Kahn, ya advirtió de que la crisis amenaza con provocar disturbios sociales, que ya se han producido de forma considerable en Letonia, Lituania, Bulgaria, República Checa y Hungría.

333 OPINIÓN TRIBUNA: MIGUEL BOYER SALVADOR En medio de la crisis: la sequía de crédito MIGUEL BOYER SALVADOR 26/03/2009 Nos hallamos en un punto crucial de la crisis: la situación en la que la concesión de créditos se paraliza o, incluso, se contrae. Lo más tóxico para todos sería prolongar la contracción del crédito bancario El plan del Tesoro de EE UU tiene el mérito de poner manos a la obra En un estudio famoso de junio de 1983, Ben Bernanke -el actual presidente de la Fed- demostró que la Gran Depresión de 1929 no tuvo la profundidad y la duración desastrosa que conocemos por falta de liquidez, como era la tesis de Friedman, sino por la contracción del crédito bancario a los empresarios y a los particulares. Esto, según Bernanke, alargó la crisis en dos años más de lo que podía haber durado. En consecuencia, desde 1930 hasta 1933 y en cifras acumuladas, el PIB norteamericano cayó un 27% -lo mismo que el empleo y el consumo-, la inversión un 77% y la Bolsa un 82%. Quebró una cuarta parte de los bancos americanos y Roosevelt, apenas llegado a la presidencia, tuvo que declarar una "vacación bancaria" (suspensión del reembolso de los depósitos) en marzo de 1933, e inyectar inmediatamente 1.000 millones de dólares para recapitalizar a las entidades. Casi nadie piensa seriamente que la presente recesión puede alcanzar una caída de tal magnitud. Es evidente, sin embargo, que la dimensión de la crisis financiera y el efecto depresivo de la caída del valor de los activos mobiliarios e inmobiliarios sobre el consumo, la inversión y el empleo, deben tomarse con la mayor preocupación y combatirse con los instrumentos más potentes que nos dan la experiencia y la teoría económica. Para frenar la caída, y, luego, impulsar la demanda agregada -ahora casi en caída libre- se han puesto en juego medidas de política presupuestaria (gasto de inversión, reducción de algunos ingresos fiscales, ayudas a los sectores más dañados), enérgicamente en Estados Unidos, modestamente en Europa y, en particular, en España. Asimismo, los bancos centrales han ido aumentando la liquidez y bajando los tipos de interés. Entre los grandes bancos centrales -la Fed, el Banco de Inglaterra, el Banco de Japón- el Banco Central Europeo se ha destacado notablemente por su falta de agudeza y perspicacia en el análisis de la situación, subiendo los tipos de interés todavía en julio de 2008 y, declarando, ¡a mediados de septiembre pasado!, "que había unanimidad entre los gobernadores de su consejo en no bajar el tipo de interés". Es lamentable, porque las medidas monetarias tardan muchos meses en hacer todo su efecto y hay que utilizarlas lo antes posible. Afortunadamente, por el impacto de la caída del grande y centenario banco norteamericano Lehman Brothers y por los problemas que siguieron, el BCE se puso en marcha y ha resuelto en gran parte la falta de liquidez en Europa. Sin embargo, la liquidez abundante y los bajos tipos no resuelven el problema, crucial en esta fase de la crisis, que es el de facilitar y reactivar el crédito bancario. La interpretación de Bernanke sobre la tremenda responsabilidad del credit crunch en la profundización de la Depresión de 1929, es una advertencia que no debemos olvidar ni un momento.

334 Me parece tan importante que no he parado de recalcar -desde una entrevista en Abc el 26 de octubre de 2008, hasta otra en La Vanguardia el 8 de este mes- que es imprescindible y urgente aliviar a los bancos de una parte considerable de los activos dañados que figuran en su balance. El riesgo en que incurrieron aquéllos, con créditos dados en el pasado sobre garantías ahora devaluadas, crece con el tiempo y es una rémora que puede seguir paralizando el flujo necesario de nuevos préstamos. Las fórmulas para aliviar la "infección" de los activos tienen que descansar, ineluctablemente, en que el Estado asuma una parte de las pérdidas implícitas y sean cuales sean las soluciones adoptadas, sus defectos serán menos nocivos que un alargamiento del periodo de sequía de créditos, que sería lo más "tóxico" para toda la economía. Apenas enviadas las líneas anteriores a EL PAÍS, se ha conocido un plan del Tesoro de Estados Unidos para afrontar el fundamental problema de los activos "tóxicos" con un nuevo enfoque, tras los fracasados intentos del anterior secretario Paulson. Como el programa constituye una iniciativa de "manos a la obra", que parte de consideraciones semejantes a las que yo hacía en lo escrito, me ha parecido coherente añadir unos comentarios a la propuesta, conocida el martes pasado. En síntesis, el Programa (PPIP) consiste en asociar dinero proveniente de ingresos privados a otra cantidad, igual, aportada por el Tesoro Público, para dotar de fondos propios a un vehículo inversor, que comprará activos tóxicos de los bancos. Sobre esta base, la Corporación Federal de Aseguramiento de Depósitos otorgará préstamos al vehículo, en cantidad de seis veces lo aportado como fondos propios. El dinero movilizado así podrá llegar a 500.000 millones de dólares (extensibles a un billón de dólares). El procedimiento para la compra de activos será el de subasta, en la que el FDIC pujará por los activos que ofrezcan los bancos y, en el caso de que a éstos les convengan los precios, el vehículo los adquirirá. El método planteado por el secretario del Tesoro -Geithner- tiene importantes ventajas si es bien acogido por los inversores. Si no es así, no quedaría más solución que la asunción total del coste por el Estado. Por una parte, resolvería la cuestión del valor actual de los activos a comprar con un criterio de mercado, menos cuestionable que el de una transacción bilateral opaca entre banco y funcionarios de Gobierno. Por otro lado, elimina el intervencionismo político en los bancos -como ocurre con las recapitalizaciones vía acciones-, y reparte una parte (mínima, es cierto) del coste y del beneficio a los inversores privados. El PPIP parece haber sido bien recibido por Wall Street y por importantes inversionistas. Los que se han precipitado a poner el programa como "chupa de dómine" han sido el Nobel Stiglitz y el Nobel Krugman (novel, por cierto, en economía española, a pesar de sus viajes y de los buenos amigos que tiene aquí). El fondo de sus protestas es la indignación por una ayuda a los bancos, a costa de los contribuyentes. Es muy respetable, que Stiglitz y Krugman tengan siempre, como preocupación, la desigualdad entre la masa del pueblo americano y la clase alta, que se ha enriquecido notablemente en las últimas décadas. Pero me sorprende que olviden la inmensa miseria que la catástrofe bancaria y el crédito crash causaron en las clases más desfavorecidas de EE UU -y de Europa- entre 1929 y 1933. La prioridad ahora, es que no se repita tal desastre.

335 En EE UU hay una antipatía congénita de la mayoría de los ciudadanos por los bancos, según me explicó un Secretario del Tesoro, como corresponde a un pueblo de pequeños y medios empresarios. Me añadió que es casi imposible conseguir que el Congreso apruebe una ley que ayude o que parezca beneficiar a los bancos. Quizá por eso Geithner ha diseñado su plan de modo que no tenga que pasar por el cedazo parlamentario. Sería una enorme desgracia que un populismo demagógico e irresponsable y la repulsión que produce una ínfima -pero escandalosa- minoría de golfos financieros impidieran acortar y atenuar el sufrimiento que la crisis económica está infligiendo, principalmente a la población trabajadora.

Miguel Boyer Salvador es ex ministro de Economía y Hacienda.

336 WSJ Blogs Mar 25, 2009 1:35 PM

REAL TIME ECONOMICS ECONOMIC INSIGHT AND ANALYSIS FROM THE WALL STREET JOURNAL.

ECONOMISTS REACT: ‘HAS HOUSING HIT BOTTOM?’ Posted by Phil Izzo

Economists and others weigh in on the unexpected increase in new-home sales. Has housing hit bottom? It is much too soon to make this call. Recent housing numbers were influenced by weather. December and January were colder than normal in the Northeast and Midwest, and February was warmer than normal in the Northeast, and about normal in the Midwest. Temperature swings will swing the housing numbers, and the seasonal adjustment factors will augment these swings. On top of this, February was the eighth driest February in the 1895—2009 period, according to the National Climatic Data Center, the government agency within NOAA that monitors climate. Drier than normal weather during the winter months can also make the housing numbers spike. One key statistic pointing to “better-times-ahead,” however, bears watching. Last week, the Census Bureau reported that single-family housing permits (which are not influenced by weather as much as other housing numbers) increased 11.2% in February, but today, it revised this increase to 16.1%. Until we get another two positive readings on single-family housing permits, at best we can say that housing has likely hit an inflection point. An inflection means that the market is shrinking, but not in collapse. –Patrick Newport, IHS Global Insight Sales remain incredibly weak, but, as with the existing sales numbers, we are prepared to hazard the view that the post-Lehman meltdown is now over and the market is stabilizing. That’s not the same as a recovery, but it is better than continued declines in sales. –Ian Shepherdson, High Frequency Economics Overall, this report is better than we had anticipated, continuing a pattern of the February housing data exceeding expectations (recall that existing home sales bounced by 5% and housing starts climbed by 22%). To be sure, the improved data last month followed months of horrendous housing data, as activity fell off of a cliff following last fall’s financial upheaval. The pickup in February also came on the heels of an especially weak January performance, suggesting that the January-February swing may have reflected in part a weather effect. Still, the fact that starts, permits, and home sales rebounded in February despite still-challenging economic conditions suggests that, at the very least, the pace of decline in housing demand may be abating. It is clearly far too early to call a bottom in the housing market, especially given the deterioration in the labor market, but the February data have allayed some fears that the housing market would continue to freefall. –Omair Sharif, RBS Greenwich Capital Even with the number of homes available for sale down another 2.9%, a twenty-second consecutive decline to a seven-year low, the months” supply of unsold new homes only moderated to 12.2 months from the record high 12.9 months hit in January. Around 5 to 6 months of supply would be consistent with a balanced market, so inventories are still

337 completely out of hand heading into the crucial spring selling season. There’s little chance that the marginal bounce off the prior record low in single-family housing starts in February (the larger gain in overall starts was almost entirely in the volatile multi-family component) can be extended with inventories so bloated. –Ted Wieseman, Morgan Stanley New home sales in February staged their largest increase in over a year, increasing 4.7% to an annual rate of 337,000. Price concessions may be an important factor bringing buyers to the market last month; both median single-family home prices and average single-family home sales prices were down by record amounts in February. Almost half of homes sold last month were under $200,000; in the same month last year only 33% of homes sold were in this price range. –Michael Feroli, J.P. Morgan Chase The rebound in the number of U.S. new home sales may just be monthly volatility rather than a sign that housing activity has stabilized. New home sales fell by a huge 13.2% in January meaning that the 4.7% rise in February is nothing to get too excited about. Sales are still a frightening 75% below their peak. Admittedly, the figures do suggest that the rebound in February’s existing home sales (figures were released on Monday) was not solely due to a surge in sales of repossessed properties –Paul Dales, Capital Economics Federal Reserve Chairman Ben Bernanke talked about early signs of some “green shoots” appearing in the economy in his recent 60 Minutes interview. This week we are seeing some further positive notes in form of better-than-expected new and existing homes sales and durable goods orders for the month of February. These, and other positive, or even “less bad”, signs are a welcome change of tune following the severe economic downdrafts extending from autumn 2008 into early 2009. However, just as green shoots can get buried by springtime snows, the small upside surprises that we have seen may yet be overwhelmed by ongoing downward momentum in business investment, labor markets, durable goods consumption, and export markets. The U.S. economy remains many months away from stability and is even farther away from sustained growth. –Robert A. Dye, PNC Only a small rise in sales after 6 consecutive monthly declines cumulating to -36%. Sales of previously-owned homes appear to be bottoming (again! After Sep-Nov downdraft), and the Mortgage Bankers Association index of mortgage applications for home purchase has stabilized in recent weeks. Nonetheless, one month’s increase in sales in newly-built homes is not enough to call a trough in this series. –Alan Levenson, T. Rowe Price New-Home Sales Rise as Prices Fall Revisions Offset Durable-Goods Orders Climb MARCH 25, 2009, 2:06 P.M. ET WASHINGTON -- New-home sales climbed for the first time in seven months during February, another favorable sign for the housing sector, but the data also showed prices tumbled. Separately, durable-goods orders unexpectedly climbed during February, but demand in the prior month was revised down deeply, an adjustment countering the idea of a rebound in the slumping manufacturing sector. Sales of single-family homes increased by 4.7% to a seasonally adjusted annual rate of 337,000, the Commerce Department said Wednesday. January new-home sales plunged 13.2% to an annual rate to 322,000; originally, the government said January sales fell 10.2% to 309,000. http://online.wsj.com/article/SB123798406285137541.html

338 http://www.calculatedriskblog.com/2009/03/new- home-sales-is-this-bottom.html WEDNESDAY, MARCH 25, 2009 New Home Sales: Is this the bottom? Earlier today I posted some graphs of new home sales, inventory and months of supply. A few key points: Please do not confuse a bottom in new home sales with a bottom in existing home prices. Please see: Housing: Two Bottoms New home sales numbers are heavily revised and there is a large margin of error. Regarding the sales for February, the Census Bureau reported: This is 4.7 percent (±18.3%) above the revised January rate of 322,000, but is 41.1 percent (±7.9%) below the February 2008 estimate of 572,000. The "rebound" in February was very small, and this is the worst February since the Census Bureau started tracking new home sales in 1963.

This graph shows the February "rebound". You have to look closely - this is an eyesight test - and you will see the increase in sales (if you expand the graph). Not only was this the worst February in the Census Bureau records, but this was the 2nd worst month ever on a seasonally adjusted annual rate basis (only January was worse). Still, I believe there is a good chance new home sales will bottom in 2009. See Looking for the Sun. Because the data is heavily revised, we won't know until many months after the bottom occurs. Also, as Dr. Yellen noted earlier, we need to distinguish between growth rates and levels. Any bottom would be at a very grim level, and any recovery would probably be very sluggish because of the huge overhang of existing homes (especially distressed homes).

339 It is theoretically possible for new home sales to go to zero (very unlikely), and it is also possible that January was the bottom. We just don't know ... Anecdotally, I just spoke to two SoCal builders - both told me sales had picked up in the last week or so (March). Of course sales in SoCal have been close to zero, so this is like a few rain drops to a thirsty man lost in a desert - it seems like a flood! For a healthy market, the distressing gap between new and existing home sales will probably close.

For a number of years the ratio between new and existing home sales was pretty steady. After activity in the housing market peaked in 2005, the ratio changed. This change was caused by distressed sales - in many areas home builders cannot compete with REO sales, and this has pushed down new home sales while keeping existing home sales activity elevated. To close the gap, existing home sales need to fall or new home sales increase - or a combination of both. This will probably take several years ... If housing bottoms (or even if the decline in residential investment just slows), this will remove a significant drag on GDP growth. This would be a positive sign for the economy. The following table, from Business Cycle: Temporal Order, shows a simplified typical temporal order for emerging from a recession. When Recovery Typically Starts

Significantly Lags End of Lags End of Recession During Recession Recession

Residential Investment, Equipment &

Investment Software Investment, non-residential Structures PCE Unemployment(1)

340 There are a number of reasons why housing and personal consumption won't rebound quickly, but they will probably bottom soon. And that means the recession is moving to the lagging areas of the economy. But we know the first signs to watch: Residential Investment (RI) and PCE. (1) In recent recessions, unemployment significantly lagged the end of the recession. That is very likely this time too. Finally, even though some signs of a bottom might emerge (housing starts, new home sales, auto sales), it is worth repeating that any recovery will probably be very sluggish. Here are a few key reasons: house prices are still too high, there is too much housing inventory (especially distressed properties), households have too much debt and need to improve their balance sheets, the recession is global, and the Obama administration has chosen a less than optimal (and very expensive) approach to fixing the financial system.

Tp be Continued in: http://www.calculatedriskblog.com/2009/03/mauldin-on-housing.html

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Boletín de Universia-Knowledge@Wharton http://www.wharton.universia.net 25 Marzo - 7 Abril, 2009 Los hedge funds vuelven al punto de mira de los reguladores Hasta el momento los fondos de inversión especulativos (hedge funds) han evitado la estricta regulación a la que están sometidos otros fondos. Pero tal vez dicha situación haya llegado a su fin a medida que la administración Obama y el Congreso buscan el modo de evitar otra crisis financiera. Aunque aún no está muy claro cuál ha sido el papel desempeñado por los fondos de inversión especulativos en la crisis actual, diversos profesores de Wharton creen que los malos resultados obtenidos por el sector, así como la demanda de mayor transparencia por parte de inversores y reguladores, provocarán grandes cambios en el modo en que operan estos secretos fondos de inversión. Es muy probable que la preocupación sobre los hedge funds haya aumentado tras la publicación el 18 de marzo en Wall Street Journal de un artículo en el que se informaba que la aseguradora AIG podría dedicar el dinero de los contribuyentes a fondos de inversión especulativos que apostaron por la caída del mercado inmobiliario. Tal y como se explicaba en dicho artículo, al mismo tiempo que el gobierno lucha para resucitar el mercado de la vivienda podría estar gastándose miles de millones de dólares en recompensar hedge funds que se beneficiaron de la caída del mismo. Hace tiempo que los numerosos detractores quieren que se tomen enérgicas medidas reguladoras en relación con los fondos de inversión especulativos, sosteniendo que tanto reguladores, inversores como el público en general saben muy poco sobre cómo las influencias de este sector sobre los mercados financieros. Pero hasta el momento el sector ha conseguido mantenerse a salvo de todo intento regulador, el más importante en el año 2005, cuando la Securities and Exchange Commission (SEC) propuso el registro obligatorio de los fondos en la agencia, así como una mayor supervisión. En 2006 un Juzgado Federal dictaminó que la SEC no tenía autoridad para imponer semejante medida. Pero cada vez son más numerosas las voces que claman regulación. El 29 de enero los senadores Carl Levin, demócrata de Michigan, y Charles E. Grassley, republicano de Iowa, introducían una propuesta de ley que otorgaría a la SEC autoridad para regular los hedge funds. Grassley sostiene que el clima político ha cambiado totalmente de dos años para acá, cuando se intentó aprobar una ley similar que no llegó a ninguna parte. Los burócratas de la administración Obama también apoyan una regulación más estricta, aunque nadie cuál será el grado de severidad. Según algunas noticias publicadas hace unas semanas, el plan general de esta administración para endurecer la regulación del sector financiero incluiría una mayor supervisión de los hedge funds por parte de la Reserva Federal. Reglas más estrictas también podría implicar mayor transparencia de los fondos. Es muy posible que una mayor regulación acabe limitando la capacidad de los hedge funds de endeudarse para sobrealimentar sus apuestas, o incluso frenando algunas inversiones de alto riesgo. La idea principal es asegurarse de que las actividades de estos fondos de inversión especulativos tengan consecuencias negativas únicamente sobre sus inversores, no sobre

342 pobres inocentes. Y parece ser que cualquier regulación se ira aprobando por etapas; inicialmente se mejorará la transparencia y luego se irán imponiendo nuevas normas a medida que se vayan detectando nuevos obstáculos. Según estimaciones del sector, 10.000 fondos de inversión especulativos controlan cerca de 1,5 billones de dólares en activos. Los hedge funds crecieron de manera espectacular en las últimas dos décadas a medida que los inversores buscaban rendimientos superiores a los del mercado, pero ahora cientos de fondos han perdido dinero y desaparecido, y los inversores pretenden recuperar su dinero en otros fondos. “El sector de los fondos de inversión especulativos está en estos momentos desvaneciéndose”, afirma Thomas Donaldson, profesor de Derecho y Ética Empresarial en Wharton. “Estamos viendo un sector cuya burbuja ha explotado”. “El año próximo veremos grandes cambios en la regulación”, añade el profesor de Finanzas de Wharton Richard Marston refiriéndose a la supervisión de todo el sector financiero, incluyendo los hedge funds. “No me importa en absoluto que los ricos de Palm Beach se queden desplumados… me importa que las empresas de Filadelfia sufran porque los fondos de inversión especulativos hayan desencadenado el pánico en los mercados financieros. Esta vez no lo han hecho. Fueron los bancos. Pero la próxima vez tal vez sean los hedge funds”. En 2008 el fondo de inversión especulativo promedio tuvo pérdidas del 20%. Si queremos ser optimistas, dichas pérdidas son sólo la mitad de las obtenidas por el mercado de valores de Estados Unidos. No obstante, resulta bastante molesto para inversores que tienen en mente el objetivo original de los hedge funds: ganar dinero incluso cuando el resto de mercados pierde. 2008 fue el segundo año con resultados negativos para los fondos de inversión especulativos; el primero fue 2002, con un 1,45% de pérdidas. El profesor de Finanzas de Wharton Marshal E. Blume señala que muchos hedge funds han desaparecido durante los últimos dos años después de haber sido virtualmente exterminados, y por tanto los resultados de los supervivientes dan una imagen mucho más positiva de la realidad. Según un estudio, cerca de 700 fondos desaparecieron en los tres primeros cuatrimestres de 2008, un incremento del 70% en comparación con el año previo. Algunas proyecciones hablan de la desaparición de 1.000 fondos al final del año, en otras palabras, el 10% del sector. “Existe un gran sesgo post-selección en los rendimientos de los hedge funds”, dice Blume. “Los fondos de inversión especulativos que fracasaron no están incluidos en esas cifras de resultados”. Errores garrafales de política Para ser justos, parte de las pérdidas de 2008 del sector de los fondos de inversión especulativos deberían ser atribuidas a errores garrafales de política federal en respuesta a la crisis bancaria, sostiene el profesor de Finanzas Richard J. Herring. Uno de esos errores garrafales ha sido, en su opinión, la decisión el pasado septiembre de permitir que Lehman Brothers se precipitase al vacío, lo cual hizo temer la llegada de más pérdidas e hizo caer el precio de los valores. Los hedge funds también se vieron perjudicados, señala Herring, por una prohibición el pasado otoño relacionada con las ventas en corto, esto es, apostar que los mercados van a caer, una práctica clave en la estrategia de inversión de muchos fondos. “Con la prohibición de vender en corto, la liquidez de varios mercados simplemente se evaporó”. Aunque posiblemente los hedge funds no sean los culpables directos de la actual crisis, hace tiempo que a muchos expertos les preocupa que estos fondos puedan desencadenar una crisis mundial. La primera alarma saltaba en 1998 con el colapso del hedge fund de Connecticut llamado “Long-Term Capital Management”, que había realizado complejas apuestas sobre el

343 precio de los bonos. Para evitar un tsunami financiero, la Reserva Federal organizó un grupo de grandes bancos para hacerse cargo de los activos de LTCM. “No eran altruistas”, dice Marston acerca de los bancos rescatadores. “Estaban salvando su propio pellejo. Es el motivo principal por el que los hedge funds deben supervisarse”. Aunque la legislación actual no obliga a la inscripción en la SEC de los fondos de inversión especulativos, muchos lo hacen porque sus inversores institucionales así lo solicitan. Las firmas registradas representan cerca del 70% de los activos de los hedge funds. Como únicamente están abiertos a gente pudiente e inversores institucionales, los hedge funds han disfrutado durante mucho tiempo de cierta excepcionalidad, no estando sujetos a los requisitos de transparencia o la regulación aplicable a los fondos de inversión, fondos que cotizan, rentas vitalicias u otras inversiones abiertas al público en general. Asimismo los fondos de inversión especulativos disponen de más opciones de inversión, como por ejemplo vender en corto, con apalancamiento o hacer apuestas sobre materias primas y derivados, estrategias en muchos casos no permitidas para el resto de fondos. La teoría es que los hedge funds se circunscriben a los inversores que pueden permitirse grandes riesgos. “No creo que deba haber una regulación que impida que inversores bien informados pierdan dinero”, dice Blume. Pero la actual crisis financiera ha dirigido el foco de atención hacia el riesgo sistémico, cuando todo el sistema financiero sufre las actividades de un pequeño grupo de jugadores, señala Blume. En los actuales mercados financieros, muy dinámicos, todo está conectado con todo lo demás. “Lo más preocupante es que grandes cantidades de capital pueden contribuir al riesgo sistémico y a recesiones sistémicas. Es un preocupación muy válida… los hedge funds disponen de enormes cantidades de dinero”. Si las apuestas de los fondos de inversión especulativos son capaces de enturbiar los mercados, pueden perjudicar a pobres inocentes. Marston señala que las donaciones de la universidad y los planes de pensiones se han convertido en grandes inversores en hedge funds, lo cual supone que cualquier fallo podría hacer daño a gente inocente. Marston citaba un estudio que muestra que la universidad estadounidense promedio había dedicado el 15% de su cartera de inversiones a “inversiones alternativas”, partida que incluye fondos de inversión especulativos otros fondos especialmente arriesgados. Tal y como explica Christopher C. Geczy, profesor adjunto de Finanzas de Wharton, los hedge funds pueden ser muy arriesgados para los inversores, pero no existe evidencia de que hayan desempeñado un papel protagonista en la actual crisis financiera. “A diferencia de lo que cree la gente, los hedge funds no han sido los causantes de esta crisis”, dice. Marston y Blume están de acuerdo. “No creo que los hedge funds hayan sido la causa de esta debacle actual”, señala Blume echándole más bien la culpa a la presión del gobierno para fomentar la propiedad de la vivienda, algo que a su vez fomentó hipotecas entre personas con poca capacidad crediticia. Dichas hipotecas fueron agrupadas en valores y estos valores vendidos a inversores de todo el mundo; el precio de dichos valores cayó al vacío cuando los propietarios empezaron a retrasarse en los pagos de sus mensualidades. “Los hedge funds compraron parte”, dice. “Si los hedge funds pierden dinero no hay problema. El problema es cuando los bancos pierden dinero”. En opinión de Marston, los bancos de inversión tienen mucha más parte de culpa en la actual crisis financiera. Insatisfechos con los beneficios obtenidos con sus actividades tradicionales – como fusiones y adquisiciones o suscripción de valores-, en los últimos años los bancos de inversión actuaron como sí ellos mismos fuesen fondos de inversión especulativos, realizando apuestas con apalancamiento muy complejas en sus propias cuentas, explica Marston.

344 Podría haber sido de gran utilidad que los reguladores hubiesen dispuesto de más información sobre las posiciones amasadas por los hedge funds, añade Blume, pero los reguladores sabían que los bancos estaban creando y vendiendo productos estructurados basados en hipotecas y otros préstamos arriesgados. “Si hubiesen tenido más información sobre los fondos de inversión especulativos, ¿habría cambiado algo? Probablemente no”. La actual estructura reguladora no trata muy bien el riesgo sistémico, señala Blume, principalmente porque la SEC, otras agencias gubernamentales y los propios entes reguladores del mercado de valores tradicionalmente se han centrado en proteger a los inversores individuales, no a supervisar el funcionamiento general de los mercados financieros. “Incluir en esta categoría a los hedge funds no contribuirá en absoluto a resolver el riesgo sistémico porque a la SEC no le preocupa este riesgo”, dice Blume. “Aquí es donde nos introducimos en nuevos terrenos. Por definición, si te preocupa el riesgo sistémico deberás asignar dicha misión a una organización, y en estos momentos no existe esa organización. Es más, habría que hacerlo a nivel mundial. Estados Unidos es poco propenso a ceder parte de su soberanía a favor de entes extranjeros… La actual estructura es por tanto inadecuada. No estoy seguro de hacia dónde nos dirigimos”. En Washington se están discutiendo varias ideas; desde simplemente fomentar la autoridad de los reguladores ya existentes hasta conceder poderes a la Reserva Federal en temas de regulación. Se habla incluso de crear una nueva “superagencia”. El diputado demócrata por Massachussets Barney Frank, que dirige el Financial Services Committee, quiere hacer a la Reserva Federal responsable de proteger la estabilidad del sistema financiero, con nuevos poderes para recabar información sobre hedge funds, aseguradoras, bancos de inversión y otros entes. Parece ser que la administración Obama quiere mostrar progresos reales en esta materia durante la reunión de abril del G-20. Los burócratas del gobierno han dado la bienvenida a las recomendaciones para una regulación más estricta propuestas en un informe del pasado año realizado por un comité internacional liderado por Paul A. Volker, ex presidente de la Reserva Federal que en la actualidad es asesor económico de Obama. El efecto Madoff Incluso sin una nueva regulación, es muy posible que el sector cambie. De hecho ya está cambiando: para retener a los inversores muchos fondos han recortado sus comisiones. Lo normal era un 2% sobre los activos gestionados y un 20% sobre los beneficios. “Cada vez hay más gente que habla de las altísimas comisiones que aplican estos fondos, algo de lo que Warren Buffet siempre ha hablado. Ahora estamos viendo cómo bajan… un par de fondos han renunciado al 20% sobre los beneficios. Algunos han bajado del 2 al 1% sobre los activos gestionados”. Los fondos también están sufriendo la presión de los inversores, contrarios a las actuales normas restrictivas para retirar dinero. De hecho, muchos fondos han endurecido dichas normas, cerrando toda puerta de salida, después de la crisis financiera que estimuló la desinversión. “Existe cierto malestar entre los inversores que ven como se ha cerrado la puerta de acceso a sus inversiones”, dice Marston. “Impedir que los inversores recuperen sus activos cuando muchos de ellos están desesperados por conseguir efectivo les alienará de manera permanente”. No obstante, permitir las desinversiones también crea problemas. Los fondos pueden quedar heridos de muerte, dificultando e incluso imposibilitando llevar a cabo estrategias de inversión complejas que requieran compromisos a largo plazo. Por último, también está la cuestión de cuáles son esas estrategias de inversión. Tradicionalmente los hedge funds han ofrecido a los inversores únicamente descripciones vagas, alegando que deben guardar el secreto sobre sus transacciones para mantener su

345 ventaja. “Dicho argumento, aunque fuerte, está cediendo lentamente a la apertura de cierta información, en especial para los inversores, para darles más confianza”, dice Donaldson. La demanda de mayor transparencia has sido fomentada por “el efecto Madoff”, eso es, una mayor desconfianza después de que saliese a la luz el pasado año el esquema Ponzi puesto en marcha por Bernard Madoff, con el que estafó unos 50.000 millones de dólares. Aunque la operación de Madoff nada ha tenido que ver con los fondos de inversión especulativos, se empleó el mismo tipo de secretismo que en los hedge funds, y se gestionó dinero para fondos de fondos, esto es, un subconjunto de hedge funds. Ahora muchos inversores quieren saber cómo se emplea su dinero y quién es el propietario de los valores que supuestamente forman parte del fondo, explica Donaldson. “Tiene sentido que haya algo más de transparencia ante la SEC y otras entidades reguladoras. También que exista el modo de atrapar a aquellos que estén haciendo un uso impropio del fondo”. No obstante, Donaldson advierte que las opciones de inversión de los fondos de inversión especulativos son tan variadas que será muy difícil regularlos de manera efectiva. Claramente estos son tiempos duros para los hedge funds. Pero no hay muchos expertos que piensen que el sector va a desaparecer. Los inversores siempre se sentirán atraídos por las promesas de grandes beneficios, y los fondos de inversión especulativos pueden emplear estrategias no permitidas a los fondos de inversión y otras inversiones. “Creo que los hedge funds van a ser evaluados más cuidadosamente por los inversores”, dice Blume, “pero no creo que el sector vaya a perder fuerza”.

IS IT BACK TO THE FIFTIES?

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Is it back to the Fifties? By John Authers Published: March 24 2009 20:12 | Last updated: March 24 2009 20:12 “My mother is 75,” said Jon Stewart, the US late-night comedian, at the end of his already famous interview with Jim Cramer, the television stock market pundit. “And she bought into the idea that long-term investing is the way to go. And guess what?” “It didn’t work,” replied Mr Cramer. The interview this month, in which Mr Stewart humiliated his guest, has earned a place in American cultural history. Mr Stewart was articulating a broad sense of betrayal among the populace that the faith all had been told to put in equities had been misplaced. That loss of faith spreads beyond retail investors. The crash has forced professional investors and academics to question the theoretical underpinnings of modern finance. The most basic assumptions of the investment industry, and the products they offer to the public, must be reconsidered from scratch. Indeed, the very reason for the industry to exist – a belief that experts make the smartest decisions on where people’s money will do best – is up for scrutiny as a result.

