John Maynard Keynes, by Paul Krugman....41 5

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 86-14º (alcance)

Alvaro Espina Vocal Asesor 23 Octubre de 2008 (20 horas)

CD 86-14º de alcance Por mucho que el drama de la Norteamérica actual se derive, al decir de Paul Krugman, del hecho casi evidente de que la administración republicana -que todavía seguimos sufriendo, y que trata de bloquear la presencia de España en la cumbre financiera mundial1- no crea en el sistema en que vive, y que no crea especialmente en la democracia ni en la libertad de expresión, el problema para ellos es que, mal que les pese, la democracia y la libertad de expresión siguen funcionando. Joseph Stiglitz denuncia en el Guardian la maniobra artera de Hank Paulson, “el de la vía equivocada”, que consiste en “mejorar” el plan de rescate de Gordon Brown para beneficio de los bancos norteamericanos y en perjuicio de la concurrencia y de los contribuyentes, que terminarán siendo un daño colateral más de los muchos producidos por las iniciativas del peor Presidente de la historia de los EEUU. Y, todavía, si el plan “mejorado” sirviera para salvar al sistema financiero habría que darse con un canto en los dientes. Pero esto nadie lo sabe, engolfados como están los banqueros americanos en la ceremonia de la opacidad más absoluta. No hay más que ver las expresiones casi contradictorias con que Eric Dash titulaba sus crónicas en NYT en dos días consecutivos. El día 16 el titular era de supervivencia: “Banks Brace for Slump as Economy Weakens” (se atrincheran contra la depresión), anunciando que JP Morgan, Wells Fargo y State Street están resistiendo bien, pese a que los dos primeros han visto caer sus beneficios durante el tercer trimestre (en un 85 % JP, tras absorber a Washington Mutual y en un 25% Wells, tras digerir a Wachovia).

1 De mantenerse esta última manifestación de animadversión contra España de George W. Bush, nuestro país –con un PIB de 1,62 billones de $, el octavo del mundo, por encima de Canadá- sería el único no presente de entre los quince mayores PIB. El puesto nº 15 lo ocupa México (0,95 billones). El número 16, Holanda, con 0,86 billones de $ de PIB –poco más que la mitad del de España-, es el primer país excluido después del nuestro. Entre el grupo de los 19 invitados –además de la UE-, Suráfrica es el que tiene menor PIB (0,3 billones). Otros cuatro invitados tienen menor PIB que Holanda: Turquía (0,75 billones), Indonesia (0,49), Arabia Saudita (0,46) y Argentina (0,32).

1 Pero incluso a estos tres bancos –que figuran entre los menos dañados y están interesados lógicamente en que esto se sepa-, no les parece conveniente lucir su musculatura, ya que todos ellos – más o menos “obligados”- van a “pillar cacho” en la cosa de Paulson, de modo que tratan de vestir el santo con ropa de penitencia -porque ahora no estamos en la escala de tiempo en la que lo que importa es captar inversores, sino producir conmiseración en el contribuyente-, llorando por lo que se les viene encima y justificando que hay que estar preparados para lo peor. Y es que, al abandonar la “recta vía” de Gordon Brown, Paulson ha emitido un sistema perverso de incentivos. Ahora ya nadie quiere aparecer como saneado. ¡Total, para lo que vale! (En cambio, los bancos alemanes sólo acudirán a lo de Merkel si no les queda otro remedio, porque el primer precio a pagar es rebajar el sueldo de los ejecutivos). Pese a lo cual, Dash se ve obligado a rectificar porque la lúgubre foto del día anterior –que había causado preocupación- era de empleados de Wachovia cuando se los recibía en Wells Fargo, no del acto de presentación de resultados del banco, celebrada ese mismo día. Y al día siguiente, una vez asimilado por los estados mayores de la banca lo suculento del colchón de lo de Paulson (¡café para todos, oye!), Louis Story y el propio Eric Dash titulan: “Banks Are Likely to Hold Tight to Bailout Money” (parece que los bancos se van a aferrar a lo de Paulson) y los grandes se atreven ya a declarar que las pérdidas en las que han incurrido desde que estalló la crisis equivalen al monto de sus beneficios desde comienzos de 2004: 305.000 millones de $ más o menos. De modo que ya a las 10:29 del día 16 Paulson cantaba victoria:

Good number of banks want equity: Paulson Thu Oct 16, 2008 10:29am EDT WASHINGTON (Reuters) - Treasury Secretary Henry Paulson on Thursday said that there were plenty of other banks interested in an equity injection under the government's $700 billion financial rescue plan.

2 "We got nine banks to sign up initially and we're going to be going out broadly. And you know, we have we have interest from a good number of other banks," he told Fox Business News in an interview. Paulson on Tuesday persuaded the country's nine largest banks to accept a total taxpayer equity injection of $125 billion to recapitalize the banking system and confront a global credit crisis.. "We took unprecedented actions on a case by case basis...now we're going to the heart of the problem. We're taking a systemic approach. These are bold actions. I'm confident they're the right actions," he said. Claro que, al no haber establecido Paulson ningún tipo de penalidad, del mismo modo que los banqueros habían venido mintiendo estos últimos años inflando las valoraciones de sus activos2 y sus beneficios -como dice el historiador Richard Sylla- es posible que también lo sigan haciendo ahora, inflando las pérdidas, para que Paulson –además de recogerles la basura, con cargo a los contribuyentes- les dé una ayudita adicional. Y es que, como decía Roubini, de poco vale la nacionalización si no se separa inmediatamente a los golfos, temerarios y/o incompetentes de los banqueros respetables. Eso mismo piensa Botin. Al menos queda el consuelo de saber que el banco que menos desastres declara es el del propio Paulson (Goldman Sachs), porque sólo faltaba que, además de incompetente (wrong-way Paulson), el Secretario del Tesoro fuera también un golfo. Y golfo no será, pero adicto a las prácticas clientelistas sí que es. NYT bromea en titulares traduciendo G&Sachs por “Gobierno y Sachs” ofreciendo las fotos de familia del tesoro con altos cargos, todos venidos de la casa (lo que parece que se remonta ya hasta los tiempos de Rubin). ¡Cómo no será la cosa que al Chairman Bernanke ya le han pillado en un lapsus: En su declaración ante el Senado pidiendo un nuevo paquete de reactivación dijo “...... el tesoro del Secretario”, ¡en lugar del “... el Secretario del Tesoro” ! (¿lo han cogido? ¡A ver si fue un lapsus simulado!). Para algunos colegas de Wall Street la apropiación del Tesoro por los de Goldman es un verdadero escándalo. Parafraseando a Charlie

2 Recuérdese que uno de los protagonistas de la Hoguera de las vanidades, de Tom Wolfe, era especialista en la “tasación de activos infravalorados”. Era, pues, un experto de esos que le gustan a Greenspan, que antes de empezar a trabajar ya saben la “verdad” que van a descubrir.

3 Wilson, hoy podríamos decir: “lo que que es bueno para Goldman and Sachs es bueno para Estados Unidos” Ante la lenidad de los reguladores y los supervisores, y la inoperancia del sistema de prevención de crisis financieras, América parece haber vuelto al período anterior a la creación de la Fed, cuando John Pierpont Morgan en persona (el american financier cosmopolita, por excelencia) y sus agentes se encargaban de arreglar las crisis como favor directo a los Presidentes Cleveland y McKinley. Las Pujo Hearings se encargaron ex post facto de dictaminar que el inevitable conflicto de intereses exigía que las crisis las resolviesen instituciones y servidores públicos capaces de mantenerse a un sólo lado del mostrador. Ya veremos qué pasa ahora. Pero la acusación de los de Lehman –según la cual a ellos se les ocurrió transformarse en Holding Banks tres meses antes de quebrar, pero no les dejaron hacer lo que luego obligaron a hacer a Morgan y Goldman, para salvarlos- resulta muy fuerte. En resumen, ¿a qué se debe todo este desaguisado? El disclaimer de Slate resulta estos días muy esclarecedor: El volumen de los contratos derivados “hechos a medida” (over de counter: OTC), tasados al valor facial de los activos que actúan como principal o referente de cada derivado, se elevaba a fines de 2007 a 596 billones de $. Un volumen que se ha multiplicado por cuatro en los últimos cinco años y viene a suponer casi el triple del valor total de los activos financieros mundiales, que suman 167 billones de $. Pero ese es su valor “nocional”, en el que obviamente existe contabilidad múltiple, porque sobre el mismo activo pueden recaer múltiples derivados, y una buena parte de los mismos se compensan entre sí: por ejemplo, las permutas de tipos de interés (IRS; interes-rate swaps), que permiten convertir una obligación contraída a tipo de interés variable en otra a tipo fijo, obligándose el emisor del derivado a aportar –o embolsarse- la diferencia entre el pago periódico real, relacionado con un tipo de referencia, como el euribor, y el tipo fijo establecido en el contrato. Otros derivados que se compensan entre sí son los credit default swaps (CDS), o seguros de riesgo crediticio, cuyo volumen se ha

4 multiplicado por veinte entre 2003 y 2008, pasando de 2,69 a 54,6 billones de $; o sea, un tercio de la riqueza financiera global. Su importancia es crucial, porque el Acuerdo de Capital de Basilea II equipara estos contratos a las garantías de tipo personal, a las que se imputa una mínima exposición al riesgo,3 por lo que las entidades que los suscriben reducen la cuantía de los recursos propios que los bancos están obligados a inmovilizar por cada crédito así asegurado, con lo que pueden expandir el negocio y ganar más, aumentando su apalancamiento: esto es, los CDS constituyen el principal vehículo para elevar la velocidad de circulación del dinero, minimizando la redundancia de los mecanismos de control del riesgo crediticio y elevando exponencialmente el riesgo de desapalancamiento cuando aparece la crisis sistémica4, a través del multiplicador financiero internacional, definido por Krugman. Brian S. Wesbury y Robert Stein se basan precisamente en la simetria entre la rápida elevación de la velocidad durante los tiempos de la burbuja financiera, el hundimiento tras la pérdida de confianza en los CDS, y su eventual recuperación tras el compromiso federal de no dejar caer a más bancos para predecir en Forbes que esta crisis será una crisis en V. Esto supone hacer abstracción de los efectos de la crisis sobre la economía real. Otros analistas también señalan que, para que se produjese ese efecto, la etapa de credit crunch tendría que haberse prolongado. Según esta interpretación, la acción rápida de los poderes mundiales habría salvado al mundo de la depresión. Bienvenidos sean los vaticinios venturoso en estos tiempos de economía lúgubre. Cabe decir, sin embargo, que se trata de intuiciones y conjeturas basadas en suposiciones muy complejas, que todavía no están

3 Para una estimación del precio de estos instrumentos, véase J. Cabedo et alia, “Cálculo del VaR en los derivados de crédito. Credit Default Swap”, disponible en: http://dialnet.unirioja.es/servlet/fichero_articulo?codigo=2471400&orden=0 4 La Depository Trust & Clearing Corporation (DTCC), encargada de la liquidación de Lehman ha anunciado el resultado final de la liquidación de los OTC-CDS: frente a un valor de los bonos fallidos asegurados de 72.000 millones, el valor recuperado fue de 5.200 millones (un 8,7%), lo que implica que los vendedores de protección deben pagar el 91% del valor de lo asegurado. Extrapolado a la masa nacional de OTC-CDS (400.000 millones de $), tan sólo las pérdidas totales en este mercado se elevarán a 360.000 millones de dólares.

5 validadas porque nos movemos en aguas no cartografiadas. Ciertamente, haciéndolo funcionar en sentido inverso, el modelito de Krugman5 predice una rápida inversión del efecto expansivo internacional de la oleada de desapalancamiento, y, en su versión para un sólo país (basada en el modelo de decisiones de cartera de Tobin), lo mismo ocurre a escala nacional, de modo que la acción concertada internacional –adoptando todos simultáneamente el mismo tipo de medidas- podría tener la virtud de conducir a una crisis en V, y la principal preocupación inmediata pasaría a ser poner los medios para que toda esta pesadilla no vuelva a ocurrir. Pero ¿quién sabe? RGE piensa que la desaceleración en el crecimiento real del crédito -desde su máximo del 16% en 2007- puede haberlo llevado ya hasta el 7% y reducirlo haste el 5% el año próximo. Con estos augurios es dificil confiar en el efecto mágico sobre la velocidad de circulación. Pero la cosa se pone todavía peor cuando se mira hacia los hedge funds. Bob Samuelson indica que los dos billones de $ de capital de estos fondos pueden esfumarse en seguida. Ello explica el ritmo de redenciones del mes de septiembre (43.000 millones de $), que parece se está acelerando. Habrá que ver lo que ocurre al final del próximo trimestre, cuando vuelva a abrirse la ventana, pero RGE Monitor estima que en el inmediato futuro estos fondos tendrán que reducir su apalancamiento a la mitad o a un tercio. Además, el efecto de este desapalancamiento puede resultar infernal: Como señala Sebastian Mallaby, si un fondo o un banco invierten 100 $ (cinco de recursos propios y 95 de recursos ajenos) una pérdida del 5% obliga a liquidar los otros 95 $, con el efecto devastador que ello tiene sobre la cotización en los mercados de activos, ya que cada punto de apalancamiento vuelca sobre el mercado dos billones de activos. Como se ha comprobado en la liquidación de Lehman, la intensidad del efecto multiplicador del

5 Para hacer justicia, habría que decir el modelo Calvo-Krugman, e incluso el modelo Calvo- Kaminsky-Reinhart-Vegh-Krugman, ya que este último se basa en los trabajos precedentes de Guillermo Calvo (1998): “Capital Market Contagion and Recession: An Explanation of the Russian Virus”, y Graciela Kaminsky, Carmen Reinhart y Carlos Vegh (2003), “The unholy trinity of financial contagion.” En este CD se incluye este último paper y el de Calvo, pero en versión revisada en abril de 2007.

6 modelito de Krugman es impresionante (tanto a escala nacional como internacional). ¿Bastará la acción concertada adoptada hasta ahora para contenerlo y para invertirlo? Piensese que estos fondos son lo principales vendedores de instrumentos derivados de todo tipo, incluídos los CDS y los CFO (collateralized fund obligations), que son otra forma generalizada de creación de activos financieros gaseosos, sin relación alguna con la posesión del más mínimo activo tangible o perceptible, cuyas prácticas más o menos fraudulentas a escala masiva son la principal causa de la crisis actual. 6 Roubini piensa más bien que la amenaza de un proceso de desapalancamiento desordenado de los hedge funds y de agudización del credit crunch puede requerir diseñar una operación de rescate “a la LTCM” pero a escala global. Como sería impensable que los poderes públicos salieran al rescate de los más ricos del planeta –y de cada casa: véase lo de Fernández Tapias en Banif-, esto sólo se podría hacer obligando a los prime brokers de estos fondos a mantener sus posiciones de riesgo, impidiendo las redenciones. Una medida de tal intensidad debería acompañarse, según Roubini, de una acción cooperativa urgente internacional con siete grandes medidas (que pueden parecer alarmistas, pero que no lo son tanto si se piensa que sus voces de alarma, de parecido calibre, ya se han materializado, con creces): 1) Una nueva ronda de reducciones de los tipos de interés de 150 pb., en promedio7

6 Y sobre cuyo carácter presuntamente delictivo poca gente duda, aunque sólo el pasado día veinte se inició una investigación seria, protagonizada esta vez, en una colaboración sin precedentes, conjuntamente por los fiscales de Nueva York y los federales (¡por fin!). Miguel Ángel Aguilar, en Cinco Días, y varios lectores de estos CD, en conversación privada, echan en falta la “cuerda de presos” enviando a los responsables a galeras para que pueda empezar a restablecerse la confianza a largo plazo, que descansa sobre la justicia. Desde luego, lo que no falta es “alarma social” al respecto. Y más, si el Gurú de Buenafuente traduce billones (trillions) por trillones de dólares: véase http://es.youtube.com/watch?v=lU-j2mIwOpE 7 Como a la Fed ya apenas le queda margen (significaría poner el tipo de interés a cero), el descenso sería asimétrico y afectaría más a los que los tienen más altos, como Latinoamérica, cuyos tipos van desde el 13,75% de Brasil y el 11,75% de Argentina al 8,25% de Chile y Colombia. Para el BCE la medida supondría situarlo en el 2,25%. En todo caso, parece que los mercados de divisas no están penalizando los descensos de tipos porque interpretan que reducciones sustanciales resultan imprescindibles para el mantenimiento de la actividad. Y

7 2) Garantía temporal de todos los depósitos, mientras se procede a cerrar las instituciones financieras insolventes (recapitalizando sólo a las solventes aunque ilíquidas)8. 3) Congelación temporal de desahucios y reducción de deuda de los hogares insolventes (mediante reestructuración judicial con condonación parcial)9 4) Provisión masiva ilimitada de liquidez a las entidades solventes10 5) Crédito público al sector corporativo solvente para evitar liquidaciones prematuras 6) Planes de reactivación públicos masivos: obra pública; infraestructura; desempleo; reducción de los impuestos para las rentas bajas y rescate de los Estados y Ayuntamientos atrapados. 7) Acuerdos entre países prestamistas-acreedores con balanzas corrientes superavitarias y países prestatarios-deudores con cuentas corrientes deficitarias para mantener esquemas adecuados de reciclaje de la financiación, evitando ajustes desordenados de las situaciones de desequilibrio (léase acuerdo chino-americano: Bretton Woods II forever) Volviendo a los contratos derivados, su valor bruto de mercado (no el de los activos referenciados) -simulando que todos ellos hubieran sido liquidados a finales de 2007- habría sido de 14,5 billones $ –o sea, algo menos de la décima parte de la riqueza financiera global- y su valor neto, eliminando doble contabilidad, de 3,3 billones (el 2% de aquella). Y, sin embargo, su capacidad para generar riesgo, ha sido casi infinita: si éste se midiese por las recientes caídas del valor de las cotizaciones de aquella riqueza en los mercados, el riesgo materializado equivaldría casi al 50% de la riqueza, por lo que el multiplicador financiero sería de –25. Probablemente es a este tipo de cobertura a la que se refería Greenspan, “el iluminado”, cuando afirmaba en 2004 que “el sistema financiero en su conjunto se ha vuelto más resistente”

bajadas de tipos de interés de este tenor contribuirían a corregir la morosidad en la economía real y que los bancos pudieran ganar algo más para enjugar sus pérdidas. 8 Lo cual es más fácil de decir que de hacer, como se pone de manifiesto en el procedimiento concursal. Sólo sería posible elevando considerablemente la discrecionalidad en la acción del supervisor. Pero a esto, Paulson ya nos tiene acostumbrados, y otros supervisores menos dados a la lenidad que el supervisor americano disponen de información más que suficiente para proceder a una consolidación bancaria objetiva (discrecional, pero no arbitraria). 9 Aquí es donde encajaría una acción española de estabilización hipotecaria “a la New Deal”. 10 Que, actuando en paralelo con la consolidación, reduciría el riesgo de las garantías ilimitadas con las que ya estamos funcionando: Al amparo de ella las instituciones menos solventes ya están realizando actuaciones temerarias (¡con depósitos al 8,5%!).

8 En cambio, el que sigue siendo listo como el hambre es Buffet, que predica con el ejemplo y compra estos días acciones norteamericanas a mansalva (Botín también anda de compras por allí, y lo dice en voz alta, aprovechando para dar una pequeña lección de banquero de los de antes, predicando lo que aprendió de su padre y de su abuelo)11. Y además Buffet anuncia la inflación pavorosa que viene, con la lluvia de “trillones” de dólares que está cayendo desde el gobierno. Esto lo aprendió Buffet de Krugman, cuando dio aquel grito de que la trampa de liquidez “Is baaaack.....”, y les dijo a los japoneses que para salir de ella tenían que crear inflación en serio y a diez años vista.12 Bernanke comparte la teoría y, aunque no lo diga, piensa seguir aparentando que lucha contra la inflación, aunque estará encantado si ésta se le dispara un poquito los próximos años, para ayudar a ajustar a la baja los precios de las burbujas (recuérdese su sofisticada definición de la política de objetivos de inflación (inflation targeting). Este es uno de los problemas derivados del gigantesco “fallo del banco central” registrado durante el último decenio. Y Krugman le apoya en esto. Porque, no nos engañemos, las consecuencias de Mr. Greenspan “el iluminado” no se limitan a lo que hizo durante su mandato y a la crisis que ahora sufrimos. Hasta estos días los bancos no se han

11 Claro que Intereconomía se apresuró a difundir el 20 de octubre –al modo del ventilador de la basura informativa- un estudio hipotético de Merril Lynch, según el cual –si las cotizaciones descendieran otro 10%- el Santander necesitaría 6.600 millones de capital adicional (un 12% de su capitalización) y el BBVA 2.200. Para las 23 primeras entidades europeas, las necesidades totales serían de 73.000 millones. No se sabe si el estudio hace hipótesis alternativas sobre un descenso de las cotizaciones hasta cero, pero es de suponer que entonces las necesidades de nuevo capital se elevasen al 100% (y es que al paso que vamos nadie puede decir “de este agua no beberé”, pero todavía hay clases). Tampoco se computan las reservas de nuestros bancos. Intereconomía tampoco comenta que Merril Lynch “casi” no tiene intereses en difundir malas noticias de los bancos competidores, después de haber perdido 40.000 millones $ el año pasado y protagonizado el 15 de septiembre la operación de salvamento en última instancia más rocambolesca de las muchas que se han visto estos meses, al ser comprada por BoA de manera fulminante tras conocer sus gestores que a Lehman lo iban a dejar quebrar. 12 Krugman, Paul. 1998a. "It's Baaack: Japan's Slump and the Return of the Liquidity Trap." Brookings Papers on Economic Activity 2, pp. 137-205. Texto y cuadros disponibles en: http://web.mit.edu/krugman/www/bpea_jp.pdf, y http://web.mit.edu/krugman/www/bpeafigs.html

9 atrevido a declarar que han perdido todo lo que ganaron desde el pinchazo de la burbuja de los nuevos mercados –que casi no fue pinchazo, aunque mucho mejor habría sido que lo fuera-. Su atrevimiento resultaría impensable sin el paraguas de la “ventana” que les proporciona el momio de Paulson –que, contra la recomendación de Roubini, ofrece barra libre para sus pérdidas, sin penalizar siquiera a los más lerdos (ya que, para escarmiento, ya bastó con lo de Lehman, que fue la única alegría que Paulson le ha dado a su cuerpo estos meses)-. Ahora bien, salvo que los de Forbes lleven razón, todo esto no significa que la crisis se resuelva así. Porque de ahora en adelante habrá que pagar también –vía impuestos o vía deuda, con el consiguiente crowding-out- el coste del mayor cortafuegos monetario de la historia, levantado por Greenspan tras la crisis de 2001 para sofocar el incendio que él mismo había provocado, tras detectar la exuberancia irracional de los nuevos mercados a finales de los noventa y no atreverse a “retirar la ginebra” a tiempo13. Y es que, probablemente, el

13 Hay que remontarse a la trampa de liquidez de los Austrias para encontrar una situación similar. En 2001 parecía evidente que algo así estaba ocurriendo entonces, pero no me atreví a afirmarlo de forma expresa, porque en aquel momento no se habría admitido –y mucho menos, referirlo a la crisis de la hegemonía económica de los EEUU de Norteamérica-. Así que decidí emplear una parábola y contar lo que estaba ocurriendo, aunque situándolo en el siglo XVII. En Hacienda Pública Española, M. Gutiérrez Lousa entendió el juego. Agradezco la comprensión de los editores de HPE en momentos poco propicios para ese tipo de aventuras. Véase “Finanzas, deuda pública y confianza en el gobierno de España bajo los Austrias”: http://www.ief.es/Publicaciones/Revistas/Hacienda%20Publica/156_AlvaroEspina.pdf; y: 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. Como sucedió en los años noventa con las nuevas tecnologías e Internet, la base real para la emergencia de la economía de las burbujas en el siglo XVII fue la innovación en el sistema de producción de la plata a mediados del siglo anterior, que permitió la formación de un mercado monetario verdaderamente global (a través de la circulación intercontinental de metales, como dijo Keynes). Este asunto lo estudié en: “Oro, Plata y mercurio, nervios de la Monarquía de España”, Revista de Historia Económica Año XIX Otoño-invierno 2001 n. 3 pp. 507--538 http://biblioteca.minhac.es/CIC/BASIS/tlpesp/www/cat2/DDW?W%3DAUTH%3D%27Espina%2C+ %C1lvaro%27%26M%3D29%26K%3D64974%26R%3DN%26U%3D1. Para mayor similitud, también allí aparecían los chinos -la dinastía Ming, coetánea de los Austrias- como suministradores de oro -“dinero político con que se financiaban las guerras-, que los chinos cambiaban por el Real de a ocho (el dólar de entonces). Finalmente, al igual que ahora, el motivo práctico para el colosal endeudamiento de los Austrias (incurriendo también en déficit gemelos) que condujo a la trampa de liquidez del siglo XVII fue la mala conducción política, traducida en una aventura imperialista unilateral y en el descuido absoluto de la regulación

10 Greenspan “no tan iluminado” estaba interesado por aquellas fechas en conseguir la ratificación para un nuevo mandato, y, pensando que iba a ganar Al Gore, no le convenía frenar el crecimiento, no fuera a ser que se le acusase de ir en contra de la elección del Vicepresidente, como ya se le había acusado de impedir la reelección de George Bush en 1994 (eso sin contar con que Robert Rubin tenía también parti pris en la operación). El jolgorio siguió hasta 2001, so pretexto de que, en ausencia de inflación galopante –medida por el IPC-, el banco central no estaba legitimado para intervenir, porque “los bancos centrales no están encargados de controlar las cotizaciones de los mercados de valores” y, en caso de que alguien les pidiera que se encargaran de hacerlo, “no disponen de modelos científicos para fijar cuál debe ser su nivel” (¡miren ustedes por dónde salió el iluminado!: cuando le conviene, existe conocimiento sobrado para confiar en que los bancos se autolimiten y el mercado actúe de manera racional; en cambio, cuando se trata de la política monetaria, que depende en gran parte de sus propias acciones, nunca se sabe lo suficiente para adoptar decisiones de sentido común). De poco sirvió que las voces más sensatas se levantaran diciendo que la inflación de los activos bursátiles era signo evidente de exceso de holgura monetaria y que había que cambiar los índices de inflación que orientan la política monetaria para incluir la evolución de los precios de los activos, previniendo el riesgo de burbujas –ya que por entonces exigir regulación y supervisión de las malas prácticas financieras de Wall Street resultaba casi impensable, entre otras cosas porque el conocimiento al respecto no gozaba de predicamento en las ciencias económicas, y además, porque nos encontrábamos en plena fiebre desregulatoria-. Las advertencias cayeron en saco roto porque Greenspan se encontraba ya luchando otra vez por la renovación y visitando semanalmente la oficina del Jefe de asesores económicos del eficiente y de la economía real de la península, persiguiendo sueños fundamentalistas, en contra de los avances de la modernidad en los países circundantes. Véase “La resistencia a la monarquía de España y el sistema europeo de estados”, Sistema, Nº 164, 2001 , Págs. 43-68: http://biblioteca.minhac.es/CIC/BASIS/tlpesp/www/cat2_avd/DDW?W%3DSUBJ%3D'MONARQUIA'%26M% 3D9%26K%3D64716%26R%3DN%26U%3D1

11 Presidente –y del Vicepresidente Cheney-, lo que significaba utilizar la política monetaria como palanca para la reelección de George W. Bush. Todo ello realizado con una desvergüenza tal que el propio Hans Tietmeyer tuvo que echarle en cara que con su comportamiento estaba poniendo en peligro la política de autonomía de los bancos centrales –que era deseable en sí misma, siempre que los gobernadores no la emplearan de forma artera-. Y para llevar a cabo esta nueva tropelía, Greenspan tuvo que cometer otro delito contra el conocimiento -todavía no tipificado, que se sepa, en ningún código penal- consistente en manifestar que se estaba aplicando la regla de Taylor –que sintetiza el más depurado conocimiento en el que se basan los manuales de buenas prácticas de los banqueros centrales-, pero trucando el indicador que sirve de parámetro de referencia para esa regla monetaria, que no es otro que el output-gap. Pretextando la superación “definitiva” del umbral de productividad potencial de EEUU, fruto de las nuevas tecnologías (cosa ésta a la que se denominó “nuevo paradigma” y hasta “nueva economía”), se sobreestimó intencionadamente el crecimiento potencial del PIB, de modo que –con tasas de crecimiento real que a mediados de 2003 ya superaban el 3%- la Fed siguió combatiendo el output-gap un año más, hasta que el pausado cambio de orientación de la política monetaria del verano de 2004 –una vez nominado Greenspan para su quinto mandato, en mayo- ya no podía afectar a las expectativas de crecimiento previas a la elección de noviembre de ese año, ya que en EEUU el plazo medio de transmisión de la política monetaria a la economía real es de seis meses. Afirmar esto ahora, a toro pasado, resulta relativamente sencillo, pero hay que situarse en 2003 y 2004 para evaluar la disponibilidad de conocimiento y los indicadores disponibles entonces. Los Cuadernos de Documentación empezaron a ocuparse por esas fechas del problema de las trampas de liquidez, y a la altura de enero de 2004 resultaba evidente ya que el mundo estaba lleno de burbujas y que el problema no era cómo prevenirlas, sino el momento en que iban a estallar y la política a

12 aplicar tras su estallido.14 Una detención a tiempo habría tenido la virtud de aminorar el desplome y de minimizar los daños, lo que seguramente había permitido contener en cierto modo el derrumbamiento de la confianza, siempre y cuando las autoridades se hubieran decidido a intervenir para evitar la difusión de malas prácticas, que todo el mundo denunciaba (y algunos fiscales estatales trataban de corregir). Pero a esas alturas faltaba liderazgo y voluntad para hacerlo (de hecho, se avocó en el fiscal federal la competencia para actuar en materia de hipotecas, se suspendió la acción contra las subprime y la SEC relajó todavía más las normas sobre productos financieros y consumo de capital). De modo que sólo quedaba librarse al fatalismo de Greenspan y esperar la llegada del miedo....: “..... the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve. Asset-price bubbles build and burst today as they have since the early 18th century, when modern competitive markets evolved....” ... haciendo bueno el dicho de que el ser humano es el único animal que tropieza varias veces en la misma piedra. Hay que mencionar aquí también un cierto efecto boomerang del conocimiento. En el CD 86 se analizaban, por ejemplo, los fallos detectados en las reformas “privatizadoras” y “mixtas” de los sistemas de pensiones latinoamericanos y se examinaba la propuesta formulada por R. Lo Vuolo y Laura Goldberg de reconducir el despilfarro que supone el mantenimiento de dos sistemas paralelos en Argentina hacia un sistema único bajo la modalidad de reparto, utilizando los activos acumulados por el sistema privado para financiar la etapa de transición, mediante “cuentas nocionales” de tipo sueco. Pues bien, so pretexto de la

14 Se encuentran disponibles en la biblioteca virtual del MEH. Puede consultarse en la intranet (http://intranet.minhac.age/C0/C0/Portal%20Biblioteca/Lists/Portal%20Biblioteca/CD%2071- 2004.pdf), aunque sólo a partir del nº 71, de abril de 2004. Sin embargo, la síntesis de todos los Cuadernos que trataron el asunto se encuentra en el trabajo “Sobre estabilidad de precios, deflación y trampas de liquidez en el G3”, aparecido en RIE en enero de 2004, disponible en: http://biblioteca.minhac.es/CIC/BASIS/tlpesp/www/cat2_avd/DDW?W%3DAU++%3D+%2 7ESPINA%27%26M%3D46%26K%3D64724%26R%3DY%26U%3D1. Este texto incorpora también la addenda, redactada en junio de 2004, tras el cambio de la política monetaria, poniéndole velas al santo para que no fuera ya demasiado tarde. Pero era pedir milagros porque el daño ya estaba causado.

13 infradotación de capital de algunos de estos fondos, Cristina Fernández acaba de nacionalizarlos, subsumiéndolos en el sistema de reparto, pero apropiándose de sus activos para hacer frente a los compromisos de pagos de la deuda y evitar otro default. De este modo, una propuesta de reforma racional puede ser reconvertida por los gobernantes autoritarios en “arreglos” expropiatorios más o menos encubiertos (tras fracasar el de expropiación de los chacareros).15 Pues bien, algo parecido ha sucedido con los estudios realizados por Paul Krugman sobre la pervivencia de la amenaza de trampa de liquidez, estudiada por Keynes –que el flamante premio Nóbel enfatiza ahora en su prólogo a la Teoría General, incluida en este CD-. Como vimos, Krugman recuperó todo aquello al hilo de la crisis japonesa, pero Greesnpan se la apropió y la malbarató, aplicando sus medicinas a destiempo, interpretando que la burbuja de los nuevos mercados significaba la amenaza del Armagedón financiero. Como vemos, Krugman no está libre de responsabilidad indirecta en este caso, pero ese es el problema que acecha siempre a los creadores de conocimiento, que, es una actividad claramente diferenciada de la de tomar decisiones políticas y no entiende de oportunismos: Krugman analizaba el caso de Japón y recomendaba las medidas a aplicar en ese caso específico –que sí atravesaba una situación de trampa de liquidez-, pero con ello proporcionaba munición a los partidarios de la reflación permanente y al activismo monetario de la Fed para sostener los mercados de valores. Además, su síntesis magistral del conocimiento sobre las políticas para combatir la trampa de liquidez infundieron la falsa seguridad de que, cualquiera que fuera el riesgo en que previamente se hubiera incurrido, llegado el caso disponíamos de herramientas para arreglar la avería. El gobernador Bernanke fue uno de los primeros en apuntarse a aquello de “a nosotros esto no nos pasará”, sencillamente porque, según su interpretación de entonces, en Japón el problema fue

15 Hay quien dice que, al igual que en la primera mitad del siglo veinte toda gran crisis internacional acababa con la expropiación de las pensiones de los alemanes –algo que ocurrió con la hiperinflación que siguió a la Gran Guerra y con la expropiación de las mutualidades por Hitler para financiar el rearme-, a finales del siglo XX el verdadero efecto mariposa consiste en que toda gran crisis financiera termina expropiando las pensiones argentinas.

14 que no se vió venir la amenaza y no se actuó a tiempo y con la suficiente intensidad.16 Eso es lo que había que hacer en 2001-2002 para producir una crisis en V (que es lo que dicen ahora los de Forbes, y ójala sea cierto). Pero, como señalaba Krugman observado el caso de Japón, la etapa post-trampa de liquidez está plagada de falsos amaneceres. La experiencia de las grandes crisis financieras nacionales de la historia reciente indica que su corrección tarda tiempo y que la absorción de las pédidas resulta costosa y lenta. ¡Cuanto más no lo será una crisis sistémica global! Acerca del paquete reactivador, Krugman cree que debe significar un esfuerzo fiscal y presupuestario de grandes dimensiones, y algo así parece decir Bernanke. Sin perjuicio de que a corto plazo esto tiene que ser así –sobre todo en un país como EEUU en que estos meses la gente tiene que elegir entre comer o comprar sus medicinas-, en el medio plazo no habrá recuperación sostenida si no se produce una revigorización de las economías ordinarias de los hogares norteamericanos –y, con ellos, de muchos otros países- a través de mecanismos de redistribución de la renta –via mercado de trabajo- que les permita una participación adecuada en el crecimiento de la productividad. Esa es la vigencia más evidente de la obra de Keynes (en su lucha contra la idea clásica de que el desempleo se combate bajando los salarios), que había quedado enterrada con la globalización de los mercados de trabajo sin reglas mínimas. El bienestar, la demanda y el crecimiento deben descansar -para ser duraderos, estables y equilibrados- sobre el Estado, sobre los hogares y sobre el mercado. Y para eso hay que establecer derechos humanos y laborales a escala global -lo que plantea el problema de China- o volver a un proteccionismo “a la Larry Summers”. Finalmente, ya es hora de pensar en la nueva arquitectura, que no saldrá seguramente de la reunión convocada por Bush, sino

16 Véase “Deflation: Making Sure ‘It’ Doesn’t Happen Here”, Remarks by Governor Ben S. Bernanke: http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm, 21 de Noviembre de 2002. Véase también A. Ahearne et alia, “Preventing Deflation: Lessons from Japan’s Experience in the 1990s”, Board of Governors of the Federal Reserve System, International Finance Discussion Papers, Number 729, Junio, de 2002, disponible en: < .

15 que tendrá que ser acordada con su sucesor. Sebastian Mallaby se mostraba estos días de atrás algo escéptico sobre las posibilidades de una cosa tan elocuente como la que se quiere montar, con lo de refundar la cosa... y todo eso. Aparte de las dificultades técnicas que presenta la regulación, la supervisión y la alerta temprana – por no decir, la acción ejecutiva- del complejo sistema financiero global, empiezan a lanzarse sugerencias que merecen estudio serio. Para empezar, los mandarines del mundo, deberán ceder algo de influencia, y compartirla, porque sin un mínimo de legitimidad nada será efectivo. El director de la LSE, Howard Davies, subsume este asunto en una propuesta de cinco puntos: 1. First, we need a simpler set of mechanisms that better reflect the shape of today's markets. The global financial system is built in three silos: banking, securities and insurance. Risks are transferred between these silos and insurance companies and brokers can pose systemic risk. We need simpler structures, with cross-sectoral coverage. 2. Second, there is a big problem of legitimacy. The Financial Stability Forum, which sits at the center of the system (without much formal authority), includes the Netherlands and Australia but not China or India. 3. Third, the new system needs to move faster. It took the Basel Committee the better part of a decade to design the Basel II standards that banks are just beginning to implement. 4. Fourth, and most crucial, we need to build a new link between macroeconomic surveillance and regulation. If asset prices or risk spreads diverge significantly from their long-term trends, supervisors would impose an across-the-board capital supplement to reflect the potential cost to the banks of a subsequent decline in prices. 5. Lastly, there is a need for new and sustained political leadership. Perhaps a standing subcommittee of the G-7 could be given a permanent role overseeing financial regulation, with the FSF as its arms and legs. It should be renamed the Financial Stability Council, given a proper staff and empowered to give instructions to the sectoral regulators. If the G-7 ministers want this to happen, it can.

16 Como se ve, aunque hable de nueva legitimidad, Davies tropieza en esa misma piedra pretendiendo retener todo el poder en el G7. ¿Por qué no ir a algo más objetivo y práctico?: los veinte países con mayor PIB del mundo, más un representante (fijo o rotatorio) por cada grupo de países abiertamente infrarrepresentados: los de la OPEC, los del África subsahariana, los del Magreb y los de Sudamérica (o sea, incluyendo a la UE, un verdadero “Grupo de los 25”)17. Y a partir de ahí ya se pueden formar órganos más reducidos, con carácter más o menos deliberante o ejecutivo, pero sometidos al control último de esa especie de “Consejo de Administración económica del mundo”. Si de la arquitectura pasamos a los contenidos, la dificultad es todavía mayor. Hay que poner a trabajar al sistema general de producción de conocimiento mundial (interdisciplinario, cambinando conocimiento económico, institucional, regulatorio y financiero). Nouriel Roubini propone que el trabajo se estructure en diez grandes áreas, que reflejan los grandes problemas en que coincide la mayoría de los diagnósticos: 1. First, the system of compensation of bankers and operators in the financial system is flawed as it is a source of moral hazard in the form of gambling for redemption..... Still, the appropriate system of compensation of bankers/traders should be evaluated as this is now an important factor that distorts lending and investment decisions in financial markets. 2. Second, the current models of securitization ( the “originate and distribute” model) has serious flaws as it reduces the incentive for the originator of the claims to monitor the creditworthiness of the borrower...... One possible solution to the lack of incentives to undertake a proper monitoring of the borrowers would be to force the originating bank and the investment bank intermediaries to hold some of the credit risk, for example in the form of their holding some part of the equity tranche in the CDOs or holding some of the MBS that they originate. But it is not obvious that such solutions would fully resolve the moral hazard problems faced by financial intermediaries. 3. Third, the regulation and supervision of banks and the lighter – on in some cases such as that of hedge funds non-existent – regulation and

17 La propuesta ganaría como adeptos para la ampliación, además de España, a Holanda, Suecia y Bélgica. Si se decidiera realizar movimientos mínimos, Arabia Saudita, Sudráfica y Argentina seguirían en el grupo y sólo habría que introducir a un representante del Magreb: Francia propone a Egipto

17 supervision of non-bank financial institutions has led to significant regulatory arbitrage: i.e. the transfer of a large fraction of financial intermediation to non-bank financial institutions such as broker dealers, hedge funds, money market funds, SIVs, conduits, etc..... Thus, an essential element of the common regulation of all non-bank financial institutions should be a greater emphasis given to the management of liquidity risk. Such firms should be asked to significantly lengthen the maturity and duration of their liabilities in order to reduce their liquidity risk. 4. Fourth, most regulatory and supervisory regimes have moved in the direction of emphasizing self-regulation and market discipline rather than rigid regulations. One of the arguments in favor of this market discipline approach is that financial innovation is always one or more steps ahead of regulation; thus, one need to design a regime that does not rely on rigid rules that would be easily avoidable via financial innovation..... Thus, while reliance on principles is useful to deal with financial innovation and regulatory arbitrage a more robust set of clear rules and regulations that go with the grain of principle-based regulation and supervision is also necessary. 5. Fifth, even before being fully implemented the Basel II agreement has shown its serious flaws: capital adequacy ratios that pro-cyclical and thus inducing credit booms in good times and credit busts in bad times; low emphasis on the importance of liquidity risk management; excessively low capital requirements given the serious financial risks faced by banks; excessive reliance on internal risk management models; excessive role given to the rating agencies and their ratings. 6. Sixth, by now the conflicts of interest and informational problems that led the rating agencies to rate – or better mis-rate – many MBS and CDO and other ABS products as highly rated are well known and recognized. Having a large fraction of their revenues and profits coming from the rating of complex structured finance products and the consulting and modeling services provided to the issuers of such complex and exotic instruments it is clear that rating agencies are ripe with conflicts of interests. Add to this the flaws of a system where competition in this credit rating market is limited given the regulatory barriers to entry and the semi-official role that rating agencies have, in general and in Basel II in particular; the potential biases of a system where rating agencies are paid by issuers rather than the investors; and the informational problems of raters that know little about the underlying risks of new complex and exotic instruments.

18 7. Seventh, there are fundamental accounting issues on how to value securities, especially in periods of market volatility and illiquidity when the fundamental long term value of the asset differs from its market price. The current “fair value” approach to valuation stresses the use of mark-to- market valuation where, as much as possible, market prices should be used to value assets, whether they are illiquid or not...... Some have suggested the use of historical cost to value assets (where assets are booked at the price at which they were bought); others have proposed the use of a discounted cash flow (DCF) model where long run fundamentals – cash flows – would have a greater role.... Some suggest that the problem is not mark-to-market accounting but the pro-cyclical capital requirements of Basel II; that is correct. But even without such pro-cyclical distortions there is a risk that financial institutions – not just banks - would retrench leverage and credit too much and too fast during periods of turmoil when they become more risk averse. 8. Eighth, the recent financial markets crisis and turmoil has been partly caused by the fact that the – over the last few years – financial markets have become less transparent and more opaque in many different dimensions. The development of news exotic and illiquid financial instruments that are hard to value and price; the development of increasingly complex derivative instruments; the fact that many of these instruments trade over the counter rather than in an exchange; the fact that there is little information and disclosure about such instruments and who is holding them; the fact that many new financial institutions are opaque and with little or no regulation (hedge funds, private equity, SIV and other off-balance sheet special purpose vehicles) have all contributed to a lack of financial market transparency and increased opacity of such markets..... Some specific ideas on how to make new complex and exotic financial instruments more liquid and easier to price would be to make such instrument more standardized and have them traded in clearing house- based exchanges rather than over the counter. The benefits of standardization are clear as such standardization would allow to compare securities with similar characteristics and would thus improve their liquidity. Moreover, instruments that are exchange-traded through a clearing house would have much lower counterparty risk, would be subject to appropriate margin requirements and would be appropriately marked-to-market on a daily basis. 9. Ninth, what are the appropriate institutions of financial regulation and supervision and the system of such regulation and supervision in a world of financial innovation and globalization? There are many alternative models that have different pros and cons..... Thus, the UK model of a single financial regulator/supervisor is – in principle – superior to a model

19 where such powers are fragmented among many and different institutions. But proper coordination and information exchange is essential to make this system work. 10. Tenth, and finally, reforms of financial regulation and supervision cannot be done only at the national level as regulatory arbitrage may lead financial intermediation to move to jurisdictions with a lighter – and less appropriate - regulatory approach. Indeed, the recent US debate on reforming capital markets was driven – before the current market turmoil – by the concerns that a tighter regulatory approach in the U.S. (say the Sarbanes-Oxley legislation) was leading to a competitive slippage of New York relative to London in the provision of financial services.... Over time financial supervision and regulation within the Eurozone will have to move from the national level to a Eurozone-wide level.

Los CD anteriores a éste ya se encuentran disponibles en la Intranet: http://intranet.minhac.age/C0/C0/Portal%20Biblioteca/Lists/Port al%20Biblioteca/BIBLIOTE111.html

20 BACKGROUND PAPERS:

1. The Real Plumbers of Ohio, by Paul Krugman....27 2. Let’s Get Fiscal, by Paul Krugman....29 3. Blog: The Conscience of a Liberal, by Paul Krugman....31 4. Introduction to The General Theory of Employment, Interest, and Money, by John Maynard Keynes, by Paul Krugman....41 5. ¿Quién era Milton Friedman?, by Paul Krugman....52 6. Krugman Proves Keynesianism Isn't Dead After All, by William Pesek....64 7. An impossible crash brought Keynes back to life, by Robert Skidelsky....66 8. 'Barbarians at the Gate,' two decades later, by JON FRIEDMAN'S....68 9. Greenspan Concedes Error in Regulatory View by THE ASSOCIATED PRESS....72 10. Five Ways to Fix Our Financial Architecture, by Howard Davies....74 11. Hedge Funds’ Steep Fall Sends Investors Fleeing, by LOUISE STORY....76 12. The Dog That Didn't Bark: Hedge Fund Industry in Trouble, RGE....79 13. Unwinding of Structured Products: Contagion Grips the $1T Corporate CDO Market, RGE....80 14. Global Deleveraging Has Set In: Real Global Credit Growth Set To Halve From Last Year And Shrink Further in 2009, RGE....83 15. TARP Implementation: $250bn Bank Capital For New Loans, Bonuses, Or Takeovers?, RGE....85 16. Final Lehman CDS Settlement: $72bn Notional Registered At DTCC Out Of $400bn Results in $5.2 Net Payout, RGE....86 17. Struggling to Keep Up as the Crisis Raced On by JOE NOCERA and EDMUND L. ANDREWS....87

21 18. A Matter of Life and Debt, by MARGARET ATWOOD....92 19. Signs of Easing Credit and Stimulus Talk Lift Wall Street, by MICHAEL M. GRYNBAUM....94 20. How to prevent a financial crisis in Hungary that would lead to serious financial contagion in Emerging Europe, by Nouriel Roubini....99 21. China’s Reserve Growth: Still Large, and Rather Volatile, by Rachel Ziemba....104 22. More unhappy numbers, by James Hamilton....108 23. A Revised Economic Outlook for Latin America, and LaTam monetary policy monitor, RGE....110 24. The Argentine Way , RGE....112 25. Party Like It's 1964, by Richard Cohen....119 26. The Founding Father of Crony Capitalism, by Thomas J. DiLorenzo....121 27. Did Joseph Wharton Cause The US Financial Meltdown?, by Tim Hartnett....124 28. U.S. Moves Toward Stimulus as Bernanke, Bush Shift, by Ryan J. Donmoyer and Scott Lanman....130 29. The Real Scandal, by Bob Herbert....133 30. U.S. Is Said to Be Urging New Mergers in Banking, by MARK LANDLER....135 31. Bernanke Says He Supports New Stimulus for Economy, by EDMUND L. ANDREWS....137 32. Joint U.S.-New York Inquiry Into Credit-Default Swaps, by VIKAS BAJAJ....139 33. Is Argentina running out of funds?, by Nicolas Magud....141 34. Bretton Woods, The Sequel?, by Sebastian Mallaby....142 35. Consensus Emerges to Let Deficit Rise, by LOUIS UCHITELLE and ROBERT PEAR....144 36. Credit Default Swaps, NYT....147

22 37. On Wall Street, Eyes Turn to the Fear Index, by MICHAEL M. GRYNBAUM....148 38. Insiders’ Share Sales on Margin on the Rise, by REED ABELSON....151 39. This toxic crisis needs more than one shot, by Wolfgang Münchau....154 40. In Good Times and Bad, by Robert J. Samuelson....156 41. ENTREVISTA: LUIS ÁNGEL ROJO Ex gobernador del Banco de España, por M. A. Noceda....158 42. Out of the Ashes The Financial Crisis Is Also an Opportunity To Create New Rules for Our Global Economy, by Gordon Brown....162 43. Buy American. I Am, by WARREN E. BUFFETT....164 44. The Guys From ‘Government Sachs’, by JULIE CRESWELL and BEN WHITE....166 45. Banks Are Likely to Hold Tight to Bailout Money, by LOUISE STORY and ERIC DASH....173 46. Banks Brace for Slump as Economy Weakens, by ERIC DASH....176 47. Unlike the UK plan, the revamped American bail-out puts banks first and taxpayers second, by Joseph Stiglitz....178 48. A better way to revive credit markets, by Robert Aliber....180 49. Bankers take a billhook to the hedge funds, by David Wighton....182 50. The Morning After, by John Cassidy....184 51. EU leaders demand recession safeguards, by Tony Barber and George Parker in Brussels....188 52. The Bankrupting of Henry Paulson, by John Tamny....190 53. Federal Reserve Board Releases....193 54. How can the derivatives market be worth more than the world's total financial assets?, by Jacob Leibenluft.... 208 55. Slash interest rates now to stave off depression, by Anatole Kaletsky.... 210

23 56. Rushing to see the apocalypse. Commentary: From calling $200 oil to economic wasteland, all in three months, by David Callaway.... 212 57. Fear Again Takes Over the Markets.Stocks Sink as Gloom Seizes Wall St. Bernanke Forecasts Prolonged Economic Turmoil; Dow Plunges 7.9%, by David Cho and Ylan Q. Mui....214 y 217 58. Markets Suffer as Investors Weigh Relentless Trouble, by PETER S. GOODMAN....219 59. Home Prices Seem Far From Bottom, by VIKAS BAJAJ...222 60. Fair Value vs. 'Alice in Wonderland' Accounting: SEC Eases Rules, by RGE Monitor....225 61. Many argue that after the $250 billion bank capital injection the government must then stem the surge in foreclosures, by Jane Sasseen....226 62. Get Used To It, by Richard Sylla....228 63. Hedge Funds Engage in Firesales Amid Margin Calls: Is There A Risk Of A LTCM Redux?, By RGE Monitor....231 64. U.S. Economy in Recession: Will the Financial Crisis Cause a More Severe and Protracted Downturn? , RGE....232 65. Do Ratings Matter?, RGE....234 66. Hayek's Legacy, by Danny Quah....236 67. Letras que son un tesoro. Las emisiones de deuda pública sacan partido al miedo de los inversores, por PIEDAD OREGUI....238 68. "In Spain we trust". El Tesoro lanza una campaña internacional para que los inversores extranjeros compren deuda española, por RAMON MUÑOZ....240 69. Crisis financiera mundial - El diagnóstico sobre las causas, por MIGUEL JIMÉNEZ....241 70. Crisis financiera mundial - El diagnóstico sobre las causas. "Son errores que no se pueden repetir", Discurso de Emilio Botín....243

24 71. Will the Bretton Woods 2 (BW2) Regime Collapse Like the Original Bretton Woods Regime Did? The Coming End Game of BW2, by Nouriel Roubini....246 72. Ten Fundamental Issues in Reform ing Financial Regulation and Supervision in a World of Financial Innovation and Globalization, by Nouriel Roubini258 73. The Unholy Trinity of Financial Contagion, by Graciela L. Kaminsky, Carmen M. Reinhart, and Carlos A. Vegh....268 74. Crises in Emerging Market Economies: A Global Perspective, by Guillermo A. Calvo....308 75. Do Credit Rating Agencies Add Value? Evidence from the sovereign rating business, by Eduardo Cavallo , Andrew Powell and Roberto Rigobon....349

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26 Opinion

October 20, 2008 OP-ED COLUMNIST The Real Plumbers of Ohio By PAUL KRUGMAN

Forty years ago, Richard Nixon made a remarkable marketing discovery. By exploiting America’s divisions — divisions over Vietnam, divisions over cultural change and, above all, racial divisions — he was able to reinvent the Republican brand. The party of plutocrats was repackaged as the party of the “silent majority,” the regular guys — white guys, it went without saying — who didn’t like the social changes taking place. It was a winning formula. And the great thing was that the new packaging didn’t require any change in the product’s actual contents — in fact, the G.O.P. was able to keep winning elections even as its actual policies became more pro-plutocrat, and less favorable to working Americans, than ever. John McCain’s strategy, in this final stretch, is based on the belief that the old formula still has life in it. Thus we have Sarah Palin expressing her joy at visiting the “pro-America” parts of the country — yep, we’re all traitors here in central New Jersey. Meanwhile we’ve got Mr. McCain making Samuel J. Wurzelbacher, a k a Joe the Plumber — who had confronted Barack Obama on the campaign trail, alleging that the Democratic candidate would raise his taxes — the centerpiece of his attack on Mr. Obama’s economic proposals. And when it turned out that the right’s new icon had a few issues, like not being licensed and comparing Mr. Obama to Sammy Davis Jr., conservatives played victim: see how much those snooty elitists hate the common man? But what’s really happening to the plumbers of Ohio, and to working Americans in general? First of all, they aren’t making a lot of money. You may recall that in one of the early Democratic debates Charles Gibson of ABC suggested that $200,000 a year was a middle- class income. Tell that to Ohio plumbers: according to the May 2007 occupational earnings report from the Bureau of Labor Statistics, the average annual income of “plumbers, pipefitters and steamfitters” in Ohio was $47,930.

27 Second, their real incomes have stagnated or fallen, even in supposedly good years. The Bush administration assured us that the economy was booming in 2007 — but the average Ohio plumber’s income in that 2007 report was only 15.5 percent higher than in the 2000 report, not enough to keep up with the 17.7 percent rise in consumer prices in the Midwest. As Ohio plumbers went, so went the nation: median household income, adjusted for inflation, was lower in 2007 than it had been in 2000. Third, Ohio plumbers have been having growing trouble getting health insurance, especially if, like many craftsmen, they work for small firms. According to the Kaiser Family Foundation, in 2007 only 45 percent of companies with fewer than 10 employees offered health benefits, down from 57 percent in 2000. And bear in mind that all these data pertain to 2007 — which was as good as it got in recent years. Now that the “Bush boom,” such as it was, is over, we can see that it achieved a dismal distinction: for the first time on record, an economic expansion failed to raise most Americans’ incomes above their previous peak. Since then, of course, things have gone rapidly downhill, as millions of working Americans have lost their jobs and their homes. And all indicators suggest that things will get much worse in the months and years ahead. So what does all this say about the candidates? Who’s really standing up for Ohio’s plumbers? Mr. McCain claims that Mr. Obama’s policies would lead to economic disaster. But President Bush’s policies have already led to disaster — and whatever he may say, Mr. McCain proposes continuing Mr. Bush’s policies in all essential respects, and he shares Mr. Bush’s anti-government, anti-regulation philosophy. What about the claim, based on Joe the Plumber’s complaint, that ordinary working Americans would face higher taxes under Mr. Obama? Well, Mr. Obama proposes raising rates on only the top two income tax brackets — and the second-highest bracket for a head of household starts at an income, after deductions, of $182,400 a year. Maybe there are plumbers out there who earn that much, or who would end up suffering from Mr. Obama’s proposed modest increases in taxes on dividends and capital gains — America is a big country, and there’s probably a high-income plumber with a huge stock market portfolio out there somewhere. But the typical plumber would pay lower, not higher, taxes under an Obama administration, and would have a much better chance of getting health insurance. I don’t want to suggest that everyone would be better off under the Obama tax plan. Joe the plumber would almost certainly be better off, but Richie the hedge fund manager would take a serious hit. But that’s the point. Whatever today’s G.O.P. is, it isn’t the party of working Americans.

28 Opinion

October 17, 2008 OP-ED COLUMNIST Let’s Get Fiscal By PAUL KRUGMAN

The Dow is surging! No, it’s plunging! No, it’s surging! No, it’s ... Nevermind. While the manic-depressive stock market is dominating the headlines, the more important story is the grim news coming in about the real economy. It’s now clear that rescuing the banks is just the beginning: the nonfinancial economy is also in desperate need of help. And to provide that help, we’re going to have to put some prejudices aside. It’s politically fashionable to rant against government spending and demand fiscal responsibility. But right now, increased government spending is just what the doctor ordered, and concerns about the budget deficit should be put on hold. Before I get there, let’s talk about the economic situation. Just this week, we learned that retail sales have fallen off a cliff, and so has industrial production. Unemployment claims are at steep-recession levels, and the Philadelphia Fed’s manufacturing index is falling at the fastest pace in almost 20 years. All signs point to an economic slump that will be nasty, brutish — and long. How nasty? The unemployment rate is already above 6 percent (and broader measures of underemployment are in double digits). It’s now virtually certain that the unemployment rate will go above 7 percent, and quite possibly above 8 percent, making this the worst recession in a quarter-century. And how long? It could be very long indeed. Think about what happened in the last recession, which followed the bursting of the late-1990s technology bubble. On the surface, the policy response to that recession looks like a success story. Although there were widespread fears that the United States would experience a Japanese-style “lost decade,” that didn’t happen: the Federal Reserve was able to engineer a recovery from that recession by cutting interest rates. But the truth is that we were looking Japanese for quite a while: the Fed had a hard time getting traction. Despite repeated interest rate cuts, which eventually brought the

29 federal funds rate down to just 1 percent, the unemployment rate just kept on rising; it was more than two years before the job picture started to improve. And when a convincing recovery finally did come, it was only because Alan Greenspan had managed to replace the technology bubble with a housing bubble. Now the housing bubble has burst in turn, leaving the financial landscape strewn with wreckage. Even if the ongoing efforts to rescue the banking system and unfreeze the credit markets work — and while it’s early days yet, the initial results have been disappointing — it’s hard to see housing making a comeback any time soon. And if there’s another bubble waiting to happen, it’s not obvious. So the Fed will find it even harder to get traction this time. In other words, there’s not much Ben Bernanke can do for the economy. He can and should cut interest rates even more — but nobody expects this to do more than provide a slight economic boost. On the other hand, there’s a lot the federal government can do for the economy. It can provide extended benefits to the unemployed, which will both help distressed families cope and put money in the hands of people likely to spend it. It can provide emergency aid to state and local governments, so that they aren’t forced into steep spending cuts that both degrade public services and destroy jobs. It can buy up mortgages (but not at face value, as John McCain has proposed) and restructure the terms to help families stay in their homes. And this is also a good time to engage in some serious infrastructure spending, which the country badly needs in any case. The usual argument against public works as economic stimulus is that they take too long: by the time you get around to repairing that bridge and upgrading that rail line, the slump is over and the stimulus isn’t needed. Well, that argument has no force now, since the chances that this slump will be over anytime soon are virtually nil. So let’s get those projects rolling. Will the next administration do what’s needed to deal with the economic slump? Not if Mr. McCain pulls off an upset. What we need right now is more government spending — but when Mr. McCain was asked in one of the debates how he would deal with the economic crisis, he answered: “Well, the first thing we have to do is get spending under control.” If Barack Obama becomes president, he won’t have the same knee-jerk opposition to spending. But he will face a chorus of inside-the-Beltway types telling him that he has to be responsible, that the big deficits the government will run next year if it does the right thing are unacceptable. He should ignore that chorus. The responsible thing, right now, is to give the economy the help it needs. Now is not the time to worry about the deficit.

30 Paul Krugman Blog: The Conscience of a Liberal October 22, 2008, 9:00 am It’s a conspiracy, I tell you The folks at Crooked Timber are having some fun with right-wing bloggers who say things like this:

Why the crescendo of economic collapse right before the election? Why didn’t the media and congress act just as concerned some time ago or wait until sometime after the election to go into crisis mode? The timing of the current financial crisis seems too planned and calculating to be just a coincidence. Polls show that people’s number one concern right now is the economy and that for the most part, voters believe Democrats are somewhat more likely to help with the economy. Could it be that the liberal media and those in Congress, knowing that, is blaring the bad economic news from the rooftops in order to manipulate voters into voting for a Democrat? If so, it won’t be the first time.

But why should we be surprised? Before the 2004 election, there was a lot of talk on the right about how George Soros would engineer a financial crisis to swing the election:

Here’s the real worry: Could the master currency trader manipulate the financial markets to create a panic, collapsing the stock market or the U.S. dollar on the eve of the November election?

Still, these are all marginal people, aren’t they? Saying this kind of thing, surely, would get you shunned by the sensible news media. Except it doesn’t. Just over a month ago the Washington Post gave Donald Luskin, who was one of the main proponents of the Evil Soros Conspiracy theory, space on the front page of its Outlook section to explain that the economy was doing OK. October 21, 2008, 10:35 am The morning after Four years ago George W. Bush narrowly won the presidential election, and Republicans achieved a 30-seat majority in the House and a 10-seat majority in the Senate. Immediately there was a vast chorus from the commentariat, proclaiming the death of liberalism; America, everyone said, was a conservative nation. I have a whole shelf of books with titles like Building Red America and One- Party Nation.

Maybe the current polls are all wrong. But at the moment they point to an Obama victory by a margin much larger than Bush’s in 2004, plus a Democratic majority of 50 or more in the House and something like 14 in the Senate.

So you know what the morning-after commentary will say — in fact, it’s already started. Yes: it will say that America is, um, a conservative nation.

October 20, 2008, 8:06 am Better Many signs this morning that the money markets are unfreezing. John Jansen gives us this table for LIBOR:

31 10/20 10/17 Change OVERNIGHT 1.51250 1.66875 -.15625 1 WEEK 2.71875 3.15625 -.43750 2 WEEKS 3.08125 3.49375 -.41250 1 MONTH 3.75125 4.18125 -.43000 2 MONTH 3.93375 4.30625 -.37250 3 MONTH 4.05875 4.41875 -.36000 4 MONTH 3.99250 4.29500 -.30250 5 MONTH 3.90125 4.20375 -.30250 6 MONTH 3.82875 4.13000 -.30125 9 MONTH 3.76875 4.02250 -.25375 12 MONTH 3.71250 3.97250 -.26000

Thank you, Mr. Brown!

But bear in mind that this just stops the credit markets from collapsing; the real economy is still rushing downhill. Across the Curve A daily bond market chronicle 1. 3 Responses to “Full Libor Posting” 2. By John C Lately on Oct 20, 2008 | There is a rumur floating around that JP morgan executed a number of questionable transactions to manipulate Ted Spread and/or Libor. Any comments for those fully initiated? 3. By John Jansen on Oct 20, 2008 | i heard rumors last week that they had “forced” the rate lower. The grassy knoll theorists suggested that Hank called Jamie and gave him marching orders. 4. By John C Lately on Oct 20, 2008 | Thanks for the response John and on a different but related topic: Bernanke during his testimony today had a parapraxis moment when he refered to the “Treasury of the Secretary” instead of the “Secretary of the Treasury”. Quite a war chest the man controls; scary the concentration of power. And evidently Bernanke agrees. October 20, 2008, 7:27 am A tale of two columns Yesterday, as I was working on something else, I happened to come across something that reminded me of an interesting contrast. As everybody knows, the general rap on me is that while I may be a good economist, I’m just too shrill and one-sided as a columnist.

Anyway, you can see the difference between what I do and what’s considered balanced and respectable by comparing my “A Can't-Do Government” (September 2, 2005 ) http://www.nytimes.com/2005/09/02/opinion/02krugman.html?_r=1&scp=1&sq=krugman%2 0katrina&st=cse&oref=slogin with “Our Back-Seat Congress”, (By David S. Broder, WP,

32 September 4, 2005; Page B07) http://www.washingtonpost.com/wp- dyn/content/article/2005/09/03/AR2005090301005.html

October 18, 2008, 3:59 pm James Galbraith lets loose An amazing debate at National Journal. The journal asked, is there room for fiscal stimulus to respond to the crisis caused by the mortgage mess. David Walker, who’s been preaching the need to rein in entitlements, treated the crisis as a chance to push his favorite line: My concern is, when will Washington wake up and start doing something to defuse the potential “super sub-prime crisis” associated with the federal government’s deteriorating finances and imprudent fiscal path? And Jamie let loose: What is Mr. Walker’s approach to subprime crisis today? His comment above makes his approach clear. It is to use the crisis as a rhetorical springboard, in order to divert the conversation back to what he calls the “super sub-prime crisis associated with the federal government’s deteriorating finances…” But the fact is, the subprime crisis is real. The collapse of interbank lending is real. The collapsing stock market is real. The disintegration of the financial system is real. The collapse of the housing sector is real. The credit crunch and the recession are real. You can see this in the interest rate spreads and in the credit that is unavailable at any price. Mr. Walker’s “super subprime crisis” of the federal government is not real. It is a pure figment of the imagination. It is something Mr. Walker sees in his mind’s eye. He sees it in his budget projections. He sees it in his balance sheets, which are the oddest balance sheets I’ve ever seen, because they have all liabilities and no assets. Read the whole thing. Go, Jamie, go! We don’t have an entitlement crisis — we have a health care crisis, one of whose manifestations is high projected costs for Medicare and Medicaid. And the way Walker tried to hijack the financial crisis on behalf of a benefit-cutting agenda deserves every bit of withering scorn you can muster.

October 18, 2008, 10:49 am We are all dead President Bush, this morning: In the long run, the American people can have confidence that our economy will bounce back. John Maynard Keynes: But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. October 18, 2008, 9:53 am

33 Great Keynes quote

The man who knew John Maynard Keynes is my economic idol, which is why I jumped at the chance to write the intro to the new edition of The General Theory. But I’d never heard this quote, from today’s FT: Words ought to be a little wild, for they are the assaults of thoughts on the unthinking. Presumably that was said in response to someone who called him shrill. October 17, 2008, 4:58 pm Manipulating the future Confirmed: someone — one large “institutional investor” — was manipulating the Intrade presidential odds, trying to drive up the price of a McCain win and thereby influence political perceptions: An internal investigation by the popular online market Intrade has revealed that an investor’s purchases prompted “unusual” price swings that boosted the prediction that Sen. John McCain will become president. Over the past several weeks, the investor has pushed hundreds of thousands of dollars into one of Intrade’s predictive markets for the presidential election, the company said. “The trading that caused the unusual price movements and discrepancies was principally due to a single ‘institutional’ member on Intrade,” said the company’s chief executive, John Delaney, in a statement released Thursday. “We have been in contact with the firm on a number of occasions. I have spoken to those involved personally.” Kudos to Nate Silver, who inferred this through circumstantial evidence. This reminds me of the California electricity crisis, when a few of us inferred, from the logic of the situation and circumstantial evidence, that power companies were deliberately creating the shortage. Later on, this was confirmed by control room recordings of Enron traders calling in instructions to shut the power off. October 17, 2008, 4:40 pm Hints of spring Both Calculated Risk and Yves Smith — both given to viewing the situation with a beady, skeptical eye — see some improvement in the credit markets, finally. I agree — some signs that the panic is

34 easing, and that private money is dipping its toe in the water (no doubt the same water used to put out the fire in the reignited slump.) Maybe, just maybe, Bailout 2.0 is starting to work. Gordon Brown may have saved the world, after all. PS: But the bottom is falling out of the real economy — it’s only the purely financial side that’s looking slightly better. October 17, 2008, 6:41 am An alternative solution

Pop economics Recession-Plagued Nation Demands New Bubble To Invest In. October 16, 2008, 2:54 pm Greatly exaggerated According to the New York Observer, someone posted a report of my death on Wikipedia. Cute.

October 16, 2008, 1:26 pm

35 Look out below

Oh no! Rate of growth of industrial production over the previous year — and it doesn’t even fully reflect the credit crunch yet. I confidently predict that this slump will be nasty, brutish, and long. October 16, 2008, 7:09 am The fascist octopus has sung its swan song OK, I know I shouldn’t be worrying about mixed metaphors when the world is ending, but still: the banner headline on today’s WSJ reads ECONOMIC FEARS REIGNITE THE MARKET SLUMP How do you set fire to a slump? October 15, 2008, 4:21 pm Holy Dow! And while I was writing the little note below, the bottom dropped out … October 15, 2008, 4:18 pm About the work Really, I don’t want to talk about me when the world is melting down, but I have had a number of requests for an informal explanation of what I got you-know-what for. So here’s an attempt. It’s really about two related things: the “new trade theory” and the “new economic geography.”

36 OK, so what was the “old” trade theory? It’s what you probably learned if you took intro economics. Countries are different – they have different levels of productivity in particular industries, they have different resources, and those differences drive trade. Tropical countries grow and export bananas, temperate countries grow and export wheat. Countries with highly educated workers export high-tech goods, countries with less educated workers export shirts and pajamas. The new trade theory starts with the observation that while this explains a lot of world trade, it also misses a lot. France and Germany sell lots of stuff to each other, even though they have similar climates and resources; so do the United States and Canada. What’s that about? The answer is that there are many goods that aren’t like wheat or bananas, but are instead like wide- bodied jet aircraft. There are only a few places in which wide-bodied jets are produced, because of the enormous economies of scale – you only want a couple of factories worldwide. Those factories have to be somewhere, and those countries that get the factories export jets, while everyone else imports them. But who gets the aircraft factories, or the factory producing a specialized kind of machine tool, or the plant producing a particular model of car that selected consumers all over the world want? The answer of new trade theory – and it was a tremendously liberating answer – is that it doesn’t matter. There are many economies-of-scale goods; everyone gets some of them; and the details, which may be largely a story of historical accident, aren’t important. What matters, instead, is the overall pattern of trade: the broad pattern of what countries produce is determined by things like resources and climate, but there’s a lot of additional specialization due to economies of scale, and there’s much more trade, especially between similar countries, than you would expect from a purely resource-based theory. You may think all this is obvious, and it is – now. But it was totally not obvious before 1980 or so – except for some prescient quotes from Paul Samuelson, you really can’t find anyone describing trade this way until after the theory had been laid out in mathematical models. The plain English version came later. And you should bear in mind that economists have been thinking and writing about international trade for a couple of centuries; to come along and say, “Hey, we’ve been missing half the story” was a pretty big thing. Now, on to geography. A decade after the original new trade stuff, I started thinking about what happens when some (but not all) economic resources, especially labor and capital, can move. In the world of the old trade theory, “factor mobility” was a substitute for trade: if factories and industrial workers can move freely, they’ll spread out to be close to the farmers, and neither food nor manufactured goods will have to be shipped long distances. But in the economies-of- scale world I had been studying, the “centrifugal” effect of widely dispersed resources, which tends to push economic activity into spreading out, would be opposed by the “centripetal” pull of access to large markets, which tend to promote concentration of economic activity. Think of Henry Ford and his Model T. He could have established many factories, spread across the country, to be close to his customers. Instead, however, he found that it was worth incurring extra shipping costs to achieve the economies of scale of one big factory in Michigan. And once you’re concentrating production in a limited number of locations, which locations will you choose? Locations where there’s a large market – which will be locations where lots of other producers have also chosen to concentrate their production. If the centripetal forces are strong enough, you’ll get a cumulative process: regions that for historical reason have a head start as centers of production will attract even more producers, becoming the economic “core” while other areas become the “periphery.” Thus for about a century, until the rise of the Sunbelt, the great bulk of U.S. manufacturing was crammed into a fairly narrow belt from New England to the inner Midwest; today, 60 million people live along a narrow stretch of the East Coast. Those 60 million people aren’t there because of the scenery; each of them is there because the other 60 million people are also there.