Mr Stewart was right about long-term investment, and not just for septuagenarians. US stocks have fallen more than 60 per cent in real terms since the market peaked in 2000. Anyone who started saving 40 years ago, when the postwar “baby boom” generation was just joining the workforce, has found that stocks have performed no better than 20-year government bonds since then, a forthcoming article by Robert Arnott for the Journal of Indexes shows. These people want to retire soon and the “cult of the equity” has let them down. To find a period that does produce an outperformance requires a span reaching back a lot further. The 2009 Credit Suisse Global Investment Returns Yearbook shows that since 1900 US stocks have averaged an annual real return of 6 per cent, compared with 2.1 per cent for bonds – while in the UK, equities have beaten gilts with a return of 5.1 per cent against 1.4 per cent. The problem is that they can perform worse than bonds for periods longer than a human working lifetime. Invest your tuppence wisely: a father pays out pocket money Further, recent experience challenges that basis of modern finance, circa 1955. The children of the “efficient markets hypothesis”, which in its strongest form holds that era, now at retirement age, are finding their holdings that prices of securities always reflect all known information. This are far short of what they implies that stocks will react to each new piece of information, yet expected without following any set trend – a description that cannot be applied to the events of the past 18 months. On these foundations, theorists worked out ways to measure risk, to put a price on options and other derivatives and to maximise returns for a given level of risk. This theory also showed that stocks would outperform in the long run. Stocks are riskier than asset classes such as government bonds (which have a state guarantee), corporate bonds

347 (which have a superior claim on a company’s resources) or cash. So the argument was that those who invested in them would in the long run be paid for taking this risk by receiving a higher return. That is now in question. “There’s no such thing as a risk that you get paid for taking. The whole point about risk is that you don’t know if you’re going to be paid for it or not,” says Robert Jaeger at BNY Mellon Asset Management. “What’s important about the current period is that now it’s true even for a very long period [that] people haven’t been paid for taking equity risks. These losses were taken by people who didn’t even think they were taking a risk.”

“It supposedly didn’t matter how long you waited. But the notion that the long run will bail you out no matter what stupid things you do in the short run I think is dead,” says Robert Arnott, who examines such performance in a forthcoming article for the Journal of Indexes. “And the notion that if you have the better asset class it doesn’t matter what you pay for it is on its deathbed.” Instead, the cult of the equity and the efficient markets hypothesis begin to look like phenomena born of the uniquely positive conditions in the middle of the last century. For decades until 1959, the yield paid out in dividends on stocks was higher than the yield paid out by bonds. This was to compensate investors for the extra risk involved in buying equities. In 1951, as the building blocks of the efficient-markets theory began to appear in academic journals, US stocks yielded as much as 7 per cent, compared with only 2 per cent on bonds. “The 1950s marked the start of a period of relative peace and prosperity. It came on the heels of a tumultuous 50 years that included two world wars and an economic depression. In

348 hindsight, the case for equities over bonds was especially compelling in the early 1950s,” says Robert Buckland, chief global equity strategist for Citigroup. So in 1959, the yield on stocks dipped below the yield on bonds – and stayed there for almost half a century until the two crossed once more last November. The theory changed to account for this and came to hold that bonds yielded more to recognise the superior long-term growth potential of equities. That growth potential made pension funds boost their allocations to equities. In the US, and later elsewhere, legislation gave individual investors more power over their retirement funds but also required them to take on the risks. As employers were no longer guaranteeing them a proportion of their final salary on retirement. Savers’ money went heavily into equities. Then came the bear market of this decade. If that bear market has damaged the case for stocks, the efficient markets hypothesis underlying it had been “dying a natural death for most of this decade”, according to Mr Arnott. In place of the standard assumption that all decisions are rational, behavioural economists began substituting findings from experimental psychology on how people actually make decisions. This helped to explain market crashes and bubbles, showed that investment decisions could be systematically irrational and led to attempts to create new models of how markets set prices. Efficient-markets theorists themselves moved away from the hardest version of the theory. They identified two anomalies: in the long run, small companies tend to outperform the larger, while cheap or “value” stocks (which have a low price in relation to their earnings or the book value on their balance sheet) outperform more expensive stocks. Burton Malkiel, a Princeton economics professor whose book, A Random Walk Down Wall Street, is the most famous statement of efficient-markets theory, suggests its strongest form is a straw man. “‘Efficient markets’ has never meant to me that the price is always right,” he says. “The price clearly isn’t right. We know markets overreact. They get irrationally exuberant and they get irrationally pessimistic.” But he says that the key implications remain intact. “What ‘efficient markets’ says is that there are no easy opportunities for riskless profit. There I still would hold that that part of the efficient markets is alive and well.” . . . Still, the search is on for a new theory to replace efficient markets. Perhaps most prominently, Andrew Lo, head of the Massachusetts Institute of Technology’s Financial Innovation Laboratory, has merged behavioural and efficient markets theory using Darwinian biology. In his “adaptive markets hypothesis”, markets behave efficiently during periods of calm. “Periods of extraordinary prosperity have behavioural effects – it gives us a false sense of security and therefore there is too much risk-taking. Eventually that kind of risk-taking is unsustainable and you get a burst of the bubble.” Once bubbles burst, Mr Lo’s theory predicts, a period of “punctuated equilibrium” will ensue, in which long-engrained behaviours no longer work. “We just had a meteorite hit us in financial markets. There will be destruction of species that have lasted a very long time. Out of the chaos will emerge new species.” Most clearly, the lightly regulated hedge fund industry – described by Mr Lo as the Galapagos of financial services – is suffering a shake-out. The sector as a whole suffered an average loss of 18.3 per cent last year, only its second losing year since 1990, according to Hedge Fund Research of Chicago. This prompted investors to pull $155bn (€115bn, £105bn) out of the funds. But the worst performing 10 per cent lost an average of 62 per cent, while

349 the top decile gained 40 per cent. The Darwinian process is well advanced: 1,471 hedge funds were liquidated last year, while only 659 new ones were launched, the lowest figure since 2000. The traditional mutual fund, in which managers run a portfolio of about 100 stocks and attempt to beat a benchmark index, may be another casualty. Last year, most equity mutual funds failed to beat their benchmark indices, even though their managers had the freedom to move into cash and to pick stocks. Mr Malkiel points out that of the 14 funds that had beaten the market in the nine years to 2008, only one did so last year. Both efficient-markets and behavioural economists say it is better just to match the index, with a tracking fund, and avoid the fees incurred in unsuccessful attempts to beat the market. Index funds have caught on over the last two decades and, recently, their growth has been driven by exchange-traded funds – index funds that can be bought and sold directly on an exchange. Mutual funds saw global net sales of $112bn last year but ETFs pulled in a net $268bn, according to Strategic Insight, a New York consultancy. Barclays Global Investors reckons there are plans to launch another 679 ETFs around the world. Index funds could become building blocks for new retirement savings products that may look much like the pensions that were the norm until confidence in equity investing took over. As it may be politically infeasible to continue to expect savers to bear all the investment risk, some benefits may have to be guaranteed. Mr Lo suggests that all these developments are consistent with a new world in which investments will largely be controlled by “herbivores” – funds that passively aim to match benchmark indices for a range of asset classes that goes beyond equities. This leaves room for a smaller group of “carnivores” to try to beat the market by exploiting inefficiencies and anomalies. Those carnivores will, moreover, be putting much less trust in theoretical models. As Mr Jaeger says: “Even with all those quantitative models, ultimately you have to make a decision. Ideally, what you are left with is people doing that somewhat old-fashioned kind of investing where you try to figure things out for yourself.” ‘I HAVEN’T OPENED A STATEMENT FOR MONTHS’ Christina Read is 61 and, at least on paper, has lost half her life’s savings in the past year, writes Deborah Brewster. “I started last year with about $400,000 – it’s down to I think about $200,000 now,” says the former dancer who now works as a nanny in Manhattan. For Ms Read, who is divorced with two college-age children, the loss means giving up her dream of a house in the country. “I had been thinking of an old farm, maybe in Nova Scotia. Now it is pretty much impossible.” But she is retaining the investments that have performed so poorly: “I will continue working, I have to keep money coming in now and, if the market doesn’t come back in the next 10 years, I will give up on having anything for myself – I will just leave it to my children.” It is this kind of stoicism that has the army of brokers, wealth managers, fund managers and product marketers who grew rich during the boom hoping individual investors will get back into the markets, and soon. Unless they do, the industry’s outlook will be dire. Retail investors, mainly through mutual funds, own a much larger part of the stock and bond markets than ever before. Bob Reynolds, chief executive of Putnam Investments, says: “It started out with 401(k)s [individual retirement accounts]. There are more mutual funds than stocks. We are an investor society.”

350 Will it stay that way? Ms Read may have sat tight but hers was not the only response to the world-shaking events. In the biggest ever exodus of money from professional management, Americans pulled a net $320bn (£218bn, €237bn) from mutual funds last year. They shifted into cash, ploughing a net $422bn into money market funds during the year. A net $212bn went into bank deposits – a figure that has since risen further, to $370bn for the 12 months to mid-March. Elbowing aside their advisers, some began trading their stocks themselves, sharply lifting retail trading volumes as they tried to take control of their investments. Others have done nothing, but for different reasons than Ms Read. Hearing the bad news, they have simply refused to open their financial statements. “I haven’t opened a statement since October,” says one Los Angeles-based business owner, who adds that his holdings were worth more than $3m at the end of 2007 but declines to estimate their value now. “I know it’s bad, but what can I do about it? There is no point in depressing myself. I need to focus on my business, which is going well. My investments are probably pretty much gone ... I had a lot of stocks – bank stocks, Bear Stearns, they’re gone. I see the statements come in the mail and I throw them right in the garbage.” George Gatch, chief executive of JPMorgan Funds, an arm of JPMorgan Chase, is working to re-engage with such investors. “We know how scared people are and we are trying to convince people to get back in, sit down and talk to their financial advisers,” he says. The 50,000 advisers with whom JPMorgan works are reporting that “it is very hard to get their clients to consider the steps they should take, to do a formal review of their portfolio ... There is a base of Americans that don’t want to look at their statements any more.” More than 90m Americans own stocks, through mutual funds and 401(k) plans. But Mr Reynolds adds: “There is a tremendous amount of cash on the sidelines today. Retail investors have close to $13,000bn sitting in money market funds and bank deposits. A year ago there was $7,000bn. That is billions that is just waiting to come back again.” In other words, retail investors have the wherewithal to get things working. The question is whether they will. “The demographics and people’s objectives haven’t changed because of the market,” says Mr Reynolds. But, like others, he sees a shift to more conservative investing. Independent financial advisers who work outside the big brokerage firms tend to be more pessimistic. “Once the money gets under the mattress, which it has, it takes a long time to pry it out again,” says one. If individual investors stay away, the consequences for the lucrative wealth management industry and its associated services and advisers are considerable. Wealth management is seen as a stable source of revenue for the Wall Street banks as they restructure themselves for a new era. For instance, Citigroup and Morgan Stanley are merging their wealth management operations, which will result in an army of more than 20,000 brokers to compete with Bank of America’s new “thundering herd”, previously part of Merrill Lynch. Jim McCaughan, chief executive of Principal Global Investors, an asset manager, says he does not see a shift away from using brokers or advisers: “Fear tends to lead people to want to talk to someone. They will go to the advisers and brokers: that is what has happened in past bear markets.” First, however, investors will need to start looking at their financial statements again.

351 WSJ Blogs March 24, 2009, 1:02 PM ET Regional Banks Are the Future The big-bank model isn’t going to last much longer, banking industry analyst Meredith Whitney said at the Journal’s Future of Finance Initiative, and said a more sustainable approach would be bigger regional banks.

Whitney, famous for foreseeing the troubles facing Citigroup, suggested that key parts of the big banking model made them susceptible to the types of problems that caused the financial crisis. One issue is the physical distance between loan originators and borrowers. Good lending results from a relationship with borrowers, and regional banks are in a better position to take advantage of those relationships. She added that five banks controlling two-thirds of mortgage origination and credit cards is fundamentally unbalanced. Instead, she suggested “supercharging” regional Meredith Whitney at the Journal’s Future of Finance Initiative. (Paul Morse) lenders. One possibility is that if stress tests help healthy banks and lead them to return TARP money, some of those funds could be transferred to local banks to encourage consolidation (on a smaller scale) in that sector. She also sees the potential for regional banks to take on business from nonblank lenders who were decimated by the subprime crisis. Regional lenders have grown angry at their larger counterparts, as evidenced by a conference in Phoenix last week. They are angry that the big players have given bankers a bad name. They cheered comments from Federal Reserve Chairman Ben Bernanke and Federal Deposit Insurance Corp. chief Sheila Bair about the need to clamp down on megabanks. However, not all smaller banks are created equal. While the majority of local banks are faring well and didn’t receive any TARP money, most of the 42 banks that have failed since the start of last year were community institutions.

352

Economy

March 25, 2009 Dissecting Bank Plan for a Way to Profit By GRAHAM BOWLEY and MARY WILLIAMS WALSH Up and down Wall Street, bankers and traders sharpened their pencils on Tuesday as they began the complex financial calculus of the latest bank rescue plan. Their goal: to find ways to profit from it. In skyscrapers across Manhattan, banking executives assessed how best to use the new Treasury proposal to sell billions of dollars of their troubled assets. Traders at giant investment houses and small hedge funds debated whether to buy them. And on a day when the Treasury secretary, Timothy F. Geithner, said he was seeking government authority to regulate or take control of nonbank financial institutions like insurance companies, insurance executives wondered whether they might use the program to ease their industry’s financial stress. “Even though they are called toxic assets, some of them are not toxic, and those are the ones that we are going to be ferreting out,” said Sherry Reeser, a spokeswoman for the California State Teachers’ Retirement System, which sees a buying opportunity in the so-called public- private investment program. But no one on or off Wall Street seemed any closer to answering the fundamental question hanging over these investments: What is this stuff really worth? Nor was there any consensus about an even more sobering question that confronts not only the financial industry but ordinary Americans: Will this be the plan that finally works? “It’s a wait-and-see attitude,” said Paul Graham, chief actuary of the American Council of Life Insurers. The proposal, which was announced officially on Monday, has provoked many responses and questions. Can banks that received government bailouts use taxpayer money to bid on toxic assets, in the hope of making a profit? Would that be bad, given that the point of the exercise is to stir up a bit of greed and animal spirits, the lack of which has been holding the economy back? Can banks sell some assets and then use the proceeds, leveraged by generous government financing, to buy more of the same? Might investment houses be tempted to overpay, if doing so buoys the value of their own investments? In the end, it will be the taxpayer who will be largely footing the bill. For the Obama administration, the challenge is to strike a balance between the potentially competing interests of investors and taxpayers. Some wonder if the proposal tips too far in favor of investors. Internet blogs were full of economists scratching their heads over how to game the plan and come out ahead of the government. Others, like Joseph E. Stiglitz, a Nobel Prize-winning

353 economist, in an interview with Reuters, called the program “very badly flawed” and said it offered “perverse incentives” that amounted “to robbery of the American people.” Despite such reservations, Goldman Sachs sent out a note to whip up investor interest in the government’s rescue plans, while BlackRock, the big money management firm, was considering the practicalities of starting, of all things, a mutual fund so everyday investors could buy into banks’ toxic assets. But Bert Ely, a prominent banking consultant, said investors would be cautious because many crucial details were still missing — the size and terms of loans they would receive from the Federal Deposit Insurance Corporation, for example, and the amount of equity they would be allowed to put in, and whether banks would be allowed to walk away if they did not like the price at auction. “Today we know a lot more than we did yesterday, right?” Mr. Ely said. “I am being facetious!” Many questioned the auction mechanism to sell toxic assets off from banks’ balance sheets. Price, most experts agree, is the biggest sticking point. The banks want to sell high. Potential investors want to buy low. Banking executives said that their institutions would not want to unload assets at fire-sale prices, a step that would compel banks to raise large amounts of additional capital. The gap is likely to be the widest for certain loans because of the way banks account for them. Because of the way they account for the assets on their books, Goldman Sachs and Morgan Stanley — Wall Street giants that converted themselves into banks last year in an effort to ride out the financial storm — may be more willing to sell assets than some commercial banks. Under accounting rules, banks must carry securities on their books at market prices. Most financial firms have already marked down these assets to prices that might be low enough to lure buyers. But banks need not carry ordinary loans at market value. Instead, they are allowed to hold them at their higher values until they are repaid. So, for many commercial banks, selling loans now, at distressed prices, would almost certainly lead to large losses. Such losses might raise questions about how some banks will fare in a so-called stress test that federal regulators are in the process of applying to about 20 lenders. “I don’t see how they are going to get the banks to sell,” said an executive at a large bank, who asked not to be named, given the delicate nature of the Treasury plan. “There are going to be substantial write-downs taken to get them off the books.” Federal regulators said privately that, in some cases, they might pressure banks to sell. Mr. Graham, of the American Council of Life Insurers, said pricing was also a crucial issue for insurance companies. Insurance companies have a long time horizon, he said, so they can hold impaired bonds through market downturns. For all the uncertainties, some big investors like BlackRock and Wilbur L. Ross Jr., a prominent figure in distressed investing, said they were willing to take the plunge. Pension funds also represent a large source of purchasing power, and Ms. Reeser, of the California State Teachers’ Retirement System, viewed the program positively. The fund, known as Calstrs, had already reduced the part of its portfolio dedicated to stocks by 5 percent, to free up money for this type of purchase, she said.

354 Institutional investors like insurance companies represent huge blocks of capital, and the success of the public-private investment program will depend in part on how eager they are to get involved as purchasers of the toxic assets. “Insurers account for 10 percent of all invested assets in the United States today,” said Robert P. Hartwig, president of the Insurance Information Institute. They would be interested in the program because of its partial government guarantee and their ability to find out what the structured assets consisted of, he said. “There is some significant upside potential here,” he said. “But you have to balance that against the fact that insurers are very conservative investors.” The problem, he said, is that companies have to maintain cash flows that match their payout obligations, and it was by no means clear that, in a pinch, they could get their cash out of the toxic assets. Eric Dash and Michael J. de la Merced contributed reporting.

355 Grasping Reality with Both Hands The Semi-Daily Journal of Economist Brad DeLong

Posted at 09:57 AM http://delong.typepad.com/sdj/ Chris Carroll Reassures Me that I Am Not Crazy... He, too, thinks that the Geithner Plan is a reasonable way for the Treasury to spend $100B of TARP money:

ft.com/economistsforum Treasury rewards waiting MARCH 24, 2009 11:56AM BY FT By Christopher D. Carroll Maybe it was worth the wait. Judging from preliminary details, the US Treasury’s plan to rescue the financial system is a lot savvier about the relationship between financial markets and the macroeconomy than are the usual-suspects: critics from both left and right who are already pouncing on the Geithner plan. Unlike the critics, the Treasury has absorbed the main lesson from the past 30 years of academic finance research: asset price movements mainly reflect changes in investors’ collective attitude toward risk. Perhaps the reason this insight has not penetrated, even among academic economists, much beyond the researchers responsible for documenting it, is that it has not been expressed in layman’s terms. Here’s a try: in the Wall Street contest between “fear” and “greed,” fear fluctuates much more than greed (in academic terms, movements in “risk tolerance” explain the bulk of movements in asset prices). Such extravagant movements in investors’ average degree of risk tolerance have proven impossible to reconcile with economists’ usual benchmark ways of understanding peoples’ attitudes toward risk. One response has been to try to reverse-engineer a “representative consumer” who would choose to behave in a way that matches the data, under the assumption that market prices are always a perfect and optimal representation of rational choice. Unfortunately, the reverse-engineered preferences look nothing like what we know of household behaviour from a vast literature that observes the choices households make in their daily lives (as documented in a variety of microeconomic datasets). The second response to the market’s remarkable fluctuations in risk attitudes is more in tune with Warren Buffett’s view, following his mentor Benjamin Graham, that market prices move much more than can be justified by the sober judgment of someone with a long horizon and stable preferences. Buffett has arrived at his current perch more by skepticism about the market than by unblinking faith in its wisdom. As Mr. Buffett has shown, patient investors who buy low and wait for underpriced assets to recover can do very well indeed. Which brings us back to the Treasury’s plan. The details flow from an overarching view that the markets for the “toxic assets” that are corroding banks’ balance sheets have shut down in

356 part because in those markets the degree of risk aversion has become not just problematic but pathological. The different parts of the plan reflect different approaches to trying to coax private investors back into the market by reducing their perceived degree of risk to levels that even a skittish risk-shy hedge fund manager might find tempting. The government and the private investor would be partners in a Buffett-like arrangement in which the assets would be held long enough that the investors can expect to receive payments that have justified the waiting. This motivation sounds suspiciously like some of the arguments for the ill-fated Paulson TARP plan from last autumn; but the problem with the Paulson plan was never fundamentally with the idea that there were problems in the market for toxic assets, but with the idea that the right way to fix that problem (and everything else wrong with the economy!) was simply to have the government drastically overpay to buy up the toxic assets from whoever was foolish enough to have ended up holding them. (Maybe this is not really what Secretary Paulson had in mind, but it seems the most sensible interpretation). Instead, the new plan from the Treasury gives private investors (who know more than Treasury about the likely payoffs of these securities) the pivotal role in competing to set the prices of the securities, via a competitive auction process. The private investors currently on the sidelines are not fools and have no incentive to lose money on the deal. In addition, there is no pretense now (as there was last autumn) that the resolution of the toxic assets problem is the sole remedy for our economic woes; it is part of a carefully conceived plan including the stimulus bill, the housing foreclosure mitigation plan, the TALF plan for reviving the market for securitised assets, the bank “stress tests” designed to triage the good banks, the salvageable banks, and the zombie banks; and a host of other measures designed to address other aspects of the crisis. Finally, the new plan’s principal goal, fostered in numerous ways, is to induce private investors to come off the sidelines and reengage with the markets, while the Paulson plan’s mechanisms for accomplishing that goal were either murky or nonexistent. When fuller details emerge, it would be useful if the economics profession and the financial community could have a mature conversation about whether the plan could be improved before it goes into operation. For example, it may be necessary to make any bank that participates agree to the sale of all their toxic assets, to prevent the kind of cherry picking that has contributed to the shutdown of these markets so far. And there is good reason to be very careful to minimize the possibility of “heads-I-win, tails-the-government-loses” kinds of bets. But broad-brush denunciations are unhelpful, whether they derive from preconceived prejudices of the left (which needs to recognise the important distinction between the greedy people who got us here and the wise captains of finance who can help us get out), or the right (which espouses a destructive ideology according to which all government action of any kind is a mistake). The rest of us should hope that even in the current fervid atmosphere, reasoned argument can win out over impassioned ideology.

Christopher D. Carroll is professor of economics at the Johns Hopkins University

357 LEX Finance & governance GEITHNER’S PLAN Geithner’s plan Published: March 23 2009 15:09 | Last updated: March 23 2009 18:34 After lambasting past announcements for being too broad brush, it is churlish to accuse Tim Geithner, US Treasury secretary, of obscuring his latest taxpayer-funded giveaway with excessive detail. In fact, the latest plan to cleanse the system of bad assets is appropriately nuanced. It is better crafted, using private involvement to lessen taxpayer risk. And there is the odd nice touch, like using a portion of fees to bolster deposit insurance funds. There are two main components to the latest plan, one targeting loans, the other securities. In the first, banks put loans up for sale to competing private sector bidders. The Federal Deposit Insurance Corporation guarantees debt of up to six times the equity in the winning fund. The Treasury takes up to 50 per cent of the equity, or about 7 per cent, of the fund. In the second part of the plan, the Treasury selects managers to run funds to buy real estate- backed securities, matching private investors dollar for dollar. Managers can top up with limited Treasury loans. The term asset-backed securities loan facility will also be expanded to finance purchases of legacy securities. Equity stakes give bidders an incentive not to overpay while competition between private funds should deter low-balling. But it is unclear that cheap leverage can close the gap between the prices at which banks will sell and investors will buy. The former depends on where banks’ assets are marked (and if they can sell without rendering themselves demonstrably insolvent.) But only one fifth of all assets are marked to market, says Credit Suisse, with ailing fundamentals yet to be recognised. The dross inevitably will be first on the block. After all, in the loan programme banks can choose what to sell and reject the result of the auction. This suggests price discovery only to the extent that prices are above banks’ marks. A tougher regulatory stick is needed to force banks to face reality. Instead, generous terms may help bridge the pricing gulf – further reason for investors fearful of a political backlash to stay clear.

358 Opinion Wednesday, March 25, 2009 March 24, 2009, 10:33 am WILL THE GEITHNER PLAN WORK? By The Editors

(Credit: Evan Vucci/Associated Press) Demonstrators standing behind Treasury Secretary Timothy Geithner before the start of a hearing of the House Financial Services Committee on Tuesday.

By offering private investors huge amounts of cheap financing at little risk to buy bad mortgage-related securities, along with an expansion of an existing federal program, the public-private plan unveiled by Treasury Secretary Timothy Geithner could buy up to $2 trillion in toxic assets now weighing down the banks. The market soared on high hopes that this will solve unfreeze credit and revive the crumbling economy. But is this plan sufficient to restore the banking system to health? We asked four economists — Paul Krugman, Simon Johnson, Brad DeLong and Mark Thoma — to tackle this question. • Paul Krugman, Op-Ed columnist, Princeton University • Simon Johnson, M.I.T. • Brad DeLong, U.C. Berkeley • Mark Thoma, University of Oregon

Perception vs. Reality

Paul Krugman, a Times Op-Ed columnist, is a professor of economics at Princeton University and winner of the 2008 Nobel economics prize. Well, the stock market loved the Geithner plan, which proves … nothing. Stock investors have no special knowledge here; they’re groping like everyone else. For what it’s worth, credit markets didn’t react much at all. But let’s back up and focus on the fundamentals.

359 In essence, the Geithner plan is the same as the Paulson plan from six months ago: buy up the toxic assets, and hope that this unfreezes the markets. Don’t be fooled by the apparent role of private enterprise: more than 90 percent of the funds will come from taxpayers. And the way the funds are structured provides a strong incentive for investors to overpay for assets (see my explanation on my blog). Subsidizing investor purchases of toxic assets has no real chance of turning things around. So can this work? Since the beginning of the crisis, there have been two views of what’s going on. View #1 is that we’re looking at an unnecessary panic. The housing bust, so the story goes, has spooked the public, and made people nervous about banks. In response, banks have pulled back, which has led to ridiculously low prices for assets, which makes banks look even weaker, forcing them to pull back even more. On this view what the market really needs is a slap in the face to calm it down. And if we can get the market in troubled assets going, people will see that things aren’t really that bad, and — as Larry Summers said on yesterday’s Newshour – the vicious circles will turn into virtuous circles. View #2 is that the banks really, truly messed up: they bet heavily on unrealistic beliefs about housing and consumer debt, and lost those bets. Confidence is low because people have become realistic. The Geithner plan can only work if view #1 is right. If view #2 is right – if the banks are really in deep trouble that goes beyond lack of confidence — subsidizing investor purchases of toxic assets, many of which aren’t even held by the most troubled banks, has no real chance of turning things around. As you can guess, I believe in view #2. We had vast excesses during the bubble years, and I don’t think we can fix the damage with the power of positive thinking plus a bit of financial engineering. But that’s where the issue lies.

A Partial Answer, Maybe

Simon Johnson is a professor at the M.I.T. Sloan School of Management, a senior fellow at the Peterson Institute for International Economics, and co-founder of the global crisis Web site BaselineScenario Secretary Geithner’s plan might work, in the sense of facilitating the removal of some “toxic” assets from the balance sheets of major banks. But it is unlikely to work, in the sense of restoring the banking system to health. There are already several trillions of troubled assets to deal with and this total may rise as we head deeper into recession. The Geithner plan needs to scale up in order to have real impact, but as it gets bigger the political backlash will grow. After less than 24 hours, the Internet already abounds with detailed and plausible proposals on how to take unreasonable advantage of the plan.

360 This kind of complex market-based scheme makes scams easy. After less than 24 hours, the Internet already abounds with detailed and plausible proposals regarding how to take unreasonable advantage of the plan, either if you are an independent hedge fund buying toxic assets or the employee of a bank selling the same or – ideally – someone with connections to both. Banks, hedge funds, insurance companies and the like are willing to stay involved only if this does not bring onerous additional government scrutiny. As scams become more apparent – and it only ever takes one or two prominent examples – controls will be tightened and private sector participation will fall off. Think of it this way. If the government offered you the chance to participate in a big new lottery at a cost of $10, you might be tempted. But what if the government wanted you to pay $1,000 and to have the I.R.S. camp at your house for a month to make sure everything you did was legal? The Geithner plan may prove to be part of the solution, but a relatively small part. If the economy continues to deteriorate, we urgently need a “resolution mechanism for large banks”; in plain English, the government will supervise their bankruptcy and had better figure out how to do this more effectively. We must learn the painful lessons of A.I.G. and create laws, put in place procedures, and hire people who can clean up massive financial messes. The magic of the market will likely not get us out of this morass; we need a new Resolution Trust Corporation-type structure and we need it fast.

Better Than Nothing

Brad DeLong is a professor of economics at University of California, Berkeley, and blogs at Grasping Reality with Both Hands. The purpose of the Geithner plan is to boost financial asset prices and so make it easier for businesses to obtain financing on terms that will allow them to expand and hire. The plan would take about $465 billion of government money, combine it with $35 billion of private- sector money, and use it to buy up risky financial assets. The sudden appearance of an extra $500 billion in demand for risky assets will reduce the quantity of risky assets other private investors will have to hold. And the sudden appearance of between five and 10 different government-sponsored funds that make public bids for assets will convey information to the markets about what models other people are using to try to value assets in this environment. That sharing of information will reduce risk — somewhat. We may need to take $4 trillion of risky assets out of the system to move asset prices to where they need to be. When assets are seen as less risky, their prices rise. And when there are fewer assets to be held their prices rise too: supply and demand. With higher financial asset prices, those firms that ought to be expanding and hiring will be able to get money on more attractive terms.

361 My guess, however, is that we would need to take $4 trillion of risky assets out of the supply currently held by private financial intermediaries to move financial asset prices to where they need to be. The Geithner plan offers only $500 billion. The Federal Reserve’s quantitative easing plan will add another $1 trillion. I should hasten to say that the administration thinks that information-sharing effects of the plan will do three times as much good in raising asset prices as the simple change in asset supply (I discount that entirely). So from their perspective the glass is 3/4 full. I think that 3/8 full is better than having no glass at all. Why isn’t the administration doing the entire job? My guess is that the Obama administration wants to avoid anything that requires legislative action. The legislative tacticians appear to think that after last week’s furor over the A.I.G. bonuses, doing more would require a Congressional coalition that is not there yet. The Geithner plan is one the administration can do on authority it already has.

How to Tell It’s Working

Mark Thoma is an economics professor at the University of Oregon and blogs at Economist’s View. A bailout plan must do two things to be effective. It must remove toxic assets from bank balance sheets, and it must recapitalize banks in a politically acceptable manner. I believe the Geithner plan has a chance of doing both of these things, but it’s by no means a sure bet that it will. How will policymakers be able to tell if the plan is working? The first thing to watch for is whether private money is moving off the sidelines and participating in the program to the degree necessary to solve the problem. If the free insurance against downside risk that comes with the non-recourse loans the government is offering doesn’t induce sufficient private sector participation, then it will be time to end the Geithner bank bailout. Even if increasing the insurance giveaway would help, legislative approval would be unlikely and the political fight that would ensue would hurt the chances for nationalization. If the price of these assets is increasing sufficiently fast, then the loans will be safe. The second factor to watch is the percentage of bad loans the government makes as part of the program. These non-recourse loans are the source of the free insurance against downside risk. Borrowers can walk away if there are large losses, and if the number of bad loans is unacceptably high (a potential political nightmare), then policymakers will need to act quickly and pull the plug on the program. Unfortunately, however, the loan terms make it unlikely that we’ll have timely information on the percentage of bad loans. But there is something else we can watch to assess the health of the loans: the price of the toxic assets purchased with the loans. If the price of these assets is increasing sufficiently fast, then the loans will be safe. But if the prices do not respond to the program, then the loans will be in trouble. In that case, we will need to end the program as quickly as possible and minimize losses. The next step will have to be bank nationalization, though the political climate will likely be

362 difficult. Sticking with the plan until it completely crashes and burns on the hope that a little more time is all that is needed will make nationalization much more difficult.

A Fix, But Maybe Not Permanent

Brad DeLong responds to Paul Krugman: Paul Krugman asks: Has the housing bust spooked investors, leading to ridiculously low prices for assets which makes banks look even weaker, which forces them to pull back even more, which leads to even more ridiculously low prices for assets. Or did the banks mess up by betting heavily on unrealistic beliefs about housing and consumer finance? The answer is: “Yes.” Both things are going on. And I suspect that in the end we will be driven down the road to some form of bank nationalization — and if that is where we are going Paul Krugman is correct to say that it is better to get there sooner rather than later. But unless Paul Krugman has 60 Senate votes in his back pocket, we cannot get there now. And the Geithner Plan seems to me to be legitimate and useful way to spend $100 billion of TARP money to improve — albeit not fix — the situation. It has the added benefit, I think, of laying the groundwork to convincing doubters of nationalization: “We tried alternatives like the Geithner Plan and they did not work” might well be an effective argument several months down the road.

Random Actions on Failing Banks

Mark Thoma responds to Simon Johnson: One of Simon Johnson’s points is very much worth emphasizing. When this crisis hit, we did not have the procedures in place for an orderly resolution for banks that were failing. Thus, because there were no well known procedures to follow, the actions that the government took when faced with a failing bank appeared ad hoc, almost random, because they were constructed on the fly to deal with problems at individual banks. The first thing we need to do is to change the regulatory structure so that banks cannot get too big and too interconnected to fail. When they are too big, their failure puts policymakers and the public in a position where there is no resolution that can confine the costs to those who were responsible for the problem. The dynamic is bad both ways: If the bank is allowed to fail, people who did nothing to cause the crisis are hurt. But if the bank is saved the people responsible are let off the hook at taxpayer expense, at least to some degree, and that brings up issues of both moral hazard and equity. But despite our best efforts, banks may become too large or too interconnected anyway, particularly if the interconnections are not transparent until trouble hits, and that’s where we need to do much, much better than we did in the present crisis. We need to have procedures available to resolve problems that are backed with a credible enforcement threat so that

363 everyone understands in advance exactly what will happen to institutions that are deemed insolvent. We simply cannot repeat the uncertainty generating ad hoc, case by case approach that was used in the present case.

A New Way to Handle Failing Banks

Brad DeLong responds to Mark Thoma: Mark Thoma is thinking about what to do with banks that fail… In the really old days, if you failed you failed: if you did not pay a debt, your creditor went to a court and got an order and the next thing you knew the sheriff was selling off the contents of your warehouse and your building on your front lawn for cash to be given to the creditor. Then came the rise of the large corporation, and the post-1869 deflation, and railroads with high fixed charges engaging in price wars; competitors began dropping like flies. The judges of New York said that it makes no sense to liquidate these enterprises — auctioning off their roadbed and their rolling stock — because, even bankrupt, they are worth much more as going concerns. So the judges made law: bankruptcy meant not a liquidation sale but rather a freezing of financial claims to the business while its operations went on. Then, under the supervision of a judge, the financial claims could be worked out and cuts administered. Later on we regularized this in legislation through the bankruptcy code: chapter 11. There was, however, a problem: how do you apply chapter 11 to finance? Letting operations continue while freezing financial claims is fine unless the operations are themselves financial claims. But we found a way. A commercial bank that goes bankrupt is seized by the FDIC. An investment bank or hedge fund going bankrupt was a stickier situation to be handled on a case-by-case basis, but it could still be handled if the cases occurred one at a time. Now we have a situation in which all our banks are merged investment-and-commercial organizations, so the FDIC cannot take them over cleanly, and in which all of them are blowing up or threatening to blow up at once. And so we need a new chapter of the bankruptcy code to deal with large financial institutions that become “bad banks.” I’d advise everyone to read Jeremy Bulow and Paul Klemperer, who have thought longer and harder about this than I have. A New Auction for Substitutes: Central Bank Liquidity Auctions, the U.S. TARP, and Variable Product-Mix Auctions, 2008, by Paul Klemperer. http://www.nuff.ox.ac.uk/users/klemperer/substsauc_NonConfidentialVersion.pdf Why Do Sellers (Usually) Prefer Auctions? Jeremy Bulow and Paul Klemperer∗ February, 2009 forthcoming, American Economic Review http://www.nuff.ox.ac.uk/users/klemperer/whysellersprefer.pdf

364 Opinion March 25, 2009 OP-ED CONTRIBUTOR

Dear A.I.G., I Quit! by Jake DeSantis The following is a letter sent on Tuesday by Jake DeSantis, an executive vice president of the American International Group’s financial products unit, to Edward M. Liddy, the chief executive of A.I.G. DEAR Mr. Liddy, It is with deep regret that I submit my notice of resignation from A.I.G. Financial Products. I hope you take the time to read this entire letter. Before describing the details of my decision, I want to offer some context: I am proud of everything I have done for the commodity and equity divisions of A.I.G.-F.P. I was in no way involved in — or responsible for — the credit default swap transactions that have hamstrung A.I.G. Nor were more than a handful of the 400 current employees of A.I.G.- F.P. Most of those responsible have left the company and have conspicuously escaped the public outrage. After 12 months of hard work dismantling the company — during which A.I.G. reassured us many times we would be rewarded in March 2009 — we in the financial products unit have been betrayed by A.I.G. and are being unfairly persecuted by elected officials. In response to this, I will now leave the company and donate my entire post-tax retention payment to those suffering from the global economic downturn. My intent is to keep none of the money myself. I take this action after 11 years of dedicated, honorable service to A.I.G. I can no longer effectively perform my duties in this dysfunctional environment, nor am I being paid to do so. Like you, I was asked to work for an annual salary of $1, and I agreed out of a sense of duty to the company and to the public officials who have come to its aid. Having now been let down by both, I can no longer justify spending 10, 12, 14 hours a day away from my family for the benefit of those who have let me down. You and I have never met or spoken to each other, so I’d like to tell you about myself. I was raised by schoolteachers working multiple jobs in a world of closing steel mills. My hard work earned me acceptance to M.I.T., and the institute’s generous financial aid enabled me to attend. I had fulfilled my American dream. I started at this company in 1998 as an equity trader, became the head of equity and commodity trading and, a couple of years before A.I.G.’s meltdown last September, was named the head of business development for commodities. Over this period the equity and commodity units were consistently profitable — in most years generating net profits of well over $100 million. Most recently, during the dismantling of A.I.G.-F.P., I was an integral player in the pending sale of its well-regarded commodity index business to UBS. As you know, business unit sales like this are crucial to A.I.G.’s effort to repay the American taxpayer. The profitability of the businesses with which I was associated clearly supported my compensation. I never received any pay resulting from the credit default swaps that are now losing so much money. I did, however, like many others here, lose a significant portion of my life savings in the form of deferred compensation invested in the capital of A.I.G.-F.P. because

365 of those losses. In this way I have personally suffered from this controversial activity — directly as well as indirectly with the rest of the taxpayers. I have the utmost respect for the civic duty that you are now performing at A.I.G. You are as blameless for these credit default swap losses as I am. You answered your country’s call and you are taking a tremendous beating for it. But you also are aware that most of the employees of your financial products unit had nothing to do with the large losses. And I am disappointed and frustrated over your lack of support for us. I and many others in the unit feel betrayed that you failed to stand up for us in the face of untrue and unfair accusations from certain members of Congress last Wednesday and from the press over our retention payments, and that you didn’t defend us against the baseless and reckless comments made by the attorneys general of New York and Connecticut. My guess is that in October, when you learned of these retention contracts, you realized that the employees of the financial products unit needed some incentive to stay and that the contracts, being both ethical and useful, should be left to stand. That’s probably why A.I.G. management assured us on three occasions during that month that the company would “live up to its commitment” to honor the contract guarantees. That may be why you decided to accelerate by three months more than a quarter of the amounts due under the contracts. That action signified to us your support, and was hardly something that one would do if he truly found the contracts “distasteful.” That may also be why you authorized the balance of the payments on March 13. At no time during the past six months that you have been leading A.I.G. did you ask us to revise, renegotiate or break these contracts — until several hours before your appearance last week before Congress. I think your initial decision to honor the contracts was both ethical and financially astute, but it seems to have been politically unwise. It’s now apparent that you either misunderstood the agreements that you had made — tacit or otherwise — with the Federal Reserve, the Treasury, various members of Congress and Attorney General Andrew Cuomo of New York, or were not strong enough to withstand the shifting political winds. You’ve now asked the current employees of A.I.G.-F.P. to repay these earnings. As you can imagine, there has been a tremendous amount of serious thought and heated discussion about how we should respond to this breach of trust. As most of us have done nothing wrong, guilt is not a motivation to surrender our earnings. We have worked 12 long months under these contracts and now deserve to be paid as promised. None of us should be cheated of our payments any more than a plumber should be cheated after he has fixed the pipes but a careless electrician causes a fire that burns down the house. Many of the employees have, in the past six months, turned down job offers from more stable employers, based on A.I.G.’s assurances that the contracts would be honored. They are now angry about having been misled by A.I.G.’s promises and are not inclined to return the money as a favor to you. The only real motivation that anyone at A.I.G.-F.P. now has is fear. Mr. Cuomo has threatened to “name and shame,” and his counterpart in Connecticut, Richard Blumenthal, has made similar threats — even though attorneys general are supposed to stand for due process, to conduct trials in courts and not the press.

366 So what am I to do? There’s no easy answer. I know that because of hard work I have benefited more than most during the economic boom and have saved enough that my family is unlikely to suffer devastating losses during the current bust. Some might argue that members of my profession have been overpaid, and I wouldn’t disagree. That is why I have decided to donate 100 percent of the effective after-tax proceeds of my retention payment directly to organizations that are helping people who are suffering from the global downturn. This is not a tax-deduction gimmick; I simply believe that I at least deserve to dictate how my earnings are spent, and do not want to see them disappear back into the obscurity of A.I.G.’s or the federal government’s budget. Our earnings have caused such a distraction for so many from the more pressing issues our country faces, and I would like to see my share of it benefit those truly in need. On March 16 I received a payment from A.I.G. amounting to $742,006.40, after taxes. In light of the uncertainty over the ultimate taxation and legal status of this payment, the actual amount I donate may be less — in fact, it may end up being far less if the recent House bill raising the tax on the retention payments to 90 percent stands. Once all the money is donated, you will immediately receive a list of all recipients. This choice is right for me. I wish others at A.I.G.-F.P. luck finding peace with their difficult decision, and only hope their judgment is not clouded by fear. Mr. Liddy, I wish you success in your commitment to return the money extended by the American government, and luck with the continued unwinding of the company’s diverse businesses — especially those remaining credit default swaps. I’ll continue over the short term to help make sure no balls are dropped, but after what’s happened this past week I can’t remain much longer — there is too much bad blood. I’m not sure how you will greet my resignation, but at least Attorney General Blumenthal should be relieved that I’ll leave under my own power and will not need to be “shoved out the door.” Sincerely, Jake DeSantis

367 Mar 24, 2009 China Proposes a Shift to the SDR: Is it Ready for A Global Role? o Zhou Xiaochun, the Chinese Central Bank governor proposed an overhaul of the global monetary system, suggesting that the U.S. dollar could eventually be replaced by the IMF's Special Drawing Right (SDR) as the world's main reserve currency. (via China Daily) PBoC vice governor, Hu Xiaolian, previously said China would consider buying bonds issued by the IMF to boost the institutions capital. These statements come as China has expressed increasing concern about the long-term value of its US assets o Zhou: The frequency and intensity of financial crises following the collapse of the Bretton Woods system suggests costs of the dollar-based system may have exceeded its benefits and that that the SDR could take on a key global role. Issuing countries of reserve currencies are constantly confronted with the Triffin dilemma, either failing to adequately meet the demand for global liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. Furthermore, member countries reserves could be instrusted to the IMF, pooling their reserves o According to Zhou: Necessary preconditions for a greater global role for the SDR - increase settlement between other currencies and SDR, promote its use in trade, create SDR denominated securities, expand currencies used in the SDR's basket, perhaps weighted by GDP o For China development of SDR bonds might allow it to diversify its holdings o Russian officials have also proposed shifting away from the U.S. dollar. A handful of countries, like Libya, peg to the SDR already o Foley: In the short term the costs to the US of losing its role as the reserve currency would be significant as it would lose seignorage benefits and ability to borrow in its own currency. In the longer term, the U.S. would benefit as it would regain some control over its currency. A central currency would make it harder for one country to get into so much debt to another and if the currency was increased along with global GDP it could provide a steady store of value. However: Obstacles include: Chinese RMB not ready to be included in the a basket as it is not fully convertible, China's role at the IMF is still limited (3% of IMF funds) o Johnson: China might be willing to provide more funds for the IMF if it receives increased votes. The US can do this - because they will keep their veto at the IMF, which is all they really want. The small Europeans may choke on this, but they increasingly feel the need for China’s commitment to the Fund. Alternatively China might try to keep the exchange rate off the table.

368 o Pettis: Zhou’s essay was not mentioned on either Xinhua or the People’s Daily. As the key of the reserve currency, the liquidity of SDR and other alternatives cannot match the US dollar. o Chinese Article IV consultation has been delayed for several years, reportedly on differences on the RMB and the results of the IMF's multilateral exchange rate surveillance. o Setser: China has tended to argue that it had no choice but to build up dollar reserves so long as the dollar occupied a central place in the global financial system. But China didn’t have to peg to the dollar and keep its peg to the dollar unchanged as the dollar fell from 2002 to 2005 o Prasad: G20 should create a reserve pool, offering participants a short-term credit line in case of a crisis. In exchange for this "coverage," each country would pay an entry fee of between $10 billion and $25 billion and an annual premium. http://www.rgemonitor.com/26/China?cluster_id=13652

Mar 24, 2009 Funding the Fed: Precedents and Purposes for Issuing Federal Reserve Bills

Federal Reserve is considering issuing its own interest-bearing bills. Mar 23, the Fed and Treasury put out a joint press release signaling increased likelihood that the Fed will ask Congress to give the Fed authority to issue bills and use Plosser's proposal for the Treasury to take some of the risk off the Fed balance sheet: "Treasury and the Federal Reserve are seeking legislative action to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves." Foreign Precedents o Central bank bills may be a novelty in the U.S. but selling central bank debt to the public is nothing new in other countries o Countries such as Korea, China, Argentina have issued monetary stabilization bonds or bills (MSBs) as a way to control the money supply without using banks o In October, Switzerland introduced MSBs to have a way to withdraw liquidity as official interest rates near zero (when official interest rates cease to exist as a monetary tool) Why is the Fed considering issuing debt? o 1) The ability to issue interest-bearing bills would give the Fed another way to fund itself and achieve the desired positive overnight rate and further expand its balance sheet without clogging up bank balance sheets with excess reserves. The ability to issue

369 interest-bearing bills would leave both reserves and bills held by the public relatively unchanged (JPMorgan, not online) o 2) The Treasury is reaching its issuance limit (debt ceiling) and the Fed is reaching its floor on the amount of Treasuries left on its balance sheet (less than a billion dollars' worth). The Treasury is unwinding the Supplementary Financing Program and may be worried about its widening sovereign CDS spreads o 3) Issuing bills helps prepares an exit strategy from QE o 4) Paying interest on reserves hasn't worked to put a floor under the effective Fed Funds Rate (JPMorgan, not online) o 5) Fed officials are uncomfortable with the speed with which the monetary base (bank reserves plus currency in circulation) has expanded, either on their own account or because the public may see this as creating a huge inflation problem down the road. (Goldman Sachs, not online) o 6) Another possible motivation is to lay the financing groundwork for large-scale direct purchases of longer-term risky assets, such as private-label mortgages and corporate bonds (which would also require congressional approval). (Goldman Sachs, not online) o 7) The other major option for funding the Fed, exempting the Treasury Supplemental Financing Program from the debt ceiling, seems to have fallen out of the running as an alternative reserve management tool (JPMorgan, not online) http://www.rgemonitor.com/168/Global_Monetary_Policy?cluster_id=13345

370 Economy

March 25, 2009 U.S. Plan Seeking Expanded Power in Seizing Firms By EDMUND L. ANDREWS and ERIC DASH WASHINGTON — The Obama administration and the Federal Reserve, still smarting from the political furor over the bailout of American International Group, began a full-court press on Tuesday to expand the federal government’s power to seize control of troubled financial institutions deemed too big to fail. In his news conference on Tuesday night, President Obama said the government could have handled the A.I.G. bailout much more effectively if it had had the same power to seize large financial companies as it did to take over failed banks. “It is precisely because of the lack of this authority that the A.I.G. situation has gotten worse,” Mr. Obama said, predicting that “there is going to be strong support from the American people and from Congress to provide that authority.” Earlier on Tuesday, the Treasury secretary, Timothy F. Geithner, offered a proposal that would allow the government to take control, restructure and possibly close any kind of financial institution that was in trouble and big enough to destabilize the broader financial system. The federal government has long had the power to take over and close banks and other deposit-taking institutions whose deposits are insured by the government and subject to detailed regulation. But the Obama administration and the Fed would extend that authority to insurance companies like A.I.G., investment banks, hedge funds, private equity firms and any other kind of financial institution considered “systemically” important. That would let the government for the first time take control of private equity firms like Carlyle or industrial finance giants like GE Capital should they falter. The Treasury and the Fed each sent their own proposals to the House Financial Services Committee on Tuesday, and President Obama has asked Congressional leaders to put the legislation on a fast track. House Democrats said they planned to act quickly and hoped to bring a bill to the House floor within the next several weeks. If Congress approves such a measure, it would represent one of the biggest permanent expansions of federal regulatory power in decades. But scores of questions remained on Tuesday about how the authority would actually work, and industry experts cautioned that it would only be one step in a broad overhaul of financial regulation that President Obama and Congress were beginning to map out. Mr. Geithner, testifying before the House Financial Services Committee, said the government could have grappled more effectively with A.I.G. — an insurance conglomerate over which neither the Fed nor any other federal bank regulator had much authority — if the Treasury had already had broader authority to “resolve” troubled institutions.

371 “As we have seen with A.I.G., distress at large, interconnected, nondepository financial institutions can pose systemic risks just as the distress at banks can,” Mr. Geithner told lawmakers. “We will do what is necessary to stabilize the financial system, and with the help of Congress, develop the tools that we need to make our economy more resilient.” Ben S. Bernanke, chairman of the Federal Reserve, said that such powers would have allowed the government to scale back A.I.G.’s contracts to pay outsize bonuses and perhaps negotiate lower payments to the domestic and foreign banks that were among its creditors. “If a federal agency had had such tools on Sept. 16, they could have been used to put A.I.G. into conservatorship, unwind it slowly, protect policyholders and impose haircuts on creditors and counterparties,” Mr. Bernanke told lawmakers. But even as they made their case, administration officials left many of the big questions unanswered. Among them: what kinds of companies are “systemically important” and how does that get decided? What should be the government’s ultimate goal — to wind down the troubled company as quickly and smoothly as possible, or to rehabilitate it and return it to health? Under Mr. Geithner’s plan, the decision-making power would lie primarily with Treasury and the F.D.I.C., though the Treasury would have to consult with the White House and the Fed. But that idea could clash with plans to create a new, overarching “risk regulator” that would be responsible for monitoring risk across the financial system. Some lawmakers have proposed that the Fed, which is already at the heart of the financial system, should play that role. Other experts say the F.D.I.C. would be a more logical choice, taking advantage of its experience in taking over smaller banks. Supporters of this approach are concerned that the Fed will be overburdened with its regulatory duties and note that the Fed failed for years to exercise its authority to regulate dangerous mortgage practices. Jamie Dimon, the chief executive of JPMorgan Chase and an outspoken supporter for creating a systemic risk regulator, said it was hard to expand the government’s authority to seize troubled financial companies without also dealing with the regulatory issues. “You can’t take care of your heart and not your lungs,” he said in a telephone interview on Tuesday. “You need someone to look behind the corners and to say something like, ‘this company is too big or too risky.’ ” Mr. Dimon said that giving the government this power would have provided a process for dealing with failing institutions like Lehman Brothers, Bear Stearns, Wachovia and A.I.G. “You don’t want too big to fail,” he said. “You want a resolution process where the process doesn’t damage the whole system.” Representative Barney Frank, chairman of the House Financial Services Committee, plans to start drafting a bill in the next several days. Senator Christopher J. Dodd of Connecticut, chairman of the Senate Banking Committee, said Congress might consider putting the oversight authority in the hands of a task force, rather than consolidating it at the Fed. Mr. Dodd talked of establishing a council that includes the Fed, the F.D.I.C. and the Office of Comptroller of the Currency to avoid giving too much power to a single agency. “I for one would be sort of intrigued in looking at alternative ideas,” Mr. Dodd said. On Thursday, Mr. Geithner plans to outline his broader plan for overhauling the financial regulatory system.

372 On Friday, President Obama plans to meet at the White House with top executives from many of the nation’s largest financial institutions to discuss his financial stabilization effort. Administration officials have said their regulatory plan will create a broad role for the Fed as the lead risk regulator. The administration is also expected to propose tighter regulation for derivative financial products, like the credit-default swaps that caused most of A.I.G.’s problems, and to require that such instruments be traded in a more transparent manner on exchanges or through clearinghouses. Mr. Geithner made it clear on Tuesday that he would be pushing for tighter oversight of executive compensation, in part to make sure that financial incentives did not encourage reckless financial practices.

U.S. Seeks Expanded Power to Seize Firms Goal Is to Limit Risk to Broader Economy By Binyamin Appelbaum and David Cho Washington Post Staff Writers Tuesday, March 24, 2009; A01 The Obama administration is considering asking Congress to give the Treasury secretary unprecedented powers to initiate the seizure of non-bank financial companies, such as large insurers, investment firms and hedge funds, whose collapse would damage the broader economy, according to an administration document. The government at present has the authority to seize only banks. Giving the Treasury secretary authority over a broader range of companies would mark a significant shift from the existing model of financial regulation, which relies on independent agencies that are shielded from the political process. The Treasury secretary, a member of the president's Cabinet, would exercise the new powers in consultation with the White House, the Federal Reserve and other regulators, according to the document. The administration plans to send legislation to Capitol Hill this week. Sources cautioned that the details, including the Treasury's role, are still in flux. Treasury Secretary Timothy F. Geithner is set to argue for the new powers at a hearing today on Capitol Hill about the furor over bonuses paid to executives at American International Group, which the government has propped up with about $180 billion in federal aid. Administration officials have said that the proposed authority would have allowed them to seize AIG last fall and wind down its operations at less cost to taxpayers. The administration's proposal contains two pieces. First, it would empower a government agency to take on the new role of systemic risk regulator with broad oversight of any and all financial firms whose failure could disrupt the broader economy. The Federal Reserve is widely considered to be the leading candidate for this assignment. But some critics warn that this could conflict with the Fed's other responsibilities, particularly its control over monetary policy. The government also would assume the authority to seize such firms if they totter toward failure.

373 Besides seizing a company outright, the document states, the Treasury Secretary could use a range of tools to prevent its collapse, such as guaranteeing losses, buying assets or taking a partial ownership stake. Such authority also would allow the government to break contracts, such as the agreements to pay $165 million in bonuses to employees of AIG's most troubled unit. The Treasury secretary could act only after consulting with the president and getting a recommendation from two-thirds of the Federal Reserve Board, according to the plan. Geithner plans to lay out the administration's broader strategy for overhauling financial regulation at another hearing on Thursday. The authority to seize non-bank financial firms has emerged as a priority for the administration after the failure of investment house Lehman Brothers, which was not a traditional bank, and the troubled rescue of AIG. "We're very late in doing this, but we've got to move quickly to try and do this because, again, it's a necessary thing for any government to have a broader range of tools for dealing with these kinds of things, so you can protect the economy from the kind of risks posed by institutions that get to the point where they're systemic," Geithner said last night at a forum held by the Wall Street Journal. The powers would parallel the government's existing authority over banks, which are exercised by banking regulatory agencies in conjunction with the Federal Deposit Insurance Corp. Geithner has cited that structure as the model for the government's plans.

374 25.03.2009 Reactions to the Geithner Plan Adam Posen Adam Posen has an interesting comment on the Geithner plan in which makes, among others, the following points. He says in terms of price discovery there is no new information for investors except the terms of the government guarantees and leverage terms, so that the price that will be discovered will reflect no more than that information. Also, he recalls the experience of Japanese financial services minister Hakuo Yanagisawa, who in 1998 got a bank recapitalisation scheme under way, but without sufficient conditions attached to the capital. The Japanese banking system failed again three year later. The Japanese banking crisis was only resolved when the banks were forced to write down their bad assets. Wolfgang Munchau Wolfgang Munchau says in his column in FT Deutschland that the Geithner plan is probably the single biggest policy error committed in this crisis, as it deliberately fails to address the problem of an undercapitalised banking sector. The programme is likely to succeed in its own limited terms – creating an artificial liquid market for bad assets – but this is not itself a solution to the problem. Moreover, it will take time to work, during which the economy will continue to deteriorate. Munchau advocates either outright nationalisation, or the setup of bad banks, good banks, but what Geithner proposes is another expensive scheme that will not do the job. Martin Wolf Martin Wolf says in his FT column that he is getting ever more worried. He is particularly worried about the politics of the Geithner plan. Even if it works, it is such a transfer of wealth from the taxpayer to the bank shareholders, that the public may get increasingly hostile to further bank rescues. He says this plan is not going to solve the problem of under- capitalised banks. The danger is that this scheme will, at best, achieve something not particularly important – making past loans more liquid – at the cost of making harder something that is essential – recapitalising banks. Jeffrey Sachs Jeffrey Sachs, writing in Vox, did some arithmetic and concludes that this plan is a massive transfer of wealth from the taxpayer to the bank shareholders. He has calcuated that investors have an incentive to bid $636bn for toxic assets worth $360bn, which means a transfers of $276bn from the taxpayer (via the Federal Deposit Insurance Corporation) to the bank shareholders. It is no surprise that stock prices were going up. Furthermore, Sachs advises Congress to block this scheme. Congress could use a 1990 Act, which would allow it to turn the off-balance sheet transfer into an appropriation. This means Geithner would have to ask Congress to get the $276bn, which is not going to happen.

375 vox Research-based policy analysis and commentary from leading economists Fiscal dimensions of central banking: The fiscal vacuum at the heart of the Eurosystem and the fiscal abuse by and of the Fed: Part 1 Willem Buiter 24 March 2009

In this first of a four-column series on fiscal aspects of central banking, Willem Buiter argues that the ECB’s lack of fiscal backing is both unusual among major central banks and a severe handicap – it is a factor in why the ECB is “fiddling while the Eurozone burns” by hesitating to undertake quantitative easing started by the Fed, Bank of England, and others. Editors’ note: This is the first of a four-part series of Vox columns culled from Willem Buiter’s recent post on his FT-sponsored blog, Maverecon. Introduction: Why central banks need fiscal backup Even operationally independent central banks are agents of the state. And like every natural or legal entity operating in a market economy, the central bank is subject to an (intertemporal) budget constraint. Some central banks are owned by the ministry of finance. The Bank of England, for instance, is owned 100% by the UK Treasury. The ECB is owned by the national central banks of the 27 EU member states. These 27 national central banks have a range of different ownership structures. The Federal Reserve System is not owned by anyone. Most of the operating profits of the Fed go to the US Treasury. The twelve regional Federal Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company. Ownership of a certain amount of stock is, by law, a condition of membership in the system. The stock may not be sold, traded, or pledged as security for a loan – dividends are, by law, fixed at 6% per year (which is a lot better, actually, risk-adjusted, than you would get these days on stock in commercial banks). Even though central banks can “print money” or create money electronically by fiat, they are constrained in their financial operations by two factors. First, there is a limit to the amount of real resources that can be extracted through the issuance of nominal base money. The demand for real base money is a decreasing function of its opportunity cost – the short-term nominal rate of interest. Increasing the rate of monetary issuance will raise the actual and expected rates of inflation, putting upward pressure on the short-term nominal interest rate. Empirically, at sufficiently high rates of expected inflation, the demand for real base money declines more than proportionally with a further increase in the rate of inflation: there is a “seigniorage Laffer curve”. Hyperinflations, where the inflation tax rate increases without bound but the inflation tax base goes to zero even faster, are the most dramatic example of that. Unexpected inflation can raise inflation tax revenues. It can erode even more dramatically the real value of long-maturity nominal fixed-interest debt, private and public. But systematic surprises tend to be beyond the ken of the monetary authorities. There is therefore a strict limit to the monetary authority’s capacity to service foreign currency

376 debt or index-linked debt, if the only resources it has at its disposal are derived from seigniorage. Second, a central bank with a price stability mandate is likely to be constrained in its ability to extract more resources through seigniorage by the fact that, even when it operates on the upward-sloping segment of the seigniorage Laffer curve, the real resources it needs for financial survival may only be extracted at an inflation rate well above its target or tolerance level. In that case, the central bank needs additional resources from somewhere else to meet its price stability mandate. Although in principle the source of additional capital for the central bank could be charitable donations, in practice, the central bank gets re-capitalised by the Treasury. Behind every viable and credible central bank with a price stability mandate stands a fiscal authority – the only economic entity with non-inflationary long-term deep pockets. Fundamental problems arise when there is uncertainty about the fiscal backup of the central bank, as there is in the case of the ECB and the Eurosystem (Buiter 2008). Other, but equally fundamental problems, arise when the central bank – voluntarily or under political pressure – engages in risky financial transactions on behalf of the Treasury, but without a full guarantee from the Treasury for the losses it may incur as a result of these risky quasi-fiscal actions. This is the case of the Fed today. Why is the ECB so timid when it comes to taking direct credit risk? The ECB is fiddling while the Eurozone burns. Both the Bank of England and the Fed have started quantitative easing, that is, purchases of longer-dated government securities financed by increasing the monetary base, albeit on a modest scale, especially in the US. Japan, which pioneered quantitative easing, is at it again. Switzerland has engaged in a special kind of quantitative easing, involving not the purchase of Swiss government securities but the purchase of foreign exchange reserves. Such non-sterilised foreign exchange market intervention is a form of quantitative easing which is targeted specifically at the exchange rate. Sweden is about to join the club. Canada may not be far behind. The Bank of England’s £150 billion Asset Purchase Facility gives it the option of buying up to £50 billion worth of private securities and at least £100 billion worth of government securities. The Bank of England has announced that it aims, for the time being, at making £75 billion worth of asset purchases under the Asset Purchase Facility, most of them in the form of UK government bond purchases. The Fed has announced purchases of up to $300bn worth of US Treasury securities – a small number, but a start. Credit easing or qualitative easing – the outright purchase by the central bank of private securities – has been a part of the Fed arsenal since it started purchases of commercial paper in 2008. The recent announcement that it will double its mortgage-debt purchases to $1.45 trillion indicates the scale of its ambitions on the credit-easing front. The Bank of England is expected to start purchasing corporate securities soon. There is no sign, however, of any quantitative or credit easing by the ECB. When challenged on this, the ECB points to what it is doing. In particular, it makes available unlimited credit at maturities from one week to six months – against eligible collateral – at the official policy rate, now 1.5%. This is good, but not good enough. The maturity for which such credit is extended should be extended to one year, 18 months, and two years. The ECB also has a very liberal definition of eligible collateral – effectively anything that does not move (and a few things that do) is eligible as collateral, as long as it originates from within the Eurozone, is euro-denominated, and is rated at least BBB-. Indeed the Eurosystem has since the crisis started accepted increasing amounts of rubbish collateral, exposing it to serious private sector credit risk (default risk) on its collateralised lending and reverse