37 The same sort of logic explains why particular industries concentrate in certain locations, except that in such cases the logic involves things like a deep labor market for specialized skills and a good market for suppliers of specialized inputs. What determines which industry locates where? Often, accident: Silicon Valley owes its existence in large part to a couple of guys named Hewlett and Packard, who started some stuff in their garage, New York is New York because of a canal that only pleasure boaters use today. Again, this may seem obvious, and it is now – but it wasn’t before 1991 or so. As with trade, the plain English version was possible only after the mathematical models had been worked out. You may ask, where’s the policy implication of all this? Actually, the policy morals are fairly subtle – for example new trade theory does suggest a possible role for government interventions, but also suggests bigger gains from trade liberalization. Mainly my work in trade and geography was about understanding the world, not driving a political agenda. So that’s what it was all about. October 15, 2008, 3:07 pm Beige fades to black

He’s baaaack … Never mind stocks, although a 500-point decline in the Dow (as of right now) is hard to ignore. Even aside from that, things are not looking good. Signs of an unfreezing in the credit markets are hard to find — maybe we shouldn’t have expected a quick result, but you do have to say that even the reformed Paulson plan has yet to produce any visible improvement in confidence. I’m most struck by the .04% yield on one-month T-bills — that’s depression-level flight to safety. And the latest Beige Book, an informal survey carried out by the Fed, adds to the list of indicators that the real economy was plunging even before the post-Lehman financial catastrophe. October 15, 2008, 2:22 pm Return of The Return Back in 1999, in response to the Asian crisis and Japan’s lost decade, I published The Return of Depression Economics, which argued that our faith in the ability of policymakers to easily fend off severe slumps was misplaced — the real possibility of liquidity traps and dangerous balance-sheet effects of financial shocks could render conventional policy ineffective.

38 As the latest crisis deepened, the editors at Norton and I decided to bring up a massively updated new edition, taking account of you-know-what; we’re all Indonesia now. That’s what this post was about, by the way. The new book, still in process — the disasters are coming thick and fast — should be out in December. October 15, 2008, 11:51 am Train headed downhill

It’s the real thing This chart comes from Calculated Risk, still my favorite housing-and-credit-bust site. It shows nominal and real retail sales, and shows that consumer spending is now plunging at serious-recession rates. This reinforces a point I’ve been trying to make: even if the rescue now in train succeeds in unfreezing credit markets, the real economy has immense downward momentum. In addition to financial rescues, we need major stimulus programs. October 15, 2008, 8:25 am Nixonland

Meet the old boss There are all sorts of connections between the Nixon administration and the Bush administration. But here’s one I didn’t know about: Hank Paulson was John Ehrlichman’s assistant in 1972 and 1973. Maybe you have to have lived through Watergate to know what that means. October 14, 2008, 5:20 pm

39 The truth comes out Andy Borowitz knows! October 14, 2008, 9:34 am But enough about that

On second thought, let’s not Somehow, this morning, I found myself thinking of this old New Yorker cartoon. But actually, I’m already sick of talking about me. Meanwhile, we still have the financial crisis of our lifetimes to deal with. And let me point something out: while the stock market has been going gangbusters, we haven’t yet seen anything like a return to normality in credit markets. TED spread is down but still at nosebleed levels; three-month T-bills at 0.48%, which shows that flight to safety remains strong. Still waiting for data on commercial paper spreads. The policy outlook has improved a lot (though I’m hearing questions about the terms of those stock purchases.) But it’s way too soon to start counting chickens.

40 Introduction by Paul Krugman to The General Theory of Employment, Interest, and Money, by John Maynard Keynes SYNOPSIS: Introduction In the spring of 2005 a panel of “conservative scholars and policy leaders” was asked to identify the most dangerous books of the 19th and 20th centuries. You can get a sense of the panel’s leanings by the fact that both Charles Darwin and Betty Friedan ranked high on the list. But The General Theory of Employment, Interest, and Money did very well, too. In fact, John Maynard Keynes beat out V.I. Lenin and Frantz Fanon. Keynes, who declared in the book’s oft-quoted conclusion that “soon or late, it is ideas, not vested interests, which are dangerous for good or evil,” [384] would probably have been pleased. Over the past 70 years The General Theory has shaped the views even of those who haven’t heard of it, or who believe they disagree with it. A businessman who warns that falling confidence poses risks for the economy is a Keynesian, whether he knows it or not. A politician who promises that his tax cuts will create jobs by putting spending money in peoples’ pockets is a Keynesian, even if he claims to abhor the doctrine. Even self-proclaimed supply-side economists, who claim to have refuted Keynes, fall back on unmistakably Keynesian stories to explain why the economy turned down in a given year. In this introduction I’ll address five issues concerning The General Theory. First is the book’s message – something that ought to be clear from the book itself, but which has often been obscured by those who project their fears or hopes onto Keynes. Second is the question of how Keynes did it: why did he succeed, where others had failed, in convincing the world to accept economic heresy? Third is the question of how much of The General Theory remains in today’s macroeconomics: are we all Keynesians now, or have we either superseded Keynes’s legacy, or, some say, betrayed it? Fourth is the question of what Keynes missed, and why. Finally, I’ll talk about how Keynes changed economics, and the world. The message of Keynes It’s probably safe to assume that the “conservative scholars and policy leaders” who pronounced The General Theory one of the most dangerous books of the past two centuries haven’t read it. But they’re sure it’s a leftist tract, a call for big government and high taxes. That’s what people on the right, and some on the left, too, have said about The General Theory from the beginning. In fact, the arrival of Keynesian economics in American classrooms was delayed by a nasty case of academic McCarthyism. The first introductory textbook to present Keynesian thinking, written by the Canadian economist Lorie Tarshis, was targeted by a right-wing pressure campaign aimed at university trustees. As a result of this campaign, many universities that had planned to adopt the book for their courses cancelled their orders, and sales of the book, which was initially very successful, collapsed. Professors at Yale University, to their credit, continued to assign the book; their reward was to be attacked by the young William F. Buckley for propounding “evil ideas.”1 But Keynes was no socialist – he came to save capitalism, not to bury it. And there’s a sense in which The General Theory was, given the time it was written, a conservative book.

41 (Keynes himself declared that in some respects his theory had “moderately conservative implications.” [377]) Keynes wrote during a time of mass unemployment, of waste and suffering on an incredible scale. A reasonable man might well have concluded that capitalism had failed, and that only huge institutional changes – perhaps the nationalization of the means of production – could restore economic sanity. Many reasonable people did, in fact, reach that conclusion: large numbers of British and American intellectuals who had no particular antipathy toward markets and private property became socialists during the depression years simply because they saw no other way to remedy capitalism’s colossal failures. Yet Keynes argued that these failures had surprisingly narrow, technical causes. “We have magneto [alternator] trouble” he wrote in 1930, as the world was plunging into depression.2 And because Keynes saw the causes of mass unemployment as narrow and technical, he argued that the problem’s solution could also be narrow and technical: the system needed a new alternator, but there was no need to replace the whole car. In particular, “no obvious case is made out for a system of State Socialism which would embrace most of the economic life of the community.” [378] While many of his contemporaries were calling for government takeover of the whole economy, Keynes argued that much less intrusive government policies could ensure adequate effective demand, allowing the market economy to go on as before. Still, there is a sense in which free-market fundamentalists are right to hate Keynes. If your doctrine says that free markets, left to their own devices, produce the best of all possible worlds, and that government intervention in the economy always makes things worse, Keynes is your enemy. And he is an especially dangerous enemy because his ideas have been vindicated so thoroughly by experience. Stripped down, the conclusions of The General Theory might be expressed as four bullet points: • Economies can and often do suffer from an overall lack of demand, which leads to involuntary unemployment • The economy’s automatic tendency to correct shortfalls in demand, if it exists at all, operates slowly and painfully • Government policies to increase demand, by contrast, can reduce unemployment quickly • Sometimes increasing the money supply won’t be enough to persuade the private sector to spend more, and government spending must step into the breach To a modern practitioner of economic policy, none of this – except, possibly, the last point – sounds startling or even especially controversial. But these ideas weren’t just radical when Keynes proposed them; they were very nearly unthinkable. And the great achievement of The General Theory was precisely to make them thinkable. How Keynes did it I first read The General Theory as a student; then, I suspect like most economists of my generation, I didn’t open it again for several decades. Modern academic economics is an endeavor dominated by the new. Often, a whole literature has arisen, flourished, and decayed before the first paper in that literature receives formal publication. Who wants to spend time reading stuff first published 70 years ago? But The General Theory is still worth reading and rereading, not just for what it tells us about the economy, but for what it tells us about the nature of progress in economic thought. As an economics student, I enjoyed Keynes’s flashes of wit and purple prose, but I labored through or skimmed his elaborate discussions of methodology. As a middle-aged economist with a

42 couple of hundred papers behind me, and with some experience of the “struggle of escape” involved in producing a new economic theory, I read the book from a very different perspective – and with a sense of awe. Parts of the book that once seemed tedious are, I now understand, part of a titanic effort to rethink economics, an effort whose success is demonstrated by the fact that so many of Keynes’s radical innovations now seem obvious. To really appreciate The General Theory, one needs a sense of what Keynes had to go through to get there. In telling people how to read The General Theory, I find it helpful to describe it as a meal that begins with a delectable appetizer and ends with a delightful dessert, but whose main course consists of rather tough meat. It’s tempting for readers to dine only on the easily digestible parts of the book, and skip the argument that lies between. But the main course is where the true value of the book lies. I’m not saying that one should skip the fun parts. By all means, read them for the sheer enjoyment, and as a reminder of what Keynes accomplished. In fact, let me say a few words about those parts of the book before I myself get to the hard parts. Book I is Keynes’s manifesto, and for all its academic tone, and even its inclusion of a few equations, it’s a thrilling piece of writing. Keynes puts you, the professional economist – for The General Theory was, above all, a book written for knowledgeable insiders - on notice that he’s going to refute everything you thought you knew about employment. In just a few pages he convincingly shows that the then conventional view about the relationship between wages and employment involves a basic fallacy of composition: “In assuming that the wage bargain determines the real wage the classical school have slipt into an illicit assumption.” [13]. From this, he quickly shows that the conventional view that wage cuts were the route to full employment made no sense given the realities of the time. And in just a few more pages he lays out enough of his own theory to suggest the breathtaking conclusion that the Great Depression then afflicting the world was not only solvable, but easily solvable. It’s a bravura performance. Modern readers who stop after Book I, however, without slogging through the far denser chapters that follow, get a sense of Keynes’s audacity, but not of how he earned the right to that audacity. Book VI, at the opposite end of The General Theory, really is a kind of dessert course. Keynes, the hard work of creating macroeconomics as we know it behind him, kicks up his heels and has a little fun. In particular, the final two chapters of The General Theory, though full of interesting ideas, have an impish quality. Keynes tells us that the famous victory of free trade over protectionism may have been won on false pretenses – that the mercantilists had a point. He tells us that the “euthanasia of the rentier” [376] may be imminent, because thrift no longer serves a social function. Did he really believe these things, or was he simply enjoying tweaking the noses of his colleagues? Probably some of both. Again, Book VI is a great read, although it hasn’t stood the test of time nearly as well as Book I. But the same caution applies: by all means, read Keynes’s speculations on the virtues of mercantilism and the vanishing need for thrift, but remember that the tough stuff in Books II through V is what gave him the right to speculate. So now let’s talk about the core of the book, and what it took for Keynes to write it. Challenges to economic orthodoxy are a dime a dozen. At least once a month I receive a new book that purports to overthrow conventional economic wisdom. The vast majority of these books’ authors, however, don’t understand enough about existing economic theory to mount a credible challenge.

43 Keynes, by contrast, was deeply versed in the economic theory of his time, and understood the power of that body of theory. “I myself,” he wrote in the preface, “held with conviction for many years the very theories which I now attack, and am not, I think, unaware of their strong points.” He knew that he had to offer a coherent, carefully reasoned challenge to the reigning orthodoxy to change peoples’ minds. In Book I, as Keynes gives us a first taste of what he’s going to do, he writes of Malthus, whose intuition told him that general failures of demand were possible, but had no model to back that intuition: “[S]ince Malthus was unable to explain clearly (apart from an appeal to the facts of common observation) how and why effective demand could be deficient or excessive, he failed to provide an alternative construction; and Ricardo conquered England as completely as the Holy Inquisition conquered Spain.” [32] That need to “provide an alternative construction” explains many of the passages in The General Theory that, 70 years later, can seem plodding or even turgid. In particular, it explains Book II, which most modern readers probably skip. Why devote a whole chapter to “the choice of units,” which doesn’t seem to have much to do with Keynes’s grand vision? Why devote two more chapters to defining the meaning of income, savings, and investment? For the same reason that those of us who developed the so-called “new trade theory”, circa 1980, lavished many pages on the details of product differentiation and monopolistic competition. These details had nothing much to do with the fundamental ideas behind the new theory. But the details were crucial to producing the buttoned-down models we needed to clarify our thoughts and explain those thoughts to others. When you’re challenging a long- established orthodoxy, the vision thing doesn’t work unless you’re very precise about the details. Keynes’s appreciation of the power of the reigning orthodoxy also explains the measured pace of his writing. “The composition of this book,” wrote Keynes in the preface, “has been for the author a long struggle of escape, and so must the reading of it be.” Step by step, Keynes set out to liberate economists from the intellectual confines that left them unable to deal with the Great Depression, confines created for the most part by what Keynes dubbed “classical economics.” Keynes’s struggle with classical economics was much more difficult than we can easily imagine today. Modern introductory economics textbooks – the new book by Krugman and Wells included – usually contain a discussion of something we call the “classical model” of the price level. But that model offers far too flattering a picture of the classical economics Keynes had to escape from. What we call the classical model today is really a post-Keynesian attempt to rationalize pre-Keynesian views. Change one assumption in our so-called classical model, that of perfect wage flexibility, and it turns back into The General Theory. If that had been all Keynes had to contend with, The General Theory would have been an easy book to write. The real classical model, as Keynes described it, was something much harder to fix. It was, essentially, a model of a barter economy, in which money and nominal prices don’t matter, with a monetary theory of the price level appended in a non-essential way, like a veneer on a tabletop. It was a model in which Say’s Law applied: supply automatically creates its own demand, because income must be spent. And it was a model in which the interest rate was purely a matter of the supply and demand for funds, with no possible role for money or monetary policy. It was, as I said, a model in which ideas we now take for granted were literally unthinkable. If the classical economics Keynes confronted had been what we call the classical model nowadays, he wouldn’t have had to write Book V of The General Theory, “Money-wages and

44 prices.” In that book Keynes confronts naïve beliefs about how a fall in wages can increase employment, beliefs that were prevalent among economists when he wrote, but play no role in the model we now call “classical.” So the crucial innovation in The General Theory isn’t, as a modern macroeconomist tends to think, the idea that nominal wages are sticky. It’s the demolition of Say’s Law and the classical theory of the interest rate in Book IV, “The inducement to invest.” One measure of how hard it was for Keynes to divest himself of Say’s Law is that to this day some people deny what Keynes realized – that the “law” is, at best, a useless tautology when individuals have the option of accumulating money rather than purchasing real goods and services. Another measure of Keynes’s achievement may be hard to appreciate unless you’ve tried to write a macroeconomics textbook: how do you explain to students how the central bank can reduce the interest rate by increasing the money supply, even though the interest rate is the price at which the supply of loans is equal to the demand? It’s not easy to explain even when you know the answer; think how much harder it was for Keynes to arrive at the right answer in the first place. But the classical model wasn’t the only thing Keynes had to escape from. He also had to break free of the business cycle theory of the day. There wasn’t, of course, a fully-worked out theory of recessions and recoveries. But it’s instructive to compare The General Theory with Gottfried Haberler’s Prosperity and Depression3, written at roughly the same time, which was a League of Nations-sponsored attempt to systematize and synthesize what the economists of the time had to say about the subject. What’s striking about Haberler’s book, from a modern perspective, is that he was trying to answer the wrong question. Like most macroeconomic theorists before Keynes, Haberler believed that the crucial thing was to explain the economy’s dynamics, to explain why booms are followed by busts, rather than to explain how mass unemployment is possible in the first place. And Harberler’s book, like much business cycle writing at the time, seems more preoccupied with the excesses of the boom that with the mechanics of the bust. Although Keynes speculated about the causes of the business cycle in Chapter 22 of The General Theory, those speculations were peripheral to his argument. Instead, Keynes saw it as his job to explain why the economy sometimes operates far below full employment. That is, The General Theory for the most part offers a static model, not a dynamic model – a picture of an economy stuck in depression, not a story about how it got there. So Keynes actually chose to answer a more limited question than most people writing about business cycles at the time. Again, I didn’t understand the importance of that strategic decision on Keynes’s part the first time I read The General Theory. But it’s now obvious to me that most of Book II is a manifesto on behalf of limiting the question. Where pre-Keynesian business cycle theory told complex, confusing stories about disequilibrium, Chapter 5 makes the case for thinking of an underemployed economy as being in a sort of equilibrium in which short-term expectations about sales are, in fact, fulfilled. Chapter 6 and Chapter 7 argue for replacing all the talk of forced savings, excess savings, and so on that was prevalent in pre-Keynesian business cycle theory – talk that stressed, in a confused way, the idea of disequilibrium in the economy - with the simple accounting identity that savings equal investment. And Keynes’s limitation of the question was powerfully liberating. Rather than getting bogged down in an attempt to explain the dynamics of the business cycle – a subject that remains contentious to this day – Keynes focused on a question that could be answered. And that was also the question that most needed an answer: given that overall demand is depressed – never mind why - how can we create more employment?

45 A side benefit of this simplification was that it freed Keynes and the rest of us from the seductive but surely false notion of the business cycle as morality play, of an economic slump as a necessary purgative after the excesses of a boom. By analyzing how the economy stays depressed, rather than trying to explain how it became depressed in the first place, Keynes helped bury the notion that there’s something redemptive about economic suffering. The General Theory, then, is a work of informed, disciplined radicalism. It transformed the way everyone, including Keynes’s intellectual opponents, thought about the economy. But that raises a contentious question: are we, in fact, all Keynesians now? Mr. Keynes and the moderns There’s a widespread impression among modern macroeconomists that we’ve left Keynes behind, for better or for worse. But that impression, I’d argue, is based either on a misreading or a nonreading of The General Theory. Let’s start with the nonreaders, a group that included me during the several decades that passed between my first and second reads of The General Theory. If you don’t read Keynes himself, but only read his work as refracted through various interpreters, it’s easy to imagine that The General Theory is much cruder than it is. Even professional economists, who know that Keynes wasn’t a raving socialist, tend to think that The General Theory is largely a manifesto proclaiming the need for deficit spending, and that it belittles monetary policy. If that were really true, The General Theory would be a very dated book. These days economic stabilization is mainly left up to technocrats in central banks, who move interest rates up and down through their control of the money supply; the use of public works spending to prop up employment is generally considered unnecessary. To put it crudely, if you imagine that Keynes was dismissive of monetary policy, it’s easy to imagine that Milton Friedman in some sense refuted or superseded Keynes by showing that money matters. The impression that The General Theory failed to give monetary policy its due may have been reinforced by John Hicks, whose 1937 review essay “Mr. Keynes and the classics” is probably more read by economists these days than The General Theory itself. In that essay Hicks interpreted The General Theory in terms of two curves, the IS curve, which can be shifted by changes in taxes and spending, and the LM curve, which can be shifted by changes in the money supply. And Hicks seemed to imply that Keynesian economics applies only when the LM curve is flat, so that changes in the money supply don’t affect interest rates, while classical macroeconomics applies when the LM curve is upward-sloping. But in this implication Hicks was both excessively kind to the classics and unfair to Keynes. I’ve already pointed out that the macroeconomic doctrine from which Keynes had to escape was much cruder and more confused than the doctrine we now call the “classical model.” Let me add that The General Theory doesn’t dismiss or ignore monetary policy. Keynes discusses at some length how changes in the quantity of money can affect the rate of interest, and through the rate of interest affect aggregate demand. In fact, the modern theory of how monetary policy works is essentially that laid out in The General Theory. Yet it’s fair to say that The General Theory is pervaded by skepticism about whether merely adding to the money supply is enough to restore full employment. This wasn’t because Keynes was ignorant of the potential role of monetary policy. Rather, it was an empirical judgment on his part: The General Theory was written in an economy with interest rates already so low that there was little an increase in the money supply could do to push them lower.

46 Consider Figure 1, which shows the rate of interest on 3-month Treasury bills in the U.S. from 1920 to 2002. Economists of my generation came of intellectual age during the 1970s and 1980s, when interest rates were consistently above 5 percent and sometimes in double digits. Under those conditions there was no reason to doubt the effectiveness of monetary policy, no reason to worry that the central bank could fail in efforts to drive down interest rates and thereby increase demand. But as the figure shows, The General Theory was written in a very different monetary environment, one in which interest rates stayed close to zero for an extended period. Modern macroeconomists don’t have to theorize about what happens to monetary policy in such an environment, or even plumb the depths of economic history, because we have a striking recent example to contemplate. There are hopes as I write this that the Japanese economy may finally be staging a sustained recovery, but from the early 1990s at least through 2004 Japan was in much the same monetary state that the U.S. and U.K. economies were in during the 1930s. Short-term interest rates were close to zero, long-term rates were at historical lows, yet private investment spending remained insufficient to bring the economy out of deflation. In that environment, monetary policy was just as ineffective as Keynes described. Attempts by the Bank of Japan to increase the money supply simply added to already ample bank reserves and public holdings of cash while doing nothing to stimulate the economy. (A Japanese joke from the late 90s said that safes were the only product consumers were buying.) And when the Bank of Japan found itself impotent, the government of Japan turned to large public works projects to prop up demand. Keynes made it clear that his skepticism about the effectiveness of monetary policy was a contingent proposition, not a statement of a general principle. In the past, he believed, things had been otherwise. “There is evidence that for a period of almost one hundred and fifty years the long-run typical rate of interest in the leading financial centres was about 5 percent, and the gilt-edged rate between 3 and 3 ½ percent; and that these rates were modest enough to encourage a rate of investment consistent with an average of employment which was not intolerably low.” [307-308] In that environment, he believed, “a tolerable level of unemployment could be attained on the average of one or two or three decades merely by assuring an adequate supply of money in terms of wage-units.” [309] In other words, monetary policy had worked in the past – but not now. Now it’s true that Keynes believed, wrongly, that the conditions of the 1930s would persist indefinitely – indeed, that the marginal efficiency of capital was falling to the point that the euthanasia of rentiers was in view. I’ll talk in a bit about why he was wrong. Before I get there, however, let me talk about an alternative view. This view agrees with those who say that modern macroeconomics owes little to Keynes. But rather than arguing that we have superseded Keynes, this view says that we have misunderstood him. That is, some economists insist that we’ve lost the true Keynesian path – that modern macroeconomic theory, which reduces Keynes to a static equilibrium model, and tries to base as much of that model as possible on rational choice, is a betrayal of Keynesian thinking. Is this right? On the issue of rational choice, it’s true that compared with any modern exposition of macroeconomics, The General Theory contains very little discussion of maximization and a lot of behavioral hypothesizing. Keynes’s emphasis on the non-rational roots of economic behavior is most quotable when he writes of financial market speculation, “where we devote our intelligences to anticipating what average opinion expects average opinion to be.” [156] But it’s most notable, from a modern perspective, in his discussion of the consumption function. Attempts to model consumption behavior in terms of rational choice were one of the main themes of macroeconomics after Keynes. But Keynes’s

47 consumption function, as laid out in Book III, is grounded in psychological observation rather than intertemporal optimization. This raises two questions. First, was Keynes right to eschew maximizing theory? Second, did his successors betray his legacy by bringing maximization back in? The answer to the first question is, it depends. Keynes was surely right that there’s a strong non-rational element in economic behavior. The rise of behavioral economics and behavioral finance is a belated recognition by the profession of this fact. On the other hand, some of Keynes’s attempted generalizations about behavior now seem excessively facile and misleading in important ways. In particular, he argued on psychological grounds that the average savings rate would rise with per capita income (see p. 97.) That has turned out to be not at all the case. But the answer to the second question, I’d argue, is clearly no. Yes, Keynes was a shrewd observer of economic irrationality, a behavioral economist before his time, who had a lot to say about economic dynamics. Yes, The General Theory is full of witty passages about investing as a game of musical chairs, about animal spirits, and so on. But The General Theory is not primarily a book about the unpredictability and irrationality of economic actors. Keynes emphasizes the relative stability of the relationship between income and consumer spending; trying to ground that stability in rational choice may be wrong-headed, but doesn’t undermine his intent. And while Keynes didn’t think much of the rationality of business behavior, one of the key strategic decisions he made, as I’ve already suggested, was to push the whole question of why investment rises and falls into the background. What about equilibrium? Let me offer some fighting words: to interpret Keynes in terms of static equilibrium models is no betrayal, because what Keynes mainly produced was indeed a static equilibrium model. The essential story laid out in The General Theory is that liquidity preference determines the rate of interest; given the rate of interest, the marginal efficiency of capital determines the rate of investment; and employment is determined by the point at which the value of output is equal to the sum of investment and consumer spending. “[G]iven the propensity to consume and the rate of new investment, there will be only one level of employment consistent with equilibrium.” [28] Let me address one issue in particular: did Paul Samuelson, whose 1948 textbook introduced the famous 45-degree diagram to explain the multiplier, misrepresent what Keynes was all about? There are commentators who insist passionately that Samuelson defiled the master’s thought. Yet I can’t see any significant difference between Samuelson’s formulation and Keynes’s own equation for equilibrium employment, right there in Chapter 3: phi(N) - chi(N) = D2[29]. Represented graphically, Keynes’s version looks a lot like Samuelson’s diagram; quantities are measured in wage units rather than constant dollars, and the nifty 45-degree feature is absent, but the logic is exactly the same. The bottom line, then, is that we really are all Keynesians now. A very large part of what modern macroeconomists do derives directly from The General Theory; the framework Keynes introduced holds up very well to this day. Yet there were, of course, important things that Keynes missed or failed to anticipate. What Keynes missed The strongest criticism one can make of The General Theory is that Keynes mistook an episode for a trend. He wrote in a decade when even a near-zero interest rate wasn’t low enough to restore full employment, and brilliantly explained the implications of that fact – in particular, the trap in which the Bank of England and the Federal Reserve found themselves,

48 unable to create employment no matter how much they tried to increase the money supply. He knew that matters had not always been thus. But he believed, wrongly, that the monetary environment of the 1930s would be the norm from then on. Look again at Figure 1, which shows what actually happened. Japan aside, the monetary conditions of the 1930s have not made a reappearance. In the United States the era of ultra- low interest rates ended in the 1950s, and has never returned (although we had a near-Japan experience in 2002-2003.) Yet the United States has, in general, succeeded in achieving adequate levels of effective demand. The British experience has been similar. And although there is large-scale unemployment in continental Europe, that unemployment seems to have more to do with supply-side issues than with sheer lack of demand. Why was Keynes wrong? Part of the answer is that he underestimated the ability of mature economies to stave off diminishing returns. Keynes’s “euthanasia of the rentier” was predicated on the presumption that as capital accumulates, profitable private investment projects become harder to find, so that the marginal efficiency of capital declines. In interwar Britain, with the heroic era of industrialization behind it, that view may have seemed reasonable. But after World War II a combination of technological progress and revived population growth opened up many new investment opportunities. And even though Ben Bernanke, the new chairman of the Federal Reserve, has warned of a “global savings glut,” the euthanasia of the rentier does not seem imminent. But there’s an even more important factor that has kept interest rates relatively high, and monetary policy effective: persistent inflation, which has become embedded in expectations, and is reflected in higher interest rates than we would have if the public expected stable prices. Inflation was, of course, much higher in the 1970s and even the 1980s than it is today. Yet expectations of inflation still play a powerful role in keeping interest rates safely away from zero. For example, at the time of writing the interest rate on 20-year U.S. government bonds was 4.7%; the interest rate on 20-year “indexed” bonds, whose return is protected from inflation, was only 2.1%. This tells us that even now, when inflation is considered low, most of the 20-year rate reflects expected inflation rather than expected real returns. The irony is that persistent inflation, which makes The General Theory seem on the surface somewhat less directly relevant to our time than it would in the absence of that inflation, can be attributed in part to Keynes’s influence, for better or worse. For worse: the inflationary takeoff of the 1970s was partly caused by expansionary monetary and fiscal policy, adopted by Keynes-influenced governments with unrealistic employment goals. (I’m thinking in particular of Edward Heath’s “dash for growth” in the UK and the Burns-Nixon boom in the US.) For better: both the Bank of England, explicitly, and the Federal Reserve, implicitly, have a deliberate strategy of encouraging persistent low but positive inflation, precisely to avoid finding themselves in the trap Keynes diagnosed. Keynes didn’t foresee a future of persistent inflation (nor did anyone else at the time.) This meant that he was excessively pessimistic about the future prospects for monetary policy. It also meant that he never addressed the policy problems posed by persistent inflation, which preoccupied macroeconomists in the 70s and 80s, and led some to proclaim a crisis in economic theory. (In fact, the models many of us use these days to explain the persistence of inflation even in the face of unemployment, notably “overlapping contracts” models that stress the uncoordinated nature of wage settlements, are quite consistent in spirit with what Keynes had to say about wage determination.) But failure to address problems nobody

49 imagined in the 1930s can hardly be considered a flaw in Keynes’s analysis. And now that inflation has subsided, Keynes looks highly relevant again. The economist as savior As an intellectual achievement, The General Theory ranks with only a handful of other works in economics. I place the highest value on economic theories that transform our perception of the world, so that once people become aware of these theories they see everything differently. Adam Smith did that in The Wealth of Nations: suddenly the economy wasn’t just a collection of people getting and spending, it was a self-regulating system in which each individual “is led by an invisible hand to promote an end which was no part of his intention.” The General Theory is in the same league: suddenly the idea that mass unemployment is the result of inadequate demand, long a fringe heresy, became completely comprehensible, indeed obvious. What makes The General Theory truly unique, however, is that it combined towering intellectual achievement with immediate practical relevance to a global economic crisis. The second volume of Robert Skidelsy’s biography of Keynes is titled “The economist as savior,” and there’s not a bit of hyperbole involved. Until The General Theory, sensible people regarded mass unemployment as a problem with complex causes, and no easy solution other than the replacement of markets with government control. Keynes showed that the opposite was true: mass unemployment had a simple cause, inadequate demand, and an easy solution, expansionary fiscal policy. It would be a wonderful story if The General Theory showed the world the way out of out of depression. Alas for romance, that’s not quite what happened. The giant public works program that restored full employment, otherwise known as the Second World War, was launched for reasons unrelated to macroeconomic theory. But Keynesian theory explained why war spending did what it did, and helped governments ensure that the postwar world didn’t slip back into depression. One can identify a number of occasions, most notably Japan in the 1990s, where depression-like conditions might well have returned without the guidance of Keynesian economics. There has been nothing like Keynes’s achievement in the annals of social science. Perhaps there can’t be. Keynes was right about the problem of his day: the world economy had magneto trouble, and all it took to get the economy going again was a surprisingly narrow, technical fix. But most economic problems probably do have complex causes and don’t have easy solutions. Of course, I might be wrong. Maybe there are narrow, technical solutions to the economic problems of today’s world, from lagging development in Latin America to soaring inequality in the United States, and we’re just waiting for the next Keynes to discover them. One thing is certain: if there is another Keynes out there, he or she will be someone who shares Keynes’s most important qualities. Keynes was a consummate intellectual insider, who understood the prevailing economic ideas of his day as well as anyone. Without that base of knowledge, and the skill in argumentation that went with it, he wouldn’t have been able to mount such a devastating critique of economic orthodoxy. Yet he was at the same time a daring radical, willing to consider the possibility that some of the fundamental assumptions of the economics he had been taught were wrong. Those qualities allowed Keynes to lead economists, and the world, into the light – for The General Theory is nothing less than an epic journey out of intellectual darkness. That, as much as its continuing relevance to economic policy, is what makes it a book for the ages. Read it, and marvel.

50 1 For a hair-raising account of the coordinated effort to prevent American students from learning Keynesian economics, read David Colander and Harry Landreth’s The Coming of Keynesianism to America, Edward Elgar, 1996. 2 “The Great Slump of 1930,” reprinted in Essays in Persuasion. 3 Gottfried Haberler, Prosperity and Depression, League of Nations, 1937.

FIGURE 1

ANÁLISIS: Primer plano ¿Quién era Milton Friedman? PAUL KRUGMAN 19/10/2008 La historia del pensamiento económico en el siglo XX es algo parecida a la del cristianismo en el XVI. Hasta que John Maynard Keynes publicó su Teoría general de la ocupación, el interés y el dinero en 1936, la ciencia económica -al menos en el mundo anglosajón- estaba completamente dominada por la ortodoxia del libre mercado. De vez en cuando surgían herejías, pero siempre se suprimían. La economía clásica, escribía Keynes en 1936, "conquistó Inglaterra tan completamente como la Santa Inquisición conquistó España". Y la economía clásica decía que la respuesta a casi todos los problemas era dejar que las fuerzas de la oferta y la demanda hicieran su trabajo. Pero la economía clásica no ofrecía ni explicaciones ni soluciones para la Gran Depresión. Hacia mediados de la década de 1930, los retos a la ortodoxia ya no podían contenerse. Keynes desempeñó la función de Martín Lutero, al proporcionar el rigor intelectual necesario para hacer la herejía respetable. Aunque Keynes no era ni mucho menos de izquierdas -vino a salvar el capitalismo, no a enterrarlo-, su teoría afirmaba que no se podía esperar que los mercados libres proporcionaran pleno empleo, y estableció una nueva base para la intervención estatal a gran escala en la economía. El keynesianismo constituyó una gran reforma del pensamiento económico. Inevitablemente, le siguió una contrarreforma. Diversos economistas desempeñaron un papel importante en la gran recuperación de la economía clásica entre los años 1950 y 2000, pero ninguno fue tan influyente como Milton Friedman. Si Keynes era Lutero, Friedman era Ignacio de Loyola, el fundador de los jesuitas. Y al igual que los jesuitas, los seguidores de Friedman han actuado como una especie de disciplinado ejército de fieles y provocado una amplia, pero incompleta, retirada de la herejía keynesiana. A finales de siglo, la economía clásica había recuperado buena parte de su anterior hegemonía, aunque ni mucho menos toda, y a Friedman le corresponde buena parte del mérito. No quiero llevar demasiado lejos la analogía religiosa. La teoría económica aspira al menos a ser ciencia, no teología; se ocupa de la tierra, no del cielo. La teoría keynesiana se impuso en un principio porque era mucho mejor que la ortodoxia clásica a la hora de dar sentido al mundo que nos rodea, y la crítica de Friedman a Keynes adquirió tanta influencia porque supo detectar los puntos débiles del keynesianismo. Y sólo a modo de aclaración: aunque este artículo sostiene que Friedman estaba equivocado en algunos aspectos, y a veces parecía poco sincero con sus lectores, le considero un gran economista y un gran hombre. Milton Friedman desempeñó tres funciones en la vida intelectual del siglo XX. Estaba el Friedman economista de economistas, que escribía análisis técnicos, más o menos apolíticos, sobre el comportamiento de los consumidores y la inflación. Estaba el Friedman emprendedor político, que pasó décadas haciendo campaña en nombre de la política conocida como monetarismo y que acabó viendo cómo la Reserva Federal y el Banco de Inglaterra adoptaban su doctrina a finales de la década de 1970, sólo para abandonarla por inviable unos años más tarde. Por último, estaba el Friedman ideólogo, el gran divulgador de la doctrina del libre mercado.

52 ¿Desempeñó el mismo hombre todas estas funciones? Sí y no. Las tres estaban guiadas por la fe de Friedman en las verdades clásicas de la economía del libre mercado. Además, su eficacia como divulgador y propagandista descansaba en parte en su merecida fama de profundo economista teórico. Pero hay una diferencia importante entre el rigor de su obra como economista profesional y la lógica más laxa y a veces cuestionable de sus pronunciamientos como intelectual público. Mientras que la obra teórica de Friedman es universalmente admirada por los economistas profesionales, hay mucha más ambivalencia respecto a sus pronunciamientos políticos y en especial su trabajo divulgativo. Y debe decirse que hay serias dudas respecto a su honradez intelectual cuando se dirigía a la masa de ciudadanos. Pero dejemos de lado por el momento el material cuestionable y hablemos de Friedman en cuanto teórico económico. Durante la mayor parte de los dos siglos pasados, el pensamiento económico estuvo dominado por el concepto del Homo economicus. El hipotético Hombre Económico sabe lo que quiere; sus preferencias pueden expresarse matemáticamente mediante una función de utilidad, y sus decisiones están guiadas por cálculos racionales acerca de cómo maximizar esa función: ya sean los consumidores al decidir entre cereales normales o cereales integrales para el desayuno, o los inversores que deciden entre acciones y bonos, se supone que esas decisiones se basan en comparaciones de la utilidad marginal, o del beneficio añadido que el comprador obtendría al adquirir una pequeña cantidad de las alternativas disponibles. Es fácil burlarse de este cuento. Nadie, ni siquiera los economistas ganadores del Premio Nobel, toma las decisiones de ese modo. Pero la mayoría de los economistas, yo incluido, consideramos útil al Hombre Económico, quedando entendido que se trata de una representación idealizada de lo que realmente pensamos que ocurre. Las personas tienen preferencias, incluso si esas preferencias no pueden expresarse realmente mediante una función de utilidad precisa; por lo general toman decisiones sensatas, aunque no maximicen literalmente la utilidad. Uno podría preguntarse por qué no representar a las personas como realmente son. La respuesta es que la abstracción, la simplificación estratégica, es el único modo de que podamos imponer cierto orden intelectual en la complejidad de la vida económica. Y la suposición del comportamiento racional es una simplificación especialmente fructífera. La cuestión, sin embargo, es hasta dónde se puede llevar. Keynes no atacó de lleno al Hombre Económico, pero a menudo recurría a teorías psicológicas verosímiles y no a un cuidadoso análisis de qué haría una persona que tomara decisiones racionales. Las decisiones empresariales estaban guiadas por impulsos viscerales (animal spirits); las decisiones de consumo, por una tendencia psicológica a gastar parte, pero no la totalidad, de un aumento de la renta; los acuerdos salariales, por un sentido de la equidad, y así sucesivamente. ¿Pero era realmente una buena idea reducir tanto la función del Hombre Económico? No, decía Friedman, que en un artículo de 1953 titulado The methodology of positive economics [La metodología de la economía positiva] sostenía que las teorías económicas no deberían juzgase por su realismo psicológico, sino por su capacidad para predecir el comportamiento. Y los dos mayores triunfos de Friedman como economista teórico procedieron de aplicar la hipótesis del comportamiento racional a cuestiones que otros economistas habían considerado fuera del alcance de dicha hipótesis. En un libro de 1957 titulado Una teoría de la función del consumo -no exactamente un título que agradara a las masas, pero sí un tema importante-, Friedman sostenía que el mejor modo de entender el ahorro y el gasto no es, como había hecho Keynes, recurrir a una teorización psicológica laxa, sino, por el contrario, pensar que los individuos hacen planes racionales

53 sobre cómo gastar su riqueza a lo largo de la vida. Ésta no era necesariamente una idea antikeynesiana; de hecho, el gran economista keynesiano Franco Modigliani planteó de manera simultánea e independiente el mismo argumento, incluso con más cuidado, al considerar el comportamiento racional, en colaboración con Albert Ando. Pero sí señalaba un retorno a los modos de pensar clásicos, y funcionaba. Los detalles son un poco técnicos, pero la "hipótesis de la renta permanente" planteada por Friedman y el "modelo del ciclo vital" de Ando y Modigliani resolvían varias paradojas aparentes sobre la relación entre renta y gasto, y todavía hoy siguen constituyendo las bases de cómo estudian los economistas el gasto y el ahorro. El trabajo sobre el comportamiento de los consumidores habría forjado por sí solo la fama académica de Friedman. Sin embargo, obtuvo un triunfo al aplicar la teoría del Hombre Económico a la inflación. En 1958, el economista neozelandés A. W. Phillips señalaba que existía una correlación histórica entre el desempleo y la inflación, de modo que la inflación iba asociada a un bajo desempleo y viceversa. Durante un tiempo, los economistas trataron esta correlación como si fuera una relación fiable y estable. Esto provocó un debate serio sobre qué punto de la curva de Phillips debería escoger el Gobierno. ¿Debería Estados Unidos, por ejemplo, aceptar una tasa de inflación más alta para alcanzar una tasa de desempleo más baja? En 1967, sin embargo, Friedman pronunciaba ante la Asociación Económica Estadounidense una conferencia presidencial en la que sostenía que la correlación entre inflación y desempleo, aun siendo visible en los datos, no representaba una verdadera compensación, al menos no a largo plazo. "Siempre hay", decía, "una compensación temporal entre inflación y desempleo; no hay una compensación permanente". En otras palabras, si los políticos intentaran mantener el desempleo bajo mediante una política de generar mayor inflación, sólo conseguirían un éxito temporal. Según Friedman, el desempleo acabaría por aumentar de nuevo, incluso con una inflación elevada. En otras palabras, la economía sufriría la situación que Paul Samuelson más tarde denominaría "estanflación". ¿Cómo llegó Friedman a esta conclusión? (Edmund S. Phelps, premio Nobel de Economía de este año, había llegado de manera simultánea e independiente al mismo resultado). Como en el caso de su trabajo sobre el comportamiento de los consumidores, Friedman aplicó la idea del comportamiento racional. Sostenía que después de un periodo de inflación sostenido, las personas introducirían las expectativas de inflación futura en sus decisiones, lo cual anularía cualquier efecto positivo de la inflación sobre el empleo. Por ejemplo, una de las razones por las que la inflación puede aumentar el empleo es que contratar a más trabajadores se vuelve más rentable cuando los precios suben más que los salarios. Pero en cuanto los trabajadores comprenden que el poder de adquisición de sus salarios se verá erosionado por la inflación, exigen por adelantado acuerdos de subida salarial más elevados, para que los salarios alcancen el mismo nivel que los precios. En consecuencia, cuando la inflación se mantiene durante un tiempo, ya no proporciona el mismo impulso al empleo que al principio. De hecho, se producirá un aumento del desempleo si la inflación no cumple las expectativas. En el momento en que Friedman y Phelps propusieron sus ideas, Estados Unidos tenía poca experiencia con la inflación sostenida. De modo que ésta fue verdaderamente una predicción, en lugar de un intento de explicar el pasado. Sin embargo, en la década de 1970, la inflación persistente puso a prueba la hipótesis de Friedman-Phelps. Sin duda, la correlación histórica entre inflación y desempleo se rompió exactamente como Friedman y Phelps habían predicho: en la década de 1970, mientras la tasa de inflación superaba el 10%, la tasa de desempleo era tan elevada o más que en las décadas de 1950 y 1960, unos años de precios estables. Al fin la

54 inflación se controló en la década de 1980, pero sólo después de un doloroso periodo de desempleo extremadamente elevado, el peor desde la Gran Depresión. Al predecir el fenómeno de la estanflación, Friedman y Phelps alcanzaron uno de los grandes triunfos de la economía de posguerra. Este triunfo, más que ninguna otra cosa, confirmó a Milton Friedman en su categoría de grande entre los economistas, independientemente de lo que pudiera pensarse de sus demás funciones. Una interesante anotación: aunque avanzó mucho en la aplicación del concepto de racionalidad individual a la macroeconomía, también sabía dónde parar. En la década de 1970, algunos economistas llevaron más lejos aún el análisis de Friedman, llegando a sostener que no hay una compensación útil entre inflación y desempleo ni siquiera a corto plazo, porque los ciudadanos anticiparán las acciones del Gobierno y aplicarán esa anticipación, así como la experiencia pasada, al establecimiento de precios y a las negociaciones salariales. Esta doctrina, conocida como las "expectativas racionales", se extendió por buena parte de la economía académica. Pero Friedman nunca la aceptó. Su sentido de la realidad le advertía de que esto era llevar demasiado lejos la idea del Homo economicus. Y así se demostró: la conferencia pronunciada por Friedman en 1967 ha superado la prueba del tiempo, mientras que las opiniones más extremas propuestas por los teóricos de las expectativas racionales en los años setenta y ochenta no la han superado. "A Milton todo le recuerda la oferta monetaria. Bien, a mí todo me recuerda el sexo, pero no lo pongo por escrito", escribía en 1966 Robert Solow, del MIT. Durante décadas, la imagen pública y la fama de Milton Friedman se definieron en gran medida por sus pronunciamientos sobre la política monetaria y su creación de la doctrina conocida como monetarismo. Sorprende darse cuenta, por tanto, de que el monetarismo se considera en gran medida un fracaso, y que parte de lo dicho por Friedman sobre el dinero y la política monetaria -al contrario que lo que dijo acerca del consumo y la inflación- parece haber sido engañoso, y quizá de manera deliberada. Para comprender de qué trataba el monetarismo, lo primero que hay que saber es que la palabra dinero no significa exactamente lo mismo en economía que en el lenguaje común. Cuando los economistas hablan de oferta monetaria [en inglés, money supply, oferta de dinero] no se refieren a riqueza en el sentido habitual. Sólo se refieren a esas formas de riqueza que pueden usarse de manera más o menos directa para comprar cosas. La moneda - trozos de papel con retratos de presidentes muertos- es dinero, y también los depósitos bancarios contra los que se pueden extender cheques. Pero las acciones, los bonos y los bienes raíces no son dinero, porque hay que convertirlos en efectivo o en depósitos bancarios antes de poder usarlos para hacer compras. Si la oferta monetaria constara sólo de moneda, estaría bajo el control directo del Gobierno, o más precisamente, de la Reserva Federal, un organismo monetario que, como sus homólogos los bancos centrales de muchos otros países, está institucionalmente un poco separado del Gobierno propiamente dicho. El hecho de que la oferta de dinero incluya también los depósitos bancarios complica un poco la realidad. El banco central sólo tiene control directo sobre la base monetaria -la suma de moneda en circulación, la moneda que los bancos tienen en sus cámaras acorazadas y los depósitos que los bancos guardan en la Reserva Federal-, pero no sobre los depósitos que los ciudadanos tienen en los bancos. En circunstancias normales, sin embargo, el control directo de la Reserva Federal sobre la base monetaria basta para darle también un control efectivo sobre la oferta monetaria total. Antes de Keynes, los economistas consideraban la oferta monetaria una herramienta primordial de la gestión económica. Pero él sostenía que en condiciones de depresión, cuando los tipos de interés son muy bajos, los cambios en la oferta monetaria tienen pocas

55 consecuencias sobre la economía. La lógica era la siguiente: cuando los tipos de interés son del 4% o del 5%, nadie quiere que su dinero quede ocioso. Pero en una situación como la de 1935, cuando el tipo de interés de las letras del Tesoro a tres meses era sólo del 0,14%, hay muy poco incentivo para asumir el riesgo de poner el dinero a trabajar. El banco central podría tratar de estimular la economía acuñando grandes cantidades de moneda adicional; pero si el tipo de interés es ya muy bajo, es probable que el efectivo adicional languidezca en las cámaras acorazadas de los bancos o debajo de los colchones. En consecuencia, Keynes sostenía que la política monetaria, un cambio en la oferta de dinero circulante para gestionar la economía, sería ineficaz. Y por eso, él y sus seguidores creían que hacía falta una política presupuestaria -en especial un aumento del gasto público- para sacar a los países de la Gran Depresión. ¿Por qué es esto importante? La política monetaria es una forma de intervención pública en la economía altamente tecnocrática y en gran medida apolítica. Si la Reserva Federal decide aumentar la oferta monetaria, todo lo que hace es comprar unos cuantos bonos del Tesoro a bancos privados, y pagar los bonos mediante anotaciones en las cuentas de reserva de esos bancos: en realidad, todo lo que la Reserva Federal tiene que hacer es acuñar un poco más de base monetaria. En cambio, la política presupuestaria supone una participación mucho más profunda del sector público en la economía, a menudo de un modo cargado de ideología: si los políticos deciden usar las obras públicas para promover el empleo, tienen que decidir qué construir y dónde. Por tanto, los economistas con una inclinación al libre mercado tienden a querer creer que la política monetaria es todo lo que hace falta; los que desean un sector público más activo tienden a creer que la política presupuestaria es esencial. El pensamiento económico tras el triunfo de la revolución keynesiana -como se refleja, por ejemplo, en las primeras ediciones del libro de texto clásico de Paul Samuelson- daba prioridad a la política presupuestaria, mientras que la política monetaria quedaba relegada a los márgenes. Como Friedman decía en la conferencia pronunciada en 1967 ante la Asociación Económica Estadounidense: "La amplia aceptación de las opiniones entre los profesionales de la economía ha hecho que durante dos décadas, prácticamente todos menos unos cuantos reaccionarios pensaran que los nuevos conocimientos económicos habían vuelto obsoleta la política monetaria. El dinero no importaba". Aunque esto tal vez fuese una exageración, la política monetaria no estuvo muy bien considerada en las décadas de 1940 y 1950. Friedman, sin embargo, hizo una cruzada a favor de la propuesta de que el dinero también importaba, la cual culminó con la publicación en 1963 de A monetary history of the United States, 1867-1960, en colaboración con Anna Schwartz Aunque A monetary history of the United States es una gran obra de extraordinaria erudición, que abarca un siglo de desarrollos monetarios, su análisis más influyente y controvertido fue el relativo a la Gran Depresión. Friedman y Schwartz afirmaban que habían refutado el pesimismo de Keynes acerca de la eficacia de la política monetaria en condiciones de depresión. "La contracción" de la economía, declaraban, "es de hecho un trágico testimonio de la importancia de las fuerzas monetarias". ¿Pero qué querían decir con eso? Desde el principio, la posición de Friedman y Schwartz parecía un poco escurridiza. Y con el tiempo, la presentación que Friedman hacía de la historia se hizo más grosera, no más sutil, y acabó pareciendo -no hay otra forma de decirlo- intelectualmente corrupta.

56 Al interpretar los orígenes de la Gran Depresión es crucial distinguir entre la base monetaria (dinero más reservas bancarias), que la Reserva Federal controla directamente, y la oferta monetaria (dinero más depósitos bancarios). La base monetaria aumentó durante los primeros años de la Gran Depresión, subiendo de una media de 6.050 millones de dólares en 1929 a una media de 7.020 millones en 1933. Pero la oferta monetaria cayó drásticamente, de 26.600 millones a 19.900 millones de dólares. Esta divergencia reflejaba principalmente las consecuencias de la oleada de quiebras bancarias de 1930-1931: a medida que los ciudadanos perdían la fe en los bancos, empezaron a guardar su riqueza en efectivo y no en depósitos bancarios, y los bancos que sobrevivieron empezaron a tener grandes cantidades de efectivo a mano en lugar de prestarlo, para evitar el peligro de un pánico bancario. La consecuencia fue que se hacían muchos menos préstamos y, por tanto, muchos menos gastos de los que habría habido si los ciudadanos hubieran seguido depositando el efectivo en los bancos, y los bancos hubieran seguido prestando los depósitos a las empresas. Y dado que el desplome del gasto fue la causa próxima de la depresión, el deseo repentino tanto por parte de los individuos como de los bancos de poseer más efectivo empeoró sin duda la recesión. Friedman y Schwartz sostenían que la caída de la oferta monetaria había convertido lo que podría haber sido una recesión ordinaria en una depresión catastrófica, un argumento de por sí discutible. Pero incluso poniendo por caso que lo aceptemos, cabe preguntar si puede decirse que la Reserva Federal, que al fin y al cabo aumentó la base monetaria, provocó la caída de la oferta monetaria total. Al menos inicialmente, Friedman y Schwartz no dijeron eso. Lo que dijeron, por el contrario, fue que la Reserva Federal pudo haber prevenido la caída de la oferta monetaria, en especial acudiendo al rescate de los bancos en quiebra durante la crisis de 1930- 1931. Si la Reserva Federal se hubiera apresurado a prestar dinero a los bancos en apuros, la oleada de quiebras bancarias podría haberse evitado, y eso a su vez podría haber evitado la decisión de los ciudadanos de guardar el dinero en efectivo en lugar de depositarlo en los bancos, y la preferencia de los bancos supervivientes por acumular los depósitos en sus cámaras acorazadas en lugar de prestar esos fondos. Y esto, a su vez, podría haber evitado lo peor de la depresión. A este respecto, tal vez sea útil una analogía. Supongamos que se desata una epidemia de gripe, y que análisis posteriores indican que una acción adecuada de los centros de control de enfermedades podrían haber contenido la epidemia. Sería justo culpar a las autoridades públicas de no tomar las medidas adecuadas. Pero sería un exceso decir que el Estado causó la epidemia, o usar el fallo de esos centros para demostrar la superioridad de los mercados libres sobre el sector público. Pero muchos economistas, y todavía más lectores legos en la materia, han interpretado que la explicación de Friedman y Schwartz significa que de hecho la Reserva Federal causó la Gran Depresión; que la depresión es en cierto sentido una demostración de los males de un Estado excesivamente intervencionista. Y en años posteriores, como he dicho, las afirmaciones de Friedman se volvieron más imprecisas, como si quisiera alimentar esta percepción errónea. En su alocución presidencial de 1967 declaraba que "las autoridades monetarias estadounidenses siguieron políticas altamente deflacionarias", y que la oferta monetaria cayó "porque el Sistema de la Reserva Federal forzó o permitió una reducción aguda de la base monetaria, al no ejercer las responsabilidades que tenía asignadas", una afirmación extraña dado que, como hemos visto, la base monetaria aumentó de hecho mientras la oferta monetaria caía. (Friedman tal vez se refiriese a dos episodios en los que la base monetaria cayó moderadamente por breves periodos, pero aun así su declaración es, como mínimo, muy engañosa).

57 En 1976, Friedman les decía a los lectores de Newsweek que "la verdad elemental es que la Gran Depresión se produjo por una mala gestión pública", una declaración que seguramente sus lectores interpretaron como que la depresión no se habría producido si el Estado se hubiera mantenido al margen, cuando de hecho lo que Friedman y Schwartz afirmaban era que el sector público debería haberse mostrado más activo, no menos. ¿Por qué los debates históricos sobre la función de la política monetaria en la década de 1930 importaban tanto en la de 1960? En parte porque encajaban en el programa más amplio de Friedman en contra del sector público, del que hablaremos más adelante. Pero la aplicación más directa era su defensa del monetarismo. De acuerdo con esta doctrina, la Reserva Federal debía mantener el crecimiento de la oferta monetaria en una tasa baja y constante, por ejemplo, el 3% anual, y no desviarse de ese objetivo, con independencia de lo que ocurriese en la economía. La idea era poner la política monetaria en piloto automático, eliminando cualquier poder por parte de las autoridades públicas. El razonamiento de Friedman a favor del monetarismo era en parte económico y en parte político. Sostenía que el crecimiento constante de la oferta monetaria mantendría una economía razonablemente estable. Nunca pretendió que siguiendo esta norma se eliminarían todas las recesiones, pero sí afirmaba que las variaciones en la curva de crecimiento de la economía serían suficientemente pequeñas como para ser tolerables, de ahí la afirmación de que la Gran Depresión no habría ocurrido si la Reserva Federal hubiera seguido una norma monetarista. Y junto a esta fe con reservas en la estabilidad de la economía con un régimen monetario se daba su desprecio sin reservas hacia la capacidad de los directivos de la Reserva Federal para hacerlo mejor si se les daba poder para ello. La demostración de la falta de fiabilidad de la Reserva Federal estaba en el inicio de la Gran Depresión, pero Friedman podía señalar otros muchos ejemplos de políticas que habían salido mal. "Un régimen monetario", escribía en 1972, "aislaría la política monetaria del poder arbitrario de un pequeño grupo de hombres no sujetos al control de los electores, y de las presiones a corto plazo de la política partidista". El monetarismo fue una fuerza poderosa en el debate económico durante unas tres décadas a partir de que Friedman expusiera por primera vez su doctrina en Un programa de estabilidad monetaria y reforma bancaria, publicado en 1959. Hoy, sin embargo, es una sombra de lo que era, por dos razones principales. En primer lugar, cuando Estados Unidos y Reino Unido intentaron poner en práctica el monetarismo a finales de los setenta, los resultados fueron decepcionantes: en ambos países, el crecimiento constante de la oferta monetaria no consiguió impedir recesiones graves. La Reserva Federal adoptó oficialmente objetivos monetarios al estilo Friedman en 1979, pero los abandonó de hecho en 1982, cuando la tasa de desempleo superó el 10%. Este abandono se hizo oficial en 1984, y desde entonces la Reserva Federal realiza precisamente el tipo de afinación discrecional que Friedman condenaba. Por ejemplo, en 2001 respondía a la recesión reduciendo los tipos de interés y permitiendo que la oferta monetaria creciese a ritmos que en ocasiones superaban el 10% anual. Cuando se convenció de que la recuperación era sólida, la Reserva Federal cambió el rumbo, subiendo los tipos de interés y permitiendo que el crecimiento de la reserva monetaria cayese a cero. En segundo lugar, desde comienzos de la década de 1980, la Reserva Federal y sus homólogos de otros países han realizado un trabajo razonablemente bueno, debilitando la imagen que Friedman daba de los banqueros centrales, a los que consideraba chapuceros irredimibles. La inflación se mantiene baja, las recesiones -excepto en Japón, país del que hablaremos enseguida- han sido relativamente breves y leves. Y todo esto ha ocurrido a pesar de las fluctuaciones de la oferta monetaria, que horrorizaban a los monetaristas y que los

58 llevaron -incluso a Friedman- a predecir desastres que no llegaron a materializarse. Como señalaba David Warsh, de The Boston Globe, en 1992, "Friedman despuntó su lanza prediciendo la inflación en la década de 1980, durante la que se equivocó profunda y frecuentemente". En 2004, el Informe Económico del Presidente, escrito por los muy conservadores economistas del Gobierno de Bush, podía no obstante hacer la altamente antimonetarista declaración de que "una política monetaria audaz", no estable ni constante, sino audaz, "puede reducir la profundidad de una recesión". Ahora, unas palabras sobre Japón. Durante la década de 1990, Japón experimentó una especie de reproducción a pequeña escala de la Gran Depresión. La tasa de desempleo nunca llegó a los niveles de la Depresión, gracias a un enorme gasto en obras públicas que hizo que cada año Japón, con menos de la mitad de población, vertiese más cemento que Estados Unidos. Pero las condiciones de tipos de interés muy bajos que se dieron en la Gran Depresión reaparecieron con fuerza. Hacia 1998, el tipo del dinero a la vista, los tipos de los préstamos a un día entre bancos, era literalmente cero. Y en esas condiciones, la política monetaria resultó tan ineficaz como Keynes había afirmado que lo fue en los años treinta. El Banco de Japón, el equivalente japonés a la Reserva Federal, podía aumentar la base monetaria, y lo hizo. Pero los yenes añadidos se guardaban, no se gastaban. Los únicos bienes de consumo duradero que se vendían bien, me dijeron por aquel entonces algunos economistas japoneses, eran las cajas fuertes. De hecho, el Banco de Japón se vio incapaz siquiera de aumentar la oferta monetaria tanto como deseaba. Puso en circulación enormes cantidades de efectivo, pero las medidas más generales de oferta monetaria crecieron muy poco. Por fin, hace dos años, iniciaba una recuperación económica, impulsada por una recuperación de la inversión empresarial para aprovechar las nuevas oportunidades tecnológicas. Pero la política monetaria nunca consiguió arrancar. En efecto, Japón en los años noventa brindó una nueva oportunidad para poner a prueba las opiniones de Friedman y Keynes respecto a la eficacia de la política monetaria en condiciones de depresión. Y claramente los resultados respaldaban el pesimismo de Keynes y no el optimismo de Friedman. En 1946, Milton Friedman debutó como divulgador de la economía del libre mercado con un panfleto titulado Roofs or Ceilings: The Current Housing Problema [Tejados o techos: el actual problema de la vivienda], escrito en colaboración con George J. Stigler, que más tarde se uniría a él en la Universidad de Chicago. El panfleto, un ataque contra el control de los alquileres, que todavía era universal inmediatamente después de la II Guerra Mundial, se publicó en circunstancias bastante extrañas: era una publicación de la Fundación para la Educación Económica, organización que, como Rick Perlstein escribe en Before the Storm (2001), su libro sobre los orígenes del movimiento conservador actual, "difundía un evangelio libertario tan drástico que rondaba el anarquismo". Robert Welch, fundador de la John Birch Society, era miembro de su consejo directivo. Esta primera aventura en la popularización del libre mercado anticipaba de dos maneras el curso de la evolución de Friedman como intelectual público a lo largo de las seis décadas siguientes. En primer lugar, el panfleto demostraba la especial voluntad de Friedman de llevar las ideas del libre mercado hasta sus límites lógicos. Ni la idea de que los mercados son medios eficientes de asignar bienes escasos ni la propuesta de que los controles de precios crean escaseces e ineficacias eran nuevas. Pero muchos economistas, temiendo la reacción negativa contra una subida repentina de los alquileres (que Friedman y Stigler predecían que sería del 30% para el país en su conjunto), podrían haber propuesto una especie de transición gradual a la liberalización. Friedman y Stigler quitaban hierro a esas preocupaciones.

59 En décadas posteriores, esta tozudez se convertiría en uno de los sellos característicos de Friedman. Una y otra vez pedía soluciones de mercado a problemas -educación, atención sanitaria, tráfico de drogas ilegales- que en opinión de casi todos los demás exigían una intervención estatal extensa. Algunas de sus ideas han sido objeto de aceptación generalizada, como sustituir las normas rígidas sobre contaminación por un sistema de permisos de contaminación que las empresas pueden comprar y vender. Otras, como los cheques escolares, tienen un amplio respaldo en el movimiento conservador, pero no han avanzado mucho políticamente. Y algunas de sus propuestas, como eliminar los procedimientos de concesión de licencia para los médicos y abolir la Administración de Alimentos y Medicamentos, las consideran estrambóticas incluso la mayoría de los conservadores. En segundo lugar, el panfleto demostraba lo bueno que Friedman era como divulgador. Está escrito de manera elegante y sagaz. No hay jerga; los argumentos se presentan con ejemplos del mundo real inteligentemente escogidos, desde la rápida recuperación de San Francisco tras el terremoto de 1906 hasta los problemas de un ex combatiente en 1946, recién licenciado del ejército, para encontrar un lugar decente donde vivir. El mismo estilo, mejorado por la imagen, marcaría la celebrada serie televisiva de Friedman en la década de 1980 Free to choose [Libre para elegir]. Hay muchas probabilidades de que la gran oscilación hacia las políticas liberales que se produjeron en todo el mundo a comienzos de la década de 1970 se hubiera dado aunque Milton Friedman no hubiese existido. Pero su incansable y brillantemente eficaz campaña a favor de los libres mercados seguramente ayudó a acelerar el proceso, tanto en Estados Unidos como en todo el mundo. Desde cualquier punto de vista -proteccionismo frente a libre comercio; reglamentación frente a liberalización; salarios establecidos mediante convenio colectivo y salarios mínimos obligatorios frente a salarios establecidos por el mercado-, el mundo ha avanzado en la misma dirección que Friedman. E incluso más llamativa que su logro en lo referente a los cambios de la política real ha sido la transformación de la opinión general: la mayoría de las personas influyentes se han convertido hasta tal punto al modo de pensar de Friedman que simplemente se da por sentado que el cambio de políticas económicas promovido por él ha sido una fuerza positiva. ¿Pero lo ha sido? Consideremos en primer lugar los resultados macroeconómicos de la economía estadounidense. Tenemos datos de la renta real -es decir, teniendo en cuenta la inflación- de las familias estadounidenses entre 1947 y 2005. Durante la primera mitad de ese periodo de 55 años, desde 1947 hasta 1976, Milton Friedman era una voz que predicaba en el desierto, cuyas ideas no eran tenidas en cuenta por los políticos. Pero la economía, a pesar de todas las ineficacias que él denunciaba, mejoró enormemente el nivel de vida de la mayoría de los estadounidenses: la renta media real se duplicó con creces. Por contraste, en el periodo transcurrido desde 1976, las ideas de Friedman se han ido aceptando cada vez más; aunque siguió habiendo intervención pública de sobra para que él pudiera quejarse, no cabe duda de que las políticas de libre mercado se generalizaron mucho más. Pero el aumento del nivel de vida ha sido mucho menos fuerte que durante el periodo anterior: en 2005, la renta media real sólo era un 23% superior a la de 1976. Parte de la razón de que a la segunda generación de posguerra no le fuese tan bien como a la primera era la tasa total de crecimiento económico más lenta, un hecho que tal vez sorprenda a quienes suponen que la tendencia hacia el libre mercado ha aportado mayores dividendos económicos. Pero otra razón importante del retraso en el nivel de vida de la mayoría de las familias es un incremento espectacular de la desigualdad económica: durante la primera generación de posguerra, el aumento de la renta se extendió ampliamente a toda la población, pero desde finales de la década de 1970, la mediana de la renta, la renta de la familia típica,

60 sólo ha subido la tercera parte de la renta media, que incluye la gran subida experimentada por las rentas de la pequeña minoría situada en lo más alto de la pirámide. Esto plantea una cuestión interesante. Milton Friedman solía asegurar a su público que no hacía falta ninguna institución especial, como el salario mínimo y los sindicatos, para garantizar que los trabajadores compartiesen los beneficios del crecimiento económico. En 1976 les decía a los lectores de Newsweek que los cuentos de los perjuicios causados por los barones ladrones eran puro mito: "Probablemente no haya habido ningún otro periodo en la historia, en este o en cualquier otro país, en el que el hombre de a pie haya experimentado una mejora tan grande de su nivel de vida como en el periodo transcurrido entre la guerra civil y la I Guerra Mundial, cuando más fuerte era el individualismo desenfrenado". (¿Y qué hay del extraordinario periodo de 30 años posterior a la II Guerra Mundial, que abarcó buena parte de la trayectoria profesional del propio Friedman?). Sin embargo, en las décadas que siguieron a ese pronunciamiento, mientras se permitía que el salario mínimo cayese por debajo de la inflación y los sindicatos desaparecían en gran medida como factor importante en el sector privado, los trabajadores estadounidenses veían cómo sus fortunas iban a la zaga del crecimiento de la economía en general. ¿Era Friedman demasiado optimista respecto a la generosidad de la mano invisible? Para ser justos, hay muchos factores que afectan tanto al crecimiento económico como a la distribución de la renta, por lo que no podemos culpar a las políticas friedmanistas de todas las decepciones. Aun así, dada la suposición común de que el cambio a las políticas de libre mercado ha hecho grandes cosas por la economía estadounidense y por el nivel de vida de los estadounidenses corrientes, es asombroso el poco respaldo que los datos proporcionan a esa afirmación. Dudas similares respecto a la falta de pruebas claras de que las ideas de Friedman funcionan de hecho en la práctica se pueden encontrar, todavía con más fuerza, en Latinoamérica. Hace una década era normal citar el éxito de la economía chilena, en la que los asesores de Augusto Pinochet, educados en Chicago, se habían pasado a las políticas del libre mercado después de que Pinochet se hiciera con el poder en 1973, como prueba de que las políticas inspiradas por Friedman mostraban la senda hacia un próspero desarrollo económico. Pero aunque otros países latinoamericanos, desde México hasta Argentina, han seguido el ejemplo de Chile en la liberación del comercio, la privatización de empresas y la liberalización, la historia de éxito chilena no se ha repetido. Por el contrario, la percepción de la mayoría de los latinoamericanos es que las políticas neoliberales han sido un fracaso: el prometido despegue del crecimiento económico nunca llegó, mientras que la desigualdad de la renta ha empeorado. No quiero culpar de todo lo que ha salido mal en Latinoamérica a la Escuela de Chicago, ni idealizar lo sucedido antes, pero hay un asombroso contraste entre la percepción que Friedman defendía y los resultados reales de las economías que se pasaron de las políticas intervencionistas de las primeras décadas de posguerra a la liberalización. Centrándonos más estrictamente en el tema, uno de los principales objetivos de Friedman era la, en su opinión, inutilidad y naturaleza contraproducente de la mayor parte de la reglamentación pública. En una necrológica para su colaborador George Stigler, Friedman elogiaba en concreto la crítica de Stigler a la normativa sobre la electricidad, y su argumento de que los reguladores normalmente acaban sirviendo a los intereses de los regulados y no a los de los ciudadanos. ¿Cómo ha funcionado entonces la liberalización?

61 Empezó bien, comenzando con la liberalización del transporte por carretera y de las aerolíneas a finales de la década de 1970. En ambos casos, la liberalización, aunque no contentó a todos, aumentó la competencia, en general bajó los precios, y aumentó la eficacia. La liberalización del gas natural también fue un éxito. Pero la siguiente gran oleada de liberalización, la del sector eléctrico, fue otra historia. Al igual que la depresión japonesa de la década de 1990, demostraba que las preocupaciones keynesianas por la eficacia de la política monetaria no eran un mito; la crisis de la electricidad en California en 2000 y 2001 -en la que las compañías eléctricas y las distribuidoras de energía crearon una escasez artificial para hacer subir los precios- nos recordó la realidad que había tras los cuentos de los barones ladrones y sus depredaciones. Aunque otros Estados no sufrieron una crisis tan grave como la de California, en todo el país la liberalización de la electricidad supuso un aumento, no una disminución, de los precios, y unos beneficios enormes para las compañías eléctricas. Aquellos Estados que, por la razón que fuera, no se subieron al vagón de la liberalización en la década de 1990 se consideran ahora afortunados. Y las más afortunadas son aquellas ciudades que por algún motivo no recibieron el memorando sobre los males del sector público y las bondades del sector privado, y siguen teniendo compañías eléctricas públicas. Todo esto demuestra que los argumentos originales a favor de la reglamentación eléctrica -la observación de que sin reglamentación las compañías eléctricas tendrían demasiado poder monopolístico- siguen siendo tan válidos como siempre. ¿Debería esto llevarnos a la conclusión de que la liberalización es siempre mala idea? No. Depende de los detalles específicos. Deducir que la liberalización es siempre y en todas partes una mala idea sería incurrir en el mismo tipo de pensamiento absolutista que, se podría decir, fue el mayor defecto de Milton Friedman. En la reseña de 1965 sobre Monetary history, de Friedman y Schwartz, el fallecido premio Nobel James Tobin acusaba levemente a los autores de ir demasiado lejos. "Considérense las siguientes tres proposiciones", escribía. "El dinero no importa. Sí que importa. El dinero es lo único que importa. Es demasiado fácil deslizarse de la segunda proposición a la tercera". Y añadía que "en su celo y euforia", eso es lo que muy a menudo hacían Friedman y sus seguidores. La defensa del laissez-faire por parte de Milton Friedman parece haber seguido una secuencia similar. Después de la Gran Depresión, muchos empezaron a decir que los mercados nunca pueden funcionar. Friedman tuvo la valentía intelectual de decir que los mercados sí funcionan, y sus dotes teatrales, unidas a su habilidad para organizar datos objetivos, lo convirtieron en el mejor portavoz de las virtudes del libre mercado desde Adam Smith. Pero caía con demasiada facilidad en la afirmación de que los mercados siempre funcionan y que son lo único que funciona. Es extremadamente difícil encontrar casos en los que Friedman reconociese la posibilidad de que los mercados pudieran funcionar mal, o de que la intervención pública podía ser útil. El absolutismo liberal de Friedman ha contribuido a crear un clima intelectual en el que la fe en los mercados y el desdén por el sector público a menudo se imponen a los datos objetivos. Los países en vías de desarrollo se apresuraron a abrir sus mercados de capitales, a pesar de las advertencias de que eso podría exponerlos a crisis financieras; después, cuando las crisis llegaron como era previsible, muchos observadores culparon a los Gobiernos de esos países, no a la inestabilidad de los flujos de capital internacionales. La liberalización de la electricidad se produjo a pesar de las claras advertencias de que el poder de monopolio podría ser un problema; de hecho, al tiempo que la crisis de la electricidad en California seguía su evolución, la mayoría de los analistas quitaban importancia a las preocupaciones por el

62 posible amaño de los precios alegando que no eran más que teorías de conspiración descabelladas. Los conservadores siguen insistiendo en que el libre mercado es la respuesta a la crisis sanitaria, frente a las abrumadoras pruebas en contra. Lo extraño del absolutismo de Friedman respecto a las virtudes de los mercados y los vicios del Estado es que en su trabajo como economista teórico era de hecho un modelo de comedimiento. Como ya he señalado, hizo grandes contribuciones a la teoría económica al resaltar la importancia de la racionalidad individual, pero, a diferencia de algunos de sus colegas, sabía cuándo parar. ¿Por qué no mostró el mismo comedimiento en su papel de intelectual público? La respuesta, sospecho, es que se vio atrapado en una función esencialmente política. Milton Friedman, el gran economista, sabía reconocer la ambigüedad y la reconocía. Pero de Milton Friedman, el gran defensor de la libertad de mercado, se esperaba que predicase la verdadera fe, no que manifestase sus dudas. Y acabó desempeñando la función que sus seguidores esperaban. A consecuencia de ello, la refrescante iconoclasia de los primeros años de su carrera se convirtió con el tiempo en una rígida defensa de algo que se había convertido en la nueva ortodoxia. A la larga, a los grandes hombres se les recuerda por sus virtudes y no por sus defectos, y Milton Friedman fue de hecho un hombre muy grande, un hombre de valentía intelectual que fue uno de los pensadores económicos más importantes de todos los tiempos, y posiblemente el más brillante comunicador de las ideas económicas a los ciudadanos en general que jamás haya existido. Pero hay buenas razones para sostener que el friedmanismo, al final, fue demasiado lejos, como doctrina y en sus aplicaciones prácticas. Cuando Friedman inició su trayectoria como intelectual público, había llegado la hora de llevar a cabo una contrarreforma contra el keynesianismo, y todo lo que eso conllevaba. Pero lo que el mundo necesita ahora, diría yo, es una contra-contrarreforma. –paul krugman

Updated: New York, Oct 20 13:26 Krugman Proves Keynesianism Isn't Dead After All Commentary by William Pesek

Oct. 20 (Bloomberg) -- It's hard to forget the first time I met Paul Krugman. It was in the men's room. It was in Singapore in August 1998 and I found myself washing my hands next to the economist -- or at least trying to. As we chatted briefly about the speech he had just delivered on the ``liquidity trap'' undermining Japan, we realized the sinks in the lavatory were broken. ``That's the trouble with liquidity problems,'' Krugman deadpanned. ``They tend to follow you around the world.'' The reason Krugman's joke comes back to me has less to do with him winning the Nobel Prize in economics than the situation in which the global financial system finds itself. The question is whether central banks will lose their ability to control credit and, ultimately, economies. Krugman, 55, didn't get the Nobel for his work on Japan's lost decade, but for ``analysis of trade patterns and locations of economic activity.'' The Princeton University professor and New York Times columnist is among President George W. Bush's most prominent critics. Coming less than a month before an election, the award left some economists wondering if the Nobel committee was playing politics. Alan Greenspan also can't be happy. Krugman's columns often connect the dots between the former Federal Reserve chairman's free-market policies and the credit crisis. Greenspan's stock as a guru is falling as fast as Krugman's is rising. Monetary Paralysis Krugman's work is getting considerable attention in Asia, and for good reason. His reputation in this region was made in the mid-1990s when he was among the most consistent predictors of the 1997 Asian crisis. A couple of years later, Krugman correctly opined that Asia would stage an impressive comeback. The economist's research on Japan's monetary paralysis could prove equally prescient in Asia and beyond.