377 operations. For reverse transactions and collateralised lending, default risk is the risk that both the borrowing bank will default and that the collateral offered by the bank will go into default. The Eurosystem’s willingness to provided unlimited security at the official policy rate of 1.5% has flooded the system with short-term liquidity to such an extent that the unsecured overnight interbank rate is now close to the ECB’s deposit rate of 0.5% (the deposit rate is the rate at which banks can deposit funds overnight with the Eurosystem). The difference between the effective overnight interbank rates in the Eurozone, the UK and the US is therefore much smaller than the difference between the official policy rates (1.5%, 0.5%, and 0 to 0.25% respectively). Conclusion The ECB/Eurosystem is hobbled severely by the non-existence of a fiscal Europe, and specifically by the absence of a fiscal authority, fiscal facility, or fiscal arrangement that can recapitalise it should it suffer losses due to credit risk assumed as part of its monetary, liquidity, or credit-enhancing policies. It has the following policy options, provided it is willing to take additional credit risk: Extend the maximum maturity of the fixed-rate credit (against eligible collateral) from six months to up to two years. Engage in unsecured lending to banks, including acting as universal counterparty of last resort in the Eurozone interbank market. This is credit easing in a bank-mediated credit system – the natural counterpart to the outright purchases of private securities by the central bank in a market-mediated credit system. Engage in quantitative easing by purchasing a basket of the 16 Eurozone government debt instruments. Engage in market-mediated credit easing by purchasing private securities outright. For all these operations (including quantitative easing through the purchase of a portfolio of Eurozone sovereign securities), the ECB/Eurosystem ought to get a full, joint-and-several guarantee for the credit risk (default risk) involved from the 16 Eurozone national governments. Without such a guarantee, the ECB/Eurosystem can pursue its financial stability objectives only by risking its capacity to pursue its price stability mandate. The Fed has compromised its independence and ability to achieve price stability in the medium and long term. It has done so by taking huge amounts of private credit risk onto its balance sheet without a full Treasury guarantee or indemnity. The opaqueness of many of its arrangements, facilities, and operations undermines Congressional and wider public accountability for this vast commitment of public resources. The Fed should insist on a full Treasury indemnity for any private sector credit risk it assumes. It should also provide a full account of the ex ante and ex post quasi-fiscal subsidies and transfers it has paid to a range of mainly private counterparties. Editors’ Note: This first appeared on Willem Buiter’s blog Maverecon. Copyedited and reposted with permission. References: Buiter, Willem (2008). “Can Central Banks Go Broke?” CEPR Policy Insight No.24, 17 May 2008. http://www.voxeu.org/index.php?q=node/3333

378 Fiscal dimensions of central banking: The fiscal vacuum at the heart of the Eurosystem and the fiscal abuse by and of the Fed: Part 2

Willem Buiter 24 March 2009

The second of this four-column series on fiscal aspects of central banking discusses the institutional constraints on quantitative easing. It argues that the ECB can and should engage in quantitative easing since its independence gives it a credible non-inflationary exit strategy. The Fed, however, seems heading for a bout of inflation stemming from Congressional pressure. Buiter argues that the Bank of England’s situation lies between. Why has there not been quantitative easing in the Eurozone? Good question. No treaty-based obstacle There is no treaty-based obstacle to the ECB/Eurosystem buying Eurozone government securities in the secondary markets. Indeed, both the ECB and the 16 national central banks of the Eurosystem hold Eurozone government securities on their balance sheets. Article 101.1 of the Consolidated version of the Treaty Establishing the European Community reads as follows: “Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.” So, no ‘ways and means advances’ to national governments and no direct purchases by the Eurosystem of Eurozone government debt in the primary issue market, but nothing about the secondary market. Governments sell their debt to any party other than the Eurosystem, and the Eurosystem can buy any amount of this debt from these parties in the secondary government debt markets. There is the minor complication of deciding on how much of each of the 16 Eurozone governments’ debt to buy, but resolving that should take no more than five minutes. Obvious national government debt shares in some sovereign debt basket purchased by the Eurosystem would be the shares of these nations’ central banks in the capital of the ECB (normalised for the share of the 16 Eurozone member states in the total capital of the ECB, which is owned by all 27 EU member state national central banks). So why aren’t they doing this? Probably because of the intergenerational transmission of memories of Weimar in the case of some of the ECB Executive Board members and for some NCB governors, that is, because of the fear that “printing money” or its electronic counterpart will ultimately lead to the Zimbabwe-ification of the Eurozone. I am one of nature’s great pessimists, always ready to see a dark lining around a silver cloud, but the fear that unbridled monetisation of public debt and deficits in the Eurozone would tip the region into high inflation, or even hyperinflation, does not exactly keep me awake at night. The risk of deflation, on the other

379 hand, is serious. Time to wake up and smell the quantitative easing roses. There is a material risk that some Eurozone national governments could default Perhaps a reason for the reluctance of the Governing Council to start large-scale purchases of sovereign debt is that there is a material risk of default on the debt of some Eurozone national governments. The 20 March 2009 spreads of 10-year government bonds over Bunds were 2.76% for Ireland, 2.66% for Greece, 1.50% for Portugal, 1.27% for Italy and 1.04% for Spain. In addition, sovereign CDS spreads suggest that even the German government’s creditworthiness is not beyond doubt. Neither, of course, are the creditworthiness of the US and UK governments. Because there is a non-negligible risk that, without external support, one or more Eurozone national governments will default on their debt, it is reasonable for the EBC/Eurosystem to insist on a joint-and-several guarantee by all 16 Eurozone governments for any Eurozone government debt acquired by the ECB. Indeed, I would extend this requirement for a joint- and-several guarantee to any sovereign Eurozone debt accepted as collateral by the ECB in its reverse operations and collateralised loans. Such a joint-and-several guarantee does not exist at the moment – a reflection of the absence of a fiscal Europe and a fiscal Eurozone. More about that later. Need for an exit strategy to avoid inflation Finally, it is clear that any large-scale quantitative easing has to be reversed when the economy recovers and the demand for base money returns to levels that are not boosted by the extreme liquidity preference of a panic-stricken banking system. Without such a reversal of quantitative easing, unacceptable inflationary consequences are likely. If the reversibility, when needed, is not credible, longer-term inflationary expectations will rise and these inflation expectations, as well as possible inflation risk premia, can raise longer-term nominal and real interest rates. Credibility of the future reversibility of quantitative easing ought not to be an issue for the Eurozone. The ECB is the world’s most independent central bank. When it decides it wants to contract its balance sheet again – reverse the quantitative easing – it will simply dump the surplus-to-its-requirements government debt into the open market. The government debt becomes the problem of the respective Eurozone governments again. Either these governments are capable of generating the primary (non-interest) budget surpluses required to make the debt sustainable (and perceived as capable by the markets), or they will default on their sovereign debt. The option of forcing the central bank not to reverse the quantitative easing is not present in the Eurozone, because of the independence-on-steroids of the ECB. Short of sending a tank column to surround the Eurotower in Frankfurt and blast it into submission, the ECB cannot be forced to monetise government debt against its will. This is why, given obvious doubt about the ability and/or willingness of some Eurozone sovereigns to pursue and achieve long-term fiscal sustainability, default on the public debt is considered by the markets and by expert observers to be a distinct possibility for some Eurozone nations, but little if any likelihood is attached to the scenario where the ECB colludes in inflating away the real value of Eurozone government debt. The Fed exit strategy? Or will Congress tell them to inflate away the debt? I consider the opposite outcome to be more likely for the country with the least independent of the leading central banks – the US. The Fed has always acted like what it is: a creature of

380 Congress: “...the Federal Reserve is subject to oversight by Congress, which periodically reviews its activities and can alter its responsibilities by statute.” More recently, it has also consented to become an off-balance sheet and off-budget dependency of the US Treasury. If, as I consider likely, the US federal government will not be able to commit itself credibly to future tax increases or future public spending cuts of sufficient magnitude, US public debt will, during the next two or three years, build up to unsustainable levels. When faced with the choice between sovereign default and inflating away the real value of the public debt, there is little doubt about the alternative that will be chosen by the US Executive and the US Congress. The Fed will be instructed to inflate the public debt away. Either Ben Bernanke or a more pliable successor will implement these instructions. Double-digit inflation in the US at a horizon of 5 years or more It is surprising that even at a horizon of 5 years or more, the markets are not yet pricing in a distinct possibility of double-digit inflation in the US. The announcement of quantitative easing in the US did weaken the external value of the US dollar, but long-term sovereign interest rates fell for the maturities targeted by the Fed (two to 10 years) and did not rise materially for longer maturities. At some point, probably not too far into the future, the future inflation expectations effects of quantitative easing that is unlikely to be reversed when required to maintain price stability should overcome the immediate demand effect of the Fed’s quantitative easing on the prices of longer-term nominally denominated US sovereign debt instruments. The UK’s exit strategy The UK is somewhere between the Eurozone and the US as regards central bank independence and as regards the likelihood that current quantitative easing will be reversed in time to prevent inflation and inflationary expectations from escalating. The UK Treasury can take back the power to make monetary policy using the Reserve Powers granted in the Bank of England Act 1998. This only requires retroactive approval by Parliament. However, the degree of polarisation of the UK polity and of UK society in general is probably rather less than that of the US. In addition, because the UK political regime is an elected dictatorship, the UK Executive is subject to minimal checks and balances and may well be able to impose the future tax increases (I am less sure about future spending cuts) required to maintain government solvency without the need to inflate away much of the real burden of the public debt. Why no credit easing in the Eurozone? When asked this question, the members of the ECB’s Governing Council tend to reply that the Eurozone is much more dependent on banks than on capital markets for financial intermediation. This is in contrast to the US and the UK where the markets-mediated or transactions-oriented model of financial capitalism has achieved a much greater degree of prominence than in the Eurozone, where the relationships-oriented model of financial capitalism still rules the roost. It is true that banks are a more important source of funds for households and non-financial enterprises in the Eurozone than in the US or the UK. However, there is an analogue to outright purchases of private securities (the expression of credit easing in the transactions- oriented model) in the relationships-oriented model. This is unsecured lending by the ECB/Eurosystem to the banks. Unsecured lending by the central bank to the commercial banks is the straightforward expression of credit easing in the relationships-oriented or banking model of financial intermediation. There is an even more aggressive version of this,

381 which has the central bank lending directly and unsecured, to non-bank counterparties, bypassing the banks completely. The ECB/Eurosystem are not lending without collateral to the banks, let alone to non-bank counterparties (indeed the ECB/Eurosystem is not lending even with collateral to non-bank counterparties). The only valid reason for the ECB/Eurosystem not to make unsecured loans to the banks would be that the banking system is in such good shape, and that financial intermediation through the banks remains sufficiently functional, that unsecured lending is redundant. If that is indeed what the ECB/Eurosystem believe, they should go to the eye doctor. It is clear that even those Eurozone member states whose banks were by-and-large not involved directly in the financial excesses that brought us the financial collapse of the North Atlantic border-crossing banking and shadow-banking system are now gasping for financial air. The quality and size of banks’ balance sheets are declining swiftly, as the rapid contraction of real economic activity feeds back on the financial intermediaries. With both the demand for credit and the supply of credit collapsing, the ECB/Eurosystem may be deriving misplaced comfort from the fact that bank finance is not necessarily the binding constraint on economic activity. A dangerously shortsighted belief That would be dangerously shortsighted. First, there are always otherwise viable enterprises for which external finance is the binding constraint on production, employment, and investment, even when the surveys indicate that for most firms demand is the binding constraint. Second, if and when the recovery starts, non-financial enterprises will have to fund their expansion plans to a large extent from external sources – retained profits will be few and far between. Banks will be more likely to meet these demands from the non- financial enterprise sector if they can fund themselves unsecured through the Eurosystem. One particularly useful form of unsecured lending by the ECB/Eurosystem to the banks would be for the national central banks of the Eurosystem to become universal counterparties for inter-bank lending and borrowing.

Banca d’Italia example The Banca d’Italia has implemented such a scheme, the MIC, but only for banks with head- offices, subsidiaries, or branches in Italy, and for banks from other Eurozone jurisdictions that have reciprocal arrangements for Italian banks. This of course means a deplorable balkanisation of Eurozone monetary and liquidity management. Indeed, it undermines the essence of the Eurosystem as an institutional arrangement setting and implementing a common monetary policy for 16 Eurozone member states. It is surprising that the Banca d’Italia has been permitted to create such a distortion of the monetary and liquidity level playing field. But if a scheme like the MIC were to be implemented uniformly across the Eurozone, it would be a helpful measure, which would strengthen the Eurosystem rather than threaten to deconstruct it into a collection of imperfectly linked subsystems. http://www.voxeu.org/index.php?q=node/3334

382 Fiscal dimensions of central banking: the fiscal vacuum at the heart of the Eurosystem and the fiscal abuse by and of the Fed: Part 3

Willem Buiter 25 March 2009

The third column in this series discusses the ECB’s lack of fiscal backing in detail and suggests three ways in which it might be provided by EU governments. An entirely valid reason for the ECB/Eurosystem to refuse to engage in either outright purchases of private securities or in unsecured lending to the banking sector (or to the non- financial enterprise sector directly), is that there is no ‘fiscal Eurozone’ – just as there is no fiscal EU. The absence of a fiscal Europe that matters here is a narrow one. I am not talking about the absence of a significant supranational fiscal authority in the EU (or in the Eurozone), with significant tax, spending, and borrowing powers – one capable of material system-wide fiscal stabilisation and cross-border redistribution. I am talking instead about two related fiscal vacuums. The first vacuum is that there is no single fiscal authority, facility, or arrangement that can recapitalise the ECB/Eurosystem when the Eurosystem makes capital losses that threaten its capacity to implement its price stability and financial stability mandates. The second related vacuum is that there is no single fiscal authority, facility, or arrangement that can recapitalise systemically important border-crossing financial institutions in the EU or provide them with other forms of financial support. When the Bank of England develops an unsustainable hole in its balance sheet, Mervyn King knows he only needs to call one person: Alistair Darling, the UK Chancellor of the Exchequer. If the Fed were to become dangerously decapitalised, Ben Bernanke also needs to call just one person, Timothy Geithner, the US Secretary of the Treasury.1 Whom does Jean-Claude Trichet call if the Eurosystem experiences a mission-threatening and mandate-threatening capital loss? Does he have to make 16 phone calls, one to each of the ministers of finance of the 16 Eurozone member states? Or 27 phone calls, one to each of the ministers of finance of the 27 EU member states whose national central banks are the shareholders of the ECB? I don’t know the answer, and I doubt whether Mr. Trichet does. This situation is intolerable. We need a fiscal Europe, at least at the level of the Eurozone, to fill the first vacuum. If we are to fill the second vacuum, we need a fiscal Europe at the EU level also. Three ways to fill the vacuum I see three alternatives. In decreasing order of desirability but increasing order of likelihood they are: (a) A supranational Eurozone-wide tax and borrowing authority, specifically dedicated to fiscal backing for the ECB/Eurosystem. This could be extended to include the provision of financial support to systemically important border-crossing financial institutions. In that case, the supranational fiscal authority would have to encompass all of the EU, not just the

383 Eurozone. This might require a two-tier authority, with a Eurozone-only tier to back up fiscally the ECB/Eurosystem, and a EU tier to financially back systemically important border-crossing financial institutions. (b) A Eurozone-wide fund, funded by the 16 Eurozone governments (in proportion, say, to their relative shares in the ECB’s capital), that the ECB/Eurosystem could draw on (subject to qualified majority support in the Eurogroup) if it were to suffer losses as a result of Eurozone-wide monetary policy, liquidity, and credit-easing operations. This fund could be capitalised by the 16 Eurozone national Treasuries, say in proportion to their shares in the ECB’s capital. Around €2.5 trillion to €3.0 trillion would be enough initially to cover the likely losses of the Eurosystem if the downturn is prolonged and deep and requires large- scale credit easing. As an interesting extra, the fund (let’s call it the Eurosystem Fund) could be allowed to borrow with its debt guaranteed joint-and-severally by the 16 Eurozone member states. This is permitted under Article 103.1 of the Treaty: “The Community shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.” What gets the camel’s nose of a joint-and-several guarantee in the tent is the reference to “…mutual financial guarantees for the joint execution of a specific project.” What, after all, is a “specific project”? Anything can be a project. Certainly the creation of a special fund dedicated to the specific purpose of providing the ECB/Eurosystem with additional capital, should the need arise, would qualify as a specific project. You could even create the Eurosystem Fund as an activity of the European Investment Bank. According to the Treaty’s Article 267: “The task of the European Investment Bank shall be to contribute, by having recourse to the capital market and utilising its own resources, to the balanced and steady development of the common market in the interest of the Community. For this purpose the Bank shall, operating on a non profit making basis, grant loans and give guarantees which facilitate the financing of the following projects in all sectors of the economy: (a) projects for developing less-developed regions; (b) projects for modernising or converting undertakings or for developing fresh activities called for by the progressive establishment of the common market, where these projects are of such a size or nature that they cannot be entirely financed by the various means available in the individual Member States; (c) projects of common interest to several Member States which are of such a size or nature that they cannot be entirely financed by the various means available in the individual Member States.” The Eurosystem Fund would fit quite snugly into category (c) above. The European Investment Bank borrows on international capital markets under something practically

384 equivalent to a joint-and-several guarantee of the 27 EU member states. If joint-and-several borrowing by the Fund is considered a bridge too far, each of the 16 Eurozone member states could guarantee just a share of the losses of the Fund equal to its share in the ECB’s capital. A larger fund, separate from the Eurosystem Fund, could also be set up to provide financial support for border-crossing systemically important financial institutions for the EU as a whole. Let’s call it the Crippled Bank Fund. We certainly will need something like that to retain meaningful border-crossing banking activity in the EU. This crisis has reminded us that there is no such thing as a safe bank, even if the bank is sound in the sense that its assets, if held to maturity, could cover its liabilities. This crisis has also reminded us that there may no such thing as a sound bank any longer, but that is a separate story. To be viable, a bank needs to be scrutinised by a supervisor/regulator, have access to the short-term deep pockets of a central bank as lender of last resort and market maker of last resort, and have access to the long-term non-inflationary deep pockets of a Treasury. If we are to continue to have meaningful cross-border banking, we will need a European supervisor/regulator for border-crossing banks and a European fiscal authority or at least a European fiscal facility like the Crippled Bank Fund. (c) An ad hoc, hastily cobbled together fiscal burden sharing rule for the 16 Eurozone national governments to restore the capital adequacy of the ECB/Eurosystem. This may well be the best we can hope for in practice. The experience of the Fortis debacle makes me doubt whether it will work. When the three-country banking and insurance group Fortis (Belgium, the Netherlands and Luxembourg) was about to go under, the authorities of the three countries agreed a joint plan to save the institution as a border-crossing bank, with Belgium putting in 50% of the agreed funds, the Netherlands 40% and Luxembourg 10%. The agreement lasted less than a week. Fortis was broken up according to the national location of its activities, with the Dutch state buying 100% of Fortis Nederland and Belgium and Luxembourg doing the same for their local subsidiaries. This repatriation of cross- border banking will become a flood wave if more cross-border banks go under and country A’s tax payers refuse to stand behind the balance sheets of subsidiaries of their banks in countries B and C. Editors’ Note: This first appeared on Willem Buiter’s blog Maverecon. Copyedited and reposted with permission.

1 It is possible that no one in the US Treasury will pick up the phone, as none of the senior political appointments below Geithner are in place yet, but Geithner clearly would be the man to call. http://www.voxeu.org/index.php?q=node/3340

385

Fiscal dimensions of central banking: the fiscal vacuum at the heart of the Eurosystem and the fiscal abuse by and of the Fed: Part 4 Willem Buiter 25 March 2009

The last column in this series on fiscal aspects of central banking reviews the differences in fiscal backing for the Bank of England, the US Federal Reserve, and the European Central Bank. The Bank of England When the Bank of England gets around to making outright private asset purchases, it will do so with an indemnity provided by Her Majesty’s Government to cover any losses arising from the use of the Facility. This is as it should be. In principle, a central bank should only take the credit risk of its sovereign – the state. If its monetary, liquidity, or credit-easing operations expose it to the credit risk of the private sector, it ought to do so with a full indemnity (guarantee for any losses) from the Treasury. The Bank of England has a full indemnity for outright purchases of private securities, but not for the private credit risk it assumes through repos and other forms of collateralised lending to banks where the collateral offered consists of private securities. I believe the UK Treasury should insure the Bank of England – for free – against all losses incurred as a result of the Bank of England taking private credit risk on its portfolio. The Fed The Fed does not have a full indemnity from the US Treasury even for its outright purchases of private securities. It has no guarantee or indemnity for private credit risk assumed as a result of its repo operations and collateralised lending. For the Fed’s potential $1 trillion exposure to private credit risk through the Term Asset- Backed Securities Loan Facility, for instance, the Treasury only guarantees $100 billion. They call it 10 times leverage. I call it the Fed being potentially in the hole for $900 billion. Similar credit risk exposures have been assumed by the Fed in the commercial paper market, in its purchases of Fannie and Freddie mortgages, in the rescue of AIG, and in a host of other quasi-fiscal rescue operations mounted by the Fed and by the Fed, the Federal Deposit Insurance Corporation, and the US Treasury jointly. I consider this use of the Federal Reserve as an active (quasi-)fiscal player to be extremely dangerous and highly undesirable from the point of view of the health of the democratic system of government in the US. There are two reasons for this. First, it undermines the independence of the Fed and turns it into an off-budget and off-balance sheet special purpose vehicle of the US Treasury. Second, it undermines the accountability of the Executive branch of the US Federal government for the use of public resources – taxpayers’ money. As for the Fed’s independence (whatever independence remains), first, even if the central

386 bank prices the private securities it purchases appropriately (that is, there is no ex ante implicit quasi-fiscal subsidy involved), it is possible that, should the private securities default, the central bank will suffer a capital loss so large that the central bank is incapable of maintaining its solvency on its own without creating central bank money in such quantities that its price stability mandate is at risk. Without a firm guarantee up front that the Federal government will fully re-capitalise the Fed for losses suffered as a result of the Fed’s exposure to private credit risk, the Fed will have to go cap-in-hand to the US Treasury to beg for resources. Even if it gets the resources, there is likely to be a price tag attached – that is, a commitment to pursue the monetary policy desired by the US Treasury, not the monetary policy deemed most appropriate by the Fed. As regards democratic accountability for the use of public funds, even if the central bank has sufficient capital to weather the capital losses it suffers on its holdings of private securities, the central bank should never put itself into the position of becoming an active quasi-fiscal player or a debt collector. The ex post transfers or subsidies involved in writing down or writing off private assets are (quasi-)fiscal actions that ought to be decided by and accounted for by the fiscal authorities. The central bank can act as a fiscal agent for the government. It should not act as a fiscal principal, outside the normal accountability framework. The Fed can deny and has denied information to the Congress and to the public that US government departments like the Treasury cannot withhold. The Fed has been stonewalling requests for information about the terms and conditions on which it makes its myriad facilities available to banks and other financial institutions. It even at first refused to reveal which counterparties of AIG had benefited from the rescue packages (now around $170 billion with more to come) granted this rogue investment bank masquerading as an insurance company. The toxic waste from Bear Stearns’ balance sheet has been hidden in some SPV in Delaware. The opaqueness of the financial operations of the Fed in support of the financial sector (which are expanding in scale and scope at an unprecedented rate) and the lack of accountability for the use of taxpayers’ resources that it entails threaten democratic accountability. Even if it enhances financial stability, which I doubt, democratic legitimacy and accountability are damaged by it, and that is too high a price to pay. The ECB The ECB has no fiscal backup. There is no guarantee, insurance, or indemnity for any private credit risk it assumes. This huge error and omission in the design of the ECB and the Eurosystem threatens to make the ECB significantly less able than the Bank of England and the Fed to engage in unconventional monetary policy, including quantitative easing and credit easing. The exposure of central banks to private sector default risk applies, of course, not only to central banks making outright purchases of private securities. It applies equally to central banks that make loans to the private sector using private financial instruments as collateral. Repos are an example. The Eurosystem has taken private sector credit risk onto its balance sheet ever since it was created. It now accepts a vast collection of private securities as collateral in repos and at its discount window (just about anything issued in euro and in the Eurozone that is rated at least BBB-). The Eurosystem has already taken some significant marked-to-market losses on loans it made to eligible Eurozone counterparty banks against rubbish ABS collateral. In the autumn of 2008, five banks (Lehman Brothers Bankhaus AG, three subsidiaries of Icelandic banks,

387 and Indover NL) defaulted on refinancing operations undertaken by the Eurosystem. The amount involved was just over €10 billion, and over €5 billion of provisions have been made against these impaired assets, because the mainly ABS dodgy collateral is, under current market conditions, worth rather less than €10 billion. Any losses incurred as a result of these defaults are, like all losses incurred by the Eurosystem in the pursuit of its monetary and liquidity operations, to be shared by all 16 national central banks in proportion to their shares in the ECB’s capital. But while the Eurosystem as a whole shares any losses incurred by its individual national central banks, there is no mechanism for recapitalising the Eurosystem as a whole. The ECB/Eurosystem is not yet hurting financially, however. The Eurosystem’s income from monetary policy operations was probably around €28.7 billion in 2008. A high degree of price stability and large denomination notes (including €500 and €200 notes, while the best the US can come up with is a $100 bill) make the euro the currency of choice for tax evaders, tax avoiders, money launderers, and other criminal elements everywhere. This makes for massive seigniorage revenue for the ECB and the Eurosystem. The combination of the obvious willingness of the ECB/Eurosystem to take serious private sector credit risk through collateralised lending to banks and its unwillingness to consider outright purchases of private securities or to engage in unsecured lending to the banking sector is difficult to rationalise. Editors’ Note: This first appeared on Willem Buiter’s blog Maverecon. Copyedited and reposted with permission http://www.voxeu.org/index.php?q=node/3341

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REALTIME ECONOMIC ISSUES WATCH

GLOBAL FINANCIAL CRISIS

The Treasury’s Financial Stability Plan: Solution or Stopgap? by Adam S. Posen | March 23rd, 2009 | 05:55 pm I hope it works. The financial stability plan presented on March 23 by Treasury Secretary Timothy Geithner could be a part of the solution because it would remove some of the bad assets from the banks’ balance sheets and put some capital into the banks. The Treasury is clearly trying clever tactics to avoid going to Congress for more upfront on-budget expenditures to fix the banks. Even in the best case, though, I worry that the avoidance of upfont costs makes it penny- wise, pound-foolish, for the US taxpayer. The private sector investors get a subsidy from the government in terms of both leverage and insurance against asset declines, and the current bank shareholders get higher prices for their assets via these subsidies. It may well thus cost the taxpayer more on net, between these subsidies and the lost upside gains, than if the government had stepped in more aggressively to take full ownership and pay low prices for these assets, even if it costs less upfront. More worrisome, this partial fix might only be temporary. The banks will still have left the worst toxic assets on their books, their incentives will not have changed, and they will be playing with a fresh stack of public money with insufficient conditions and probably insufficient capital. Then, 18 months or so down the road, the US government would still have to put capital into the banks, because lending will have broken down again, and many banks will again be under water. But in that case, the necessary recapitalization would have to take place after this round of money is squandered and the current fiscal stimulus will have run out. The explicit premise of this plan is that the real issue here is a market panic. Treasury is assuming that the private money managers on the sidelines are just sitting there because they are scared, and that the risks they fear (about the economy in general) are very unlikely to be realized, and that the banks’ investors need assurances to encourage them to buy. While markets do get things wrong, I think the panic is a misdiagnosis of the situation. Part of the problem is that some of these assets are genuinely toxic because they are part of larger securitized packages, and there is an inability to see what is behind them. Under this plan, those toxic assets are not restructured, because doing that would require government

389 supermajority ownership, which will not happen. So some will fail to find a market. In that case the FDIC will end up having to pay out on the insurance for overpriced assets. Another part of the problem is that the banks’ current management and shareholders have been unwilling to sell some of the assets for which there is a market at the prevailing low prices because they have been hoping for a government bailout. Bailout is what this plan may give them, with all the subsidies. Given the apparent deep motivation of the Treasury to minimize both on-budget costs and even temporary public ownership of anything, the Obama team is apparently willing to risk overpaying current owners of these assets rather than forcing sales. The Treasury plan is also supposed to lead to “price discovery” through the use of auctions and then resales. This sounds very nice, but since there is no new information for the private investors, except the government guarantee and leverage terms, what price will be discovered besides the worth of that subsidy? Nothing here transforms the worth of those assets. Who will be the eventual market for these assets unless that insurance and subsidy is transferred? If that is the real asset being sold, then why not have these investment firms sell derivative contracts stripping out and offering that insurance, based on the public guarantees? I am skeptical about the amount of price discovery that will occur in such a scenario. I and others have been arguing for a more direct government approach [pdf] not only to get the taxpayer the least cost in the end, though government should indeed be concerned with the long-term instead of temporary budget illusions. The main reason I argue for a more aggressively interventionist strategy—with clean lines between public and private ownership and more stringent pricing of bad assets—is that bolder intervention is the one proven way to resolve such a situation lastingly. Japan in 1998 had a reformer, Hakuo Yanagisawa, come in as Financial Services Minister, and he got a bank recapitalization underway—but he did so without putting on enough conditions on the capital, and three years later the Japanese banking system failed again. Only when Heizo Takenaka became the responsible Minister, and forced the banks to truly write down the value of the distressed assets before injecting capital, was the Japanese banking crisis resolved. Various Japanese government efforts to play with bad asset purchases before that only resulted in overpayments and the eventual accumulation of more bad assets. I hope that the current Treasury plan contributes to stabilizing the US banking system in a lasting way, even if it comes at excessive cost to the taxpayer and offers too much benefit to the private participants. But I also worry that in the end Treasury will have to just do this again with more public money for the same banks amidst renewed financial disruption a little later. http://www.petersoninstitute.org/realtime/?p=565

390 24.03.2009 GEITHNER’S TRILLION DOLLAR GAMBLE

Global stocks soared after US treasury secretary Tim Geithner announced his $1,000bn package to extricate toxic assets from the balance sheets of debilitated US banks. The dollar was also up against the euro and the yen. But while global equities rallied, many observers were still left sceptical or confused because of the lack of detail in Mr Geithner’s statement. We found the most succinct description and analysis how the schemes works, and why it is rip-off, coming from Colm McCarthy in the Irish Economy Blog. Essentially the Geithner plans creates a vehicle in which private equity accounts for 3%, public equity for 12%, and the rest is provided as debt by the public sector the (through the Federal Deposit Insurance Corporation, FDIC). McCarthy makes the point that the private guys do the bidding, and they get the debt on such preferential terms (non-recourse lending, interest rates close to T-bills), that they are bound to end up with a profit. The blogger Nemo (hat tip Felix Salmon) has produced an interesting post on how the Geithner Plan works in more detail, using a numerical example, which shows that from an investor’s point of view this is a Heads I Win Tails You Lose proposition. The only party that always loses, in all conceivable scenarios, is the tax payer. Paul Krugman came up with a similar calculation. The FT's editorial argues that Geithner’s plan assumes that buyers and sellers will agree on a price for bad assets if the government is willing to subsidise them enough. But this implies that assets are not trading today mainly because of a lack of liquidity. But no one knows whether the market malfunction is due more to long-term losses or short-term liquidity risk. A virtue of this plan is that it should help us find out. But this is a gamble, which could fail in two ways. (A short comment from us: We have noticed that the US blogging community is a lot more positive about the Geithner plan than the Paulson plan, even though they are essentially the same plan minus some insignificant details, such as who is in charge of the bidding process. So in our view the reactions to the Geithner plan are very a good metric of the partisanship in the US blogging community. Some bloggers like Krugman, Johnson and Naked Capitalism have remained consistent

391 throughout. Some of the others are merely telling us that they are Democrats, right or wrong.) ¿Opportunity? Projected fall in world trade The WTO expects world trade to fall by 9% this year. This would be the largest contraction since world war 2. After the oil price shock trade fell by 6.2%, the highest reduction to date. FT Deutschland reports that the RWI institute even forecasts a 12% fall. German growth forecasts revised downwards Bad news also for Germany, as the Ifo, DIW and RWI economic institutes revised downwards their growth forecasts, reports the FT Deutschland. Ifo institute forecasts a 6% fall under a worst case scenario, if e.g. world trade continue to contract on its current pace. The DIW forecasts a contraction of 4-5%, the RWI of 4.3%. The most pessimistic private sector forecast comes from Commerzbank, which is looking at 6-7%. The security implication of the crisis The German Foreign ministry sets up a special task force to evaluate the security risks resulting from the global financial and economic crisis. The Germans thereby follow the US counterpart by ranking the social and political repercussions of the crisis higher than that of a terrorist attack, reports the FT Deutschland. The scenarios include state defaults in politically unstable regions such as the Caucasus. Risk aversion recedes Prices on so called most-traded leveraged loans – loans to sub-investment grade companies – have recovered to the highest levels since October, reports the FT. Prices have been recovering since the start of this year after an onslaught of forced selling of loans by banks and hedge funds in the last quarter of 2008 pushed loan prices to record lows. However, Moody’s warned on Monday of rising loan defaults and said that recoveries for investors could deteriorate further during the course of 2009. IMF gloomy over UK’s public finances The IMF gets gloomy over Britain’s public finances , forecasting that the deficit will balloon to 11% of GDP in 2010, far more than the US (8.9%) or the G20 average (6.3%), reports the FT. Falling profits and rising job losses are taking a toll on public finances, £17bn more than expected in the pre budget report of November last year. In February total receipts were £40.7bn down from £45bn, expenditures £26.7bn higher than in the previous year John Taylor on inflation A good comment by John Taylor in the FT this morning. He says that the Fed’s monetary policy has boosted the size of reserve account from $8bn to $778bn by last week, which will go up to $3365bn by the end of this year, once all the announced programmes are implemented. There is no question that this will lead to inflation eventually, so the Fed will have to mob up some $3000bn, at a time when

392 the Treasury is loading up with debt. In the long-run, the Fed is sacrificing its independence, he concludes. The end of financial globalisation Brad Setser has an impressive post on financial de-globalisation. According to the latest US balance of payment data, the US has become a net lender to the rest of the world. Foreign investors have been withdrawing more credit from the US than they have been supplying. Setser concludes that Bretton Woods II has come to an end. As the US is still running a current account deficit, this can only be due to US withdrawals of funds from the rest of the world. Setser gets so excited about these data that he says: “Words cannot really capture the sheer violence of the swings in private capital flows that somehow produced a a rise (net) private demand for US financial assets”

March 23, 2009, 10:11 am Paul Krugman GEITHNER PLAN ARITHMETIC Leave on one side the question of whether the Geither plan is a good idea or not. One thing is clearly false in the way it’s being presented: administration officials keep saying that there’s no subsidy involved, that investors would share in the downside. That’s just wrong. Why? Because of the non-recourse loans, which reportedly will finance 85 percent of the asset purchases. Let me offer a numerical example. Suppose that there’s an asset with an uncertain value: there’s an equal chance that it will be worth either 150 or 50. So the expected value is 100. But suppose that I can buy this asset with a nonrecourse loan equal to 85 percent of the purchase price. How much would I be willing to pay for the asset? The answer is, slightly over 130. Why? All I have to put up is 15 percent of the price — 19.5, if the asset costs 130. That’s the most I can lose. On the other hand, if the asset turns out to be worth 150, I gain 20. So it’s a good deal for me. Notice that the government equity stake doesn’t matter — the calculation is the same whether private investors put up all or only part of the equity. It’s the loan that provides the subsidy. And in this example it’s a large subsidy — 30 percent. The only way to argue that the subsidy is small is to claim that there’s very little chance that assets purchased under the scheme will lose as much as 15 percent of their purchase price. Given what’s happened over the past 2 years, is that a reasonable assertion? Update: Another way to say this is that by financing a large part of the purchase with a non- recourse loan, the government is in effect giving investors a put option to sweeten the deal.

March 23, 2009, 10:13 am INCOMMUNICADO, PROBABLY I’m working at home today, waiting for the Fios guy. Which means that I’m probably going to drop off the face of the earth for much of today.

393 March 24, 2009, 8:14 am LARRY, LARRY From The Hill: “I was surprised by Paul’s comments,” Summers told Bloomberg News on Monday. “He didn’t seem to recognize that this is one component of the plan, and I don’t know of any economist who doesn’t believe that better functioning capital markets in which assets can be traded are a good idea.” Futhermore, Summers accused Krugman of not actually recognizing what was announced today. “Paul has views on the state of the banking system. Certainly many observers don’t share those views,” Summers declared. “But more relevantly, that wasn’t what today’s announcement was about.” Summers added: “I didn’t understand his argument.” I’m fine with this. Larry is a first-rate economist with a job to do, and I wish him luck in it. He understands what I’m saying, of course, but he’s doing his best to support the official line. That line now goes like this: first, the Geithner put is just “one component of the plan” — although the other components are invisible to the rest of us, now that the stress test seems to have been downgraded to irrelevance. Second, rather than defending the large subsidy the plan creates for anyone who buys troubled assets, administration officials tout the virtues of markets in general, and say, hey, this creates a market, so it must be good. It’s a bit disappointing to see the Obama administration engaging in this sort of market- worship — hailing markets as a Good Thing in themselves, rather than as an often but not always useful means to an end. But I have reason to think that unlike the Bushies, they don’t really believe it; it’s just politics. Which is actually better than having genuine market fanatics running things, I guess.

394 PRICES OF MOST-TRADED RISKY LOANS RECOVER

Published: March 23 2009 18:05 | Last updated: March 23 2009 18:05 Prices of most-traded risky loans recover By Anousha Sakoui The prices of the most-traded risky loans have recovered to levels not seen since October as the fear of more assets being dumped on the market has receded. However, Moody’s warned on Monday of rising loan defaults and said that recoveries for investors could deteriorate further during the course of 2009. Last week, the prices of most-traded European leveraged loans – loans to sub-investment grade companies – rose for a second successive week, according to Standard & Poor’s LCD. Based on pricing from Markit, the average bid on a European risky loan rose to 70.69 basis points, up 17bp since March 12. Pricing for a broader composite of loans, which are less traded, has continued a downward decline, with the least liquid loans falling to 57.12bp, a record low. Prices on most-traded leveraged loans have been recovering since the start of this year after an onslaught of forced selling of loans by banks and hedge funds in the last quarter of 2008 pushed loan prices to record lows. Since then, the fear of forced loan sales has eased. (is a quarterly problem: June) One manager of a collateralised loan obligation – which pools leveraged loans and sells differently rated investment notes with varying risk profiles – said he believed loan prices could fall further as corporate earnings deteriorated. This year, rating agencies are forecasting that defaults will rise to a peak in the fourth quarter of 2009. Moody’s said on Monday that the default rate on bank loans to speculative-grade corporations had risen sharply in 2008 and recovery rates on leveraged loans dropped over the same period. It warned that this trend was likely to accelerate in 2009. While recovery rates fall and defaults rise, the complex and large debt loads put on companies in recent years will damp recoveries further. Sharon Ou, associate vice- president at Moody’s, said: “Given tight credit markets, a worldwide economic slump and a deteriorating issuer ratings mix, we expect default rates on leveraged loans will continue to climb in 2009 while recovery rates are expected to fall further.” Kenneth Emery, director at Moody’s, said: “The recent strong increase in loans’ share of total debt in issuers’ capital structures implies less protection for loan investors.”

395 THE THREAT POSED BY BALLOONING FEDERAL RESERVES

Published: March 23 2009 20:09 | Last updated: March 23 2009 20:09 The threat posed by ballooning Federal reserves By John Taylor An explosion of money is the main reason, but not the only one, to be concerned about last week’s surprise decision by the Federal Reserve to increase sharply its holdings of mortgage backed securities and to start purchasing longer term Treasury securities. First consider the monetary effects. When the Fed purchases public or private securities or makes loans to banks or to other private firms, it must finance them. The Fed can borrow the funds, or it can ask the Treasury to borrow the funds, or it can do it the old- fashioned way: create money. The Fed creates money in part by printing it but mostly by crediting banks with deposits at the Fed. Those deposits are called reserve balances and are the key component – along with currency – of base money or central bank money which ultimately brings about changes in broader money supply measures. These deposits or reserves have been exploding as the Fed has made loans and purchased securities. Six months ago reserves were $8bn, in a range appropriate for its interest rate target at the time. As of last week, reserves were nearly 100 times larger at $778bn, the result of creating money to finance loans to banks, investment banks, AIG, central banks and purchases of private securities. Before last week’s federal open market committee meeting, I projected these would increase to $2,215bn by the end of this year if the new Consumer and Business Loan Initiative of the Treasury were to be financed by money creation. With last week’s dramatic announcement, the Fed will have to increase reserves by another $1,150bn to $3,365bn by the end of the year if the securities purchases are financed by money creation. Quantitative easing or credit easing means that the growth rate of the quantity of money increases, but there is no monetary principle or empirical evidence supporting such an explosion. There is no question that this enormous increase from $8bn to $3,365bn will lead to higher inflation unless it is reversed. With the economy in a very weak state and commodity prices falling, inflation does not appear to be a problem now. The growth of reserves has led to an increase in the growth rate of the broader money aggregates, but less than proportionately because banks are still holding excess reserves. The Fed has expressed its concern about inflation with its new target-like longer term forecasts for inflation and by saying it will remove the reserves in due time. However, increases in money growth affect inflation with a long and variable lag. Will the Fed be able to change course in time? To do so, it will have to undertake the politically difficult task of getting more than $3,000bn of government securities, private securities and loans off its balance sheet. Making it more difficult are the extraordinary borrowing demands by the Treasury and the announcement of Treasury purchases by the Fed. Some argue that the unprecedented actions by the Fed are filling in for a lacklustre performance by the Congress and the administration, especially in light of the uproar over the AIG bonuses. But even if there are short-term benefits, they will be offset by the cost of lost independence of the Fed. What justification is there for an independent government agency to engage in such selective lending activities? The announcement by the Fed that it will

396 purchase long-term Treasuries is reminiscent of the period just before the Accord of 1951 when the Fed had little independence. The reason for these interventions is that the Fed wants to improve the flow of credit and lower interest rates for a wide range of borrowers. However, it is by no means clear that the interventions will be effective beyond a very short period, and they may be counterproductive. I found, for example, that the Term Auction Facility, set up to improve the functioning of the money market and drive down spreads on term interbank lending relative to overnight loans, had no noticeable impact on interest rate spreads. Such actions may have prolonged the crisis by not addressing the fundamental problems in the banks. These extraordinary measures have the potential to change permanently the role of the Fed in harmful ways. The success of monetary policy during the great moderation period of long expansions and mild recessions was not due to large discretionary interventions, but to following predictable policies and guidelines that worked. The writer, a professor of economics at Stanford and a senior fellow at the Hoover Institution, is the author of Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis.

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FINANCIAL DE-GLOBALIZATION, ILLUSTRATED Posted on Monday, March 23rd, 2009 By bsetser The financial world has changed — even if the scale of the change isn’t obvious in the financial sector’s 2008 bonuses.

Here is one indication of the scale of the change: the US government was — according to the latest US balance of payments data – a large net lender to the world. Yes, a net lender, not a net borrower. Foreign central banks are no longer providing the US with much new credit. Indeed, they withdrew $13.6 billion of credit from the US in the fourth quarter, as central banks’ agency sales ($96b) and the fall in their deposits in US banks (bank CDs fell by $80 billion) produced a net outflow despite record purchases of US treasuries ($179b, all short-term bills). And the US — through the Fed’s swap lines — provided a rather large sum of credit ($268 billion) to the rest of the world. For the year as a whole, the BEA data indicates the US government lent $534 billion to the rest of the world while foreign governments lent “only” $421 billion to the US. Judging from the data on net flows, Bretton Woods II has in some sense come to an end. The world’s central banks are no longer building up reserves and thus are no longer a net source of financing to the US. It just didn’t end in the way the critics of Bretton Woods II expected — on this, Dooley and Garber are right. The fall in official flows* was offset by a rise in (net) private inflows.

398 Then again, Bretton Woods II also didn’t anchor a stable international financial system in the way Dooley and Garber suggested either. Both private and official demand for US financial assets has collapsed. Gross inflows are close to zero.

How then can the US still run a large current account deficit if the rest of the world isn’t buying its financial assets? There is only one answer: Americans have pulled funds from the rest of the world (call it deleveraging, call it a reversal of the carry trade or call it a flight to safety) faster than foreigners have pulled funds from the US market. Words cannot really capture the sheer violence of the swings in private capital

399 flows that somehow produced a a rise (net) private demand for US financial assets. The modest change in net flows reflects an enormous contraction in gross flows. Look at the quarterly data — not a rolling four quarter sum — scaled to US GDP.** To put in in plain terms, Lehman’s collapse had a bigger impact on cross-border flows than 9.11. Compare q4 2008 to q3 2001. The enormous withdraw of private US lending to the world was offset, in part, by a surge in US official lending to the world. It was just the Fed, not the Treasury, that did all the heavy lifting.

For now, Dan Drezner doesn’t need to worry too much about the United States’ ability to be the world’s lender of last resort. A crisis may come when the US government cannot play a similar stabilizing role. But that crisis would be marked by a run out of the dollar — not a global scramble for dollars. The current crisis has constrained the United States’ ability to be the world’s importer of last resort, but not its ability to be the world’s lender of last resort. Not so long as the the world is scrambling to find dollars, the one currency the Fed can create. Here, my earlier concerns haven’t been born out. Still, it is hard to look at these charts and conclude all is well in the world. Cross-border financial flows rose to crazy heights during the credit boom. Thank the shadow financial system. Over the past year those flows have collapsed with stunning speed. Had the collapse in inflows and outflows not offset, there would now be talk of a sudden stop in capital flows to the US. But so long as the fall in demand for US assets is matched by a fall in US demand for foreign assets, a collapse in gross flows need not to lead to a collapse in net inflows. To date, the United States “sudden stop’ has manifest itself as a credit crisis not a currency crisis. The “great contraction” in private capital flows actually started in the summer of 2007. The pressure that led to Lehman’s failure — and the near-failure of a host of other financial institutions, not the least AIG — had been building for a while.

400 And it is also striking, at least to me, that financial globalization collapsed of its own weight, not because of any political decision to throw sand into its gears. That may yet happen. The political reaction to the financial excesses of the past few years is just beginning. But the fall in financial flows to date largely reflects the unwinding of a a host of leveraged bets made by the City and the Street — not demands from Whitehall or Washington. Indeed, without government intervention, the collapse in cross-border flows would have been far larger. If the government hadn’t stepped in, a host of financial institutions would have collapsed, leading to an even sharper contraction in capital flows. That is something that often seems to be lost in the debate over financial protectionism. The data for the charts can be found here. • The BEA data understates official flows from mid 2007 to mid 2008, as it hasn’t been revised to reflect the results of the survey data. Even the revised BEA data understates the impact of central banks and sovereign funds as it doesn’t capture those funds that have been handed over to private fund managers, or the purchases of US securities by European banks with a large dollar balance sheet as a result of large central bank deposits. This isn’t an issue for the tail end of 2008 though. The fall off in official demand is real. Central banks were in aggregate selling off there reserves — as the IMF’s forthcoming COFER data will show. • ** A negative outflow is functionally the same as an inflow; a current account deficit can be financed by borrowing from the world (an inflow), selling equity to the world (an inflow) or by reducing your lending to the world (a negative outflow, and since outflows have a negative sign of the balance of payments data, a negative outflow generates a positive flow) and/ or selling your existing stock of foreign investments (a negative outflow). http://blogs.cfr.org/setser/2009/03/23/financial-de-globalization-illustrated/

401 vox Research-based policy analysis and commentary from leading economists Reorganising the banks: Focus on the liabilities, not the assets

Jeremy Bulow and Paul Klemperer 21 March 2009

Fixing the banks is an absolute priority in G7 nations. Doing this by buying toxic assets is costly, inefficient, and risky. Governments should focus on which liabilities, rather than which assets, they need to support. This column proposes creating “bridge” banks as a way of re- establishing a healthy banking system. Summary of the argument 1. We cannot efficiently value or transfer “toxic” assets - so a good plan cannot depend upon this. 2. The UK’s Special Resolution Regime, or one similar to that of the US FDIC, can cleanly split off the key banking functions into a new "bridge" bank, leaving liabilities behind in an "old” bank, thus also removing creditors’ bargaining power. 3. Creditors left behind in the old bank can be fairly compensated by giving them the equity in the new bank. 4. We can pick and choose which creditors we wish to “top up” beyond this level, but should not indiscriminately make all creditors completely whole as in recent bailouts. 5. Coordinating actions with other countries will reduce any risks. As we pour good money after bad in trying to save the banks, far too much time and attention has been focused on attempting to value or transfer or shore up the so-called “toxic” assets. This is natural enough, since they arguably caused the crisis, but it’s also wrong. Here’s why. Flaws of the current approach First, the toxic assets are very difficult to value. Many are held by only one or two owners so there is no real market even in good times. And even if a hedge fund buyer and a bank seller both thought that an asset was worth 50, the bank might demand 80 in the hopes of receiving that price in the next government bailout. Furthermore, the banks may be the “natural” owners of these assets. Say a bank makes a construction loan. Even if the loan sours, the bank may be the most knowledgeable party to hold and possibly renegotiate the loan. Second, purchasing or guaranteeing “toxic” assets creates other problems too. Putting aside the obvious inequity of paying bank creditors a “risk premium” for having invested in failed businesses, how can we ever again rely on market signals to allocate capital efficiently among banks if their capital structures are effectively guaranteed by the government? And under schemes like the recent Citigroup, RBS and Lloyds bailouts, banks’ incentives to manage the “insured” assets are drastically reduced, as the government bears up to 90% of any marginal losses. Lastly and perhaps most important, the obvious fiscal risks associated with the huge

402 incremental costs of current policies may undermine confidence far more than paying off creditors in full may temporarily boost it, however superficially attractive the latter approach may seem. Re-establishing a healthy banking system is crucial, but doing so through the purchase of toxic assets is costly, inefficient, and risky. How to reorganise the banks How then can we make banks healthy without separating the “bad assets”? The answer is, instead, to separate the “bad liabilities”.* Take Citigroup, for example. At the end of 2008 the bank had roughly $1.8 trillion in liabilities on its consolidated balance sheet, of which less than $800 billion were deposits. Say Citi’s assets were worth $1.5 trillion. A new (“bridge”) bank that included all the assets plus say $1 trillion of the old bank’s most senior liabilities would still be comfortably well capitalised, even if the asset values were overestimated. The original bank would be left with all the equity in the new bank, worth $500 billion, and the remaining $800 billion in liabilities. The original bank would still be insolvent, but that would not prevent the healthy new bank from operating efficiently and making good loans. If a risky original bank's marginal cost of funds is, say, 10% it will not be profitable for it to make new riskless loans at 7%, even if the market riskless rate is zero. By contrast, because the new bank is well capitalised, it can borrow on sensible terms if it has a profitable investment to fund.1 Giving the old bank an equity stake in the new bank is the best way to compensate the holders of old bank’s liabilities to the full liquidation value -- but not more than that value -- of their claims. It may also facilitate the reorganisation of the old bank if, as is likely, it goes into bankruptcy, since creating marketable equity in the new bank resolves the difficulty of valuing the old bank's assets, and avoids any need to sell the new bank on to a third-party – a transaction from which the government might be unlikely to get full value.2 The reorganisation could be managed under a regime like the UK’s Special Resolution Regime (SRR) or similar to that of the US Federal Deposit Insurance Corporation (FDIC)3 (there may be other possibilities too). The government’s role ends when the old bank has sold its shares or allocated them amongst its creditors. Who loses? Paying all creditors at least their liquidation claims is probably a pre-requisite for maintaining market confidence. It is anyway mandated by the Fifth Amendment in the US and by Human Rights legislation in Europe, and it is enshrined as the “no creditor worse off” principle in the recently-enacted UK Banking Act. So both the FDIC and the SRR assure the non-guaranteed creditors of the banks that they will be paid at least as much as they would receive under a liquidation of the institution, but not that they will get back every penny they are owed.4 Under a liquidation the junior creditors would suffer losses of $300 billion in our example (and the old bank’s shareholders would be wiped out), unless there were further government subsidies. A key virtue of isolating the junior liabilities rather than the troubled assets is that while the government may then choose to subsidise some of the junior creditors’ losses, it can more easily get off its current path towards subsidising them 100%. For example, in the U.S. system the order of priority for debts is the following: (1) administrative expense of liquidation; (2) secured claims up to the value of collateral; (3) domestic deposits (both insured and uninsured); (4) foreign deposits and other general

403 creditor claims; (5) subordinated creditor claims; and (6) equity investors. Recently issued subordinated debt has been guaranteed by the government, which would therefore take any loss on those securities in a reorganisation. (The UK prioritisation is a little different; in particular, it does not make domestic deposits senior to foreign deposits or other general creditors). For a large bank like Citi or Bank of America the first three categories would be placed in the new bank, and so would be fully protected. Foreign depositors should probably also be made whole. As when the Icelandic banks defaulted, countries will try to “ring fence” the operations within their borders if their deposits are not paid. Furthermore, not paying foreign deposits would lead to tit-for-tat behavior and might increase systemic risk. Making these depositors whole, and protecting domestic depositors in a jurisdiction like the UK that does not have depositor preference, may give them more than their liquidation values, so the government would have to either infuse the new bank with enough capital that the claims of the remaining creditors would be worth as much as in a no-intervention insolvency, or make a cash payment directly to the old bank. (The infusion to the new bank makes its equity more valuable and therefore raises the value of the claims of the “original bank” creditors in insolvency. The amount of the equity infusion or cash payment is easily calculable if the new bank’s stock is traded, as explained in this note.5) However, other general creditors (other than those with a government guarantee) including non-guaranteed bondholders and owners of credit default swaps that are not fully collateralised need not be paid in full. The government may, if it wishes, choose to pay these creditors more than they would receive in liquidation. (It can even buy their claims from the old bank at full value and place them in the new bank.) But because the old bank’s creditors’ leverage would be reduced to their financial claims, and they would not have the threat of bankrupting the new healthy bank were they not paid in full, this need only be done when not doing so would contribute to systemic risk. If there is still concern that the new bank is undercapitalised, the government can infuse more equity, but in contrast to the current situation the infusion would no longer have to be large enough to pay off the junior creditors. Finally, coordinating actions with other countries would resolve the concern that some have expressed that if one country alone fails to bail out a category of creditors, its institutions will find it hard to raise funding in the future. International coordination may also make it politically much easier to favour some groups of systemically-important creditors (especially foreign ones) over others. For some banks, particularly those whose liabilities are almost entirely deposits, this approach may save little money relative to the current bailouts. And, of course, if it is systemically important to make every creditor completely whole, then there is no saving at all. But if the authorities do not believe that any bank creditors can be asked to lose a penny then they should say so. We can then stop worrying about things like whether, if the government buys (or “insures”) the troubled assets from the banks the government pays fair price or an extra couple of hundred billion, since in this case any overpayment simply reduces the amount the government will ultimately have to pay to make good all the creditors, by an equal amount. If governments feel that they need to absorb more of the risk in the system, they should consider whether providing subsidies to bank creditors is the most effective use of their funds. Conclusion A plan that isolates the bad liabilities rather than the bad assets of the banks, and pays the

404 owners of those claims everything they legally deserve in liquidation but does not fully immunise them from losses, will achieve three major objectives. • It will help unfreeze the credit markets by creating healthy banks able to lend. • It will assure that depositors are paid in full, and all creditors are paid at least their entitlement. • It will make the bailout cheaper for the government, increasing its flexibility. Finally, as an additional benefit, paying creditors based on market values rather than government guarantees reduces moral hazard in bank finance, and increases the prospect of better monitoring by sophisticated private creditors in determining the future allocation of capital across financial institutions. There will be a lot more we will need to do to solve the financial crisis -- let's not make the bank bailouts more expensive than absolutely necessary.

* While presented in the form of a plan, what follows is intended to raise questions that deserve answers, rather than make definitive recommendations; some of this might require other legal means than those suggested here.

1. Why do undercapitalised banks have difficulty funding good, relatively safe loans? First, because any new capital raised is effectively bailing out the senior creditors. If any capital raise has to come primarily from junior creditors, as is likely since the supply of depositors’ funds is relatively fixed, the senior creditors benefit because there will be more collateral available to secure their claims. If the new funds are used for any new zero net present value investment, then any gain of the senior creditors must be matched by an equal loss for the junior creditors – regardless of the riskiness of the new investment. So an undercapitalised bank will need a higher return on even the riskiest investments, if the funding must come from issuing more equity or junior debt. Second, shareholders in a risky bank are biased against safe investments. Say that a bank that wished to borrow 80 pounds had to promise to return 100 – reflecting a 20% chance of not paying – even when the riskless interest rate is zero. Say that it could make a riskless investment with these funds that would pay off 90 – well above the riskless market rate (of zero). The sum of these two transactions would be a bad deal for the shareholders because they will receive 10 pounds less if the bank is able to pay all its obligations in full, and nothing otherwise. In addition, the probability that they will wind up with nothing will increase, because the risky assets the bank already holds will need a 10 pounds higher payoff to pay off the bank’s debts in full. 2. We have put all the assets, including the "toxic" assets, into the new bank, because this avoids the need to value or trade them (except to the extent that the market will estimate the value when putting a price on the new bank’s equity). A possible danger--depending in part

405 upon regulatory rules--is that the new bank might nevertheless feel under pressure to sell these assets to improve its regulatory capital position. In that case, the "bad assets" might be better left behind in the old bank if the old bank’s liquidation procedures did not create even greater pressures to sell rather than to run to maturity or renegotiate, etc., as appropriate. (A plan that credibly focuses the government’s bailout efforts on liabilities rather than assets should reduce the difficulties of trading the troubled assets, but it may still be inefficient to trade them.) 3. An important difficulty in the US is that the FDIC procedures cannot be applied at the bank holding company level (where some large US banks hold significant assets and liabilities) rather than at the bank level, and subsidies may also be required at the holding company level to curtail system risk. It is easy to imagine a situation where the operating banks are themselves insolvent and perhaps appropriate for a “bridge” bank reorganisation, while at the same time the holding company would be required to go through Chapter 11 of the bankruptcy code in the US. In this case the US government might perhaps provide Debtor in Possession financing to the holding company as it resolved its affairs. 4. In fact, the SRR guarantees only that creditors will get back what would have been their liquidation values in the absence of prior government assistance. So the benefits they gained from the recent government schemes to insure their assets could be discounted from their liquidation values to compute their guaranteed minima. Whether the benefits that some groups of creditors gained from earlier bailouts, including the Lloyds/HBOS merger, can also be "taken back" by the government is beyond our legal expertise. 5. Say for example, that a bank had liabilities in the amounts of L1 and L2, both equal priority, but the government wished to elevate the seniority of L1 by making it a debt of the new bank. If the new bank, with this liability, establishes an equity value of E and a debt value of L1, the value of the L2 claim becomes E, whereas its previous value as an equal priority claim was ((E+L1) times L2/(L1+L2)), so the amount of a fair cash payment to the old bank is the difference between these values, which equals (L2-E) times L1/(L1+L2). (This reflects the facts that the excess of liabilities over assets is (L2-E), and the owners of L1 originally bore share L1/(L1+L2) of these losses).

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406

vox Research-based policy analysis and commentary from leading economists Global imbalances and the crisis: A solution in search of a problem Michael Dooley Peter Garber 21 March 2009

This column argues that current account imbalances, easy US monetary policy, and financial innovation are not the causes to blame for the global crisis. It says that attacking Bretton Woods II as a major cause of the crisis is an attack on the world trading system and a sure way to metastasise the crisis in the global financial system into a crisis of the global economic system. The current crisis is likely to be one of the most costly in our history, and the desire to reform the system so that it will not happen again is overwhelming. Our fear is that almost all this effort will be misdirected and unnecessarily costly. Three important misconceptions could lead to a disastrous reform agenda: 1. That the crisis was caused by current account imbalances, particularly by net flows of savings from emerging markets to the US. 2. That the crisis was caused by easy monetary policy in the US. 3. That the crisis was caused by financial innovation. In our view, a far more plausible argument is that the crisis was caused by ineffective supervision and regulation of financial markets in the US and other industrial countries driven by ill-conceived policy choices. The important implication of the crisis itself is that for the next few years, at least, the misbehaviour that flourished in this environment will not be a problem, unless replicated under government pressure to restore the flow of credit to the uncreditworthy. If anything, excessive risk aversion and deleveraging will limit effective private financial intermediation. So the first precept for reform is that there is no hurry. When markets recover, the key lesson is that the industrial countries need to focus on moral hazard, public and private, as the source of the problem and apply the prudential regulations they already have to financial entities that are too large to fail. It is not sensible to try to limit international trade and capital flows, to ask central banks to abandon inflation targeting, to stifle financial innovation, or to regulate entities such as hedge funds1 that do not generate systemic risks. International capital flows One “lesson” that seems to be emerging is that international capital flows associated with current account imbalances were a cause of the crisis and therefore must be eliminated or at least greatly reduced.2 The idea that fraud and reckless lending flourished because US financial markets were unable to honestly and efficiently intermediate a net flow of foreign savings equal to about 5% of GDP, while having no problem with intermediating much larger flows of domestic savings, is astonishing to us. If so, would not the much larger gross capital

407 flows into and out of the US also cause an outbreak of bad behaviour even without a net imbalance? If this were true, we would have to stop all capital flows, not just net imbalances. In the US context, we are unable to think of any plausible model for such behaviour. If capital inflows did not directly cause the crisis perhaps they did so indirectly by depressing real interest rates in the US and other industrial countries. We have emphasised that capital inflows to the US from emerging markets associated with managed exchange rates caused persistently low long-term real interest rates in both the US and generally throughout the industrial world (Dooley, Folkerts-Landau and Garber 2004, 2009). Low real interest rates in turn drove asset prices up, particularly for long-duration assets such as equity and real estate.3 At the same time, low real interest rates temporarily reduced credit risks and a stable economic environment generated a marked decline in volatility of asset prices. We have not argued that a “savings glut” in emerging markets is the fundamental driving force behind these capital flows. We have argued that the decisions of governments of emerging markets to place an unusually large share of domestic savings in US assets depressed real interest rates in the US and elsewhere in financial markets closely integrated with the US. These official capital flows are not offset, but reinforced, by private capital flows because managed exchange rate pegs are credible for China and other Asian emerging markets. Low risk-free real interest rates that were expected to persist for a long time, in the absence of a downturn, generated equilibrium asset prices that appeared high by historical standards. These equilibrium prices looked like bubbles to those who expected real interest rates and asset prices to return to historical norms in the near future. Along with our critics, we recognised that if we were wrong about the durability of the Bretton Woods II system and the associated durability of low real interest rates, the decline in asset prices would be spectacular and very negative for financial stability and economic activity. The hard landing predicted for Bretton Woods II was not to be caused by low real interest rates per se but by the sudden end to low interest rates as unsustainable capital inflows to the US were reversed. This is not the crisis that actually hit the global system. But the idea that an excessive compression of spreads and increased leverage were directly caused by low real interest rates seems to us entirely without foundation.4 The alternative hypothesis is that an effective deregulation of US markets driven by government-dictated social policy, especially in mortgage origination and packaging, allowed the ever-present incentive to exploit moral hazard to flourish.5 This could just as well have happened with stable or rising real interest rates, as it did, for example, during the lead up to the US S&L crisis in the 1980s, another government manufactured disaster. Falling real interest rates in themselves should make a financial system more stable and an economy more productive. Imagine a global system with permanent 4% equilibrium real interest rates. Now imagine a system with permanent 2% real interest rates. Why is one obviously more prone to fraud and speculation than the other? The vague assumption seems to be that capital inflows were large and interest rates were low, and this encouraged “bad” behaviour. The current conventional interpretation is that low interest rates and rising asset prices generated an environment in which reckless and even dishonest financial transactions flourished. One version of this story is that rising real estate prices led naïve investors to believe that prices would always rise so that households with little income or assets could always pay for a house with capital gains on that house. Moreover, households could borrow against these expected capital gains to maintain current consumption at artificially high levels. This pure bubble idea does not provide much guidance for reforming the international

408 monetary system. Clearly we should enforce prudential regulations that discourage people from acting on such expectations. But do we really want to reform away anything that causes real interest rates to fall and asset prices to rise? Easy money and financial innovation There is no sensible economic model that suggests that monetary policy can depress or elevate real long-term interest rates. The Fed could in theory target nominal asset prices (for example equity prices), but it would then lose control over the CPI. Would Alan Greenspan’s critics have preferred a monetary contraction necessary to depress the CPI enough to allow the real value of equities to rise? The Fed could, and may still, inflate away the real value of financial assets but this requires inflation as conventionally measured. This may yet come, but it was not a part of the story in recent years, and it is still not expected by market participants. Third in the roundup of usual suspects in the blame game is financial innovation. There is no doubt that innovation has dramatically altered the incentives of financial institutions and other market participants in recent years. Securitisation of mortgages, for example, clearly reduces the incentives for those that originate credits to carefully screen applications. But securitisation also reduced the cost of mortgage credit and increased the value of housing as collateral. Private equity facilitated the dismantling of inefficient corporate structures. Venture capital has directed capital to high-risk but high-reward activities. Before we give up these benefits we need to ask if it is possible to retain the advantages of these innovations without the costs associated with the current crisis. The problem was not financial innovation but the failure of regulators to recognise that innovation generated new ways to exploit moral hazard. Even more, it was the wilful ignorance of policymakers in often overriding the instincts of regulators and financial institutions in order to implement a desired flow of funds to uncreditworthy borrowers. Fraud is not a financial innovation. The unhappy fact is that any change in the financial environment can generate new ways to undertake dishonest and imprudent positions. The regulators in turn have to adapt their procedures for monitoring and discouraging such activities. If it is really the case that regulators cannot understand the risks associated with modern financial markets and instruments, then there is a strong case for trying to return to a simple and relatively inefficient system. But we do not believe the story that no one can understand these innovations. To the contrary, it seems clear to us that the bankers that used these innovations to exploit moral hazard knew very well what they were doing and why. The first-best response to this is to attract a few of the many quants who are now unemployed to help enforce the prudential regulations already on the books. Conclusions In this crisis, three macro-financial institutional arrangements remain to hold the financial system together. These are the dollar as the key reserve currency with US Treasury securities as the ultimate safe haven, the integrity of the euro, and the global monetary system as defined by the Bretton Woods II view. Attacking the latter as a major cause of the crisis and seeking its end is, at the end of the day, an attack on the basis of the international trading system. It is a sure way to metastasise the crisis in the global financial system further into a crisis of the global economic system. References Bernanke, Ben (2007) “Global Imbalances: Recent Developments and Prospects" speech delivered at Bundesbank Berlin September 11. BIS 78th Annual Report (2008).