64 In July, this column explored the risk that lost decades may become the global rule, not the exception. Considering how much worse the crisis has gotten since then, it's becoming harder and harder to dismiss such an outlook. Since January, the Fed has cut its key interest rate from 4.25 percent to 1.50 percent. Has it helped the U.S. economy? While there's a considerable lag between central-bank moves and their effect on the economy, U.S. consumers haven't yet begun to feel the full fallout from the credit crisis. Fed Chairman Ben Bernanke will be under pressure to push rates even lower. Turning Japanese ``For all practical purposes, we're in liquidity trap territory,'' Krugman told Bloomberg's Tom Keene on Oct. 6. ``Bernanke can cut rates some more, but it's not going to have any impact on the real economy. So yes, traditional, conventional monetary policy is out of room. No more bullets.'' America, Krugman added, ``has turned Japanese.'' Added Jon Corzine, the New Jersey governor and former chairman of Goldman, Sachs & Co., in an Oct. 12 interview with NBC: ``What is maybe most important, we need a real economic stimulus. We're in what you call a liquidity trap.'' Krugman did as much as anyone to popularize the phrase generally thought to be coined by John Maynard Keynes. The Nobel committee honoring Krugman at this point in time seems part of a growing realization that Keynesianism, with its emphasis on the government's role in the economy, isn't dead after all. `Comrade Bush' Far from it. At the rate the U.S. is socializing its financial system, it seems only a matter of time before airlines, automakers and major retailers find their way onto the government's balance sheet. It would be the ultimate irony if the U.S. had to bail out Wal-Mart Stores Inc. with borrowed Chinese money so that it can support all those Chinese factory workers. Globalization is bringing the world full circle -- from state-owned companies to privatization to the re-nationalization of those enterprises. It's no wonder Venezuelan President Hugo Chavez is referring to the U.S. leader as ``Comrade Bush'' and saying ``now Bush is to the left of even me.'' While that's an overstatement, the policies long advocated by Keynes, and more recently by Krugman, will have more sway than those of laissez-faire capitalism enthusiast Milton Friedman. You can bet worsening market turmoil will prompt Asian governments to follow the U.S.'s lead on public bailouts. Among the biggest risks is central-bank impotence. As Neil Mellor, London-based currency strategist at Bank of New York Mellon Corp., points out, the mere fact investors are talking about liquidity traps could feed a ``self-perpetuating gloom.'' Keynes, after all, spoke of the mysterious role of ``animal spirits'' in economies. It was in a similar vein that in 1998 Krugman published his widely circulated paper on Japan's liquidity woes. Krugman speaks of the forces haunting Asia's biggest economy as if they were ghosts in an otherwise functioning machine. Japan's credit system remains more trapped than free. It's a reminder things could get worse if other nations turn Japanese. (William Pesek is a Bloomberg News columnist. The opinions expressed are his own.)

October 23, 2008 An impossible crash brought Keynes back to life It seemed that the great economist was history - just like the Great Depression. But recent events have proved him right Robert Skidelsky

When Alistair Darling said that “much of what Keynes wrote still makes sense”, anyone under 40 might well have asked: “And who on earth is Keynes”? When I first started writing about him in the early 1970s, John Maynard Keynes was a name to conjure with - not in the league of Led Zeppelin, to be sure, but certainly familiar to the mythical educated layman. Economic policy was “Keynesian” - that is, governments aimed to keep unemployment below the “magic” figure of one million, as they had for the previous 30 years, by expanding public spending or cutting taxes. Then Keynesian policy suddenly became obsolete and the theory that backed it was consigned to history's dustbin. He might have been a great economist, right for his times - the Great Depression of the 1930s - but he had nothing to offer the modern world, and moreoever was responsible for the “stagflation” of the 1970s. In her assault on inflation, Margaret Thatcher put the Keynesian engines into reverse and created three million unemployed. Keynes seemed as dead as the dodo. In fact, while dead to the public, Keynes lived a ghostly half-life in the corridors of the Bank of England and the Treasury. In setting interest rates, the Bank continued to pay attention to what was happening to output, the amount of economic activity, as well as inflation - although the inflation rate was its only “target”. Gordon Brown's fiscal rules allowed for the influence of the “automatic stabilisers”: the movement of the budget into deficit or surplus as the economy slowed or speeded up. BACKGROUND • Darling adopts spending stance of Keynes doctrine • Careful with your Keynes, Mr Brown • Gordon Brown admits UK recession is likely • Repossessions must be a 'last resort' But basically the authorities relied on “managing expectations”, by the gentlest adjustments to interest rates, to keep us in perpetual non-inflationary boom; we lived in a world from which inflations and depressions had been banished, and for which Keynes was no longer needed. For ten years the new formula worked. We were blessed with what Mervyn King, the Governor of the Bank of England, called a “nice” environment - a combination of strong growth in the US and Far East and the downward pressure on prices of a competitive globalising economy. More fundamentally, Keynesian economics was rejected by most of the economic profession as having caused inflation in the 1970s.

66 The main prescription of the “new” classical economics was to minimise the role of government and let markets do their job. It rested on an assumption that if economic agents are rational - the key assumption on which the claim of economics to be a science is based - the market system accurately prices all trades at each moment in time. If this is so, boom-bust cycles must be caused by outside “shocks” - wars, revolutions, above all political interference with the delicate adjustment mechanisms of the “invisible hand” of the market. But this view has been blown sky- high by the present crisis. For this crisis was generated by the market system itself, not some outside “shock”; moreover, within a system that had been extensively deregulated in line with mainstream teaching. The automatically self-correcting market system to which the economics profession has mostly paid homage has been shown to be violently unstable. And this is exactly how Keynes expected it to behave. What was left out of the mainstream economics of his day, and its “post-Keynes” successor, was the acknowledgement of radical uncertainty. “The outstanding fact,” he wrote in his magnum opus, The General Theory of Employment, Interest and Money (1936) “is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made”. We disguise this uncertainty by resorting to a variety of “pretty, polite techniques”, of which economics is one, “which try to deal with the present by abstracting from the fact that we know very little about the future”. But any view of the future based on “so flimsy a foundation” is liable to alternating waves of irrational exuberance and blind panic. When panic sets in there is a flight into cash. But while this may be rational for the individual, it is disastrous for the economy. If everyone wants cash, no one will lend. As Keynes tellingly reminded us “there is no such thing as liquidity... for the community as a whole”. And that means that there may be no automatic barrier to the slide into depression, unless a government intervenes to offset extreme reluctance to lend by huge injections of cash into the economy. This is exactly what world governments have been doing, in defiance of the contemporary theory that tells them that the huge mispricing of debt which provoked the present meltdown is impossible. What the Chancellor rightly pointed out is that the rescue of the banking system may not be enough to avert a deep recession, and a fiscal stimulus may be needed. The International Monetary Fund is predicting that output will fall short of trend by 1.05 per cent of GDP this year, rising to 3.16 per cent next year. With unchanged policy, the result may well be three million unemployed by the end of next year. Yes, the economy will ultimately correct itself without government stimulants. But it may take a long time, with huge damage while the required “corrections” are taking place. This is the case for a Keynesian rescue operation. Beyond the ambulance work, there is the question of working out a policy framework, domestic and international, that will at least minimise the danger of these self- destructive market-generated storms arising in future. Politics, of course, will compel all kinds of new regulations, good and bad, to rein in the wild excesses of recent times. But politics is blind: the politicians are like passengers on the Titanic rushing to the lifeboats. But unless their policies are backed by a more adequate theory of economic behaviour than is currently available they will not survive when times return to

67 “normal”. Keynes tried to supply that theory. He may not have clinched his case, but even his arch- critic Milton Friedman conceded that it was “the right kind of theory” for his times. Because the possibility of collapse is always present, Keynesian theory remains a better guide to policy than one that assumes that markets are inherently stable. Keynes understood that it is ultimately theory that determines policy, and that one cannot for a long time justify policies that run counter to accepted theory. He also said: “In the long run we are all dead.” That is one observation which happily does not apply to him. Over to you, Darling. Lord Skidelsky is author of John Maynard Keynes: Economist, Philosopher, Statesman

JON FRIEDMAN'S MEDIA WEB 'Barbarians at the Gate,' two decades later Commentary: The best biz book ever offers nostalgia -- and cautionary tales By Jon Friedman, MarketWatch Last update: 12:01 a.m. EDT Oct. 22, 2008 NEW YORK (MarketWatch) -- "Barbarians at the Gate," which chronicles the wild and crazy 1988 takeover battle for RJR Nabisco, is the best business book ever published -- and especially relevant today. "Barbarians" chronicled the frenetic Wall Street fight for the tobacco and food giant -- at the time the biggest takeover in Wall Street history. The major players were the ambitious Peter Cohen, who headed the Shearson Lehman Hutton unit of American Express the ferociously independent Teddy Forstmann of Forstmann Little and Henry Kravis, the ultra-competitive leader of Kohlberg Kravis Roberts. Perhaps the book's greatest contribution to the beleaguered Wall Streeters today is much needed relief, in the form of nostalgia. The RJR deal was rich in melodrama and the kinds of outsized personalities who are largely absent from the Street today. (Perhaps they've migrated to the Internet!) A simpler time I covered Wall Street in the late 1980s for Investor's Daily (now known as Investor's Business Daily). It was relatively easy to gain access to a chief executive, and even the guys who sported bright red suspenders didn't take themselves so seriously. Like the leaders in the Internet world before the bubble burst, Wall Street titans, back then, were fun to cover. Everyone, it seemed, craved publicity, was rich beyond his or her wildest dreams and acted a little nuts.

68 The riveting fly-on-the-wall narrative in "Barbarians" (Collins Business), by co-authors Bryan Burrough and John Helyar, also presents a lesson or two as finance professionals ponder the disintegration of their investment banking industry. The ultimate lesson is that greed is not good, whether it applies to the go-go 1980s or the subprime wave of the 21st century. The Gordon Gekko character notoriously said "greed is good" and "greed works" in "Wall Street." Oliver Stone's movie came out late in 1987, on the heels of a stock market crash and a sweeping insider-trading scandal, and neatly served as a precursor for the madness of the RJR Nabisco saga the following year The book is rich in appreciation for what in retrospect, seems like a simpler time. How simple? Time published an explosive cover story entitled "Greed on Wall Street," which was so powerful that it actually influenced the outcome of the deal as it detailed the lavishness of life on the Street. (Can you imagine today Time or Newsweek, whose impact has been diluted in the generation of digital media and 24-hour cable news channels, possessing the power to make waves with one of its covers?) "Barbarians at the Gate," the classic business yarn that chronicles the 1988 takeover battle for RJR Nabisco, is full of relevance and nostalgia, says Jon Friedman. Creating a genre "Barbarians" is that rare business book that can enter the pop culture lexicon. The title of the book quickly became a catch-phrase. The book's success -- it was a No. 1 New York Times best seller for more than 40 weeks -- also made waves in publishing houses. Its unexpected runaway success prompted envious publishing houses to scramble for finance yarns of their own (including, truth be told, 1992's creditable but highly inferior "House of Cards: Inside the Troubled Empire of American Express," which John Meehan and I co- wrote). "Barbarians," originally published in 1990, virtually invented the fly-on-the-wall reporting style applied to business books. Before it came along, these tomes mainly focused on get-rich- quick schemes, gushing biographies and stock market primers. From another perspective, the success of "Barbarians" also represented the best of The Wall Street Journal, the newspaper where both Burrough and Helyar starred when they worked on the book. They applied the precepts of Norman Pearlstine, then the editor of the Journal and now, after a circuitous journey, the chief content officer of Bloomberg. (Today, News Corp. owns the Wall Street Journal, Fox News, the Collins Books unit of HarperCollins and MarketWatch, the publisher of this column) Pearlstine stressed the idea that the best narratives contained ample contradictions and conclusions (and the Journal still does it better than any newspaper today). The formula subsequently transferred smoothly to books, as Susan "Backlash" Faludi and James B. "Den of Thieves" Stewart proved in best sellers of their own. Michael Lewis, a renegade from Wall Street, came the closest to toppling Burrough and Helyar. Lewis wrote "Liar's Poker," a witty account of life at a Salomon Brothers trading floor in the 1980s. In its way, "Liar's Poker" revealed as much about America in that period as "Barbarians" did. "Barbarians" today It's fascinating to ponder how the RJR fight would have played out had it taken place today.

69 Back in 1988, the world moved at a more leisurely pace. There were no Internet communications to speak of. The Fox News Channel had yet to emerge, giving CNN the 24- hour news field to itself. Gossip wasn't necessarily king. Newspapers were by far the dominant medium when it came to following mergers and acquisitions. Magazines struggled to compete with the dailies. Business-television stations like CNBC weren't a factor and the networks seldom spent much time covering Wall Street, unless someone got arrested or the Dow Jones Industrial Average. Today, of course, newspapers are trying hard to compete against the Web. Magazines seem to be in danger of going the way of vinyl records. Many cable TV networks beat their brains out in the hope of finding out where Britney Spears had lunch. Meanwhile, the spirit of the 1980s may not be dead altogether. Word is, Oliver Stone is trying to make a sequel to the chronicle of Gordon Gekko. Timing is everything in life, and with Wall Street collapsing, "Wall Street" is especially relevant. So is the 20th anniversary edition of "Barbarians at the Gate." Jon Friedman is a senior columnist for MarketWatch in New York.

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71 Economy

October 24, 2008 Greenspan Concedes Error in Regulatory View By THE ASSOCIATED PRESS WASHINGTON (AP) — Alan Greenspan, the former Federal Reserve chairman, said Thursday that the current financial crisis had uncovered a flaw in how the free market system works that had shocked him. Mr. Greenspan told the House Oversight Committee on Thursday that his belief that banks would be more prudent in their lending practices because of the need to protect their stockholders had proved to be wrong. Mr. Greenspan said he had made a “mistake” in believing that banks operating in their self- interest would be enough to protect their shareholders and the equity in their institutions. Mr. Greenspan said that he had found “a flaw in the model that I perceived is the critical functioning structure that defines how the world works.” Mr. Greenspan, who headed the nation’s central bank for 18.5 years, said that he and others who believed lending institutions would do a good job of protecting their shareholders are in a “state of shocked disbelief.” He said that the current crisis had “turned out to be much broader than anything that I could have imagined.” The committee called Mr. Greenspan to testify along with former Treasury Secretary John W. Snow and the Securities and Exchange Commission chairman, Christopher Cox, as lawmakers sought to discover if regulatory failings had contributed to the crisis. The committee chairman, Henry A. Waxman, said he believed that the Federal Reserve, which regulates banks, the S.E.C. and the Treasury had all played a role in contributing to the mistakes. “The list of mistakes is long and the cost to taxpayers is staggering,” Mr. Waxman, a California Democrat, told the three men. “Our regulators became enablers rather than enforcers. Their trust in the wisdom of the markets was infinite. The mantra became that government regulation is wrong. The market is infallible.” In his testimony, Mr. Greenspan blamed the problems on heavy demand for securities backed by subprime mortgages by investors who did not worry that the boom in home prices might come to a crashing halt. “Given the financial damage to date, I cannot see how we can avoid a significant rise in layoffs and unemployment,” Mr. Greenspan said. “Fearful American households are attempting to adjust, as best they can, to a rapid contraction in credit availability, threats to retirement funds and increased job insecurity.” Mr. Greenspan said that a necessary condition for the crisis to end would be a stabilization in home prices but he said that was not likely to occur for “many months in the future.”

72 When home prices finally stabilize, Mr. Greenspan said, then “the market freeze should begin to measurably thaw and frightened investors will take tentative steps towards re-engagement with risk.” Mr. Greenspan said until that occurred, the government was correct to move forward aggressively with efforts to support the financial sector. He called the $700 billion rescue package passed by Congress on Oct. 10 “adequate to serve the need” and said that its impact was already being felt in markets. Mr. Greenspan did not specifically address the criticism he is receiving now as being partly to blame for the current crisis. Mr. Greenspan’s critics charge that he left interest rates too low in the early part of this decade, spurring an unsustainable housing boom, while also refusing to exercise the Fed’s powers to impose greater regulations on the issuance of new types of mortgages, including subprime loans. It was the collapse of these mortgages and rising defaults a year ago that led to the current crisis. In his testimony, Mr. Greenspan put the blame for the subprime collapse on overeager investors who did not properly take into account the threats that would be posed once home prices stopped surging upward. “It was the failure to properly price such risky assets that precipitated the crisis,” Mr. Greenspan said.

Five Ways to Fix Our Financial Architecture By Howard Davies Thursday, October 23, 2008; A19 Some urgent reforms need to be made to the architecture of international financial regulation, but talk of a second Bretton Woods conference is misleading. Neither the International Monetary Fund nor the World Bank is a financial regulator in the sense of being a body that sets the rules for and supervises individual institutions. Those important tasks are carried out by less glamorous entities such as the Basel Committee and the International Organization of Securities Commissions. The real issues relate to the way in which these bodies carry out their jobs. As government leaders grapple with the flaws in those processes, they need to keep five objectives in mind: First, we need a simpler set of mechanisms that better reflect the shape of today's markets. In a book on regulatory architecture published this year, David Green and I tried to describe the existing structures. They are impenetrably complex. When I became chairman of the United Kingdom's Financial Services Authority in 1997, the authority -- Britain's only financial regulator -- was a member of about 75 international bodies or committees. By the time I left in 2003, that number had doubled. One problem is that the global financial system is built in three silos: banking, securities and insurance. That structure no longer reflects reality. We know that risks are transferred between these silos and that insurance companies and brokers can pose systemic risk. We need simpler structures, with cross-sectoral coverage. Second, there is a big problem of legitimacy. The Financial Stability Forum, which sits at the center of the system (without much formal authority), includes the Netherlands and Australia but not China or India. Ten of the 13 members of the Basel Committee, which sets bank capital ratios, are from Europe; there is only one Asian member. The crisis presents a good opportunity to make these bodies more representative. If we do not allow China to participate in making the rules governing finance, how can we expect it to obey them? Third, the new system needs to move faster. It took the Basel Committee the better part of a decade to design the Basel II standards that banks are just beginning to implement. That's right: These guidelines on leverage and capital are already out of date before coming into service. Regulatory clocks must be speeded up. Fourth, and most crucial, we need to build a new link between macroeconomic surveillance and regulation. That is where the IMF comes in. Looking back over the past decade, it is easy to find warnings of trouble ahead. The IMF's global financial stability reports included dark alarms about the unwinding of imbalances. The Bank for International Settlements has a better record, regularly pointing to asset price bubbles and systematic risk mispricing. But those warnings did not feed through into the setting of bank capital requirements. Such connections need to be made. We also need a mechanism that can induce banks to hold more capital in boom times, which would help to restrain the expansion and

74 provide a softer cushion if and when prices begin to fall, and take other countercyclical precautions. In other words, if asset prices or risk spreads diverge significantly from their long-term trends, supervisors would impose an across-the-board capital supplement to reflect the potential cost to the banks of a subsequent decline in prices. Lastly, there is a need for new and sustained political leadership. The Group of Seven concerns itself with regulation only at times of crisis. For example, the Financial Stability Forum was created after the Asian crisis of the late 1990s, and then the finance ministers all but forgot about it until the end of last year. Perhaps a standing subcommittee of the G-7 could be given a permanent role overseeing financial regulation, with the FSF as its arms and legs. The forum is the only place where regulators meet central bankers, finance ministry officials and representatives of the international financial institutions. It brings all the right people together in a room. It should be renamed the Financial Stability Council, given a proper staff and empowered to give instructions to the sectoral regulators. If the G-7 ministers want this to happen, it can. Of course, better architecture is just the first step. Difficult problems such as how much capital is needed in the system and how to regulate liquidity remain to be solved. We need to grapple with unregulated firms and with the "black holes" of offshore centers. And in some countries, notably the United States, there is a desperate need for change in the domestic financial system. These issues present enough material for several summits. President Bush will not be there to see how this story plays out, but his successor will surely be spending much time with Nicolas Sarkozy and Gordon Brown. The writer is director of the London School of Economics and has served as deputy governor of the Bank of England.

75 Business

October 23, 2008 Hedge Funds’ Steep Fall Sends Investors Fleeing By LOUISE STORY The gilded age of hedge funds is losing its luster. The funds, pools of fast money that defined the era of Wall Street hyper-wealth, are in the throes of an unprecedented shakeout. Even some industry stars are falling back to earth. This unregulated, at times volatile corner of finance — which is supposed to make money in bull and bear markets — lost $180 billion during the last three months. Investors, particularly wealthy individuals, are heading for the exits.

Times Topics: Credit Crisis — The Essentials

As the stock market plunged again on Wednesday, with the Dow Jones industrial average sinking 514 points, or 5.7 percent, the travails of the $1.7 trillion hedge fund industry loomed large. Some funds dumped stocks in September as their investors fled, and other funds could follow suit, contributing to the market plummet. No one knows how much more hedge funds might have to sell to meet a rush of redemptions. But as the industry’s woes deepen, money managers fear hundreds or even thousands of funds could be driven out of business.

76 The implications stretch far beyond Manhattan and Greenwich, Conn., those moneyed redoubts of hedge-fund lords. That is because hedge funds are not just for the rich anymore. In recent years, public pension funds, foundations and endowments poured billions of dollars into these private partnerships. Now, in the midst of one of the deepest bear markets in generations, many of those investments are souring. Granted, hedge funds are not going to disappear. In fact, some are still thriving. Even many of the ones that have stumbled this year are doing better than the mutual fund industry, which has also been hit with withdrawals that have forced their managers to sell. But the reversal for the hedge fund industry represents a sea change for Wall Street and its money culture. Since hedge funds burst onto the scene in the 1990s, they have recast not only the rules of finance but also notions of wealth and status. Hedge-fund riches helped inflate the price of everything from modern art to Manhattan real estate. Top managers raked in billions of dollars a year, and managing a fund became the running dream on Wall Street. Now, for lesser lights, at least, that dream is fading. “For the past five or six years, it seemed anybody could go to their computer and print up a business card and say they were in the hedge fund business, and raise a pot of money,” said Richard H. Moore, the treasurer of North Carolina, which invests workers’ pension money in hedge funds. “That’s going to be gone forever.” As are some hedge funds. For the first time, the industry is shrinking. Worldwide, the number of these funds dropped by 217 during the last three months, to 10,016, according to Hedge Fund Research. Even some of the industry’s most well-regarded managers are starting to retrench. Richard Perry, who until now had not had a down year for his flagship fund in more than a decade, has laid off some employees. Mr. Perry, who began his career at Goldman Sachs, is moving away from stock-picking to focus on the troubled credit markets. Three other hedge fund highfliers — Kenneth C. Griffin, Daniel S. Loeb and Philip Falcone — have suffered double-digit losses through the end of September. Steven A. Cohen, the secretive chief of a fund called SAC Capital, has put much of the money in his funds into cash, reducing trading by some of his workers. Many hedge fund investors, particularly the wealthy individuals, are flabbergasted by their losses this year. The average fund was down 17.6 percent through Tuesday, according to Hedge Fund Research. “You’re seeing a lot of shock, a lot of inaction, a lot of reassessment of where their allocations are and what to do going forward,” said Patrick Welton, chief executive of the Welton Investment Corporation, whose fund is up double-digits this year. Many investors, Mr. Welton said, had hoped hedge funds would protect them from a steep decline in the broader market. But in many cases, that has not happened. Now Wall Street is buzzing about how much money could be pulled out of hedge funds — and which funds might bear the brunt of the redemptions. Funds have set aside billions of dollars in cash to prepare for withdrawals, and many prominent funds require their investors to leave their money in the funds for years. That could help relieve some of the pressure. But because hedge funds are largely unregulated, they do not publicly disclose the identity of their investors or whether they have received requests for withdrawals. While it might make

77 sense to pull money out of poorly performing funds, investors might also exit funds that are doing well to offset losses elsewhere. Institutions — pension funds, endowments and the like — pushed into hedge funds after the Nasdaq stock market bust at the turn of the century. Many hedge funds had prospered as technology stocks crashed, leading these investors to believe they would in the future. In Massachusetts, for instance, Norfolk County broached the issue with the state’s pension oversight commission, said Robert A. Dennis, the investment director of the commission. Mr. Dennis was impressed that hedge funds had fared so much better than the broader stock market. Though Mr. Dennis says he recognizes the risks that come with selecting hedge funds, he thinks they remain a good investment. Next week, the state commission will vote on whether to allow some towns with pension funds below $250 million to invest in hedge funds, a move Mr. Dennis supports. “Hedge funds are having a bad year, absolutely, but they’re still holding up better than stocks,” Mr. Dennis said. “Losing less money than another investment is, while not great, it’s still something to be at least satisfied with.” But now that the days of easy money are over, some fund managers are throwing in the towel. One manager, Andrew Lahde, was blunt about his decision. “I was in this game for the money,” Mr. Lahde wrote to his investors recently. He made a fortune betting against the mortgage markets, calling those on the other side of his trades “idiots.” “I have enough of my own wealth to manage,” Mr. Lahde wrote. He did not return telephone calls seeking comment. And what wealth there has been. More than anything else, hedge funds are vehicles for their managers to take a big cut of profits. The lucrative economics of the industry is known as “two and 20.” Managers typically collect annual management fees equal to 2 percent of the assets in their funds, and, on top of that, take a 20 percent cut of any profits. Last year, one manager, John Paulson, reportedly took home $3 billion. But with the industry under pressure, those fat fees are being questioned. Mr. Moore and other investors are starting to ask whether hedge funds deserve all that money. Mr. Griffin, who runs Citadel Investment Group in Chicago, plans to offer funds with lower fees. More changes could be coming, including increased regulation. The House Committee on Oversight and Government Reform is scheduled to hold a hearing about regulation next month with five hedge fund managers who reportedly made more than $1 billion last year: Mr. Griffin, Mr. Falcone and Mr. Paulson, as well as George Soros and James Simons.

78 Oct 23, 2008 The Dog That Didn't Bark: Hedge Fund Industry in Trouble o Lynn: Anyone tracking markets in recent years will remember the prediction that the unregulated, feverish trading of hedge funds, and the massive debts and complex financial engineering of buyout firms, would cause the next crash. The crash happened, but it was started by what appeared to be safer institutions. The dog didn't bark. That doesn't mean it won't. The hedge and private-equity funds will be the next dominos to fall. o Oct 22 Bloomberg: Banks are driving up the cost of corporate debt protection as they seek to guard against losses on credit-default swap contracts bought from hedge funds. Short-sale bans and client redemptions triggered the record monthly losses at hedge funds in September, according to Eurekahedge Pte. o Authers:Hedge funds had three key advantages: 1) Unlike most conventional funds, they can sell stocks or commodities short, to profit from declines in price. 2) They can borrow; a trade that makes not even 1 per cent is worth doing if you borrow enough money to make the same trade 10 times. And 3) they can limit withdrawals by investors, allowing them more flexibility than funds that must be prepared for redemptions every day. All 3 hedge funds’ critical evolutionary advantages had been removed. o ad 1) Hedge fund indices agree that hedge funds started to lose money in July – and lost it in a big way last month. Why? This must be guesswork, but a popular hedge fund strategy involved selling short the stocks of banks while betting on energy prices to increase. The argument was that lower rates to combat the credit crisis would feed through into inflation and cause funds to flow into oil. In the year to mid-July, this trade netted 345 per cent. But then the oil bubble burst. Since then, the “long oil short banks” trade has lost 57 per cent. o ad 2) The end of September gave hedge fund investors one of their periodic opportunities to remove money. It appears many took it. According to Hedge Fund Research, $31bn was yanked from the sector in the third quarter, while investment losses reduced their assets by $210bn. TrimTabs estimates that withdrawals were even higher, at $43bn in September alone. The industry's total size was reduced to $1.8 trillion. o ad 3) Then came the ban on shorting financial stocks. Once hedge funds cracked, equity markets also cracked, with the MSCI World index falling more than 30 per cent since early September. o Lynn: Hedge fund share prices also suggest a bleak future. Man Group Plc, the world's largest publicly traded hedge fund, has dropped to 352 pence from 600 pence in July. RAB Capital Plc, another star of the industry, has slumped to 13 pence from 126 pence last year. It's hard to see anything positive in that.

79 o cont.: At the same time, the outlook for buyout funds is turning scary. They won't be able to make new deals, and the old ones are about to turn sour. o Hedge funds’ great outperformance dates from a period when leverage (proxied by the three-month Libor interbank lending rate) was historically cheap in 2002. Hedge funds will suffer because they won't be able to leverage investments anymore. The credit won't be available. They will also face more restrictions as part of the regulatory backlash. o Roubini: If larger and systemically important hedge funds were at risk of failing the Fed will have to engineer a massive private sector bail-in of such hedge funds (a larger scale rescue a la LTCM) where the prime brokers of such funds are forced to maintain repo exposure to such funds rather than be allowed to shut off such exposure. This is a radical suggestion but the alternative of a Fed liquidity bailout of systemically important hedge fund is not politically feasible (although technically possible as TARP mandate is broad enough.) Unwinding of Structured Products: Contagion Grips the $1T Corporate CDO Market Oct 23, 2008 o As banks default, many structured products involving credit derivatives written on the defaulted company need to be unwound. E.g. a synthetic CDO repackages not a portfolio of bonds but a portfolio of CDS without owning the underlying bonds. Other structured products include CPDOs that incorporate a large amount of credit protection selling as a means for leverage. Unwinding these structures requires to enter offsetting trades by buying credit protection. As an unintended consequence, buying protection in a systematic way is equivalent to betting against a company's credit worthiness (like shorting the stock in equity markets)--> this sends investment grade companies' CDS and borrowing costs higher. Regulators are looking at how to regulate this over the counter market. (WSJ) o Fitch (via RiskCenter) October 21: The 'AAA' ratings of Derivative Product Companies (DPCs) are premised on the bankruptcy remoteness of their structures and are not linked to the ratings of their sponsors. Fitch is evaluating this premise following the voluntary filing for Chapter 11 reorganization by two DPCs in the Lehman Brothers corporate structure. o S&P: (via Bloomberg): The collapse of Lehman, WaMu and the Icelandic banks, as well as the U.S. government's seizure of the mortgage agencies, will have a ``substantial'' impact on corporate CDO ratings. o Oct 22 Baring analyst: ``The same kind of shudders that went through the asset- backed CDO market will probably go through the corporate CDO market. We'll see a pickup in default rates." o WSJ Oct 20: Perhaps the weakest link in the market are specialized funds, known as "constant-proportion debt obligations" (CPDO) which typically borrowed about $15 for every dollar their investors put in. They also contain safety triggers that force them to get out of their investments if their losses reach a certain level. Analysts estimate that most

80 CPDOs reach those triggers when the cost of default insurance hits about the level where it is now. o SIFMA Q2 update: Global issuance of CDOs from 2004 - 4Q2007 totaled $1.47 trillion. Only $17.3bn worth of CDOs issued in q2 2008 compared to $175.9bn in Q2 2007. These products rely significantly on credit enhancement provided by AAA insurers and monolines. See details in: Collateralized Debt Obligations (CDO): Will the Asset- Class Survive? o SIFMA: CDO issuance by underlying collateral in 2007: -$254.8bn structured finance CDOs (collateral pool consisting of RMBS, CMBS, CMOs, ABS, CDOs, CDS, and other securitized/structured products) -$148.3bn high-yield loans (rated below BBB-/Baaa3) CDOs -$78bn investment-grade bonds CDOs o CDOs by issuance type in 2007: -$86.8bn Market Value CDOs (triggers unwinding if net asset value falls below theshold); -$51.5bn Synthetic funded CDOs (synthetic CDOs sell credit protection via credit default swaps (CDS) rather than purchase cash assets. 'Funding' requires from investors in CDO tranche a cash deposit as collateral); -$347.4bn Cash flow and Hybrid CDOs (cash-flow CDOs pay off liabilities with the interest and principal payments of their collateral. Hybrid CDOs combine the funding structures of cash andsynthetic CDOs.) o Geithner, NY Fed: The sheer number of financial contracts that would have to be unraveled in the context of a default, the challenge that a former colleague of mine likes to refer to as "unscrambling the eggs," could exacerbate and prolong uncertainty, and complicate the process of resolution. After the Wreckage: What's Next for Universal Banks? Roy C. Smith and Ingo Walter | Oct 22, 2008 The dramatic actions in the last few days of the European and American central banks and treasuries suggest the beginning of the end of the global debt crisis. Some of them, especially the partial nationalization of national banking systems and the unlimited government guarantees of financial contracts, are unprecedented in modern finance. More surprises are probably still to come. But it is not too early to think about what kind of global financial architecture will emerge after the dust settles – and what impact this may have on some of the key banks and financial centers. The basic functions of global banking and finance will continue, or course, but they are unlikely to return to business as usual anytime soon. The leaders of the global wholesale banking business have suffered greatly during the gales that have been blowing though financial markets for months: In the US, Lehman Brothers and Bear Stearns have disappeared into Barclays, Nomura and JP Morgan Chase; Merrill Lynch was forced into an unwanted merge;, Citigroup is on the ropes while Morgan Stanley and Goldman Sachs have suddenly turned themselves into bank holding companies and raised new capital to weather the storm. Now the US Treasury will buy equity stakes in all of them to bolster their capital whether they like it or not – and with the use of taxpayer money will inevitably come some basic changes in business strategies and market practices.

81 Their European counterparts have been ravaged as well. Fortis, trying to stabilize after last year’s indigestible takeover of ABN-Amro, has collapsed. UBS has been rescued in a massive bail-out by the Swiss government and Credit Suisse has been forced to raise additional capital. UniCredit seems shaky despite Italy’s assertion that all is well. The British government has had to take over Royal Bank of Scotland and HBOS, and to recapitalize Lloyds TSB. After an last-minute effort to coordinate policies, a more systematic EU approach has evolved, centered on some sensible principles, which likewise involve significant government ownership stakes in banks until the emergency has passed. It is hard to say at this time who the leading banks will be in the global financial marketplace that will emerge after the present storm has passed. Most likely the same ten firms (two of them Swiss) that accounted for about 80% of transactions before will, in whatever new configuration they may appear in, should continue to lead the industry – at least for a while until changes in the regulatory and competitive environment take hold. All of these firms, however, are now large, complex universal banks or financial conglomerates that have been classified as too-big-to-fail. One thing that seems quite sure is that these firms will be subject to greater regulatory control than before. Looking ahead, three issues come to mind in trying to define the future architecture of global finance: First: Is this the end of aggressive “Americanized Finance?” Probably not. The strongest American firms are still there and two in particular, Morgan Stanley and Goldman Sachs (both with more than half of their revenues outside the US) are among the industry’s most international firms, doing business locally all over the world. For them, the capital markets of the world after the crisis will be fully integrated and available to corporations, governments and global investors. Each is now a bank holding company, and ought to be able to resume leadership roles in global finance once the storm has passed. Together with Citigroup, Bank of America – Merrill Lynch and JP Morgan Chase they will comprise perhaps half of the global players, in each case after some major organizational and strategic changes likely to get underway shortly. Second: Does the current turbulence vindicate Europe’s belief in the supremacy of the universal banking model over all other forms of financial organization? Again, probably not. Universal banks in Europe and the US have been no better than the so-called “stand-alone investment banks” in their ability to avoid the leveraged exposures to toxic assets or to maneuver adroitly to avoid trouble - nor have they found a better way to provide adequate and durable investment returns for their stockholders. If the data are to be believed, some 42% of impaired US mortgage-related debt now rests on the balance sheets of European banks and investors. The universal banking debate is likely to continue for some time, but the pressure today seems to be for a number of leading universal banks to dispose of their hard-to-manage investment banking units. And there is plenty of evidence that financial conglomerates fare no better than industrial conglomerates in how investors value their shares. So perhaps the current shift to the universal banking model is not the end of the story. Third, how could so much systemic damage occur in an Industry that has been diligently regulated for decades? What happened to the Basel minimum risk-adjusted bank capital adequacy regime? The storm was one that destroyed liquidity under massively leveraged conditions rather than one that caused damage from credit defaults. The Basel approach does not regulate liquidity. It turns out that even the most adroit credit risk modeling, in full compliance with national and international banking regulations, completely missed the source of a risk domain that has threatened the integrity of the banking system.

82 In the near future bank regulators will have to agree that a couple of aggregate ratios are not enough to provide adequate safety and soundness of individual institutions or of the banking system. They will have to have the power to slow down excessively rapid financial growth, disallow excessive leverage and trading exposures, and in general treat the leading banks more as providers of essential economic services such as those provided by public utilities. The riskier and more aggressive activities in the market – still welcome – may well be provided by smaller organizations – perhaps a new generation of investment banks alongside more transparent hedge funds and private equity firms - with less leverage and less capacity to injure the entire system if they fail. This could result in the largest banks, whether American or European, universal or stand-alone, deciding not to continue giant institutions with many of the characteristics of public utilities, but rather to break themselves up into less regulated and more agile units. Investors in the financial industry could then decide how to deploy their capital among firms with very different growth prospects and risk exposures. Caveat emptor would still apply, but the core functions of banking and securities markets would not be as vulnerable as they have turned out to be this time. We think it is too early for the surviving large banks to congratulate themselves on the prospects for taking up the market shares left behind by the departed. The next evolution will be the strategic repositioning that firms will make to adjust to the regulatory changes that will be forthcoming: Some will perhaps chose to break themselves up into smaller, more manageable and less regulated parts. Some will p[refer to occupy the leadership slots in the industry while reducing their risk exposures and perhaps their ROIs and growth potential. But there will be changes. Modern capitalism is very adaptive and very much a process of creative destruction. Global Deleveraging Has Set In: Real Global Credit Growth Set To Halve From Last Year And Shrink Further in 2009 o Oct 21 Fitch: The financial crisis will halve real growth in credit this year as financial firms reduce leverage, investors' appetite for risk declines and the worldwide economy slows. In particular, real global credit growth, which peaked at almost 16 percent in 2007, will slow to 7 percent by year-end and shrink to nearer 5 percent next year. ``The slowdown will continue to be most pronounced in emerging Europe but will spread to all regions." o Oct 13: George Magnus: Even if a financial meltdown is averted, we should be under no illusion that the deleveraging in the financial and household sectors will stop. As a result, four big battlegrounds remain. First, there is a high possibility of further bouts of financial stress and failures. Money markets are still broken and recovery will take time. Second, illiquidity, a preference for cash-type instruments, even over government bonds, and a considerably expanded supply of government bonds raise the threat of an untimely increase in bond yields. Third, the global recession that has started may yet turn out to be sharper than expected – and certainly longer. This will bring sustained, and some new, credit risks. Fourth, much slower growth and the risk of some home-made financial crises in emerging markets warrant close scrutiny. o Roubini before coordinated G7 action: Urgent and immediate necessary actions that need to be done globally include:

83 • 1) another rapid round of policy rate cuts of the order of at least 150 basis points on average globally; • 2) a temporary blanket guarantee of all deposits while a triage between insolvent financial institutions that need to be shut down and distressed but solvent institutions that need to be partially nationalized with injections of public capital is made; • 3) a rapid reduction of the debt burden of insolvent households preceded by a temporary freeze on all foreclosures; • 4) massive and unlimited provision of liquidity to solvent financial institutions; • 5) public provision of credit to the solvent parts of the corporate sector to avoid a short-term debt refinancing crisis for solvent but illiquid corporations and small businesses; • 6) a massive direct government fiscal stimulus packages that includes public works, infrastructure spending, unemployment benefits, tax rebates to lower income households and provision of grants to strapped and crunched state and local government; • 7) a rapid resolution of the banking problems via triage, public recapitalization of financial institutions and reduction of the debt burden of distressed households and borrowers; • 8) an agreement between lender and creditor countries running current account surpluses and borrowing and debtor countries running current account deficits to maintain an orderly financing of deficits and a recycling of the surpluses of creditors to avoid a disorderly adjustment of such imbalances. o Total U.S. credit market debt as % of GDP started to shoot up in the early 1980s and reached 350% of GDP in 2008. The only other spike in the series is in the 1930s during the Great Depression--> this series tends to be mean-reverting, meaning that deleveraging from current record levels could be protracted and painful. (nc) o Bill Gross: What Happens During Deleveraging? 1) All risk spreads go up; 2) Delevering slows/stops when assets have been liquidated and/or sufficient capital has been raised to produce an equilibrium; 3) Raising sufficient capital depends on new sources of liquidity (or balance sheets) coming in; absent that, prices of almost all assets will go down--> only new source of liquidity available on the scale needed for a bull market anywhere is the Treasury. (Bill Gross at PIMCO) o Frank Veneroso (via NC): The bursting of the commodities bubble will be the last one after Japan, Asia, technology, housing--> serious deleveraging process around the corner. o McCulley (PIMCO): if all financial institutions deleverage at the same time the result is macroeconomic asset deflation--> only medicine is governement sponsored countercyclical intervention with both fiscal and monetary measures--> ensuing fiscal deficit is lesser evil! o Satyajit Das: ABS CP conduits, SIVs and CDOs are being gradually dismantled and the assets returning onto bank balance sheets. Hedge funds have been forced to reduce leverage by between a third and a half times. Prime brokers and banks have significantly tightened credit, increasing the level of collateral needed even against high quality assets. Each 1 times leverage reduction in hedge fund leverage represents in excess of US$2 trillion of assets. This accelerates the de-leveraging process.

84 TARP Implementation: $250bn Bank Capital For New Loans, Bonuses, Or Takeovers? • Oct 22, 2008 • Treasury Secretary Henry Paulson has repeatedly emphasized that the government's investment is to restore confidence in the banking sector, so banks will lend again and private investors will put up capital for banks. There is however no guarantee that banks will lend instead of hoarding the money as they have up to now ('pushing on a string'). If new loans make business sense they will get done but that is not certain in the current economic outlook. New reports say that the capital might instead be used for takeovers and industry consolidation (WJS) o Oct 15 Bloomberg: Treasury operatives have admitted, despite Henry Paulson's protestations to the contrary, that the government can only hope for the best in how the nine banks given a collective $125 billion cash infusion early in the week make use of the loot-->Jamie Dimon (Deal Journal): “Today a financial company can’t make a car loan and make a profit, so they’re not doing it.” o Oct 21 Jonathan Weil: You can imagine the devilish grins on the faces of Morgan Stanley employees last week, after the Treasury Department said it would pump $10 billion into the bank--> Morgan Stanley has accrued $10.7 billion of employee- compensation expense this year which will now probably be paid out. The rescue of Morgan Stanley's bonus pool is an unpleasant downside of Treasury Secretary Hank Paulson's decision to inject $250 billion of cash into U.S. banks in exchange for preferred stock--> From the start of their 2004 fiscal years through yesterday, the big standalone investment banks lost about $83 billion of stock-market value. During the same period, they reported about $239 billion of employee-compensation expense. o Oct 14: Secretary Paulson announces a plan to stimulate frozen credit markets that includes spending $250bn out of the $700bn for ownership stakes banks ($125bn of which in nine major banks who have already agreed to participate) The government is set to buy preferred equity stakes without voting rights in Goldman Sachs., Morgan Stanley, J.P. Morgan., Bank of America Corp., Merrill Lynch, Citigroup., Wells Fargo., Bank of New York Mellon and State Street Corp. The same terms will be available to a broad array of small and medium-sized banks and thrifts across the nation. o Willem Buiter: The US tax payer is getting a terrible return on the $125bn worth of capital that was injected on his behalf by US Treasury Secretary Paulson into the nine largest US banks compared to AIG, where the Fed and the Treasury imposed rather tough terms on the shareholders and obtained pretty favourable terms for the US tax payer generally. It was also unlike the case of Fannie and Freddie, where the old shareholders are likely not to recover anything. cont.: In the case of the Fortunate Nine, the injection of capital is through (non-voting) preference shares yielding a ridiculously low interest rate (5 percent as opposed to the 10 percent obtained by Warren Buffett for his capital injectcion into Goldman Sachs). Without voting shares, the government has no voice in the running of these banks. It also has no seats on their boards. There are no attractively valued warrants (options to convert, at some future time, the preference shares into ordinary shares at a set price or at a price

85 determined by some known formula). Quite the opposite, the preference shares purchased by the US state, can be repurchased after three years, at the banks’ discretion, on terms that are highly attractive to the banks. Final Lehman CDS Settlement: $72bn Notional Registered At DTCC Out Of $400bn Results in $5.2 Net Payout Oct 22, 2008 Oct 22: "The Depository Trust & Clearing Corporation (DTCC) announced that its Trade Information Warehouse (Warehouse) successfully completed the automated credit event processing and settlement of over-the-counter (OTC) credit default swap (CDS) contracts related to the Lehman credit event. This processing resulted in approximately US$5.2 billion in net funds transfers from net sellers of protection to net buyers of protection. At the time of the bankruptcy of Lehman Brothers Inc., approximately $72 billion in credit default swaps written on Lehman Brothers were registered in the Warehouse." The total gross amount outstanding is $400bn according to ISDA. o October 21 is the settlement date between Lehman CDS protection buyers and sellers. The recovery value of defaulted bonds is 8.7% as established at October 10 auction. Protection sellers have to pay out 91% of insured face value. The outstanding notional volume is around $400bn which implies that the gross payout will be around $360bn. o DTCC, ISDA say that the notional amount ignores bilateral trades that cancel out--> after netting, only $6bn will have to be settled. ISDA CEO Pickel: That's the way it turned out to be, the OTC infrastructure works! o Oct 17: Andrea Cicione, BNP Paribas (via Telegraph): "They keep coming up with this $6bn number by 'netting' but we think the amount is going to anywhere from $220bn to $270bn. The chain broke in the CDS market when Lehman Brothers went down. We may now see other counter-parties defaulting." o RGE: Major dealer banks have access to Fed liquidity if they need to pay up. The problem are net protection sellers such as structured finance companies, monolines, and hedge funds that do not have strong capital bases or access to unlimited liquidity--> Oct 22: Signs of contagion in corporate CDO market. o Fitch (via RiskCenter) October 21: Fitch Ratings is currently evaluating its 'AAA' ratings on Derivative Product Companies (DPCs) in light of the recent voluntary filing for Chapter 11 reorganization by two DPCs in the Lehman Brothers corporate structure--> The 'AAA' ratings of DPCs are premised on the bankruptcy remoteness of their structures and are not linked to the ratings of their sponsors. Fitch is evaluating this premise following the voluntary filing for Chapter 11 reorganization by two DPCs in the Lehman Brothers corporate structure. o Prof. Figlewski/Smith (NYU via Forbes): "After netting out offsetting positions, cash payments will be approximately $270 billion, a huge amount even for this crisis, which has seemed to know no limits on the size of write-offs. And all this for just one default!" o Satyajit Das (Minyanville): Settlement of credit default swaps on Lehman totaled around $365 billion. o Reggie Middleton: see list of Lehman's CDS counterparties and unsecured creditors.

86 Business

October 23, 2008 THE RECKONING Struggling to Keep Up as the Crisis Raced On By JOE NOCERA and EDMUND L. ANDREWS “I feel like Butch Cassidy and the Sundance Kid. Who are these guys that just keep coming?” — Treasury Secretary Henry Paulson Jr. It was the weekend of Sept. 13, and the moment Treasury Secretary Henry M. Paulson Jr. had feared for months was finally upon him: Lehman Brothers was hurtling toward bankruptcy — fast. Knowing that Lehman had billions of dollars in bad investments on its books, Mr. Paulson had long urged Lehman’s chief executive, Richard S. Fuld Jr., to find a solution for his firm’s problems. “He was asked to aggressively look for a buyer,” Mr. Paulson recalled in an interview. But Lehman could not — despite what Mr. Paulson described as personal pleas to other firms to buy some of Lehman’s toxic assets and efforts to persuade another bank to acquire Lehman. With all options closed, he said, the government’s hands were tied. Although the Federal Reserve had helped bail out Bear Stearns — and was within days of bailing out the giant insurer American International Group — it could not help Lehman, even as its default threatened to wreak havoc on financial markets. “We didn’t have the powers,” Mr. Paulson insisted, explaining a decision that many have since criticized — to allow Lehman to go bankrupt. By law, he continued, the Federal Reserve could bail out Lehman with a loan only if the bank had enough good assets to serve as collateral, which it did not. “If someone thinks Hank Paulson could have made the Fed save Lehman Brothers, the answer is, ‘No way,’ ” he said. But that is not the way that many who have scrutinized his actions see it. Bankers involved say they do not recall Mr. Paulson talking about Lehman’s impaired collateral. And they said that buyers walked away for one reason: because they could not get the same kind of government backing that facilitated the Bear Stearns deal. In retrospect, they added, it was emblematic of the miscalculations by the government in reacting to the crisis. The day after Lehman collapsed, the Fed saved A.I.G. with an emergency $85 billion loan, but the credit markets around the world began freezing up anyway. It was at this point that Mr. Paulson — feeling outgunned by pursuers, like Butch and Sundance — decided he had to find a systemic solution and stop lurching from crisis to crisis, fixing one company’s problems only to find several more right behind. “Ben said, ‘Will you go to Congress with me?’ ” said Mr. Paulson, referring to the Federal Reserve chairman, Ben S. Bernanke. “I said: ‘Fine, I’m your partner. I’ll go to Congress.’ ”

87 Seeing a Problem Earlier In nearly a century, no Treasury secretary has faced a more difficult financial crisis than that Mr. Paulson is contending with. For months, he and his team have been working around the clock, often seven days a week, trying — in vain — to keep it from deepening. In an hourlong interview with The New York Times, Mr. Paulson defended Treasury’s actions, saying that he and his aides had done everything they could, given the deep-rooted problems of financial excess that had built up over the past decade. “I could have seen the subprime problem coming earlier,” he acknowledged in the interview, quickly adding in his own defense, “but I’m not saying I would have done anything differently.” History will be the final judge. But in contrast with Mr. Paulson’s perspective, other government officials and financial executives suggest that Treasury’s epic rescue efforts have evolved as chaotically as the crisis itself. Especially in the past month, as the financial system teetered on the abyss, questions have been raised about the government’s — and Mr. Paulson’s — decisions. Executives on Wall Street and officials in European financial capitals have criticized Mr. Paulson and Mr. Bernanke for allowing Lehman to fail, an event that sent shock waves through the banking system, turning a financial tremor into a tsunami. “For the equilibrium of the world financial system, this was a genuine error,” Christine Lagarde, France’s finance minister, said recently. Frederic Oudea, chief executive of Société Générale, one of France’s biggest banks, called the failure of Lehman “a trigger” for events leading to the global crash. Willem Sels, a credit strategist with Dresdner Kleinwort, said that “it is the clear that when Lehman defaulted, that is the date your money markets freaked out. It is difficult to not find a causal relationship.” In addition, Mr. Paulson and Mr. Bernanke have been criticized for squandering precious time and political capital with their original $700 billion bailout plan, which they presented to Congressional leaders days after the Lehman bankruptcy. The two men sold the plan as a vehicle for purchasing toxic mortgage-backed securities from banks and others. But even after the House finally passed the bill on Oct. 3, markets remained in turmoil. It was not until Britain and other European countries moved to put capital directly into their banks, and the United States followed their lead, that some calm returned. In the interview, Mr. Paulson said that even before the House acted, he had directed his staff to start drawing up a plan for using some of the $700 billion to recapitalize the banking system — something that Congress was never told and that he had publicly opposed. Why? Because in the week before the plan passed Congress, conditions deteriorated significantly, Mr. Paulson said. But many complain the worst of the turmoil might have been avoided if it hadn’t been for Mr. Paulson sticking with an original bailout plan that they viewed as poorly conceived and unworkable. “They were asking the most basic questions,” said one Wall Street executive who spoke to Treasury officials after the bailout bill was passed. “It was clear they hadn’t thought it through.” Senator Charles E. Schumer, Democrat of New York, who had called for an infusion of capital into banks in mid-September, said, “They are so much more on top of this recapitalization plan than they were about the auction plan.” Even as he defended his actions, Mr. Paulson said he was worried that some of the government’s moves could wind up haunting future Treasury secretaries. He pointed in particular to the decision to guarantee all bank deposits and interbank loans, something the

88 United States did to keep pace with similar decisions in Europe. “We had to,” Mr. Paulson said. “Our banks would not have been able to compete.” But the federal guarantees could create “moral hazard” and simply encourage banks to take on dangerous risk, he acknowledged. “This is the last thing I wanted to do,” he said. Summer of Eroding Conditions The subprime mortgage debacle began emerging in the summer of 2007, about a year after Mr. Paulson left his job as head of Goldman Sachs and joined the Bush administration. But the true depth and extent of the losses did not become clear until earlier this year, Mr. Paulson said. “We thought there was a reasonable chance of getting through this,” he recalled. Then came the near failure in March of Bear Stearns, which was rescued in a takeover by JPMorgan Chase only after the Fed agreed to cover $29 billion in losses. That briefly lulled the markets into thinking the worse might be over. But during the summer, conditions deteriorated, and in early September the government was forced to take over Fannie Mae and Freddie Mac, the mortgage finance giants. With increasing speed, other problems emerged, most notably Lehman and A.I.G., which was also burdened with bad mortgage-related investments. Both became the focus of intense meetings the weekend of Sept. 13-14. Mr. Paulson, by then, had become frustrated with what he perceived as Mr. Fuld’s foot- dragging. “Lehman announced bad earnings around the middle of June, and we told Fuld that if he didn’t have a solution by the time he announced his third-quarter earnings, there would be a serious problem,” Mr. Paulson said. “We pressed him to get a buyer.” Here the views of Mr. Paulson and his critics start to diverge, over what transpired in marathon meetings with Wall Street executives at the Federal Reserve Bank of New York that weekend. Lehman officials said they believed the firm had not one but two potential buyers: Bank of America and Barclays, the big British bank. But both had conditions. Bank of America wanted the Fed to make a $65 billion loan to cover any exposure to Lehman’s bad assets, according to one person privy to the discussions who did not want to be identified because of their sensitive nature. Although this was more than double what the Fed had made available to facilitate the takeover of Bear Stearns by JPMorgan, Bank of America justified the request on the grounds that Lehman was larger. Barclays also wanted a guarantee to protect against losses should Lehman’s business worsen before Barclays could compete its takeover. The government initially was not clear in telling Bank of America and Barclays that no help would be forthcoming, participants said. The New York Fed president, Timothy F. Geithner, in particular, was uncomfortable about drawing a line in the sand against government support for a Lehman takeover. Participants said they were left with the impression from Mr. Paulson and Mr. Geithner that the government might well provide help for a serious buyer, with Mr. Paulson also trying to get Wall Street firms to create a $10 billion fund to absorb some of Lehman’s bad assets. It remains unclear whether a more consistent message would have changed the outcome. But by Saturday, Bank of America, frustrated by the government’s unwillingness to commit to a deal, turned its attention to Merrill Lynch, which agreed to a takeover. Barclays, equally frustrated, walked away on Sunday, said the person with knowledge of the discussions.

89 Mr. Paulson said in the interview that Treasury was not at fault. The $10 billion industry fund had not worked because executives in the room realized that bailing out Lehman would not end the crisis. There were too many other firms that needed help. “I didn’t want to see Lehman go,” Mr. Paulson said. “I understood the consequences better than anybody.” At a White House briefing on Sept. 15, Mr. Paulson shed no tears over Lehman’s failure. “I never once considered it appropriate to put taxpayer money on the line in resolving Lehman Brothers,” he told reporters. In the interview, however, Mr. Paulson said the main issue was whether it was legal. Under the law, the Fed has the authority to lend to any nonbank, but only if the loan is “secured to the satisfaction of the Federal Reserve bank.” When pressed about why it was legal for the Fed to lend billions of dollars to Bear Stearns and A.I.G. but not Lehman Brothers, Mr. Paulson emphasized that Lehman’s bad assets created “a huge hole” on its balance sheet. By contrast, he said, Bear Stearns and A.I.G. had more trustworthy collateral. People close to Lehman, however, say it was never told this by the government. “The Fed and the S.E.C. had their people on site at Lehman during 2008,” said a person in the Lehman camp. “The government saw everything in real time involving Lehman’s liquidity, funding, capital, risk management and marks — and never expressed any concerns about collateral or a hole in the balance sheet.” The aftermath of the Lehman bankruptcy was disastrous. “Lehman was one of the single largest issuers of commercial paper in the world,” said Joshua Rosner, a managing director at Graham Fisher & Company, referring to short-term debt issued by companies to finance day- to-day operations; this market locked up in the wake of Lehman’s failure. “How could you let it go bankrupt and not expect the commercial paper market to be completely crushed?” Why Bear Stearns but not Lehman, wonders Representative Barney Frank. Mr. Frank, Democrat of Massachusetts and chairman of the House Financial Services Committee, has generally been a supporter of Mr. Paulson during the crisis. “If it was the right thing to do, why did they do it only once?” he asked. In response, Mr. Paulson said that only now that the bailout bill has been passed does the government have the authority to intervene in a nonbank failure in cases of firms that lack adequate collateral, like Lehman. A Difficult Sell Lehman’s failure was followed by another strategic misstep by Treasury, critics say. They assert that Mr. Paulson initially pushed the wrong systemic fix: a bailout plan that revolved around buying up toxic securities, rather than putting capital into the banking system, a far more direct way of providing assistance. Mr. Paulson rejects this view. In the interview, he cited several reasons he and Mr. Bernanke concentrated initially on purchasing distressed assets. First, he said, this plan had been in the works for months and was much further developed. “If we had felt going in that the right way to deal with the problem was to put equity in, we would have taken some time and developed a program,” he said. He also worried that Congress would not be receptive to the idea of Treasury taking an ownership stake in banks: “This is a very complicated and difficult sell. We want to put equity in, but we don’t want to nationalize the banks. And I don’t know how to sell that.” But he doesn’t dispute that he changed direction. Mr. Paulson said that by Oct. 2, as he was departing for a weekend getaway to an island with his family — his first weekend off in nearly two months — he told his staff, “We are going to put capital into banks first.”

90 Although the bailout bill still had not passed, the financial markets had deteriorated. He did not, however, inform Congress of his change of heart, and the House debate revolved almost entirely around the asset-purchase plan. Just 11 days later, Treasury had come up with a plan to inject capital into the banks — which Mr. Paulson sold to the nation’s nine largest financial institutions on Oct. 13. “I can imagine being dinged for some things,” he said, “but not for moving that quickly.” He also defended Treasury’s recapitalization plan against critics who say that he did not extract a high enough price from the banks getting taxpayers’ money. “I could not see the United States doing things like putting in capital on a punitive basis that hurts investors. And we don’t want to run banks.” The Global Extent Asked what he might have done better, Mr. Paulson replied, “I could have made a better case to the public.” He added, “I never felt worse than when the House voted no” on the bailout plan Sept. 26, its initial rejection before ultimately passing the plan. As for Lehman, Mr. Paulson insisted that it was “a symptom and not a cause” of the financial meltdown that took place in recent weeks. The real problem, he contended, is that banks all over the world made wrong-headed loans that have now come back to haunt them. After meeting recently with European central bankers, he said, “the thing that took your breath away was the extent of the problem. Look at country after country that said they didn’t have a problem, and it turned out they had a huge problem.” Mr. Paulson added, “Ten years from now no one is going to say that this crisis was brought about because Lehman Brothers went down.” Nelson D. Schwartz and Stephen Labaton contributed reporting.

91 Opinion

October 22, 2008 OP-ED CONTRIBUTOR A Matter of Life and Debt By MARGARET ATWOOD THIS week, credit has begun to loosen, stock markets have been encouraged enough to reclaim lost ground (at least for now) and there is a collective sigh of hope that lenders will begin to trust in the financial system again. But we’re deluding ourselves if we assume that we can recover from the crisis of 2008 so quickly and easily simply by watching the Dow creep upward. The wounds go deeper than that. To heal them, we must repair the broken moral balance that let this chaos loose. Debt — who owes what to whom, or to what, and how that debt gets paid — is a subject much larger than money. It has to do with our basic sense of fairness, a sense that is embedded in all of our exchanges with our fellow human beings. But at some point we stopped seeing debt as a simple personal relationship. The human factor became diminished. Maybe it had something to do with the sheer volume of transactions that computers have enabled. But what we seem to have forgotten is that the debtor is only one twin in a joined-at-the-hip pair, the other twin being the creditor. The whole edifice rests on a few fundamental principles that are inherent in us. We are social creatures who must interact for mutual benefit, and — the negative version — who harbor grudges when we feel we’ve been treated unfairly. Without a sense of fairness and also a level of trust, without a system of reciprocal altruism and tit-for-tat — one good turn deserves another, and so does one bad turn — no one would ever lend anything, as there would be no expectation of being paid back. And people would lie, cheat and steal with abandon, as there would be no punishments for such behavior. Children begin saying, “That’s not fair!” long before they start figuring out money; they exchange favors, toys and punches early in life, setting their own exchange rates. Almost every human interaction involves debts incurred — debts that are either paid, in which case balance is restored, or else not, in which case people feel angry. A simple example: You’re in your car, and you let someone else go ahead of you, and the driver doesn’t nod, wave or honk. How do you feel? Once you start looking at life through these spectacles, debtor-creditor relationships play out in fascinating ways. In many religions, for instance. The version of the Lord’s Prayer I memorized as a child included the line, “Forgive us our debts as we forgive our debtors.” In Aramaic, the language that Jesus himself spoke, the word for “debt” and the word for “sin” are the same. And although many people assume that “debts” in these contexts refer to spiritual debts or trespasses, debts are also considered sins. If you don’t pay back what’s owed, you cause harm to others. The fairness essential to debt and redemption is reflected in the afterlives of many religions, in which crimes unpunished in this world get their comeuppance in the next. For instance, hell, in Dante’s “Divine Comedy,” is the place where absolutely everything is remembered by

92 those in torment, whereas in heaven you forget your personal self and who still owes you five bucks and instead turn to the contemplation of selfless Being. Debtor-creditor bonds are also central to the plots of many novels — especially those from the 19th century, when the boom-and-bust cycles of manufacturing and no-holds-barred capitalism were new and frightening phenomena, and ruined many. Such stories tell what happens when you don’t pay, won’t pay or can’t pay, and when official punishments ranged from debtors’ prisons to debt slavery. In “Uncle Tom’s Cabin,” for example, human beings are sold to pay off the rashly contracted debts. In “Madame Bovary,” a provincial wife takes not only to love and extramarital sex as an escape from boredom, but also — more dangerously — to overspending. She poisons herself when her unpaid creditor threatens to expose her double life. Had Emma Bovary but learned double-entry bookkeeping and drawn up a budget, she could easily have gone on with her hobby of adultery. For her part, Lily Bart in “The House of Mirth” fails to see that if a man lends you money and charges no interest, he’s going to want payment of some other kind. As for what will happen to us next, I have no safe answers. If fair regulations are established and credibility is restored, people will stop walking around in a daze, roll up their sleeves and start picking up the pieces. Things unconnected with money will be valued more — friends, family, a walk in the woods. “I” will be spoken less, “we” will return, as people recognize that there is such a thing as the common good. On the other hand, if fair regulations are not established and rebuilding seems impossible, we could have social unrest on a scale we haven’t seen for years. Is there any bright side to this? Perhaps we’ll have some breathing room — a chance to re- evaluate our goals and to take stock of our relationship to the living planet from which we derive all our nourishment, and without which debt finally won’t matter. Margaret Atwood is the author of “The Handmaid’s Tale” and, most recently, “Payback: Debt and the Shadow Side of Wealth.”

93 Business

October 21, 2008 Signs of Easing Credit and Stimulus Talk Lift Wall Street By MICHAEL M. GRYNBAUM After weeks of extraordinary efforts by the world’s governments and central banks, the frozen flow of credit began to thaw on Monday. The tentative re-emergence of trust among lenders — a rare commodity of late — raised hopes that the immediate financial pressures on banks, businesses and municipalities could ease somewhat, cushioning the blow of a likely recession. That encouraging signs appeared at all was enough to bring a wave of relief to Wall Street, where the Dow Jones industrial average rose 413 points, or 4.7 percent. As recently as last Friday, it was far from certain how quickly the unprecedented moves to unlock global credit, including the partial nationalization of some of the world’s biggest banks, would make a difference. “Fear really appears to have receded considerably,” said John V. Miller, the chief investment officer of Nuveen Asset Management. A benchmark borrowing rate among banks, known as Libor, dropped on Monday by the largest amount in nine months, an indication of growing confidence in the financial system. Local and state governments found buyers for bonds that had gathered dust for weeks. Banks and money market funds opened their coffers to corporate borrowers, reducing rates on short- term loans. The improvements in the credit markets came as welcome news to American businesses large and small, which depend on short-term financing for their daily operations. Economists warned, however, that American consumers might face a more difficult road. On Capitol Hill, the chairman of the Federal Reserve, Ben S. Bernanke, told lawmakers that the “risk of a protracted slowdown” merited the introduction of new measures to help individual Americans gain access to credit. Mr. Bernanke did not specify the size or scope of any plan. The Bush administration is under pressure to do more to help the economy and Democrats in Congress plan to devise a second stimulus measure. The Treasury Department, meanwhile, hopes to spur a new round of mergers among banks by steering some of the money in its $250 billion rescue package to banks that are willing to buy weaker rivals, according to government officials. While these efforts may provide some relief, the concern is that it may take time before they have a major impact on the economy. Loans are likely to remain scarce for many small businesses and consumers. Credit is unlikely to flow freely soon, said Max Bublitz, chief strategist at SCM Advisors, an investment firm in San Francisco. “It’s going to be doled out in small pieces over the next few months,” he said.

94 Since the collapse of Lehman Brothers in mid-September, the credit markets entered a state of near paralysis, keeping many businesses and municipalities from obtaining financing. For now, market watchers can celebrate that credit is being given out. Interest rates on common types of commercial paper — effectively short-term i.o.u.’s issued by businesses — fell to a four-month low. Companies began registering on Monday for a new program that would allow them to sell commercial paper to the Fed, the first time the central bank would lend directly to American businesses since the Great Depression. The program will go into effect next Monday and appeared to help build confidence in the short-term financing market. Companies sold about $3.3 billion of bonds in the United States last week — a historically low level — but are now looking to raise about $15.5 billion, according to Bloomberg News. Prices for municipal debt held steady for a third day on Monday after a monthlong sell-off. “The money market funds are feeling, based on what we are hearing, a little bit more comfortable and confident,” said Mr. Miller of Nuveen Asset Management, who specializes in the market for municipal bonds. The Pennsylvania Turnpike Commission sold $180 million of short-term loans on Monday. The market for longer-term municipal bonds, which had stagnated through last Friday, improved for the first time in weeks. Still, the biggest municipal debt sales came from big names like the Long Island Power Authority, Harvard and the State of California, Mr. Miller said. Credit remains very tight for smaller outfits that are more directly threatened by the looming recession. “The demand is re-emerging, but initially, it’s only emerging for certain types of bonds,” Mr. Miller said. The market for newly issued bonds, he said, had been “effectively shut down” for two months and remained stagnant on Monday. “So it’s early in the process,” he said. “You can’t call it a healthy market just yet.” In a sign that investors are willing to take risks in other parts of the financial markets, the yields on three-month Treasury bills rose to a one-month high. Investors also showed more confidence in banks like Citigroup, Merrill Lynch and Morgan Stanley, as measured by the cost to insure their corporate debt, although those costs remained historically elevated. In the corporate bond market, Illinois Power sold $400 million of 10-year bonds and Freddie Mac raised $2 billion. Other investors appeared to cast off those caveats, moving out of Treasury bonds and showing a new willingness to brave the winds of the stock market. The Standard & Poor’s 500-stock index gained almost 4.8 percent, and the Nasdaq composite index climbed 3.4 percent. Shares of energy companies led the gains. Chevron and Exxon Mobil shares gained more than 10 percent. A measure of volatility in the market, the VIX index, fell 25 percent from Friday, when it reached a record high. All major industry groups in the S.& P. 500 posted gains, and all 30 stocks on the Dow Jones industrial average rose for the day. “Credit markets have been leading the equity markets in recent weeks,” said David Kovacs, who oversees quantitative investing at Turner Investment Partners in Berwyn, Pa. The gains on Wall Street followed positive sessions on the European and Asian exchanges. Stocks in London on the FTSE 100 index ended more than 5 percent higher. Shares in Paris on the CAC 40 index rose 3.5 percent and Frankfurt’s DAX index gained 1.1 percent.

95 European stocks rallied after the Dutch government announced late Sunday that it would inject about $13.4 billion of new capital into ING, one of the country’s largest financial institutions. “It’s pretty clear that the moves by the policy makers are slowly but surely unclogging the inability to lend and borrow,” Mr. Bublitz of SCM Advisors said. “I suppose a little bit of thaw feels a little good.” In Asia on Tuesday morning, stocks opened higher. The Nikkei index in Tokyo was up 2.6 percent and the Seoul composite in South Korea was trading up 1.6 percent. David Jolly and Bettina Wassener contributed reporting.