409 Dooley, Michael P., David Folkerts-Landau and Peter M. Garber (2004) “The Revived Bretton Woods System,” International Journal of Finance and Economics, 9:307-313. Dooley, Michael P., David Folkerts-Landau and Peter M. Garber (2009) “Bretton Woods II Still Defines the International Monetary System,” NBER Working Paper 14731 (February). Dunaway, Steven, Global Imbalances and Financial Crisis, Council for Foreign Relations Press, March, 2009. Economic Report of the President (2008) Economist (2009) When a Flow Becomes a Flood,” January 22. Paulson, Henry (2008) “Remarks by Secretary Henry M. Paulson, Jr., on the Financial Rescue Package and Economic Update,” U.S. Treasury press release, November 12. Sester, Brad (2008) “Bretton Woods 2 and the Current Crisis: Any Link?", Council on Foreign Relations Notes 1. Of course, a bank thinly disguised as a hedge fund should be regulated as a bank just as a hedge fund thinly disguised as a bank should be. 2. See Paulson (2008), Dunaway (2009). 3. This is arithmetic, not economics. A permanent fifty percent decline in the level of real interest rates, for example from 4% to 2%, is the same thing as a doubling of an infinite maturity financial asset’s price, provided that the payout from that asset is unchanged. For practical purposes, thirty years is good enough to about double prices. 4. This view has taken hold in central banks see Bernanke (2007), Hunt (2008), BIS (2008). In the financial press, see Sester (2008) and Economist (2009). It should be noted for the record that these claims are always raw assertions, without theoretical, empirical, or even logical basis. 5. The financial system problems in many other countries are independent of regulatory problems in the US. The banking collapses in Iceland, the UK, and Ireland were home grown. The loans of the European banking system to Eastern Europe and to emerging markets in general were independent of US financial system behavior. http://www.voxeu.org/index.php?q=node/3314

410 CREDIT BUBBLE BULLETIN MISTAKES BEGET GREATER MISTAKES by Doug Noland

March 20, 2009 March 18 – Bloomberg (Kathleen Hays and Dakin Campbell): “Bill Gross, co-chief investment officer of Pacific Investment Management Co., said the Federal Reserve’s purchases of Treasuries and mortgage securities won’t be enough to awaken the economy. ‘We need more than that,’ Gross said… The Fed’s balance sheet ‘will probably have to grow to about $5 trillion or $6 trillion,’ he said.”

“The problem with discretionary central banking is that it virtually ensures that policy mistakes will be followed by only greater mistakes.” Here, I’m paraphrasing insight garnered from my study of central banking history. Naturally, debating the proper role of central bank interventions - in both the financial sector and real economy – becomes a much more passionate exercise following boom and bust cycles. The “Rules vs. Discretion” debate became especially heated during the Great Depression. It was understood at the time that our fledgling central bank had played an activist role in fueling and prolonging the twenties boom - that presaged The Great Unwind. Along the way, this critical analysis was killed and buried without a headstone. I believe the Bernanke Fed committed a historic mistake this week – compounding ongoing errors made by the Activist Greenspan/Bernanke Federal Reserve for more than 20 years now. I find it rather incredible that Discretionary Activist Central Banking is not held accountable – and that it is, instead, viewed as critical for a solution. Apparently, the inflation of Federal Reserve Credit to $2.0 TN was judged to have had too short of a half-life. So the Fed is now to balloon its liabilities to $3.0 TN, as it implements unprecedented market purchases of Treasuries, mortgage-backed securities, and agency and corporate debt securities. And what if $3.0 TN doesn’t go the trick? Well, why not the $5 or $6 TN Bill Gross is advocating? What’s the holdup? Washington fiscal and monetary policies are completely out of control. Apparently, the overarching objective has evolved to one of rejuvenating the securities and asset markets and inciting quick economic recovery. I believe the principal objective should be to avoid bankrupting the country. It is also my view that our policymakers and pundits are operating from flawed analytical frameworks and are, thus, completely oblivious to the risks associated with the current course of policymaking. Today’s consensus view holds that inflation is the primary risk emanating from aggressive fiscal and monetary stimulation. It is believed that this risk is minimal in our newfound deflationary backdrop. Moreover, if inflation does at some point rear its ugly head the Fed will simply extract “money” from the system and guide the economy back to “the promised land of price stability.” Wording this flawed view somewhat differently, inflation is not an issue - and our astute central bankers are well-placed to deal with inflation if it ever unexpectedly does become a problem. Our federal government has set a course to issue Trillions of Treasury securities and guarantee multi-Trillions more of private-sector debt. The Federal Reserve has set its own course to balloon its liabilities as it acquires Trillions of securities. After witnessing the disastrous financial and economic distortions wrought from Trillions of Wall Street Credit

411 inflation (securities issuance), it is difficult for me to accept the shallowness of today’s analysis. In reality, the paramount risk today has very little to do with prospective rates of consumer price inflation. Instead, the critical issue is whether the Treasury and Federal Reserve have set a mutual course that will destroy their creditworthiness - just as Wall Street finance destroyed theirs. Additionally, what are the economic ramifications for ongoing market price distortions? The counterargument would be that Treasury and Fed stimulus are short-term in nature – necessary to revive the private-sector Credit system, asset markets and the real economy. That, once the economy is revived, fiscal deficits and Fed Credit will recede. I will try to briefly explain why I believe this is flawed and incredibly dangerous analysis. First of all, for some time now global financial markets and economies have operated alongside an unrestrained and rudderless global monetary “system” (note: not much talk these days of “Bretton Woods II”). There is no gold standard - no dollar standard – no standards. I have in the past referred to “Global Wildcat Finance,” and such language remains just as appropriate today. Finance has been created in tremendous overabundance – where the capacity for this “system” to expand finance/Credit in unlimited supplies has completely distorted the pricing for borrowings. As an example, while Total US Mortgage Credit growth jumped from $314bn in 1997 to about $1.4 TN by 2005, the cost of mortgage borrowings actually dropped. It didn’t seem to matter to anyone that supply and demand dynamics no longer impacted the price of finance. Yet such a dysfunctional marketplace (spurred by unrestrained Credit expansion) was fundamental in accommodating Wall Street’s self-destruction. Today, the markets will lend to the Treasury for three months at 21 bps, 2 years at 84 bps and 30 years at 371 bps. I would argue that this is a prime example of a dysfunctional market’s latest pricing distortion. As it did with the Mortgage Finance Bubble, the marketplace today readily accommodates the Government Finance Bubble. And while on the topic of mortgage finance, the Fed’s prodding has borrowing costs back below 5%. This cost of finance also grossly under-prices Credit and other risks. I would argue that market pricing for government and mortgage finance remains highly distorted – a pricing system maligned by government intervention on top of layers of previous government interventions. These contortions become only more egregious, and I warn that our system will not actually commence its adjustment and repair phase until some semblance of true market pricing returns to the marketplace. Yet policymaking has placed peddle to the metal in the exact opposite direction. The real economy must shift away from a finance and “services” structure – the system of “trading financial claims for things” – to a more balanced system where predominantly “things are traded for other things.” Such a transition is fundamental, as our system commences the unavoidable shift to an economy that operates on much less Credit of much greater quality. But for now, today’s Washington-induced distorted marketplace fosters government and mortgage Credit expansion – an ongoing massive inflation of non-productive Credit. I would argue this is tantamount to a continuation of Bubble Dynamics that have for years misallocated financial and real resources. In short, today’s flagrant market distortions will not spur the type of true economic wealth creation necessary to service and extinguish previous debts – not to mention the Trillions and Trillions more in the pipeline. Market confidence in the vast majority of private-sector Credit has been lost. This Bubble has burst, and the mania in “Wall Street finance” has run its course. The private sector’s capacity to issue trusted (“money-like”) liabilities has been greatly diminished. The hope is that

412 Treasury stimulus and Federal Reserve monetization will resuscitate private Credit creation; that confidence in these types of instruments will return. I would counter that once government interventions come to severely distort a marketplace it is a very arduous process to get the government out and private Credit back in (just look at the markets for mortgage and student loan finance!). This is a major, major issue. The marketplace today wants to buy what the government has issued or guaranteed (explicitly and implicitly). Market operators also want to buy what our government is going to buy. In particular, the market absolutely adores Treasuries, agency MBS, and GSE debt. There is no chance that such a system will effectively allocate resources. There is today no prospect that such a financial structure will spur the necessary economic overhaul. None. There is indeed great hope policymakers will succeed in preserving the current economic structure. On the back of massive stimulus and monetization, the expectation is that the financial system and asset prices will stabilize. The economy will be, it is anticipated, not far behind. And the seductive part of this view is that unprecedented policy measures may actually be able to somewhat rekindle an artificial boom – perhaps enough even to appear to stabilize the system. But seeming “stabilization” will be in response to massive Washington stimulus and market intervention – and will be dependent upon ongoing massive government stimulus and intervention. It’s called a debt trap. The Great Hyman Minsky would view it as the ultimate “Ponzi Finance.” As I’ve argued on these pages, our highly inflated and distorted system requires $2.0 TN or so of Credit creation to hold implosion at bay. It is my belief that this will ONLY be possible with Trillion-plus annual growth in both Treasury debt and Federal Reserves liabilities. Private sector Credit creation simply will not bounce back sufficiently to play much of a role. Mortgage, consumer, and business Credit – in this post-Bubble environment - will not re- emerge as much of a force for getting total system Credit near this $2 TN bogey. In this post- Bubble backdrop, only government finance has a sufficient inflationary bias to get Trillion-plus issuance. But the day that policymakers try to extract themselves from massive stimulus and monetization will be the day they risk an immediate erosion of confidence and a run on both government and private Credit instruments. Also as I’ve written, once the government "printing press" gets revved up it’s very difficult to slow it down. This week currency markets finally took this threat seriously. http://www.prudentbear.com/index.php/home Conclusión: Es la Solución Bill Gross-PIMCO. Hay que parar a Geither, pero no porque su plan no vaya a funcionar. Probablemente funcionará, porque los precios de los activos de respaldo ya están próximos a su valor sostenible. Pero a la larga, la solución será peor porque la industria bancaria sumergida y corrupta será quien salve la situación, apoderándose del sistema. A no ser que Geither tenga otros cortafuegos preparados.

413 February 26, 2009 A Proven Framework to End the US Banking Crisis Including Some Temporary Nationalizations | Apr 2, 2009 Testimony before the Joint Economic Committee of the US Congress hearing, “Restoring the Economy: Strategies for Short-term and Long-term Change” Chairwoman Maloney, members of the Committee, thank you very much for inviting me to testify today at this critical juncture in American economic policymaking. I am especially honored to be following the testimony of Paul Volcker, one of the greatest public servants this country has had in the economic sphere, to whose wisdom we all would do well to listen. Today, we face extreme financial fragility and, as a result serious, risks to our economy’s prospects for a sustainable recovery from its current troubles. Congress must grapple with difficult choices about America’s banks, and it must make those choices soon. Making the right choices now will require money upfront, large amounts of taxpayer money, and thus it is necessary as well as right for Congress to lead on this issue. But making the right policy choices now will restore US economic growth much sooner, at much lower cost, and on a sounder basis than trying to kick the trouble down the road or waiting for events to force the issue. Members of this committee are well familiar with such warnings, usually with respect to far-off economic problems. This time and this problem, however, are costing our citizens their jobs, homes, and hard-earned savings right here and now. And the correct policy response right now will make all the difference. Luckily, although the scale of the banking problem that we now face is unfamiliar to us, the kind of banking problem we face today is familiar, and in fact well understood. We have seen this before in the United States in the mid-1980s Savings and Loan crisis, in Japan’s post bubble Great Recession of the 1990s, in the Nordic countries from 1992–95, and many times in many other countries. It is reasonable to ask why these kinds of crises keep happening, and how to prevent them in future. I would be happy to discuss that, but that is of lesser importance to our current circumstances. It is also reasonable to ask why economists who did not foresee the current crisis can be trusted to give advice with great assurance now that the crisis has hit. I would say this is analogous to the doctor who does not foresee that his patient’s common cold will turn into pneumonia (or at least saw it as quite unlikely), but knows how to treat the pneumonia once it occurs. So today I would like to advise you on how to cure our financial pneumonia, rather than letting it runs its course, before it causes permanent damage or leads to the hospitalization of our economy. And the prescriptions I will give are based on many prior cases, particularly what worked to bring financial recovery in the United States in 1989 and in Japan in 2001, which are the crisis most similar to the current condition.[1] In brief, I would urge the Congress to have the US government: • Recognize that the money is gone from the banking system, and banks already are in a dangerous public-private hybrid state;

414 • Immediately evaluate the solvency and future viability of individual banks; • Rapidly sort the banks into those that can survive with limited additional capital and those that should be closed, merged, or nationalized; • Use government ownership and control of some banks to prepare for rapid resale to the private sector, while limiting any distortions from such temporary ownership; • Buy illiquid assets on the Resolution Trust Corporation (RTC) model, and avoid getting hung up on finding the “right price” for distressed assets or trying to get private investment up front, which will only delay matters and waste money; • When reselling and merging failed banks, do so with some limit on bank sizes; • And do all of this before the stimulus package’s benefits run out in mid-2010. This set of decisive actions is feasible and can be rapidly implemented, and follows a proven path to the resolution of banking crises. Implementing this program should spare us the fate of squandering additional national wealth and of postponing recovery for years that resulted from policy half- measures in Japan in the 1990s and in the United States in the 1980s. Similar policy frameworks were adopted and resolved those crises in the end, but only after delay cost dearly. Recognize That the Money Is Gone from the Banking System, and Banks Already Are in a Dangerous Public-Private Hybrid State There are statements in the press of late by bank managers and unnamed administration sources that some major banks currently under suspicion of insolvency actually have sufficient capital, or, slightly less dubiously, would have sufficient capital if only they were not forced to mark their assets to current low market values. These statements should be treated with extreme skepticism if not disdain. There are certainly some American banks that are either solvent, or sufficiently close to solvency that they can be returned to viability at little cost, despite the severe recession and market declines. But I agree with the vast majority of independent analysts and the obvious market verdict that sadly for many of our largest banking institutions solvency is but a far-off aspiration at present. And it is the present condition that matters. In the mid-1980s in the United States and most of the 1990s in Japan, bank supervisors engaged in regulatory forbearance, meaning they held off intervening in or closing banks with insufficient capital in the hope that time would restore asset values and heal the wounds. One can easily imagine the incentives for the bank supervisors, well documented in historical cases and the economic data, not to have a prominent bank fail on their watch. The problem, also evident in these historical cases and in the economic data, is that top management and shareholders of banks know that supervisors have this interest, and respond accordingly. The managers and shareholders do everything they can to avoid outright failing, which fits their own personal incentives. That self-preservation, not profit-maximization, strategy by the banks usually entails calling in or selling off good loans, so as to get cash for what is liquid, while rolling over loans to bad risks or holding on to impaired assets, so as to avoid taking obvious losses, and gambling that they will return to value. The result of this dynamic is to create the credit crunch of the sort we are seeing today, and this only adds to the eventual losses of the banks when these losses are finally recognized.[2] The economy as a whole, and nonfinancial small businesses in particular, suffer in order to spare the positions of current bank shareholders and top management (and, on the firing line, bank supervisors).

415 The guarantees that the US government has already extended to the banks in the last year, and the insufficient (though large) capital injections without government control or adequate conditionality also already given under Troubled Assets Relief Program (TARP), closely mimic those given by the Japanese government in the mid-1990s to keep their major banks open without having to recognize specific failures and losses. The result then, and the emerging result now, is that the banks’ top management simply burns through that cash, socializing the losses for the taxpayer, grabbing any rare gains for management payouts or shareholder dividends, and the banks end up still undercapitalized. Pretending that distressed assets are worth more than they actually are today for regulatory purposes persuades no one besides the regulators, and just gives the banks more taxpayer money to spend down, and more time to impose a credit crunch. These kinds of half-measures to keep banks open rather than disciplined are precisely what the Japanese Ministry of Finance engaged in from the time when their bubble burst in 1992 through to 1998, and over that period the cost to the Japanese economy from bad lending quadrupled from 5 percent to over 20 percent of Japanese GDP. In addition, this “convoy” system, as the Japanese officials called it, punished any better-capitalized and -managed banks that remained by making it difficult for them to distinguish themselves in the market; falsely pumping up the apparent viability of bad banks will do that. That in turn eroded the incentive of the better and more-viable banks to engage in good lending behavior versus self- preservation and angling for government protection. I believe, regrettably, that is what is happening now in the United States under the current half- measures. This is why further government intervention in the banking system, based on recognizing real losses and insolvencies is to be welcomed, not feared. So long as American banks have partial government guarantees and public funds to play with, but retain current shareholders and top management, they have perverse incentives and losses will mount. Think of Fannie Mae and Freddie Mac gambling with taxpayer dollars when having government guarantees but private claims on the profits and thus incentives for management and shareholder self-preservation. Hybrids are a good technology for autos; public-private hybrids are a terrible form for financial institutions. Thus, bending over backwards to keep all of the banking system in private hands without changing their management, while extending further government guarantees and investments is a recipe for disaster on the public’s accounts. Immediately Evaluate the Solvency and Future Viability of Individual Banks The first step to ending these perverse incentives, and getting us away from the destructive, undercapitalized, private-public hybrid banking system we now suffer under, is to get the books in order without hesitation about declaring banks insolvent based on current valuations. It was that kind of aggressive, intrusive, and published, honest evaluation by Japanese officials of their banks in 2002 that was the first policy step in finally ending their banking crisis. Treasury Secretary TimothyGeithner has acknowledged the need for evaluations, and will shortly be implementing “stress tests” on the 20 largest US banks. Unfortunately, it remains to be seen whether the supervisors and regulators sent in to make these evaluations will be sufficiently merciless in discounting the value of current assets. The administration has given conflicting signals on this point so far. Much of the opening rhetoric in the Secretary’s statements on the matter is tough, which I applaud. The statement that the stress tests will be implemented in a “forward-looking” manner, however, potentially opens the door to backsliding. We are in the midst of a very severe recession, and a huge asset price decline, when most things that could have gone wrong have gone wrong. So it seems reasonable that the current situation is about the most stress that banks’ balance sheets could be expected to come under. Why bother considering worse

416 situations, since all too many banks will fail the tests under the present stresses? In the United States in the 1980s with the Savings and Loans crisis, and in Japan in the 1990s with all their banks, forward-looking (by other names) assessments ended up being forms of forbearance. When the assessments took into account future periods when conditions would be calmer and asset values would be higher than they were during the crises, they gave the banks an unjustified reprieve. Granting such a self-defeating lifeline would also seem to be consistent with the administration’s repeated statements that they wish to keep the examined banks not only open and lending, but under continued private, and thus current, shareholder and management control. If this is the case, and I hope I am worrying unduly, it would be a grievous mistake. The fact that bank shares for many suspect banks have stopped dropping with the announcement of these programs, however, is another signal that many believe the stress tests will be beneficial to current bank shareholders. This stabilization, if not bump, in bank share prices cannot be based on a belief that the suspect banks will be revealed by the stress tests to be in truly better shape than the market believed them to be in until now, for then the private money sitting on the sidelines would be moving to acquire the (in that case) undervalued banks. Another red herring, which I also fear indicates reluctance to do what is needed, are the occasional statements that the process will take several weeks or more, and will be difficult to implement given staffing constraints and the complexity of banks’ balance sheets. There is no shortage of unemployed financial analysts looking for consulting work, and there is no need to be all that caught up in getting precisely the “right” price on various distressed assets (as I will explain). The implementation difficulties of such evaluations are surmountable, as they were in other countries, such as Japan, which had a new, unproven Financial Services Agency in place when it got tough in 2002, and here at home when the first Bush administration took on the S&L crisis in 1989–91. Furthermore, what have the bank supervisors of the FDIC, the Federal Reserve Bank of New York, et al. been doing for the last several years if not getting some sense of these banks’ balance sheets? The Treasury cannot make public claims that the banks’ balance sheets will be revealed to be better than expected, based on supervisory information, at the same time that it claims that making the evaluations of the balance sheets will be daunting. So, strict, immediate evaluations of bank balance sheets are agreed upon at least in form. Regrettably, there is some risk that the forward-looking stress tests may indeed be yet another transfer of taxpayer dollars to current bank shareholders. The people’s representatives in Congress should not stand for this. If it turns out that congressional insistence on tough love for the banks merely stiffens the spine of the Treasury, FDIC, and Federal Reserve to do what they intended to do anyway, so much the better. Their apparent reluctance to pull the trigger on tough evaluations may be based on fears in the administration that such forced write-offs would require the unpopular steps of another injection of public funds and/or a round of closures, either way involving some government ownership of those banks. Those fears can be forestalled through your committee clearly stating that this kind of tough evaluation is in the public interest, and the benefits outweigh the costs. You and your colleagues can and should make the stress tests work. Rapidly Sort the Banks into Those That Can Survive with Limited Additional Capital and Those That Should Be Closed, Merged, or Temporarily Nationalized Banks think with their capital. As discussed, when their capital is too low, the incentives for their top management and shareholders are perverted and run contrary to the public interest. Simply giving capital to all the banks that are judged to need some, however, is a mistake. It

417 spends taxpayer money we do not need to spend, and it rewards bad behavior by treating all banks equally, no matter how much capital they squandered. It is better to triage the banks quickly into categories by their viability on the basis of capitalization.[3] This is what the Swedish government did rapidly with great success in 1992, when their banking crisis hit, and is what the Japanese government got around to finally doing in 2002, when their banking resolution became serious. The capitalization criteria should not be simply whether the net position after strict balance sheet evaluation is above or below zero, i.e., solvency. As we learnt during the Savings and Loan crisis, and as therefore reflected in the Federal Deposit Insurance Corporation Improvement Act (FDICIA), which allows supervisors to take over banks that have capital ratios of 2 percent, by the time you get to zero it is too late (of course, right now, the problem is that capital ratios will already be well below zero for many of the largest banks). So the three categories should be: 1. Banks with clearly positive capital that only need a topping-off to return to health and healthy behaviors; 2. Banks with low or slightly negative capital where removal of limited bad assets could restore viability; 3. And banks with clearly negative capital and large, difficult to unwind, portfolios of bad assets. The first category should receive their capital topping-off from public fund injections through preferred shares or other loans of liquid nonvoting capital. This format, combined with a clean bill of health from credible inspections, should lead to rapid repayment of these banks’ public funds. Yes, this is what was tried in the early days of the crisis and TARP; that did not work because it was wishful thinking at best to do so for all the major banks indiscriminately before credible balance sheet evaluations were completed. But for those banks within striking distance of solidly positive capital ratios, this is the right way to go. The second category of banks likely includes many of the mid- to large-size, but not the largest-size, banks in our system. These are banks that cannot get back to clearly positive capitalization once their bad assets are fairly written off, but whose balance sheets can be rapidly cleaned up by bad asset sales and whose capital needs are not overwhelming. Banks in this category are usually sold off, in part or whole, to other banks, or are merged with stronger banks combined with some injection of public capital. As part of this process, current top management is usually replaced (perhaps“naturally” in a merger process), and current shareholders’ equity is diluted (though discounted purchases of bank components, public minority ownership of some common equity, or both). It is the third category that grabs the political attention and that unfortunately is likely to include some of our most systemically important banks. Clearly insolvent banks with no rapid way to sell off their assets at a discount would be unwound in an orderly fashion under FDICIA, but in essence liquidated over time if they were small and did not present a systemic risk. That has already happened during this cycle to a few American institutions, such as IndyMac, and even in Japan’s lost decade, some minor institutions (like Hokkaido Tokushokku bank, Japan’s 19th or 20th largest in 1998 when it was allowed to fail) were wrapped up in this fashion, despite the general reluctance to close banks. Obviously, the issue is what to do about systemically important large institutions with difficult to unwind balance sheets. And this is the category for which temporary nationalization of the insolvent banks is the right answer.

418 In short, nationalization is only relevant for a part of the banking system under crisis, even for only a part of the technically insolvent banks, but it is necessary for the most systemically important banks that are insolvent. These banks must be kept in operation and have their positions and bad assets unwound in deliberate fashion. They also must have top management replaced and current shareholders wiped out. This is because the amount of capital required to restore them back to functionality is so large, and the process of restructuring their balance sheets so complex, with both having the potential to influence markets for other banks’ equity and asset prices, that only the government can do it. There will likely be private buyers a plenty for such a bank when the recapitalization and unwinding process is complete, but not before the restructuring begins. In a corporate takeover that requires significant restructuring of the acquired company, new private owners will always demand majority voting control and removal of current top management, who are accountable for the accumulated problems. The American taxpayer would be ill-served to receive anything less for putting in the vast amount of money needed to restructure and recapitalize these failed private entities. And the American taxpayer, just like any acquirer of distressed assets, deserves to reap the upside from their eventual resale. That basic logic is why failed banks that are too systemically important to shut down should be nationalized temporarily. That is what the Japanese government ended up doing with Long Term Credit Bank and Nippon Credit Bank, two of Japan’s systemically most important banks at the start of the 1990s, and thus banks that could not simply be shut down. Use Government Ownership and Control of Some Banks to Prepare for Rapid Resale to the Private Sector, While Limiting Any Distortions from Such Temporary Ownership Nationalization of some banks is solely the damage-limiting option under the current crisis circumstances. It beats the alternative of taxpayer handouts to the banks without sufficient conditionality, leaving financial fragility undiminished. Nationalization has its costs, however, beyond the upfront money provided and risks assumed by the government. No one in their right mind wants the United States or any government owning banks for any longer than absolutely necessary.[4] The Mitterand government nationalized French banks in the early 1980s as a matter of socialistideology, not necessity, intending to keep the banks in the public sector, and that was a huge mistake. The resultant misallocation of capital interfered with innovation and discipline in the French economy, and reduced the annual rate of growth in productivity and GDP by three or four tenths of a percent, which compounded over several years makes a huge difference.[5] But that was an unneeded governmental takeover of viable banks kept in place for a long period. The key is that government control is kept temporary, with sell-offs of distressed assets and viable bank units back to the private sector to commence as soon as possible, some of which can begin almost immediately. The historical record suggests that this kind of turnaround is not so difficult to achieve. That is what was seen with what became Shinsei bank in Japan (purchased by American investors after Long- Term Credit Bank was nationalized and cleaned up) as well as with the top five banks in Sweden in 1992–95. In both Japan and Sweden, most nationalized banks were reprivatized within two years, and all within three. And in all these cases there were private buyers when the governments were ready to reprivatize the banks, something that did not exist for these failing institutions before the government undertook restructuring. As is well known, in these cases the responsible government made back at least 80 percent of their costs, in the Swedish case turning significant profits for the taxpayers.

419 Furthermore, these banks continued most of their day-to-day operations during the nationalization period, retaining most personnel except top management. Given government majority ownership, it is possible to set up independent management, just as boards representing owners, public or private, always delegate to managers of complex organizations. New managers could be easily brought in from the among the many bank executives who specialized in traditional lending and banking and who ended up on the outs when American banks emphasized investment banking and other bonus- based securities businesses in recent years. The new managers could even be incentivized properly, the way we should consider incentivizing all bank managers: with long-term stock options instead of annual bonuses (some combination of public-service motivations, very high upside potential, and facing unemployment would yield sufficient numbers). Of course, there will be some pressures for politically driven lending, but transparency arrangements could go a long way to limiting that, and it is difficult to imagine that remaining shareholders and top management of banks in the current public-private hybrid situation would not have every (destructive) incentive to politically pander in hopes of keeping their job and their stake. The difference in efficiency and politicization of lending between the current situation and full nationalization of some banks will not be all that great, which is what was seen with the zombie banks in Japan in the late 1990s, and our Savings and Loans in the mid- to late-1980s—just pandering to politically connected borrowers in order to stay open as private concerns. Importantly, the existence of nationalized banks in banking systems that still had private banks operating as well did not lead to excessive pressures on their private competitors, let alone significant shifts of business or deposits away from those private banks. This can be seen today in the United Kingdom, where the government’s large ownership stakes in some major banks such as RBS and HBOS has not led to closures of or runs on the remaining private banks; in Switzerland, where the de facto public takeover and guarantee of UBS has not noticeably harmed the still private Credit Suisse; and in Germany and France, where private banking firms have continued to operate despite theongoing presences of Credit Lyonnais and the Sparkassen as government subsidized and part-owned entities. Again, nationalization is not cost free, for over time such public ownership arrangements do eat away at the private banks’ profitability and proper allocation of credit, which in turn hurts productivity and income growth. But additional inaction today regarding the fragile US banks leaving current management in charge has the prospect of rapidly adding several full- percentage points of GDP to the total of bad loans and losses in just the span of months, which is a much higher cost. It also risks a failure of a major financial institution without warning, before the government can respond, which would have large negative repercussions in the current environment: Nationalization wins out on the stability criteria as well, versus our status quo, in the short-run. Japan in 1998 demonstrated the unfortunate lesson that half- measures that stop short of nationalization backfire, when it gave the private banks more capital, only to find them running out of money and having accumulated further bad assets when a new, more actively reformist government took power three years later. Buy Illiquid Assets on the RTC Model, and Avoid Getting Hung up on Finding the “Right Price” for Distressed Assets or Trying to Get Private Investment up Front, Which Will Only Delay Matters and Waste Money To complete the full restructuring of the nationalized banks, or for that matter even the more- minor capital topping-off of the viable banks, when starting from honest evaluations of balance sheets, someone has to get the bad assets off of the banks’ books. The utility of so doing is widely recognized. The Treasury has proposed setting up a complicated not-bad but

420 aggregator public-private entity to serve this purpose. As with the stress tests, if the current US Treasury only says such things to sugar coat a tougher, less passive intent in practice, so much the better. The American government should be benefitting the taxpayer by paying as conservatively low a price as possible for our banking system’s distressed assets, and if that means having to increase the capital injections on one hand to make up for the write-offs from low prices on the other, in terms of net public outlay it is little different, but more of the future claims on the bad assets’ value is kept in US taxpayers’ hands. As Alan Greenspan has observed, if we nationalize the banks, we do not need to worry about the pricing.[6] The Treasury’s proposal for creating a complex, public-private aggregator bank instead of a wholly publicly owned, simple, RTC-like bad bank is motivated by two aspirations: to mobilize “smart money” currently sitting on the sidelines to share the upfront costs of buying the bad assets; and to generate price discovery about what the bad assets are really worth, particularly for illiquid assets for which there is no market. These are well-motivated aspirations, but in my opinion penny wise and pound foolish with taxpayer funds at best, and simply unattainable at worst. It is worth noting that there is no historical precedent for making such an attempt for price discovery and costs sharing with the accumulated bad assets. Simple, publicly owned, RTC-like entities sufficed in the Swedish and Japanese cases, and of course in the US Savings and Loan case that set the precedent. A new and clever approach always could be an improvement in theory, but this particular one seems to share with the reverse auction ideas of the initial TARP proposal a desire to be too clever by half. It is just as arbitrary to set prices for the bad assets by deciding how much guarantee or subsidy the private investors receive from the government to induce them to get back into the game as it would be to go into the banks and just pay what the markets are offering, which would be zero right now.

There will not be any price discovery through private-sector means by undertaking such a program because the only difference between these assets, unwanted now and then, is the value of the government guarantee (subsidy) on offer. Private investors are obviously not buying the distressed assets now, which they could do at the current low price, so the price will be set by the amount of the US government’s transfer to these private buyers. At best, this gets the toxic assets off of the various banks’ balance sheets, but at a far higher eventual cost to the taxpayer than would arise if the government purchased them outright and recouped the entire upside when there is eventual restructuring of and then real demand for these assets later. It is again Congress’ role to stand up for the American taxpayer, to say to the administration that they should not fear having to put up more money upfront if in the end it will save the taxpayer significant money to do so now. At worst, employing such a complicated scheme trying to hold restructuring up until meaningful prices somehow emerge (when the only change in the assets is a government subsidy with purchase) leads to a worse outcome. Uncertainty hangs over our banking system for longer, with all the noted perverse incentives for good and bad banks that induces. Possibility of a disorderly, outright bank failure persists, since the illiquid assets are not rapidly moved off of the balance sheets of some of the most vulnerable banks. The US government ends up overpaying for some assets in terms of guarantees and subsidies versus simply buying them at today’s low values, but only manages to sell the more liquid and attractive upside assets to the voluntary private participants. In short, the US taxpayer gets left with the lower future return lemons, while paying for the privilege of having private investors get the assets with the most upside potential. Eventually, there has to be a wholly public, RTC-type bad bank anyway, but now only for the worst remaining parts of the portfolio.

421 A wholly public, simple, RTC-type bad bank approach not only avoids these risks, but offers an advantage that the public-private hybrid (again a bad idea) aggregator bank does not. In fact, the additional complexity, and thus toxicity or illiquidity, of today’s securitized assets versus what our original RTC or Japan’s or Sweden’s faced is an additional argument for having them all be bought by the US government outright: If the US government buys most or all of entire classes of currently illiquid assets from the banks, it would have a supermajority or 100 percent stake in most of the securitized assets that have been at the core of our problems in this area. That would make it feasible to reassemble sliced and diced securities, going back to the underlying investments, such as mortgages. This would detoxify most of these assets, making them attractive for resale by unlocking their underlying value, removing the source of their illiquidity, and thus offering the possibility of significant upside benefit entirely for the US taxpayer when sold back to the private sector. It would be an actual value- added transformation, not just an attempt to game the pricing. In theory, a set of private-sector investors or public-private partnership also could do this kind of reassembly voluntarily, but in practice the coordination problems are insurmountable, as seen in the complete lack of a market for these assets at present. The use of the word “toxic” to describe these assets leads to an apt and valid analogy: Just as the EPA can go to a Superfund site, one on which no one can currently live and no private entity is willing or able to clean up, it can literally detoxify that real estate by changing its underlying nature, and then have it come back on the market at a good value. The Treasury and FDIC can do the same with these currently toxic securities, if the US government has ownership and puts up the funding and effort to do the clean-up. Without a wholly public RTC initially owning the supermajorities, such a literal detoxification of the assets is impossible. And without that kind of fundamental change in the nature of the bad assets on the banks’ books, it is difficult to see any reason for private smart money to buy them except to pick up a sufficiently large government subsidy. A hedge fund, sovereign wealth fund, or private equity firm with cash is not staying out of these markets for distressed assets at present just because the priceshave not yet “fallen enough”; such investors are staying out because the assets are indeed toxic with indeterminate prices. When Reselling and Merging Failed Banks, Do So with Some Limit on Bank Sizes One aspect of the financial crisis so far is that it has put pressure on banks and supervisors to increase concentration in the US banking system. When the government, for understandable reasons, will treat bigger banks as systemically important, and thus subject to bailouts and guarantees, it advantages them over smaller banks in the eyes of some potential depositors and borrowers. In addition, in each successive wave of banking fragility we have had up until now, US bank supervisors have tended to encourage stronger banks to merge with or buy up weaker banks, which is indeed in line with the standard, crisis-response best practice I outlined above, but also has contributed to greater concentration of the US banking system into fewer, bigger businesses. The deregulation of interstate branching has also played a role. In each case, concentration was a side effect of well-motivated policies, and never became a major problem on its own terms; obviously many smaller and community banks continue to do business just fine. We now approach a situation, however, where the US government will have capital stakes in a large portion of the US banking system, biased toward larger investments in the bigger institutions, and where there will be additional instances after triaging the banking system that seem to require mergers. Given the structural leverage over the US banking system inherent in upcoming decisions, and the sheer scale of the potential upcoming further consolidation, it is time to consciously put a limit on this process. As Paul Volcker has pointed out in the

422 recent G-30 Report that if we get into trouble with banks being simultaneously too big to manage their portfolio risks and too big to be allowed to fail, we probably should not have banks that big.[7] This is not a matter of the normal antitrust consumer protection against monopoly, since these developments have largely benefitted consumers on the usual pricing and choice criteria, but of other public interests at stake. Economically speaking, there is no clear logic to encouraging banks to be as big as possible. Years and years of empirical research by well-trained economists in the United States and abroad has been unable to establish any robust evidence of economies of scale or of scope in banking services. In other words, banks do not perform their key functions more efficiently or cheaply when they produce them in greater volume, and banks do not gain profitable synergies by expanding their range of services and products.[8] There was another reasonable theory that larger banks might be able to diversify their risks across a broader and more varied portfolio than smaller banks, and thus be more stable. The developments of the last two years in the United States, the United Kingdom, Switzerland, and elsewhere, as well as those seen in Japan’s highly concentrated banking system in the 1990s, however, reject that hypothesis rather dramatically, as do more-formal econometric studies. Finally, some people concerned with US economic competitiveness have argued that larger banks confer advantages, either because they allow for easier, large-scale funding of US export industries, or because they allow US banks to compete better for market share in global finance, and thus exportfinancial services. Unlike the previous two testable hypotheses, which were confronted with rigorous data analysis, these competitiveness claims have not been seriously studied. But the major threat to financing for American nonfinancial companies is market disruption caused by systemic bank failures, not limits on the credit available to them in normal times, and the export of financial services has been no more in the US national interest than picking any other single “strategic industry,” a thoroughly discredited practice.[9] So the Treasury, FDIC, and Federal Reserve should show some regard for excessive bank size and concentration in the US banking system when they are required to make decisions about banking structure upon returning parts of the system to fully private control. They cannot duck this, for even a nondecision to go with the likely outcomes of other priorities would result in defaulting to greater bank concentration at the end of the process. Unfortunately, unlike with regard to other aspects of the banking-crisis resolution framework I have outlined, there is no well-established practice for how to deal with this issue. I would suggest that two guidelines be employed: First, when any of the fully nationalized banks, which are likely to include among them some of the largest of current US banks, are brought back to market from public ownership, they should be broken up, either along functional or geographic lines. This has the additional advantage of allowing some parts of the temporarily nationalized banks to return to private hands sooner, and the return of investment to the US taxpayer also to arrive sooner. There will be some component operating units of the largest failed banks whose own sub-balance sheets can be cleaned up rather quickly. Second, preference should be given to mergers of equals for the publicly recapitalized but not nationalized banks that normally would be encouraged by regulators to be merged or taken over by other banks. Since this group of banks is likely to be of a smaller average size than the nationalized group, this should be feasible. While it remains for Congress to pass regulation to determine the rules of how the US banking system should be structured in the future, I believe that current law does give our bank supervisors enough authority and discretion over mergers of banks, especially for those involving a distressed

423 institution, that these guidelines can be followed when the bank clean-up moves forward in the near term, as it must. Do All of This Before the Stimulus Package’s Benefits Run Out Implementing the preceding framework for resolving the US banking crisis will restore financial stability as quickly as possible and at the lowest cost possible (though still high) to American taxpayers.[10] The experience of other countries, notably of Japan in the 1990s, but also of the United States itself in the 1980s, is highly relevant to today’s dangerous situation. Those historical examplesshow not only the right way to resolve our banking problems, but also that the rapidity and sustainability with which the US economy will recover from its present financial crisis is directly dependent upon our willingness to tackle these problems aggressively, including in some instances temporarily nationalizing banks. When the US government engaged in regulatory forbearance with undercapitalized S&L’s in the mid-1980s and when the Japanese government similarly pandered to its bankers and dawdled through the entire 1990s, the losses grew larger and the problems persisted. When the US government truly took on the Savings and Loan crisis in 1989–91 and when the Japanese government truly confronted its banking crisis in 2001–03 following this framework, the financial uncertainty was lifted and growth was restored. The only thing that makes the United States different from other countries facing banking crises has nothing to do with the nature of our banking problems. What is special about the United States in this context is the fortunate fact that we as a nation are rich enough, with enough faith in our currency, to be able to engage in fiscal stimulus to soften the blow to the real economy while the bank clean-up is done. Emerging markets and even most smaller advanced economies generally have to engage in austerity programs, further cutting growth, at the same time that they tackle their banking crises in order to be able to pay for the clean- up. This gives us a window of opportunity, but the clock is ticking. If we can resolve the US banking crisis in the next 18 months before the stimulus program’s impact on the economy runs out, the private sector will be ready to pick up the baton from the public sector, demand will grow, and recovery will be sustained. And following the common framework I have set out, it would be feasible to resolve most of our financial problems, if not return the entire banking system back to private ownership, within that time frame if we start right now. If we fail to move aggressively enough on our banking problems, this window will close because even the United States cannot afford to engage in deficit spending indefinitely, as President Obama rightly explained to Congress and the nation on Tuesday night. In that case, when the fiscal stimulus runs out, the private sector will be unable to grow strongly on its own, because the banking problems will prevent it from doing so. Japan showed us that fiscal stimulus indeed works in the short-term, but growth cannot be restored to a self- sustaining path without resolution of an economy’s banking problems. I ask the members of this Committee to carefully scrutinize and oversee the proposed programs of the US Treasury for banking crisis resolution. If those programs live up to their associated rhetoric, and are thus tough enough on the current shareholders and top management of our undercapitalized banks, we can in 2011 be like Japan in 2003, at the beginning of a long and much-needed economic recovery. If unneeded complexity of the bad- bank construct, excessive reliance on and generosity to private capital, and unjustified reluctance to temporarily nationalize some US banks turn the proposed bank clean-up programs into only half-measures, then we will be like Japan in 1998, squandering national wealth and leaving our economy in continuing decline, only to have to take the full measures a few years down the road when in even greater debt. I am hopeful that the Obama administration, with strong congressional oversight, will do what it is need in time.

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[1] I draw on a wide range of research by me and others. A good overview is given in Japan’s Financial Crisis and Its Parallels with US Experience, 2001, eds. Ryoichi Mikitani and Adam Posen, Washington: Peterson Institute for International Economics. [2] Arguably, repeated forbearance of this kind when major American banks previously made poor decisions about emerging-market lending and regional real-estate booms also contributed to getting us into the terrible situation of today, by encouraging the largest banks to believe that they would always be bailed out without having to take the worst losses. [3] We are already sorting banks on the basis of systemic risk by virtue of stress testing the largest, and thus probably most systemically important, banks first. No one worries about closing small banks, usually. [4] I have been on the record attacking state ownership and subsidization of banks in Europe for years. See, for example, Adam S. Posen, 2003, Is Germany Turning Japanese? Peterson Institute for International Economics Working Paper 03-5, a condensed version of which was published in the National Interest under the title “Frog in a pot,” Spring, 2003). That is completely different from temporary back nationalization. [5] There is a vast and empirically robust literature on the effect of differing financial systems on economic growth, led by the contributions of Jerry Caprio, Stijn Claessens, and Ross Levine, along with their numerous coauthors, from whom I take this simplified estimate. [6] Quoted in the Financial Times, February 18, 2009. [7] Federal Reserve Bank of Minneapolis President Gary Stern has been calling attention to this potential problem for some years now. More recently, my PIIE colleague William Cline has written about it as well. [8] In some trivial sense, back office consolidation of certain types of processing of transactions could yield economies of scale, but even attempts to find evidence for these have proven unsuccessful, perhaps because so many of those services are available on an outsourced and comptetitive basis these days. [9] Some top US economic officials during the 1990s and earlier this decade sincerely believed that financial liberalization was in the economic self-interest of developing countries and thus was in the foreign policy interest of the United States. That is probably valid, and I am broadly sympathetic to that view, subject to some important cautions raised by Dani Rodrik, Joseph Stiglitz, and others. But some of these officials then took that to mean that promoting the export of financial services by US financial institutions and the opening of foreign markets to US financial institutions’ investments and sales were in the US foreign policy, as well as export, interest. This was an unnecessary step, and one that is backfiring on the US reputation now that our financial “model” and aggressive advocacy thereof are being blamed (excessively, but not entirely unfairly) for the current global crisis. [10] See, for example, what I recommended for Japan in 2001, which was largely and successfully implemented by Japanese financial services minister Heizo Takenaka in 2002–03 (“Japan 2001: Decisive Action or Financial Panic,” available at: http://www.iie.com/publications/pb/pb.cfm?ResearchID=72). Many current, senior US economic officials, such as Treasury Secretary Geithner and NEC Chair Summers, advocated the same for Japan and for the Asian countries during the 1997–98 financial crisis there.

425 The new Geithner plan is a flop BY LUIGI ZINGALES Wednesday, March 25th 2009, 4:00 AM On Monday, the market rallied 7% at the announcement of Treasury Secretary's Timothy Geithner's plan to deal with banks' toxic assets. Should taxpayers celebrate as well? The answer is a resounding no. Geithner's plan is just a more risky and cagey version of the original plan by his predecessor, Henry Paulson: to buy toxic assets. Not only is it as likely to fail as his predecessor's, but it is also likely to create major political unrest. The premise underlying both plans was that banks were facing a temporary liquidity problem: Many mortgages and related securities allegedly were trading below their long-term values, making banks appear insolvent. According to this view, it would be enough to inject liquidity into this market to make valuation return to its "fundamental" level, restoring the health of banks. Hence the idea to pump the government's money into this market to fix the problem. As banks know well, however, no debtor on the verge of bankruptcy would ever admit to being insolvent; he will always perceive his own problem as a temporary liquidity one. The credibility of this position depends on the duration of the "liquidity" problem and on the existence of legitimate reasons to think that the long-term value has not dropped. When Paulson first asked Congress for money from the Troubled Assets Relief Program, several indexes of subprime, residential, mortgage-backed securities were trading around $65 a share. Now they are trading around $30. With delinquency approaching 12% and house prices down almost 30% and falling, these losses seem more than temporary illiquidity. Even Citigroup analysts, when they judge other banks, estimate losses on subprime loans at 25% to 40% and losses on credit cards at 26% to 38%. In other words, these problems are about as temporary as General Motors' ones. In the automakers' case, the government has used a tough-love approach, asking all the various stakeholders (including the bondholders) to make concessions. For the banks, on the other hand, Geithner has asked for concessions from no one. In fact, he has even grandfathered the managers' bonuses, while offering taxpayers' money to make bondholders and shareholders whole. It's no surprise the market rallied. It loves to be rescued at taxpayers' expense. And it's no wonder that hedge funds endorsed the plan; they love the subsidy Geithner is providing. Between the money lent by the Federal Deposit Insurance Corp. and the money invested by the Treasury, hedge funds can buy assets for $100 - when they invest only $7. In this way, they retain 50% of the upside and only $7 of the downside. To them, it is almost free. The irony of the plan is that it seems to replicate the same excesses that brought the crisis - carrying enormous economic and political risk. So, what happens now? The worst-case scenario is that the assets are really worth what the currently illiquid market thinks they are worth. In this case, the Treasury, but in particularly the FDIC, will face enormous losses. Had Paulson applied this strategy in late September, the Treasury would now be facing losses equal to 47%. On a trillion- dollar investment, we are talking about $470 billion in losses. The best-case scenario is that the value of the toxic assets bounces back so that the government recovers all its money and the hedge funds become filthy-rich. Even in this happy scenario, however, there is a very serious political problem: How would taxpayers

426 react when they find out that those who reap the biggest benefits of this program are the very same people who created this mess to begin with? Because let's realize this now: The most savvy buyers of toxic assets will certainly be those who created them. If you think that the revelation of AIG lavish bonuses has shown all the rage of the American people, think again. When former subprime lenders will become the new billionaires, we run the risk of a populist revolution. Zingales is a professor at the University of Chicago Booth School of Business. http://faculty.chicagobooth.edu/luigi.zingales/research/papers/geithner_plan_flop.pdf

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Exclusive: PIMCO to participate in U.S. toxic asset plan Mon Mar 23, 2009 11:03pm EDT By Jennifer Ablan NEW YORK (Reuters) - Bill Gross, the influential manager of the world's largest bond fund, gave the Obama administration's financial stability effort a much-needed endorsement on Monday, saying PIMCO will participate in the public-private plan. "This is perhaps the first win-win-win policy to be put on the table and it should be welcomed enthusiastically," the founder and co-chief investment officer of PIMCO told Reuters. Gross' Pacific Investment Management Co oversees roughly $800 billion. He manages PIMCO's flagship Total Return fund, which currently has $139 billion in assets. "We intend to participate and do our part to serve clients as well as promote economic recovery," he said, adding PIMCO will both buy toxic assets and manage some of them. Another influential money manager, BlackRock Inc, told Reuters on Sunday that it too intends to be involved as one of the investment managers in the public-private investment fund. A Kohlberg Kravis Roberts & Co executive said on Monday the private equity firm would be "happy and willing" to partner with the government if an investment deal to buy assets made sense. The U.S. Treasury Department on Monday rolled out detailed plans for persuading private investors to help rid banks of up to $1 trillion in toxic assets that are seen as a roadblock to economic recovery. Generous government financing will underpin the Public-Private Investment Program, which the Treasury will launch with $75 billion to $100 billion from its $700 billion bailout fund approved by Congress last fall. "From PIMCO's perspective, we are intrigued by the potential double-digit returns as well as the opportunity to share them with not only clients but the American taxpayer," Gross said. Gross's endorsement is important after the lack of big investor interest in the debut of the Federal Reserve's consumer lending program last week. The Fed's Term Asset-Backed Securities Loan Facility, or TALF, received only $4.7 billion in requests for loans out of $200 billion on offer, heightening fears that big money managers will also shun the government's toxic-asset plan. TSUNAMI OF DISTRUST AFTER AIG Gross' vote of confidence also comes after last week's political furor surrounding the American International Group Inc bonus payment debacle and the anti-Wall Street mood, which raised the risks for private capital firms thinking about partnering with the Treasury. Congress is moving to clamp down on companies receiving financial bailout money by severely taxing bonus payments. There is concern that any financial firm getting involved in the toxic asset plan could face retroactive limits on compensation or profits.

428 "There's a sense of having gone too far and that there's fear that anyone that participates in this or any other government program would be subject to increased scrutiny and standards that didn't exist in the past ... I couldn't discourage that thinking," Gross told Reuters Financial Television. "I would point to Secretary (Timothy) Geithner's guarantee and promise as well as that from (Federal Reserve Chairman) Ben Bernanke that basically they want to maintain and ultimately produce a thriving private sector and the limitations that may be placed on AIG connections, I guess, won't exist in this particular program. So PIMCO has no fear of that, so to speak." He said the Treasury's public-private partnership plan has "an objective of liquefying relatively frozen portions of the credit market and promoting the extension of new loans in the U.S. economy." Gross added: "To succeed, it will require participation from both willing buyers as well as sellers, in addition to the substantial government assistance being provided in the proposed policy package." (Additional reporting by Daniel Burns, Chris Sanders and Megan Davies; Editing by Dan Grebler)

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Global Central Bank Focus

McCulley | February 16 2009

Saving Capitalistic Banking From Itself

At its core, capitalism is all about risk taking. One form of risk taking is leverage. Indeed, without leverage, capitalism could not prosper. Usually, we think of this imperative in terms of entrepreneurs being able to lever their equity so as to grow. And indeed, this is the case. But more elementally, economies – both capitalist and socialist – require leverage because savers for very logical reasons do not want to have one hundred percent of their stock of wealth in equity investments. Rather, they logically want a portion of their portfolios in a fixed-commitment instrument that is senior to equity. And savers want some portion of that fixed-commitment allocation in literal money, defined as a government-guaranteed obligation that always trades at par. If you have any doubt about this, put your hands into your pockets and you will find just such an instrument. It’s called currency, a zero-interest, perpetual liability of the Federal Reserve, itself a levered entity, capitalized by its Congressionally-legislated monopoly over the creation of money. As a practical matter, of course, you don’t hold all of your always-trades-at-par liquidity in currency. You most likely have a demand deposit, also known as a checking account, as well as shares in a money market mutual fund, which is putatively supposed to always trade “at the buck.” You probably also have some longer-dated bank deposits, such as certificates of deposits, or CDs, which don’t necessarily trade at par in real time, but are guaranteed to do so at maturity. The Nature of Fractional Reserve Banking The public’s demand for at-par liquidity inherently creates the raw material for leverage in the economy. Indeed, from time immemorial, fractional reserve banking has been built on the simple proposition that the public’s collective ex ante demand for at-par liquidity is greater than the public’s collective ex post demand for such liquidity. Accordingly, the genius of banking1, if you want to call it that, has always been simple: A bank can take more risk on the asset side of its balance sheet than the liability side can notionally support, because a goodly portion of the liability side, notably deposits, is de facto of perpetual maturity, although it is de jure of finite maturity, as short as one day in the case of demand deposits. Thus, the business of banking is inherently about maturity and credit quality transformation:

1 “The Paradox of Deleveraging Will Be Broken,” Global Central Bank Focus, November 2008. http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2008/Global+Central+Bank+Foc us+11-08+McCulley+Paradox+of+Deleveraging+Will+Be+Broken.htm

430 banks can hold assets that are longer and riskier than their liabilities, because their deposit liabilities are sticky. Depositors sleep well knowing that they can always get their money at par, but because they do, they don’t actually ask for their money, affording bankers the opportunity to redeploy that money into longer, riskier, higher-yielding assets that don’t have to trade at par. Enter the Government A key reason that depositors sleep well at night is the fact that since 1913 here in the United States, banks have had access to the Federal Reserve’s discount window, where assets can be posted for loans to redeem flighty depositors. A second sleep-well governmental safety net was introduced in 1933: deposit insurance, in which the federal government insures that deposits – up to a limit – will always trade at par, regardless of how foolish bankers may be on the other side of their balance sheets. Thus, the genius of modern day banking, again if you want to call it that, has always been about exploiting the positive spread between the public’s ex ante and ex post demand for liquidity at par, in the context of levering the two safety nets – the central bank’s discount window and deposit insurance underwritten by taxpayers – which provide comfort to depositors that they can always get their money at par, even if their bankers are foolish lenders and investors. Yes, I know that sounds harsh. But it really is how the banking world works. In turn, banks can be very profitable enterprises, because the yield on their risky assets is greater than the yield on their less-risky liabilities. And that net interest margin can be particularly sweet when recomputed as a return on equity, given that banks are very levered institutions (recall, banks must hold only 8% of liabilities in the form of Tier 1 capital). Put differently, equity investors in banks can lose only 8% of a bank’s footings, but they earn the net interest margin on 100% of those footings, so long as they don’t make so many dodgy loans and investments, destroying capital, that the providers of the two government safety nets cut them off. Thus, it has always been somewhat of an oxymoron, at least to me, to think of banks as strictly private sector enterprises. To be sure, they have private shareholders. And, yes, those shareholders get all the upside of the net interest margin intrinsic to the alchemy of maturity and risk transformation. But the whole enterprise itself depends on the governmental safety nets. That’s why banks are regulated. Conceptually, as is the case in socialist countries, banks could be – and usually are – simply owned by the government, the ultimate form of regulation. Such an arrangement has the benefit of the taxpayer sharing in the upside, not just the downside. Such an arrangement also has the cost of putting the government in the lending and investing business, with little regard

2 “Comments Before the Money Marketeers Club, Minsky and Neutral:Forward and in Reverse,” Global Central Bank Focus, December 2007. http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2007/GCBF+Dec+2007.htm 3 “The Paradox of Deleveraging,” Global Central Bank Focus, July 2008. http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2008/GCBF+July+2008.htm 4 “All In,” Global Central Bank Focus, December 2008/January 2009. http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2008/GCB+December+2008+Mc Culley+All+In.htm

431 for the pursuit of profit, picking winners and losers on the basis of political clout. Thus, capitalist economies usually want their banking systems owned by the private sector, where loans and investments are made on commercial terms, in the pursuit of profit. But also in the context of prudential regulation, so as to minimize the downside to taxpayers of the moral hazard inherent in the two safety nets for depositors. The Mae West Doctrine But as is the wont of capitalists, they love levering the sovereign’s safety nets with minimal prudential regulation. This does not make them immoral, merely capitalists. And over the last decade or so, the way for bankers to maximally lever the inherent banking model has been to become non-bank bankers, or as I dubbed them a couple years ago, shadow bankers. The way to do this has been to run levered-up lending and investment institutions – be they investment banks, conduits, structured investment vehicles, hedge funds, et al – by raising funding in the non-deposit markets, notably: unsecured debt, especially interbank borrowings and commercial paper; and secured borrowings, notably reverse repo and asset-backed commercial paper. And usually – but not always! – such shadow banks relied on conventional banks with access to the central bank’s discount window as backstop liquidity providers. Structured accordingly, without explicit access or use of the government’s safety nets, shadow banks essentially avoided regulation, notably on the amount of leverage they could use, the size of their liquidity buffers and the type of lending and investing they could do. To be sure, Shadow Banking needed some seal of approval, so that providers of short-dated funding could convince themselves that their claims were de facto “just as good” as deposits at banks with access to the government’s liquidity safety nets. Conveniently, the rating agencies, paid by the shadow bankers, stood at the ready to provide such seals of approval. And it was all grand while ever-larger application of leverage put upward pressure on asset prices. There is nothing like a bull market to make geniuses out of levered dunces. Call it the Mae West Doctrine, where if a little fun is good and more is better, then way too much is just about right.

Also call it the Forward Minsky Journey,2 where stability begets ever riskier debt arrangements, until they have produced a bubble in asset prices. And then the bubble bursts, in something called a Minsky Moment, followed by a Reverse Minsky Journey, characterized by ever-tighter terms and conditions on the availability of credit, inducing asset price deflation

432 and its fellow traveler, debt price deflation. This dynamic is inherently self-feeding, begetting the Paradox of Deleveraging,3 where private sector bankers – conventional bankers and shadow bankers alike – all move to the offer side of both asset markets and bank capital markets, trying to reduce their leverage ratios by selling assets and paying off debt, and/or issuing more equity. But by definition, if everybody tries to do it at the same time, as has been the case over the last 18 months or so, it simply can’t be done. What is needed is for the government to take the other side of the trade, effectively becoming the bid side, (1) buying assets, (2) guaranteeing assets, (3) providing cheap funding for assets, and (4) buying bank equity securities (of both conventional banks and shadow banks that are permitted to become conventional banks after the fact). Government Goes All In4 And indeed, all four of these techniques have been put into play since the fateful decision to let Lehman Brothers fall into disorderly bankruptcy. Put more bluntly, the hybrid character of banking – always a joint venture between private capital and governmental liquidity safety nets – is morphing more and more towards government-sponsored banking. Yes, I know that is harsh, but sometimes the truth is harsh. Capitalism and banking may not be divorced, but certainly are engaged in some form of trial separation. The Treasury, the FDIC and the Fed – the big three – are caught in the middle, serving both as mediators as well as deep pockets to the estranged parties. It’s not wholesale nationalization. And it’s not likely to become that. But only because the big three are committed to doing whatever it takes to prevent that outcome. Along the way, the big three would also like – need! – to restart the engines of credit creation, so as to pull the economy out of its gaping hole of insufficient aggregate demand for goods and services, also known as a recession. Will it work? Judging from the markets’ collective reaction to Treasury Secretary Geithner’s announcement last week of the new administration triage plans, there is room for doubt. I do not, however, take one-week swings in the markets as indicative as to where this game will end. And a key reason is actually the special powers of the Fed and the FDIC, which can lever the taxpayer monies that Congress provides for the Treasury. As evidenced in recent months, the Fed has two incredibly powerful tools: • Section 13(3) of the Federal Reserve Act of 1932, which permits the Fed, upon declaration of “unusual and exigent circumstances” to lend to anybody against collateral it deems adequate, and • Total freedom to expand its balance sheet, essentially creating liabilities against itself that trade at par – also called printing money – so long as the Fed is willing to surrender control over the Fed funds rate, letting it trade at zero, or thereabouts. The Fed has used both of these tools vigorously in recent months, expanding its lending programs mightily, to both conventional banks and shadow banks (i.e., investment banks who have re-chartered as banks, as well as primary dealers), while also doubling the size of its balance sheet, as it let the Fed funds rate fall to effectively zero. The FDIC also has an incredibly powerful tool: the so-called Systemic Risk Exception under the FDIC Improvement Act of 1991, which allows the FDIC to forgo using the “lowest cost” solution to dealing with troubled banks if using such a solution “would have serious adverse effects on economic conditions or financial stability” and if bypassing the least cost method would “avoid or mitigate such adverse effects.”

433 It’s actually not an easy clause for the FDIC to invoke, unlike Section 13(3) for the Fed, which can be invoked simply by a supermajority of the Board of Governors. For the FDIC, the Systemic Risk Exception must be deemed necessary by two-thirds of both the Board of Directors of the FDIC and the Fed’s Board of Governors, as well as by the Secretary of the Treasury, who must first consult and get agreement from the President of the United States. But where there is a will, there is a way, and the FDIC is now living firmly in the land of the Systemic Risk Exception, legally allowed to guarantee unsecured debt of banks as well as to put itself at risk in guaranteeing banks’ dodgy assets. Bottom Line The United States government now has both the tools and the will to save the private banking system, and more importantly, the real economy, from its own debt-deflationary pathologies. Not that it will be easy. But it can be done, notwithstanding the catcalls that greeted Secretary Geithner last week. And the essential game plan is clear: use the power of the Fed, the FDIC and the Treasury to create government-sponsored shadow banks, such as the Term Asset-Backed Securities Lending Facility (the TALF) and the Public-Private Investment Fund (the P-PIF). The formula? Take a small dollop of the Treasury’s free-to-spend taxpayer money (there is still $350 billion left) to serve as the equity in a government sponsored shadow bank, and then lever the daylights out of it with loans from the Federal Reserve, funded with the printing press. That’s the formula for the TALF, to provide leverage, with no recourse after a haircut, to restart the securitization markets. The same formula applies for the P-PIF, with the addition of FDIC stop out loss protection for dodgy bank assets that private sector players might buy. With such goodies, such players, it is hoped, will be able to pay a sufficiently high price for those assets to avoid bankrupting the seller bank. Unfortunately, Secretary Geithner hasn’t laid out the precise parameters of how to mix these three ingredients, which is driving the markets up the wall. But make no mistake, these are the ingredients, along with continued direct capital infusions into banks where necessary. Uncle Sam has the ability to substitute itself – not himself or herself! – for the broken conventional bank system, levering up and risking up as the conventional banking system does the exact opposite. Yes, there will be subsidies involved, sometimes huge ones. And yes, the process will seem arbitrary and capricious at times, reeking of inequities. Such is the nature of government rescue schemes for broken banking systems, while maintaining them as privately owned. You might not like it. I don’t like it, because regulators should never have let bankers, both conventional bankers and shadow bankers, run amok. But they did. So it’s now time to hold the nose and do what must be done, however stinky it smells, not because it’s pleasant but because it is necessary. Only with the full force of the sovereign’s balance sheet can the Paradox of Deleveraging be broken. Paul McCulley, Managing Director, February 16, 2009 [email protected] http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2009/GCB+February+20 09+McCulley+Saving+Capitalistic+Banking.htm

434 Economy

September 25, 2008 Managing the Bailout: He’d Do It for Nothing By EDWARD WYATT NEWPORT BEACH, Calif. — One of the chief concerns about the Treasury Department’s $700 billion bailout plan is that the same Wall Street firms that helped create the crisis could make a killing cleaning it up. William H. Gross, the manager of the country’s largest bond mutual fund, has a solution: he is offering to sort through the toxic assets — free. “We have a large and brilliant staff that can analyze and has analyzed subprime mortgages that can help the Treasury out,” Mr. Gross, the co-chief investment officer for the Pacific Investment Management Company, said in an interview at the company’s headquarters here. He added, “And I’d even be willing to say that if the Treasury wanted to use our help, it would come, you know, free and clear.” Mr. Gross explained his offer as a philanthropic one. With Pimco’s $830 billion under management, “we make fees aplenty,” he said. That could be considered an understatement. Pimco is a behemoth in credit markets, and Mr. Gross talks about them with a confidence that reflects his ability to maneuver in them. But maneuvering is becoming a lot harder these days. After breathing an initial sigh of relief when the Treasury plan was first announced, credit markets are again showing signs of stress. Mr. Gross pointed it out on Tuesday morning, standing on Pimco’s trading floor as Henry M. Paulson Jr., the Treasury secretary, and Ben S. Bernanke, the Federal Reserve chairman, testified before a Senate committee. “Today’s the worst day yet and nobody knows it,” he said. “Everybody is squirreling away cash. Even the big banks are refusing to lend money.” Bid-ask spreads on bonds in almost every sector of the debt markets stretched to a full point or more. “It’s not a pretty situation today, much worse than last week,” Mr. Gross said. “Those who just look at the stock market wouldn’t know it,” he added, because the Dow Jones industrial average was down only 126 points at the time. “But the credit markets are doing a pretty good job of freezing up.” Despite his proposal to offer his talents, gratis, some investment managers say the government should be wary of giving authority for the auction of mortgage securities to anyone in the private sector, particularly someone with as dominant a position in the bond market as Mr. Gross. Luis Maizel, a senior managing director of LM Capital Group in San Diego, said the government should instead turn to someone like a former official of the Federal Home Loan Bank Board, which is now defunct, or the Federal Reserve. “They should start with somebody who doesn’t have a conflict,” Mr. Maizel said. “Bill Gross is a good friend of mine, but if you put this in Bill’s hands, Pimco is going to come out great and I don’t know that the government will.”