Money

Velocity And The V-Shaped Recovery Brian S. Wesbury and Robert Stein 10.21.08, 12:01 AM ET The U.S. economy has weakened substantially in the past several weeks, and the National Bureau of Economic Research will eventually get around to declaring an official recession. Conventional wisdom believes that the current recession will be longer and deeper than any recession the U.S. has experienced since the early 1980s, continuing through 2009 and perhaps into 2010. When the NBER picks the start date of this recession, we suspect that they will reach back to the fourth quarter of 2007, when real gross domestic product fell by a slight 0.2%. We do not agree that the U.S. was in recession then, or for that matter up through August 2008. Despite a horrible housing market, real GDP expanded at a 2.8% annual rate in Q2, while real GDP was basically flat in the third quarter. Nonetheless, when the government releases its advance estimate of Q3 real GDP growth on Oct. 30, the report will probably show a slightly negative number, something in the -0.1% to - 0.5% range. This will be based on some more-pessimistic-than-necessary estimates of data that are not yet available. When the final data comes in and GDP is revised, we expect that negative figure to move into slightly positive territory. But in September, the economy fell off a cliff, with real GDP likely contracting at a 3% annual rate in the fourth quarter, making it the worst quarter since 1982. Rather than being the first of several negative quarters of economic growth, we expect this will be a temporary capitulation to the credit crunch, with almost all of the economic losses postponing economic activity into what will turn out to be a healthy period of growth in the second half of 2009. To be precise, we expect real GDP to be flat in Q1-2009 but then grow at an average annual rate of 3% in the final three quarters of next year. The reason: This sharp drop in growth is due to a temporary drop in velocity, due to a true credit crunch, with some panic thrown in for good measure. It is not a typical recession caused by fundamental, economy-changing events such as higher tax rates, tighter money, protectionism or other public policies that stifle innovation or entrepreneurship. The failure of Lehman Brothers, money market fund losses, widening credit spreads and a sudden tightening in bank credit--even an unwillingness of banks to lend to one other--hit hard in September. As a result, the velocity of money--the speed with which money moves through the economy--fell rapidly. The monetary equation MV=PQ helps explain what is happening. Normally, monetary velocity (V) is stable, so once money (M) is known, we can forecast nominal GDP (PQ or real growth plus inflation). If there is a slowdown in the turnover of money--say a 5% decline--the impact on nominal GDP growth is no different than if the money supply itself shrinks by 5%.

97 But there is good news. After ham-handing the rescue operation for months, the cavalry has finally arrived. The Fed has injected massive amounts of liquidity, driving the federal funds rate to roughly 1%--where it traded last week. Moreover, the Treasury Department has drawn a line in the sand. It has decided that no more banks will fail due to a lack of liquidity. We still wish the SEC would have suspended mark-to-market accounting, but instead the Treasury injected capital (by buying preferred shares) in order to stabilize the system and bring back investor confidence. This will work, but it is clearly a sub-optimal policy, involving the federal government more deeply in the private sector than is comfortable for a democracy. Despite the downside for free markets, these actions by the Fed and Treasury will help unlock the credit markets and turn velocity upward. With velocity and the money supply both heading up, a "V" shaped recovery is likely. While the conventional wisdom is betting on an "L" shaped economy, and the equity market is pricing in the risk of a prolonged slump in earnings, we think the odds favor a "V" shaped recovery, with only a temporary hit to earnings and a Dow Jones industrials average that recovers to 11,000 by the end of this year, with another 20% climb in 2009 all the way up to 13,250. The economy has succumbed to a panicky credit crisis, not a typical policy-induced recession. As a result, the downturn is unlikely to last long. Brian S. Wesbury is chief economist, and Robert Stein senior economist, at First Trust Advisors in Lisle, Ill.

98 How to prevent a financial crisis in Hungary that would lead to serious financial contagion in Emerging Europe Nouriel Roubini | Oct 21, 2008 I recently spent a few days visiting Hungary, a country that is now at the center of financial pressures in emerging markets. In recent weeks the stock market has sharply fallen, interest rates have increased, the currency has weakened and financial institutions have suffered of shortages of liquidity. A fully fledged currency and financial crisis can still be avoided with appropriate and coherent policy actions but the financial pressures have intensified in the last week. The macro, financial and policy weaknesses of Hungary – in many ways similar to those of many other countries in the Emerging Europe region – are not new; here at RGE we covered them as early as June 2006 in two analyses about vulnerabilities in Hungary and in Emerging Europe. But the global financial crisis has been the external trigger that has led now to a liquidity and credit crunch, the risk of a sudden stop and of a reversal of capital inflows. The vulnerabilities of the economy include a large current account deficit, a still excessive fiscal deficit, a partially overvalued currency, serious maturity and currency mismatches in the financial system, the household sector and the corporate sector, low stock of foreign reserve and high level of short term foreign currency debt that is at risk of a roll-off. Mary Stokes, RGE’s analyst on Emerging Europe, has recently well analyzed and summarized these vulnerabilities: Hungary is the latest hotspot in the ongoing global financial turmoil. On October 15, the currency plunged almost 7%, the biggest daily decline in five years and stocks tumbled almost 12%. Meanwhile, demand for Hungary’s government bonds dried up. This turmoil comes at a time when Hungary is in recovery mode. In mid-2006, after years of extremely loose fiscal policy that resulted in major imbalances, Hungary implemented a fiscal austerity package, which improved the current account and pushed down the budget deficit (from a record 9.2% of GDP in 2006 to a projected 3.4% of GDP or lower this year). So how did Hungary become the latest target in the global financial turmoil? While the immediate trigger seems to be a liquidity squeeze prompted by the global financial turmoil, the country has a number of vulnerabilities that contributed to the recent Hungarian asset sell-off. High Foreign Currency Lending Foreign currency lending in Hungary has increased by leaps and bounds in recent years as shown in the graph below. While swiss franc and euro loans appeal to companies and households because of their lower interest rates, this type of lending is particularly risky because it leaves unhedged borrowers exposed to currency swings.

99 Domestic Banks: Heavy Reliance On Non-Deposit, Foreign Financing While the rapid growth in foreign currency lending in Hungary is concerning, some of Hungary’s regional peers have similarly high levels. A key problem specific to Hungary is an exceptionally high ratio of foreign currency loans to foreign currency deposits. Over 60% of total loans to businesses and households were in foreign currencies (primarily euro, Swiss franc), while foreign currency deposits accounted for just over 20% of total deposits, according to a Fitch report from January 2008. This, combined with Hungary’s high loan-to-deposit ratio of over 140%, suggests a heavy reliance on non-deposit foreign funding, which tends to be volatile especially in the context of the current global credit crunch. Domestic Banks: Deteriorating Maturity Structure According to a recent report from Hungary’s central bank, the maturity profile of foreign funding has deteriorated and the domestic banking sector must be prepared to face ‘sustained tight liquidity conditions.’ This deterioration in the maturity profile increases ‘roll-over risk’ – the risk that investors are unwilling to refinance the debt coming due – and is a common feature of financial crises. Potential Spillover From Foreign Parent Banks In a blog post back in April, I noted that the CEE area is clearly vulnerable to any financing issues experienced by the major foreign parent banks that dominate the region’s banking systems. That is, problems in the EU banking sector could potentially impact Hungary and other Eastern European economies and vice-versa. Given the growing concerns about the stability of the EU banking sector, this potential contagion channel is a vulnerability and important to watch. (See related spotlight issue: How Safe Is the EU Banking Sector? Watch High Leverage Ratios and Derivatives Exposure) (See this UniCredit report for details on which foreign banks operate in Hungary.) Adverse Financing Composition Of Current Account Deficit Hungary’s current account deficit is high, but nothing compared to the double-digit deficits in Bulgaria, Romania, and the Baltics. The key issue is its financing composition. In 2007, Hungary’s current account corrected to 5% of GDP, down from 6.1% in 2006, and the gap is projected to be even lower this year. The problem is that net FDI covered just 20% of the gap in 2007, and debt-generating inflows financed the rest, according to Pasquale Diana of Morgan Stanley, who expects some improvement this year. Reserves Coverage of Short-term Debt Hungary’s short-term debt (18% of GDP) is roughly covered by net international reserves, according to the IMF. The build-up of short-term debt was a key vulnerability in the run-up to the Asian financial crisis in 1997 and the Russia crisis in 1998, among others. Hungary’s foreign exchange reserves totaled EUR17 billion at end-September (less than 3 months of imports, which is normally considered a critical level for FX reserves in terms of liquidity). Budget Deficit and Government Debt Levels Highest in the Region Notably, Hungary still suffers from twin deficits - the current account deficit mentioned above, as well as a budget deficit. Despite Hungary’s fiscal austerity measures, Willem Buiter still described Hungary as being in a 'deep fiscal mess' earlier this year. With public debt standing around 65% of GDP, Hungary is an outlier among its regional peers. Buiter says the public debt load will turn out to be unsustainable unless there is a major change in the political equilibrium.

100 Political Risk As Edward Hugh notes in a recent blog post, there is considerable political risk in Hungary. The ruling Socialist Party now governs from a minority position after the Free Democrats pulled out of coalition in April 2008. Meanwhile, the government has become unpopular in the wake of the 2006 fiscal austerity package, making it difficult for the government to pursue a reform agenda Growth Laggard Hungary's growth is lowest of any CEE country. Real GDP growth of 1.3% in 2007 was down from over 4.0% a year earlier, largely due to the fiscal austerity measures implemented in 2006. However, at this point the crucial issue - beyond dissecting the macro, policy and financial vulnerabilities that have led to the recent financial pressures – is to figure out what are the possible policy actions that may restore confidence and prevent and currency and financial crisis. Such a crisis would be devastating not only for Hungary but also for the Emerging Europe region: if Hungary goes bust the risk of a domino effect – like the one that in 1997 led the East Asian crisis to spread from Thailand to Malaysia, Indonesia and Korea – would be significant as many of the Emerging Europe region economies share the same vulnerabilities as Hungary (and indeed significant financial pressures are already underway in Estonia, Latvia, Poland, Romania, Bulgaria and Turkey). A crisis in Hungary would lead to a crisis in a large part of Emerging Europe; so preventing such a crisis in Hungary is essential to prevent a broader regional financial crisis. So what can be done to prevent such a crisis? There are several options on the table that, together, can lead to a coherent policy response that restores confidence and credibility. Let us discuss next in some detail such options… First of all, a meaningful further reduction in the fiscal deficit is essential as large fiscal deficits have been at the center of concerns by international and domestic investors. The current government has already reduced the fiscal deficit from about 9% of GDP in 2006 to a level slightly above 3% this year. But this fiscal adjustment is not sufficient given the current confidence crisis. The government is now planning to revise the fiscal deficit for 2009 to 2.9% from the originally planned 3.2% but a somewhat stronger fiscal adjustment – towards a 2.5% deficit together with commitments to further structural fiscal consolidation – would help to boost further investors’ confidence. Of course, over the medium term, the bloated public sector should shrink, with sharp spending cuts allowing cuts in tax rates that are now excessive. But, in the short term and in a period of a crisis, postponing tax cuts and achieving some reduction in spending is more important as it will lead to a confidence-boosting reduction of the fiscal deficit. Second, the government has now access to 5 billion euros that were made available by the ECB in a swap operation. The willingness of the ECB to “bail out” a country that is not yet member of the Eurozone is quite significant and signals the concerns that EMU members now have about the disruptive effects of a crisis in Hungary. Also, the ECB liquidity support, unlike IMF conditionality loans, does not come with any attached string. The additional issues that the ECB action has caused are however important: if 5 billion is not enough if the financial pressures intensify would the ECB lend more? Will the ECB do similar swaps with other Emerging Europe economies that are likely candidates – in the next few year - for EMU membership? Also should Hungary now use this additional international liquidity to prevent a further depreciation of its currency or should it save this additional ammunition in case things get worse?

101 Third, Hungary may want to consider intervening in the forex market to inflict pain on “speculators” that are shorting the currency. This strategy is risky if aggressive intervention fails to stem the speculation and fails to reverse the fall in the currency value. Also sterilized intervention may not be very effective as it would not increase domestic short term interest rates and thus make more costly to short the currency. While unsterilized intervention may be more effective but it would come at the cost of a sharp increase in short rates. And if unsterilized intervention is performed the authorities may achieve the same increase in domestic interest rates through domestic open market operations that don’t require the use of precious foreign currency reserves. Fourth, the authorities can try to use an interest rate defense of the currency (that is in principle equivalent to an unsterilized forex intervention). This is the approach taken this past week by Romania where overnight and seven day rates have spiked to over 40%. This approach is risky: interest rate defense of a currency under pressure is costly as a weak economy cannot take – for too long – such a sharp increase in real interest rates. Unless such interest rate defense is temporary and able to break the back of speculation in a short period of time (a couple of weeks) it becomes very expensive (leading to the risk of a severe economic contraction and a worsening fiscal balance) and it loses its credibility: if the currency is fundamentally overvalued that defense fails (as in the UK, Italy and Sweden in 1992 and in Turkey in 2001) as investors realize that such defense cannot last too long. Fifth, the authorities may want to seek an IMF program as they have signaled in the past week. There is intense debate in Hungary on whether such an IMF program would boost confidence or not. Some worry that an IMF program would be a stigma for the country as only countries in serious trouble and crisis would apply for such a program. There is also some concern that the IMF botched its conditionality in previous emerging market crisis episodes. But an IMF program may rather boost confidence and provide much needed foreign currency liquidity necessary to stem speculative pressures. The IMF appears to have learned from some of its previous mistakes and more willing to disburse in short order (and with fewer strings attached) international liquidity to countries that are deemed – like Hungary – to be illiquid but solvent. Also in many previous emerging market crisis the IMF support arrived only after a full blown crisis had erupted. In this case, instead, the liquidity support may come early and before the crisis has really erupted. So while some in Hungary argue that an IMF plan should be only a last resort policy there are good arguments in favor of an early IMF financial support rather than waiting to see if things get much worse. If the country waits too long that IMF support may indeed signal stigma and desperation. Ideally the country should have asked for an early disbursement IMF program in conjunction with its rapid receipt of the ECB support. While the public communication of the authorities approaching the IMF was partially botched this past week there is still time to repair the damage and seek a rapid – and short-in-conditionality – IMF liquidity support. Sixth, the government may have to consider whether a soft bail in of foreign investors, especially foreign banks operating in Hungary, is necessary and desirable. About 85% of the banking system in Hungary is foreign owned, mostly Italian, German and Austrian banks. There is now a risk that such foreign banks may reduce their exposure to their Hungarian subsidiaries and – in an extreme crisis situation – even let such subsidiaries go bust (as some US banks did in Argentina in 2001) if that is necessary to save their home country operation. But so far the Hungarian subsidiaries of such foreign banks have been quite profitable even if – of course – the foreign currency borrowing of the household sector and corporate sector (in swiss francs, euros and more recently yen) has become excessive and dangerous. The maturity of the cross border financing of this foreign currency lending by banks has also shortened over the last year as longer term financing has become more scarce and expensive.

102 Since Hungarian operations of foreign banks are profitable it should not be in their interest to roll-off their exposure to Hungary. On the other hand many European banks have their own domestic stresses given the financial turmoil in the eurozone and their need to deleverage and reduce risk exposure is leading to destabilizing pro-cyclical behavior towards their Emerging Europe subsidiaries (this pro-cyclicality of the credit behavior of foreign banks in emerging markets is a well known phenomenon in the empirical academic literature on this subject). So hopefully foreign banks operating in Hungary will maintain their cross-border exposure to Hungarian cross-border operations and will not sharply cut off the provision of new credit to the real economy (a new credit that is rapidly shrinking). But things get sourer and an incipient financial crisis looks like imminent a bail-in of foreign banks operating in Hungary may become necessary to prevent a sharp and destructive roll-off of the cross border exposure. Such bail-in of cross border interbank exposure took a more coercive form in the 1997 Korean crisis and a less coercive (voluntary subject to IMF monitoring) form in the 1999 Brazil and 2001 Turkey episodes. But if all else fails and international liquidity support (from ECB and/or IMF) is not sufficient to stop a cross border run on the country’s short-term liabilities (especially those of the banking system) such soft or coercive bail-in of foreign banks may become necessary to avoid a more destructive crisis. Hopefully such bail-in will not be necessary or it will take a soft form if necessary but such policy option may need to be considered in due time. In the short run the authorities may want to engage foreign banks – and use light-touch moral suasion – to convince them to stay in rather than run. After all, this crisis of confidence has self-fulfilling elements: if a bank stays in and all the other run, the losses for those who don’t roll off their claims would be severe; thus, there is an incentive for every player to rush to the exit in this non-cooperative Nash game. It is thus the role of the policy authorities to prevent this destructive rush to the exits outcome if the run does start to occur. Thus, for the time being using moral suasion to convince foreign banks to maintain exposure and continue cautious lending may be enough; but if a generalized run driven by panic were to occur more robust and possibly coercive forms of bail-in will have to be considered. In conclusion, while the situation is dire a full blown crisis can still be prevented in Hungary and in other countries in the region. But rapid and coherent policy action is essential to restore investors’ confidence and prevent a destructive currency and financial crisis. One should hope that the political forces – government and opposition - will stop bickering in public about what the right policy response should be and realize that the times are dangerous and further political uncertainty leads to policy uncertainty that does not boost confidence for nervous and trigger happy investors. Appropriate policy action together with the provision of international liquidity can still prevent a crisis that would have destructive effects on Hungary and most of the Emerging Europe region

103 China’s Reserve Growth: Still Large, and Rather Volatile Rachel Ziemba | Oct 21, 2008 China’s foreign exchange reserves reached over $1.9 trillion at the end of September, taking its stocks to almost twice that of Japan, the second largest holder of reserves and almost four times that of Russia ($540 billion) This implies an increase of about $100 billion over the quarter or less than the reserve accumulation of the last two quarters. More significantly, it is about the same as the combination of the trade surplus and FDI, indicating that hot money inflows may have been reduced or even reversed. However, on a monthly basis, the flows continue to be quite volatile, given some indication of the pressures Chinese macro policy makers are facing - and possibly suggesting that China could experience more outflows in the future.

Note - this graph replaces an old one which truncated the data set Reserve watchers tend to scour the reserves data for indications of short-term inflows. As a rough gauge what’s left after subtracting out the inflows from China’s trade surplus and FDI (and interest payments and remittances) is thought to be hot money, though some analysts have warned against relying too heavily on this measure. While not all of such unexplained flows are necessarily hot money, some may have been the repatriation of Chinese assets, the unwinding of onshore fx swaps or RMB investment from Hong Kong, there were clearly ways money was finding its way into China and was being bought by the PBoC. For a much more detailed analysis of the components of China’s capital account and reserves, see this state street analysis. Rough estimates suggest these funds could have been as high as $150 billion in the first half of 2008 and that they could have reversed or stalled more recently as RMB appreciation expectations ebbed.

104 In Q3, record trade surpluses in August and September as import growth slowed in price and volume terms took the Trade surplus and FDI total to over $100 billion, or about the same as reserve growth… or was it? China’s reserve growth might actually be higher than the raw figure indicates though. Assuming that China has maintained a 70% dollar share, China’s reserve accumulation might have been in the neighbourhood of $150 billion for the quarter and as much as $70 billion in August alone. The dollar’s rally reduced the value of PBoC’s euro and pound holdings. Given that the PBoC likely holds around $500 billion in euros and pounds, a 10%+ swing in the currencies can have a major effect on the dollar value of its portfolio. All of this suggests that China may still be attracting inflows, even if their pace has slowed from earlier this spring. Furthermore it suggests that China’s reserve accumulation patterns continue to be volatile.

As Michael Pettis and Brad Setser have pointed out more eloquently, policy measures including the requirement that state banks apply the increases in required reserves in dollars not in RMB, held down the headline reserve accumulation earlier this year. So too did transfers to the Chinese investment corporation. This suggests then that the over $250 billion in reserve growth earlier this year was even higher. However, China stakes suggested that in the more recent reduction in required reserves, the PBoC returned funds in RMB in USD- thus one question is answered, it is the PBoC and not the state banks that bear the foreign exchange risk. So if China’s reserves grew by $150 billion in Q3, this implies several things Speculative inflows seem not to have reversed – China is still receiving inflows, though the trade surplus and FDI account for a greater share. It is possible China’s capital controls are doing a better job stopping the flows of capital. But so far it seems China has not suffered outflows. Chinese attempts to channel money abroad have lapsed in the midst of the financial crisis. China is still buying a lot of dollars, even as it increased its holdings of EU equities earlier this year. And with a wariness of taking on risk, much of this is likely in the treasury market, now that agencies are shunned.

105 However, hot money or unexplained flows do seem to be slowing. They were minimal in September, but August data suggested large inflows. However, the recent data makes it clearer and clearer that China and Saudi Arabia are now basically the only EM governments adding to their foreign exchange reserves. The foreign assets of the Saudi Arabian Monetary agency rose to $420 billion at the end of August, about $ 15 billion over the month and over $100 billion so far this year. But overtime, Saudi Arabia’s asset growth will slow significantly if oil stays below $80 a barrel. Other countries are now spending their reserves to support their currencies. China’s large reserve growth only barely offset the decline in reserves in the rest of Asia in the month of September as Korea, India, Hong Kong, Taiwan and others saw reserve levels fall. So too did Russia, whose reserves slipped from almost $600 billion in July to about $546 billion Oct 3. However not all of this was spent, like China, others saw the value of their non dollar assets increased by the dollar’s rally. However, on net the trend has shifted away from the accumulation. In 2007 and early in 2008, massive foreign exchange reserve accumulation and the large stocks of pre-existing holdings, led to the establishment and growth of many sovereign wealth funds or to central banks investing in more high yielding assets. While sovereign wealth funds still have a lot of money to invest, it may not be as much as some thought, which puts discussion regarding the Santiago principles released on Saturday into context. Over the last year, since sovereign wealth funds exploded on to the pages of the financial press, there has been a process of familiarization with many of the funds, helped by detailed press coverage, an increase in analysis and research (including many many words on this website) willingness of many funds to meet with key officials and to channel material to the press. While the Santiago principles don’t remove all concerns, they do set a series of (albeit voluntary) regulations with which most funds will come up with ways to meet. in fact, many sovereign funds are investing more at home Countries that have deployed or plan to deploy sovereign wealth fund assets to support domestic asset markets or banks to improve sentiment. Doing so not only is an attempt to cushion economies but it may also accelerate Kuwait: KIA has increased its allocation to the domestic market. Russia: So Far Russia seems to have avoided use of its sovereign funds in its pledged $200 billion liquidity provision and bank backstopping plan, perhaps fearing the effects on its sovereign rating if it did so. A portion of its reserves will be spent to stand in for Russian banks and corporate external debt though. Qatar: The Qatar investment Authority agreed to contribute 10-20% of Qatari banks capital base (on Sunday’s prices) to insure funding for development projects. Many GCC countries including Qatar have faced increasing project finance costs even before the global money markets froze. Stakes in the Qatari state banks were transferred to the QIA some months ago. UAE: While Neither ADIA or the Abu Dhabi investment Council which holds stakes in local banks and other institutions and MENA equities, are confirmed to have made purchases, the Central banks liquidity facility is thought to be a transfer of funds from Abu Dhabi to Dubai’s cash strapped banks. However, the capital provided is still costly and little has been taken. Kazakhstan will use part of its $26 billion stabilization fund to create a state fund to offset the costs of the crisis and slowing growth. The country plans to create a national well-being fund

106 that will subsume its two state holding companies, Kazyna and Samruk, which had been intended as Temasek like vehicles to improve the performance of State owned enterprises. Around $10 billion would come from the stabilization fund China: China’s CIC reportedly bought stakes in the big three banks in which it is already the largest shareholder. This contributed to one of the short-lived surges in Chinese equity markets in September. CIC has yet to deploy most of its capital, and Bloomberg suggested, the CIC may have had funds in the now-frozen Reserve Primary Fund Taiwan has used its stabilization fund to purchase shares. Hong Kong authorities suggested a share of Hong Kong’s $180 billion in foreign exchange reserves might be used to stabilize domestic markets. The HKMA also did so during the Asian financial crisis as a means to defend the HKD’s peg to the dollar. Hong Kong equities made up around 5% of the Hong Kong Exchange Fund’s assets earlier this year

107 More unhappy numbers James Hamilton | Oct 21, 2008 Updates on some of the series we regularly follow, and they're not good. On Thursday the Federal Reserve Board announced that its index of industrial production fell by 2.8% in the month of September (yes, as in 33.6% at an annual rate). That's the biggest monthly decline in the index since January 1975. To put it in perspective, UCLA Professor Ed Leamer suggested last August that a 6-month decline of more than 3% should be characterized as a recession. That had been the one holdout among Leamer's four indicators in suggesting that the economic situation was still not so bad. But according to Leamer's criterion, the September drop in industrial production almost counts as a recession all by itself.

The good news is that the Fed attributed 2.25 percentage points of that 2.8% decline in September to the temporary disruption caused by hurricanes. On the other hand, another way to summarize the trend in industrial production is to become alarmed when there is a cumulative drop of more than 1% over a 12-month period. The August industrial production figure had already put us across that threshold, even if we completely ignore the September report.

108

On Friday we learned that the University of Michigan/Reuters index of consumer sentiment fell by 12.8. That's the biggest drop ever recorded since the index began in 1978, and is enough to wipe out the bounce up in consumer sentiment provided by falling gas prices since this summer.

And, to complete a threesome of updates, the TED spread has remained above 350 basis points for most of the month, though it eased slightly during the last week. Ted spread, as obtained from Bloomberg on Oct 18.

109 Oct 20, 2008 A Revised Economic Outlook for Latin America o There is much more than ‘good luck’ to explain the recent economic boom that Latin countries have experienced in the last five years. However, the time has come for Latin Central Banks to also acknowledge that now is no longer the time to be concerned about inflation. The author suggests that Latin central banks should implement a coordinate rate cut, in a similar way that the G7 promoted. (Saddi) o The Chilean peso (CLP) has been one of the biggest casualties in this period of synchronized disorderly currency adjustments, strongly influenced by a sustained decline in copper prices (down 50% in the last five months) and expectations of a sharp deterioration in global economic activity for the coming year; the CLP closed the week at 617 per USD, accumulating a loss of 26% in the past six months. Finally, the Argentine peso (ARS) which has, until now, been easily controlled by the central bank, is showing signs of increasing distress; in fact, non-deliverable forward (NDF) contracts now discount that the ARS will trade as high as 4.30 per USD in the coming months, implying a 25% devaluation from current levels. The direction of the Brazilian real will remain a major determinant of currency trends in Argentina (Scotiabank) o In the week that began on October 6th the Brazilian real and the Mexican peso both plunged sickeningly, as did stock markets. This week saw modest recoveries. But confidence in the region’s new-found stability has taken a knock. That is because the currency movements were sudden and violent. They prompted both countries’ central banks to intervene. Mexico’s had to spend 10% of its reserves in just a few hours to prop up the peso. Some foreign investors began selling Latin American assets to cover losses at home. But once it started, the currency slide seemed to provoke a collective nervous twitch that led many to seek safety in the dollar. This followed years in which Mexico had worked to create confidence in the stability of the free-floating peso (Economist) o In Brazil, we expect growth to be 2.8% in 2009, down from 3.3% previously. Our smaller revision to Brazilian growth reflects the fact that we had already built in a substantial slowdown in our previous forecast. Moreover, domestic demand carries more momentum going into 2009 in Brazil than elsewhere in the region. In Chile and Colombia, we have shaved our 2009 growth estimates by over 1 percentage point to 3.2% and 2.8% respectively. Despite the correction in copper prices, Chile should be well protected by its large off-shore fiscal savings and its negligible external debt. Colombia could potentially suffer more, given the ongoing sharp slowdown in domestic demand and its exposure to Venezuela (BNP Paribas) o Grupo Votorantim, Brazil's biggest diversified industrial group, said Oct. 10 it spent 2.2 billion reais to end loss-making currency swaps. Its pulp-making unit, Votorantim Celulose e Papel SA, said last week in a regulatory filing it will likely report a non-cash loss of 145 million reais related to derivatives, instruments whose value are based on and

110 determined by the underlying value of another security. VCP, based in Sao Paulo, is scheduled to release earnings Oct. 17 (Bloomberg) o Latin American Central bank presidents and leading economists said on Sunday the region is well prepared to face growing global financial turbulence and agreed to share information on monetary and financial markets (Mercopress)

LatAm Monetary Policy Monitor

Oct 15, 2008 Brazil (hiking) Latest COPOM decision raised the Selic by 75 bps to 13.75%in line with consensus. Decision was a 3-5 split suggesting the monetary authority might reduce the hiking pace to 50 bps - bias starts to shift from inflation to growth concerns. Mexico (hold): CB kept interest rate unchanged at 8.25% after three consecutive rate hikes. The decision was highly expected by market practitioners. CB's note state that economic growth may slow and inflation will probably remain within forecasts. UBS (via Bloomberg): Statement was less hawkish and the fact that it said inflation will be within the forecasts confirms the cycle is finished Chile (hold): Chile's central bank kept its benchmark interest rate unchanged at 8.25% as concern that a global credit crisis might damage the country's economy outweighed the threat from consumer price inflation. Chilean economists have lowered their expectations for the country's economic growth next year, suggesting the global credit crisis may help restrain consumer prices Colombia (hold): Colombia's central bank left borrowing costs unchanged as policy makers bet a slowing economy and 16 interest rate increases in the past 28 months are enough to stem inflation. Policy makers held the overnight interbank rate at a seven- year high of 10 percent. Argentina (unclear / could tighten): Cottani -> If the new government wants to keep an undervalued exchange rate they need to complement domestic price liberalization with a mix of tight monetary and fiscal policies, and trade liberalization. In his view, the current undervalued FX policy is not sustainable b/c it leads to strong inflationary pressures; JP Morgan -> Argentina may not continue implementing a devalued domestic currency - instead it can let the currency appreciate.

111 Oct 21, 2008 The Argentine Way: Using Social Security

Funds to Pay the Debt Argentina's government took over the management of $28.7 billion in private pension funds that sharply declined in value this year due to global turmoil. The government intends to increase the pool of money it can borrow from to meet debt obligations next year. As of now, retirement and pension fund administrators, known as AFJP, manage private pension accounts for 9.5 million depositors, of which some 40 percent are active contributors. Essentially, most mandatory funds that flow into the private pension system would now become part of the government's pay-as-you-go public pension scheme. The global financial meltdown has put Argentina's private pension assets in jeopardy. Besides that, the government would have access to some USD 1.2bn per year in new flows currently deposited in the system, a move would certainly help the government financially. The idea of using social security funds to avoid a default (or to pay the debt) next year should cause a sharp drop in confidence in the country and in this government Argentine bond yields soared above 23 percent and stocks sank the most in a decade as the government sought to take over pension funds, a move analysts said is a bid to seize assets and stave off the second default this decade. President Cristina Fernandez de Kirchner proposed legislation today to nationalize pension funds, which would give the government control of $29 billion in retirement accounts. Argentina has struggled to cover financing needs that have swelled as the global financial crisis pushed down prices on the country's commodity exports. Borrowing needs will climb to as much as $14 billion next year from $7 billion in 2007(Bloomberg) Argentine stock, bond and currency markets are expected to be hit hard if the government moves to takeover the private pension funds. President Cristina Kirchner is set to announce the complete nationalization of Argentina's private pension funds when she reveals reforms to the country's retirement system. In addition to decreased volume, the move is likely to add more downside pressure to capital markets, which are already reeling due to the international financial crisis. The pension fund takover is also likely to put pressure on the peso, and the Argentine Central Bank intervened heavily in early foreign exchange trading (WSJ) The collapse in commodity prices and the slowdown in global activity look to be placing the Kirchner administration in front of the nasty realization that their funding for next year is highly compromised. The government could look to nationalize the private pension funds. In 2001, Cavallo stuffed the pension funds with public paper to finance the deficit but at least he did not go as far as nationalizing them. Essentially, most mandatory funds flows into the private pension system would now become part of the government's pay-as-you-go public pension scheme. The reasons the government is likely to give is that the global financial meltdown has put Argentine's private pension assets in jeopardy. The truth is more likely that the government would have access to some USD 1.2bn per year in new flows currently deposited in the system, on top of the fact that some of 35% of AFJPs's USD30bn in assets

112 are not currently in government securities. This move would certainly help the government financially, but its sets the clock back almost 15 years in terms of economic structural progress in Argentina. Under a PAYG scheme, retirees count on the tax payments made by future generations to receive their money. Given that the economic clouds are darkening in Argentina, their money is much less likely to grow or be returned under a scheme managed by the government (where the liberated funds are unlikely to be ring-fenced) than by a more diversified private scheme (BNP Paribas) WIll Argentina Devalue Its Currency? Oct 20, 2008 o Scotiabank:The current exchange rate between the Argentine peso (ARS) and the USD does not reflect the deteriorating business climate and market conditions. We expect that the ARS will remain on the defensive and that the central bank will continue to use its reserve assets to support the currency. Such a strategy may erode the country’s reserve position and remains subject to constant public and investor scrutiny o Argentina may ease its defense of the peso, allowing for a 16 percent slide by year-end, to stem the loss of foreign reserves amid the worst global financial crisis since the Great Depression. The central bank may opt for a one-time devaluation this year to 3.8 per dollar from 3.2086 today. It is possible that the Central Bank of Argentina adopt a crawling band/peg such that it let the exchange rate to reach 3.8 under a gradual depreciation (Bloomberg) o Prefinex: In Argentina, the BCRA decided to strengthen the peso to offset the capital outflow, which coupled with an unstopping inflation is eroding the multilateral Real Exchange Rate o The peso’s lag relative to the Brazilian real’s weakening suggests that the pressures on BCRA to continue to spend reserves will linger. Considering this week’s levels, the peso has appreciated 20% against trading partner currencies this year—and stands at 1.9 vs the 1.0 prevailing in December 2001 prior to the maxi-devaluation. High domestic inflation has been an issue raised by Argentine industrialists to lobby in favor of less intervention and allowing the peso to weaken (JP Morgan) o BNP Paribas: The trade surplus was USD1.0bn in July. While higher than the market had anticipated, the number confirmed the pre-release made by President Fernandez last week. Exports rose 53% y/y, while imports increased by 46% y/y. Export prices increased by 36% y/y and volumes by 12% y/y. Import volumes, in turn, increased by 28% y/y while prices rose by 15% y/y. By product, exports were led by primary products, which increased by 94% y/y. Clearly, the end of the rural strike played in favour of these numbers

• More of the Same: Will There Be Another Round of the Farmers' Strike in Argentina? • Oct 16, 2008 o Prefinex:After the worst 120 days of the still unresolved farm conflict,Argentina is gradually regaining the path previous to March 11. This is far from being a breath of fresh

113 air: the problems are still pending and, far from being solved, have noticeably rooted. In this sense, three structural issues stand as the most pressing concerns, which should be addressed immediately and relentlessly, although the current administration has ignored them bluntly, despite the uncertainty they breed o Mercopress: Argentine farm leaders this week end urged the federal government to put an end to the so-called superpowers that allow the Cabinet Chief office to reallocate funds o BNP Paribas: Political noise goes on. The leaders of the farm sector continue to call for changes on the agricultural sector regulation. Demands continue focused on changes on caps on products prices, subsidies and restrictions on some export products such as dairy, wheat and meat. However, complains about the level of exchange rate became a new topic of the discussions. Farm leaders are kicking off demonstration in different cities and calling for a assembly on Aug30th to decide on a new strike. The conflicts with the farm sector do not bode well for country's credit spreads, as government is still working to rebuild credibility following the meltdown of Argentinean bond market early August. In the INDEC front, no news is bad news. Up to now, no formal changes on the management of the statistics institute were announced o FT:Argentine President Cristina Fernández has scrapped her controversial plan to hike farm export tariffs one day after suffering a swingeing Senate defeat.Farm leaders had demanded the president swiftly revoke the resolution, unveiled in March, which introduced a variable scale of tariffs that rose or fell according to international prices. o WSJ: Argentine democrats chalked up a big win last week when the Senate in Buenos Aires voted down a tax bill sent to it by President Cristina Kirchner. The significance of the defeat for Mrs. Kirchner goes well beyond her fiscal agenda to the heart of the rule of law in one of the most important countries in Latin America. To wit, for the first time in seven years, the office of the Argentine president has been forced to accept limits to its power How Sustainable is Argentina's Fiscal Position? Oct 14, 2008 o MS: The pace of fiscal spending has fallen. Last year fiscal spending grew near 40%, nearly double last year’s 24% nominal GDP growth. In contrast, in the first three months of this year the growth in fiscal spending has been running near 30%. Compare that with our estimate of first quarter nominal GDP growth at 30%, and there is evidence of policy tightening from last year. Thus, the monetarists argue, the pace of fiscal spending o Bloomberg: Argentina's budget surplus probably widened in July from a year earlier as higher commodity prices and increased economic activity boosted government revenue. The Economy Ministry may report the budget surplus, excluding interest payments, rose to about 2.8 billion pesos ($920 million) last month from 2.65 billion pesos in June and 2.6 billion pesos in July 2007 o BNP Paribas: Tax revenues disappointed in May. It reached ARS24.3bn, up 28.5%y/y, while consensus was for a higher ARS26.2bn. Moreover, it represents a sharp slowdown from the 52.4%y/y pace of expansion seen in April. Income taxes rose by a mere 0.9%y/y, a situation that the AFIP attributes to corporations having anticipated payments on this tax more heavily this year than last in recent months. Tax revenues from exports were not

114 unduly affected by the rural strike, increasing 79%y/y, while social security and VAT revenues rose by 48% and 33%y/y respectively. o Prefinex: Amid a context of stability/decline in international prices, to achieve a primary surplus above 3% over GDP in 2009 would require one of these measures (or a combination): a) To pull down the battery of subsides the Government has so far used to maintain prices frozen. b) Drastically reduce increases in pensions and wages for public employers. c) A devaluation that liquefies debt and real wages o JP Morgan: Fiscal constraints are biting hard forcing the authorities to allow these tariff hikes. So far this year, fiscal subsidies (up by 0.7% point oya to 1.7% of GDP for energy and by 0.2% pt to 0.7% of GDP for transportation) have provided a cushion, absorbing cost increases in the regulated service sector—but their burden on the budget has evidently skyrocketed From Boom to Doom: Prospects of a Slowdown in Argentina's Growth Oct 13, 2008 o Wells Fargo: The Argentine economy has started to show important signs that it is weakening considerably due to the insurmountable issues that this administration, as well as the past, have been accumulating during the last five years. Industrial production increased by only 1.6% year-on-year in June, the slowest growth rate since November of 2002. While it is possible that here were some seasonal factors affecting this meager performance that has not been captured properly by the seasonally adjusted index, this index has been negative for 5 months out of the 6 months already released for this year. Thus, even if there are problems with the seasonality of this number, it is clear that the economy is slowing down. The only thing that is very difficult to ascertain is the magnitude of the slowdown o FT: Argentina expects its economy, which has been growing at rates of over 8 per cent for the last five years, to expand by 4 per cent in 2009. International financial turmoil in the wake of the collapse of Lehman Brothers and the global credit crunch have recently sent Argentina’s country risk soaring and revived fears that a fresh default could be brewing, echoing the country’s giant 2001-02 debt and default crash o JP Morgan: The farmers’ strike, have promoted capital flight and are depressing the economic outlook. In 1Q08, real GDP advanced 8.4%oya and although the moderation in over-year-ago real GDP growth from the 9.1% advance in 4Q07 looks modest, the sequential deceleration stands out: on a q/q, saar basis output expansion slumped from 7.4% in 4Q07 to just 2.4% last quarter o Prefinex: The never ending farm strike had a negative impact on most industries and deteriorated expectations, thus reducing consumption, investment and the growth outlook for 2008/09. Primary fiscal surplus was revised downward as the farm strike took a blow revenues and government spending shows no signs of deceleration. The reduction of the trade balance in 2009 responds to difficulties of energetic provision offset with higher imports and lower exports, while we expect the rise of commodity prices to come to an end before the end of 2008

115 o Bloomberg: Barclays Capital cut its forecast for Argentina's economic growth to 5.5 percent this year from 7.4 percent. The forecast for 2009 growth was cut to 2 percent from 5 percent o BNP Paribas: The financial turmoil has spilled over to the real economy only to a very limited extent. According to Indec data, the government statistical agency, real GDP growth exceeded 9% year-on-year in Q4 2007. This would make 2007 the fifth consecutive year of above 8.5 % growth Artificially Low Inflation In Argentina: Is It A Gradual Default On Inflation Indexed Bonds? Oct 13, 2008 o Prefinex: Inflation figures were revised upwards as the problem remains unacknowledged by the government and a comprehensive plan doesn’t appear. It will decelerate once the economic growth comes to an end. The shift of the BCRA monetary policy reduced the expected end of year NER, but not the 2009 figure. We believe that the administration will return to the “weak peso” stance to privilege the fiscal surplus. Rumors of a possible 2009 default hit the price of public bonds o JP Morgan: despite a July CPI print that was markedly below expectations (table, next page), potentially imminent changes of leadership at INDEC provided an additional boost to asset prices (first chart). Those changes—while not root and branch—could result in a partial regularization of CPI inflation compilation methods, leading to a current pace 13- 15%oya (vs the 9.1% July advance just reported) o Clarin: Domingo Cavallo, the ex-Economy Minister under Carlos Menem and Fernando de la Rua, said that the manipulation of figures at INDEC represents a "gradual default" as various public debt bonds are adjusted according to the inflation index. "What is reflected in the rise in country-risk is that Argentina doesn't respect nor promises to respect its obligations. The lie of the INDEC is a gradual default," he added, while reiterating that "hidden inflation" for delayed power rates add to more than 50% per year o Mercopress:Accumulated inflation in Argentina over the last 12 months by the end of July was 28%, with food prices having risen 39% in that period and index-linking already beginning to take place o Reuters: Argentina said on Friday that June inflation was 0.6 percent due to higher prices for household goods, education and health care. Although the government unveiled a new inflation methodology in May, economists say it did not solve the problem. INDEC said the price of household goods jumped 1.6 percent last month, while education costs rose 1.5 percent and health-care costs gained 1.3 percent. Heavily weighted food prices rose 0.7 percent o Wells Fargo: Fernández-Kirchner administration introduced a new consumer price index with a base of April 2008. According to this new CPI, the rate of inflation during May of this year was 0.6%, and this means that inflation increased to 9.1% over a year ago. However, analysts are putting the real level of inflation at more than 30% and deteriorating. It is interesting that the new index did not reflect the strong increases in prices produced by the strikes and protests by the agricultural and cattle sector. This means that the biggest risk for the Argentine economy continues to be the administration’s manipulation of economic numbers, which no longer can be assumed to be limited to the level of inflation but to all numbers coming from the statistical institute

116 o BNP Paribas (not online): Official inflation for the month of September was released at 0.5% m/m, bringing the y/y reading to 8.7%. This was much lower than what private readings of inflation suggest it was last month. Nevertheless, there is also speculation that with the authorities working to line up financing for next year ad looking to draw close to the IMF that going forward official INDEC statistics will soon have to reflect reality. With the economy slowing sharply and commodity prices falling, this convergence should be made easier o Bloomberg: Argentina's National Statistics Institute may report that consumer prices continued to rise in June, though at about one-third the rate at which economists calculate the real pace of inflation. The institute will report that consumer prices rose 0.6 percent last month from May No Doubts: Argentina Will Repay the Paris Club Oct 2, 2008 o The International Monetary Fund on Thursday welcomed Argentina's decision to repay Paris Club creditor nations and said an IMF mission hoped to visit the country shortly to assess its economy. 'We welcome the normalization of relations between Argentina and its creditors,' IMF spokesman Masood Ahmed told a news briefing. The IMF conducted its last Article IV economic consultation with Argentina in mid-2006 (Forbes) o The Paris Club held a meeting Wednesday on the subject, and praised the Argentine government's September 2 debt announcement as a very significant step towards the normalization of Argentina's relationship with all its external creditors. The administration of President Cristina Fernandez de Kirchner is planning to pay the debt with Central Bank international reserves (Mercopress) o The head of President Cristina Fernandez's Cabinet said Argentina will meet next year's debt obligations.International investors have expressed concern that slowing tax income could narrow Argentina's budget surplus and delay payments. But Sergio Massa says Argentina has made a "clear decision" to pay off around US$12 billion in debt that matures next year. He says Argentina will continue to accumulate international reserves, which now stand at some US$47 billion(Herald) Why Are Argentine Bond Price Declining? Sep 29, 2008 o Wells Fargo: The recent issues with the $1 billion in Argentine bonds bought by Venezuela at hefty 15% interest rate is just the tip of the iceberg of what is ahead for the country. The Venezuelan government, i.e., Hugo Chávez, bought $1 billion in Argentine bonds and then immediately got rid of those bonds by turning them to the Venezuelan banking system. The Venezuelan banking system saw the opportunity and dumped the bonds into the market,producing a steep fall in Argentine bond prices. This adds to the government’s financing problems and could be a preview of what is in store for the country in the near future o Bloomberg: Argentina will buy back dollar- and peso-denominated bonds in a bid to halt a tumble in prices sparked by mounting concern that President Cristina Fernandez de

117 Kirchner will fail to curb an inflation surge. The Economy Ministry said in a statement that it will repurchase several different securities including bonds known as Bodens and Bonars. The ministry didn't say how much debt it plans to buy. Newspaper Clarin reported, without saying how it obtained the information, that the government may buy $250 million of bonds this week o MS: The decision by the authorities in mid-August to open a program of debt buybacks highlights one of the key investor concerns for next year – the specter of increased risk of default. Even as many of the region’s economies have seen credit rating upgrades – Brazil and Peru have achieved investment grade, while Colombia may be next in line – in the past year the discussion in Argentina has moved in the opposite direction. Investors appear more concerned about the risk of default in Argentina despite the wave of abundance that has swept Latin America in recent years. While Argentina’s decision to buy back debt at distressed prices is prudent, it underscores the larger investor concerns about debt sustainability. What do we think? While we acknowledge investor concerns, we doubt that the risk of default is likely during the next 12-18 months o JP Morgan: Following a collapse in bond prices the previous week (caused by several factors: see last week’s Argentina data watch), markets enjoyed some relief this week, lifted by a debt buyback program. The latter targets both ARS and USD-denominated treasury bonds with depressed valuations and significant amortization payments due in 2008 and 2009. The debt buyback can be seen as an intelligent initial response to the sharp sell-off in the bond market. It finally provides a signal that the government is concerned about the loss of market confidence and the possibility that this will damage the economy o Mercopress: The Argentine government announced the purchase of 2008 and 2009 bonds, --plus interest payments in advance-- in an effort to ease markets which have shown great anxiety over the political situation and economic slowdown of Argentina, particularly last week Molano: Argentine bond prices plunged more than 6 percent on Friday, as the market gave up hope that President Cristina Kirchner would amend her ways. Argentina suffered its worst week since the default of 2002. The Argentine EMBI+ jumped to 727, the widest spread in the region.

118

Party Like It's 1964 By Richard Cohen Tuesday, October 21, 2008; A17 A column, like a good movie, should have an arc -- start here, end there and somehow connect the two points. So this column will begin with the speech Condi Rice made to the Republican National Convention in 2000 in praise of George W. Bush and end with Colin Powell's appearance Sunday on "Meet the Press" in praise of Barack Obama. Between the first and the second lie the ruins of the GOP, a party gone very, very wrong. It is hard to avoid the conclusion that Bush and now John McCain have constructed a mean, grumpy, exclusive, narrow-minded and altogether retrograde Republican Party. It has the sharp scent of the old Barry Goldwater GOP -- the angry one of 1964 and not the one perfumed by nostalgia -- that is home, by design or mere dumb luck, to those who think that Obama is "The Madrassian Candidate." Karl Rove, take a bow. It is worth remembering that both Rice and Powell spoke at that Philadelphia convention. And it is worth recalling, too, that Bush ran as a "compassionate conservative" and had compiled a record as Texas governor to warrant the hope, if not the belief, that he was indeed a different sort of Republican. When he ran for reelection as governor in 1998, he went from 15 percent of the black vote to 27 percent, and from 28 percent of the Hispanic vote to an astounding 49 percent. Here was a coalition-builder of considerable achievement. Now, all this is rubble. It is not merely that Barack Obama was always going to garner the vast majority of the black vote. It is also that the GOP, under Rove and his disciples in the McCain campaign, has not only driven out ethnic and racial minorities but a vast bloc of voters who, quite bluntly, want nothing to do with Sarah Palin. For moderates everywhere, she remains the single best reason to vote against McCain. But the GOP's tropism toward its furiously angry base, its tolerance and currying of anti- immigrant sentiment, its flattering of the ignorant on matters of undisputed scientific consensus -- evolution, for instance -- and, from the mouth of Palin, its celebration of drab provincialism, have sharpened the division between red and blue. Red is the color of yesterday. Ah, I know, the blues are not all virtuous. They are supine before self-serving unions, particularly in education, and they are knee-jerk opponents of offshore drilling, mostly, it seems, because they don't like Big Oil. They cannot face the challenge of the Third World within us -- the ghetto with its appalling social and cultural ills -- lest realism be called racism. Sometimes, too, they seem to criticize American foreign policy simply because it is American. Still, a Democrat can remain a Democrat -- or at least vote as one -- without compromising basic intellectual or cultural values. That, though, is not what Colin Powell was saying Sunday about his own party. "I have some concerns about the direction that the party has taken in recent years," Powell said. "It has moved more to the right than I would like." He

119 cited McCain's harping on that "washed-out terrorist" Bill Ayers as an effort to exploit fears that Obama is a Muslim (so what if he were? Powell rightly asked) and mentioned how Palin's presence on the ticket raised grave questions about McCain's judgment. In effect -- and at least for the time being -- Powell was out of the GOP. S'long, guys. Those of us who traveled with Bush in the 2000 campaign could tell that when he spoke of education, of the "soft bigotry of low expectations," he meant it. Education, along with racial and ethnic reconciliation, was going to be his legacy. Then came Sept. 11, Afghanistan and finally the misbegotten war in Iraq. After that, nothing else really mattered. But just as Bush could not manage the wars, he could not manage his own party. His legacy is not merely in tatters. It does not even exist. In the end, Powell was determined not to be one of the GOP's useful idiots. Those moderates willing to overlook the choice of Palin, those capable of staying in a party where, soon enough, she could be an important or dominant force, retain the intellectual nimbleness that enabled them to persist in championing a war fought for duplicitous reasons and extol cultural values they do not for a minute share. Powell walked away from that, and others will follow -- the second time that a senator from Arizona has led the GOP into the political wilderness.

120 The Founding Father of Crony Capitalism by Thomas J. DiLorenzo| Posted on 10/21/2008 As soon as the federal government announced its trillion-dollar bailout (for starters) of Wall Street plutocrats, defenders of the bailout pulled out what they apparently believed was their secret weapon: the myth of Alexander Hamilton as the alleged inventor of American capitalism. Hamilton, they said, would approve of the bailout. Case closed. How could anyone dispute "the architect of the American economy"? Forbes.com immediately published an article entitled "Alexander Hamilton versus Ron Paul" to make the point that libertarian critiques of the bailout should be dismissed, since Hamilton was such a great statesman compared to Congressman Paul and his supporters. The Wall Street Journal Online published a piece by business historian John Steele Gordon in which he argued that our real problem is that central banking is not centralized enough; called for a financial-market dictator/regulator; supported the bailout; and, most importantly, blamed the current economic crisis on ... Thomas Jefferson! Jefferson opposed America's first central bank, Hamilton's bank of the United States, and was a hard-money advocate. It is this kind of libertarian, free-market thinking, said Gordon, that is the cause of the current crisis. What all this frantic Hamilton idolatry demonstrates is how the myth of Alexander Hamilton is the ideological cornerstone of the American system of crony capitalism financed by a huge public debt and legalized counterfeiting through central banking. It is this system that is the real cause of the current economic crisis - contrary to the false proclamations issued by Forbes.com and the Wall Street Journal. We live in "Hamilton's republic," as the writer Michael Lind has proudly stated. Americans may like to quote Jefferson, George Will once wrote, but we live in Hamilton's country. This is true, but it is not the blessing that people like Lind, Will, and others proclaim. Just the opposite is true, as I argue in my new book, Hamilton's Curse: How Jefferson's Archenemy Betrayed the American Revolution - And What It Means for America Today. The Real Hamilton Hamilton was the intellectual leader of the group of men at the time of the founding who wanted to import the system of British mercantilism and imperialistic government to America. As long as they were on the paying side of British mercantilism and imperialism, they opposed it and even fought a revolution against it. But being on the collecting side was altogether different. It's good to be the king, as Mel Brooks might say.

121 It was Hamilton who coined the phrase "The American System" to describe his economic policy of corporate welfare, protectionist tariffs, central banking, and a large public debt, even though his political descendants, the Whig Party of Henry Clay, popularized the slogan. He was not well schooled in the economics of his day, as is argued by such writers as John Steele Gordon. Unlike Jefferson, who had read, understood, and supported the free-market economic ideas of Adam Smith, David Ricardo, John Baptiste Say (whom Jefferson invited to join the faculty of the University of Virginia), Richard Cantillon, and Turgot (a bust of whom still sits in the entrance to Monticello), Hamilton either ignored or was completely unaware of these ideas. Instead, he repeated the mercantilist myths and superstitions that had been concocted by apologists for the British mercantilist state, such as Sir James Steuart. Hamilton championed the cause of a large public debt - which he called "a public blessing" - not to establish the credit of the US government or to finance any particular public works projects but for the Machiavellian idea of tying the interests of the more affluent to the state: being government bondholders, they would, he believed, then support all of his grandiose plans for heavy taxation and a government much larger than what was called for in the Constitution. He was right. They, along with Wall Street investment bankers who have marketed the government's bonds, have always provided effective political support for bigger government and higher taxes. That is why Wall Street investment bankers were first in line for a bailout, administered by one of their fellow investment bankers, Treasury Secretary Paulson. Hamilton argued for a large standing army not because he feared an invasion by France or England, but because he understood that the European monarchs had used such armies to intimidate their own citizens when it came to tax collection. Evidence of this is the fact that Hamilton personally led some 15,000 conscripts into Western Pennsylvania (with George Washington) to attempt to quell the famous Whiskey Rebellion. He was eventually put in charge of the entire expedition, and rounded up two dozen tax protesters, every one of whom he wanted to hang. They were all pardoned by George Washington, however, to Hamilton's everlasting regret. In a publication entitled "A History of Central Banking in America" the Fed proudly labels Hamilton as its founding father, boasting that he even spoke just like a contemporary Fed chairman. The First Bank of the United States, which was opposed by Jefferson and Madison, created 72 percent inflation in its first five years of operation, as Murray Rothbard wrote in A History of Money and Banking in the United States. It was not rechartered in 1811, but was resurrected by Congress in 1817, after which it created America's first boom-and-bust cycle, which led to the Panic of 1819, the title of another of Rothbard's great works on American economic history. After years of generating political corruption and economic instability, Hamilton's bank finally came to an end by the early 1840s, thanks to President Andrew Jackson. This led to the twenty-year "free banking" era. Hamiltonian central banking was resurrected once again in the 1860s with the National Currency Acts. This is an important reason why some historians have labeled the postwar decades as a period of "Hamiltonian hegemony." When Anna Schwartz, Michael Bordo, and Peter Rappaport evaluated this precursor to the Fed in an academic publication, they concluded that it was characterized by "monetary and cyclical instability, four banking panics, frequent stock market crashes, and other financial disturbances" (see their paper in Claudia Goldin, ed., Strategic Factors in Nineteenth-Century Economic Growth). Naturally, the government's response to all of this economic panic and instability caused by centralized banking was to create an even more centralized banking system with the Federal Reserve Act.

122 Hamilton is perhaps best known among economists for his Report on Manufactures. In his 1905 biography of Hamilton, William Graham Sumner wrote that Hamilton's report advocated "the old system of mercantilism of the English school, turned around and adjusted to the situation of the United States." Thomas Jefferson also wrote that Hamilton's "schemes" for protectionism, corporate welfare, and central banking were "the means by which the corrupt British system of government could be introduced into the United States." They were right. Hamilton's reputation as having had great expertise in economics and finance has been greatly exaggerated, wrote Sumner, who also wrote that Hamilton's economic thinking was marred by "confusion and contradiction" and that Hamilton was "befogged in the mists of mercantilism." Unfortunately for us, all of Hamilton's bad ideas "proved a welcome arsenal to the politicians" who succeeded him, noted Sumner. At the constitutional convention Hamilton proposed a permanent president who would appoint all the governors of the states and would have veto power over all state legislation. His opponents correctly interpreted this as advocating a monarchy and, worse yet, a monarchy based on mercantilism. The reason for consolidating all political power first in the central government, and then in the hands of one man, the permanent president, was so that an American mercantilist empire could be centrally planned and controlled without any dissenters, such as tax protestors or free traders who resided in the various states. Hamilton (and his political heirs) understood that forced national uniformity is the only way in which such a central-planning scheme could work. The socialists of the 20th century understood this as well.

Hamiltonian mercantilism is essentially the economic and political system that Americans have lived under for several generations now: a king-like president who rules through "executive orders" and disregards any and all constitutional constraints on his powers; state governments that are mere puppets of the central government; corporate welfare run amok, especially in light of the most recent outrage, the Wall Street Plutocrat Bailout Bill; a $10 trillion national debt ($70 trillion if one counts the government's unfunded liabilities); a perpetual boom-and-bust cycle caused by the Wizard of Oz- like central planners at the Fed; constant military aggression around the world that only seems to benefit defense contractors and other beneficiaries of the warfare state; and more than half of the population bribed with subsidies of every kind imaginable to support the never-ending growth of the state. This is Hamilton's curse on America - a curse that must be exorcized if there is to be any hope of resurrecting American freedom and prosperity.

123 Did Joseph Wharton Cause The US Financial Meltdown? Daily Article by Tim Hartnett | Posted on 10/21/2008

Joseph Wharton (1826–1909) founder of the Wharton business school co-founder of the Bethlehem Steel company When the economic chips began to fall last winter, legislators on Capitol Hill spared neither time nor words informing us of their priorities: no matter what might happen in the financial markets, we were told, funding for student loans will continue to flow. This is one promise from Washington we can take to the bank. Our government, representing the forces of goodness itself, isn't about to abandon that holiest of all cash cows, vulgarly known as the education industry. If there were such a thing as academic stock, only an idiot would sell it short. Americans are raised to believe there can be no such thing as a glut in sheepskins. The idea that any form of schooling can do harm is close to blasphemy. The benefits of university are commonly equated to a panacea, a philosopher's stone, and a moral sponge bath rolled into one. As far as Barack Obama is concerned, a college degree is no different from a chicken in a pot or a car in the garage: everybody is supposed to get one — or several. The logical next step is the construction of institutions of higher learning near the nation's most porous border points, fully equipped to provide credentials to aliens of any status. That way newcomers won't be overwhelmed in an environment of such general erudition. The dynamics of popular enthusiasm for formal education are roughly reflected in presidential history. George Washington's classroom education was sparse. His successor, John Adams, was a Harvard-educated lawyer. In the next century, seven out of 23 presidents never attended college. The 20th century saw only one of 19 presidents, Harry Truman, occupy the White

124 House sans degree. The first chief executive elected in the new millennium possesses degrees from the best-known brand names in American learning: Harvard and Yale. President Bush is also the first man to preside over the United States with an MBA. We will never know what might have happened with an MBA in the White House when the market crashed in 1929; the pressing need for them had not yet been invented. The Master of Business Administration is the great American contribution to the ubiquity of postgraduate degrees. It was an honorific cooked up in the 1930s, an era when businessmen might have had reason to be wary of entitling themselves. It is worth noting that among the most highly regarded presidents of the 19th century, only one, Thomas Jefferson, attended college or university. Abraham Lincoln, Andrew Jackson, and Grover Cleveland were all self-educated. These three are generally recognized as more original and independent than most of their executive peers. Early leading American businessmen were far less likely to be well schooled than politicians. Our first millionaire, John Jacob Astor, had no formal training. The first really big player on Wall Street, transportation tycoon Cornelius Vanderbilt, took a notoriously wry view of pedagogy. He once famously remarked, "If I had an education, I would not have had time to learn anything else." The slogan fails to appear beneath his name at the university bearing it in Nashville. Andrew Carnegie was a telegrapher and then worked his way up in the Pennsylvania Railroad; his book learning was extensive, but he acquired it from the library, not a blackboard. Jay Gould's experience as a surveyor and tannery manager served as his Wall Street apprenticeship. J.D. Rockefeller was a bookkeeper and a clerk. Henry Ford was a self- taught mechanic. E.H. Harriman learned his financial skills as a Wall Street flunky, and hence, J.P. Morgan dubbed him the "two-dollar broker." Of all early American magnates, Morgan was the only one with a college degree whose name is a household word today. And of the above mentioned, he was the lone standout who was born already rich. "Americans are raised to believe there can be no such thing as a glut in sheepskins." None of these facts justifies gratuitous attacks on the value of a college degree. But if certain kinds of diplomas are to qualify their holders for special opportunity to acquire wealth and power, then the performance of this elect is rightly subject to our utmost scrutiny. The evidence that the media are routinely indulgent of society's golden boys is ample if not overwhelming. The reciprocal arrangements between government and Wall Street are so pervasive that reporters and readers alike are long inured and oblivious to the blatancy of vested interest. The members of this world-shaking club are linked, almost to a man, through alma mater. When we examine what is required for an ordinary applicant to enter America's most exclusive universities, it is difficult to understand why these skills are relevant to success in the marketplace. The ability to distinguish between several similar obscure words unlikely to be used in a lifetime may be unusual but how it could facilitate successful business strategy is less than apparent. The career benefits of youthful contacts made at America's most exclusive universities, however, are obvious to everyone. What is a lot less obvious is what, exactly, are the talents of the guys who rise to the top of established business empires. A damned good lot of them seem to specialize in finding ways of producing revenue but not much of anything else. Well into the 20th century, journeymanship in a business was a natural route to an executive position in big-time corporate America. People with the hands-on experience in mechanics, sales, manufacturing, and agriculture were residing at the top of many fields of trade. As late as the 1950s,

125 entrepreneurs with widely divergent perspectives arising from a vast array of influences and experiences held sway in American industry. Those back roads are almost unknown to anyone aiming at a pinnacle of commerce today. People bound for upper management in large public companies have usually immersed themselves in a conformity campaign from high school and few of them ever emerge from it. They join large organizations and acquire the talent of enduring both maddening redundancy and contradictory policies. A life sentence of lengthy meetings begins at about age 16 for the future "success," ensuring that only masochists can couple their careers to an engine on the fast track. None of this takes the aspiring executive very far, though, without mastering the sublime art of the grovel. Genuine self-respect and human decency are the very qualities the modern leadership process is designed to purge. Upstanding individuals are as poisonous to the corporatocracy as kryptonite is to Clark Kent. Old-school "idea" men sank or swam on the profitability of the innovations they backed. Modern corporate stardom is a different game. The survivor must have the guts to wait for the risks taken by others to start paying off before deciding which side he was always on. Leadership, in the corporate lexicon, is a process of finding pulpits above a captive audience of hapless peons. The White House, of course, is the ultimate pulpit. That it was reached by an MBA whose fortune was built on cronyism and public largesse is an irony even incumbents regents at Vanderbilt University appreciate. What percentage of similar men can weigh down the top of society before the structure begins to creak and twist in strong winds? Education, as a means of spreading uncommon abilities further down the line of aptitude, is a great boon to prosperity. But the use of college degrees as clubs to clear the field of otherwise able competitors is a desperate measure of control that, intentionally or not, rigs the competition. Still the MBA grip on corporatocracy has many loyal defenders ideating in the halls of think tanks, publishing in the rags and newspapers, and doing the TV circuit. Apparently it is possible for an executive to take a once-solvent, even thriving, company, turn it into a government dependent, and remain worthy of fabulous remuneration from stockholders. Tales of big business have always included a healthy supply of sordid anecdotes. No number of them, though, ever seems to crack the mystique commonly associated with high finance. The idea that it is all so very arcane tends to overwhelm small investors' natural skepticism. But corporate glamour awes those in the thick of it as well. Every new rung on the ladder leaves executives feeling more delphic. Delusions of grandeur are at the heart of every leadership crisis. As the economy heated up in the 1980s, boomer careers began to take off, along with their salaries. This dynamic meshed with individual-income-tax-shelter legislation in a way that dumped money onto the NYSE and the other exchanges. Between 1980 and 2000, the Dow Jones Industrial Average rose by over 1,000%. During this same period, the population grew by roughly 25% and average incomes slightly more than doubled. Clearly government inducement was a major factor. Still, the gurus and experts never hinted at any risk of overcapitalization. The conventional wisdom implied perpetual opportunity on Wall Street. When P/E ratios predictably went through the roof, as the pool of bidders for common stocks and other securities mushroomed over night, experts generally failed to take note of any relationship between those factors. This process was institutionalized by tax legislation. Whatever the intentions, government action shifted huge amounts of capital into Wall Street products. Today a large percentage of the boomer generation is desperate that the Dow Jones Industrial Averages, buoyed by stock purchases for their retirement accounts, maintain

126 present levels and advance. One of the things that kept investment bank employees busy over the last 25 years was inventing new ways to absorb so much funding. In 2000, a New Jersey teenager, Jonathon Lebed, was pressured by the SEC to surrender $285,000 he had garnered in so-called pump-and-dump schemes. But it was difficult to understand how his methods were more morally compromised than those of some the most recognizable brokerage houses in the world. They almost invariably touted highly stocks their research departments "independently" assessed for market worth. Lebed, under any other pseudonym, was nothing more than "some random guy" on the Internet and certainly never enjoyed the cachet of a Morgan Chase, Bear Stearns, Goldman Sachs, Salomon Brothers, or any number of other name brands of the day. The SEC never suggested any of them surrender the billions, if not trillions, they gained in fees and other revenue from recommending stocks that temporarily bubbled. The uncredentialed are barred from fleecing gullible investors while licensed financial experts may even charge for their harmful advice. "One of the things that kept investment bank employees busy over the last 25 years was inventing new ways to absorb so much funding." In 1995, Britain's oldest merchant bank, Baring Brothers, was ruined by Nick Leeson, an arbitrageur who turned 28 one day before the company was declared insolvent. Leeson was not a college graduate. He was able to wreak fiscal havoc through a lengthy series of bad bets and the lax accounting supervision of his employer. Losses that had accumulated to 204 million pounds in December 1994 were quadrupled into the first 7 weeks of 1995. The process took nearly 3 years to reach fruition and through much of it Leeson was able to convince superiors of huge successes as the bank met his margin calls. Financial writers the world over were astounded that such an established institution could proceed so recklessly. The stakes were paltry, however, by comparison to the present crisis, which ultimately involved wagering against much larger odds. The current situation was carefully engineered using the most sophisticated resources of thousands of the largest corporations in the world. It was based on a simple formula: everyone wants a nice house. American builders were able and willing to create this wealth. All that was lacking was the means to pay them. This was just the kind of metafiscal obstacle that the ivory towers of commercial philosophy were poised to surmount. Without the fetters of a gold standard, money (literally) is no object. What it is, at the temples of world finance in south Manhattan, defies any recognizable definition. Debt, theoretically, is a bottomless well of enrichment. The sin of Charlie Ponzi was thinking small. We would expect the role of high finance in the real-estate market to involve providing credit in an organized fashion at a competitive price. Hypothetically, the invention of a financial "product" deriving regular revenue from mortgage payments could produce a sound arrangement. Instead, we found out that highly trained, sophisticated experts, with educational backgrounds enabling them to hold the rest of us in contempt, generally exercise the self- control of junior-high children in the throes of the latest fad. Somebody invented the mortgage-backed security and soon all of them had to have one of their own. All that was needed now was an endless supply of qualified home buyers. The Harvard School of Business overestimated its students and forgot to offer a course on the limits of supply in this commodity. Soon the world financial markets were funding new home construction in the United States the way Yahweh dropped manna on the wandering tribes. The fact that American incomes lagged far behind the pace of housing prices didn't fit into the "business model" discussed in 25th-floor meetings on Wall or Nassau or William Street. This mystery was left to be plumbed by carpenters and their helpers during lunch as they raised another 4,500 square footer.

127 Zachary Karabell, on the Wall Street Journal Op-Ed ("Bad Accounting Rules Helped Sink AIG"), phrased things a bit differently: What AIG was saying then, and what others from Lehman to Bear Stearns to the world at large have been saying since, is that the losses showing up aren't "real." Yes, the layer upon layer of derivatives built on the foundation of mortgages is mind-boggling. One reason that AIG had floated beneath the radar screen of the business media (relative to Wall Street investment firms) is that its business model is so complex and opaque that it is impossible to describe simply. It was briefly in the news in 2005, after it was accused of improper accounting by the SEC and the New York attorney general. Then it faded from view, until now. "Reality," wrote American philosopher C.S. Pierce (who was something of an "expert" himself unfortunately), "is that whose character is independent of what anyone might think." Whether computer-generated models, paradigms, and virtual realities would have caused the logician (who died in 1914) to hedge or expand this definition we'll never know. But Mr. Karabell's succeeding paragraph doubtless would have been worthy of Pierce's attention: Among its many products, AIG offered insurance on derivatives built on other derivatives built on mortgages. It priced those according to computer models that no one person could have generated, not even the quantitative magicians who programmed them. And when default rates and home prices moved in ways that no model had predicted, the whole pricing structure was thrown out of whack. (Emphasis added). Alas, computer-generated models, like MBAs, were unable or unwilling to submit to a limitation as confining as a finite supply of money. "Facts are stubborn things" is a line that frequently crops up in Wall Street Journal editorials. Indifference to the actual size of the market for a product priced to require annual interest payments alone that, in many cases, nearly equaled average American income took stubbornness too. No one needed an advanced degree or even a computer to recognize the defects of a scheme that ignored such facts. But maybe we underestimate them; did Wall Street kingpins know all along that the problem would be resolved by simply printing more money? However random and anarchic the markets appear under a fractional-reserve central-banking system, the end results have unnerving consistency. The decision makers in government and commerce have a philosophy of liquidity that borrows from Homer Simpson on his favorite liquid asset: "Here's to alcohol: the cause of, and the solution to, all of life's problems." Later in his article, Karabell says, A few years from now, there will be a magazine cover with someone we've never heard of who bought all of those mortgages and derivatives for next to nothing on the correct assumption that they were indeed worth quite a bit. That knowledge doesn't comfort anyone with assets retaining "underlying" value that is caught in a liquidity crunch. What it means is that Wall Street's obliviousness to fiscal reality has once again facilitated the concentration of private property into fewer hands. The bungling incompetence of our betters inevitably leads to the further enserfment of everyone. And in the meantime, the magnitude of the present crisis is undoubtedly serving as cover for countless varieties of new financial mischief. Society's economic vigilantes are presently enraptured by the lofty abstractions of Bernanke, Paulson, and numerous senators whose righteous indignation is roused at last. Just how Uncle Hank garnered his towering cash cache from Goldman Sachs is irrelevant. That foundering

128 Wall Street icon has been shored up by Warren Buffett in a way that is eerily reminiscent of Richard Whitney's purchase of 10,000 shares of US Steel in October of 1929. The experts just keep on giving and we'd better start asking how much more elite guidance we can stand. The important thing, they assure ever so reluctantly, is that the uncredentialed masses pony up. No one ever said that people who don't drag letters behind their names will be rendered slaves in this country. Properly educated businessmen mind what they do say as much as what they don't. The latest line is that government bailouts are good investments. This comes from politicians, ex-politicians, TV personalities, and people who run the cocktail circuit from the west side of the District to the east side of Manhattan. "Remember Chrysler?" is the ubiquitous refrain. "We all made out big on that one." Skeptics might have difficulty recalling it as quite so clear cut. Sure, number three, of the one-time "Big Three," is still with us, but who got what out of that sweetheart deal remains hazy. Money passing back and forth from the amorphous fiscal blob in DC and listed corporations is as difficult to follow as a shell game. Finding our end of the "profits" is like trying to unravel one of the more enigmatic derivatives. So what everyone ends up doing is taking their word for it that all is soundly managed. "In five or ten years," the suits reassure us between cigar puffs, "everyone will be sitting pretty." The public is expected to sit blinking like a corporate mistress in a James Thurber cartoon. Get a Real Education

$40 $15 "The experts just keep on giving and we'd better start asking how much more elite guidance we can stand." Last March, when Congress began hearings on the credit crisis, Representative Tom Davis of Fairfax County, Virginia cautioned that highly compensated CEOs and ex-CEOs of ruined corporations should not be "sacrificed" like "virgins to a volcano." Thankfully, he was able to restrain himself from allusions to the crucifixion. With an MBA president, a Wall Street fat cat at Treasury, and an academician at the Fed, those lustful volcanoes will be settling for virgins into the indefinite future. Barren harvest or no, the witch doctors of venture capital will be dancing in their leis, feasting on pork and poi, and making those ageless jokes about what all the poor people must be doing. We'll be slogging through traffic at $6 a gallon, hearing on C-Span that prosperity is just around the corner. Somebody about to catch the shuttle to New York — or back again to Reagan National — will be doing the talking.

129

Updated: New York, Oct 21 04:31 London, Oct 21 09:31 U.S. Moves Toward Stimulus as Bernanke, Bush Shift (Update1) By Ryan J. Donmoyer and Scott Lanman

Oct. 21 (Bloomberg) -- Lawmakers and officials moved toward forging a second fiscal stimulus bill after Federal Reserve Chairman Ben S. Bernanke endorsed the idea and the Bush administration dropped its opposition. Bernanke warned legislators yesterday the credit crunch is ``hitting home,'' with Americans unable to get auto loans and companies denied cash, and recommended measures to help borrowers. White House Press Secretary Dana Perino said President George W. Bush was ``open to the idea'' of a new stimulus. Momentum for fresh measures built after an earlier stimulus package failed to prevent a jump in the unemployment rate to a six-year high and the longest slump in retail sales since at least 1992. Bernanke ``had to do what he did'' in supporting a further federal stimulus measure, said Lyle Gramley, a former Fed governor who is now senior economic adviser at Stanford Group Co. in Washington. ``If he went up there and said, `Well, I'm indifferent to a stimulus package, I'm opposed to it,' he would be sending the wrong signal.'' House Budget Committee Chairman John Spratt said a new push would be patterned after earlier proposals made by House Speaker Nancy Pelosi that extend jobless benefits, fund

130 infrastructure projects such as road and bridge construction, and help cash- strapped state and local governments. `Protracted Slowdown' Bernanke told the Budget Committee yesterday that the danger of a ``protracted slowdown'' and a ``weak'' outlook for the U.S. economy into next year convinced him to support a new round of economic stimulus. A similar endorsement by Bernanke earlier this year helped clear the way for a $168 billion measure enacted in February. ``The big development is that Bernanke came and said, in Fed-speak, `You'd be wise to consider this,''' Spratt, a South Carolina Democrat, told reporters after the hearing. ``The momentum increased meaningfully because of Bernanke's endorsement.'' Spratt said the package may have to be structured in a way that increases deficits in the short term to avoid a longer-term economic slump that would have bigger budget effects in the long run. The Bush administration is `òpen to the idea'' of another economic stimulus package, though approval would depend on details drafted by Congress, Perino said. Proposals ``put forward so far'' by Democratic leaders in Congress ``were elements of a package we did not think would actually stimulate the economy, so we would want to take a look at anything very carefully,'' Perino said. Paulson Plan Separately, U.S. Treasury Secretary Henry Paulson said yesterday the government has set aside enough money to buy stakes in every financial company that qualifies for the crisis program aimed at halting the credit freeze. The New York Times and Wall Street Journal reported the government may use the aid to foster bank mergers, citing unnamed officials. Barack Obama, the Democratic presidential candidate, last week urged Congress to act `às soon as possible'' before the Bush administration leaves office on Jan. 20 to pass a stimulus measure. If Congress and the president didn't act `ìt will be one of the first things I do as president of the United States,'' Obama said in an Oct. 13 speech in Toledo, Ohio. Pelosi yesterday cited Bernanke's testimony to buttress her case for a new package. He ``made it clear that a new economic recovery package is critical to boost our weakening economy,'' Pelosi said in a statement. Ohio Republican Representative John Boehner, the House minority leader, said the Democrats' proposals amounted to ``hundreds of billions in new government spending masquerading as èconomic stimulus.''' `Pro-Growth Policies' ``House Republicans agree with Chairman Bernanke that action to strengthen our economy is needed, and it should come in the form of pro-growth policies that create new jobs, lower energy costs and protect taxpayers,'' Boehner said. Bernanke told lawmakers they ``should consider including measures to help improve access to credit by consumers, homebuyers, businesses and other borrowers'' saying such measures ``might be particularly effective at promoting economic growth and job creation.'' In a further break from his message three years ago that he would refrain from making recommendations to Congress on fiscal matters, Bernanke offered to help Congress craft specific tax measures to aid credit. That blurs one distinction he had made from his

131 predecessor, Alan Greenspan, who was widely interpreted in 2001 congressional testimony to have endorsed Bush's proposal to cut taxes by $1.6 trillion over 10 years. Confirmation Hearing Bernanke told lawmakers in his Senate confirmation hearing in November 2005: ``What I would like to do is refrain from making recommendations on specific matters of taxes and spending, or recommendations on specific measures.'' ``Bernanke is so afraid of depression that it trips all other considerations,'' Robert Eisenbeis, chief monetary economist at hedge fund Cumberland Advisors Inc. in Vineland, New Jersey, who used to work at the Atlanta Fed, said yesterday. In the hallways outside the Budget Committee hearing room in the Cannon office building, rank-and-file lawmakers split along party lines. Wisconsin Representative Paul Ryan, the top Republican on the panel, said he didn't think Bernanke's endorsement would bolster the Democratic agenda. ``Throwing more money out the door may help for a quarter, but it won't help to create jobs,'' Ryan said. Democrat Lloyd Doggett of Texas called Bernanke `à very reluctant endorser'' but said the Fed chairman's comments were ``notable'' because of the role he's played in managing the government's day-to-day response to the credit crunch. Senate Resistance He said Bernanke's comments, coupled with the election results, may change the outcome for the Democrats' proposal in the Senate, where the proposal has been met with resistance by Republicans who can easily block legislation. Senate Majority Leader Harry Reid, a Nevada Democrat, said Bernanke might make a difference. `Ì hope his testimony will convince President Bush and congressional Republicans that it is time to stand up for hard- working Americans who continue to struggle throughout the nation, not just bankers on Wall Street,'' Reid said in a statement. California Representative Xavier Becerra, a Democrat who also sits on the tax-writing House Ways and Means Committee, said Democrats ought to be willing to negotiate with Republicans who want to include tax-reducing measures. ``We have to make room for the discussion,'' he said. `Èverything should be on the table. We won't put the `Mission Accomplished' sign up until everyone is back to work and their 401(k)s are doing well.'' To contact the reporters on this story: Ryan J. Donmoyer in Washington at [email protected]; Scott Lanman in Washington at [email protected]. Last Updated: October 21, 2008 04:09 EDT

132 Opinion

October 21, 2008 OP-ED COLUMNIST The Real Scandal By BOB HERBERT It never ends. The Republican Party never gets tired of spraying its poison across the American political landscape. So there was a Republican congresswoman from Minnesota, Michele Bachmann, telling Chris Matthews on MSNBC that the press should start investigating members of the House and Senate to determine which ones are “pro-America or anti-America.” Can a rancid Congressional committee be far behind? Leave it to a right-wing Republican to long for those sunny, bygone days of political witch-hunting. Ms. Bachmann’s demented desire (“I would love to see an exposé like that”) is of a piece with the G.O.P.’s unrelenting effort to demonize its opponents, to characterize them as beyond the pale, different from ordinary patriotic Americans — and not just different, but dangerous, and even evil. But the party is not content to stop there. Even better than demonizing opponents is the more powerful and direct act of taking the vote away from their opponents’ supporters. The Republican Party has made strenuous efforts in recent years to prevent Democrats from voting, and to prevent their votes from being properly counted once they’ve been cast. Which brings me to the phony Acorn scandal. John McCain, who placed his principles in a blind trust once the presidential race heated up, warned the country during the presidential debate last week that Acorn, which has been registering people to vote by the hundreds of thousands, was “on the verge of maybe perpetrating one of the greatest frauds in voter history.” It turns out that a tiny percentage of these new registrations are bogus, with some of them carrying ludicrous names like Mickey Mouse. Republicans have tried to turn this into a mighty oak of a scandal, with Mr. McCain thundering at the debate that it “may be destroying the fabric of democracy.” Please. The Times put the matter in perspective when it said in an editorial that Acorn needs to be more careful with some aspects of its voter-registration process. It needs to do a better job selecting canvassers, among other things. “But,” the editorial added, “for all of the McCain campaign’s manufactured fury about vote theft (and similar claims from the Republican Party over the years) there is virtually no evidence — anywhere in the country, going back many elections — of people showing up at the polls and voting when they are not entitled to.” Two important points need to be made here. First, the reckless attempt by Senator McCain, Sarah Palin and others to fan this into a major scandal has made Acorn the target of vandals and a wave of hate calls and e-mail. Acorn staff members have been threatened and sickening,

133 murderous comments have been made about supporters of Barack Obama. (Senator Obama had nothing to do with Acorn’s voter-registration drives.) Second, when it comes to voting, the real threat to democracy is the nonstop campaign by the G.O.P. and its supporters to disenfranchise American citizens who have every right to cast a ballot. We saw this in 2000. We saw it in 2004. And we’re seeing it again now. In Montana, the Republican Party challenged the registrations of thousands of legitimate voters based on change-of-address information available from the Post Office. These specious challenges were made — surprise, surprise — in Democratic districts. Answering the challenges would have been a wholly unnecessary hardship for the voters, many of whom were students or members of the armed forces. In the face of widespread public criticism (even the Republican lieutenant governor weighed in), the party backed off. That sort of thing is widespread. In one politically crucial state after another — in Ohio, Michigan, Wisconsin, you name it — the G.O.P. has unleashed foot soldiers whose insidious mission is to make the voting process as difficult as possible — or, better yet, impossible — for citizens who are believed to favor Democrats. For Senator McCain to flip reality on its head and point to an overwhelmingly legitimate voter-registration effort as a “threat to the fabric of democracy” is a breathtaking exercise in absurdity. Miles Rapoport, a former Connecticut secretary of state who is now president of Demos, a public policy group, remarked on the irony of elected Republican officials deliberately attempting to thwart voting. Some years ago, he said, he “and all the other secretaries of state” would bemoan the lack of interest in voting, especially among the young and the poor. Now, he said, with the explosion of voter registration and the heightened interest in the presidential campaign, you’d think officials “would welcome that, and encourage it, and even celebrate it.” Instead, he said, in so many cases, G.O.P. officials are “trying to pare down the lists.”

134 Economy

October 21, 2008 U.S. Is Said to Be Urging New Mergers in Banking By MARK LANDLER WASHINGTON — In a step that could accelerate a shakeout of the nation’s banks, the Treasury Department hopes to spur a new round of mergers by steering some of the money in its $250 billion rescue package to banks that are willing to buy weaker rivals, according to government officials. As the Treasury embarks on its unprecedented recapitalization, it is becoming clear that the government wants not only to stabilize the industry, but also to reshape it. Two senior officials said the selection criteria would include banks that need more capital to finance acquisitions. “Treasury doesn’t want to prop up weak banks,” said an official who spoke on condition of anonymity, because of the sensitivity of the matter. “One purpose of this plan is to drive consolidation.” With bankers traumatized by the credit crisis and the loss of investor confidence, officials said, there are plenty of banks open to selling themselves. The hurdle is a lack of well- capitalized buyers. Stable national players like Bank of America, JPMorgan Chase, and Wells Fargo are already digesting acquisitions. A second group of so-called super-regional banks are well positioned to take over their competitors, officials said, but have been reluctant to undertake or unable to complete deals. By offering capital at a favorable rate, the government may encourage them to expand. In this category, industry analysts point to regional leaders, like KeyCorp of Cleveland; Fifth Third Bancorp of Cincinnati; BB&T of Winston-Salem, N.C.; and SunTrust Banks of Atlanta. With $125 billion left over after investing in the nine largest banks, the Treasury secretary, Henry M. Paulson Jr., said there was enough capital to invest in every qualified bank. “We have received indications of interest from a broad group of banks of all sizes,” he said at a news conference. “This program is not being implemented on a first-come, first-served basis.” Mr. Paulson did not address the issue of bank mergers in his remarks, but officials say it has been widely discussed within the Treasury, the Federal Reserve and the Federal Deposit Insurance Corporation, which has been burdened in recent months by having to support teetering banks like Wachovia. Providing capital to help facilitate a merger, officials say, is also a way to track how the capital is used. Some analysts have questioned how much control the government can exert over its investment, when it is injected into banks in return for nonvoting preferred shares. “We think there will be pressure behind the scenes by Treasury to push together companies that should have merged months or years ago,” said Gerard Cassidy, a banking analyst at

135 RBC Capital Markets in Portland, Me. “If you can create stronger companies, that is a positive.” In selecting banks, Mr. Paulson said the Treasury would also rely on advice from the quartet of regulators who oversee the banking industry: the Fed, the F.D.I.C., the comptroller of the currency and the Office of Thrift Supervision. But Mr. Paulson made clear that the final decision of who gets federal money rests with the Treasury. And he reiterated that the government expected the banks that got money to lend it out rather than hoard it — putting in a special plea for homeowners with troubled mortgages. “We expect all participating banks to continue to strengthen their efforts to help struggling homeowners,” he said. “Foreclosures not only hurt the families who lose their homes, they hurt neighborhoods, communities and our economy as a whole.” The Treasury’s bank rescue comes amid a rising clamor in Washington that the government should focus on helping mortgage holders directly. But officials say it is unlikely that the Bush administration will present a new plan for homeowners between now and the election. “There’s no inexpensive, easy way to address the terms of people’s mortgages,” said Robert J. Shapiro, an economic consultant who is chairman of the globalization initiative of NDN, a left-leaning research group in Washington. “I think that’s why they haven’t addressed it.” Most likely, he said, the campaigns of Senator John McCain and Senator Barack Obama will hone their own proposals. Then, if Congress reconvenes after the election in a lame-duck session, the new president-elect will try to push through a bill with new measures. Under the terms of the $700 billion rescue plan approved by Congress early this month, the Treasury has authority to purchase whole mortgages. Treasury officials also note that Mr. Paulson has pressed banks and loan servicers to show flexibility in modifying loans to avoid foreclosures. Still, Treasury’s recent efforts have been almost wholly focused on stabilizing the banks — first by proposing to buy distressed assets from the banks, and later by injecting capital directly into them. There were some signs in the credit markets Monday that those efforts were paying off. On Monday, Mr. Paulson described a process for banks to apply for government investments that is little more complicated than the one-page term sheet he handed to the chief executives of the nation’s nine largest banks at a meeting last week at the Treasury Department. The institutions, he said, must fill out a standardized two-page form and submit it to their primary regulator by Nov. 14. The Treasury will receive the applications, with a recommendation, from the regulator. Once it decides whether to inject capital, it will announce its investment within 48 hours. It will not disclose banks that withdraw or are turned down. The Treasury’s program is open to large and small banks, as well as thrifts. Officials said they had received inquiries from other financial institutions, including insurance companies, but the plan did not provide for them. Given the potential weakness of insurers, some analysts said the government should consider expanding the eligibility for capital injections. These analysts said $250 billion would not be enough. “They should see themselves as having $700 billion to recapitalize the industry in creative ways,” said Simon Johnson, a former chief economist at the International Monetary Fund.

136 While the Treasury’s offer of capital is attractive, analysts cautioned that cash alone might not be enough to reshape the industry. Recent deals, they note, have featured distressed banks sold at fire-sale prices. “There are a lot of obstacles to mergers in the banking industry,” Mr. Cassidy of RBC Capital Markets said. “I don’t know how the government could persuade banks to do deals at below book value.”

Economy

October 21, 2008 Bernanke Says He Supports New Stimulus for Economy By EDMUND L. ANDREWS WASHINGTON — The chairman of the Federal Reserve, Ben S. Bernanke, said on Monday that he supported a second round of additional spending measures to help stimulate the economy. “With the economy likely to be weak for several quarters, and with some risk of a protracted slowdown, consideration of a fiscal package by Congress at this juncture seems appropriate,” Mr. Bernanke told the House Budget Committee. His remarks are his first endorsement of another round of energizing stimulus, which Democrats on Capitol Hill have advocated. The Bush administration has been cool to the notion. Mr. Bernanke said the economic outlook was still so uncertain that the optimal size, composition and timing for any new stimulus plan were unclear. But he said Congress should try to develop a plan that would have its maximum impact when the economy was probably at its weakest. Many if not most private forecasters contend that the economy has already entered a recession, which would seem to argue for measures that would bolster overall spending as soon as possible. “If Congress proceeds with a fiscal package, it should consider including measures to help improve access to credit by consumers, homebuyers, businesses and other borrowers,” Mr. Bernanke said. “Such actions might be particularly effective at promoting economic growth and job creation.” It was unclear what kind of measures he had in mind. The government announced last week that it would invest $250 billion directly into the nation’s banks as part of a $700 billion bailout package to ease the financial turmoil and loosen the credit markets. In addition, the government has helped bail out the mortgage finance giants Fannie Mae and Freddie Mac as well as the insurance giant the American International Group. Democratic leaders have called for an additional $300 billion package of spending measures that would include a big increase in spending on infrastructure projects, an additional

137 extension of unemployment benefits and increases in spending for food stamps, home heating subsidies and state Medicaid programs. Mr. Bush has repeatedly asked American consumers to be patient and give the bailout package time to work. Many Republicans instead have favored tax cuts to corporations and individuals. Mr. Bernanke also cautioned that “any program should be designed, to the extent possible, to limit longer-term effects on the federal government’s structural budget deficit.” In his comments, Mr. Bernanke essentially reiterated the grim economic outlook he provided in a speech last week. “Even before the recent intensification of the financial crisis, economic activity had shown considerable signs of weakness,” he told lawmakers. Private sector employers shed 168,000 jobs in September and a total of 900,000 jobs since January. Real consumer spending, adjusted for inflation, declined during the summer and appears to have declined yet again in September. “The pace of economic activity is likely to be below that of its longer-run potential for several quarters,” he said. Mr. Bernanke and his colleagues at the Federal Reserve meet later this month, and many economists say they believe the Fed could again lower rates. Earlier this month, the Fed, along with the European Central Bank and other central banks, reduced primary lending rates by a half percentage point. An earlier stimulus package, in which the government mailed out about $50 billion in checks in April and May, provided a lift to income and consumer spending. Consumer spending increased 0.4 percent in May, but dried up after that.

138 Business

October 20, 2008 Joint U.S.-New York Inquiry Into Credit- Default Swaps By VIKAS BAJAJ In an unusual partnership, New York State and federal prosecutors are investigating trading in credit-default swaps, the insurancelike securities that have come under close scrutiny for their role in the financial crisis. Prosecutors are looking at whether traders manipulated the largely unregulated market for credit-default swaps to drive down the price of financial shares over the last year, people briefed on the investigation said. In the swaps market, investors buy and sell insurance protection against defaults on bonds. The cost of the protection, also known as a spread, rises when investors grow more concerned about the viability of companies. Since the spring, spreads surged on swaps tied to debt issued by Lehman Brothers, Morgan Stanley, Goldman Sachs and other financial firms. Those companies’ shares also tumbled, in part, analysts say, because the cost of protecting their debt was rising. Collaborations between the New York attorney general, Andrew M. Cuomo, and the United States attorney in Manhattan, Michael J. Garcia, are not frequent, legal experts say. That suggests the two men believe the case is too big and significant to pursue independently. Representatives for both men confirmed their effort on Friday. The Securities and Exchange Commission is also looking into credit-default swaps. Mr. Cuomo and Mr. Garcia are investigating whether investors drove up the price of swaps in transactions that were reported to data providers but never actually completed, according to people briefed on the investigation. If so, that would have helped anybody who sold short financial shares. In a short-sale, investors sell stocks they do not own in the hopes of buying them back later at a lower price. To identify whether there was any manipulation, Mr. Cuomo’s office has issued subpoenas seeking data from various parts of the industry, including stock exchanges, investment firms and three companies involved in processing trades in swaps and stocks, according to people briefed on the inquiry. Those firms are: the Depository Trust Clearing Corporation, which serves as the clearing agent for most financial transactions including swaps and stocks; Markit, which provides swaps data to Wall Street banks and investors; and Bloomberg, the financial data company whose electronic system is used by traders to track markets and communicate with one another. The inquiry is in preliminary stages, and people familiar with the investigation say it may not lead to a prosecution.

139 One investor, who asked for anonymity to avoid drawing attention to his firm, said the swaps market was becoming a convenient scapegoat for regulators. He added that evidence of traders’ manipulating share prices was largely circumstantial. Concerns about the market have prompted the Federal Reserve Bank of New York to push investment firms to move trading in credit-default swaps to a regulated exchange by year’s end. Joseph A. Grundfest, a former commissioner at the Securities and Exchange Commission and now a professor at Stanford Law School, said a partnership between Mr. Cuomo and Mr. Garcia made sense given the complexity of the swaps market. This is “an international market and it might well be easier for the United States attorney to get information from some foreign sources than have a local prosecutor pursue the information,” he said. In the past, the state attorney general and the United States attorney’s office have often competed with each other on major white-collar crime cases, like the investigation of Frank Quattrone, the former Credit Suisse banker who was acquitted last year of federal obstruction of justice charges. Tensions between the offices ran high when Eliot Spitzer, the former New York governor, was attorney general. While the United States attorney’s office brings criminal cases, the attorney general’s office typically pursues civil cases, though it can pursue criminal charges. “The efforts of the U.S. attorney’s office, whose primary role will be to determine whether any federal laws have been violated, will serve to complement the broader mandate of the attorney general’s office,” Yusill Scribner, a spokeswoman for Mr. Garcia, said in a statement. Several senior lawyers in Mr. Cuomo’s office, including his deputy counselor and special assistant, Benjamin M. Lawsky, previously worked in the United States attorney’s office. “The probe will bring together top prosecutors from both offices while simultaneously avoiding multiple competing investigations,” Alex Detrick, a spokesman for Mr. Cuomo, said in a statement.

140 Is Argentina running out of funds?, Nicolas Magud | Oct 20, 2008 The Argentine government is, apparently, in the process of reabsorbing the retirement and pension system privatized in the 1990s’. The official argument, of course, is the international financial crisis. (Wasn’t Argentina de-coupled, and totally resilient to the crisis, as per the authorities?). I would interpret it differently, though. The government seems unable to rein in public expenditures. In turn, this is worsened by 2009 being an election year in the context of an economy that slowdowns markedly (and mainly due to internal wrong macro- management much more than and prior to the external shock), and very limited financial access—I have elaborated extensively on these topics in previous posts and the use of temporary high tax revenues to finance quasi-permanent expenditures. You can also add a presidential image that plummeted through 2008. Thus, the government is desperate to obtain funds to increase expenditures, which are quite scarce for Argentina. Some commentators argue that the external shock calls for a fiscal response to smooth the business cycle—that should not exist in the first place as per the previous calculations of the government regarding the international shock. Isn’t the U.S. doing it? But Argentina is not the U.S. Clearly, its default history differs substantially, as well as respect for property rights; and the list follows on and on. Only when a country’s reputation is high enough is that economy able to step in to temporarily buy equity in firms to stabilize a crisis. This does not apply to Argentina’s current administration. But this is not new. The Kirchners ‘administration have made use of this “tricks” more than once—and so did Peron. In the name of retired people’s benefits—not true, though—the administration is able to obtain current funds that otherwise will be unable to borrow. The intertemporal magnitude of this is not trivial: by acquiring the present flow of funds to finance current (but potentially quasi-permanent) expenditures, the federal government also incurs in present and, more importantly, future liabilities (mainly not taken into account)—not to mention the efficiency losses derived from “governmental” managers not usually chosen due to their technical ability. Will this affect the future ability to roll-over debt? This is still an open question. No wonder that Argentina’s country-risk increased—and might keep on increasing. Furthermore, the short run impact of this affect the banking system—probably the only sector with some resilience of the crisis, since the real sector will be strongly affected. Add to the latter that the government wants to exchange its debt—so as to transfer over time the burden of capital repayment—would you like to be in charge in 2011? I wonder if someone will… Finally, let me comment on the response of the current administration to the international financial crisis. The idea seems to be to increase public expenditures (as mentioned above), closing the economy and potentially gradually depreciating the exchange rate. Closing the economy is not the right answer. The adjustment of the exchange rate would have been correct, provided that the past macroeconomic policy had been responsible—the latter not being true. Had Argentina respected property rights, not manipulated inflation and other official data, pumping up the economy to increase inflation, stimulated investment (instead of only consumption) and productivity, etc, the answer would have been different. But now, however, there is higher probability that changes in the exchange rate will be transferred to prices—nobody will be surprised why this did not happen in Brazil or Chile, right? The administration preferred not to slow down the economy to control the inflation rate when things were manageable. May be it is time to start paying the bills (sooner rather later).

141

Bretton Woods, The Sequel? By Sebastian Mallaby Monday, October 20, 2008; A15 The financial crisis is by no means over, but the urge to extract lessons from it already is irresistible. The Europeans have pressed successfully for a new Bretton Woods summit, modeled after the 1944 gathering that inoculated the world against a repeat of the Great Depression. Although the original Bretton Woods took place years after the Depression, Britain and France are bent on staging the new version within weeks. "Europe wants it. Europe demands it. Europe will get it," French President Nicolas Sarkozy said before jetting off to Camp David, where President Bush meekly gave in to him. The Bretton Woods analogy is contrived, to put it mildly. That summit created the World Bank to reconstruct Europe after the ravages of World War II. Today, bombed-out infrastructure is hardly the issue. Bretton Woods also created the International Monetary Fund, to support a system of fixed exchange rates. But the world has largely abandoned that system, and today's chief exchange-rate challenge is to move even further from Bretton Woods by persuading China to float its currency. Bretton Woods boosters assert that a global financial system needs global regulatory fixes. This claim deserves scrutiny. The fix that rightly commands widest support is moving the swap contracts between financial institutions onto centralized exchanges, so the collapse of one large player does not threaten others that entered into swaps with it. But this reform can be achieved with a minimum of international coordination. Countries can unilaterally establish swaps exchanges, and financial institutions all over the world can use them. The second fix on most reformers' lists is to shrink the pyramids of debt in the financial system. When a bank or a hedge fund buys $100 million of assets with $5 million in capital and $95 million in debt, a 5 percent loss is enough to wipe it out, forcing liquidation of the remaining $95 million worth of stocks or bonds in its portfolio. Such fire-sale liquidation has driven part of the recent market turmoil; it forces prices down and damages other debt-laden players, which then join in the selling. Although such debt, or "leverage," is certainly dangerous, a new Bretton Woods summit is not going to tame it. We know this because we've tried already. It took five years, not a handful of photo-op summits, to negotiate the so-called Basel II standards that govern leverage at banks, and the resulting deal proved ineffectual anyway. Daniel Tarullo, who has just published a Peterson Institute book on Basel, points out that the next attempt to control leverage may need to be broader. After the events of recent months, that is surely right. Given AIG's failure, the next round should probably encompass insurers. Given the vast growth of hedge funds, it should also cover some of them. Creating sensible leverage rules for such disparate institutions will be fiendishly complex, perhaps even impossible. So what might a new Bretton Woods conference usefully do? Well, it could reform the IMF, which has evolved from its original role into a rescue fund for collapsing currencies. During the emerging market crises of a decade ago, the IMF was central to all the bailouts. Its status has since dwindled. As my Council on Foreign Relations colleague Brad Setser notes, the Chinese have tried to muscle in on the IMF's turf by helping Pakistan. The Russians have tried to help Iceland. The European Union has helped Hungary.

142 Reestablishing the IMF as the agreed provider of bailouts would be a worthwhile project. The IMF puts economic conditions on its loans while governments place political ones; we don't want to revive the cronyism of the Cold War, when countries from Cuba to Zaire could pursue absurd policies and know they would be bailed out because they were strategically useful. The irony is that Britain and France will be the first to resist a serious effort to revive the IMF. British Prime Minister Gordon Brown talks vacuously about giving the organization the role of creating an early-warning system for crises, even though this is what thousands of economic forecasters already try to provide. What Brown does not stress is that serious IMF reform needs to begin with the modernization of its board. Rising powers such as China and India deserve more say. Declining powers need to give up some influence -- and that includes France and Britain. Of course there is a role for global cooperation. The coordinated interest rate cuts and bank rescues of recent days have been constructive. But it's worth remembering that after the last global crisis, in 1997-98, there was lots of grand talk about a new international financial architecture. In the end, the only important reforms were national ones. Governments ran budget surpluses and built up foreign reserves to protect themselves from the next shock. That shock has arrived, and we are about to find out if those changes were enough. One thing is certain: They were not the result of any international conference.

143 Economy

October 20, 2008 Consensus Emerges to Let Deficit Rise By LOUIS UCHITELLE and ROBERT PEAR Like water rushing over a river’s banks, the federal government’s rapidly mounting expenses are overwhelming the federal budget and increasing an already swollen deficit. The bank bailout, in the latest big outlay, could cost $250 billion in just the next few weeks, and a newly proposed stimulus package would have $150 billion or more flowing from Washington before the next president takes office in January. Adding to the damage is that tax revenues fall as the economy weakens; this is likely just as the government needs hundreds of billions of dollars to repair the financial system. The nation’s wars are growing more costly, as fighting spreads in Afghanistan. And a declining economy swells outlays for unemployment insurance, food stamps and other federal aid. But the extra spending, a sore point in normal times, has been widely accepted on both sides of the political aisle as necessary to salvage the banking system and avert another Great Depression. “Right now would not be the time to balance the budget,” said Maya MacGuineas, president of the Committee for a Responsible Federal Budget, a bipartisan Washington group that normally pushes the opposite message. Confronted with a hugely expensive economic crisis, Democratic and Republican lawmakers alike have elected to pay the bill mainly by borrowing money rather than cutting spending or raising taxes. But while the borrowing is relatively inexpensive for the government in a weak economy, the cost will become a bigger burden as growth returns and interest rates rise. In addition, outlays for Medicare and Social Security are expected to balloon as the first baby boomers reach full retirement age in the next three years. “The next president will inherit a fiscal and economic mess of historic proportions,” said Senator Kent Conrad, Democrat of North Dakota and chairman of the Senate Budget Committee. “It will take years to dig our way out.” The Congressional Budget Office estimates that the deficit in the current fiscal year, which started this month, will reach roughly $700 billion, up more than 50 percent from the previous year. Measured as a percentage of all the nation’s economic activity, the deficit, at 5 percent, would rival those of the early 1980s, when a severe recession combined with stepped-up federal spending and Reagan-era tax cuts resulted in huge budget shortfalls. Resorting to credit has long been the American solution for dealing with expensive crises — as long as the solution has wide public support. Fighting World War II certainly had that support. Even now many Americans tolerate running up the deficit to pay for the wars in Iraq and Afghanistan, which cost $11 billion a month combined. And so far there is wide support for an initial outlay of at least $250 billion for a rescue of the financial system, if that will stabilize banks and prevent a calamitous recession.

144 “There are extreme circumstances when a larger national debt is accepted as the lesser of two evils,” said Robert J. Barbera, chief economist at the Investment Technology Group, a research and trading firm. There are also assumptions that help to make America’s deficits tolerable, even logical. One is that people all over the world are willing, even eager, to lend to the United States, confident that the world’s most powerful nation will always repay on time, whatever its current difficulties. “So far the market is showing that it is quite willing to finance our needs,” said Stephen S. McMillin, deputy director of the White House Office of Management and Budget. Lenders are accepting interest rates of 4 percent or less, often much less, to buy what they consider super-safe American debt in the form of Treasury securities. The 4 percent rate means that the annual cost of borrowing an extra $1 trillion is $40 billion, a modest sum in a nearly $14 trillion economy, helping to explain why the current growing deficit has encountered little political resistance so far. But if recent history repeats itself, the deficit is likely to be an issue again when the economy recovers. Interest rates typically rise during a recovery, so the low cost of servicing the nation’s debt will not last — unless a recession set off by the banking crisis endures, repeating the Japanese experience in the 1990s and perhaps even stripping the United States and the dollar of their pre-eminent status. The assumption is that will not happen, and as the economy recovers, the private sector will step up its demand for credit, making interest rates rise. Higher rates in turn would increase the cost of financing the deficit, and there would probably be more pressure to reduce it through cuts in spending. That happened in the late 1980s, as Congress and the White House coped with the swollen Reagan deficits. The Gramm-Rudman- Hollings Act, with its attempt to put a ceiling on deficits, came out of this period. Another assumption, also based on 60 years of post-World War II experience, is that although the economy is sliding into recession, in a year or two that recession will end and the national income (also known as the gross domestic product) will expand once again. When that happens, the national debt — the accumulated borrowing to finance all the annual deficits — will shrink in relation to the income available to pay off the debt. The nation’s debt as a percentage of all economic activity, while growing alarmingly now, is not at historic highs. The portion held outside the American government, here and abroad, in the form of Treasury securities was $5.8 trillion at the end of last month. That is a relatively modest 40.8 percent of the nation’s annual income, far below the 109 percent coming out of World War II or the nearly 50 percent in much of the 1990s. Put another way, if the entire national income were dedicated to debt repayment, the debt would be paid off in less than five months. For most of the years since 1940, paying down the debt would have taken longer, putting a greater strain on income. Still, these are not ordinary times. The banking system is broken, and the national economy, in response, is plunging toward recession in a manner that evokes comparisons with the Great Depression. To soften the blow, the administration and Congress ran up a record $455 billion deficit in the just-ended 2008 fiscal year, and they are en route to a shortfall of $700 billion or more this year.

145 “I do think we need to be ready for a very significant increase in the budget deficit,” said Peter Orszag, director of the Congressional Budget Office. Apart from the war spending, outlays for unemployment insurance have risen by one-third and spending on food stamps has increased 13 percent over the last 12 months. Congress has agreed to expand education benefits for veterans of the current wars, and last spring it authorized $168 billion for a stimulus package, most of it in the form of tax rebate checks. Now the Democratic Congressional leadership is pushing for another stimulus of at least that much. All of this is happening as tax revenues are falling, particularly corporate tax receipts, which were down $66 billion, or 18 percent, in the fiscal year that just ended. The decline accelerated in September. Many Republicans would probably go along with two elements in the stimulus package proposed by the Democrats — a tax cut of some sort and extended unemployment benefits. But they resist stepped-up spending on public works projects and a temporary increase in federal aid to the states. Representative Roy Blunt of Missouri, the House Republican whip, said the stimulus bill should not be used to finance “a huge public works plan” or to bail out “states that spent a lot more money than they should have on Medicaid and other social programs.” To pay for the surge in spending — and the shortfall in taxes — the federal government increased the national debt by $768 billion over the last year, to the present $5.8 trillion, with $300 billion of that amount going to the Federal Reserve for a variety of rescue initiatives for the financial system. The outlays swell as each day brings fresh reports of a financial system that is costly to repair and a rapidly sinking economy in need of a leg up. “The deficit is a burden in a long-term sense,” Mr. Barbera, the economist, said, “but it is small beer compared to the concerns of the moment.”

146 Times Topics Monday, October 20, 2008

Credit Default Swaps

Credit default swaps, which were invented by Wall Street in the late 1990's, are financial instruments that are intended to cover losses to banks and bondholders when a particular bond or security goes into default -- that is, when the stream of revenue behind the loan becomes insufficient to meet the payments that were promised. In essence, it is a form of insurance. Its purpose is to make it easier for banks to issue complex debt securities by reducing the risk to purchasers, just like the way the insurance a movie producer takes out on a wayward star makes it easier to raise money for the star's next picture. Here is a more detailed, but still simplified explanation of how they work, given by Michael Lewitt, a Florida money manager, in a New York Times Op-Ed piece on Sept. 16, 2008: "Credit default swaps are a type of credit insurance contract in which one party pays another party to protect it from the risk of default on a particular debt instrument. If that debt instrument (a bond, a bank loan, a mortgage) defaults, the insurer compensates the insured for his loss. "The insurer (which could be a bank, an investment bank or a hedge fund) is required to post collateral to support its payment obligation, but in the insane credit environment that preceded the credit crisis, this collateral deposit was generally too small. "As a result, the credit default market is best described as an insurance market where many of the individual trades are undercapitalized." The market for the credit default swaps has been enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market. Also in sharp contrast to traditional insurance, the swaps are totally unregulated. When the mortgage-backed securities that many swaps were supporting began to lose value in 2007, investors began to fear that the swaps, originally meant as a hedge against risk, could suddenly become huge liabilities. The swaps' complexity and the lack of information in an unregulated market added to the market's anxiety. Bond insurers like MBNA and Ambac that had written large amounts of the swaps saw their shares plunge in late 2007. Credit default swaps also played an integral role in the federal government's decision to bail out the American International Group, one of the world's largest insurers, in September 2008. The Federal Reserve concluded that if A.I.G. failed and defaulted on its swaps, throwing the liability for the insured securities onto the swaps' counterparties, the result could be a daisy chain of failures across the international financial system.

147 Business

October 20, 2008 On Wall Street, Eyes Turn to the Fear Index By MICHAEL M. GRYNBAUM Fear is running high on Wall Street. Just look at the Fear Index. With all those stomach-churning free falls and sharp reversals in the stock market recently, traders are keeping a nervous eye on an obscure index known as the VIX. The VIX (officially the Chicago Board Options Exchange Volatility Index) measures volatility, the technical term for those wrenching market swings. A rising VIX is usually regarded as a sign that fear, rather than greed, is ruling the market. The higher the VIX goes, the more unhinged the market looks.

So how scared are investors? On Friday, the VIX rose to 70.33, its highest close since its introduction in 1993. To some experts, that suggests that the wild ride is far from over. “Right now, it’s an extremely important part of the puzzle,” Steve Sachs, a trader at Rydex Investments, said of the VIX. “It’s showing a huge amount of fear in the marketplace.” The VIX is hardly a household name like the Dow. But lately, it has become a fixture on CNBC and other financial news outlets, with commentators often invoking an index that most of the general public was blissfully unaware of only a few weeks ago. Some traders think all the publicity has only added to the anxieties that the VIX is intended to reflect. “The VIX is a self-fulfilling prophecy,” said Ryan Larson, head equity trader at Voyageur Asset Management. “It’s almost adding to the problems.” Speaking on Thursday, when the VIX hit an intraday high of 81.17 before closing lower, he said: “You see the VIX trade north of 80, and of course the media starts to pick it up.” Mr. Larson continued, “It’s blasted on the TV, and for the average investor sitting at home, they think, oh, my gosh, the VIX just broke 80 — I’ve got to go sell my stocks.”

148 Put simply, the VIX measures the degree to which investors think stocks will swing violently in the next 30 days. It is calculated in real time throughout the trading day, fluctuating minute to minute. The higher the VIX, the bigger the expected swings — and the index has a good track record. It spiked in 1998 when a big hedge fund, Long-Term Capital Management, collapsed, and after the 9/11 terrorist attacks. Mr. Sachs, with some incredulity, said that the swings in the stock market have reflected the volatility implied by the VIX. “We had a 17 percent peak-to-trough trading range this week,” he said. “It should take two years under normal circumstances for the S.& P. 500 to have that type of trading range.” The VIX had its origin in 1993, when the Chicago Board Options Exchange approached Robert E. Whaley, then a professor at Duke, with a dual proposal. “The first purpose was the one that is being served right now — find a barometer of market anxiety or investor fear,” Professor Whaley, who now teaches at the Owen Graduate School of Management at Vanderbilt University, recalled in an interview. But, he said, the board also wanted to create an index that investors could bet on using futures and options, providing a new revenue stream for the exchange. Professor Whaley spent a sabbatical in France toying with formulas. He returned to the United States with the VIX, which gauges anxiety by calculating the premiums paid in a specific options market run by the Chicago Board Options Exchange. An option is a contract that permits an investor to buy or sell a security at a certain date at a certain price. These contracts often amount to insurance policies in case big moves in the market cause trouble in a portfolio. A contract, like insurance, costs money — specifically, a premium, whose price can fluctuate. The VIX, in its current form, measures premiums paid by investors who buy options tied to the price of the Standard & Poor’s 500-stock index. In times of confusion or anxiety on Wall Street, investors are more eager to buy this insurance, and thus agree to pay higher premiums to get them. This pushes up the level of the VIX. “It’s analogous to buying fire insurance,” Professor Whaley said. “If there’s some reason to believe there’s an arsonist in your neighborhood, you’re going to be willing to pay more for insurance.” The index is not an arbitrary number: it offers guidance for the expected percentage change of the S.& P. 500. Based on a formula, Friday’s close of around 70 suggests that investors think the S. & P. 500 could move up or down about 20 percent in the next 30 days — an almost unheard-of swing. So the higher the number, the bigger the swing investors think the market will take. Put another way, the higher the VIX, the less investors know about where the stock market is headed. The current level shows that “investors are still very uncertain about where things will go,” said Meg Browne of Brown Brothers Harriman, a currency strategist who was keeping a close eye on the VIX as the stock market soared last Monday.

149 Since 2004, investors have been able to buy futures contracts on the VIX itself, providing a way to hedge against volatility in the market. Options on the VIX have been available since 2006. “You have seen more and more investors using it as an avenue toward hedging their portfolios,” said Chris Jacobson, chief options strategist at the Susquehanna Financial Group. In times of crisis, “while you’re losing your portfolio, you could make some money on the increase in volatility,” he said. Some investors are skeptical about the utility of the index. “If you’re trading the markets, you pretty much know the fear, you know the volatility. I don’t need an index to tell me there’s volatility out there,” Mr. Larson said.

150 Business

October 20, 2008 Insiders’ Share Sales on Margin on the Rise By REED ABELSON When executives own big stakes in the companies they run, investors can rest a little more easily at night, knowing those managers have the shareholders’ best interests at heart. Except when maybe they don’t.

As the staggering destruction of wealth in the stock market has recently revealed, executives can sometimes appear to own shares in a company, but have actually pledged them as collateral for a loan. And if there is a sharp drop in the stock’s value, the executive may suddenly be forced to dump those shares, very likely adding to the stock’s downdraft. And the other shareholders probably never saw it coming. As it turns out, while corporate insiders must disclose their comings and goings in their companies’ shares, experts say there are no hard and fast rules requiring that the public be told when an executive has put a big block of shares at risk by borrowing against them. Already this month, there have been about $1 billion in sales by company insiders dumping stock to meet margin calls, as lenders’ demands for the stock sales are known. According to Equilar, an executive compensation research firm in Redwood Shores, Calif., executives at three dozen companies have disclosed such sales since October. One of the companies was Life Time Fitness, a chain of gyms, whose founder and chief executive, Bahram Akradi, had been the company’s largest shareholder. He owned slightly more than 10 percent of the shares outstanding, according to the company’s 2008 proxy statement. A year ago, the company’s shares were trading at about $65. And the stock was

151 still around $40 within the last month, when Mr. Akradi’s stake would have been worth some $164 million. What the company did not tell investors until about a week ago, when the stock was trading under $20, was that Mr. Akradi had pledged virtually all of his 4.1 million shares as collateral. On Oct. 10, the company disclosed he had sold 582,000 shares of his stock to cover margin loan obligations. As part of its announcement, the company went on to alert investors that nearly all of Mr. Akradi’s stock was “subject to pledges under these loans.” In all so far, he has sold about 1.5 million shares, worth some $28 million at about $19 a share, according to Equilar. A company spokesman said Mr. Akradi used the money for his personal investing. The spokesman, Jason Thunstrom, said Mr. Akradi and other company officials would not comment further. Under Securities and Exchange Commission rules, executives are typically required to disclose insider sales within two days of making them and indicate why they were sold, including as a result of a margin call. But experts say there are no rules requiring that the public be told ahead of time that an executive has pledged stock in a margin loan or how the borrowed money is being used. It might be a loan to buy more shares of the company’s stock — which would indicate a vote of confidence in the shares. Or it might be a loan to buy some other company’s stock or something else altogether — possibly a sign that the executive thinks there are better places to invest. “The disclosure rule is vague,” said Ben Silverman, director of research at InsiderScore, which tracks the buying and selling of company insiders. Over the last 25 years or so, investors have come to take on faith the need for executives to own significant amounts of company stock, as a way to make sure the interests of the people running a company are aligned with those of the shareholders. But the ability to use the shares as collateral for a loan may change that dynamic, said Charles M. Elson, a corporate governance expert at the University of Delaware. “It may be at certain levels de-aligning,” he said. Although individual circumstances may not require public disclosure of an executive’s decision to pledge the stock, Mr. Elson said, he argues that the boards of directors should be told. Paul Hodgson, a senior analyst at the Corporate Library, a governance research group, says it is too easy for investors to be misled when executives are not holding the stock outright. “The disclosure is a problem,” Mr. Hodgson said. Most investors will look at the executives’ holdings in the proxy statement, he said, and say, “ ‘They own a lot of stock — they are really committed.’ ” Some companies forbid their executives to use their shares as collateral, Mr. Silverman said. Others require at least a certain amount of disclosure. At Boston Scientific, the company alerted investors in its 2008 statement that some of the holdings of its two founders, Pete Nicholas and John Abele, had been pledged as collateral. The two sold about $270 million of stock in October, according to Equilar. Mr. Silverman says the use of pledged stock seems to occur mainly at companies where a founder or other senior executive has a particularly large holding. Technology companies do not tend to have executives with margin loans using company stock, he said, because they prefer to use stock options to reward their managers. For investors who are not aware the stock is pledged, the risk is greatest when an executive is forced to sell a significant position, as the chief executive of Chesapeake Energy was forced to do recently, adding to the downward pressure on the stock, Mr. Silverman said.

152 The executive, Aubrey K. McClendon, was forced to sell substantially all of his stock this month — some 32 million shares, or more than 5 percent of the company, worth nearly $600 million, according to Equilar. The company’s largest individual shareholder for the previous three years, Mr. McClendon had bought shares on margin and was subject to margin calls when the stock fell as part of the recent market rout. Brian M. O’Hara, the chairman of XL Capital, a Bermuda insurer, was forced to sell about 80 percent of his holdings, which he said had been used to buy more shares to avoid the expiration of his stock options. Both he and Mr. McClendon said in public statements that the sales in no way reflected a lack of confidence in the shares. In those two cases, at least, the executives’ pledged stock represented “super-strong incentives to look out for the shareholders’ interests,” said Wayne R. Guay, a professor who specializes in executive pay at the Wharton School of the University of Pennsylvania. But he is troubled by borrowing used to make completely unrelated investments — the sort of borrowing that indicates executives see better places to put their money or want to diversify their holdings without telling investors they are selling shares. “It does put the integrity of executive compensation, incentives and corporate governance in jeopardy,” he said. And when executives borrow so much, even to buy more stock, Mr. Guay and others say, investors have a right to question their judgment. They may be bullish, expecting the stock to be up, but they do not seem to be showing an ability to assess risk, even if it is their own personal risk. In such cases, Mr. Guay points out, they are like homeowners around the country who became saddled with too much debt through home equity loans, because they thought the price of houses could go only up. “What are they thinking?” he asked.

153 COLUMNISTS This toxic crisis needs more than one shot By Wolfgang Münchau Published: October 19 2008 18:34 | Last updated: October 19 2008 18:34 What makes this credit crisis so toxic is that it involves numerous feedback loops with the real economy. This is why simple one-shot solutions such as last week’s rescue plans are not going to be as effective as many people think. Let us look at the present dynamic of this crisis in some detail. First, the housing market. US house prices have fallen by about 20 per cent. To get back to the long-term real price trend, the market would have to fall by another 10 per cent to 15 per cent. This would also bring price-to-rent and price-to-income ratios closer to a long-term equilibrium. But there is no reason to assume that prices will stay on trend – not if there is a credit crunch, a dysfunctional money market and a deep recession with rising unemployment. The property market is more likely to overshoot, which is what it normally does even without those exceptionally bad circumstances. I do not want to produce a numeric estimate, but without a plan to stabilise house prices – which is not all that easy – we should expect substantial overshooting to take place. The same applies to the UK, Spain and Ireland, where prices have also fallen. Second, credit cards. In a credit crunch, they are often the last source of freely available credit for many households. The last few weeks have seen large increases in credit default swap spreads for cards and car loans. The securitised market for credit cards is about as large as that for subprime mortgages. As the recession bites, credit card defaults will be rising and securitised credit card products will take a big hit. Third, corporate bankruptcies and payment defaults. As we have entered a long and brutish recession in the US, a rise in corporate bankruptcies is certain. What is not clear is whether default rates will rise to above 10 per cent, as they did in the last two recessions. I see no reason why this should not happen. Whether the $62,000bn (€46,000bn, £35,800bn) credit default swaps market is going to withstand the fall of Lehman Brothers, one of its biggest counterparties, plus a full-blown recession with double-digit default rates, is not clear at all. Fourth, valuations of stocks and credit products. The temporary relief from mark-to-market accounting rules amounts to little if present valuations are there to stay after a short period. In that case, no accounting trick will be able to deflect from the fact that many financial firms are, in effect, insolvent. There are other things that could go wrong, and quite possibly will, such as a contagious hedge fund crisis or an emerging markets meltdown. After Iceland, the crisis is now hitting other countries with serious current account imbalances. The credit crunch is also beginning to disrupt international shipping and there are reports that letters of credit are no longer universally accepted. So, if you think you see light at the end of the tunnel, you might want to take a second look. If faced with this set of risks, what then is the optimal policy response? First, given the multiple interactions between the real economy and the credit market, any sensible response would have to address both financial stability and economic growth. To pass an extremely

154 generous financial rescue package but refuse to accept the logic of a fiscal stimulus, as European Union leaders did last week, is both inefficient and inequitable. It is inefficient because an unnecessarily deep recession would have a hugely negative impact on the health of financial institutions. And it is inequitable as the present approach amounts to a large transfer of resources from lower to higher income earners. There are also imbalances within the packages themselves. Some offer the possibility of a recapitalisation of the entire banking system, a task that is bound to overwhelm the capacity of any state. The British were right to limit this to eight banks. I also wonder whether a de facto guarantee of newly issued paper was necessary. If it was, then the situation might be worse than even I had imagined. But what is completely lacking is an explicit insurance of the interbank lending markets. In the eurozone, many loans and mortgages are tied to money market rates, such as Euribor (the euro interbank offered rate). Central bank interest rate cuts, welcome as they may be, have insufficient effect as long as the money markets remain dysfunctional. The most likely reason why European governments failed to produce interbank lending insurance was that this could not effectively be done at national level, since interbank lending is a eurozone market. It is a bad reason. The European Central Bank argues that those massive injections of liquidity of varying maturities are miraculously going to revive this defunct market. I am not so sure. It is true that the money market rates came down a little last week, but there was hardly any trading. At the moment, banks get all the liquidity they need from the ECB, but they are still parking their funds with the central bank and not yet lending it to the money market. As this crisis continues, we will need to fix those imbalances. Targeted recapitalisation, money market insurance and a stimulus package to sustain consumption and allow for some redistribution of income are all needed as part of a comprehensive strategy. Last week’s packages may have prevented an imminent meltdown. But this is not the kind of crisis where we should settle for the usual second-best policy responses.

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In Good Times and Bad By Robert J. Samuelson Monday, October 20, 2008; A15 A dozen years ago, James Grant -- one of the wisest commentators on Wall Street -- wrote a book called "The Trouble With Prosperity." Grant's survey of financial history captured his crusty theory of economic predestination. If things seem splendid, they will get worse. Success inspires overconfidence and excess. If things seem dismal, they will get better. Crisis spawns opportunities and progress. Our triumphs and follies follow a rhythm that, though it can be influenced, cannot be repealed. Good times breed bad, and vice versa. Bear that in mind. It provides context for today's turmoil and recriminations. The recent astounding events -- the government's takeover of Fannie Mae and Freddie Mac, the Treasury's investments in private banks, the stock market's wild swings -- have thrust us into fierce debate. Has enough been done to protect the economy? Who or what caused this mess? We Americans want instant solutions to problems. We crave a world of crisp moral certitudes, but the real world is awash with murky ambiguities. So it is now. Start with the immediate question: Has enough been done? Well, enough for what? If the goal is to prevent a calamitous collapse of bank lending, the answer is probably yes. Last week, the government guaranteed most interbank loans (loans among banks) and pressured nine major banks to accept $125 billion of added capital from the Treasury. Together, these steps make it easier for banks to borrow and lend. There's less need to hoard cash. But if the goal is to inoculate us against recession and more financial turmoil, the answer is no. We're probably already in recession. In September, retail sales dropped 1.2 percent. The housing collapse, higher oil prices (now receding), job losses and sagging stocks have battered confidence. Consumer spending may have dropped in the third quarter for the first time since 1991. Loans are harder to get because lax lending standards have been tightened. Unemployment, now 6.1 percent, may reach 7.5 percent or higher by the end of next year. Similar qualifications apply to financial perils. "The United States has an enormous financial system outside the banks," says economist Raghuram Rajan of the University of Chicago. Consider hedge funds. They manage perhaps $2 trillion and rely heavily on borrowed money. They've suffered heavy redemptions ($43 billion in September, reports the Financial Times). Selling pressures could destabilize the markets. There's also a global spillover. Brazil's stock market has lost about half its value since the spring. In this fluid situation, one thing is predictable: The crisis will produce a cottage industry of academics, journalists, pundits, politicians and bloggers to assess blame. Is former Fed chairman Alan Greenspan responsible for holding interest rates too low and for not imposing tougher regulations on mortgage lending? Would Clinton Treasury Secretary Robert Rubin

156 have spotted the crisis sooner? Did Republican free-market ideologues leave greedy Wall Street types too unregulated? Some stories are make-believe. After leaving government, Rubin landed at Citigroup as a top executive. He failed to identify toxic mortgage securities as a big problem in the bank's own portfolio. It's implausible to think he'd have done so in Washington. As recent investigative stories in the New York Times and The Post show, the Clinton administration broadly supported the financial deregulation that Democrats are now so loudly denouncing. Greenspan is a harder case. His resistance to tougher regulation of mortgage lending is legitimately criticized, but the story of his low-interest-rate policies is more complicated. True, the overnight Fed funds rate dropped to 1 percent in 2003 to offset the effects of the burst tech bubble and the Sept. 11 attacks. Still, the Fed started raising rates in mid- 2004. Unfortunately and surprisingly, long-term interest rates on mortgages (which are set by the market) didn't follow. That undercut the Fed and is often attributed to a surge of cheap capital from China and other Asian countries. There's a broader lesson. When things go well, everyone wants on the bandwagon. Skeptics are regarded as fools. It's hard for government -- or anyone -- to say: "Whoa, cowboys; this won't last." As the housing boom strengthened, existing home prices rose 50 percent from 2000 to 2006. Investment bankers packaged dubious loans in opaque securities. To their eventual regret, bankers kept many bad loans. Almost everyone assumed that home prices would rise forever, so risks were considered minimal. Congress allowed Fannie and Freddie to operate with meager capital. Congress also increased the share of their mortgages that had to go to low- and moderate-income buyers, from 40 percent in 1996 to 52 percent in 2005. This promoted subprime mortgage lending. So Grant's thesis is confirmed. We go through cycles of self-delusion, sometimes too giddy and sometimes too glum. The consolation is that the genesis of the next recovery usually lies in the ruins of the last recession.

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ENTREVISTA: LUIS ÁNGEL ROJO Ex gobernador del Banco de España "Ni Greenspan, ni el FMI, ni el BCE han funcionado bien" MIGUEL ÁNGEL NOCEDA - Madrid - 19/10/2008 Luis Ángel Rojo Duque (Madrid, 1934) recibe en su casa, repleta de libros y buenos cuadros. Sobre la mesa del despacho, la agenda abierta y el ordenador cerrado. Desde que dejó el Banco de España, al que se incorporó en 1971 y fue gobernador entre 1992 y 2001, ése es su refugio. Y que abandona, entre otras cosas, para acudir dos veces por semana al Grupo Santander, del que es consejero y presidente de las comisiones de auditoría y nombramientos. Catedrático de Teoría Económica desde 1966, formó a muchas generaciones de economistas, que le veneran. La política iniciada por el Banco de España de Rojo es hoy referencia en Europa. Es una autoridad que se expresa con una concisión y claridad que impone. Contesta sin pelos en la lengua, quizá por la libertad que le da no tener ataduras. Pregunta. ¿Cuándo va a acabar esto, señor Rojo? Respuesta. No lo sé. Es para pensar que, normalmente, se acabará en año y medio o cosa así, en el mundo. Pero en España va a durar más porque tenemos una crisis inmobiliaria muy grave. P. O sea que nos hinchamos de decir que el sistema financiero español es el mejor, y nos encontramos con que la crisis va a durar más por los excesos inmobiliarios. R. Sí, yo creo que sí. P. ¿Es esta crisis peor que las otras? R. Yo diría que es más desconcertante. Y más difícil de salir de ella. P. A su juicio, ¿por qué empezó? R. Por muy diferentes causas; pero las más importantes fueron las relativas al mundo financiero. Tiene su origen en Estados Unidos y se genera como consecuencia de una actuación de los bancos muy compleja, con muy poco criterio y una falta muy considerable de rigor en los préstamos concedidos. Ése es el origen básico del problema. Luego ha habido otros adicionales como el precio del petróleo, las materias primas y, finalmente, la crisis alimenticia. Todo ha determinado una situación muy difícil de atajar. P. ¿A eso se podría añadir que algunos Gobiernos y organismos reguladores no han sabido tomar las medidas oportunas? R. Pues sí, claro. Lo que ha pasado también es que la regulación bancaria y la actuación de las autoridades han sido muy deficientes. No me cabe la menor duda. Y ha sido, además, una política cuyas medidas se han adoptado con muchísimo retraso. P. ¿En todo el mundo? R. En todas partes. P. ¿Incluida España?

158 R. Sí. En España algunas medidas se han tomado más a tiempo; pero en conjunto se ha producido un retraso muy considerable. P. Usted predijo en 2006 que iba a haber una recesión y que iba a empezar en EE UU. Acertó. R. Cuestión de suerte. P. Supongo que hay algo más que suerte. R. La verdad es que vi en 2001 que las cosas iban mal y que irían a peor. Y, ciertamente, así ha sido. Tras los ataques a las Torres Gemelas, Estados Unidos adoptó una política a mi juicio equivocada. Les ha pasado lo que les tenía que pasar, se ha reventado la burbuja porque se tenía que reventar inevitablemente. P. ¿Por qué ocurrió? R. Por no actuar con demasiado rigor y no fijarse en lo que tenían delante. Ha sido muy perturbador. P. ¿Hubo demasiada ambición? ¿Demasiado quererse hacer rico muy deprisa? R. Sí, sí. Pero eso que ha dicho el señor [Alan] Greenspan de que la culpa la tienen los banqueros porque se han dejado llevar por su ambición, no lo veo así. Los banqueros siempre habrán sido más o menos ambiciosos, pero ése no es el problema. Francamente, Greenspan no ha estado demasiado afortunado con ese diagnóstico de la situación. P. La crisis ha desnudado a Greenspan, que era intocable. R. Era inevitable. Su política era absurda. Yo me he pasado bastantes años diciendo que la política del señor Greenspan no me gustaba y todo el mundo me miraba. Y yo les decía ¿qué queréis que os diga? No me gustaban nada las cosas que hacía y cómo las hacía. Al final, mire, nos hemos dado todos el batacazo. P. Ustedes, desde el Banco de España, impidieron la aplicación de hipotecas subprime y sus derivaciones que él permitió. R. Nosotros adoptamos las medidas correspondientes en 2000, como las exigencias de provisiones, para que no pudieran pasar cosas así. Lo vimos bastante claro. Yo me he equivocado en sentido contrario porque creí que la crisis iba a estallar antes. Luego ha reventado y ha sido peor, evidentemente. P. Y mientras la figura de Greenspan se derrite, la suya y la del Banco de España se agigantan. R. Porque adoptamos las medidas que nos parecían razonables. Yo las expuse en el Banco Central Europeo [BCE] y no me hicieron ningún caso, excepto Francia que lo estuvo dudando. Pensaron que eran excesivas, que las cosas no eran para tanto, como para adoptar medidas tan duras. Y bueno, pues ahí están los resultados. P. ¿Qué medidas? R. Mayor control del riesgo y ser más estricto en la regulación y en los criterios de provisiones, entre otras. P. Se le ve muy crítico con el BCE. R. Tenía que haber actuado antes y bajar los tipos. Pero mis críticas mayores son para el Fondo Monetario Internacional [FMI]. Lo del señor [Dominique] Strauss-Kahn [director del FMI] en los últimos 10 días ha sido como para que se dedique a otra cosa. P. ¡Ah, sí!

159 R. Cuando se están hundiendo los bancos, el FMI no puede entrar en el escenario y decir que la situación es terrible, que los bancos se van a hundir. No me fastidie, ¿usted qué ha hecho? ¿ha hecho una política sensata de suavizar las cosas y mejorar a los bancos? No. Entonces, ¡cállese, por Dios! Ni Greenspan, ni el FMI, ni el BCE me parece que han funcionado bien. P. ¿Y en la época de Rato? R. No hizo nada. No sé si lo dejó porque vio lo que se le venía encima o por qué. De todos modos son las instituciones... P. ¿Y qué hay que hacer? R. He estado yendo durante años al FMI y al BCE y no puede ser ese funcionamiento... P. Habrá que crear las instituciones de nuevo. R. Pues sí. Pero poner de acuerdo a tantos países... Además, en estos momentos en Europa no hay mucha gente muy brillante. Es muy difícil. P. ¿El BCE debe cambiar? R. Lo que pasa es que nació bajo el dominio de Alemania y Francia, que querían oxígeno, que se inyectara liquidez porque tenían problemas. Así no pueden funcionar los bancos centrales. Estoy de acuerdo en que tiene que adoptar una política antiinflacionista; pero no por eso ponerla delante de todo cuando hay otras cosas que están funcionando mal. Luego pasa lo que pasa. P. Y pasa que no baja los tipos. R. Creo que hay bajarlos más. P. Aunque las medidas hayan llegado tarde, ¿son buenas y suficientes? R. Que son buenas y que van en la buena dirección, no me cabe ninguna duda. Ahora, que sean suficientes, ya lo veremos. Lo peor es que han llegado muy tarde. P. ¿El plan de Estados Unidos le convence? R. Está bien, pero es brutal, como hacen las cosas los americanos, aunque las debían haber tomado bastante antes. P. ¿Y las medidas españolas, son suficientes? R. Si son suficientes, eso no hay quién lo sepa. Pero como es una cuestión de confianza en buena medida, todo lo que sea reforzar la confianza de la gente es importante. La gente también es muy exagerada. Yo creo que las medidas funcionarán, aunque tardarán porque lo de la construcción es algo tremendo. Lo que ha sido eso es un disparate. Me parece absolutamente grave. Cuando veo las inacabables urbanizaciones me pregunto cómo se ha podido pensar que puede funcionar. Arreglar eso va costar tiempo. P. Eso puede llevar a que la morosidad de la banca, ahora en el 2%, se dispare. R. El 2% es poco; pero va a ir a más. Por eso el ajuste va a ser más largo. Realmente es muy duro ver hasta las palas por el suelo. P. ¿Se atreve a pronosticar un ratio de morosidad? R. No me atrevo a pronosticar nada. P. ¿Le gusta la política de nacionalizaciones de la banca como han decidido algunos países con la compra de acciones?

160 R. No me gusta nada. No sé si no tenían más remedio, pero que se nacionalice no me gusta absolutamente nada. P. ¿Usted cree que va a haber fusiones entre entidades financieras en España? R. Las va a haber seguro. Esta situación, cuando se prolongue, va a presionar a las entidades para que estudien si les resulta conveniente e incluso necesario fusionarse. Pero, por otra parte, tienen que cambiar las normas, porque con las actuales no puede ser. Si quieren, tienen que pedir permiso a las autoridades competentes, que son las entidades políticas, que no van a querer de modo alguno que se produzca... P. ¿Se está refiriendo a las cajas y a los gobiernos autonómicos, claro? R. No puede mantenerse así. P. De todos modos, ¿cuántas cajas tendrían que quedar, hay cuarentaytantas? R. Pues un número mucho más reducido de las que hay, desde luego. Yo no digo que no funcionen bien y que no ganen dinero, que sí; pero es evidente que va por ese camino. P. ¿Y entre los bancos? R. Es posible que algún banco mediano; pero veo menos posibilidad que en las cajas. La gran banca está muy bien y ahí no lo veo. P. ¿Pueden convertirse los grandes bancos españoles en los primeros del mundo? R. Ya están en cabeza. P. ¿Qué le pareció el discurso de Botín? R. Tremendo. Está bien lo que ha dicho. P. ¿Se lo enseñó a usted antes de pronunciarlo, siendo consejero del banco? R. No, no tiene nada que ver. P. ¿Usted recomienda mirar a la Bolsa en momentos de crisis? R. No es lo que más hay que mirar. La Bolsa es importante desde el punto de vista de la relación de las expectativas de la confianza del público. P. ¿Habría que modificar los Presupuestos como pide el PP? R. Son bastante restrictivos ya. Pero cuando se está en una situación como la actual, lo que no pueden hacer los partidos políticos es ponerse a pelear por los presupuestos y no se qué. De lo que se trata es de ver si se sale entre todos de ésta y luego ya tendrán oportunidad de pelearse. Pero decir eso en este país, es cantarle a la luna. P. ¿Está apuntando con el dedo a Rajoy y su reacción al plan de apoyo del Gobierno? R. Es muy desagradable ver que se tiran piedras contra el propio tejado en un momento tan complicado y tan difícil. P. ¿Qué lecciones nos deja la crisis? R. En primer lugar que no se puede seguir con esas regulaciones laxas. Tampoco puede ser que haya retribuciones de los ejecutivos tan inmensas. ¡Hay que ver las cantidades que están ganando los americanos! La gente se irrita con razón. En España hay que procurar que el sistema funcione y no se produzcan desequilibrios con el sistema financiero y la construcción.

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Out of the Ashes The Financial Crisis Is Also an Opportunity To Create New Rules for Our Global Economy By Gordon Brown Friday, October 17, 2008; A25 This is a defining moment for the world economy. We are living through the first financial crisis of this new global age. And the decisions we make will affect us over not just the next few weeks but for years to come. The global problems we face require global solutions. At the end of World War II, American and European visionaries built a new international economic order and formed the International Monetary Fund, the World Bank and a world trade body. They acted because they knew that peace and prosperity were indivisible. They knew that for prosperity to be sustained, it had to be shared. Such was the impact of what they did for their day and age that Secretary of State Dean Acheson spoke of being "present at the creation." Today, the same sort of visionary internationalism is needed to resolve the crises and challenges of a different age. And the greatest of global challenges demands of us the boldest of global cooperation. The old postwar international financial institutions are out of date. They have to be rebuilt for a wholly new era in which there is global, not national, competition and open, not closed, economies. International flows of capital are so big they can overwhelm individual governments. And trust, the most precious asset of all, has been eroded. When President Bush met with the Group of Seven finance ministers last weekend, they agreed that we all had to deal with not only the issue of liquidity in the banking system but also the capitalization and funding of banks. It was clear that national action alone would not have been sufficient. We knew we had to send a clear and unambiguous message to the markets that governments across the world were prepared to act in a coordinated manner and do whatever was necessary to stabilize the system and address the fundamental problems. Confidence about the future is vital to building confidence for today. We must deal with more than the symptoms of the current crisis. We have to tackle the root causes. So the next stage is to rebuild our fractured international financial system. This week, European leaders came together to propose the guiding principles that we believe should underpin this new Bretton Woods: transparency, sound banking, responsibility, integrity and global governance. We agreed that urgent decisions implementing these principles should be made to root out the irresponsible and often undisclosed lending at the heart of our problems. To do this, we need cross-border supervision of financial institutions; shared global standards for accounting and regulation; a more responsible approach to executive remuneration that rewards hard work, effort and enterprise but not irresponsible risk-taking; and the renewal of our international institutions to make them effective early-warning systems for the world economy. Tomorrow, French President Nicolas Sarkozy and European Commission President José Manuel Barroso will meet with President Bush to discuss the urgent reforms of the international financial system that are crucial both to preventing another crisis and to restoring confidence, which is necessary to get banks back to their essential purpose -- maintaining the flow of money to individuals and businesses. The reforms I have outlined are vital to ensuring

162 that globalization works not just for some but for all hard-pressed families and businesses in all our communities. It is important, too, that in the international leaders' meeting that has been proposed we seek a world trade agreement and reject the beggar-thy-neighbor protectionism that has been a feature of past crises. There are no Britain-only or Europe-only or America-only solutions to today's problems. We are all in this together, and we can only resolve this crisis together. Over the past week, we have shown that with political will it is possible to agree on a global multibillion-dollar package to recapitalize our banks across many continents. In the next few weeks, we need to show the same resolve and spirit of cooperation to create the rules for our new global economy. If we do this, 2008 will be remembered not just as a year of financial crisis but as the year we started to build the world anew. The writer is prime minister of Britain.

163 Opinion

October 17, 2008 OP-ED CONTRIBUTOR Buy American. I Am. By WARREN E. BUFFETT Omaha THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary. So ... I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities. Why? A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now. Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over. A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price. Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497. You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought

164 stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy. Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts. Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.” I don’t like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: “Put your mouth where your money was.” Today my money and my mouth both say equities. Warren E. Buffett is the chief executive of Berkshire Hathaway, a diversified holding company.

165 Business

October 19, 2008 The Guys From ‘Government Sachs’ By JULIE CRESWELL and BEN WHITE THIS summer, when the Treasury secretary, Henry M. Paulson Jr., sought help navigating the Wall Street meltdown, he turned to his old firm, Goldman Sachs, snagging a handful of former bankers and other experts in corporate restructurings. In September, after the government bailed out the American International Group, the faltering insurance giant, for $85 billion, Mr. Paulson helped select a director from Goldman’s own board to lead A.I.G.

Photo illustration by The New York Times

Treasury faces, from left: Steve Shafran (formerly of Goldman), Kendrick Wilson III (ditto), Henry Paulson Jr. (you guessed it), Edward Forst (yep) and Neel Kashkari (see a trend?).

And earlier this month, when Mr. Paulson needed someone to oversee the government’s proposed $700 billion bailout fund, he again recruited someone with a Goldman pedigree, giving the post to a 35-year-old former investment banker who, before coming to the Treasury Department, had little background in housing finance. Indeed, Goldman’s presence in the department and around the federal response to the financial crisis is so ubiquitous that other bankers and competitors have given the star-studded firm a new nickname: Government Sachs.

166 The power and influence that Goldman wields at the nexus of politics and finance is no accident. Long regarded as the savviest and most admired firm among the ranks — now decimated — of Wall Street investment banks, it has a history and culture of encouraging its partners to take leadership roles in public service. It is a widely held view within the bank that no matter how much money you pile up, you are not a true Goldman star until you make your mark in the political sphere. While Goldman sees this as little more than giving back to the financial world, outside executives and analysts wonder about potential conflicts of interest presented by the firm’s unique perch. They note that decisions that Mr. Paulson and other Goldman alumni make at Treasury directly affect the firm’s own fortunes. They also question why Goldman, which with other firms may have helped fuel the financial crisis through the use of exotic securities, has such a strong hand in trying to resolve the problem. The very scale of the financial calamity and the historic government response to it have spawned a host of other questions about Goldman’s role. Analysts wonder why Mr. Paulson hasn’t hired more individuals from other banks to limit the appearance that the Treasury Department has become a de facto Goldman division. Others ask whose interests Mr. Paulson and his coterie of former Goldman executives have in mind: those overseeing tottering financial services firms, or average homeowners squeezed by the crisis?

Robert Rubin, right, an ex-Goldman co-chairman and a Treasury secretary in the Clinton administration, promoted Timothy F. Geithner at Treasury. Mr. Geithner now leads the New York Fed. Still others question whether Goldman alumni leading the federal bailout have the breadth and depth of experience needed to tackle financial problems of such complexity — and whether Mr. Paulson has cast his net widely enough to ensure that innovative responses are pursued.