435 Mr. Gross says that all he wants in return for helping the Treasury Department is for Pimco “to be recognized for the way we’ve seen this crisis coming, and for the way we’ve talked about what’s required.” For more than a year, Mr. Gross, whose investment expertise has earned him a net worth estimated at more than $1 billion, according to Forbes, has indeed played the role of the financial markets’ Cassandra. Beginning in July 2007, he warned that the subprime mortgage crisis would become far worse before it would improve. Other sectors of the financial markets, he predicted, also could seize up if the Federal Reserve and the Treasury did not do something to help keep the markets liquid. But Mr. Gross and Pimco also attracted criticism when it became clear that the Pimco Total Return fund earned more than $1.7 billion on the day the federal government bailed out Fannie Mae and Freddie Mac. Mr. Gross had been advocating such a move for more than a year, at the same time that he was moving more than 60 percent of his fund’s assets into government-agency bonds. The shift in investment strategy began in earnest shortly after Pimco hired Alan Greenspan, the former Federal Reserve chairman, as an adviser last year. Mr. Gross said there was nothing wrong with that advocacy because Pimco had no official role in formulating the plan to rescue Fannie Mae and Freddie Mac. “We had a role on CNBC,” he said, “in that every time we were asked, or I guess every time that The New York Times would call, they would say, ‘What are you doing?’ and we would say: ‘Well, we want safe, agency-guaranteed mortgages. We don’t want to take a lot of risks in subprime space.’ ” With the current liquidity crisis touching virtually every sector, any firm in a position to advise the Treasury on its rescue plan would have potential conflicts of interest, Mr. Gross said. “There’s fewer of them here than anywhere else,” he added. “Simply because we saw the crisis coming and we don’t have much of this paper.” The calm of the Pimco trading floor is perhaps a reflection of that reality. Even in the midst of the Wall Street tumult, it is less cacophonous pit than library, the low murmur of conversation among portfolio managers drowned out only by the clacking keyboards. Mr. Gross, a lanky 64-year-old who practices yoga and sometimes speaks so softly that colleagues lean toward him, drifted around the room on Tuesday, an unknotted pale blue Hermès tie draped around his neck, his gray and brown hair extending down over his ears, reminiscent more of the 1970s than today. Pimco’s headquarters sit on a bluff overlooking the Pacific Ocean. On a clear day, the view extends westward beyond Catalina Island, which sparkles like a jewel in the midday sun. The windows on the Pimco trading floor, where Mr. Gross spends most of his time, however, face in the opposite direction — toward Wall Street and Washington, two arenas where Mr. Gross and his firm carry outsize influence. Mr. Gross, who talks regularly with Mr. Paulson, believes the bailout plan should grant broader relief for homeowners and others weighed down by unmanageable debt. He says foreign banks should be allowed to take part in the program, but he argues against any measures that would try to restrict executive compensation — a move that Mr. Paulson tentatively backed Wednesday.

436 “I don’t even know if it’s legal,” Mr. Gross said of attempts to limit executive pay. “And so I think that complicates the situation. That’s not to defend those that are making big checks, but I don’t think it should be attached to this.” Mr. Gross is also skeptical of proposals to have the Treasury take ownership stakes in banks that sell troubled assets to the government. Buying a pool of subprime mortgages is not like buying part of a company, he said. The Treasury would own something — the mortgages themselves, which, if it pays the right amount for those loans, could earn it a yearly return of 12 to 13 percent when they are resolved. “All the capital gains will accrue to the Treasury,” he said. “There’s tons of equity here. It’s just that it’s very difficult for American taxpayers to understand.” The key, of course, is price, which is where an adviser to the Treasury would come in. Mr. Gross says much of the opposition to the plan stems from a misunderstanding that the Treasury would buy troubled mortgage bonds at face value. On the contrary, Mr. Gross said, he would advise the Treasury to pay closer to 60 or 65 cents on the dollar for the mortgage bonds. “If the price is right, the Treasury’s going to make money,” Mr. Gross said. “They made money on Chrysler. They can make money on this,” he said, referring to the federal bailout of the carmaker in 1979 and 1980. Still, when asked how he saw the broader economy here and abroad over the next year, Mr. Gross responded simply, “Not pretty.” “There will definitely be a prolonged period of either slow growth or recession for 12 to 18 to 24 months,” he said. “We’re not going to get out of this easily or scot-free. It’s just gone too far to now turn around quickly and to move into a positive growth mode.” In the meantime, a surge in regulation of the financial sector will be unleashed, probably an inevitable result of the problems and rescues of recent months. “Twelve to 24 months down the road, all of these high-flying investment banks and banks will be reregulated and downsized,” Mr. Gross said. “They won’t become arms of the government, but they will be supervised and held on a tight leash.” The greater regulation should draw investors back to the market and away from what seems to be their current financial strategy — stuffing their cash in mattresses. Even Mr. Gross admits that he has been, at times, reluctant to commit. “We were offered this morning a six-month sizable piece of Morgan Stanley,” he said on Tuesday. “Here’s the surviving investment bank that just last night got equitized or bailed out by a Japanese bank. We were offered a sizable piece of a six-month Morgan Stanley obligation at a yield of 25 percent, O.K.?” Pimco did not buy the bonds, “because we thought we could get it even cheaper,” Mr. Gross said, adding that thinking of that kind was at the heart of today’s market paralysis. “That’s where the fear builds in and makes for totally illiquid markets,” he said. “Where no one trusts anybody; no one trusts any price.” http://www.nytimes.com/2008/09/25/business/economy/25pimco.html

437

How Main Street Will Profit By William H. Gross Wednesday, September 24, 2008; A23 Capitalism is a delicate balance between production and finance. Today, our seemingly guaranteed living standard is threatened, much like it has been in previous recessions or, some would say, the Depression. Finance has run amok because of oversecuritization, poor regulation and the excessively exuberant spirits of investors; the delicate balance has once again been disrupted; production, and with it jobs and our national standard of living, is declining. If this were a textbook recession, policy prescriptions would recommend two aspirin and bed rest -- a healthy dose of interest rate cuts and a fiscal package that mildly expanded the deficit. That, of course, has been the attempted remedy over the past 12 months. But recent events have made it apparent that this downturn differs from recessions past. Today's housing bubble, unlike that of the stock market's before it, was financed with excessive and poorly regulated mortgage debt, and as housing prices began to tumble from the peak, the delinquencies and foreclosures have led to a downward spiral of debt liquidation that in turn led to even lower prices and more foreclosures. And so, instead of mild medication and rest, it became apparent that quadruple bypass surgery is necessary. The extreme measures are extended government guarantees and the formation of an RTC-like holding company housed within the Treasury. Critics call this a bailout of Wall Street; in fact, it is anything but. I estimate the average price of distressed mortgages that pass from "troubled financial institutions" to the Treasury at auction will be 65 cents on the dollar, representing a loss of one-third of the original purchase price to the seller, and a prospective yield of 10 to 15 percent to the Treasury. Financed at 3 to 4 percent via the sale of Treasury bonds, the Treasury will therefore be in a position to earn a positive carry or yield spread of at least 7 to 8 percent. Calls for appropriate oversight of this auction process are more than justified. There are disinterested firms, some not even based on Wall Street, with the expertise to evaluate these complicated pools of mortgages and other assets to assure taxpayers that their money is being wisely invested. My estimate of double-digit returns assumes lengthy ownership of the assets and is in turn dependent on the level of home foreclosures, but this program is, in fact, directed to prevent just that. In effect, the Treasury will have the fate of the American taxpayer in its hands. The Resolution Trust Corp., created in the late 1980s to deal with the savings and loan crisis, dealt with previously purchased real estate, which was flushed into government hands with a "best efforts" future liquidation. Today, the purchase of junk mortgages, securitized credit card receivables and even student loans will be bought at prices significantly below "par" or cost, and prospectively at levels allowing for capital gains. This is a Wall Street-friendly package only to the extent that it frees up funds for future loans and economic growth. Politicians afraid of parallels to legislation that enabled the Iraq war are raising concerns about a rush to judgment, but the need for speed is clear. In this case, there really are weapons of mass destruction -- financial derivatives -- that threaten to destroy our system from within. Move quickly, Washington, with appropriate safeguards.

438 The Treasury proposal will not be a bailout of Wall Street but a rescue of Main Street, as lending capacity and confidence is restored to our banks and the delicate balance between production and finance is given a chance to work its magic. Democratic Party earmarks mandating forbearance on home mortgage foreclosures will be critical as well. If this program is successful, however, it is obvious that the free market and Wild West capitalism of recent decades will be forever changed. Future economic textbooks are likely to teach that while capitalism is the most dynamic and productive system ever conceived, it is most efficient over the long term when there is another delicate balance -- between private incentive and government oversight. The writer is chief investment officer and founder of the investment management firm PIMCO. http://www.washingtonpost.com/wp-dyn/content/article/2008/09/23/AR2008092302322.html

It's the Housing Market Deflation By William H. Gross Thursday, January 31, 2008; A21 It seems to me that the U.S. economy requires a new orthodoxy, a redirection from consumption toward the stabilization of the housing market and an emphasis on infrastructure. America's economy is faltering because of an exhaustion of free-market capitalism that has mutated in recent years to something resembling a pyramid scheme. Our levered, derivative-based financial system, seemingly so ascendant after the dot-com madness that preceded it, has met its match with the subprime lending and poorly structured, opaque mortgage-backed securities of today's marketplace. The result has been a dangerous deflation in America's most important asset class -- housing. Preventing home prices from declining even further is job No. 1 for monetary and fiscal authorities. So far, only Fed Chairman Ben Bernanke seems to appreciate the necessity for timely, creative solutions. The Fed has cut interest rates twice in eight days, by one-half of a percentage point yesterday and by three-quarters of a percentage point at an unscheduled meeting last week, and implemented a revised discount window framework in the form of its newly created Term Auction Facility. This "TAF" is designed to lower risk spreads in the high-quality end of the credit markets, and so far it is succeeding. Yet monetary policy has its limits. It cannot make bad assets turn good, nor can it be expected to lower mortgage rates to a level necessary to engender the buying power that would clear the tracts of unoccupied homes and place a floor under the deflating prices feared by American homeowners. The adjustable-rate mortgage, so dependent on lower short-term yields, is all but dead these days, thanks to increased regulatory scrutiny and the inevitability of future lawsuits. The heavy lifting, then, must be done by the 30-year mortgage, rates for which need to come down at least an additional percentage point before it can stop housing's deflation. With inflation higher than it was during the halcyon days of 2003-04, such a reduction is not likely even if Bernanke were to drop the Fed's target interest rate to its previous floor of 1 percent. So we do need a fiscal helping hand, and one that is timely and targeted, but current stimulus legislation appears to be aimed in the wrong direction. Granted, a measure that President Bush

439 and House leaders agreed to and that the House approved this week has a provision to allow Fannie Mae and Freddie Mac to back larger mortgages. But that would do little to help those Americans who purchased homes over the past five years and whose monthly mortgage payments are now substantially higher, as well as those people who are being forced out of their homes entirely. Granted, the bipartisan plan would put money into the hands of consumers, helping them pay overdue debt and regain some lost ground from bill collectors. The Senate's proposal to increase food stamp benefits may be helpful as well. But the big problem with the proposed "stimulus" is that it is really directed toward consumption, not toward the housing deflation that threatens the U.S. economy. Our economic problem today resembles the Japanese property market crisis of the 1990s. What's needed is not just $600 checks that will flow into Wal-Mart (and then to the Chinese) but an expanded Federal Housing Administration program offering below- market, 30-year mortgage refinancings with minimal down payments, which the private market and Bernanke cannot provide. Republican orthodoxy seems so intent on curtailing the past abuses of Fannie Mae and Freddie Mac that some politicians are looking past a government agency solution in their own back yard. Housing and our finance-based market mania got us into this mess. Housing and government-based financial solutions must begin to get us out of it. Ultimately, America's economy will require more than a $150 billion shot in the arm to resolve its slow-growth predicament. One hopes that Americans will come to recognize that a better direction for our economy will be neither tax-based nor consumption-oriented. We have followed that path to our detriment in recent years. If government is ascendant vis-¿-vis the hegemony of the private market, then it must invest more wisely than its economic partner has. For now, however, to be effective, the right temporary fix requires additional focus on where the damage lies -- and that is centered on our housing market deflation. The writer is founder and chief investment officer of PIMCO, the world's largest bond mutual fund. http://www.washingtonpost.com/wp- dyn/content/article/2008/01/30/AR2008013003211_pf.html

Why We Need a Housing Rescue By William H. Gross Friday, August 24, 2007; A15 During times of market turmoil, it helps to get down to basics. Goodness knows it's not easy to understand the maze of financial structures that appear to be unwinding. They were created by wizards of complexity: youthful financial engineers trained to exploit cheap money and leverage and who have, until the past few weeks, never known the sting of the market's lash. My explanation of how the subprime crisis crossed the borders of mortgage finance to swiftly infect global capital markets is perhaps unsophisticated. What Federal Reserve Chairman Ben Bernanke, Treasury Secretary Hank Paulson and a host of other sophisticates should have known is that the bond and stock market problem is not unlike the game "Where's Waldo?" -- Waldo being the bad loans and defaulting subprime paper of the

440 U.S. mortgage market. While market analysts can guesstimate how many Waldos might appear over the next few years -- $100 billion to $200 billion worth is a reasonable estimate -- no one knows where they are hidden. There really are no comprehensive data on how many subprimes rest in individual institutional portfolios. Regulators have been absent, and releasing information has been left to individual institutions. Many, including pension funds and insurance companies, argue that accounting rules allow them to value subprime derivatives for what they cost. Defaulting exposure therefore can hibernate for months before its true value is revealed. The significance of proper disclosure is the key to the current crisis. Financial institutions lend trillions of dollars, euros, pounds and yen to and among each other. The Fed lends to banks, which lend to prime brokers such as Goldman Sachs and Morgan Stanley, which lend to hedge funds, and so on. The food chain is not one of predator feasting on prey but a symbiotic credit extension, always for profit but never without trust that the money will be repaid upon contractual demand. When the trust breaks down, money is figuratively stuffed into Wall Street and London mattresses as opposed to extended to the increasingly desperate hedge funds and other financial conduits. These structures in turn are experiencing runs from depositors and lenders exposed to asset price declines of unexpected proportions. In such an environment, markets become incredibly volatile as more and more financial institutions reach their risk limits at the same time. The past few weeks have exposed a giant crack in modern financial architecture, created by the youthful wizards and endorsed as a diversifying positive by central bankers present and past. While the newborn derivatives may hedge individual, institutional and sector risk, they cannot hedge liquidity risk. In fact, the inherent leverage that accompanies derivative creation may foster systemic risk when information is unavailable or delayed. Only the central banks can solve this, with their own liquidity infusions and perhaps a series of rate cuts. Should markets be stabilized, policymakers must then decide what to do about the housing market. Seventy percent of American households are homeowners. Granted, a dose of market discipline in the form of lower prices might be healthy, but forecasters are projecting more than 2 million defaults before this cycle is complete. The resulting impact on housing prices is likely to be close to a 10 percent decline. Such an asset deflation has not been seen in the United States since the Great Depression. Housing prices could probably be supported by substantial cuts in short-term interest rates, but even cuts of 2 to 3 percentage points by the Fed would not avert an increase in interest rates of adjustable-rate mortgages; nor would they guarantee that the private mortgage market -- flush with fears of depreciating collateral -- would follow along in terms of 30-year mortgage yields and relaxed lending standards. Additionally, cuts of such magnitude would almost guarantee a resurgence of speculative investment via hedge funds and levered conduits. Such a move would also more than likely weaken the dollar -- even produce a run -- which would threaten the long-term reserve status of greenbacks and the ongoing prosperity of the U.S. hegemon. The ultimate solution must not emanate from the Fed but from the White House. Fiscal, not monetary, policy should be the preferred remedy. In the early 1990s the government absorbed the bad debts of the failing savings and loan industry. Why is it possible to rescue corrupt S&L buccaneers yet 2 million homeowners must be thrown to the wolves today? If we can bail out Chrysler, why can't we support American homeowners? Critics warn of a "moral hazard." If we bail out homeowners this time, they claim, it will just encourage another round of speculation in the future. But there's never been a problem in

441 terms of national housing price bubbles until recently. Home prices have been the most consistent, least bubbly asset aside from Treasury bills for the past 50 years. Only in the past few years, when regulation has broken down, when the Fed has failed to exercise appropriate supervision, have we seen "no-doc" and "liar" loans and "100 percent plus" loans. If you enforce regulation, you'll have no problem with moral hazard. This rescue, which admittedly might bail out speculators who deserve much worse, would support millions of hardworking Americans. Those who would still have them eat Wall Street cake (as a Wall Street Journal editorial suggested, saying they should get used to renting once again) should look at it this way: your stocks and risk-oriented leveraged investments will spring to life anew. Republican officeholders would win a new constituency of voters for generations. Get with it, Mr. President. This is your moment to one-up Barney Frank and the Democrats. Create a Reconstruction Mortgage Corporation. Or, at the least, modify the existing FHA program, long discarded as ineffective. Bail 'em out -- and prevent a destructive housing deflation that Ben Bernanke cannot avert. After all, you're the Decider, aren't you? The writer is founder and chief investment officer of PIMCO, the world's largest bond mutual fund. This column was adapted from his September investors outlook newsletter. http://www.washingtonpost.com/wp-dyn/content/article/2007/08/23/AR2007082301834.html

442

WILLIAM H. GROSS — THE KING “If Any One Man has put Bonds on the Map, it's Bill”

William H. Gross Bill Gross is widely recognized as the King of Bonds due to his ability to outperform the major bond indices, in all markets. His talent has become legendary. He is certainly the highest paid fund manager in the world, which is hardly surprising when you consider that he manages America's largest bond fund ($128 billion in assets, June 2008) and under his lead it consistently chalks up outstanding results. (Up 7.75% p.a. since he took the helm in '87.) When it comes to navigating turbulent seas, Bill has few rivals. He can make money as readily in bull markets as in bear with impeccable judgment and an unerring eye. Some say he can even walk on water. His secret? For a start, Bill is more aggressive than most bond managers. In his own words: "I've always said that a good institutional bond manager has to be one-third mathematician, one-third horse trader, and one-third economist." Most likely it is simply his passion to beat the odds. Born in Middletown, Ohio, he was raised there and California and as a young man, while recovering from an auto accident in Duke Hospital (NC), he read a book on beating the odds in gambling and discovered his true calling. He promptly headed to Las Vegas where he generated the money he needed to attend business school. Vegas taught Bill that with new ideas, patience and hard work he could beat the system! He has never looked back. Bill gained a BA in psychology at Duke University, Durham (NC) in 1966 and an MBA at UCLA in 1971 before founding Pacific Investment Management Co, LLC. From Bill's point of view there's no difference between gambling and money management. "The goal is to spread risk and avoid becoming emotional while staying focused on the odds." His investment philosophy is no secret at all. Bill respects secular trends rather than short-term interest rate movements, using diversity to temper risks, and aims for performance consistency by avoiding extreme swings in either maturity or duration. He relies more on interest rate and sector bets than individual bond selection. From this position he aims to beat the market. And he succeeds. He also aims to provide clients with the highest standard of excellence in asset management, emphasizing service, value, stability and vision. His own genius and PIMCO's huge analysis resource base help him get both of these right more often than not.

443 Today, Bill practices yoga, writes about investing (2 books and numerous newsletters and articles) and always believes in bonds. William H. Gross is founder and chief investment officer with Pacific Investment Management Company. ($829 billion assets under management - June 2008) In 1993 he was recognized as the most influential authority on the bond market in the United States. Gross and his team have three times been awarded Morningstar's "Fixed-Income Manager of the Year" award. (1998, 2000, and 2007) Bill is a Chartered Financial Analyst and a member of the Los Angeles Society of Financial Analysts. The fund we are investing in to gain access to Money Master Bill Gross is:

Fund Name: PIMCO Total Return

Fund Symbol: PTRAX

Fund Summary:

PIMCO Total Return fund invests in a diversified portfolio of fixed income securities - normally for 3-5 years - utilizing interest rate volatility, yield curve movements, and credit trends. Taken together, these sessions set the basic portfolio parameters, including duration, yield-curve positioning, sector weightings and credit quality. Bottom-up strategies, including credit analysis, quantitative research and individual issue selection, are then meshed with the top-down strategies to add value. We may at times use futures to replicate bond positions The fund may invest all assets in derivative instruments and up to 20% of fund assets may be invested in securities denominated in foreign currencies.

Pacific Investment Management Company LLC (PIMCO)

• More than 1,000 employees including 258 investment professionals. • Founded in 1971 and based in Newport Beach, California. • PIMCO is one of the world's leading fixed-income fund-management companies with more than $829 billion of assets under management; led by William Gross, noted bond manager. • Clients include more than half of the 100 largest U.S. corporations • Includes America's largest bond fund, PIMCO Total Return Fund, with $128 billion AUM as of June 30, 2008. • The company is majority owned by Munich-based Allianz Group, a leading global insurance company with over $1 trillion in assets and represented in 70 countries around the globe. * Notes: The 10-year average return shown for PTRAX is for the 10-year period 01/01/98 - 12/31/07. The average was calculated by adding the results for the 10 consecutive calendar years shown and dividing that result by 10. The 10-year average return and 10 individual annual performance results are shown with all dividends and gains reinvested and are net of all fund fees. All fund expenses have already been deducted from the percentage results shown. http://www.moneymasters.com/default.aspx?page=GrossWilliam

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AMERICAN.COM A MAGAZINE OF IDEAS Guess Who Really Pays the Taxes By Stephen Moore From the November/December 2007 Issue Yes, income in America is skewed toward the rich. But taxes are skewed far, far more. The top 5 percent pay well over half the income taxes. STEPHEN MOORE has the numbers.

1. Are income taxes fair? That depends on who is offering the opinion. Democratic candidates for president certainly don’t think so. John Edwards has said, “It’s time to restore fairness to a tax code that has been driven badly out of whack.” Hillary Clinton laments that “middle-class and working families are paying a much higher percentage of their income [in taxes].” Over the past seven years, however, Americans in general think taxes have become more fair, not less. The Gallup Organization found in an April poll that 60 percent of respondents believe the income taxes that they themselves pay are fair, compared with 37 percent who believe the taxes they pay are unfair. In 1997, the figures were 51 percent fair and 43 percent unfair. 2. What income group pays the most federal income taxes today? The latest data show that a big portion of the federal income tax burden is shouldered by a small group of the very richest Americans. The wealthiest 1 percent of the population earn 19 percent of the income but pay 37 percent of the income tax. The top 10 percent pay 68 percent of the tab. Meanwhile, the bottom 50 percent—those below the median income level—now earn 13 percent of the income but pay just 3 percent of the taxes. These are proportions of the income tax alone and don’t include payroll taxes for Social Security and Medicare.

3. But didn’t the Bush tax cuts favor the rich? The New York Times reported recently that the average family in America with an income of $10 million or more received a half-million-dollar tax cut, while the middle class got crumbs

445 (less than $100 shaved off their tax bill). If we examine the taxes paid in a static world—that is, if we assume that there was no change in behavior and economic performance as a result of the tax code—then these numbers are meaningful. Most of the tax cuts went to the super wealthy. But Americans did respond to the tax cuts. There was more investment, more hiring by businesses, and a stronger stock market. When we compare the taxes paid under the old system with those paid after the Bush tax cuts, the rich are now actually paying a higher proportion of income taxes. The latest IRS data show an increase of more than $100 billion in tax payments from the wealthy by 2005 alone. The number of tax filers who claimed taxable income of more than $1 million increased from approximately 180,000 in 2003 to over 300,000 in 2005. The total taxes paid by these millionaire households rose by about 80 percent in two years, from $132 billion to $236 billion.

4. But haven’t the tax cuts put more of the burden on the backs of the middle class and the poor? No. I examined the Treasury Department analysis of how much the rich would have paid without the Bush tax cuts and how much they actually did pay. The rich are now paying more than they would have paid, not less, after the Bush investment tax cuts. For example, the Treasury’s estimate was that the top 1 percent of earners would pay 31 percent of taxes if the Bush cuts did not go into effect; with the cuts, they actually paid 37 percent. Similarly, the share of the top 10 percent of earners was estimated at 63 percent without the cuts; they actually paid 68 percent. 5. What has happened to tax rates in America over the last several decades? They’ve fallen. In the early 1960s, the highest marginal income tax rate was a stunning 91 percent. That top rate fell to 70 percent after the Kennedy-Johnson tax cuts and remained there until 1981. Then Ronald Reagan slashed it to 50 percent and ultimately to 28 percent after the 1986 Tax Reform Act. Although the federal tax rate fell by more than half, total tax receipts in the 1980s doubled from $517 billion in 1981 to $1,030 billion in 1990. The top tax rate rose slightly under George H. W. Bush and then moved to 39.6 percent under Bill

446 Clinton. But under George W. Bush it fell again to 35 percent. So what’s striking is that, even as tax rates have fallen by half over the past quarter-century, taxes paid by the wealthy have increased. Lower tax rates have made the tax system more progressive, not less so. In 1980, for example, the top 5 percent of income earners paid only 37 percent of all income taxes. Today, the top 1 percent pay that proportion, and the top 5 percent pay a whopping 57 percent. 6. What is the economic logic behind these lower tax rates? As legend has it, the famous “Laffer Curve” was first drawn by economist Arthur Laffer in 1974 on a cocktail napkin at a small dinner meeting attended by the late Wall Street Journal editor Robert Bartley and such high-powered policymakers as Richard Cheney and Donald Rumsfeld. Laffer showed how two different rates—one high and one low—could produce the same revenues, since the higher rate would discourage work and investment. The Laffer Curve helped launch Reaganomics here at home and ignited a frenzy of tax cutting around the globe that continues to this day. It’s also one of the simplest concepts in economics: lowering the tax rate on production, work, investment, and risk-taking will spur more of these activities and will often produce more tax revenue rather than less. Since the Reagan tax cuts, the United States has created some 40 million new jobs—more than all of Europe and Japan combined. 7. Are lower tax rates responsible for the big budget deficits of recent decades? There is no correlation between tax rates and deficits in recent U.S. history. The spike in the federal deficit in the 1980s was caused by massive spending increases. The Congressional Budget Office reports that, since the 2003 tax cuts, federal revenues have grown by $745 billion—the largest real increase in history over such a short time period. Individual and corporate income tax receipts have jumped by 30 percent in the two years since the tax cuts.

8. Do the rich pay more taxes because they are earning more of the income in America? Yes. There’s no doubt that the share of total income earned by the wealthy has increased steadily over the past 25 years. Since 1980, the share of income earned by the richest 1 percent has more than doubled, from 9 percent to 19 percent. The share of the income going to the poorest income quintile has declined. Income disparities, in absolute dollars, have grown substantially.

447 What is significant is that for the top 5 percent and 10 percent of earners, the ratio of taxes paid compared with income earned has risen. For example, in 1980, the top 10 percent earned 32 percent of the income and paid 44 percent of the taxes—a ratio of 1.4. In 2004, this group earned more of the income (44 percent) but paid a lot more of the taxes (68 percent)—a ratio of 1.6. In other words, progressivity—in terms of share of total taxes paid—has risen. On the other hand, for the top 1 percent of earners, progressivity has declined from a ratio of 2.2 in 1980 to 1.9 in 2004. 9. Have gains by the rich come at the expense of a declining living standard for the middle class? No. If Bill Gates suddenly took his tens of billions of dollars and moved to France, income distribution in America would temporarily appear more equitable, even though no one would be better off. Median family income in America between 1980 and 2004 grew by 17 percent. The middle class (defined as those between the 40th and the 60th percentiles of income) isn’t falling behind or “disappearing.” It is getting richer. The lower income bound for the middle class has risen by about $12,000 (after inflation) since 1967. The upper income bound for the middle class is now roughly $68,000—some $23,000 higher than in 1967. Thus, a family in the 60th percentile has 50 percent more buying power than 30 years ago. To paraphrase John F. Kennedy, this has been a “rising tide” expansion, with most (though not all) boats lifted. 10. Does the tax distribution look a lot different if we factor in other federal taxes, such as the payroll tax? It’s true that the distribution of taxes is somewhat more equally divided when payroll taxes are accounted for—but the change is surprisingly small. Payroll taxes of 15 percent are charged on the first dollar of income earned by a worker, and most of the tax is capped at an income of just below $100,000. The Tax Policy Center, run by the Urban Institute and the Brookings Institution, recently studied payroll and income taxes paid by each income group. The richest 1 percent pay 27.5 percent of the combined burden, the top 20 percent pay 72 percent, and the bottom 20 percent pay just 0.4 percent. One reason that the disparity in tax shares is so large is that Americans in the bottom quintile who have jobs get reimbursed for some or all of their 15 percent payroll tax through the earned-income tax credit (EITC), a fairly efficient poverty-abatement program. 11. How do tax rates in the United States compare with tax rates abroad? Overall, taxes are between 10 percent and 20 percent lower in the United States than they are in most other industrial nations. This gives America a competitive edge in world markets. But America’s lead in low tax rates is shrinking. For example, the United States now has the second-highest corporate income tax in the developed world, after Japan. Our personal income tax rate is still low by historical standards. But in recent years many European and Pacific Rim nations have been slashing income taxes—there are now ten Eastern European nations with flat-tax rates between 12 percent and 25 percent—while the political pressure in Washington, D.C., is to raise them. 12. Do tax cuts on investment income, such as George W. Bush’s reductions in tax rates on capital gains and dividends, primarily benefit wealthy stockowners? The New York Times reported that America’s millionaires raked in 43 percent of the investment tax cut benefits in 2003. It’s true that lower tax rates have been a huge boon to shareholders—but most of them are not rich. The latest polls show that 52 percent of Americans own stock and thus benefit directly from lower capital gains and dividend taxes. Reduced tax rates on dividends also triggered a huge jump in the number of companies paying out dividends. As the National Bureau of Economic Research put it, “The surge in

448 regular dividend payments after the 2003 reform is unprecedented in recent years.” Dividend income is up nearly 50 percent since the 2003 tax cut.

The same phenomenon occurred with the capital gains tax, which is essentially a voluntary tax because asset owners can avoid it by simply holding onto their stock, home, or business. This “lock-in” effect, as it is called, can be economically inefficient, since owners have a tax incentive to keep poor investments, rather than drawing out the cash and putting it into assets that are more productive. When the capital gains tax is cut, people unlock their assets and reinvest in other enterprises. The 1997 tax reform, passed under President Clinton, reduced the capital gains tax rate from 28 percent to 20 percent, and taxable capital gains nearly doubled over the next three years. The 2003 reform brought the rate down to 15 percent, and between 2002 and 2005 there was a 154 percent increase in capital gains reported as income. This explosion in realized gains cannot be explained only by the rise in the stock market, which averaged just 13 percent annually between 2003 and 2005. Capital gains tax receipts also far outpaced the revenues that the government’s static models predicted. Between 2003 and 2007, actual tax receipts exceeded expectations by $207 billion. Stephen Moore is senior economics writer for the Wall Street Journal editorial board and a contributor to CNBC TV. He was the founder of the Club for Growth and has served as a fiscal policy analyst at the Cato Institute and the Heritage Foundation. His latest book is “Bullish on Bush: How George Bush’s Ownership Society Will Make America Stronger” (Madison Books).

Image credit: chart illustrations by MacNeill & MacIntosh. http://www.american.com/archive/2007/november-december-magazine-contents/guess-who- really-pays-the-taxes

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