167 “He’s brought on people who have the same life experiences and ideologies as he does,” said William K. Black, an associate professor of law and economics at the University of Missouri and counsel to the Federal Home Loan Bank Board during the savings and loan crisis of the 1980s. “These people were trained by Paulson, evaluated by Paulson so their mind-set is not just shaped in generalized group think — it’s specific Paulson group think.” Not so fast, say Goldman’s supporters. They vehemently dismiss suggestions that Mr. Paulson’s team would elevate Goldman’s interests above those of other banks, homeowners and taxpayers. Such chatter, they say, is a paranoid theory peddled, almost always anonymously, by less successful rivals. Just add black helicopters, they joke. “There is no conspiracy,” said Donald C. Langevoort, a law professor at Georgetown University. “Clearly if time were not a problem, you would have a committee of independent people vetting all of the potential conflicts, responding to questions whether someone ought to be involved with a particular aspect or project or not because of relationships with a former firm — but those things do take time and can’t be imposed in an emergency situation.” In fact, Goldman’s admirers say, the firm’s ranks should be praised, not criticized, for taking a leadership role in the crisis. “There are people at Goldman Sachs making no money, living at hotels, trying to save the financial world,” said Jes Staley, the head of JPMorgan Chase’s asset management division. “To indict Goldman Sachs for the people helping out Washington is wrong.” Goldman concurs. “We’re proud of our alumni, but frankly, when they work in the public sector, their presence is more of a negative than a positive for us in terms of winning business,” said Lucas Van Praag, a spokesman for Goldman. “There is no mileage for them in giving Goldman Sachs the corporate equivalent of most-favored-nation status.” MR. PAULSON himself landed atop Treasury because of a Goldman tie. Joshua B. Bolten, a former Goldman executive and President Bush’s chief of staff, helped recruit him to the post in 2006. Some analysts say that given the pressures Mr. Paulson faced creating a SWAT team to address the financial crisis, it was only natural for him to turn to his former firm for a capable battery. And if there is one thing Goldman has, it is an imposing army of top-of-their-class, up-before- dawn über-achievers. The most prominent former Goldman banker now working for Mr. Paulson at Treasury is also perhaps the most unlikely. Neel T. Kashkari arrived in Washington in 2006 after spending two years as a low-level technology investment banker for Goldman in San Francisco, where he advised start-up computer security companies. Before joining Goldman, Mr. Kashkari, who has two engineering degrees in addition to an M.B.A. from the Wharton School of the University of Pennsylvania, worked on satellite projects for TRW, the space company that now belongs to Northrop Grumman. He was originally appointed to oversee a $700 billion fund that Mr. Paulson orchestrated to buy toxic and complex bank assets, but the role evolved as his boss decided to invest taxpayer money directly in troubled financial institutions. Mr. Kashkari, who met Mr. Paulson only briefly before going to the Treasury Department, is also in charge of selecting the staff to run the bailout program. One of his early picks was Reuben Jeffrey, a former Goldman executive, to serve as interim chief investment officer.

168 Mr. Kashkari is considered highly intelligent and talented. He has also been Mr. Paulson’s right-hand man — and constant public shadow — during the financial crisis. He played a main role in the emergency sale of Bear Stearns to JPMorgan Chase in March, sitting in a Park Avenue conference room as details of the acquisition were hammered out. He often exited the room to funnel information to Mr. Paulson about the progress. Despite Mr. Kashkari’s talents in deal-making, there are widespread questions about whether he has the experience or expertise to manage such a project. “Mr. Kashkari may be the most brilliant, talented person in the United States, but the optics of putting a 35-year-old Paulson protégé in charge of what, at least at one point, was supposed to be the most important part of the recovery effort are just very damaging,” said Michael Greenberger, a University of Maryland law professor and a former senior official with the Commodity Futures Trading Commission. “The American people are fed up with Wall Street, and there are plenty of people around who could have been brought in here to offer broader judgment on these problems,” Mr. Greenberger added. “All wisdom about financial matters does not reside on Wall Street.” Mr. Kashkari won’t directly manage the bailout fund. More than 200 firms submitted bids to oversee pieces of the program, and Treasury has winnowed the list to fewer than 10 and could announce the results as early as this week. Goldman submitted a bid but offered to provide its services gratis. While Mr. Kashkari is playing a prominent public role, other Goldman alumni dominate Mr. Paulson’s inner sanctum. The A-team includes Dan Jester, a former strategic officer for Goldman who has been involved in most of Treasury’s recent initiatives, especially the government takeover of the mortgage giants Fannie Mae and Freddie Mac. Mr. Jester has also been central to the effort to inject capital into banks, a list that includes Goldman. Another central player is Steve Shafran, who grew close to Mr. Paulson in the 1990s while working in Goldman’s private equity business in Asia. Initially focused on student loan problems, Mr. Shafran quickly became involved in Treasury’s initiative to guarantee money market funds, among other things. Mr. Shafran, who retired from Goldman in 2000, had settled with his family in Ketchum, Idaho, where he joined the city council. Baird Gourlay, the council president, said he had spoken a couple of times with Mr. Shafran since he returned to Washington last year. “He was initially working on the student loan part of the problem,” Mr. Gourlay said. “But as things started falling apart, he said Paulson was relying on him more and more.” The Treasury Department said Mr. Shafran and the other former Goldman executives were unavailable for comment. Other prominent former Goldman executives now at Treasury include Kendrick R. Wilson III, a seasoned adviser to chief executives of the nation’s biggest banks. Mr. Wilson, an unpaid adviser, mainly spends his time working his ample contact list of bank chiefs to apprise them of possible Treasury plans and gauge reaction. Another Goldman veteran, Edward C. Forst, served briefly as an adviser to Mr. Paulson on setting up the bailout fund but has since left to return to his post as executive vice president of Harvard. Robert K. Steel, a former vice chairman at Goldman, was tapped to look at ways to shore up Fannie Mae and Freddie Mac. Mr. Steel left Treasury to become chief executive of Wachovia this summer before the government took over the entities.

169 Treasury officials acknowledge that former Goldman executives have played an enormous role in responding to the current crisis. But they also note that many other top Treasury Department officials with no ties to Goldman are doing significant work, often without notice. This group includes David G. Nason, a senior adviser to Mr. Paulson and a former Securities and Exchange Commission official. Robert F. Hoyt, general counsel at Treasury, has also worked around the clock in recent weeks to make sure the department’s unprecedented moves pass legal muster. Michele Davis is a Capitol Hill veteran and Treasury policy director. None of them are Goldmanites. “Secretary Paulson has a deep bench of seasoned financial policy experts with varied experience,” said Jennifer Zuccarelli, a spokeswoman for the Treasury. “Bringing additional expertise to bear at times like these is clearly in the taxpayers’ and the U.S. economy’s best interests.” While many Wall Streeters have made the trek to Washington, there is no question that the axis of power at the Treasury Department tilts toward Goldman. That has led some to assume that the interests of the bank, and Wall Street more broadly, are the first priority. There is also the question of whether the department’s actions benefit the personal finances of the former Goldman executives and their friends. “To the extent that they have a portfolio or blind trust that holds Goldman Sachs stock, they have conflicts,” said James K. Galbraith, a professor of government and business relations at the University of Texas. “To the extent that they have ties and alumni loyalty or friendships with people that are still there, they have potential conflicts.” Mr. Paulson, Mr. Kashkari and Mr. Shafran no longer own any Goldman shares. It is unclear whether Mr. Jester or Mr. Wilson does because, according to the Treasury Department, they were hired as contractors and are not required to disclose their financial holdings. For every naysayer, meanwhile, there is also a Goldman defender who says the bank’s alumni are doing what they have done since the days when Sidney Weinberg ran the bank in the 1930s and urged his bankers to give generously to charities and volunteer for public service. “I give Hank credit for attracting so many talented people. None of these guys need to do this,” said Barry Volpert, a managing director at Crestview Partners and a former co-chief operating officer of Goldman’s private equity business. “They’re not getting paid. They’re killing themselves. They haven’t seen their families for months. The idea that there’s some sort of cabal or conflict here is nonsense.” In fact, say some Goldman executives, the perception of a conflict of interest has actually cost them opportunities in the crisis. For instance, Goldman wasn’t allowed to examine the books of Bear Stearns when regulators were orchestrating an emergency sale of the faltering investment bank. THIS summer, as he fought for the survival of Lehman Brothers, Richard S. Fuld Jr., its chief executive, made a final plea to regulators to turn his investment bank into a bank holding company, which would allow it to receive constant access to federal funding. Timothy F. Geithner, the president of the Federal Reserve Bank of New York, told him no, according to a former Lehman executive who requested anonymity because of continuing investigations of the firm’s demise. Its options exhausted, Lehman filed for bankruptcy in mid-September. One week later, Goldman and Morgan Stanley were designated bank holding companies.

170 “That was our idea three months ago, and they wouldn’t let us do it,” said a former senior Lehman executive who requested anonymity because he was not authorized to comment publicly. “But when Goldman got in trouble, they did it right away. No one could believe it.” The New York Fed, which declined to comment, has become, after Treasury, the favorite target for Goldman conspiracy theorists. As the most powerful regional member of the Federal Reserve system, and based in the nation’s financial capital, it has been a driving force in efforts to shore up the flailing financial system. Mr. Geithner, 47, played a pivotal role in the decision to let Lehman die and to bail out A.I.G. A 20-year public servant, he has never worked in the financial sector. Some analysts say that has left him reliant on Wall Street chiefs to guide his thinking and that Goldman alumni have figured prominently in his ascent. After working at the New York consulting firm Kissinger Associates, Mr. Geithner landed at the Treasury Department in 1988, eventually catching the eye of Robert E. Rubin, Goldman’s former co-chairman. Mr. Rubin, who became Treasury secretary in 1995, kept Mr. Geithner at his side through several international meltdowns, including the Russian credit crisis in the late 1990s. Mr. Rubin, now senior counselor at Citigroup, declined to comment. A few years later, in 2003, Mr. Geithner was named president of the New York Fed. Leading the search committee was Pete G. Peterson, the former head of Lehman Brothers and the senior chairman of the private equity firm Blackstone. Among those on an outside advisory committee were the former Fed chairman Paul A. Volcker; the former A.I.G. chief executive Maurice R. Greenberg; and John C. Whitehead, a former co-chairman of Goldman. The board of the New York Fed is led by Stephen Friedman, a former chairman of Goldman. He is a “Class C” director, meaning that he was appointed by the board to represent the public. Mr. Friedman, who wears many hats, including that of chairman of the President’s Foreign Intelligence Advisory Board, did not return calls for comment. During his tenure, Mr. Geithner has turned to Goldman in filling important positions or to handle special projects. He hired a former Goldman economist, William C. Dudley, to oversee the New York Fed unit that buys and sells government securities. He also tapped E. Gerald Corrigan, a well-regarded Goldman managing director and former New York Fed president, to reconvene a group to analyze risk on Wall Street. Some people say that all of these Goldman ties to the New York Fed are simply too close for comfort. “It’s grotesque,” said Christopher Whalen, a managing partner at Institutional Risk Analytics and a critic of the Fed. “And it’s done without apology.” A person familiar with Mr. Geithner’s thinking who was not authorized to speak publicly said that there was “no secret handshake” between the New York Fed and Goldman, describing such speculation as a conspiracy theory. Furthermore, others say, it makes sense that Goldman would have a presence in organizations like the New York Fed. “This is a very small, close-knit world. The fact that all of the major financial services firms, investment banking firms are in New York City means that when work is to be done, you’re going to be dealing with one of these guys,” said Mr. Langevoort at Georgetown. “The work of selecting the head of the New York Fed or a blue-ribbon commission — any of that sort of work — is going to involve a standard cast of characters.”

171 Being inside may not curry special favor anyway, some people note. Even though Mr. Fuld served on the board of the New York Fed, his proximity to federal power didn’t spare Lehman from bankruptcy. But when bankruptcy loomed for A.I.G. — a collapse regulators feared would take down the entire financial system — federal officials found themselves once again turning to someone who had a Goldman connection. Once the government decided to grant A.I.G., the largest insurance company, an $85 billion lifeline (which has since grown to about $122 billion) to prevent a collapse, regulators, including Mr. Paulson and Mr. Geithner, wanted new executive blood at the top. They picked Edward M. Liddy, the former C.E.O. of the insurer Allstate. Mr. Liddy had been a Goldman director since 2003 — he resigned after taking the A.I.G. job — and was chairman of the audit committee. (Another former Goldman executive, Suzanne Nora Johnson, was named to the A.I.G. board this summer.) Like many Wall Street firms, Goldman also had financial ties to A.I.G. It was the insurer’s largest trading partner, with exposure to $20 billion in credit derivatives, and could have faced losses had A.I.G. collapsed. Goldman has said repeatedly that its exposure to A.I.G. was “immaterial” and that the $20 billion was hedged so completely that it would have insulated the firm from significant losses. As the financial crisis has taken on a more global cast in recent weeks, Mr. Paulson has sat across the table from former Goldman colleagues, including Robert B. Zoellick, now president of the World Bank; Mario Draghi, president of the international group of regulators called the Financial Stability Forum; and Mark J. Carney, the governor of the Bank of Canada. BUT Mr. Paulson’s home team is still what draws the most scrutiny. “Paulson put Goldman people into these positions at Treasury because these are the people he knows and there are no constraints on him not to do so,” Mr. Whalen says. “The appearance of conflict of interest is everywhere, and that used to be enough. However, we’ve decided to dispense with the basic principles of checks and balances and our ethical standards in times of crisis.” Ultimately, analysts say, the actions of Mr. Paulson and his alumni club may come under more study. “I suspect the conduct of Goldman Sachs and other bankers in the rescue will be a background theme, if not a highlighted theme, as Congress decides how much regulation, how much control and frankly, how punitive to be with respect to the financial services industry,” said Mr. Langevoort at Georgetown. “The settling up is going to come in Congress next spring.”

172 Business

October 17, 2008 Banks Are Likely to Hold Tight to Bailout Money By LOUISE STORY and ERIC DASH Even as the government moves to plug holes in the nation’s banks, new gaps keep appearing.

As two financial giants, Citigroup and Merrill Lynch, reported fresh multibillion-dollar losses on Thursday, the industry passed a grim milestone: All of the combined profits that major banks earned in recent years have vanished.

173 Since mid-2007, when the credit crisis erupted, the country’s nine largest banks have written down the value of their troubled assets by a combined $323 billion. With a recession looming, the pain is unlikely to end there. The problems that began with home mortgages, analysts say, are migrating to auto, credit card and commercial real estate loans. The deepening red ink underscores a crucial question about the government’s plan: Will lenders deploy their new-found capital quickly, as the Treasury hopes, and unlock the flow of credit through the economy? Or will they hoard the money to protect themselves? John A. Thain, the chief executive of Merrill Lynch, said on Thursday that banks were unlikely to act swiftly. Executives at other banks privately expressed a similar view. “We will have the opportunity to redeploy that,” Mr. Thain said of the new capital on a telephone call with analysts. “But at least for the next quarter, it’s just going to be a cushion." Granted, the banks are in a deep hole. For every dollar the banks earned during the industry’s most prosperous years, they have now wiped out $1.06. Even with the capital from the government, analysts say, the banking industry still needs to raise around $275 billion in light of the looming losses. But Treasury Secretary Henry M. Paulson Jr. is urging them to use their new capital soon. On Monday, Mr. Paulson unveiled plans to provide $125 billion to nine banks on terms that were more favorable than they would have received in the marketplace. The government, however, has offered no written requirements about how or when the banks must use the money. “There is no express statutory requirement that says you must make this amount of loans,” said John C. Dugan, the comptroller of the currency. “But the economics work so that it is in their interest to do so.” Mr. Dugan added that he would not examine how the banks used the money, but he said their actions would “be open to the court of public opinion.” The banks could use the money from the government for any number of things. Some analysts say the banks may use it to acquire weaker competitors. Others say they might use it to avoid painful cost-cutting. And still others say the banks may sit on the capital. Lenders have been pulling back on credit lines for businesses, mortgages, home equity loans and credit card offers, and analysts said that trend was unlikely to be reversed by the government’s money. “I don’t think that the market wants to see that capital being put to work to leverage the business up again,” said Roger Freeman, an analyst at Barclays Capital, which acquired parts of the now-bankrupt Lehman Brothers last month. “My expectation is it’s quarters off, not months off, before you see that capital being put to work.” Many banks are still plagued by past excesses. Losses on a variety of different types of loans of all sorts are growing and spreading beyond the country’s borders. Citigroup and Merrill Lynch have each lost money every quarter in the last year, as deteriorating assets wiped out revenue. Merrill, which is in the process of merging with Bank of America, reported a $5.15 billion loss, dragged down by about $12 billion in write-downs. Citigroup lost $2.82 billion, as its $13.2 billion in charges related to credit losses more than overwhelmed every bit of revenue that the bank generated. And analysts say Citigroup is likely to face several more quarters of loan losses as the global economy slows.

174 Every corner of the economy goes through cyclical ups and downs. But the banking downturn has acted with ferocious speed to erase past profits. In the case of the nine-largest commercial banks — Citigroup, Merrill Lynch, Bank of America, Morgan Stanley, JPMorgan Chase, Goldman Sachs, Wells Fargo, Washington Mutual and Wachovia — profits from early 2004 until the middle of 2007 were a combined $305 billion. But since July 2007, those banks have marked down their valuations on loans and other assets by just over that amount. “The losses now are showing that in some sense the profits reported in earlier years were not real, because they were taking too much risk then,” said Richard Sylla, an economist and financial historian at the Stern School of Business at New York University. Mr. Sylla said that the average profit of the financial industry in the first decade of this century will be abysmal, despite the fact that there were a handful of record years in the middle. The ways banks value their investments has already come under scrutiny. Bankers are supposed to be skilled at valuing assets, and many of their sky-high bonuses before the credit crisis were based on the lofty values attached to mortgage securities. In the future, when Wall Street finds a new profit center, as it surely will, analysts may look back at the losses in this downturn as they question new earnings. At Citigroup, for instance, the write-downs on mortgages and other loans have eaten away 60 percent of all the profits made by the bank during the boom years. At Morgan Stanley, the cost has reached 70 percent of those profits, and at Merrill Lynch, the tally is 250 percent of the investment bank’s record earnings over those three and half years. It is those same banks that are in some shape benefiting from the government’s recent capital infusion. Three of the nine — Merrill Lynch, Washington Mutual and Wachovia — are in the process of mergers with others in the group. Two other banks — State Street and Bank of New York Mellon — also received capital from the government this week. Several of the banks, including Wells Fargo, Morgan Stanley, and Goldman Sachs, declined to comment on how they will spend the government funds once they arrive. Bank of America said in a statement that the money “will add to our capital, which will increase our capacity to expand our balance sheet and make more loans.” It did not say if it was willing to increase its lending. Indeed, observers point to the growing well of bank losses, deeper by the quarter, as reason to question whether the government funding will be used as a financial Band-Aid, instead of an engine to move forward. “It is the government’s responsibility to set the terms and conditions on this money,” said David M. Walker, the former federal comptroller general and now president of the Peter G. Peterson Foundation. “This is the people’s money. They’re giving it out with no rules.” Bank executives, meanwhile, said on conference calls this week that it was premature to discuss their plans. Jamie Dimon, the chairman and chief executive of JPMorgan, said his bank was in a stronger position to use the money than some of its competitors. “It’s clear that the government would like us to use the capital,” Mr. Dimon said on a conference call with analysts on Wednesday. “If you are a bank that is filling a hole, you obviously can’t do that.”

175 And Gary L. Crittenden, Citigroup’s chief financial officer, on Thursday called the government’s $25 billion investment in Citigroup “incremental to our thinking.” “We now have more capital than we anticipated,” he said in an interview. It will “allow us to opportunistically build what we have not been able to do.”

October 16, 2008 Banks Brace for Slump as Economy Weakens By ERIC DASH JPMorgan Chase, Wells Fargo, and State Street have weathered these bad times better than most banks. But things are about to get worse. Sobered by the prospect of a drawn-out erosion in the economy, investors drove down the shares of all three Wednesday even after they reported earnings that beat the low expectations of Wall Street analysts. “If you made it past the credit crisis, you are not making it past the economic carnage,” said Meredith A. Whitney, a banking analyst at Oppenheimer & Company. “And there is more to come.” The banks are among the first to announce their results in what is expected to be yet another dismal quarter for nearly all financial firms. Bank of America already reported disappointing earnings as it struggled to raise $10 billion in fresh capital. And Citigroup, Merrill Lynch, PNC Financial, and Bank of New York Mellon are expected to release weak results on Thursday, followed by regional and small banks whose fortunes have been changed by the upheaval of the American financial landscape. Profit at JPMorgan Chase slumped 84 percent, to $527 million, or 11 cents a share, in the third quarter as the bank weathered losses of $3.6 billion on bad investments, leveraged loans and a bevy of unusual charges, including ones tied to its takeover of Washington Mutual last month. In a sign it is preparing for more fallout from a contracting economy, the bank set aside another $2.2 billion to cover current and future losses on credit card, mortgages and commercial real estate loans. Wells Fargo & Company said profit fell 25 percent, to $1.64 billion, or 49 cents a share, after absorbing big losses on investments in Fannie Mae, Freddie Mac and Lehman Brothers. It also bolstered its reserves by $2.5 billion as it braces for higher loan losses, and will soon inherit tens of billions in new losses from its takeover of Wachovia. At State Street Corporation, a custodial bank based in Boston, profit rose 33 percent, to $477 million, or $1.09 a share, as it booked higher trading fees amid volatile markets. But it, too, faced heavy losses on investments, including loan collateral from Lehman Brothers. It also may need to set aside as much as $450 million to prop up some of its battered investors in its fixed-income funds. The banks were among the nine firms compelled by Treasury Secretary Henry M. Paulson Jr. on Tuesday to take a big cash infusion from the government. Both JPMorgan Chase and Wells Fargo agreed to received $25 billion investments; State Street, which has a much smaller balance sheet, received about $2 billion. Though all of the firms denied needing the money, federal officials hope they use it to increase lending.

176 Even if the flow of credit improves soon, executives are planning for a future shaped by thousands of lost jobs in the economy, weaker consumer spending and more market turmoil and uncertainty. “We necessarily need to be prepared for a bad environment,” said Jamie Dimon, JPMorgan’s chairman and chief executive. With losses on housing far worse than anticipated, he said the bank was “getting braced” to increase its reserves against losses on loans over the next couple of quarters, and for “very tough” trading results. The finance chief, Michael J. Cavanagh, said the bank believed the economy was already experiencing “recessionary conditions” that would worsen. On Wednesday, Ben S. Bernanke, the chairman of the Federal Reserve, warned that the American economy was headed toward an extended period of difficulty in spite of a worldwide effort to stabilize the markets. Investors, fearful that the worst is still to come, sent financial stocks plummeting. The KBW Index, a popular measure of the sector, fell more than 7 percent on Wednesday. It is down more than 45 percent since last year. A continued contraction may make it even tougher for consumers to pay off loans, especially credit card and auto debt, creating another layer of risk. And banks are also being hurt by narrower lending margins. Without the volume of new business, banks will find it especially challenging to be profitable. “Profit pressure is picking up at a time when you are trying to build it up as fast as you can to handle these credit problems,” said Gerard Cassidy, an analyst at RBC Capital Markets. Wells Fargo’s chief financial officer, Howard I. Atkins, warned that the bank faced intense pressure on its huge consumer loan portfolio. He cited weakness in residential real estate, rising unemployment and increases in bankruptcies. JPMorgan outlined signs of strain already showing up in its big consumer businesses. Its Chase retail banking operations reported $247 million in net income, a 61 percent drop from the period last year. It has pulled back on new lending, tightening standards on mortgages and home equity loans. And Chase’s big credit card division reported $292 million in net income, a 63 percent drop from last year. The unit took a $2.2 billion write-down to buffer against potential losses, as more consumers struggled to pay their credit card balances. “Credit has deteriorated meaningfully this quarter, and it is going to get worse before it gets better,” Mr. Cassidy said. “That is going to continue to drive the results well into 2009.” Mr. Dimon, on a conference call with analysts, said he expected lending to return to normal eventually. But now, he added, is the time to be prudent. “We are not going to say, ‘Yahoo, this is over,’ and go extend credit like we did without fear,” he said. “If you are not fearful, you are crazy.” Ms. Whitney, one of the most bearish banking analysts on the call, shot back, “I’m fearful, thanks.” Mr. Dimon deadpanned: “We know you are. We are waiting for you to reverse your position.” This article has been revised to reflect the following correction: Correction: October 17, 2008 A picture caption on Thursday with an article about earnings reports from Wells Fargo and JPMorgan Chase misidentified the event taking place. The picture showed employees of Wachovia, which is being taken over by Wells Fargo, listening to Wells Fargo’s chief executive, John Stumpf, at a ceremony on Wednesday welcoming them to the company. They were not listening to a presentation of Wells Fargo’s earnings report, which was also delivered on Wednesday.

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Paulson tries again Unlike the UK plan, the revamped American bailout puts banks first and taxpayers second

Joseph Stiglitz Thursday October 16 2008 Gordon Brown has won plaudits over recent days for inspiring the turnaround in Hank Paulson's thinking that saw him progress from his "cash for trash" plan - derided by almost every economist, and many respected financiers - to a capital injection approach. The international pressure brought to bear on America may indeed have contributed to Paulson's volte-face. But Paulson figured he could reshape the UK approach in a way that was even better for America's banks than his original cash strategy. The fact that US taxpayers might get trashed in the process is simply part of the collateral damage that has been a hallmark of the Bush administration. Will this bail-out be enough? We don't know. The banks have engaged in such non- transparency that not even they really know the shape they are in. Every day there are more foreclosures - Paulson's plan did little about that. That means new holes in the balance sheets are being opened up as old holes get filled. There is a consensus that our economic downturn will get worse, much worse; and in every economic downturn, bankruptcies go up. So even if the banks had exercised prudent lending - and we know that many didn't - they would be faced with more losses. Britain showed at least that it still believed in some sort of system of accountability: heads of banks resigned. Nothing like this in the US. Britain understood that it made no sense to pour money into banks and have them pour out money to shareholders. The US only restricted the banks from increasing their dividends. The Treasury has sought to create a picture for the public of toughness, yet behind the scenes it is busy reassuring the banks not to worry, that it's all part of a show to keep voters and Congress placated. What is clear is that we will not have voting shares. Wall Street will have our money, but we will not have a full say in what should be done with it. A glance at the banks' recent track record of managing risk gives taxpayers every reason to be concerned. For all the show of toughness, the details suggest the US taxpayer got a raw deal. There is no comparison with the terms that Warren Buffett secured when he provided capital to Goldman Sachs. Buffett got a warrant - the right to buy in the future at a price that was even below the depressed price at the time. Paulson got for the US a warrant to buy in the future - at whatever the prevailing price at the time. The whole point of the warrant is so we participate in some of the upside, as the economy recovers from the crisis, and as the financial system starts to work. The Paulson plan responded to Congress's demand to have something like a warrant, but as a matter of form, not substance. Buffett got warrants equal to 100% of the value of what he put in. America's taxpayers got just 15%. Moreover, as George Soros has pointed out, in a few years time, when the economy is recovered, the banks shouldn't need to turn to the

178 government for capital. The government should have issued convertible shares that gave the right to the government to automatically share in the gain in share price. Whether we were cheated or not, the banks now have our money. The next Congress will have two major tasks ahead. The first is to make sure that if the taxpayer loses on the deal, financial markets pay. The second is designing new regulations and a new regulatory system. Many in Wall Street have said that this should be postponed to a later date. We have a leaky boat, some argue, we need to fix that first. True, but we also know that there are really problems in the steering mechanism (and the captains who steer it) - if we don't fix those, we will crash on some other rocks before getting into port. Why should anyone have confidence in a banking system which has failed so badly, when nothing is being done to affect incentives? Many of those who urge postponing dealing with the reform of regulations really hope that, once the crisis is passed, business will return to usual, and nothing will be done. That's what happened after the last global financial crisis. There is a hope: the last financial crisis happened in distant regions of the world. Then it was the taxpayers in Thailand, Korea and Indonesia who had to pick up the tab for the financial markets' bad lending; this time it is taxpayers in the US and Europe. They are angry, and well they should be. Hopefully, our democracies are strong enough to overcome the power of money and special interests, and we will prove able to build the new regulatory system that the world needs if we are to have a prosperous and stable global economy in the 21st century. • Joseph E Stiglitz is university professor at Columbia University and recipient of the Nobel memorial prize in economic science in 2001. He was chief economist at the World Bank at the time of the last global financial crisis.

179 COMMENT & ANALYSIS A better way to revive credit markets By Robert Aliber Published: October 16 2008 19:27 | Last updated: October 16 2008 19:27 The chatter that the American taxpayers will pay $700bn to save the banks is nonsense. I have a straightforward plan that should revive the market in mortgage-related securities (MRS), greatly enhance bank capital and earn several tens of billions of dollars for the US Treasury. The distress in the US credit market reflects that MRS are no longer priced on a rational basis. Rather, a few companies with a desperate need for cash have sold these securities for 25 cents on the dollar; the accounting conventions require that this price is used to value similar securities owned by other banks. There are 40m mortgages on residential real estate in the US. Ninety seven per cent or 98 per cent of homeowners make their mortgage payments on a timely basis. The median home price in the US is $250,000. Assume 1m homeowners are subject to foreclosure and that the lenders incur a loss of $100,000 each time a borrower defaults. The losses to the lenders then would total $100bn. If 4 per cent of the homeowners with mortgages default, the losses to the lenders would total about $150bn. The ownership of these MRS is concentrated; 20 US banks have 80 per cent of the mortgage- related securities that are not owned in Europe and Asia. The face value of MRS owned by US companies might be $5,000bn-$6,000bn or more (there is triple-counting because these securities have been sliced and diced) and the economic losses on these securities are likely to be in the range of $100bn-$200bn. US banks already have reported losses approaching $350bn, or more than twice the estimate of eventual losses of $150bn. There are two key elements in the plan. One is that each of the troubled US banks would place all of the MRS it owns in a trust and then issue a new security that would be a claim on all of the cash received by the trust each month from its holdings of MRS. The other is that once a week, a new US government agency (Tarp) would offer to buy $10bn-$15bn of these new securities in a reverse auction. Each bank that wishes to participate in one of the weekly auctions would indicate the minimum price that it would accept for $50m, $100m and $250m of the new securities issued by its trust. Each bank would also indicate the interest income and the debt service payments associated with the MRS that it had placed in the trust. Tarp would accept those bids that offer the highest rate of return, which would be measured by the relationship between the interest income earned by the trust and the price at which the bank was offering to sell the securities. Tarp would set one buying price at each weekly auction; some banks would get a bonus because their offer price was below the price that would clear the market. Initially it seems likely that the banks that are most desperate to improve their capital position would place a relatively low price on the securities that they would offer to sell.

180 Once a weekly auction had been concluded, Tarp would announce the price that it had paid, which would establish a value for the underlying MRS. If Tarp had paid $350 for securities with $1,000 of principal value, each bank could value its holdings of MRS at $350. If a bank previously had carried these securities at $250, the bank could reprice them at $350, which would lead to a corresponding increase in the bank’s capital. Once Tarp had announced the prices that it had paid at the auction, private financial institutions would have three days to buy these securities from Tarp at the prices that Tarp had paid. The prospect is that the prices that Tarp would pay would increase from one weekly auction to the next. Each bank could revalue the MRS that it owns at the higher auction prices, which would automatically lead to an increase in its capital. At some stage, liquidity would return to the market in MRS and their market prices would reflect their prospective debt service receipts. Tarp would then sell the securities that it had purchased back to these banks at these prices. The accountants and their confrères that insisted on mark-to-market accounting should be made to stand in the corner for six months. The economic and business journalists that have shrilled about bail-outs should be given a six-month assignment to cover the daily fire and police department activities. This plan is easy to understand, even by Washington standards. The banks that have some of the tarnished MRS would have no opportunity to “cherry pick” and sell only those securities to Tarp that they believe have an exceptionally large amount of toxic waste. Moreover, the bureaucrats in charge of implementing the plan would have no basis for favouring one seller over another – always a problem when “free money” from Washington is involved. Finally, the price discovery process is transparent and continuous, the data on the winning bids in each weekly auctions would be published in the business press. The success of this reverse auction would restore confidence and trust in the US Treasury and the Federal Reserve, which have been shattered by their myopia and opaqueness. How much money will the US Treasury earn? No one knows. However, the gains to the global economy from reviving the US credit markets will be worth many hundreds of billions. The writer is emeritus professor of international economics and finance at the Graduate School of Business, University of Chicago. He is the author of The New International Money Game and brought out the fifth edition of Charles Kindleberger’s classic, Manias, Panics, and Crashes

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From The Times October 17, 2008 Bankers take a billhook to the hedge funds David Wighton: Business Editor's commentary

Hedge fund managers are paranoid. And they are right to be. The other day I had lunch with a senior financial official whose view of hedge funds was simple. “They were a con. The returns were all due to leverage. And now that the leverage has gone everyone will see they were a con.” You may disagree with this analysis. You may be convinced that for some hedge funds at least the returns were down to skill. You may argue that their role in the credit crisis has been at worst neutral. But you cannot deny it is pretty worrying for hedge funds when this is the view of a top regulator. And my lunch companion is not alone. According to an e-mail from Dick Fuld, the former chairman of Lehman Brothers, quoted by The Wall Street Journal, Hank Paulson, the US Treasury Secretary, said he wanted to “kill” the bad hedge funds and “heavily regulate the rest”. The Italian Finance Minister has promised to put the extermination of hedge funds on the international agenda when Italy takes over presidency of the G8 in January. The bankers are all blaming the hedge funds. Even John Mack, chief executive of Morgan Stanley, which has made a fortune out of hedge funds, blamed hedge funds shorting the stock for bringing the bank to the brink a couple of weeks ago. The regulatory backlash has already started with the ban on short-selling of financial stocks. It is not clear what difference this has made to bank stocks. They have continued to decline, though with much wilder swings. Perhaps short-sellers did cause the sharp fall in bank share prices that forced the Government to mount its bailout plan. But is that a bad thing? Perhaps they should be congratulated for forcing the authorities to act now, rather than later. It was hedge funds that first questioned Northern Rock's reckless dependence on wholesale funding five years ago and started shorting the shares. If the Financial Services Authority had also questioned bank business models at that time, the taxpayer might not be looking at such a monstrous bill to clear up the resulting mess. Of course, the question of whether regulators are justified in cracking down may be rather academic. Mr Paulson may not need to kill the bad hedge funds. The market may do it for him. Hedge funds are having a very tough time. Performance has been dismal this year, with the average fund down about 10 per cent according to Hedge Fund Research. That may be a lot better than the stock market but it is hardly the absolute returns that hedge funds are supposed to deliver. (Down a bit is the new up, runs the gag.) The ban on short-selling has not helped by undermining some important hedge fund strategies. Nor have the problems of the investment banks, which have forced them to cut

182 back on lending to hedge funds. Access to leverage will never return in the same way, which has serious implications for funds that relied on borrowings to spice up their returns. The wild market gyrations of recent weeks are likely to have caught out some funds. And investors are now spooked with funds suffering a flood of redemptions. But the good funds should survive, indeed may thrive, given the reduced competition. The regulatory backlash may merely drive them offshore. The industry will be smaller but its predicted demise looks as exaggerated now as it was after the collapse of LTCM ten years ago. A senior German politician memorably described private equity funds as locusts. Hedge funds are more like cockroaches. They get a bad press but are very hard to kill.

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Economics The Morning After by John Cassidy The next president will inherit an economic mess. Where to begin the cleanup.

AFTER PARTY The economy is now the prevailing issue for the next president.

In the summer of 1998, during the Asian financial crisis, I went to Japan with Larry Summers, the Harvard economist who was then deputy secretary of the Treasury. Back then, American politicians often flew around the world telling other countries how to manage their economies, a task Summers, who often referred to “the power of the American idea,” took to with gusto. Shortly before Summers arrived in Tokyo, the Japanese government had asked the United States for assistance in propping up the yen. Vanloads of reporters followed him around town, in part because he didn’t refrain from telling his hosts that, in return for American help, they needed to overhaul their antiquated financial system: make it more competitive, more modern, more freewheeling, and—he didn’t use this precise phrase; he didn’t have to—more American. When I put it to him that he sounded like a triumphalist, he retreated into academic jargon but didn’t deny the charge. Summers, like most of his compatriots, took it as self-evident that the American model represented the best way to organize an economy—and the proof was the fact that the U.S. had emerged as the sole economic superpower. Ten and a half years later, American economic hegemony looks much less secure. The U.S. economy is suffering through a serious slump, the second in a decade; many American families face eviction from their homes; American workers haven’t received a decent pay raise in almost 10 years; and U.S. taxpayers are being railroaded into committing the better part of a trillion dollars to bail out feckless Wall Street institutions. The

184 Iranian president isn’t the only one hailing the end of the American era. Take, for example, this passage from George Soros’ latest book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means: “I contend that it means the end of a long period of relative stability based on the United States as the dominant power and the dollar as the main international reserve currency. I foresee a period of political and financial instability, hopefully to be followed by the emergence of a new world order.” Is Soros right? Up to a point, he is. Three pillars of American economic supremacy have been badly dented: the unrivaled power of Wall Street, our ability to dictate policy to other countries, and the appeal of the dollar. With the U.S. government heavily dependent on foreigners’ purchases of Treasurys to finance its deficit, American officials, when they visit places like China and Japan, are already less arrogant than they used to be. In the future, they will surely be even more reluctant to sound off, which is just as well. Today, many Japanese and Chinese officials would struggle to keep a straight face upon hearing an American policymaker dispensing economic advice. But the humbling of the U.S. doesn’t mean that the Asians and Europeans are going to be bossing us around the way we used to boss them. The U.S. may no longer be the bully on the block, but its economy is still by far the biggest in the world, and even now it attracts money and talent from around the globe. After a punishing period of wealth destruction and rising unemployment, the financial markets will stabilize and growth will resume. America will be a bruised giant, but a giant it will remain. One of my first assignments in journalism was covering the Big Bang—the deregulation of Britain’s financial markets—which took place in October 1986. All too aware that the City of London was slipping behind Wall Street, Margaret Thatcher’s government abolished the regulations that had prevented foreign investment firms from competing with the snooty, undercapitalized British banks that had dominated Britain for centuries. Within a few years, the titans of Wall Street— Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers—had barged into town, buying out many local outfits and eliminating many venerable British customs such as the three-hour liquid lunch. In today’s City, cocktails at noon are a thing of the past, but so too is the cocky American investment banker. Lehman is bankrupt; Merrill is a subsidiary of Bank of America; Morgan and Goldman, fearful they were about to become subsidiaries of the People’s Republic of China or perhaps even meet the same fate as Lehman, have converted themselves into commercial banks; and Goldman has sold a chunk of itself to Warren Buffett. Washington Mutual is gone. Citi, another big player in London, is referred to in some circles as the Bank of Arabia. (Following the firm’s latest mishaps, Arab investors own about 20 percent of its equity.) The eclipse of Wall Street is mirrored in the demise of the Washington Consensus, an interrelated set of free-market policies that the U.S., often operating through the World Bank and the International Monetary Fund, once imposed on less developed nations. Stripped to its basics, the American recipe for economic success had three elements: open markets, deregulation, and macroeconomic stability—all of which have now been called into question. Even Summers, who in many ways embodied the Washington Consensus, today opposes elements of it. Summers recently advocated a more restrained approach to future trade treaties, since previous agreements, such as Nafta, had failed to benefit American workers. In an interview with Lloyd Grove on Portfolio.com, Summers also questioned the wisdom of excessive financial deregulation. Comparing the Asian crisis, which

185 decimated the banking system in countries such as Korea, Taiwan, and Thailand, with what the U.S. is now experiencing, he said, “Some of the very same mistakes—excessive budget deficits, failure to regulate financial institutions, excessive leverage—that led to those problems are what led to our problems.” With the Treasury Department taking over Fannie Mae and Freddie Mac, the two biggest mortgage firms in the country, the Federal Reserve purchasing 80 percent of the biggest insurance firm in the country, and Congress grappling with possible bailout plans, it hardly needs pointing out that the U.S. is no longer in a position to lecture others on the virtues of laissez-faire and sound economic management. The demise of the Washington Consensus undercuts America’s ability to use what Joseph Nye, the Harvard political scientist, refers to as “soft power”—or economic heft—rather than military might, to exert its influence. One way the U.S. did this was by relying on the attractiveness of the American ideal to shape the preferences and beliefs of people around the world. When countries in economic transition, such as Poland and Vietnam, opened their markets to McDonald’s and Budweiser and Microsoft, they did so not because their leaders were kowtowing to powerful American multinationals but because their citizens demanded it. “Soft power uses a different type of currency—not force, not money—to engender cooperation,” Nye wrote in a 2004 article. “It uses an attraction to shared values and the justness and duty of contributing to the achievement of those values.” Today, the images of America being broadcast around the world often feature desperate homeowners, failing banks, and panicked policymakers—none of which are likely to inspire confidence in, or affection for, Uncle Sam. On the Monday after Treasury Secretary Hank Paulson announced his bailout plan, the dollar suffered its biggest fall against the euro in almost a decade. Currency traders know an overstretched government when they see one, and the sight of the U.S. Treasury taking on what looked, at first glance, to be the financial equivalent of another Iraq war sent them fleeing from the greenback. “What’s weighing on the dollar is the question of how [the bailout] will ultimately be financed,” Sue Trinh, a currency strategist at RBC Capital Markets, told Reuters. In nationalizing Fannie Mae and Freddie Mac, the U.S. government had already added $5.3 trillion to the national debt. Much of this debt is owed to foreign central banks, particularly the Bank of Japan and the Bank of China, which have both announced plans to diversify their reserves. To be sure, Japan and China have a strong interest in preventing a precipitous decline in the U.S. currency, which would devalue their existing holdings. Still, the spectacle of Paulson asking Congress for a blank check, and the Federal Reserve asking the Treasury to issue bonds on its behalf, must give those countries pause about buying yet more dollars, which is what is required if the U.S. is to finance its vast trade deficit and regain its currency’s privileged status. With the chairman of Standard & Poor’s rating committee having recently stated that the U.S. government didn’t have a “god-given gift” of a triple-A rating, some longtime dollar bears foresee the moment when foreigners will no longer lend to the U.S. at modest rates of interest and the Fed will thus be presented with the awful choice of either hiking the funds rate to maintain the inflow of foreign capital or letting the dollar collapse and beginning the process of monetizing the country’s debts. A more likely scenario, in my opinion, involves foreign central banks gradually diversifying their portfolios, shifting some of their reserves into euros and other currencies. The demand for Treasurys won’t collapse overnight, but the days of the U.S. merrily borrowing from abroad in virtually unlimited amounts, as it has been doing in recent years, would come to an end. And who knows? In 20 or 30 years,

186 the euro or the yuan could replace the dollar as the favored currency of Russian gangsters and Arab oil sheiks. Having said all that, for all the weaknesses in the U.S. model that the housing crisis has revealed, America still has many underlying economic strengths, including its enormous physical and human capital resources, its technological leadership, its entrepreneurial bent, and its ability to bolster the output of its patchy education system with a steady influx of highly skilled immigrants. It is important not to conflate the financial sector with the economy as a whole. In terms of productivity—G.D.P. per worker—the U.S. economy still leads other developed countries by a wide margin. Of the world’s 500 biggest public companies, as ranked by the Financial Times, 169 are in the U.S.—more than are in Japan, the United Kingdom, France, China, Germany, and Russia combined. Even in the battered financial sector, Bank of America and Citigroup remain the two biggest banks on the planet when ranked by market capitalization.

Then there are the growth industries of the future: high tech, entertainment and leisure, consulting, health care, biotechnology, environmental products, and, sadly, defense. In all of these areas, U.S. companies have a commanding presence. Of course, other countries could cut into this lead, but in places like Silicon Valley, Hollywood, Boston’s medical research centers—and, yes, Wall Street—the U.S. has clusters of expertise that are extremely difficult to replicate. Most important of all, the U.S. economy retains an enviable capacity to re-create itself. In one way, the unfolding of the credit crunch reads like a left-wing conspiracy theory: Rich Wall Street bankers concoct an explosive brew of exotic mortgage securities that bubbles over and blows up the financial system, or large parts of it. Amid the carnage, the government—the executive committee of the capitalist class, as Marx called it—offers to bail out the bankers at the taxpayers’ expense. But from another perspective, that of Austrian economist Joseph Schumpeter, the subprime catastrophe can be seen as the inevitable by- product of a crucial and ultimately beneficial innovation: the securitization of illiquid assets such as mortgages, credit-card debt, and auto loans. Whenever something exciting and new comes along, Schumpeter pointed out, entrepreneurs and investors gear up to take advantage of it, which can easily lead to the emergence of “reckless” finance. It happened with the building of the railroads of the mid-19th century, the development of radio and television in the 1920s, and the commercialization of the internet in the 1990s. As a longtime critic of financial deregulation and the Greenspan-Bernanke policy of stoking asset-price booms, I don’t totally buy into the Schumpeterian story, but neither do I buy the argument that American capitalism is collapsing under the weight of its internal contradictions. A period of living within its means, behaving less arrogantly toward other countries, and relying for its prosperity on creativity and honest toil rather than speculative bubbles would be good for the U.S. It might well make it more popular; it could certainly make it stronger. Posted: Oct 16 2008 8:56pm ET. By Bill4201

The idea that the best thing the government can do for the economy is to stand aside and allow the markets to work their magic has not always been a central piller of American Capitalism. Our first finance minister, Alexander Hamilton, designed his policies around the idea that for the economy to grow it needed to be giuded by government regulation. Almost two centuries latter, FDR used the new deal to bolster the country. The idea that the market is infallable seemed to infect our country the last 30 years. If recent events have finally cured us of

187 this fallacy and America can find a way to guide the economy without hurting innovation we can emerge from this crises with a stronger, mnore secure economy.

EU leaders demand recession safeguards

By Tony Barber and George Parker in Brussels Published: October 16 2008 10:21 | Last updated: October 16 2008 16:51 European Union leaders on Thursday demanded swift measures to shield their manufacturers against the threat of a severe economic recession triggered by the global financial meltdown. After long and sometimes sharp discussions, the bloc’s 27 leaders also decided to stick to a December deadline for thrashing out a deal on climate change, but promised to take into account the concerns of Poland and other former communist countries. Wrapping up a two-day summit in Brussels, the leaders said they intended to work with the US and other countries to bring about “a real and complete reform of the international financial system”, based on new standards of transparency, cross-border supervision and crisis management. Nicolas Sarkozy, France’s president, led the call for assistance to European manufacturers, saying: “If we had a co-ordinated response to the financial crisis in Europe, shouldn’t we have a co-ordinated response to the economic crisis in Europe?” He won enthusiastic support from Silvio Berlusconi, Italy’s premier, who pointed to $25bn in low-interest loans that Congress has approved for carmakers in the US. “Since the US is taking massive steps to support its auto companies, it shouldn’t be a scandal if some EU states find it necessary to give support to their own,” Mr Berlusconi said. European carmakers are asking for €40bn in loans, partly to match the US aid package and partly because they anticipate heavy costs in meeting strict new EU fuel emission standards for fighting climate change. In their summit communiqué, the EU leaders called on the European Commission to present proposals by the end of December “to preserve the international competitiveness of European industry”. The statement reflected the view of France, Germany, Italy and others that the emergency measures adopted this week to protect Europe’s financial sector from collapse, though necessary, risked leaving manufacturers in the lurch. The EU statement almost included language that could have been interpreted as a call for a Europe-wide fiscal boost for manufacturing industry. But the UK insisted on removing a French-inspired phrase that referred to “necessary steps to react to the slowdown in demand”. David Miliband, Britain’s foreign secretary, highlighted a clause in the communiqué that stressed the need to observe EU state aid rules in developing new policies. “I think we’d rather stick to the financial sector,” one UK official said.

188 German officials suggested Gordon Brown, the UK prime minister, was trying to gain credit for initiatives to tighten global financial regulation that had been proposed by Berlin some years ago but were resisted by the UK. This dispute was, however, small compared with the heated exchange of views that took place on the EU’s climate change and energy security policies. According to participants in the talks, Italy and several central and eastern European countries raised fierce objections to what they see as the EU’s strategy of cutting carbon dioxide emissions and boosting renewable energy use. They see it as particularly costly and difficult at a time of economic crisis. But Mr Sarkozy told them that the EU would cover itself in ridicule if it scaled back its plans, less than two years after announcing it would be the world’s leader in tackling global warming. The EU’s reaffirmation of the plan owed much to Angela Merkel, Germany’s chancellor, who is under pressure from powerful industrial lobbies at home to seek changes. She told fellow summit leaders that Germany supported the plan and was determined to get an agreement in December. Nonetheless, Poland, a nation almost entirely dependent on coal for its electricity, won an important concession when its partners agreed that the final EU steps in December should be decided by unanimity rather than majority vote. Some leaders at the summit complained that they had not been in power in March 2007, when the EU committed itself to its “20-20-20” plan – a 20 per cent cut in CO2 emissions from 1990 levels, a promise to derive 20 per cent of all energy from renewable sources, and energy efficiency savings of 20 per cent, all by 2020. But when these leaders talked of “red lines”, or non-negotiable national interests, José Manuel Barroso, the European Commission president, retorted that he too had a “red line” – the 20-20-20 plan. Mr Barroso and Mr Sarkozy will hold talks on Saturday with George W. Bush, the US president, and set out their case for a wholesale redesign of the world’s financial architecture, including broader powers for the International Monetary Fund.

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October 16, 2008 The Bankrupting of Henry Paulson By John Tamny ‘while nationalization has enabled some industries to postpone job losses for a time, the resulting overmanning has usually proved unsustainable and the eventual job losses consequentially greater.’ • Nigel Lawson, The View From No. 11 Nigel Lawson served as Margaret Thatcher’s chancellor of the exchequer, and as the Thatcher and Reagan eras in England and the U.S. were most notable for governments removing themselves from the doings of private enterprise, it’s passing strange that politicians in the U.S. and around the world would take their hysterics to such astonishing levels. It’s as though the capitalistic economic revival of the last twenty-five years didn’t happen, and that the denationalization of industry was irrelevant to our subsequent good fortune. Indeed, this week’s announcement that Henry Paulson’s Treasury will buy stakes in U.S. banks regardless of their health, and regardless of their desire for government funds would be truly shocking if we hadn’t already been conditioned to a resurgent federal government under the alleged heirs of Reagan conservatism. Sure enough, if there previously existed any uncertainty about the level of policy principle within today’s GOP, those questions were answered this week. There is none. The very leaders voters sent to Washington based on their stated belief in small, non-intrusive government have betrayed those same voters on a stratospheric scale. What’s remarkable is that GOP partisans still comfort themselves with knowing references to the “socialist” instincts of Barack Obama; these comments made despite a growing level of federal intrusion by card-carrying Republicans into the workings of private markets that would make the few remaining New Dealers in our midst blush. The Paulson plan to force formerly private money into banks was attempted once before; on President Herbert Hoover’s watch. Apparently untroubled by the past result, Paulson will try again. So if we’re willing to ignore the unfortunate history when it comes to a government-owned banking sector, it’s at least worthwhile to discuss the various holes and contradictions that are part of the Paulson plan. First up, the federal government will now “guarantee new debt issued by banks for three years” as a way of encouraging interbank and customer lending. What’s impressive here is the very arrogance of such a proclamation. Last this writer heard, the federal government creates no wealth; meaning those in America who pay taxes will guarantee all government debt. The plan also presumes that the very kind of careful money that was not being lent in the private sector can somehow be taken from that same private sector, shoved into banks by bureaucrats, and then be lent out profitably despite market signals suggesting the opposite.

190 From an economic perspective, the above becomes even scarier due to the basic truth that capitalism is reliant on the efficient deployment of capital. But with the federal government as backstop, the need to be prudent when it comes to lending will become less pressing. Not only is Paulson seemingly unaware of Hoover’s mistakes, but he’s also unaware of what happened the last time Congress effectively told the S&Ls to go hog-wild with the funds entrusted to them. Furthermore, it’s quite simply naïve to assume that in return for debt guarantees, the federal government won’t require new forms of non-economic lending. Many have made lots of noise about the Community Reinvestment Act, but with the federal government a preferred shareholder of the banking system, won’t the CRA become a minor nuisance relative to “soft” requests made to banks for loans to other politically preferred entities? As it is, Neel Kashkari, Paulson’s young lieutenant charged with oversight of the unfortunate plan, has made plain that a bank’s minority and/or gender status will be carefully considered when the money is passed around. Treasury officials will of course protest that new federal oversight means more prudent lending, but even if this were somehow a good thing (the U.S. economy in the ‘80s was largely built on loans to firms whose debt was referred to as “junk”), the certain emasculation of our banking system by our federal minders promises to be bad for the innovation that will be lost. For those who doubt the above, they need only reference the curtailment of executive pay that is part and parcel of the nationalization plan. And there lies the contradiction: Paulson et al ask us to have faith in their activities out of one side of the mouth, then they expect us to believe this will work alongside compensation rules that will surely drive the best-and- brightest away from the banking sector. Taxpayers beware. Lastly, as Lawson noted in The View From No. 11, what “public ownership does is to eliminate the threat of takeover and ultimately of bankruptcy, and the need, which all private undertakings have from time to time, to raise money from the market.” Exactly. It is the fear of takeover, and the fear that markets will ignore capital requests that drives banks and companies of all stripes to be more efficient. With one fell swoop whereby Paulson is forcing all banks to take government money, the total sector’s future strength is understandably a major question mark. Establishment economist Joseph Stiglitz has said in response to recent market troubles that “those who believe in free markets have received another rude shock.” But he mistakes the process in which markets correct for Washington mistakes with actual mistakes of capitalism. In short, Stiglitz misses the point. What we’re experiencing is the correct market response to a collectivist ideology that has infected the political class. The weak-dollar policies of the Bush administration meant to redistribute wealth to the manufacturing and commodity sectors were surely the match that lit the property fire given the “money illusion” that made home purchases more and more profitable in terms of weakening dollars. Added to that, both parties to varying degrees endorsed all manner of lending practices given Washington’s politically correct, but ultimately impoverishing view that homeownership is something good. So while Paulson and politicians generally will say bank bailouts are a necessity, be very wary. If you didn’t like the end result of government subsidization of the housing sector, just think how you’ll feel once the preferred owner of banking shares imposes its “compassionate” ideology on other parts of the economy.

191 Lawson concluded that the dangers of state ownership were “greater than even the Thatcher government realized.” But in a blast to the past, one that will bring us less economic vibrancy alongside rising unemployment, the very GOP operatives who would publicly refer to Thatcher and Ronald Reagan as the 20th century’s greatest leaders are seeking to undo all that they accomplished. So this is why we elect Republicans? John Tamny is editor of RealClearMarkets, a senior economist with H.C. Wainwright Economics, and a senior economic advisor to Toreador Research and Trading. He can be reached at [email protected]. Page Printed from: http://www.realclearmarkets.com/articles/2008/10/the_bankrupting_of_henry_pauls.ht ml at October 16, 2008 - 01:13:01 PM CDT

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Release Date: October 21, 2008 Federal Reserve announces the creation of the Money Market Investor Funding Facility (MMIFF) For release at 9:00 a.m. EDT The Federal Reserve Board on Tuesday announced the creation of the Money Market Investor Funding Facility (MMIFF), which will support a private-sector initiative designed to provide liquidity to U.S. money market investors. Under the MMIFF, authorized by the Board under Section 13(3) of the Federal Reserve Act, the Federal Reserve Bank of New York (FRBNY) will provide senior secured funding to a series of special purpose vehicles to facilitate an industry-supported private-sector initiative to finance the purchase of eligible assets from eligible investors. Eligible assets will include U.S. dollar-denominated certificates of deposit and commercial paper issued by highly rated financial institutions and having remaining maturities of 90 days or less. Eligible investors will include U.S. money market mutual funds and over time may include other U.S. money market investors. The short-term debt markets have been under considerable strain in recent weeks as money market mutual funds and other investors have had difficulty selling assets to satisfy redemption requests and meet portfolio rebalancing needs. By facilitating the sales of money market instruments in the secondary market, the MMIFF should improve the liquidity position of money market investors, thus increasing their ability to meet any further redemption requests and their willingness to invest in money market instruments. Improved money market conditions will enhance the ability of banks and other financial intermediaries to accommodate the credit needs of businesses and households. The attached term sheet describes the basic terms and operational details of the facility. The MMIFF complements the previously announced Commercial Paper Funding Facility (CPFF), which on October 27, 2008 will begin funding purchases of highly rated, U.S.-dollar denominated, three-month, unsecured and asset-backed commercial paper issued by U.S. issuers, as well as the Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), announced on September 19, 2008, which extends loans to banking organizations to purchase asset backed commercial paper from money market mutual funds. The AMLF, CPFF, and MMIFF are all intended to improve liquidity in short-term debt markets and thereby increase the availability of credit. MMIFF Terms and Conditions (95 KB PDF)

193 Release Date: October 21, 2008 Federal Reserve announces results of auction of $150 billion in 28-day credit held on October 20, 2008 For release at 10:00 a.m. EDT On October 20, 2008, the Federal Reserve conducted an auction of $150 billion in 28-day credit through its Term Auction Facility. Following are the results of the auction:

Stop-out rate: 1.110 percent

Total propositions submitted: $113.271 billion Total propositions accepted: $113.271 billion Bid/cover ratio: 0.76

Number of bidders: 74

The awarded loans will settle on October 23, 2008, and will mature on November 20, 2008. The stop- out rate shown above will apply to all awarded loans. Institutions that submitted winning bids will be contacted by their respective Reserve Banks by 11:30 a.m. EDT on October 21, 2008. Participants have until 12:30 p.m. EDT on October 21, 2008, to inform their local Reserve Bank of any error. Release Date: October 20, 2008 Federal Reserve will offer $150 billion in 28-day credit through its Term Auction Facility today For release at 10:00 a.m. EDT On October 20, 2008, the Federal Reserve will offer $150 billion in 28-day credit through its Term Auction Facility. Additional information regarding the auction is listed below; the auction will be conducted as specified in this announcement, Regulation A, and the terms and conditions of the Term Auction Facility (www.federalreserve.gov/monetarypolicy/taf.htm).

Description of Offering and Auction Parameters Offering Amount: $150 billion Term: 28-day loan Bid Submission Date: October 20, 2008 Opening Time: 11:00 a.m. EDT Closing Time: 12:30 p.m. EDT Notification Date: October 21, 2008 Settlement Date: October 23, 2008 Maturity Date: November 20, 2008 Minimum Bid Amount (per bid): $5 million Bid Increment: $100,000 Maximum Bid Amount (per $15 billion (10% of Offering institution): Amount) Minimum Bid Rate: 1.11 percent

194 Incremental Bid Rate: 0.001 percent Minimum Award: $10,000 $15 billion (10% of Offering Maximum Award: Amount) Submission of Bids Participants must submit bids by phone to their local Reserve Bank between the opening time and closing time on the bid submission date. Notification Summary auction results will be published on the website of the Board of Governors of the Federal Reserve System (www.federalreserve.gov/monetarypolicy/taf.htm) at approximately 10:00 a.m. EDT on the notification date. Between 10:00 a.m. and 11:30 a.m. EDT on the notification date, Reserve Banks will notify individual institutions in their districts that have submitted winning bids of their awards. Participants have until 12:30 p.m. EDT on the notification date to inform their local Reserve Bank of any error. Rounding Convention Pro rata awards will be rounded to multiples of $10,000. Normal rounding convention will be used, except that awards under $10,000 will be rounded to $10,000.

Release Date: October 16, 2008 Federal Reserve announces interim final rule to allow bank holding companies to include senior perpetual preferred stock issued to the Treasury Department in Tier 1 capital For immediate release The Federal Reserve Board on Thursday announced the adoption of an interim final rule that will allow bank holding companies to include in their Tier 1 capital without restriction the senior perpetual preferred stock issued to the Treasury Department under the capital purchase program announced by the Treasury on October 14, 2008. Treasury established the capital purchase program under the Emergency Economic Stabilization Act of 2008, which became law on October 3, 2008. Details about the capital purchase program are available on the Treasury's website. The Board adopted the rule on an interim final basis to immediately provide guidance to bank holding companies concerning the regulatory capital treatment of such senior perpetual preferred stock and to support and facilitate the timely provision of capital to bank holding companies under the capital purchase program. The Board continues to work with Treasury, the other federal banking agencies, and other parties on other capital and related matters associated with the capital purchase program. The interim rule will be effective as of October 17, 2008. The Board is, however, seeking public comment on the interim rule. Comments must be submitted within 30 days of publication of the interim rule in the Federal Register, which is expected soon. The draft Federal Register notice for the rule is attached. http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20081016a1.pdf

195 Release Date: October 16, 2008 For immediate release Federal Reserve issues guidance for consolidated supervision of bank holding companies and combined U.S. operations of foreign banking organizations The Federal Reserve on Thursday issued enhanced guidance that refines and clarifies its programs for the consolidated supervision of bank holding companies and the combined U.S. operations of foreign banking organizations (FBOs). The Federal Reserve also released guidance clarifying supervisory expectations with respect to firmwide compliance risk management. While initiation of these efforts predated the recent period of considerable strain in the financial markets, these enhanced approaches to consolidated supervision and firmwide compliance risk management emphasize several elements that should support a more resilient financial system. The Federal Reserve continues to work, both independently and in conjunction with other supervisors and functional regulators, on a number of initiatives to strengthen supervisory approaches and reinforce expectations for sound practices in response to market events. "This supervisory guidance on consolidated supervision and compliance risk management will better equip our supervisory staff, working closely with other U.S. and foreign supervisors and regulators, to understand and assess the full range and scope of a banking organization's operations and risks," said Federal Reserve Board Governor Randall S. Kroszner. "This guidance should not only provide greater clarity regarding our longstanding responsibilities as a consolidated supervisor, but is also responsive to ongoing developments in the financial sector. The objectives of fostering financial stability and deterring or managing financial crises will be furthered by the Federal Reserve having a more complete view of firmwide risks and controls," Governor Kroszner said. The continuing growth in the size and complexity of many banking organizations exposes these firms to a wide array of potential risks, while at the same time making it more challenging for a single supervisor to have a comprehensive perspective on the firm as a whole. In this regard, the consolidated supervision guidance is designed to foster consistent Federal Reserve supervisory practices and assessments across institutions with similar activities and risks. The guidance describes how Federal Reserve staff develops an understanding and assessment of the consolidated operations of a bank holding company and the U.S. operations of an FBO through continuous monitoring activities, discovery reviews, and testing activities, as well as through interaction with, and reliance to the fullest extent possible on, other relevant supervisors and functional regulators. The separate compliance risk management guidance endorses the principles set forth in the April 2005 paper issued by the Basel Committee on Banking Supervision entitled Compliance and the compliance function in banks. This guidance clarifies certain Federal Reserve supervisory policies regarding compliance risk management programs and oversight at large banking organizations with complex compliance profiles. The supervisory guidance on both consolidated supervision and compliance risk management is attached. http://www.federalreserve.gov/boarddocs/srletters/2008/SR0808.htm http://www.federalreserve.gov/boarddocs/srletters/2008/SR0809.htm

196 Release Date: October 16, 2008 Approval of proposal by Caja de Ahorros and Caja Madrid Cibeles For immediate release The Federal Reserve Board on Thursday announced its approval of the proposal by Caja de Ahorros y Monte de Piedad de Madrid and Caja Madrid Cibeles S.A., both of Madrid, Spain, and CM Florida Holdings, Inc., Coral Gables, Florida, to acquire 83 percent of the voting securities of City National Bancshares, Inc. and thereby acquire control of its subsidiary bank, City National Bank of Florida, both of Miami, Florida. Attached is the Board's Order relating to this action: http://www.federalreserve.gov/newsevents/press/orders/orders20081016a1.pdf Release Date: October 12, 2008 Approval of proposal by Wells Fargo & Company to acquire Wachovia Corporation For immediate release The Federal Reserve Board on Sunday announced its approval of the application and notice under sections 3 and 4 of the Bank Holding Company Act by Wells Fargo & Company, San Francisco, California, to acquire Wachovia Corporation and its subsidiary banks, Wachovia Bank, National Association, both of Charlotte, North Carolina, and Wachovia Bank Delaware, National Association, Wilmington, Delaware, and the nonbanking subsidiaries of Wachovia Corporation. Attached is the Board's Order relating to this action. http://www.federalreserve.gov/newsevents/press/orders/orders20081012a1.pdf Release Date: October 9, 2008 Statement on the efforts of Citigroup and Wells Fargo to reach an accord regarding the acquisition of Wachovia Corporation For immediate release

The Federal Reserve acknowledges the considerable efforts of Citigroup Inc. and Wells Fargo & Company to reach an accord regarding the acquisition of Wachovia Corporation.

While no agreement between Wells Fargo and Citigroup was reached, the two parties have indicated that they will no longer seek injunctive relief to prevent a transaction.

The Federal Reserve will immediately begin consideration of the filings submitted by Wells Fargo for approval to acquire Wachovia Corporation.

197 Release Date: October 7, 2008 Board issues statement concerning its approval of the proposal by Mitsubishi UFJ Financial Group to acquire voting shares of Morgan Stanley For immediate release The Federal Reserve Board on Tuesday released a Statement concerning its action of October 6, 2008, approving the application and notice under sections 3 and 4 of the Bank Holding Company Act by Mitsubishi UFJ Financial Group, Inc., Tokyo, Japan, to acquire up to 24.9 percent of the voting shares of Morgan Stanley, New York, New York, and to acquire an indirect interest in Morgan Stanley's subsidiary bank, Morgan Stanley Bank, National Association, Salt Lake City, Utah; subsidiary savings association, Morgan Stanley Trust, Jersey City, New Jersey; and subsidiary trust company, Morgan Stanley Trust National Association, Wilmington, Delaware. Attached is the Board's Statement relating to this action: http://www.federalreserve.gov/newsevents/press/orders/orders20081007a1.pdf Release Date: October 6, 2008 Approval of proposal by Mitsubishi UFJ Financial Group to acquire voting shares of Morgan Stanley For immediate release The Federal Reserve Board on Monday announced its approval of the application and notice under sections 3 and 4 of the Bank Holding Company Act by Mitsubishi UFJ Financial Group, Inc., Tokyo, Japan, to acquire up to 24.9 percent of the voting shares of Morgan Stanley, New York, New York, and to acquire an indirect interest in Morgan Stanley's subsidiary bank, Morgan Stanley Bank, National Association, Salt Lake City, Utah; subsidiary savings association, Morgan Stanley Trust, Jersey City, New Jersey; and subsidiary trust company, Morgan Stanley Trust National Association, Wilmington, Delaware. A statement discussing the approval will be released at a later date. Attached is the Board's Order relating to this action: http://www.federalreserve.gov/newsevents/press/orders/orders20081006a1.pdf

198 Joint Press Release Board of Governors of the Federal Reserve System Federal Deposit Insurance Corporation Office of the Comptroller of the Currency Office of Thrift Supervision

October 8, 2008, for immediate release

Shared National Credits Program1 Reports Large Increase in Credit Volume and Significant Deterioration in Credit Quality The volume of Shared National Credits (SNC),2 loan commitments of $20 million or more and held by three or more federally supervised institutions, rose 22.6 percent to $2.8 trillion, and the volume of criticized credits increased to $373.4 billion, or 13.4 percent of the SNC portfolio, according to the 2008 SNC review results released today by federal bank and thrift regulators. The results of the review--reported by the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision--are based on analyses prepared in the second quarter of 2008 of credit data provided by federally supervised institutions as of December 31, 2007. The record growth in credit volume is concentrated in large syndicated loans that were underwritten in late 2006 and the first half of 2007 led by the Media and Telecom, Utilities, Finance and Insurance, and Oil and Gas industry sectors. The SNC portfolio experienced nominal growth in the last half of 2007. Criticized credits3 increased $259.3 billion and represent 13.4 percent of the SNC portfolio compared with 5.0 percent in the 2007 SNC review. Credits rated special mention (potentially weak credits) increased by $167.9 billion and represent 7.5 percent of the SNC portfolio compared with 1.9 percent in the 2007 SNC review. Classified credits (credits with well- defined weaknesses) increased $91.5 billion and represent 5.8 percent of the SNC portfolio compared with 3.1 percent in the 2007 SNC review. The criticized credits and related ratios do not include the effects of hedging or other techniques that organizations often use to mitigate risk. Classified credits held by United States (U.S.) domiciled banking organizations increased to $47.2 billion from $19.2 billion, and the classified ratio increased to 4.1 percent from 2.0 percent, still low compared to the entire portfolio. Classified credits held by foreign banking organizations increased to $45.9 billion, and the classified ratio increased to 4.2 percent from 1.9 percent. Classified credits held by non-bank entities increased to $70.0 billion from $34.8 billion and represent 42.9 percent of classified credits. The volume of classified credits held by non-banks is particularly significant given their relatively small 19.9 percent share of the SNC portfolio. For the second consecutive year, the review included an assessment of underwriting standards. Examiners again found an inordinate volume of syndicated loans with structurally weak underwriting characteristics particularly in non-investment grade or leveraged transactions.

199 Table 1: SNC Commitments ($ billions) Total Commitments % Change 2001 2002 2003 2004 2005 2006 2007 2008 2007 - 2008 Substandard 87.0 112.0 112.1 55.1 44.2 58.1 69.6 154.9 122% Doubtful 22.5 26.1 29.3 12.5 5.6 2.5 1.2 5.5 373% Loss 8.0 19.1 10.7 6.4 2.7 1.2 0.8 2.6 231% Total Classified 117.5 157.1 152.2 74.0 52.5 61.8 71.6 163.1 128% Percent of 5.7% 8.4% 9.3% 4.8% 3.2% 3.3% 3.1% 5.8% Commitments Memo: Nonaccrual N/A 74.1 68.4 37.6 24.8 17.7 3.9 22.3 472% classified Special Mention 75.4 79.0 55.2 32.8 25.9 33.4 42.5 210.4 395% Total Criticized 192.8 236.1 207.4 106.8 78.3 95.2 114.1 373.4 227% Percent of 9.4% 12.6% 12.6% 6.9% 4.8% 5.1% 5.0% 13.4% Commitments Total SNC Commitments 2,049 1,871 1,644 1,545 1,627 1,874 2,275 2,789 22.6% Note: Figures may not add to totals due to rounding.

Year dates represent the official SNC review period. Credit data is collected as of December 31 and updated through the end of the annual review. Overview The 2008 SNC review included 8,746 credits totaling $2.8 trillion extended to 5,742 borrowers. Credit commitments increased by a record $514 billion, or 22.6 percent, following $401 billion growth, or 21.4 percent, in the 2007 SNC Review. This represents the largest percentage growth since 1998 and reflects the merger and acquisition financing boom that continued through the first half of 2007. Total outstandings, or drawn amounts, of $1.2 trillion were up $373 billion, or 44.6 percent, and represent 43.3 percent of commitments compared with 36.7 percent in 2007. Criticized credits rose to $373.4 billion and represent 13.4 percent of the SNC portfolio compared with only 5.0 percent in the 2007 SNC review. Special mention credits increased to $210.4 billion from $42.5 billion in 2007 and represent 7.5 percent of the SNC portfolio compared with only 1.9 percent in 2007. Special mention credits also constitute a much higher percentage of total criticized credits this year at 56.4 percent compared with 37.3 percent in 2007. A large number of special mention credits support highly leveraged merger and acquisition transactions originated in 2006 and 2007 that are characterized by weak underwriting standards. Classified credits rose to $163.1 billion from $71.6 billion and represent 5.8 percent of the SNC portfolio compared with 3.1 percent in 2007. Credits classified substandard rose to $154.9 billion from the 2007 review. The severity of the classifications increased this year with doubtful and loss credits totaling $8.1 billion compared with $2.0 billion in 2007. Nonaccrual4 classified credits increased to $22.3 billion from $3.9 billion, but represent a relatively low 0.80 percent of the total portfolio.

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Industry Trends The agencies are introducing an industry presentation format that aggregates industries vertically along product origination and distribution lines. The industry format places credits in seven primary groups, largely following the outline of the 2007 Census NAICS codes (See Appendix B). The seven primary groups are further dissected into twenty-four sectors constructed from ninety-three sub-sectors. An industry mapping file (92 KB PDF) is included as an attachment to the press release. Services is the largest group at $788 billion, or 28.3 percent of the total portfolio, and increased by 33.7 percent from 2007. Commodities is the second largest group at $597 billion, or 21.4 percent of the total portfolio, and increased 35.9 percent. Financial is the third largest group at $545 billion, or 19.6 percent of the total portfolio. Within the industry groups, sectors with the largest growth are Media and Telecom at $78 billion, or 36.4 percent, Utilities at $63 billion, or 38.3 percent, Finance and Insurance at $62 billion, or 13.2 percent, and Oil and Gas at $50 billion, or 36.2 percent. Eighteen of the twenty-four sectors experienced double digit growth rates. Criticized credits are concentrated in Services, $151.4 billion or 40.6 percent of total criticized credits, Commodities, $69.5 billion or 18.6 percent, and Manufacturers, $53.4 billion or 14.3 percent. Special mention credits constitute 70.4 percent and 78.0 percent of the criticized credits in the Services and Commodities groups, respectively, but only 24.7 percent of the Manufacturers group. The highest criticized industry groups by percentage are Services, 19.2 percent; Real Estate, 15.6 percent; and Manufacturers, 13.4 percent. Within the industry groups, the highest criticized sectors by percentage are Automotive, 41.5 percent; Commercial Services, 40.8 percent; Transportation Services, 24.3 percent; and Media and Telecom, 24.0 percent. Classified credits are concentrated in Services, $44.8 billion, Manufacturers, $40.2 billion, Financial, $29.9 billion, and Real Estate, $25.3 billion. Real Estate is the highest classified group at 11.4 percent followed by Manufacturers at 10.1 percent. Within the industry groups,

201 highly classified sectors include Automotive, 34.7 percent, Food and Drug Stores, 14.0 percent, Transportation Services, 12.4 percent, and Real Estate and Construction, 11.4 percent. Special mention credits are concentrated in the Media and Telecom sector, $47.1 billion or 22.4 percent of special mention; Materials and Commodities Excluding Energy, $27.9 billion or 13.3 percent; Commercial Services, $23.8 billion or 11.3 percent; and Utilities, $23.6 billion or 11.2 percent. Trends by Entity Type The portion of SNC credit commitments held by U.S. domiciled banking organizations declined slightly to 41.1 percent from 42.7 percent, the fourth consecutive year of decline. Holdings by foreign banking organizations declined as well to 39 percent from 41.4 percent. Holdings by non-bank organizations, such as securitization pools, hedge funds, insurance companies, and pension funds, increased to 19.9 percent from 15.9 percent. Non-bank organizations hold the largest volume and percentage of classified credits at $70 billion, or 42.9 percent of total classified credits compared with 48.6 percent in 2007. In addition, 12.6 percent of non-bank organization credits are classified compared with only 4.1 percent of the U.S. bank portfolio and 4.2 percent of the foreign bank portfolio. Although non-bank organizations continue to hold the largest dollar volume and percentage of classified credits, the growth in classified credits over the past year was evenly distributed. Classified credits held by U.S. banks increased $28.0 billion, or 145.8 percent, with foreign banks classified credits increasing $28.3 billion and non-banks classified credits increasing $35.2 billion, or 101.2 percent. SNC Underwriting The SNC Review included an evaluation of underwriting standards on approximately one thousand credits booked, or funded, in 2007. Areas evaluated included structure, repayment terms, pricing, collateral, loan agreements, and financial analysis and monitoring techniques. Examiners continued to identify an inordinate volume of syndicated loans with structurally weak underwriting characteristics, particularly for credits supporting M&A transactions of highly leveraged companies. Nearly all these credits were underwritten prior to the disruptions in the credit market in mid 2007. The most commonly cited types of structurally weak underwriting were liberal repayment terms, repayment dependent on refinancing or recapitalization, and nonexistent or weak loan covenants. Examiners also found that an excessive number of loan agreements did not provide adequate warnings and allow for proactive control over the credit. The impact of the volume of syndicated loans with structurally weak underwriting characteristics is evidenced by the rise in criticized credits this year. In fact, 56 percent of the 2007 vintage credits included in this year's underwriting review were criticized special mention or substandard compared with 21 percent last year. In addition, most of the 2006 vintage credits that were analyzed during the 2007 SNC review remain outstanding, and the criticized percentage of those credits has increased to 33 percent. The agencies have longstanding guidance, particularly through their April 2001 Interagency Guidance on Leveraged Financing, Sound Risk Management Practices, stressing the importance of prudential underwriting for leveraged financial transactions. However, examiners have found that underwriting practices are more likely to be compromised when syndicated loans are underwritten for resale versus more prudential underwriting standards used for loans held for investment. Consequently, banks that originate syndicated loans for

202 distribution should have risk management systems in place to ensure underwriting standards are reasonably consistent with underwriting standards used if holding the loan for investment. More specifically, banks should ensure underwriting practices include a comprehensive and realistic assessment of a borrower's capacity to repay or de-lever over a reasonable period of time. SNCs with structurally weak underwriting characteristics and borrower financial performance and projections that do not support the prospects of reasonable repayment will be subject to regulatory criticism by the agencies. In addition, syndicated pipeline commitments are expected to be periodically evaluated to determine if creditworthiness, pricing, and covenant structures provide reasonable protection in the event of a change in market credit risk appetite. Credit commitments that do not fit an institution's hold for investment criteria should be subjected to concentration limits and stress testing processes that evaluate a borrower's ability to perform under different economic scenarios. Appendix A Committed and Outstanding Balances (Dollars in Billions) Year Special Sub- Doubtful Loss Total Total Total Total Mention standard Classified Criticized Committed Outstanding 1989 24.0 18.5 3.5 0.9 22.9 46.9 692 245 1990 43.1 50.8 5.8 1.8 58.4 101.5 769 321 1991 49.2 65.5 10.8 3.5 79.8 129.0 806 361 1992 50.4 56.4 12.8 3.3 72.5 122.9 798 357 1993 31.7 50.4 6.7 3.5 60.6 92.3 806 332 1994 31.4 31.1 2.7 2.3 36.1 67.5 893 298 1995 18.8 25.0 1.7 1.5 28.2 47.0 1,063 343 1996 16.8 23.1 2.6 1.4 27.1 43.9 1,200 372 1997 19.6 19.4 1.9 0.9 22.2 41.8 1,435 423 1998 22.7 17.6 3.5 0.9 22.0 44.7 1,759 562 1999 30.8 31.0 4.9 1.5 37.4 68.2 1,829 628 2000 36.0 47.9 10.7 4.7 63.3 99.3 1,951 705 2001 75.4 87.0 22.5 8.0 117.5 192.8 2,049 769 2002 79.0 112.0 26.1 19.1 157.1 236.1 1,871 692 2003 55.2 112.1 29.3 10.7 152.2 207.4 1,644 600 2004 32.8 55.1 12.5 6.4 74.0 106.8 1,545 500 2005 25.9 44.2 5.6 2.7 52.5 78.3 1,627 522 2006 33.4 58.1 2.5 1.2 61.8 95.2 1,874 626 2007 42.5 69.6 1.2 0.8 71.6 114.1 2,275 835 2008 210.4 154.9 5.5 2.6 163.1 373.4 2,789 1,208

203 Appendix B5 Summary of Shared National Credit Industry Trends (Dollars in Billions) Industry 2002 2003 2004 2005 2006 2007 2008 Services Commitment 462.8 407.6 377.1 401.6 464.0 589.3 788.1 Classified 56.5 51.9 21.6 24.0 20.1 18.1 44.8 Special Mention 19.9 11.9 12.7 5.7 13.3 14.3 106.6 % Classified 12.2% 12.7% 5.7% 6.0% 4.3% 3.1% 5.7% % Special Mention 4.3% 2.9% 3.4% 1.4% 2.9% 2.4% 13.5% Commodities Commitment 395.1 345.7 312.0 325.6 364.1 439.6 597.4 Classified 35.2 55.3 32.7 18.0 18.3 10.7 15.3 Special Mention 26.7 26.7 15.2 8.9 7.6 7.0 54.2 % Classified 8.9% 16.0% 10.5% 5.5% 5.0% 2.4% 2.6% % Special Mention 6.8% 7.7% 4.9% 2.7% 2.1% 1.6% 9.1% Financial Commitment 414.4 381.6 372.7 363.2 431.1 506.3 545.2 Classified 12.0 9.5 4.2 0.9 2.1 19.2 29.9 Special Mention 4.7 3.7 0.6 0.5 2.9 3.3 13.9 % Classified 2.9% 2.5% 1.1% 0.3% 0.5% 3.8% 5.5% % Special Mention 1.1% 1.0% 0.2% 0.1% 0.7% 0.7% 2.5% Manufacturers Commitment 337.5 283.8 261.7 271.9 289.4 339.4 397.4 Classified 42.6 27.9 11.6 7.3 18.8 18.8 40.2 Special Mention 16.7 8.7 2.6 9.6 8.1 10.8 13.2 % Classified 12.6% 9.8% 4.4% 2.7% 6.5% 5.5% 10.1% % Special Mention 5.0% 3.1% 1.0% 3.5% 2.8% 3.2% 3.3% Real Estate Commitment 106.2 97.9 99.5 122.9 159.2 203.6 221.1 Classified 3.0 2.3 1.6 0.6 0.6 2.9 25.3 Special Mention 1.4 1.6 0.9 0.2 0.5 2.2 9.2 % Classified 2.8% 2.4% 1.6% 0.5% 0.4% 1.4% 11.4% % Special Mention 1.3% 1.6% 0.9% 0.1% 0.3% 1.1% 4.2% Distribution Commitment 129.7 112.0 108.7 122.3 146.1 175.7 206.9 Classified 8.0 5.4 2.2 1.7 1.5 1.9 7.5 Special Mention 9.5 2.6 0.9 1.0 0.9 4.7 13.2

204 % Classified 6.2% 4.8% 2.0% 1.4% 1.0% 1.1% 3.6% % Special Mention 7.3% 2.3% 0.8% 0.8% 0.6% 2.7% 6.4% Government Commitment 20.9 18.4 14.3 19.1 20.1 21.6 33.1 Classified 0.2 0.2 0.0 0.0 0.4 0.1 0.0 Special Mention 0.1 0.1 0.1 0.0 0.1 0.1 0.1 % Classified 0.9% 0.8% 0.3% 0.1% 1.8% 0.5% 0.0% % Special Mention 0.5% 0.5% 0.6% 0.0% 0.4% 0.2% 0.4% All Industries (Total) Commitment 1,866.7 1,647.0 1,546.1 1,626.6 1,873.9 2,275.4 2,789.2 Classified 157.5 152.4 74.0 52.5 61.8 71.7 163.0 Special Mention 79.1 55.3 32.8 25.9 33.4 42.4 210.4 % Classified 8.4% 9.3% 4.8% 3.2% 3.3% 3.2% 5.8% % Special Mention 4.2% 3.4% 2.1% 1.6% 1.8% 1.9% 7.5% Note: Figures may not add to totals due to rounding. Appendix C: Exposures by Entity Type Share of Total Commitments (%) 2001 2002 2003 2004 2005 2006 2007 2008 US Banking Institutions 46.2 45.3 45.4 46.5 44.8 44.3 42.7 41.1 Insured 43.8 42.8 42.5 43.4 41.5 40.8 38.9 37.4 Uninsured(*) 2.3 2.5 2.9 3.1 3.3 3.5 3.8 3.7 FBOs 45.4 44.8 43.8 41.6 42.1 41.5 41.4 39.0 Insured 5.0 5.1 5.4 5.5 6.0 6.2 6.4 5.1 Uninsured(*) 40.4 39.7 38.4 36.1 36.1 35.3 35.0 33.9 Nonbanks 8.4 9.9 10.8 12.0 13.1 14.3 15.9 19.9 Total Classifications ($ billion) 2001 2002 2003 2004 2005 2006 2007 2008 US Banking Institutions 48.5 53.7 43.6 18.8 11.9 13.1 19.2 47.2 Insured 43.9 47.6 37.8 16.0 8.6 9.0 13.2 38.3 Uninsured(*) 4.6 6.0 5.8 2.8 3.2 4.1 6.0 9.0 FBOs 44.0 60.0 65.0 31.3 15.5 17.3 17.6 45.9 Insured 7.3 8.4 6.8 2.8 1.5 1.6 2.3 5.1 Uninsured(*) 36.7 51.6 58.3 28.5 14.0 15.7 15.4 40.8 Nonbanks 25.0 42.1 43.6 24.0 25.0 31.5 34.8 70.0 Totals 117.5 155.8 152.2 74.2 52.5 61.8 71.6 163.1

205 Classifieds as % of Commitments 2001 2002 2003 2004 2005 2006 2007 2008 US Banking Institutions 5.1 6.4 5.8 2.6 1.6 1.6 2.0 4.1 Insured 4.6 5.7 5.1 2.2 1.2 1.1 1.4 3.3 Uninsured(*) 0.5 0.7 0.8 0.4 0.4 0.5 0.6 0.8 FBOs 4.7 7.2 9.0 4.9 2.3 2.2 1.9 4.2 Insured 0.8 1.0 0.9 0.4 0.2 0.2 0.2 0.5 Uninsured(*) 3.9 6.2 8.1 4.4 2.0 2.0 1.6 3.7 Nonbanks 14.4 22.9 24.5 13.0 11.7 11.8 9.6 12.6 Totals 5.7 8.4 9.3 4.8 3.2 3.3 3.1 5.8 Total Nonaccrual Commitments ($ billion) 2001 2002 2003 2004 2005 2006 2007 2008 US Banking Institutions n.a. 22.5 18.4 7.7 3.9 2.8 0.8 7.4 Insured n.a. 19.4 16.5 0.1 3.1 1.8 0.5 6.3 Uninsured(*) n.a. 3.1 1.9 7.6 0.8 1.0 0.3 1.1 FBOs n.a. 30.5 29.5 17.6 9.0 4.7 0.9 5.6 Insured n.a. 3.9 3.2 - 0.4 0.4 0.2 1.0 Uninsured(*) n.a. 26.6 26.3 17.6 8.6 4.3 0.7 4.6 Nonbanks n.a. 21.1 20.5 12.3 11.9 10.2 2.2 9.3 Totals n.a. 74.1 68.4 37.6 24.8 17.7 3.9 22.3 (*)Uninsured refers to organizations that do not take consumer deposits such as holding companies, brokerage firms, finance companies, etc. Note: Figures may not add to totals due to rounding

Footnotes 1. The Shared National Credit (SNC) Program was established in 1977 by the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency. In 2001, the Office of Thrift Supervision became an assisting agency. The annual program seeks to provide an efficient and consistent review and classification of shared national credits. Return to text 2. A SNC is any loan and/or formal loan commitment, and any asset such as other real estate, stocks, notes, bonds and debentures taken as debts previously contracted, extended to borrowers by a supervised institution, its subsidiaries and affiliates. Further, a SNC must have an original amount that aggregates $20 million or more and either 1) is shared by three or more unaffiliated supervised institutions under a formal lending agreement or 2) a portion is sold to two or more unaffiliated supervised institutions with the purchasing institutions assuming their pro rata share of the credit risk. Credits include syndicated loans and loan commitments, letters of credit, commercial leases, as well as other forms of credit. Credit commitments include both drawn and undrawn

206 portions of credit facilities. This release reports only the par amounts of commitments; these may differ from the amounts at which loans are carried by investors. A supervised institution is one which is subject to supervision by one of the federal bank regulatory agencies, including all FDIC-insured banks, their branches, subsidiaries, and affiliates; bank holding companies and their non-bank subsidiaries and affiliates; and federal and state-licensed branches and agencies of foreign banks. Return to text 3. Criticized credits are the total of credits classified substandard, doubtful, and loss--and credits rated special mention. Classified credits are only those rated substandard, doubtful, and loss. Under the agencies' Uniform Loan Classification Standards, classified credits have well-defined weaknesses, including default in some cases. Special mention credits exhibit potential weaknesses, which may result in further deterioration if left uncorrected. Excerpt from federal banking agencies' examination manuals defining regulatory classifications: A Substandard asset is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. An asset classified Doubtful has all the weaknesses inherent in one classified Substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Assets classified Loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value but rather that it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future. Amounts classified Loss should be promptly charged off. Excerpt from the June 10, 1993 Interagency Statement on the Supervisory Definition of Special Mention Assets: A Special Mention asset has potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution's credit position at some future date. Special Mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. Return to text 4. Nonaccrual loans are defined for regulatory reporting purposes as "loans and lease financing receivables that are required to be reported on a nonaccrual basis because (a) they are maintained on a cash basis due to a deterioration in the financial position of the borrower, (b) payment in full of interest or principal is not expected, or (c) principal or interest has been in default for 90 days or longer, unless the obligation is both well secured and in the process of collection."

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EXPLAINER $596 Trillion! How can the derivatives market be worth more than the world's total financial assets? By Jacob Leibenluft Posted Wednesday, Oct. 15, 2008, at 4:18 PM ET

Iowa Sen. Tom Harkin issued a call on Tuesday for regulation of the "over the counter" derivatives market, which has an estimated size of about $596 trillion. By contrast, the value of the world's financial assets—including all stock, bonds, and bank deposits—was pegged at $167 trillion last year by McKinsey. How can the derivatives market be larger than the entire world's financial wealth? Because the same assets might be involved in several different derivatives. A derivative is a financial instrument whose value depends on something else—a share of stock, an interest rate, a foreign currency, or a barrel of oil, for example. One kind of derivative might be a contract that allows you to buy oil at a given price six months from now. But since we don't yet know how the price of oil will change, the value of that contract can be very hard to estimate. (In contrast, it's relatively easy to add together the value of every share being traded on the stock market.) As a result, financial experts have to make an educated guess about the total amount at stake in all these contracts. One method simply adds up the value of the assets the derivatives are based on. In other words, if my contract allows me to buy 50 barrels of oil and the current price is $100, its "notional value" is said to be $5,000—since that's the value of the assets from which my contract derives. If you make that same calculation for every derivative and add those numbers together, you get something around $596 trillion—the "notional value" of the world's over-the-counter derivatives at the end of 2007, according to the Bank of International Settlements. ("Over the counter" derivatives refer to contracts that are negotiated between two parties rather than through an exchange.) But the "notional value" isn't usually a very good representation of what a contract might really be worth to the parties involved, or how much risk they are taking. (And it isn't easily compared with other measures of financial wealth—after all, owning the right to buy $5,000 worth of oil isn't the same as actually owning $5,000 of oil.) Within that $596 trillion are derivatives that effectively relate to the same assets—if you have a contract to buy euros in January and I have one to buy euros in April, we may end up buying the same currency, but its notional value will get counted twice. Moreover, in many instances, the "notional amount" is just a benchmark that never even changes hands—as in the case of the interest-rate swap, by far the most common type of derivative. Likewise, because derivatives are often used to hedge risks, there's a good probability that many contracts in the system essentially cancel one another out. An alternative way to measure the size of the derivatives market is to calculate the instruments' market value—which refers to how much they would be worth if the contracts had to be settled today. Gross market value of all outstanding derivatives was $14.5 trillion at

208 the end of 2007, less than one-fortieth of the $596 trillion estimate. (That number shrinks to about $3.3 trillion once you take into account contracts that directly offset one another.) Still, the concept of "notional value" is not entirely irrelevant. For one, growth in the notional value of all derivatives—which has gone up about fourfold in the last five years—does give a reasonable indication of how fast the market is expanding. And for credit default swaps, a derivative at the center of the current financial crisis, the growth has been especially large— with the total notional amount rising from just $2.69 trillion in 2003 to $54.6 trillion this year. Got a question about today's news? Ask the Explainer. Explainer thanks Karsten von Kleist and Carlos Mallo of the Bank of International Settlements, Richard Metcalfe of the International Swaps and Derivatives Association, Kevin Mukri of the Office of the Comptroller of the Currency, and Rene Stulz of Ohio State University. Jacob Leibenluft is a writer from Washington, D.C.

Article URL: http://www.slate.com/id/2202263/

209

From The Times Anatole Kaletsky October 16, 2008 Slash interest rates now to stave off depression More co-ordinated international action will be needed to build on the opportunity created by the bank bailout Nobody can dispute any longer, as I rashly did two months ago, that we are living through the worst financial crisis of our lifetimes. Historians can argue about the causes of the near-collapse of almost every bank in the world - a catastrophe never threatened even by the two world wars. Conventional wisdom will no doubt view it as the inevitable consequence of a decade of credit excesses and banking follies. I will continue to argue, as I have since the chronic credit squeeze turned suddenly into meltdown in September, that it was an avoidable accident, caused mainly by the blunders of one individual: Henry Paulson, the US Treasury Secretary, when he hubristically bankrupted Lehman Brothers and expropriated the shareholders of Fannie Mae. But there are far more urgent items on the political and economic agenda. The first is how to prevent the recession made inevitable by this meltdown becoming a Japanese-style “lost decade” of economic stagnation and falling prices. The second is how to fine-tune the financial rescue plans announced by all leading governments, to promote economic revival. The third is how to reform regulation and global economic governance to reflect the lessons of both the upswing and the slump. The second and third issues are rather technical but, in a nutshell, I believe that Britain has missed a crucially important issue by failing to remove the lethal distortions in regulation and accounting that were have been largely responsible for the boom and bust. Gordon Brown has also been overly punitive to bank shareholders and his terms will have to be relaxed to avoid unnecessary damage to what is still the country's most important industry. In America, by contrast, Mr Paulson has been far too generous. As a result, there must be a serious risk that his sweetheart deals with the banking industry will unravel if the Democrats win the White House and both Houses of Congress on November 4. One issue that will hang over financial markets is what happens to US financial and economic policy in the three-month hiatus between November 4 and the inauguration of the new president on January 20. But I want to focus on what must be done to prevent this recession turning into depression. Moderating the recession will require drastic changes in monetary, fiscal, financial and international policy, preferably done in concert in the world's main economies. Interest rates everywhere must be cut urgently. Central bank base rates must fall to the lowest levels in the postwar era to offset the much wider credit spreads that banks will demand for lending, even to their best customers. Governments must not be intimidated by shock-horror headlines that exaggerate the modest costs of bank rescue packages, which should mostly pay for themselves. Financial policy must ensure that government- led bailouts result in the increased lending promised to companies and households.

210 Last but not least, governments must deal with the enormous imbalances in the global economy that have been financed by the credit boom and are bound to reverse. Since the mid-1990s, most of the impetus for global growth has come from the consumer and housing booms in America, Britain and Southern and Central Europe, while the Asian economies and Germany, have relied to a disproportionate extent on export-led growth. This will inevitably change. As previously consumer-driven economies endure a period of belt-tightening, imports will weaken and exports will soar, as is happening in America. To prevent a global depression resulting from belt-tightening in countries such as the US, Spain and Britain, it is imperative that China, Japan and Germany recognise that they can no longer rely on export-led growth and redirect their economic policies to stimulate domestic consumer spending, infrastructure investment and housing. If they refuse, they will face a protectionist backlash, certainly in the US. How might these principles be translated into practice in the US and Britain? In America there will be little room for further rate cuts after the Federal Reserve Board reduces its policy rate to just 1 per cent, as it surely will this month. The top priority will be to ensure that lenders pass on the benefits of ultra-low rates to the rest of the economy. There will probably a big role for the US Government in direct lending to homeowners and businesses, and substantial revisions to the bailout deals struck by Mr Paulson this week with the private banks. The biggest policy stimulus in the US is likely to come from tax cuts and public spending, whoever wins the election. The most effective tax cuts would be directed at low-income households and these are likely after a Democrat victory. In Europe, and especially Britain, the scope for interest-rate cuts is huge. The European Central Bank is likely to move slowly, because of its federal structure, Germanic traditions and continuing upward wage pressures from powerful public sector unions. But in Britain, there is no such excuse. It is preposterous that Britain, the G7 economy most gravely threatened by the collapse of activity in housing and international finance, should have higher interest rates than the EU and the US. The Monetary Policy Committee should aim for a base rate of 3 per cent by the end of the year and 2 per cent or below, roughly in line with the US, by next summer. To show that it means business, the MPC should cut by a full percentage point in November. The only alternative would be an explosion in the government deficit, to well over £100 billion. If that were to happen in the year ahead, it would certainly be less of a disaster than increasing taxes or slashing public spending in the recession. Amid a financial crisis of the kind the world is now facing, the litmus test of fiscal prudence is not the budget deficit this year or next, but the credibility of long-term plans to put government finances on a sustainable footing. In short, Britain needs a steep rate reductions, combined with a fiscal policy that permits much bigger deficits in the short term, followed by big tax increases and spending reductions once the recession abates. Is such a programme conceivable? Recall what the Major Government did in 1992. Within three months of Black Wednesday, interest rates were cut from 12 to 8 per cent. The government deficit was allowed to expand to almost 7 per cent of national income, but the 1993 Budget set a credible course for bringing finances back into surplus by 1997. The result was a rapid economic recovery, followed by 16 years of uninterrupted growth. In the months after Black Wednesday, only the wildest optimist imagined such a golden future to be possible. In 1992 I was that wildest optimist - and today I believe that, with the right policies, a similar miracle could be repeated in the decade ahead.

211

DAVID CALLAWAY Rushing to see the apocalypse Commentary: From calling $200 oil to economic wasteland, all in three months By David Callaway, MarketWatch Last update: 12:34 a.m. EDT Oct. 16, 2008 SAN FRANCISCO (MarketWatch) -- It was still pitch black at 5:45 a.m. on Monday morning and the stock market was 45 minutes from opening as I got out of my car at the local ferry terminal on San Francisco Bay and saw an entire mountain on fire. A fast-moving blaze on Angel Island, the jewel of the bay, had engulfed more than half of the 700-acre island and created a wall of flame up to the peak of the 780-foot Mount Livermore at its center. From a mile away, I stood with friends from the boat and watched as the flames silently lit the night sky. "Looks like your portfolio," I said to one buddy, an investor who like everybody else has been scorched by the inferno raging through the global financial system in the last six weeks. The small group of commuters, mostly workers in the financial district, nodded and laughed knowingly, and then headed to the boat for the ride to work and what was expected to be another pummeling in the markets.

Yet that day turned out to be one of the best days ever for the stock market, as the Dow Jones Industrial Average (INDU INDU) soared 937 points, or the equivalent of its gains for the first 69 years of its existence, between 1896 and 1965. At times like these, where new records are set daily and five hundred and six hundred point- days in either direction are regarded as more of the same, it's easy to suspend reality and indulge in talk of new eras, ends of Wall Street and capitalism, and collapsing of empires. So it was in the aftermath of 9/11, when experts predicted a severe global depression. But a quick look at history shows that very often these grand statements and feelings are nothing but just that -- statements and feelings. In reality, not much really changes. As I check the headlines on the news sites and listen to the talking heads on TV, there is this week an overwhelming rush to describe where we're going in the worst possible terms, with

212 hundreds of thousands of job losses, industries in ruin, and frightened investors hoarding cash in safes, mattresses and lockboxes.

At the same time, I look at the price of oil today closing under $75 a barrel Sure, we're in a Wednesday and I notice how far we've come in just three months, when recession. But the price was at almost $150 a barrel and everyone from the pundits to the will it really be analysts to OPEC was predicting $200 oil, or $300 oil in the near future. as bad as In the wake of such colossal and universal misjudgment about oil prices everybody is and runaway economic growth from India to China, might we now be predicting? overshooting in our dire predictions of where the global economy is heading? Sure, we're in a recession now. And we'll be in one when the Obama administration takes over in January. But will it really be as bad as everybody is now collectively predicting? After all, when's the last time anybody remembers the world's central banks pumping $2 trillion into the global economy and the financial system? We don't know what the impact of that financial equivalent of the "surge" will be because we've never seen it before. We do know that third-quarter earnings didn't fall off the face of the earth. Some companies in the consumer sector and even in technology are still reporting pretty good numbers, albeit with vague warnings about the fourth quarter. Maybe, just maybe, this market rout is more tied to vicious hedge fund unwinding than a broad economic calamity, and perhaps it will bottom in coming days, with the tough period ahead of layoffs and closings and failures far shorter than we now expect. Like the market itself over the last few years, the economy has been revved up to hyper-speed and is now capable of changing months and years more quickly than we are used to. When oil was a sure thing to hit $200, some people made money betting the other way. Where are those bets now that a depression is the new sure thing? As I traveled home Monday evening before sunset, and witnessed the charred remains of more than half of Angel Island, I wondered how many years or decades it might take for the island to be what it once was. Yet the next day's paper quoted experts saying that the grass will begin growing with the rains this winter and that by the spring it should be largely back to normal. One guy said it will look like a golf course before the end of the year. And just as growth will return to Angel Island much sooner than its smoldering ruins suggest today, our economy and way of life will rebound long before we can possibly imagine right now as we stand before the flames. David Callaway is editor-in-chief of MarketWatch.

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Stocks Sink as Gloom Seizes Wall St. Bernanke Forecasts Prolonged Economic Turmoil; Dow Plunges 7.9%

By David Cho and Ylan Q. Mui Washington Post Staff Writers Thursday, October 16, 2008; A01

Troubling new signs of a deep economic malaise touched off some of the worst stock market losses in history yesterday, a day after the government announced a massive intervention that officials hoped would boost investor confidence. New data showed that consumers stayed away from malls, nixed plans for new cars and made do with old clothes in September, forcing the largest monthly decline in retail sales in three years. Federal Reserve Chairman Ben S. Bernanke added to the gloom, cautioning that the nation should not expect an economic rebound any time soon. The Dow Jones industrial average fell 733.08, or 7.9 percent, its second-biggest point drop in history, while the Standard & Poor's 500-stock index, a broader measure, sank 90.17 points, or 9 percent, the most since the crash of 1987, infamously dubbed Black Monday. The sell-off spread to Asia today, with Japan's benchmark Nikkei average falling as much as 10 percent in early trading. The market declines came after the Treasury Department said it would spend at least $250 billion to take ownership stakes in financial firms and insure most forms of bank debt. Officials had hoped those measures would calm investors' nerves and heal the crippled financial system. Bernanke said, "the turmoil in financial markets and the funding pressures on financial firms pose a significant threat to economic growth." His remarks appeared to signal that the central bank was open to lowering its benchmark interest rate, which it cut just last week to 1.5 percent. The credit crisis has penetrated so deeply into the American psyche that consumers, whose spending is the most important component of economic activity, have become too scared to shop. "The consumer has been hit over the head by so many two-by-fours that the consumer may end up going into a coma here," said Brian Bethune, chief U.S. financial economist for consulting firm Global Insight. "How do you bring them back?" The rate banks charge each other for loans, a critical gauge of whether the government's proposal is working, has barely shown any improvement since the Treasury's new plan was unveiled. This rate, known as the London interbank offered rate, or Libor, remains higher than it was a week ago and about 61 percent higher than a month ago. Joseph Stiglitz, a Nobel Prize-winning economics professor at Columbia University, said it was a "mystery" why Libor didn't drop after the government guaranteed lending between banks.

214 "Clearly, there still is some uncertainty . . . about the terms of the guarantee," said Stiglitz. "There could be uncertainty about the speed of collection. For someone in the market, that could be very worrying. We don't know how much of a "It is nearly impossible for companies to fully counteract a complete pullback in consumer spending," said Rosalind Wells, chief economist for the National Retail Federation, a trade group. At the Regency Furniture store in Largo yesterday afternoon, the storeroom was empty but for two customers, Gerald Dyiches and his girlfriend, who were looking for a dining room set and sofa for their apartment. Outside the store, giant signs blared, "No Credit . . . No Problem" and "Instant Approval. Everyone Qualifies!" n injection is really required. There are a lot of unanswered questions." Japanese Prime Minister Taro Aso said today that the U.S. bank bailout is "insufficient" and is contributing to the renewed plunge in global stock markets, the Associated Press reported. Aso told Japanese lawmakers that continued market volatility suggests more action is needed but did not elaborate, AP reported. U.S. regulators pleaded for patience yesterday, saying it would take time for the effects of the government's actions to work their way through the financial system. "Stabilization of the financial markets is a critical first step, but even if they stabilize as we hope they will, broader economic recovery will not happen right away," Bernanke said in a speech to the Economic Club of New York. "Economic activity will fall short of potential for a time." Bernanke also raised concerns that the banking industry has become overly consolidated as big financial institutions have collapsed or been swallowed up by one another during the crisis. Now the nation may have a "too-big-to-fail problem," in which the collapse of any of the big banks could threaten the entire system. Despite his grim outlook, Bernanke also attempted to inspire confidence in the government's response to the crisis. "Americans can be confident that every resource is being brought to bear to address the current crisis," he said. "We now have the tools we need to respond." After meeting with small-business owners yesterday in Ada, Mich., President Bush also put a good face on the worsening crisis. "I'm optimistic that we're going to come through it," Bush told reporters. "I'm realistic about how tough the situation is . . . and I believe when we come through it, we're going to be better than ever." But several key reports pointed to serious trouble ahead for the economy. Three of the nation's largest banks reported that consumers are having increasing difficulty paying off their credit card debt and more are going into default. Meanwhile, economic activity weakened across every region of the country last month as businesses and consumers pulled back, the Fed said in its monthly state of the economy, known as the "beige book." Labor market conditions also deteriorated, though the Fed noted that inflation moderated in some areas. The U.S. Commerce Department yesterday released data that underscored how broadly shoppers have pulled back. Retail sales in September -- which cover everything from sofas to sporting goods -- dropped 1.2 percent compared with the previous month. Auto dealers were

215 the biggest drag, with their sales falling 4.2 percent, followed by sales at furniture and clothing stores. "They have really good terms, but I'm going to look around some more," said Dyiches, manager of a local Outback Steakhouse. William Cook, a retired shipping and receiving manager for Chevrolet, has already started scaling back his holiday shopping plans. "I'm slowing down my spending, careful about my shopping, not buying clothes or prime ribs or lobster or steaks," said Cook, who has seen the price of his GM stock -- a significant part of his portfolio -- plummet nearly 80 percent in the past year. The auto industry was particularly hard hit last month. Demand for new vehicles was drying up, and loans were more difficult to come by for those who were in the market. Compared with September 2007, sales at auto dealers were down 20 percent, the Commerce Department said. The only two categories in the department's report that posted gains last month were gas stations and health and personal-care stores, and even they rose less than half a percentage point. For the third quarter, consumer spending is expected to decline for the first time in 17 years. New York University economics professor Nouriel Roubini, who had long been predicting a housing downturn that would trigger a recession, said he expected an economic slowdown to last 18 to 24 months. The average recession is about 10 months, he said. "It's not going to be short and shallow," Roubini said. "The macro news from now on is going to be really awful." Shares in many companies with ties to credit markets declined this week. Investors drove down the price of Domino's Pizza stock by 32.8 percent after the company disclosed Tuesday that Lehman Brothers had been the primary part of a $150 million credit facility the chain had lined up. But Domino's chief executive David Brandon said that the pizza company had enough cash and that the credit facility was "untapped and unused." "The materiality of that to my company is like a spit in the tea of life," Brandon said. "People are very spooked, and it's almost unnerving to me that the reflexes of the market are such that all we had to do is mention the word Lehman and our stock is being pounded as though we relied on them." Staff writers Peter Whoriskey, Lori Montgomery, Steven Mufson, Binyamin Appelbaum, Anita Huslin, Dan Eggen and Heather Landy in New York contributed to this report.

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Fear Again Takes Over the Markets Stocks Plunge, Nearly Wiping Out Monday's Gains, as Signs of Recession Grow Stronger By Renae Merle Washington Post Staff Writer Thursday, October 16, 2008; D01 Investors fled stocks again yesterday as a wave of grim economic data hit the market and set off a stampede to the exits in the final hour. The Dow Jones industrial average nearly wiped out Monday's historic 936-point rally, falling 7.87 percent, or 733.08, to close at 8577.91. It was the second-largest point loss in the Dow's more than 100-year history, ninth-largest on a percentage basis. The Standard & Poor's 500-stock index, a broader measure widely watched by market professionals, was off 9 percent, or 90.17, to close at 907.84. It was its largest loss on a percentage basis since the 1987 crash. Three of the S&P's 10 largest percentage losses have come in the past month. The tech-heavy Nasdaq composite index was down 8.47 percent, or 150.68 points, to close at 1628.33. Wall Street's tumble followed sharp declines in Europe. London's FTSE 100 and the CAC 40 in Paris were down about 7 percent, and Germany's DAX fell 6.5 percent yesterday. The losses spread to Asia today, as stocks in Japan fell 10 percent in early trading and South Korea's currency dropped as much as 12 percent against the dollar. After Monday's U.S. rally, analysts expected some selling as traders took profits but had hoped that investors would find comfort in the latest government attempts to stabilize the financial sector. But credit markets remained tight despite the efforts. Investors focused on a bleak consumer spending report from the Commerce Department for September which reinforced fears that the country is slipping into a recession. Consumer spending makes up two-thirds of economic activity, and analysts now predict a dismal holiday season in the malls. Retail sales were down 1.2 percent in September, the steepest monthly decline in three years. "I think anybody who expects retail sales or consumer sentiment to be positive is delusional. The expectations were bad, and they were met," said Matt McCormick, portfolio manager and banking analyst at Bahl & Gaynor Investment Counsel. Also, wholesale prices fell 0.4 percent in September, according to the Labor Department. But excluding food and energy, wholesale prices rose by 0.4 percent. Investors' concerns were reinforced by the Federal Reserve's release of its "beige book," information about the economy from its 12 regional banks, which found economic activity weakening and manufacturing slowing in most places. Fed Chairman Ben S. Bernanke also said that government efforts to rescue the economy will not work immediately. "Despite the good news as far as [the government] addressing the problems, the market doesn't have a feel for how low low is and how deep the recession will be," said John Wilson, co-director of equity strategy at Morgan Keegan, a Memphis investment firm. "As much as I am itching to step in here, I don't know whether it's here or 500 points below here."

217 Investors have also grown nervous about a flood of grim earnings reports. J.P. Morgan Chase and Wells Fargo both managed to turn a profit in the third quarter, but their balance sheets showed the impact of the financial crisis. J.P. Morgan's profit tumbled 84 percent, to $527 million, during the quarter. It was dragged down by the cost of its acquisition of Washington Mutual, increasing losses from mortgage investments and boosting its loan-loss reserves. Wells Fargo recorded profit of $1.64 billion, down nearly 25 percent from the year-ago period. J.P. Morgan closed down 5.5 percent, at $38.49. Wells Fargo was down 0.5 percent at $33.35. Expectations that the economic slump would continue to hurt demand pushed oil prices down again yesterday. A barrel of light, sweet crude fell 5.2 percent, or $4.09, to $74.54 on the New York Mercantile Exchange. This is the first time crude oil has closed below $75 a barrel since August 2007. Some analysts now expect prices to fall as low as $50 a barrel this year. Correspondent Blaine Harden contriuted to this report from Japan.

218 Economy

October 16, 2008 Markets Suffer as Investors Weigh Relentless Trouble By PETER S. GOODMAN Stock markets plunged anew on Wednesday, nearly wiping out the record gains of Monday and sending another wave of wealth destruction washing over American households. The government’s rescue of the banks has been widely embraced, but the frenzied selling, which pushed the Dow Jones industrial average down 733 points, underscored how the economy’s troubles are too broad to be fixed by the bailout of the financial system. Investors are recognizing that the financial crisis is not the fundamental problem. It has merely amplified economic ailments that are now intensifying: vanishing paychecks, falling home prices and diminished spending. And there is no relief in sight. Wednesday’s rout began in the morning with the latest evidence of the nation’s economic deterioration — reports showing that retail spending slipped in September and broader signs of a pullback among suddenly thrifty American consumers. Selling picked up momentum in the afternoon as the Federal Reserve’s chairman, Ben S. Bernanke, cautioned Americans that the bailout would not swiftly lift the economy and that continued weakness was certain. “Stabilization of the financial markets is a critical first step, but even if they stabilize as we hope they will, broader economic recovery will not happen right away,” Mr. Bernanke said in a speech to the Economic Club of New York. “Economic activity will fall short of potential for a time.” By day’s end, the Dow had surrendered most of Monday’s 936-point gain, dropping 7.87 percent. The broader Standard & Poor’s 500-stock index was down 9 percent, and the technology-heavy Nasdaq was down 8.47 percent. Expectations that a worldwide slowdown will reduce demand for oil pushed prices below $75 a barrel. Signs of improvement continued in the credit markets, making it somewhat easier for companies and states to secure financing, but interest rates remained elevated. Mr. Bernanke’s remarks — offered in the sober tones of a man cognizant that a stray syllable may prompt the loss of more billions on Wall Street — underscored the reality that the economy’s troubles go well beyond the financial crisis. The United States and many other major economies are almost certainly headed into a slog through economic purgatory, one that could last many months. “People have focused so much on the immediate financial crisis that they haven’t realized how much the real economy is going down, largely independently,” said Dean Baker, co- director of the Center for Economic and Policy Research in Washington. “I don’t think there’s a way we can get out of this without a full-fledged recession and a lot of people losing their jobs. All we can really talk about is ameliorating it, making sure the people who are hit have support.”

219 On Monday, as the Dow posted its fifth-largest one-day percentage gain in history, some investors found quantifiable proof that the crisis was solved. Yet an unpalatable historical detail complicated that idea: The four previous largest percentage gains occurred from October 1929 to March 1933, in the early days of the Depression. Then, it must be noted, the markets swung far more widely than they do in this era, and an epic collapse would still be required to bring the United States anywhere near a comparable depression. Mr. Bernanke, a leading academic expert on the Depression, offered pointed assurances that no repeat of that disaster would unfold on his watch. The Fed stands ready to use all its tools to battle the financial crisis, he said. He exuded confidence that the American economy “will emerge from this period with renewed vigor.” But when? Mr. Bernanke could not say. That uncertainty added to the gnawing worry gripping the economy. “Ultimately, the trajectory of economic activity beyond the next few quarters will depend greatly on the extent to which financial and credit markets return to more normal functioning,” he said. Strikingly, Mr. Bernanke expressed concern about how huge amounts of capital are increasingly concentrated in a handful of enormous financial institutions. “The real concern that we have is that we have got and developed, in this country, a very serious ‘too big to fail’ problem,” Mr. Bernanke said. “And that problem, we’ve just recognized now in the current situation, how severe it is.” It seemed a curious concern for a man whose central bank has worked with the Treasury to engineer a series of shotgun corporate weddings, such as Bank of America’s purchase of Merrill Lynch and JPMorgan Chase’s acquisition of Bear Stearns — deals that have further concentrated money in fewer hands. Mr. Bernanke’s prognosis and the latest carnage on Wall Street lent urgency to the debate over what the government should do now to soften the blow to the economy. In Washington, and on the campaign trail, conversation centers on putting together a second round of so-called government stimulus spending, following the $152 billion unleashed this year via tax rebates to households and tax cuts for businesses. Democrats in the House are drafting a roughly $150 billion package of spending measures aimed at spurring the economy, according to senior aides, including aid for states, large-scale construction projects to generate jobs and the expansion of unemployment benefits. Senator Barack Obama of Illinois, the Democratic presidential nominee, is urging $175 billion worth of relief measures. The Republican nominee, Senator John McCain of Arizona, has declined to outline his own proposal, though his senior economic adviser, Douglas Holtz-Eakin, said he is “open to any measure that genuinely stimulates the economy.” Republicans on Capitol Hill have emphasized tax cuts for businesses in any stimulus package, a stance that puts them at odds with Democrats, though recent signs suggest greater potential for a compromise. “We need fiscal stimulus,” said Douglas W. Elmendorf, a former Treasury and Federal Reserve Board economist, and now a fellow at the Brookings Institution in Washington. “The outlook is much darker than it was even a few months ago.”

220 The checks the government sent to households last summer appear to have kept the economy growing, but economists are skeptical such a course could work again. “The spend rate will be really low because people are scared to death,” Mr. Baker said. When economists met with House leaders on Monday to suggest a course, the favored means appeared to be aiding state and local governments, whose property tax revenues are diminishing as home values fall. Local governments are a crucial source of employment and social services relied upon by the poor. “The states are taking steps right now that are deepening the recession, through no fault of their own,” said Jared Bernstein, senior economist at the Economic Policy Institute in Washington. “They’re forced to either raise taxes or cut services. Neither of those are where we need to be right now.” The crisis on Wall Street has sown fears that banks would hold tight to their dollars and starve the economy of capital, preventing businesses from securing finances to hire people and expand. If the bailout succeeds in restoring confidence, that should eventually get money flowing and lift economic activity. But regardless of Wall Street’s travails, a broader set of difficulties has been taking money out of the economy, putting the squeeze on American households and businesses. The economy has lost 760,000 jobs since the beginning of the year, and millions of workers have seen their hours cut, shrinking paychecks just as plunging real estate prices prevent households from borrowing against the value of their homes. In short, American spending power is declining, and this has become a downward spiral: As wages shrink, workers spend less, and that limits demand for workers at the businesses that once captured their dollars. Many economists now assume that unemployment, currently at 6.1 percent, will climb to 9 percent by the end of next year. Some now envision it could reach 10 percent — a level not seen in 25 years. “At this point, the thing has probably just got to play out,” said Martin N. Baily, a chairman of the Council of Economic Advisers under President Bill Clinton and now a fellow at the Brookings Institution. “I don’t know that there’s anything that we can do to avoid a mild recession. The question is what can we do to avoid a very severe recession.” Peter S. Goodman contributed reporting.

221 Economy

October 16, 2008 Home Prices Seem Far From Bottom By VIKAS BAJAJ The American housing market, where the global economic crisis began, is far from hitting bottom.

Home prices across much of the country are likely to fall through late 2009, economists say, and in some markets the trend could last even longer depending on the severity of the anticipated recession. In hard-hit areas like California, Florida and Arizona, the grim calculus is the same: More and more homes are going up for sale, but fewer and fewer people are willing or able to buy them. Adding to the worries nationwide are rising unemployment, falling wages and escalating mortgage rates — all of which will reduce the already diminished pool of would-be buyers. “The No. 1 thing that drives housing values is incomes,” said Todd Sinai, an associate professor of real estate at the Wharton School at the University of Pennsylvania. “When incomes fall, demand for housing falls.” Despite the government’s move to bolster the banking industry, home loan rates rose again on Tuesday, reflecting concern that the Treasury will borrow heavily to finance the rescue.

222 On Wednesday, the average rate for 30-year fixed rate mortgages was 6.75 percent, up from 6.06 percent last week. While banks are moving aggressively to sell foreclosed properties, the number of empty homes is hovering near its highest level in more than half a century. As of June, 2.8 percent of homes previously occupied by an owner were vacant. Nearly 1 in 10 rentals was without a tenant. Both numbers are near their highest levels since 1956, the earliest year for which the Census Bureau has such data. At the same time, the number of people who are losing jobs or seeing their incomes decline is rising. The unemployment rate has climbed to 6.1 percent, from 4.4 percent at the end of 2007, and wages for those who still have a job have barely kept up with inflation. In New York and other cities that rely heavily on the financial sector, economists expect that job losses will increase and that pay heavily tied to year-end bonuses will decline significantly. One reliable proxy of housing values — the ratio of home prices to rents — indicates that in many cities prices are still too high relative to historical norms. In Miami, for instance, home prices are about 22 times annual rents, according to analysis by Moody’s Economy.com. The average figure for the last 20 years is just 15 times annual rents. The difference between those two numbers suggests that a home valued at $500,000 today might be worth only $341,000 based on the long-term relationship between prices and rents. The price-to-rent ratio, which provides one measure of how much of a premium home buyers place on owning rather than renting, spiked across the country earlier this decade. It increased the most on the coasts and somewhat less in the middle of the country. Economy.com’s calculations show that while it remains elevated in many places, the ratio has fallen sharply to more normal levels in places like Sacramento, Dallas and Riverside, Calif. The current housing downturn is much more national in scope and severe than any other in the postwar period, partly because of the proliferation of risky lending practices. Today, foreclosures are running ahead of the downturn in the economy, a reversal of previous housing slumps. “We are in uncharted waters,” said Brian A. Bethune, an economist at Global Insight, a research firm. Colleen Pestana, a real estate agent in Orange County in California, said many people losing their homes in Southern California used to work at mortgage and real estate companies. Many of them bet heavily on real estate by upgrading to bigger houses every few years. Now, many are losing their homes. At the same time, Ms. Pestana said, her clients who are looking to buy are having a harder time lining up financing. One of her clients recently had to give up on a home after the lender that had offered a pre-approved loan changed its mind — a frequent occurrence, according to real estate agents and mortgage brokers. “I am working harder than I have ever had to work to get a deal together and keep it together,” said Ms. Pestana, who has been a real estate agent for seven years. To cushion themselves from potential losses if homes lose value, Fannie Mae and Freddie Mac, the mortgage finance companies that the government took over in September, have increased fees on loans made to borrowers who have good but not excellent credit records, even those who are making down payments as big as 30 percent.

223 Those higher fees are generally invisible to borrowers because banks factor them into mortgage interest rates. While the national average rate for a 30-year fixed-rate mortgage is now 6.75 percent, according to HSH Associates, mortgage brokers say the rates for many borrowers in the Southwest or Florida can be as high as 8 percent, especially for so-called jumbo loans that are too big to be sold to Fannie Mae and Freddie Mac. (Those loan limits vary by area from $417,000 to roughly $650,000.) Higher interest rates result in bigger monthly payments, pricing some potential buyers out of the market. For example, monthly payments are $2,700 on a 6 percent 30-year, fixed-rate loan of $450,000. If the interest rate rises to 7 percent, those monthly payments jump to $3,000. All things being equal, when rates rise prices generally fall. This month, Fannie and Freddie canceled a fee increase that would have applied to markets where home prices are falling, but the companies still have many other fees in place. In an effort to help drive down rates, the Treasury Department has announced plans to buy mortgage-backed securities issued by Fannie and Freddie. The government also recently increased the amount of loans the companies can buy and hold. Still, those efforts will take time to have an impact and it is not clear whether they will be sufficient to get banks to lend more freely, especially in areas where jumbo loans make up a bigger percentage of lending, like New York and parts of California and Florida. Economists say that prices in those places will probably fall further. In some of those places, price declines are being driven by a sharp increase in sales of foreclosed homes. Hudson & Marshall, a Dallas-based auctioneer that holds sales for lenders, reports that banks are accepting prices that they refused to consider just 12 months earlier. In a recent auction of 110 foreclosed homes in the Las Vegas area, for instance, the auctioneer’s clients accepted 90 percent of the bids submitted by buyers, up from 60 percent a year earlier, said David T. Webb, a co-owner of the company. Single-family home prices in Las Vegas have already fallen 34 percent from their peak in the summer of 2006, according to the Standard & Poor’s Case-Shiller home price index. Prices in San Diego have fallen 31 percent since late 2005. While those declines have been painful to homeowners in those cities, economists said the quick decline might help the markets reach bottom faster than in previous housing cycles, said Edward E. Leamer, an economist at the University of California, Los Angeles. In a previous boom, home prices peaked in the Los Angeles area in 1990 but did not hit bottom until 1996. Prices remained near that low for more than a year before starting to climb again. “In some areas of California, we are really at appropriate levels,” Mr. Leamer said of current home prices. But he added: “The risk is that we are going to get some overshooting, meaning that prices will be lower than they ought to be.” In Florida, Jack McCabe, a real estate consultant, said that while some cities, like Fort Myers, are showing tentative signs of a rebound, others like Miami and Fort Lauderdale are still under pressure. Two homes on his street in Fort Lauderdale that sold for about $730,000 apiece in 2005 recently sold for $400,000 — a 44 percent decline. “The rocket has run out of fuel, and now it’s plunged back down to earth,” he said. Tara Siegel Bernard contributed reporting.

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Fair Value vs. 'Alice in Wonderland' Accounting: SEC Eases Rules • Oct 16 Bloomberg: SEC agreed to back an effort by banks that may delay writedowns on perpetual preferred securities--> Banks in certain cases may account for perpetual preferred securities as debt, allowing them to postpone writing down their value. o Proponents of fair value, including FASB, say fair-value adds to transparency and gives investors more information about publicly traded companies. FASB agreed Oct. 10 to offer companies guidance on valuing assets in inactive markets, without changing the current rule. o Fed Board: The further a security is repackaged away from a simple pass-through RMBS, the less its value depnds on the underlying cash-flow rather than on credit enhancement and inherent leverage o IIF proposal May 22 (via Lex): Use of mark-to-market accounting for illiquid assets should be replaced by historical accounting; banks should be freed from the requirement to hold them to maturity and should be able to sell assets after two years--> Goldman threatens to leave IIF upon 'Alice-in-Wonderland' accounting proposal. IIF modifies its language since then. Final IIF draft due July. o WSJ May 28: SEC's Cox (=chairman of IOSCO) against industry calls for watering down fair- value accounting. Pushes for international accounting standard. o Financial Stability Forum: Recognize and write down non-performing assets aggressively and immediately for a fresh start, even at the cost of government intervention. Increase in transparency is priority to establish confidence--> Guha (FT): One idea discussed at FSF is simultaneous disclosure to avoid stigma. o IMF GFSR: The weaknesses arising from the use of fair value in a crisis need to be addressed: e.g. reconsider 'trigger' thresholds of market value CDOs. o Zielke, Starkie, Seeberg (EFRAG TEG): If requirements for a liquid and orderly financial market are not met, then mark-to-market price is erratic and does not reflect fair value. To do: adopt a six- or 12 month average price as a reference price for writedowns. o PWC/Deloitte (via FT): If investors believe an asset or entity is technically undervalued that's a buying opportunity. o Gross (Slate): No one in the industry complains when markets are irrationally optimistic as in 2003-2006. Volatile and 'irrational' markets are nevertheless real. o Adrian/Shin (Fed/Princeton): In today's market-based financial system where emphasis is on trading rather than hold to maturity, shocks are not transmitted through the system primarily via defaults (naive domino model of contagion), but through market price movements and resulting changes on balance sheets--> credit spreads and prices do not reflect credit risk alone but also liquidity and market risk. o Allen/Carletti (Wharton): In times of stress asset prices in some markets may reflect the amount of liquidity available in the market rather than the future earning power of the asset. Mark-to-market accounting is not a desirable way to assess the solvency of a financial institution in such circumstances. o Economist: For all its pain, mark-to-market is still the best way to value businesses: Under historic-cost accounting the banks had every reason not to restructure assets, because that meant owning up to their losses (see Japanese experience)--> Regulators could ease mark-to-market issues by requiring thicker capital buffers or forcing securitized asset trading on exchanges.

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News October 15, 2008, 9:39PM EST The Feds' Next Step After Rescuing Banks Many argue that after the $250 billion bank capital injection the government must then stem the surge in foreclosures By Jane Sasseen The financial system, perhaps, has been saved. Now, what about homeowners? So far, attempts to slow the foreclosure epidemic at the center of the crisis have had little impact. Despite "voluntary" industrywide efforts to rework troubled mortgages—efforts that Treasury Secretary Henry Paulson jawboned banks and mortgage servicers into undertaking last fall—the numbers continue to soar. In 2008 some 1.69 million homeowners will lose their houses—double the rate of two years ago, says Rod Dubitsky, managing director for asset- backed securities at Credit Suisse (CS). He thinks 3.6 million more foreclosures could pile up through 2012. Both Presidential candidates now want the federal government to take a more active role in buying up troubled mortgages and helping homeowners refinance with more affordable loans. Congress has also insisted the Treasury do more. But many of the proposals, which are based on the Depression-era Home Owners' Loan Corp., are likely to run into the same legal woes that have stymied mortgage workouts so far. The government may have to find a more extreme legal solution to get mass workouts going. The reason: No one has figured out how to untie the Gordian knot created by the mass securitization of mortgage loans. Hundreds of investors may own an interest in the trust that holds any given mortgage. If a loan is reworked, some of those investors would lose more than others. In many cases, mortgage servicers are prohibited from modifying a pool of loans without the consent of two-thirds of the investors; often, the servicers also earn more in foreclosure than in reworking a loan. "The servicer or the lender needs more flexibility to reach a rational economic decision," says John L. Douglas, chair of the banking and financial institutions group at law firm Paul, Hastings, Janofsky & Walker. What might that mean? Douglas thinks servicers need protection from investor lawsuits. But others say the government may have to nullify or supersede some of their obligations or investors' rights. To give securities holders more incentive to loosen the trust rules that govern them, Georgetown University Law Center associate professor Adam Levitin argues that Congress could reduce the favorable tax status for trusts that don't go along. Or, he says, what's known as the Gold Clause could be invoked. Under this New Deal-era legal precedent, the government, citing the need to preserve gold because of the economic emergency, abrogated private contracts that required payment in bullion. Washington could use the Gold Clause to give trusts leeway to modify mortgages. Those tactics could spark enormous litigation, however. Uncle Sam might also have to reimburse investors for lost value. That's why many argue it would be better for Congress to change the bankruptcy laws. Currently, homeowners who go belly-up cannot renegotiate their mortgages in court. Democrats have tried to alter the law so bankruptcy judges can trim

226 interest or principal. "It gets around the biggest impediment to workouts without costing taxpayers a penny," says Jaret Seiberg, an analyst for the Stanford Group brokerage. Republicans have blocked the effort, arguing that if courts were granted these new powers, lenders would see their losses soar and pass the cost on through pricier mortgages. But should foreclosures continue to skyrocket—and should Barack Obama, who backs the bankruptcy measure, be elected President—mortgage holders could find themselves on the losing end of the battle.

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Commentary Get Used To It Richard Sylla 10.15.08, 2:00 PM ET Banking has been a highly politicized business throughout American history. With the U.S. Treasury now planning to inject $250 billion of equity capital into our banks, the business may well become even more politicized. A quick review of what we have learned from past episodes of politicized banking might therefore be in order. The very first U.S. bank, the Bank of North America in Philadelphia, was chartered by Congress in 1781 at the behest of Robert Morris, the superintendent of finance, to help fund the American Revolution. Morris used the proceeds of a French loan to buy most of the bank's shares for the national government. Several states, doubting that Congress had the authority to charter a bank, blessed the venture with charters of their own. Pennsylvania's legislature revoked the bank's charter in the mid- 1780s, forcing it to obtain one from Delaware to continue in business. But the bank was able to secure a more restrictive charter from Pennsylvania a couple of years later. From that time to now, banking has been a political issue between U.S. states as well as between the states and the federal government. Treasury Secretary Alexander Hamilton in 1790 recommended that Congress charter a Bank of the United States as a national and proto-central bank. Federalist majorities enacted the plan, which called for the bank to have 20% government ownership. But the Republican opposition, led by Congressman James Madison and Thomas Jefferson, the secretary of state, advised President Washington that the measure was unconstitutional. Hamilton effectively countered their arguments, and Washington signed the bill into law. The bank became an effective institution, aiding federal finances and opening branches in several states so that the country had interstate banking. That would not last. In 1811, on the negative vote of the vice president breaking a tie in the Senate, the bank's charter was allowed to lapse. Some states-rights proponents still thought a federal bank was unconstitutional. More important was the opposition of many state-chartered banks, some of which were partly owned by states, and state legislators representing the banking interests. These interests reasoned that, with the federal bank gone, they would both get rid of a regulator and get the federal government's banking business. It was just the wrong time to abandon a central bank. A year later, the War of 1812 broke out, and the absence of the national bank made war finance difficult, which reduced the effectiveness of U.S. military efforts. At least a lesson was learned. Right after the war, Congress chartered a second Bank of the United States, with many of the first bank's opponents, including President Madison, becoming staunch supporters of the new central bank. After a rocky start connected with post-war deflation, the second bank gave the country financial stability during the Era of Good Feeling in the 1820s and the early 1830s. Once again, it did not last. President Andrew Jackson vetoed Congress's re-charter of the second bank in 1832, and it ceased to be America's central bank in 1836. The reasons were the same ones as in 1811. Jackson thought the bank was an unconstitutional conferral of special privileges on elites. And the 700 or so state banks once again reasoned that they would benefit by getting rid of a central-bank regulator and getting the federal government's banking

228 business. Jackson pleased them by removing government deposits from the second bank and placing them in state "pet banks" friendly to his Democratic party. Without a central bank, the country immediately plunged into a protracted period of financial instability. There were bank panics in 1837 and 1839. As land and other asset prices plunged, state revenues declined, and by 1842, nine states had defaulted on debts incurred to build transportation and financial infrastructures. Congressmen from those states asked for a federal bailout, but Congress voted down that proposal. Aided by investment in railroads and gold discoveries in California, the U.S. economy recovered from the Jackson-inspired financial disaster. But the country's currency was a mess, with each of some 1,500 banks issuing several denominations of individual bank notes. Counterfeiting was rife. And the system was unstable, with several minor crises and a major financial panic in 1857. The Civil War provided an opportunity for Abraham Lincoln's administration to bring some order out of the chaos. In 1863 to 1864, Congress passed National Currency and Banking acts to create the National Banking System of federally chartered national banks. These banks would issue a uniform national currency backed by U.S. government bonds, which not so incidentally aided the war effort by enlarging the demand for those bonds. State bank notes were taxed out of existence in the hope that all banks would be forced into the national system. That didn't work because some state banks, preferring laxer state regulation, abandoned note issuing and continued as deposit banks. This was the origin of our so-called dual banking system of federal- and state-chartered banks. By the early 20th century, the U.S. had by far the largest banking system of any country. Its more than 20,000 individual banks held more than 40% of the world's bank deposits. What the U.S. lacked was a central bank, having abandoned that concept in the 1830s. As a result, the world's largest economy was prone to financial instability. Major banking panics occurred in 1873, 1884, 1893 and 1907, in part because there was no lender of last resort to provide liquidity during bank runs. After the panic of 1907, in which private banker J. P. Morgan acted as a one-man central bank, Congress studied other countries' financial systems and created a new central bank, the Federal Reserve System, in 1913 to 1914. The Fed made major mistakes in the Great Depression of the 1930s and the Great Inflation of the 1970s, but the U.S. had far fewer financial crises under the Fed than it did when there was no central bank. Something like the current Treasury plan for capital injections into banks occurred in the Great Depression. President Hoover established the Reconstruction Finance Corp. in 1932 to lend to distressed banks and other businesses. In 1933, President Roosevelt expanded that mandate to authorize the RFC to invest in preferred stock in banks. From then until 1935, the RFC purchased approximately $1.3 billion of such preferred stock in approximately 6,000 banks. As a percent of gross domestic product then, this was roughly equivalent to the current $250 billion plan. Along with FDIC deposit insurance that came in at the same time, the 1930s injections did stabilize the banking system. There were far fewer bank failures after 1933 than before. It's clear from this review of government involvement in banking over the course of U.S. history that the current interventions are not without precedents extending back more than two centuries. We don't like our governments to be involved in banking, fearing that it such involvement will politicize what should be economic and business matters.

229 Secretary Paulson this week blurted out that he wished he didn't have to take the actions he was taking, but he saw no reasonable alternative. Government finance and banking are both part of an integrated U.S. financial system. They can't avoid being heavily involved with each other. It has been that way from the birth of our country. We might as well get used to it. Richard Sylla is the Henry Kaufman professor of the history of financial institutions and markets and professor of economics at the Stern Business School at NYU.

230 Hedge Funds Engage in Firesales Amid Margin Calls: Is There A Risk Of A LTCM Redux? • Oct 15: Lehman Brothers Holdings Inc.'s hedge-fund clients may have to pay more collateral on $65 billion of assets frozen when the investment bank went bankrupt a month ago--> "If your bank fails, you still have to pay your mortgage." Moreover, hedge funds are among the net sellers of credit protection in the $54 trillion credit derivatives environment and might be called to perform on their obligations wrt Lehman, WaMu, Kaupthing, etc. o Oct 1: There are dozens of hedge funds whose Lehman prime-brokerage accounts were frozen when the company filed for protection from creditors on Sept. 15. "One executive who used Lehman as a prime broker -- and who asked not to be named because his firm is private -- estimates that hedge funds had between $50 billion and $70 billion in Lehman prime- brokerage accounts." Moreover, hedge funds had pledged equity securities as collateral that Lehman then loaned to other investors under a practice known as rehypothecation - PWC says in that case "clients may cease to have any proprietary interest in them." o cont.: PWC, Lehman's bankruptcy administrator in the U.K., where its European prime brokerage was based, doesn't know how much money is at stake. PwC said last month it's trying to recoup about $8 billion in cash that Lehman's parent company allegedly withdrew from its European unit before the collapse. It will take weeks, if not longer, to sort out the mess, according to PwC. o Perfect Storm for Hedge Funds: Short-selling rules were altered in a flash, the implosion of brokerages reduces the possibility for borrowing money, they’re stuck with delevering, and to top it off, many are getting hit with redemptions as September comes to a close, marking the end of the year for many funds. (MarketBeat) Redemptions could lead to fire sales and vicious circle. o FT Alphaville: Because so many firms hold similar positions, forced selling by one in response to redemptions can have ripple effects, forcing other funds to sell. More nimble hedge funds have sought to profit from the dynamic by taking short positions in securities known to be widely held by rivals --> HF adopt strategies to take advantage of competitirs' unwinding positions o Roubini: If larger and systemically important hedge funds were at risk of failing the Fed will have to engineer a massive private sector bail-in of such hedge funds (a larger scale rescue a la LTCM) where the prime brokers of such funds are forced to maintain repo exposure to such funds rather than be allowed to shut off such exposure. This is a radical suggestion but the alternative of a Fed liquidity bailout of systemically important hedge fund is not politically feasible. o NYT: In the month of July, hedge funds experienced nearly $12 billion in outflows. September 30 is the deadline when many funds are scheduled to accept withdrawal requests for the end of the year. To pay back investors, some funds may be forced to dump investments at a time when the markets are already shaky thus fuelling a vicious circle--> some hedge funds are reported to block withdrawals. o Attari/Ruckes: Redemption feature causes fundamental maturity mismatch with borrowing short term and lending/investing long-term and illiquid e.g. in leveraged loans--> when redemptions increase, hedge funds have no other choice than liquidate assets thus fuelling a negative spiral. Evidence from leveraged loan market shows that this is unravelling is underway. o cont.: Rating agencies start to downgrade collateralized fund obligations (C.F.O.) which are the hedge fund equivalent of mortgage-backed securities: securities backed by hedge funds. Some have a 7-year lock-up period. While few in number, C.F.O.’s represent a broad swath of the $2 trillion industry. o In terms of performance, this year looks like the worst on record: the average fund is down nearly 10 percent so far, according to Hedge Fund Research.

231 o About 350 were liquidated in the first half of the year and if the trend continues, the number of closures would be up 24 percent this year from 2007. o Seides (InvestorsInsight): Hedge funds are sellers of 32% of all CDS, insuring exposure of $14.5 trillion. Recent estimates indicate that the entire hedge fund market is approximately $2.5 trillion in net assets under management. Thus, hedge funds are bearing risk in excess of their ability to pay the piper if anything goes wrong--> risk might well land again with former investment banks and broker dealers. o Roubini: “one cannot rule out that some systemically important hedge fund may get into trouble with systemic consequences.”

U.S. Economy in Recession: Will the Financial Crisis Cause a More Severe and Protracted Downturn? o Since the U.S. economy is already in recession, intensification of financial crisis (and impact of credit tightening on households and firms) might deepen and lengthen (longer than the avg 12 months in past decades) the downturn leading to a U-shaped recession o Roubini: U.S. will suffer worst recession in 40 yrs lasting 18-24 months with unemployment rate rising up to 9%, credit losses hitting close to $3 trillion and home prices falling another 15% o Financial turmoil characterized by banking crisis are associated with severe and (2-4 times) longer downturns with (2-3 times) larger impact on growth (IMF study); unless the ongoing global central bank and govt intervention are effective, a severe financial meltdown, policy missteps, debt deflation, low interest rates might pose risk of an L-shaped recession o Fed's Yellen: Economy might contract from Q3-09 to Q1-09 as financial shock hits every sector of the economy and housing is still far from bottoming out; Bernanke: Marked slowdown in consumption, investment, labor market; continued weakness in housing; economic activity in next few quarters depends on improvement in credit and financial markets o NBER measures for recession in negative territory: personal disposable income declining since June; continuous 9-mo employment decline of 760,000; retail sales, ISM manufacturing contracting since July; contracting and at lowest level since 2001, industrial production declining since August o After stronger than expected growth in Q2-08 boosted by rebate induced consumer spending and export growth, domestic demand and GDP growth will weaken significantly during H2-08/H1-09 as consumption will contract starting Q3 (first time in 17 yrs on rising job losses, falling real wage/asset income, high debt, tight credit), capex will decline in H2-08 and contract through 2009 since residential and even non-residential construction spending are in negative territory (on high borrowing cost, weak corporate earnings, elevated production costs); large inventory liquidation; non-manufacturing ISM stagnating; export orders at 2-yr low, contribution of exports to GDP will soften ahead (on slowing G-7, EM growth, stabilizing USD); correction in home price till 2010 will keep putting pressure on consumers and banks o IMF: Growth forecast lowered to 1.6% in 2008, 0.1% in 2009; looming recession given the size of mortgage market and role of residential investment; need substantially large recapitalization of the financial system to resume lending o Feldstein: Financial turmoil may lead to a longer recession (than avg of 12 months) and greater output loss, higher unemployment rate; recession began in Dec- 07/Jan-08; exports not strong enough and Fed rate cut not effective to support recovery

232 o Merrill Lynch (not online): Growth will be flat in Q3, negative in Q4-08/Q1-09, 2008: 1.6%; 2009: -0.3% with a recovery by mid-2009 at the earliest; 'saucer-shaped' recovery-->longer duration of recovery a bigger risk than magnitude of decline in growth o Morgan Stanley: Economy might contract by 1% or more in the year ending in Q2-09; UBS: growth in contract in Q3/Q4 2008 and Q1-09 growing 1.4% in 2008; 0.3% in 2009 o JPMorgan: Growth will be flat in Q3-08 (0%), contract -0.5% in Q4-08/Q1-09; 2008: 1.6%, 2009; 0.6%; Deutsche: GDP will contract in Q3/Q4 growing at 1.4% in 2008, 0.0% in 2009 o Goldman Sachs (not online): credit tightening unlikely to ease soon, will impact economic activity causing severe and longer recession, 8% unemp rate by end of 2008 and Fed rate cut of 1% or lower; consumer spending will contract during 3Q08-1Q09 recovering only in 2H09; GDP growth will contract in 4Q08/1Q09 and remain flat in 3Q08/2Q09; GDI (a better indicator) is showing more weakness than GDP o NABE: Credit-market deterioration will push the US economy into recession (-1.1% in Q4-08, - 0.5% in Q1-09); without the $700bn bailout plan, growth in 2009 would be 0.75% lower, unemployment rate would be 0.5% higher by 2009-end o IIE: Sluggish consumer spending through 2009, declining contribution of net exports to GDP will lead to 0% or small negative growth in H2-08 and modestly positive growth in H1-09 o Alliance Bernstein: Weakening 6-mo diffusion index on leading indicators; slowdown in growth even before financial crisis worsened will impede economic recovery resulting in a longer trough o Wachovia: Continued weakness in labor market implies consumer spending will decline in H2-08; high production costs, low demand will cause corporate profits to decline o IIF: sub-par growth starting H2-07 will likely extend to 2010 with negative consumption, longer and deeper housing recovery, declining boost from net exports o Krugman: U.S. may have an L-shaped recession as home prices are yet to fall to pre-bubble levels; unemployment may continue to rise; growth may remain sluggish till 2010-11 even after official recession is over o Fed revised 2008 GDP growth forecast upward from 0.3-1.2% in April to 1-1.6% in June; kept unemployment rate forecast unchanged at 5.5-5.7%

233 Do Ratings Matter? Eduardo Cavallo, Andrew Powell and Roberto Rigobon | Oct 21, 2008 The role of Credit Rating Agencies has come to the forefront of the policy debate in recent months. The sudden collapse of complex structured financial instruments that were once categorized as safe “investment grade” products has cast doubts on the way rating agencies do their business, the structure of incentives they face, and the appropriateness of the existing regulatory framework and surveillance mechanisms. Yet one question that few people have asked in this context is if ratings really matter. In other words: do ratings provide information above and beyond what is already reflected in the prices and yields of traded financial instruments? If rating agencies add no new information to markets their actions are not a public policy concern. Given the nature of their business, it is clear that rating agencies probably have more information than the average investor. What it is not clear, and where there is considerable debate in the literature, is whether the opinion of rating agencies matter for the determination of market prices of financial instruments, even after controlling for the fundamentals underlying the value of these assets. Whether they do or not is an important policy question; especially for policy makers concerned about financial stability and access to finance. In a recent paper, we explore this question by scrutinizing the sovereign ratings’ market. Ratings are oftentimes anticipated by the market because rating agencies appear to try to signal when rating changes may occur. Financial instruments are either given a positive or negative outlook (suggesting an upgrade or a downgrade may be the next change respectively) and additionally may be placed on a “rating watch” (indicating that a decision may be about to be made). Moreover, agencies publish what a particular issuer would have to do to improve its rating and while targets may not be precise, the information required to make a judgment is generally public and indeed may become a focus of market research and analysis. Market anticipation means that it is a real challenge to answer the question as to whether ratings agencies add value and standard “event study” techniques may not be appropriate. If rating agency actions are fully anticipated then we would see no contemporaneous effects of rating changes on, for example, bond spreads. But seeing no effects would not mean that rating agencies do not add value. It just implies that whatever effect ratings had on spreads may have already been incorporated into spreads before the rating change. We suggest therefore that we need to seek novel methods to tackle this question that do not rely on unobservable economic fundamentals and that takes into account that rating changes are possibly anticipated. For this purpose, we first devise a simple specification test that is robust to these features of the data. The question we are interested in answering is to evaluate the informational content that the rating has in addition to the observed spread on marketable sovereign debt. In other words, the null hypothesis is that all the information in the rating is already reflected in the spread. This is equivalent to say that the spread is a sufficient statistic. The alternative hypothesis, on the other hand, implies that spreads and ratings are imperfect measures of the unobservable fundamentals of the economy; and therefore ratings provide information above and beyond what spreads reflect. Across several variants of the test, we find high rejection rates for the null hypothesis. In other words, there does seem to be informational content in country ratings that is not captured by the sovereign spreads.

234 Having established that spreads are not a sufficient statistic, we turn to estimating a new model in which we exploit the informational content of ratings in order to explain the variation in three macro variables (i.e., stock market indices, nominal exchange rates, spreads one day forward) using high frequency (daily) data. We consider a horse-race between ratings and spreads as to how well they are correlated to the other macroeconomic variables. We find that ratings typically explain part of the variation in the selected macro variables, even after controlling for the spread. The fact that the rating is significant after controlling for the spread is supportive evidence in favor of the hypothesis that spreads are not a sufficient statistic.

Our results across several methods and for the three main credit rating agencies (Standard and Poor’s, Moody’s and Fitch) are significant and highly consistent. We find that we cannot reject the view that rating agencies add information. We find that this is true for all rating changes, upgrades and downgrades, as well as only for changes in asset classes (rating changes from investment to non-investment grade and vice-versa). We also find that less anticipated rating changes (i.e., we suggest that if the outlook change precedes the rating change by only a reasonably small number of days, then the rating change may not be fully anticipated) have even more significant effects. We conclude that rating agencies do matter in the sense that rating changes contain information that is not fully incorporated into the observed prices of financial assets – in this case sovereign debt. In turn this implies that the appropriate functioning of the rating market is indeed a valid public policy concern.

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Hayek's Legacy Daily Article by Danny Quah | Posted on 10/17/2008 This article is excerpted from the preface to Prices and Production and Other Works y F.A. Hayek. Economics never labels anything any more. Well, more accurately, it does; only now it hardly ever uses labels formed from people's names. In part, this is due to the smorgasbord approach to ideas taken by economics. Like many other academic disciplines, economics ruthlessly mixes and matches, customizes and adapts, rips and mashes the most penetrating insights, the most appropriate models from all different sources, applying those to whichever economic problem is currently being addressed. In those circumstances the message gets through to the practitioner economist that it is more useful to know an idea itself, and how to apply and modify it, than to peer into its provenance or to understand how the originator of that idea thought about three or five other substantively different problems. In mathematics, this idea is taken even further. The most powerful and insightful practitioners are those whose names become so merged with a discovery that their surnames get lowercased whenever mentioned with the matching idea. The proper name disappears as anything distinctive, and instead becomes just vocabulary. In economics, perhaps partly at fault as well, those intellectual leaders in the profession now, whose names are most likely to deserve such adjectivization, themselves eschew debates that might lead to such identification. Thus, for instance, the same economists who argued that the money supply is the fundamental cause of inflation also argued for the importance of fiscal balance and discipline in determining, again, inflation. The same economists whose work set the agenda for decades of business cycles research were also the ones who provided calculations showing that such economic fluctuations are fundamentally insignificant for society's well-being overall. Mainstream economics pragmatically emphasizes debate about results, not about methodologies. So, certainly, individual's names can be bolted onto specific curves, econometric estimators, statistical tests, probability inequalities, interest-rate rules, and mathematical equations and models - but not onto entire systems or ways of thinking. The case of Friedrich Hayek, however, provides a rare example of a consistent body of work in the profession where such identification might be justified.

236 Living the frenetic cultured existence of the mid 1900s - as political events forever changed the global geography of intellectual endeavor - Hayek became one of the 20th century's most influential economists and political philosophers. In economics he made profound and enduring contributions in areas as diverse as monetary and business cycle theory, the social organization of dispersed knowledge, and the spontaneous emergence of order. But while seemingly varied, all these research questions were attacked by Hayek in a consistent, unified perspective. It is this single perspective then that potentially can be most identified with Hayek. However, matters are complex from the opposite direction as well. Hayek viewed business cycles as having their initiating impulse of central-bank credit overexpansion and their propagation mechanism as misallocation of capital across short- and long-term investments. This sees echo in many modern technical treatments - both empirical and theoretical - of economic fluctuations. Hayek saw the price system to be the single leading mechanism by which limited local knowledge and actions can be efficiently aggregated into optimal social outcomes - through human action, not human design. This is, in one guise, simply the fundamental theorem of welfare economics. But combining these two Hayek propositions - that on business cycles and that on local knowledge - also recovers critical ingredients of Robert Lucas's rational expectations reconciliation of the short-run Phillips curve with monetary neutrality. Being clear on the distinction between monetary and credit overexpansion brings to the fore modern econometric investigations of the different roles for money and credit over business cycles. Exploring the full implications of whether markets perfectly aggregate imperfect information is precisely the idea underlying a rich seam of technical research in microeconomics. Hayek's description of order emerging spontaneously, in a self-organized way, from out of seeming chaos - the application of which to economics he coined the term catallaxy - turns out to be the defining characteristic of the science of complex adaptive systems. It is an idea that sees profound application not only, again, in the fundamental theorems of welfare economics, but in areas as varied as Alan Turing's explanation for the black and white speckled patterns on cattle, hypotheses on the emergence of peaks and troughs in economic activity across not just time but geographical space, and indeed is embedded deeply in speculations on the origins of life itself, in research on computational and mathematical biology. While pre-Thatcher, pre-Reagan mainstream politics and social policy worldwide might have grown interventionist with fine-tuning and demand management, and thus distant from Hayek's intellectual position, by contrast, many mainstream economists and social scientists never really left Hayek. Instead, the great majority have absorbed his ideas so implicitly that the name has been not just lowercased but left unmentioned altogether. Hayek's ideas are seamlessly intertwined with so much of modern academic economics that, indeed, practically everyone in the profession has come into contact with or uses (lowercase) hayekian insights. What this does for intellectual history is likely unfortunate. But, on the other hand, it might be the ultimate accolade for Friedrich Hayek, an intellectual concerned with ideas and knowledge, and their use for good in society. I congratulate the Ludwig von Mises Institute for bringing back into print Hayek's writings on business cycles. This collection will be a critical touchstone for future thinking in the area.

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REPORTAJE: Dinero & inversiones Letras que son un tesoro Las emisiones de deuda pública sacan partido al miedo de los inversores PIEDAD OREGUI 12/10/2008 El dinero es miedoso y mucho más en estos días en los que se multiplican las malas noticias sobre la salud de algunas entidades financieras -por el momento, ninguna española-; se aprueban macroplanes de rescate -casi ningún país ha renunciado a poner dinero encima de la mesa-, se toman medidas concertadas sobre los tipos de interés para reactivar los mercados - las Bolsas siguen bajando-, se lanzan mensajes de tranquilidad que, sin embargo, parecen caer en saco roto... Y, con el miedo en el cuerpo resulta difícil que los inversores se planteen tomar posiciones en cualquier activo, de renta fija o variable, que pudiera incorporar realmente (o sólo teóricamente) algún tipo de riesgo por mínimo que éste sea. Dicen del mercado de renta fija

238 privada que está prácticamente "muerto": no hay compradores -la quiebra de Lehman le ha dado la puntilla-; del de renta variable, se comenta que está "más que tocado". Hace unos días, una conocida entidad gestora española de patrimonio ofrecía a uno de sus clientes preferenciales un pagaré de una entidad financiera de primera línea al 5,75% a 12 meses. Éste declinó la propuesta y sólo dijo "compren letras del Tesoro. Su rentabilidad no es ahora excesivamente relevante". Tan sólo se trata de una anécdota pero refleja, a decir de los expertos, el sentir de los inversores. Y no sólo los nacionales. En Estados Unidos la demanda de estos títulos ha llegado a ser tan elevada que su rentabilidad, en el mercado secundario, se ha acercado a cero. Al inversor americano, preservar su capital le ha resultado "suficiente". En España, la situación no ha llegado ni mucho menos tan lejos. Pero algo de intranquilidad y miedo también hay. Desde el Tesoro lo saben y aprovechando el momento se han decidido a lanzar una campaña publicitaria sobre la deuda pública. Bajo el lema "si tu vida es como tú eliges que sea, ¿tu inversión no debería ser igual? Elige Tesoro Público" se multiplican los anuncios en prensa, televisión y radio (con polémica incluida sobre la actitud sexista o no de uno de ellos con referencias a las croquetas de mi Puri). Y la verdad es que al Tesoro no le está yendo mal esta campaña. En la última subasta de letras a 12 meses, llevada a cabo a mediados de septiembre -la próxima está fijada para el próximo 15 de octubre- se solicitaron algo más de 4.708 millones de euros. Se adjudicaron 4.000 millones a un tipo de interés medio del 4,29% y a un marginal del 4,34%. Esto es el mercado primario. En el secundario, la situación es diferente. Los inversores, particulares o institucionales que desean adquirir estas mismas letras del Tesoro, se han de conformar con un rendimiento significativamente menor. De hecho, esta semana han estado cotizando, con fuerte presión de la demanda, de tal manera que su rentabilidad final se ha llegado a situar en el 3,1%. Más de un punto de diferencia que se explica por las ansias de los inversores de tomar posiciones seguras aun a costa de reducir sus ganancias potenciales. En los bonos a tres años, más de lo mismo. En la última subasta del Tesoro, su tipo medio quedó establecido en el 4,33% mientras que su marginal se fijó en el 4,34%. En esta semana, el aumento de su demanda ha estrechado los márgenes. Los compradores de estos activos en el mercado secundario se han conformado con un 3,56%. En las emisiones de obligaciones a 10 años, el tipo de interés medio en la última subasta quedó establecido en el 4,58% (marginal, 4,61%), pero a lo largo de estos días ésta ha caído hasta el 4,3% en el mercado secundario. La fuerte demanda de títulos públicos ayudará a financiar el plan de apoyo que el Gobierno ha anunciado esta semana para comprar activos no contaminados de los bancos españoles. Así que para el inversor de a pie con dinero fresco en principio es más recomendable, si se cuenta con el dinero pertinente y se quiere gozar de tranquilidad, acudir al mercado primario de emisiones de deuda pública. Los caminos son varios: a través de Internet, el Tesoro permite suscribir valores, traspasarlos, consultar las operaciones... En principio, cualquier inversor, sea persona física o jurídica, residente en España puede ser titular de una Cuenta Directa en el Banco de España, que no tiene gastos ni de apertura ni de mantenimiento. Bastará con adquirir una obligación, un bono o una letra (inversión de aproximadamente mil euros). Cuando los particulares presenten sus peticiones de suscripción de deuda pública, deberán depositar con carácter previo como mínimo el 2% de su importe nominal en metálico, o mediante cheque, ya sea bancario o contra cuenta corriente. Servirá de garantía. En tercer lugar, el inversor particular puede adquirir estos títulos a través de su intermediario financiero, banco, caja y sociedad o agencia de valores.

239 Por cualquiera de estos canales, el inversor puede realizar dos tipos de peticiones de suscripción: las competitivas (el participante tiene que indicar qué importe nominal desea adquirir y a qué precio desea hacerlo, expresado este último en tanto por ciento del valor nominal) y las no competitivas en las que sólo es preciso indicar el importe nominal que se desea adquirir. El precio a pagar por los valores será el precio medio ponderado que resulte de la subasta. Las peticiones no competitivas son, en general, las más adecuadas para el pequeño inversor, puesto que a través de ellas éste se asegura que su petición sea aceptada (salvo que la subasta quede desierta), y que reciba un interés en línea con el promedio resultante de la subasta. Los depósitos, a por todas Como el miedo es libre y más en unos días de zozobra en que todo el mundo habla de esta crisis financiera de alcance mundial, la aparente seguridad que ofrecen las entidades financieras españolas no les parece argumento suficiente a particulares e inversores para convencerles de la bondad de depositar sus ahorros en estas instituciones. Ni bancos ni cajas están, sin embargo, dispuestos a tirar la toalla. En estos días se multiplican sus ofertas; las más sencillas, las más tradicionales, las que tan sólo, sin vinculación a ningún factor de riesgo (léase valor o índice bursátil), ofrecen un alto rendimiento en un relativo corto periodo de tiempo. Ahí están la veintena de depósitos de este tipo, que se diferencian entre sí en el plazo -como mucho se alarga ligeramente por encima de los dos años pero, en general, se establece en torno a los doce meses- y en la rentabilidad final que, si bien de media se sitúa en el 5,5% puede llegar a ser del 6,1% hasta el 31 de enero de 2009, es decir, unos cuatro meses. Muy cerca les sigue otra cuenta, en este caso, la conocida Cuenta Naranja de ING Direct que, igualmente, desde mediados de julio ha decidido subir su tipo de remuneración en medio punto porcentual, hasta el 6% a un plazo de cinco meses. O el depósito a dos meses de Bankinter al 8%. O del depósito denominado El Estirón del Popular a 18 meses al 6%. O del depósito a nueve meses de Caixa Galicia al 5,37%. O el de Uno-E, con su Depósito al 5,1%, entre otros muchos.

Crisis financiera mundial "In Spain we trust" El Tesoro lanza una campaña internacional para que los inversores extranjeros compren deuda española RAMON MUÑOZ - Madrid - 17/10/2008 In Spain We trust ('Confiamos en España') Con este lema, que parafrasea el que llevan inscritos los billetes de dólar (In God We Trust, Confiamos en Dios) el Tesoro Público ha lanzado una campaña de publicidad internacional con el objetivo de convencer a los inversores de que inviertan en deuda pública española. El anuncio, que se puede ver hoy en al edición del Financial Times, sobrepone ese lema sobre un billete-collage que incluye un billete de un yen, una libra esterlina, un dólar y un riyal saudí. En la parte inferior se puede leer en inglés "España es una economía muy productiva con una sólida posición fiscal. Compre deuda pública española y aproveche su alta liquidez con vencimiento de hasta 30 años". El anuncio recoge también que la deuda española goza de la

240 máxima calificación que asignan las agencias que miden el riesgo de los créditos, la AAA, que significa casi cero riesgo. Con el fin de garantizar la liquidez del sistema bancario (bancos y cajas de ahorros), el Gobierno ha aprobado un fondo de liquidez de hasta 50.000 millones de euros para comprar activos financieros de esas instituciones. El fondo, que pagará el Tesoro, debe financiarse con deuda pública. Con esta medida, se pretende dar liquidez al sistema financiero, proporcionando a la banca unos recursos con los que hacer frente a los vencimientos de la deuda que tiene contraída y también podría ser utilizado para dar crédito a empresas y particulares.

El anuncio del Tesoro publicado en la prensa económica británica.-

Crisis financiera mundial - El diagnóstico sobre las causas Botín culpa de la crisis a los excesos de los banqueros durante la bonanza El presidente del Santander cree que los bancos españoles no necesitan la toma de participaciones por el Gobierno, "dada su solvencia y fortaleza" MIGUEL JIMÉNEZ - Madrid - 17/10/2008 Pese a que también ha cometido algunos errores, Emilio Botín, presidente del Banco Santander, se ha convertido en los últimos meses en uno de los banqueros más admirados del mundo, pues la entidad que preside ha emergido como una de las ganadoras de la crisis financiera internacional. Ayer, Botín hizo su más detallado diagnóstico de la crisis hasta la fecha. Pese a que también ha cometido algunos errores, Emilio Botín, presidente del Banco Santander, se ha convertido en los últimos meses en uno de los banqueros más admirados del mundo, pues la entidad que preside ha emergido como una de las ganadoras de la crisis financiera internacional. Ayer, Botín hizo su más detallado diagnóstico de la crisis hasta la fecha. El banquero lanzó un mensaje de confianza sobre las entidades españolas, alertó sobre los riesgos de que las ayudas a las entidades en crisis acaben dando ventajas a los malos

241 gestores, criticó la deificación de los consejeros independientes y evitó un análisis simplista sobre la crisis. En el mismo día en que Zapatero decía que ésta es una crisis que viene de Estados Unidos y que se va a solucionar gracias a Europa, Botín rechazó que el origen esté "en un mercado concreto", como el estadounidense, o que se ciña "a un negocio en especial, como las subprime". Según el banquero, el origen de la crisis, como en otras ocasiones está en los "excesos" cometidos por los propios banqueros y "la pérdida de referentes en un entorno extraordinariamente favorable". El dedo de Botín no es el primero que señala a los banqueros como culpables de la crisis. El famoso financiero Warren Buffet ya señalaba en un entrevista con EL PAÍS en mayo pasado que "los bancos han asumido demasiados riesgos". "Son quienes tienen la culpa. No hay que echársela a nadie más", decía. El valor que tiene la declaración de Botín es que proviene precisamente de uno de los banqueros más destacados. ¿Un ejercicio de autocrítica? No del todo. Primero, porque la referencia de Botín va especialmente dirigida a la banca de inversión, aunque es extensible a otros bancos. Y, segundo, porque el Santander habla desde la posición de haber capeado la crisis mejor que los demás, así que los errores que critica no los considera propios. De hecho, las recetas que el banquero cántabro da para el futuro son en realidad las que él mismo dice aplicar: una vuelta a los orígenes, a los fundamentos de la banca. El foco en el cliente, la apuesta por el negocio recurrente, el control de riesgos y un gobierno corporativo capaz. Botín aprovechó su discurso para ajustar cuentas pendientes con aquellos, como los redactores del Código Conthe, que situaron a los consejeros independientes en los altares. "Parecían la panacea", ironizó. "El mejor consejero era el que estaba más alejado del negocio porque, se decía, era más independiente. Lo que se necesitan son consejeros capaces y que conozcan bien el negocio". Botín lanzó un mensaje de confianza sobre la banca española. En su opinión, las entidades no necesitan inyecciones de capital del Gobierno, "dada su solvencia y fortaleza". El problema es en este caso la liquidez. Pero Botín, que habla desde el grupo de los ganadores, no olvida el negocio y la competencia. El Santander no quiere que el apoyo de los Gobiernos frente a la crisis acabe otorgando ventajas competitivas a quienes han hecho una mala gestión. "No podemos transmitir el mensaje de que se puede actuar sin responsabilidad sobre los errores que se cometan", señaló. Las medidas que se adopten no deben afectar al funcionamiento del mercado y deben mantener el estímulo a la buena gestión.

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Crisis financiera mundial - El diagnóstico sobre las causas "Son errores que no se pueden repetir" Discurso de Emilio Botín en la Conferencia de Banca Internacional del Banco Santander 17/10/2008 La crisis que estamos viviendo nos hace valorar, más que nunca, la importancia de contar con un sistema financiero solvente, rentable, sano y sostenible. En los últimos tiempos se han puesto muchas cosas en cuestión: desde la complejidad que alcanzaron algunas innovaciones financieras que resultaron ser muy nocivas, hasta el funcionamiento de las agencias de rating y ciertas estructuras de regulación y supervisión, que han cometido errores importantes. El Banco de España, nuestro regulador y supervisor, ha desempeñado un papel ejemplar, como ha sido internacionalmente reconocido. Las respuestas a estas cuestiones no son fáciles, pero parece claro que pasan por recuperar los fundamentos. Porque hay una serie de realidades que parecían olvidadas: los ciclos existen, el crédito no puede crecer indefinidamente, la liquidez no siempre es abundante y barata y la innovación financiera no puede hacerse a espaldas del riesgo que conlleva. Y ahora sobre la mesa tenemos tres problemas globales(...): liquidez, activos tóxicos y capitalización de las entidades financieras. Voy a centrar mi intervención en cómo creo que las entidades y supervisores pueden contribuir a que el sistema financiero, en particular en Europa, salga de esta crisis fortalecido. En mi opinión, la aportación de las entidades debe venir de recuperar el foco en el cliente, potenciar el negocio recurrente, gestionar con prudencia el riesgo y reforzar el gobierno corporativo. Por su parte, la contribución de las autoridades es clave en cuestiones como la liquidez, transparencia y supervisión. En primer lugar, las entidades tienen que recuperar el foco en el cliente. La base del negocio bancario está en las relaciones estables y directas con nuestros clientes. Para mantenerlas tenemos que aportarles valor, servicios y productos adecuados y ajustados a sus necesidades (...) a precios razonables (...). La segunda clave es centrarse en el negocio recurrente. Un modelo de negocio recurrente, bien gestionado, basado en la relación con el cliente a largo plazo, es rentable y no necesita inversiones en títulos y estructuras financieras opacas para generar beneficios. Esto me lleva al tercer punto, quizás el más importante: las entidades tenemos que gestionar con prudencia el riesgo. Si hay algo que ha quedado claro en esta crisis es la necesidad de poner el foco en la gestión de los riesgos. Y para esto no hay que innovar mucho. No hay que inventar nada nuevo. Hay que dedicarle tiempo y atención al más alto nivel. Hace unos meses nos visitó un ex presidente de la Reserva Federal de EE UU. Se sorprendió al saber que la Comisión Delegada de Riesgos del Banco Santander, compuesta por cinco consejeros, se reúne dos veces a la semana para analizar riesgos durante al menos cuatro horas, y que la Comisión Ejecutiva del banco, compuesta por cinco consejeros y cinco ejecutivos, se reúne todos los lunes del año durante cuatro horas, en las que dedica una gran parte de su tiempo a la revisión de riesgos y aprobación de operaciones. Decía no haber

243 conocido ningún banco americano donde se aplicase una política de riesgos similar. Es verdad, son muchas horas de dedicación por parte de nuestros consejeros, pero a nosotros nos parece fundamental. Y nunca nos parecen demasiadas. Compartimos plenamente las recomendaciones de los distintos organismos internacionales en esta materia. La función de riesgos debe ser independiente del negocio, y en ella debe implicarse la más alta dirección del banco. Este esquema exige, evidentemente, que el Consejo conozca y entienda el sistema financiero. Por eso es tan importante el cuarto punto al que quiero referirme: la necesidad de contar con un fuerte gobierno corporativo dentro de las entidades. Durante años ha habido muchas voces defendiendo a los consejeros independientes en el Consejo de las entidades financieras. Parecía la panacea: el mejor Consejero era el que estaba más alejado del negocio porque, se decía, era más independiente. Lo que se necesita son consejeros capaces y que conozcan bien el negocio. Hablamos de un sector complejo, sujeto a innovaciones continuas, y en el que cualquier error de gestión tiene implicaciones importantes, como hemos visto. De hecho, en el Banco Santander actualmente contamos con nueve presidentes o ex presidentes de entidades financieras en nuestro Consejo. El Tesoro Británico, en su informe sobre la caída de Northern Rock, apunta como una de sus principales causas la falta de cualificación financiera de sus máximos responsables. Son errores que no se pueden volver a cometer. Paso ahora a hablar de cómo creo que las autoridades pueden contribuir positivamente al reforzamiento del sistema financiero. Una primera lectura de la crisis nos dice que las soluciones técnicas no han sido suficientes para devolver la confianza a los mercados. Se necesita dar señales inequívocas bajo un liderazgo claro (...) y compartido. Esto pasa por dar respuestas coordinadas que no generen confusión ni problemas en diferentes mercados. Y en especial, en Europa. En todo caso, las soluciones que planteemos deben dejar claras las reglas a seguir en caso de crisis. Necesitamos una hoja de ruta. También deben evitar generar riesgo moral: no podemos transmitir el mensaje de que se puede actuar sin responsabilidad sobre los errores que se cometan. ¿Cuáles deben ser las prioridades? En primer lugar, atender la liquidez. La línea de flotación de las entidades es, o era hasta ahora, el capital, y en ese aspecto se centraban los supervisores para analizar la solvencia de las entidades. Pero tras esta crisis, la liquidez debe recibir también atención, pues ha demostrado su capacidad de poner en peligro a algunas entidades financieras. En segundo lugar, fomentar la transparencia. La magnitud de esta crisis está relacionada con la incertidumbre sobre quiénes y en qué medida se han visto afectados por ella. La falta de información ha derivado en una crisis de confianza generalizada (...). Y, en general, hay que reforzar la supervisión. La crisis nos ha enseñado que, tan importante como la transparencia de las propias entidades, son los mecanismos de control y valoración de la información. Es necesario que los supervisores conozcan profundamente las entidades que supervisan, dicten reglas claras y tengan muy en cuenta que los ciclos económicos y financieros existen y que hay que estar siempre preparados para ello (...). Por último, en Europa se hace ahora imprescindible una mayor coordinación entre supervisores.

244 Las medidas acordadas el pasado fin de semana en la reunión del Eurogrupo, inspiradas en el plan del Reino Unido, apuntan en esta dirección, pues suponen una respuesta coordinada, aportan una hoja de ruta de actuación para los diferentes Gobiernos del área euro y apuntan a temas señalados, como la liquidez. El Gobierno español ya ha aprobado su paquete de medidas acorde con este acuerdo, aunque, en mi opinión, las entidades españolas no necesitan la toma de participaciones por parte del Gobierno, como ha ocurrido en otros mercados, dada su solvencia y fortaleza. En todo caso, me parece muy importante que, dentro de este conjunto de medidas, no se pierda de vista la necesidad de mantener un adecuado equilibrio competitivo entre las entidades financieras. Es esencial que las medidas que se puedan adoptar no afecten al funcionamiento del mercado y se mantenga el estímulo a la buena gestión. Termino con algunas conclusiones. Mi lectura es que el origen de la crisis no está en un mercado concreto, como el americano, ni se ciñe a un negocio en especial, como las hipotecas subprime. Activaron la crisis pero no la causaron. El problema ha sido el mismo que ha originado otras crisis anteriores: los excesos y la pérdida de referentes en un entorno extraordinariamente favorable, que ha llevado a olvidar los fundamentos de la banca, que son la necesidad de conocer muy bien a los clientes y a los productos que se intermedian, la prudencia para no aceptar niveles de endeudamiento desproporcionados al riesgo que se asume al financiarles, la valoración adecuada de todos los riesgos en que se incurre, la existencia de ciclos económicos y financieros. Estoy seguro de que si el sistema financiero recupera estos principios y se dota de un marco de supervisión más completo y coordinado, de los incentivos adecuados y de una mayor transparencia, saldrá reforzado de la crisis y podrá continuar contribuyendo positivamente al crecimiento económico.

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Will the Bretton Woods 2 (BW2) Regime Collapse Like the Original Bretton Woods Regime Did? The Coming End Game of BW2 by Nouriel Roubini, July 6, 2008

Will the Bretton Wood 2 Regime of fixed and/or heavily managed exchange rates in many emerging market economies collapse in the same way as the Bretton Woods 1 regime (the “dollar standard” regime that ruled after 1945 in the global economy) collapsed in the early 1970s? What are the similarities and differences between those two regimes? It is interesting to note that the same factors – U.S twin deficit, U.S. loose monetary policies and fixed pegs to the U.S. in the dollar standard regime of Bretton Woods (1945-1971) - that led to the commodity inflation and goods inflation in the early 1970s and thus to the demise of the Bretton Woods 1 regime (in the 1971-73 period) are also partially the same factors that are leading now to the rise in commodity and goods inflation in emerging markets that are pegging to the U.S. dollar and/or heavily managing their exchange rates.

Thus, like the rise of commodity and goods inflation led to the demise of BW1 the current rise in commodity and goods inflation in emerging market economies may be the trigger that will lead – as argued in my 2005 BW2 paper with Brad Setser and a more recent 2007 paper of mine – to the demise of BW2. It is true that BW2 is still alive as the massive ongoing reserve accumulation by BRICs, GCC and other emerging markets suggests. But the rise in inflation that these exchange rate policies are causing may soon lead to its demise: abandoning pegs and/or letting currencies appreciate at a faster rate will be the necessary step to control inflation in such emerging market economies.

Let us flesh out this comparison between BW1 and BW2 in more detail…

First, note that there are a number of similarities between the current US recession and rising inflation (a stagflationary episode) and the episode of rising inflation in the early 1970s that, by the fall of 1973, erupted into a full fledged global stagflationary shock following the Yom Kippur war and the ensuing spike in oil prices. Indeed. there has been a debate on how much the of the 1974-75 global recession was due to the supply side stagflationary shock of 1973 and how much of it was due to a rise in global inflation and commodity prices that started in 1970 and accelerated in 1973.

Note that the rise in inflation in the 1970s started much earlier than the supply side shock of 1973. Rather, the breakdown of the Bretton Woods (BW) regime was an important factor behind the rise in global inflation before the oil shock of 1973. This collapse of BW1 in the early 1970s has some uncanny similarities to the rise in global inflation that the current Bretton Woods 2 regime of fixed rates or heavily managed rates has triggered 247

in the last few years. Like in the current episode - where a number of countries heavily managed their currencies relative to the US dollar by keeping them weak via aggressive partially sterilized intervention and thus caused excessively low interest rates and excessive growth of base money and of credit that eventually led to asset inflation and goods inflation in 2008 - a similar phenomenon occurred in period that led to the demise of Bretton Woods 1 in the early 1970s.

Indeed, in the late 1960s the U.S. was running large twin fiscal and current account deficits caused by the costs of the Vietnam War and an increasingly overvalued US dollar (while today the twin deficits are also partly related to the Iraq war/homeland security spending and a strong dollar until the early 2000s). The members of Bretton Woods 1 – formally a regime of fixed pegs to the U.S. – were instead running current account surpluses – Germany, most of Europe, Japan – and thus accumulating foreign reserves to prevent their currencies from appreciating relative to the U.S. dollar. Eventually that excessive reserve accumulation and ensuing monetary growth led to a rise in domestic inflation and a rise in commodity prices as global monetary conditions were too loose given the U.S. policies. And many of the creditors of the U.S. – especially France – became restless about accumulating larger and larger reserves of dollar assets that were yielding low returns and were effectively not convertible to gold at the set price by the “dollar standard” regime as it was increasingly clear that the supply of dollar assets created by the US external deficits was massively outstripping the gold backing the “dollar standard” regime. Eventually by 1971 those growing imbalances led to the collapse of the Bretton Woods dollar standard regime, a move to managed rates by 1971 and by 1973 a move to a full float of major currencies. That collapse in Bretton Woods 1 then fed the commodity bubble of the early 1970s as the ensuing weakness of the U.S. dollar following the breakdown of BW1 led to a further rise in commodity prices that were already rising before because of excessive U.S. and global monetary growth.

The same is happening today as the exchange rate policies of China, the GCC, Russia, India, Argentina and other informal members of BW2 – have fed the commodity inflation and the domestic inflation in many emerging market economies, a rise in inflation that is now spilling back to the U.S., Europe and other advanced economies. In the early 1970s the tensions created by the fix pegs to the US dollar – in the presence U.S. twin deficits and loose U.S. monetary policies – led to the breakdown of BW1 as Germany, France, Japan and other economies decided to abandon the pegs and revalue their currencies to prevent even further rise in their inflation rates. But the by product of that abandonment of pegs was further dollar weakness, further loosening of monetary policies in the U.S., further commodity inflation that – by the time of the 1973 stagflationary oil shock – led to an ugly U.S. and global stagflation.

Similarly, today the rise in commodity and goods inflation that U.S. twin deficits, loose monetary policy (to deal with the recession and the financial crisis) and the exchange rate policies of the BW2 members has created is likely to lead to the demise of BW2. In my 2005 paper with Brad Setser and in the follow-up papers on BW2 we argued that the demise of BW2 would be triggered – among other reasons - by the rise in asset inflation and goods inflation that these exchange rate policies of partially sterilized interventions 248

would entail. That rise in asset inflation and goods inflation has now occurred in emerging market economies – with over 30 of such economies now having double digit inflation. Also, the asset inflation – in equity markets and real estate in countries such as China, the Gulf States, India, Russia, etc. – that the BW2 policies created has now started to go bust at least in the equity markets of the China, India, Gulf States and other emerging markets (where equity markets are already in a 20% bearish downturn).

In May of 2007 I wrote a paper titled “Asia is Learning the Wrong Lessons from Its 1997-98 Financial Crisis: The Rising Risks of a New and Different Type of Financial Crisis in Asia” that presented a more recent assessment of the vulnerabilities of BW2 and the risks of rising asset and goods inflation in that regime.

Then I wrote in that paper:

[Asia] has learned some wrong lessons from that [1997-98] crisis and – in trying to address that crisis – planted the seeds of new and different financial vulnerabilities that could lead to a different crisis in the medium term, or even in the short term if global shocks such a US hard landing take place. Paradoxically, part of the policy responses to the 1997-98 crisis were mistaken and created excessive liquidity and asset bubbles that will come to haunt the region once external shocks take place.

So, what are the problems with the current Asian economic, currency and financial model? The answer is, in brief, the effective return to fixed exchange rates in spite of the rhetoric of a move to floating rates. In other terms the problem of Asia today is its membership of the Bretton Woods 2 (BW2) and the economic distortions, and financial and asset bubbles that this BW2 regime generates. Let me elaborate. After the 1997-98 Asia only formally moved to a regime of flexible exchange rates. Effectively, instead, most countries in the region tried to avoid the appreciation of their currencies that had collapsed during the crisis, were thus severely undervalued and were thus subject to appreciating pressures once their economies and external balances recovered…That new model of growth was first and foremost chosen by China. And following the Chinese bandwagon most of the East Asian countries joined this BW2 model of fixed rates and undervalued currencies leading to export-led growth with current account surpluses and reserve accumulation attempting to prevent nominal and real appreciation…

One may then ask: what is wrong with that BW2 growth model if it has led to high growth in China and East Asia and strong and well performing financial and asset markets? The answer is clear.

First, this new economic and financial model is leading to excessive monetary and credit growth, asset bubbles in stock markets, housing markets and other financial markets that will eventually lead to a build up of financial vulnerabilities – like the capital inflows and bubbles the preceded the Asian crisis of 1997 in a region of semi-fixed exchange rates – that could trigger a financial crisis different from that of 1997-98 but that could be potentially as severe. 249

Second, reliance on an economic growth model based on rising growth of net external demand and domestic investment aimed at rising capacity for such exports; low reliance on domestic demand and production for domestic markets, especially private consumption and production of necessary non-tradable public and private services. This model of growth with excessive reliance on net exports and production of capacity for exports is dangerous for several reasons: it makes Asia – that used to rely in the 1990s on capital flows from the rest of the world for its growth – now reliant on US and global demand from outside Asia for its growth; given the current risks of a US hard landing or even a serious US growth slowdown this is a dangerous and vulnerable model of growth. Moreover, reliance on an ever increasing level of next exports (both absolute and as a share of GDP) increases the risks of a protectionist backlash in the US and Europe. Thus, this export-led only growth model is unsustainable and a more balanced growth pattern with greater reliance on domestic demand is essential to ensure long run growth stability.

Let me elaborate on why the wholesale acceptance – with a few exceptions – of BW2 and of its related export-led growth model is dangerous for China, East Asia and the whole of the Asian continent. Notice also that many other economies outside of East Asia are following this BW2 regimes of fixed exchange rate, aggressive attempt to prevent appreciation via reserve accumulation and export-led growth. These include countries as far as India, Russia, Argentina, the GCC countries and other Middle East countries that are oil exporters and, until recently, even Brazil and other parts of Latin America. So the problems and financial vulnerabilities that we will outline below are relevant not just for East Asia but also for a broader group of emerging market economies around the world…

Here are ten points and observation on how Asia has not learned the true lessons of the 1997-98 crisis and how its policies are creating the basis of a future financial crisis in the region.

First, notice that BW2, fixed rates, easy monetary condition and low interest rates, asset bubbles and excessive reliance on export-led growth are all interconnected. Weak currencies, aggressive forex intervention to prevent appreciation in spite of current account surpluses and capital inflows lead to distorted relative prices – an undervalued real exchange rate – that punishes domestic private consumption and production of productive non-tradable services and rewards exports, investment for exportables, and investment in not-directly productive real estate and housing.

Second, the move to flexible exchange rate after the 1997-98 crisis was only temporary and soon these economies returned to effectively fixed or semi-fixed exchange rates in the new BW2 regime. Before the crisis the currency levels were somewhat overvalued; today they are grossly undervalued. Moreover, the attempt to prevent the necessary nominal and real appreciation of currencies - that are both undervalued and under appreciation pressure because of current account surpluses and net private capital inflows in the form of FDI, capital inflows in equity and bond market and hot money short term inflows – is leading to a massive and unprecedented increase in forex reserves in all of Asia… 250

Third, the ability of these economies to sterilize their forex reserve accumulation is severely limited…

Fourth, partially sterilized intervention is leading to lower than equilibrium interest rates, massive growth in the monetary based and massive growth of bank lending and credit growth. China has been attempting to control credit growth and the ensuing investment and asset bubbles that it generates via administrative controls on credit and real investment. But such controls are increasingly ineffective and source of further distortions in the allocation of savings to investment. Excessively low policy rates and short term interest rates and the accompanying credit bubbles are now becoming pervasive throughout Asia, especially the effective members of BW2.

Fifth, these monetary and credit growth and easy financial conditions are leading to inflationary pressures in these economies. Since the real exchange rate is undervalued relative to its much appreciated equilibrium level there are only two ways via which the actual real exchange rate can appreciate towards the stronger equilibrium one: either a nominal exchange rate appreciation or via domestic inflation. Since in most countries – with Korea, Thailand and Indonesia being partial exception – the nominal appreciation is prevented the real appreciation is often occurring via an increase in domestic inflation…in other economies where labor markets are not as flexible and/or where energy subsidies have been phased out inflation is rising: both in BW2 economies in East Asia and among effective members of BW2 outside that region (specifically in India, Russia, Argentina, GCC countries and other Middle East countries, etc.).

Sixth, these monetary and credit growth and easy financial conditions are leading to asset price inflation, especially in countries like China where goods inflation is limited, but more generally among most BW2 economies.

…easy credit has led to a massive surge in leveraged investments in stock markets in many of these economies. In China alone it is estimated that retail stock market investors – most clueless about the financial risks that they face – are now estimated to be over 100 million; day-trading of the type observed during the US dot.com bubble in the late 1990s are now common throughout Asia. Similar housing and stock market bubbles – and at times temporary busts – have been observed in India, Russia, Mid-East oil exporters, Argentina and other BW2 member countries. Of course, some of the increases in equity prices and in other asset prices are related to the much improved economic fundamentals. But there are now increasing signals of asset price overheating and bubble conditions, as recent episodes of stock market turmoil in China, India, and the Middle East suggest.

Seventh, the fiscal and financial costs of forex accumulation and partial sterilization are increasing…

Eighth, undervalued currencies and rising current account surpluses imply that Asia is excessively reliant on US growth and growth outside of Asia and too little on domestic demand… 251

Thus, while the US is the consumer of first and last resort with its spending well in excess of its income (leading to a massive current account deficits), China is the producer of first and last resort with its spending well below its income (leading to massive current account surpluses). More importantly, via the trade with China, most of East Asia depends on net exports and on the health of the US economy as much as China does.

Ninth, the currency and economic policies of China and East Asia have contributed – among many other factors – to unsustainable global current account imbalances whose rebalancing now risks becoming disorderly rather than orderly. Global imbalances have many causes and sources including – crucially – the low levels of US private and public savings. But China and Asia have had an important role in aggravating these unsustainable imbalances…

Tenth, the excessively easy monetary and credit conditions caused by BW2 and partially sterilized forex intervention, as well as low global nominal and real interest rates generated by this Asian excess of savings over investment have created conditions that exacerbated the excess of spending over income in the US and have fed global assets bubbles in a variety of risky assets, be it equities, credit spread, sovereign emerging market spreads, worldwide housing bubbles, commodity price booms. Low long term interest rates (Greenspan’s bond market conundrum) from excessive savings and low short interest rates given partially sterilized massive forex intervention together with the slosh of global liquidity that forex intervention, easy money in Japan and massive yen carry trade and excessive savings create excessive liquidity in the global economy that is behind the asset bubbles, credit boom, excessive leverage among private equity, hedge funds and other leveraged institutions that we are observing today. These excesses have led to an imbalance global economies where real (global current account imbalances and excessive global dependence on now fragile US growth) and financial imbalances (credit booms, risky leverage, and asset bubbles) are growing.

In summary, BW2 was always a disequilibrium for Asia and the global economy; but now from a stable disequilibrium is becoming an unstable one. Partially sterilized intervention is feeding risky credit and asset bubbles; undervalued currencies that are prevented from appreciating via massive and increased interventions are causing both goods and asset inflation and bubbles. Policies of export led growth and undervalued currencies are causing growing global imbalances that are becoming unsustainable and increasing the dependence of China and Asia on a fragile and now faltering US economic growth as the risk of a US hard landing is rising. They are leading to excessive liquidity, asset bubbles and disequilibria not just in the region but also globally. And they are increasing the risks of protectionism in the US and Europe. Thus, this economic growth model is unstable for China, for East Asia and for the world economy. A more balanced global economy requires greater domestic demand in China and Asia and smaller global imbalances…

To achieve all this [rebalancing of the global economy and of domestic demand in BW2 economies] a more flexible exchange rate regime and greater currency flexibility is necessary in Asia and throughout Asia. The policy dilemma that China and Asia faces 252

today is the classic Triffin’s inconsistent trinity: no country can have fixed exchange rates, an independent monetary and credit policy and capital mobility with no capital controls. In China, in spite of formal capital controls, capital mobility is widespread as such controls on inflows are very leaky. Thus, China by trying to keep an effective currency peg (as the rate of currency crawl is at a snail’s pace) has completely lost control of monetary and credit policy as interest rates are forced to be much lower than they should be given the overheating of the economy. And the desperate attempts of the Chinese to control the overheating via administrative controls on credit are failing given that excessive liquidity moves from controlled to uncontrolled sectors (from a boom in capex investment to a boom in housing investment; from a bubble in housing prices to a bubble in stock prices). The only solution to regain monetary and credit policy independence is to allow greater exchange rate flexibility. Similarly throughout Asia and among other BW2 members – India, Russia, the Middle East, Argentina - the same inconsistent trinity problems are emerging causing credit booms, economic overheating, goods inflation and asset bubbles.

As in the case of the Asian crisis where overheating, massive capital inflows, fixed exchange rates, credit booms and asset bubbles in equities and housing eventually led to financial imbalances before 1997 and an eventual crisis in 1997-98, the seeds of the next financial crisis are being planted today in Asia and in the other parts of the unstable BW2 system. It is true that today – compared to 1997 some vulnerabilities are different: we have current surpluses, large stock of foreign reserves, low stocks of short term foreign currency debts. Thus, a financial crisis coming from the unraveling of BW2 would not take the form – as it did in 1997 – of an external debt crisis. But like in the 1995-97 period, attempts to follow the US dollar and maintain fixed rates are feeding capital inflows, monetary creation and asset bubbles. It is easily forgotten that what triggered the Asian crisis were global conditions: then a strong dollar, a weak yen and carry trade that eventually unraveled; concerns about a global slowdown after 1995 and negative terms of trade shocks. This time around, as long as the US economy growing at a good rate the stable disequilibrium of BW2 could be maintained. But the trigger for its unraveling is likely to be, as in 1996-97, a change in global conditions external to Asia, specifically today the risk of a US hard landing as the housing recession is now spreading to the rest of the economy, creating a credit crunch and leading to a slowdown of private consumption.

As long as the US achieves a soft landing in 2007 the stable disequilibrium of BW2 can continue for a while longer. But a US hard landing (in the form of a growth recession or outright recession) will tip the BW2 disequilibrium from a stable one to an unstable one for many reasons.

First, a US hard landing would imply a sharp reduction of Chinese growth given the dependence of China on net exports and investment to produce exportables…

Second, a US hard landing of either type would not only lead to a painful growth slowdown in Asia and around the world. It would also undermine the basis of the BW2 regime. That regime in which China and Asia provide cheap goods to the US and, at the 253

same time, the financing of the US current account deficit (a system of “vendor financing”) is stable only as long as Chinese and Asian growth can continue via ever expanding net exports. The US hard landing undermines that key condition for vendor financing, a rise in US imports from China and Asia. Also, while US imports would fall in a US hard landing scenario the US current account deficit would not shrink as now net factor income payments in the US current account are negative and increasing (as the stock of foreign debt is rising and the interest payments on US liabilities rising). Thus, while until now a system of vendor financing was financing an increase in Asian exports to the US, a US hard landing would imply Asian to continue financing the increased US foreign debt and its factor income servicing rather than growing exports to the US. Thus, the willingness of Asia and other BW2 regime members to finance the US would be undermine at the time that downward pressures on the US dollar from the US hard landing lead to greater expected capital losses on holdings of dollar reserves and dollar assets.

Third, in a US hard landing protectionist pressures that are already high in a soft landing outlook would become severe with tensions on currency values turning into increasingly acrimonious trade conflicts and trade wars. In a US hard landing the US would want China to let the RMB to appreciate even more that it is pressing for it now; but in that lower growth environment where Chinese growth suffers even more, China would resist even more strongly further RMB appreciation. Thus, the outcome of this currency conflict would be a trade war between the US and China.

Fourth, a US hard landing would lead to the unraveling of the bubbly conditions in financial markets, of the credit booms and leveraged investments that that fed Asian and global asset bubbles. Risk aversion would sharply rise and investors’ confidence would sharply fall. In the spring of 2006 an inflation scare in the US led to sharp market turmoil in G7 equity markets and in emerging markets’ financial markets. In February and March 2007 a growth scare in the US following the subprime carnage led to another episode of financial turmoil in G7 and emerging markets. Now, if instead of growth “scare” we were to experience a real US growth “downfall” that takes the form of a hard landing (either a growth recession or an outright recession) the consequences for financial markets and real economies would be severe. Economies would sharply slow down, financial markets and risky assets would be shaken, global imbalances would not shrink as both US imports and exports would fall with the slowdown in global growth, dollar weakness and currency tensions would increase, and the risks of a protectionist trade war would increase.

Economic fragilities, boom and busts in housing, and policy weaknesses in the US are at the core of global economic imbalances that are leading to the risk of a US hard landing and a disorderly rebalancing of global imbalances. But it is also true that Asian currency and financial policies have fed such US imbalances creating a climate of global excess liquidity, low policy rates and easy monetary conditions (including easy money in Japan and massive yen carry trades), low global interest rates given the excess of savings over investment that have fed the US imbalances via an easy financing of the US fiscal deficits 254

and the feeding of the US housing bubble, low private savings and consumption boom that is now under threat given the bust of the housing bubble.

In the meanwhile the Asian policies have both fed the US bubbles and imbalances and made Asian growth even more hostage to US economic growth. The entire Asian economic development for the last six years has been based on creating and feeding the US excesses that are now at risk of unraveling, a system of global imbalances that is now in danger of falling apart. In the short run Asia can do little to resolve this fragile disequilibrium. If the US hard landing occurs in 2007 the consequences for China and Asia would be painful even if easing of fiscal and monetary conditions would allow the region to partially absorb the US shock.

The key to this rebalancing of Asian growth is a faster rate of appreciation of the RMB, greater currency flexibility in China and the ensuing generalized appreciation of Asian currencies relative to the US dollar once China allows a greater appreciation of the RMB. Until recently most Asian economies have been wary to allow their currencies to appreciate too much because of the persistent Chinese policy to maintain an effective RMB peg with a very small and slow rate of upward crawl.

Most Asian economies realized that maintaining an effective peg to the US dollar (or equivalently to the RMB) is costly: it leads to excessive forex reserve accumulation with its ensuing short run fiscal costs and long run large capital losses; it leads to excessive monetary growth – via partial sterilization - and credit booms that feed asset bubbles. Thus, there is increasing Asian economies’ uneasiness with staying inside BW2. But as long as China keeps on pegging its currency most Asian economies can ill afford to get off the BW2 unstable train as the loss of competitiveness of their currencies relative to the RMB, relative to the other Asian currencies and relative to the G7 currencies would be serious and cause a loss of competitiveness and growth.

A few countries tried to get off the BW2 regime given the current and expected costs of staying in this regime and accumulating a dangerous stock of excessive forex reserves: these are Korea, Thailand and Indonesia that allowed some significant appreciation of their currencies in the last few years…

At the same time other East Asian economies such as Hong Kong, Taiwan, Singapore, Malaysia – as well as members of BW2 as far as India, Russia, Middle East/GCC, Argentina – have decided so far to stick with BW2, in Asia because China is still shadowing the US dollar and these economies in East Asia think they can ill afford to allow a loss of competitiveness of their currencies relative to the RMB given their direct and indirect trade links with China. But this continued membership of BW2 is leading to a continuation of the imbalances and financial vulnerabilities generated by BW2.

These policy dilemmas and tensions will remain as long as China decides to remain the leading economy of this BW2 and maintains its effective peg to the US dollar (as the rate of upward crawl of the RMB is extremely small and slow). But these economic and financial imbalances and vulnerabilities generated by BW2 are serious and building over 255

time increasing the risks of a new and different type of financial crisis in Asia once the unraveling of BW2 becomes disorderly rather than orderly.

Thus, even leaving aside the risks of protectionism in the US, it is of tantamount importance that China realizes that its exchange rate regime is creating economic and financial instability in its own economic and creating serious problems for its trading partners in Asia…

In conclusion, Asia should now worry about not fighting the last war rather than getting prepared to deal with the next war or next financial stresses that will hit the region given its current financial and currency policies..

This policy of semi-fixed exchange rates supported by massive forex reserve accumulation is creating massive financial imbalances – excessive monetary and credit growth, a variety of financial asset bubbles, an excessive dependence on net exports and on US economic growth, an imbalanced pattern of aggregate demand – that will eventually end in a a new and different type of financial crisis, a crisis that would occur sooner rather than later if the US experiences a growth hard landing.

Thus Asia appears to have learned only some of the lessons of its 1997-98 financial crisis (the need to have sound macro and financial policies). It has not learned the real lessons of the crisis, i.e. that fixed exchange rates and poorly managed financial markets eventually lead to a build-up of vulnerabilities that can cause financial crises. The return to effectively fixed exchange rate and massive forex reserves accumulation in a good part – but not all – of East Asia is thus a worrisome sign that the lessons of the past have not been appropriately learned. Current financial and currency policies in East Asia have the risks of planting the seeds of its next financial crisis, a crisis that will have features and characteristics that will be different from those of 1997-98. Such a crisis can be avoided but it will take East Asia accepting a true move to more flexible exchange rate regimes and a significant and rapid phase-out of the current reckless policy of accumulating forex reserves in ways that are excessive and financially dangerous for East Asia.

Today, a year after I wrote that paper on the risks that Asia and other members of BW2 faced, the main predictions and implications of that paper – that the BW2 regime will lead to asset bubbles and goods inflation that would put a severe strain on that regime – have developed exactly as then predicted.

As argued then the rational response for these economies was then to let their currencies to appreciate at a faster rate (and/or phase out their pegs) to avoid the further rise in asset and goods inflation. Some degree of extra exchange rate flexibility did occur in China, India, Russia, and Brazil but not in the GCC countries or Argentina. But even that greater flexibility was not significant as very aggressive forex reserve accumulation occurred among the BRICs and other emerging market economies at rates that actually accelerated in 2008 relative to 2007. Thus, by early 2008 inflationary pressures became severe – with rising and/or double digit inflation in a large set of emerging market economies – and 256

some asset bubbles started to deflate sharply (especially equity markets in China, Asia, GCC and other emerging markets).

By now inflation has become so high in so many emerging market economies that – in some dimensions – it is almost too allow these currencies to appreciate: inflation is so high that only an abandonment of pegs or of heavily managed rates and a very sharp nominal exchange rate appreciation would be able to control inflation Even in that case nominal appreciation would not be enough to control expected inflation: a much tighter monetary and credit policy – that is feasible only if enough exchange rate flexibility is allowed – would be necessary to control actual and expected inflation. But now the global economic outlook has much worsened with the US recession and the sharp economic slowdown in most advanced economies. The need to control inflation with a stronger currency and much tighter monetary policy in emerging markets is happening at a time when downside risks to growth are emerging in these countries because of the US recession and the slowdown in the advanced economies growth rate. Thus, emerging market policy makers face a serious dilemma: controlling inflation requires exchange rate flexibility and much tighter monetary and credit policy. But such policy may exacerbate the growth landing of these economies at the time when global conditions are leading to a sharp slowdown of growth in advanced economies that – in due time – will slow down exports and growth of the emerging market economies.

Thus, it is not obvious that the members of BW2 will decide to phase out this regime and move to greater currency flexibility and tighter monetary and credit conditions. Rising oil, energy and food inflation in these economies is already leading to popular unrest, riots and – in some cases – ruling governments being toppled. Thus, the last thing that these economies need is a sharp growth slowdown on top of socially unpopular rising inflation. That is why – while the rational choice would be phasing out BW2, allow greater exchange rate flexibility, regain monetary autonomy, allow currencies to appreciate and tighten monetary/credit conditions – many of these BW2 may be reluctant to follow this painful policy path.

Indeed, while some monetary tightening has occurred in emerging market economies it has been so far well behind the curve: the rise in policy rates has been much less than necessary to control actual and expected inflation. If – as possible – these economies refuse to do what is necessary to control the rise in inflation the outcome will be one in which inflation will rise further and become entrenched in these economies. If that were to be the case these economies will accept a higher – and possibly double digit - inflation rate as a way to avoid a sharp growth slowdown. Indeed, the recent rise in inflation in emerging market is becoming a true test of whether these economies are able and willing to stick to low inflation policies and/or to formal inflation targeting. In most emerging markets with inflation targets such targets have now been breached big time and in some of them – namely Turkey – formally abandoned as being unrealistic.

Also, if these economies will decide to accommodate most of the rise in inflation rather than fight it as a way to prevent an excessive growth slowdown the outcome will be one where the real appreciation of their currencies will occur through this process of rising 257

inflation. Thus, letting inflation remain high will effectively erode the competitiveness that the pegged or heavily managed currencies policies of BW2 had tried to maintain. Eventually the real appreciation had to occur: and since it was mostly not allowed to occur via a nominal appreciation it will occur – and it is now occurring – via a rise in inflation.

When this rise in inflation becomes significant and persistent three additional outcomes will emerge. First, the competitiveness will be eroded by rising inflation. Second, downward pressures will occur on currencies that from undervalued become – via high inflation – overvalued; an example of that is the case of Argentina. Third, the rise in commodity and goods inflation in emerging markets will lead to an ensuing rise in inflation in advanced economies. This may be thus the beginning of the end of the period of “great moderation” in the global economy where growth was high and inflation low. This great moderation was indeed in part due to the low inflation that the rise of China, India and other emerging markets – with their production of cheap goods and services – had generated. Imported inflation is certainly rising in the US because of rising import prices for goods from China and Asia, a weak dollar and commodity. And it is rising in other advanced economies – even in those whose currencies are rising relative to the US dollar – because of rising prices in emerging markets and in commodity markets.

Thus, even if the BW2 economies were to resist further their currency appreciation and desperately hold on BW2 - as the rate of accelerated forex accumulation in 2008 so far suggests – the result, like the demise of BW1 shows, would be a rise in global inflation that would – at some point – destroy BW2 as rising inflation would erode the competitiveness of the BW2 club. Thus, either way we are now closer to the end game of BW2: formally BW2 is still alive and well as the reserve accumulation is as aggressive as ever or even more aggressive than in 2006-2007 among many – but not all – members of the BW2 club. But continuing with BW2 is leading now – with certainty – to inflation becoming so unhinged in the BW2 club that the basis of undervalued currencies and export-led growth will be destroyed by the real appreciation that a rise in inflation induces. So the delusion – exposed by the proponents of BW2 – that this regime would last for 20 years or more is rapidly being challenged. Either way, we are now much closer to the end game of BW2. 258

Ten Fundamental Issues in Reforming Financial Regulation and Supervision in a World of Financial Innovation and Globalization

Nouriel Roubini | March 31, 2008

U.S. Treasury Secretary Hank Paulson recently presented his proposals for a reform of the system of supervision and regulation of financial markets following the most severe – and still ongoing – financial crisis in the U.S. since the Great Depression. And soon the Draghi Commission within the Financial Stability Forum will report its conclusions and proposals for reform of the financial system to the G7 Finance Ministers.

To understand whether the U.S. Treasury proposals make sense one should first analyze what are the problems that an increasingly complex and globalized financial system faces and what are the shortcomings of the current system of financial regulation and supervision, in the U.S. and around the world. Only a detailed consideration of such problems and shortcomings can lead to the recognition of the appropriate reforms of the system. So, let us consider in more detail such problems and shortcomings of the financial system and of its regime of regulation and supervision.

They can be summarized in ten points or issues.

First, the system of compensation of bankers and operators in the financial system is flawed as it is a source of moral hazard in the form of gambling for redemption. The typical agency problems between financial firms’ shareholders and the firms’ managers/bankers/traders are exacerbated by the way the latter are compensated: since a large fraction of such compensation is in the form of bonuses tied to short-term profits and since such bonuses are one-sided (positive in good times and, at most zero, when returns are poor) managers/bankers/traders have a huge incentive to take larger risks than warranted by the goal of shareholders’ value maximization. The potential solutions to this gambling for redemption bias are varied: restricted stock that has to be maintained for a number of years; or a pool of cumulated bonuses that is not cashed out yearly but that can grow or shrink depending on the medium-term returns to particular investments.

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But even leaving aside the problem of how to change such compensation in a highly competitive labor market for talent in the financial sector, it is not obvious that the suggested solutions would fully work: for example in the case of Bear Stearns about 30% of the firm was owned by its employees and such employees had restricted stock. However this system of compensation did not prevent Bear Stearns from making reckless investment that eventually made it insolvent. Possibly this was the case because the individual compensation was not tied to the individual investment/lending decision. Still, the appropriate system of compensation of bankers/traders should be evaluated as this is now an important factor that distorts lending and investment decisions in financial markets.

Second, the current models of securitization ( the “originate and distribute” model) has serious flaws as it reduces the incentive for the originator of the claims to monitor the creditworthiness of the borrower. In the securitization food chain for U.S. mortgages every intermediary in the chain was making a fee and eventually transferring the credit risk to those least able to understand it and bear it. The mortgage broker, the home appraiser, the bank originating the mortgages and repackaging them into MBSs, the investment bank repackaging the MBSs into CDOs, CDOs of CDOs and even CDO- cubed, the credit rating agencies giving their AAA blessing to such toxic instruments: each of these intermediaries was earning income from charging fees for their step of the mortgage intermediation process and transferring the credit risk down the line to other invetstors.

One possible solution to the lack of incentives to undertake a proper monitoring of the borrowers would be to force the originating bank and the investment bank intermediaries to hold some of the credit risk, for example in the form of their holding some part of the equity tranche in the CDOs or holding some of the MBS that they originate. But it is not obvious that such solutions would fully resolve the moral hazard problems faced by financial intermediaries. In fact, while the securitization process implied a partial transfer of the credit risk from the mortgage originators and the managers of the CDOs to final investors the reality is that – even with widespread securitization - banks and other financial institutions maintained a significant exposure to mortgages, MBS and CDOs. Indeed in the US about 47% of all the assets of major banks are real estate related; and the figure for smaller banks is closer to 67%. I.e. the model of “originate and distribute” securitization did not fully transfer the credit risk of mortgages to capital market investors: rather, banks, other financial institutions and broker dealers (for example Bear Stearns) did keep in a variety of forms a significant fraction of that credit risk on their balance sheet. Indeed, if that credit risk had been fully transferred such banks and other financial intermediaries would have not suffered the hundreds of billions of dollars of losses that they have recognized so far and the many more that they will have to recognize in the near future.

Thus, excessive risk taking and gambling for redemption did occur in spite of the fact that financial institutions were still holding part of the credit risk. So proposing that such institutions hold some of that risk – rather than try to transfer all of it – does not seem to be a solution that will fully resolve the problems deriving from the wrong set of financial

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incentives faced by bankers and from the poor risk management within financial institutions. If the fundamental problem is one of the moral hazard deriving from the way that bankers are compensated forcing financial institutions to hold more of the credit risk will not resolve the problem that led in the first place to the poor monitoring of the creditworthiness of the borrowers and to the poor underwriting standards.

Third, the regulation and supervision of banks and the lighter – on in some cases such as that of hedge funds non-existent – regulation and supervision of non-bank financial institutions has led to significant regulatory arbitrage: i.e. the transfer of a large fraction of financial intermediation to non-bank financial institutions such as broker dealers, hedge funds, money market funds, SIVs, conduits, etc.

The problems with this financial innovation are twofold: first, some of the institutions in this shadow banking system (or shadow financial system) are systemically important. Two, most of these institutions are at risk of bank-like runs on their liabilities as they borrow in short-term and liquid ways, they are highly leveraged and they invest and lend in longer-term and more illiquid ways.

In the case of banks the risk of runs is significantly prevented by the existence of deposit insurance and by the lender of last resort support that the central bank can provide to depository institutions. Publicly provided deposit insurance is generally not warranted for non-bank financial institutions as the protection of small investors/depositors - who don’t have the expertise to monitor the lending/investment decisions of banks - is not generally an issue for such non banks. But as the recent Bear Stearns episode as well as the run on and collapse of other members of the shadow financial system suggest bank- like runs on non-banks can occur and are likely to occur more often if such institutions do not properly manage their liquidity and credit risks.

While provision of lender of last resort support to non-bank financial institutions that are not systemically important is not warranted such support may be justified for the very few institutions that are systemically important. And indeed the recent Fed actions - $30 billion rescue of Bear Stearns, and two new facilities that allow non-bank primary dealers to access the Fed ‘s discount window and to swap their illiquid MBS products for safe Treasuries – imply that the lender of last resort support of the Fed has been now extended to systemically important non-bank institutions. This is the most radical change in monetary policy and in the role of the Fed since the Great Depression as the Fed is not suppose to lend to non-banks. Thus, if these systemically important institution now benefits from the safety net of the Fed the same regulation and supervision that is applied to banks should also be applied to these systemically important financial firms, not just in periods of turmoil (as recently recommended by Hank Paulson) but on a more permanent basis. Otherwise the moral hazard distortions of such financial safety net would be serious and severe.

But if these institutions should be regulated like banks because they are systemically important and receive the Fed’s lender of last resort support one cannot have a system where the regulation and supervision of a subset of non-bank financial institutions is

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different depending on whether the institution is systemically important or not. Otherwise regulatory arbitrage would lead financial intermediation to move from banks and systemically important broker dealers to more lightly regulated smaller broker dealers and other non-bank financial institutions.

Thus, while the safety net of the Fed and other central banks should remain restricted to banks/depository institutions and to – subject to some constructive ambiguity - systemically important non-banks, the regulatory and supervisory framework should be similar for banks and non-bank financial institutions: regulatory capital, type of supervision, liquidity ratios, compliance and disclosure standards, etc; they should all be similar for banks and other financial institutions. Otherwise regulatory arbitrage will shift financial intermediation and risks to other more lightly regulated institutions.

For example, the loophole that allowed SIVs and conduits to operate with little supervision and no formal capital requirements under the pretense that these were off- balance sheet units – when the sponsoring bank was providing large credit enhancements and guaranteed liquidity lines that made these units de facto on-balance sheet activities of the firm – was deeply flawed. Unless these and a whole host of other special purpose vehicles are regulated and supervised as if they were on-balance sheet units this type of regulatory arbitrage will lead again to the financial mess that the SIVs created.

Moreover, a comprehensive supervisory and regulatory regime that covers both banks and non-banks would also allow a better monitoring and assessment of systemic financial risks that, at the moment, are not properly supervised. Providing both regulators/supervisors as well as investors with the reporting and disclosure of information that allows an assessment of systemic financial risks will be essential to have a sounder financial system.

Poor liquidity risk management and the risk of bank-like runs on non-bank financial institutions has been shown to be a severe problem in the shadow financial system: the entire SIV/conduit regime has recently collapsed given the roll-off of their ABCP liabilities; hedge funds and private equity funds collapsed because of risky investments and redemptions or roll-off of short term credits; money market funds whose NAV fell below par had to be rescued to avoid a run on them; Bear Stearns collapsed because of poor credit/investment choices but also because of a sudden run on its liquidity. While banks have are fundamentally maturity-mismatched given their reliance on short-term deposits there is no reason for non-bank financial institutions to run large liquidity/rollover risk especially as they do not have deposit insurance and no access – apart from the systemically important ones - to the central banks’ lender of last resort support.

Thus, an essential element of the common regulation of all non-bank financial institutions should be a greater emphasis given to the management of liquidity risk. Such firms should be asked to significantly lengthen the maturity and duration of their liabilities in order to reduce their liquidity risk. A firm that makes money only because it borrows very short, has little capital, leverages a lot and lends long and in illiquid ways is reckless

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in its risk management. Such firms should certainly fully disclose to their supervisors and investors the liquidity and other risks that it is undertaking. But it should also be required to reduce its liquidity risk with a variety of tools that ensure a greater liquidity buffer.

Fourth, most regulatory and supervisory regimes have moved in the direction of emphasizing self-regulation and market discipline rather than rigid regulations. One of the arguments in favor of this market discipline approach is that financial innovation is always one or more steps ahead of regulation; thus, one need to design a regime that does not rely on rigid rules that would be easily avoidable via financial innovation.

This market discipline approach is behind the reliance on “principles” rather than “rigid” rules, the reliance on internal models of risk assessment and management in determining how much capital a firm needs, the reliance on rating agencies assessments of creditworthiness, and a key element of the philosophy behind the Basel II agreement. But this model based on market discipline has been proven vastly flawed given that the way bankers are compensated; also, the risk-transfer incentives provided by the “originate and distribute” model implies that internal risk managers are effectively ignored in good times when “the music plays and you gotta dance”; similarly the conflicts of interests of rating agencies led to mis-ratings of new and exotic financial instruments.

Thus, while reliance on principles is useful to deal with financial innovation and regulatory arbitrage a more robust set of clear rules and regulations that go with the grain of principle-based regulation and supervision is also necessary. Strict reliance on market discipline has been proven flawed in a world where bankers are improperly compensated, where agency problems lead to poor monitoring of lending, where a flawed transfer of credit risk to those least able to understand it and manage it occurred, and where regulatory arbitrage was widespread and rampant.

Fifth, even before being fully implemented the Basel II agreement has shown its serious flaws: capital adequacy ratios that pro-cyclical and thus inducing credit booms in good times and credit busts in bad times; low emphasis on the importance of liquidity risk management; excessively low capital requirements given the serious financial risks faced by banks; excessive reliance on internal risk management models; excessive role given to the rating agencies and their ratings. These are serious shortcomings of the new capital regime for large internationally active banks and depository institutions.

To reform Basel II given the current severe financial crisis is not an easy and simple task; but the urgency of this reform is undeniable. Particular importance should be given to: measures that would reduce the pro-cyclicality of capital standards, a factor that is a source of boom and busts in credit; and measures that increase – rather than decrease - the overall amount of capital held by financial institutions. Indeed, recent history suggests that most financial institutions were vastly undercapitalized given the kind of market, liquidity, credit and operational risks that they were facing in an increasingly globalized financial system.

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Sixth, by now the conflicts of interest and informational problems that led the rating agencies to rate – or better mis-rate – many MBS and CDO and other ABS products as highly rated are well known and recognized. Having a large fraction of their revenues and profits coming from the rating of complex structured finance products and the consulting and modeling services provided to the issuers of such complex and exotic instruments it is clear that rating agencies are ripe with conflicts of interests. Add to this the flaws of a system where competition in this credit rating market is limited given the regulatory barriers to entry and the semi-official role that rating agencies have, in general and in Basel II in particular; the potential biases of a system where rating agencies are paid by issuers rather than the investors; and the informational problems of raters that know little about the underlying risks of new complex and exotic instruments.

What are the potential solutions to these conflicts of interest and other problems in the rating business? Open up competition in the rating agencies market; drop the semi- official role that rating agencies have in Basel II and in the investment decisions of asset managers; forbid activities (such as consulting or modeling) that cause conflicts of interest; change the model of ratings paid by issuers rather than by investors; the free riding problem of having investors pay for ratings can be solved by pooling the investors’ resources in a pool that can be used to collectively purchase the ratings. Certainly rating agencies have lost a lot of their reputation in this ABS ratings fiasco; and only serious and credible reforms – not just cosmetic changes – will be required to restore their credibility in the rating business.

Seventh, there are fundamental accounting issues on how to value securities, especially in periods of market volatility and illiquidity when the fundamental long term value of the asset differs from its market price. The current “fair value” approach to valuation stresses the use of mark-to-market valuation where, as much as possible, market prices should be used to value assets, whether they are illiquid or not.

There are two possible situations where mark-to-market accounting may distort valuations: first, when there are bubbles and market values may be above fundamental values; second, when bubbles burst and, because of market illiquidity, asset prices are potentially below fundamental values. The latter case has become a concern in the latest episode of market turmoil as mark-to-market accounting may force excessive writedowns and margin calls that may lead to further fire sales of illiquid assets; these, in turn, could cause a cascading fall in asset prices well below their long term fundamental value. However, mark-to-market accounting may also create serious distortions during bubbles when its use may lead to excessive leverage as high valuation allow investors to borrow more and leverage more and feed even further the asset bubble. In either case, mark-to- market accounting leads to pro-cyclical capital bank capital requirement given the way that the Basel II capital accord is designed.

The shortcomings of mark-to-market valuation are known but the main issue is whether one can find an alternative that is not subject to gaming by financial institutions. Some have suggested the use of historical cost to value assets (where assets are booked at the price at which they were bought); others have proposed the use of a discounted cash flow

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(DCF) model where long run fundamentals – cash flows – would have a greater role. However, historical cost does not seem to be an appropriate way to value assets. The use of a DCF model may seem more appealing but it is not without flaws either. How to properly estimate future cash flows? Which discount rate to apply to such cash flows? How to avoid a situation where those using this model to value asset subjectively game the model to achieve the valuations that they want as the value of the asset in a DCF model strongly depend on assumptions about future cash flows and the appropriate discount factor? Possibly mark-to-market may be a better approach when securities are held in a trading portfolio while DCF may be a more appropriate approach when such securities as held as a long term investment, i.e. until maturity. But the risk of a DCF approach is that different firms will value very differently identical assets and that firms will use any approach different from mark-to-market to manipulate their financial results.

The other difficult problem that one has to consider is that any suspension of mark-to- market accounting in periods of volatility would reduce – rather than enhance – investors’ confidence in financial institutions. Part of the recent turmoil and increase in risk aversion can be seen as an investors’ backlash against an opaque and non- transparent financial system where investors cannot properly know what is the size of the losses experienced by financial institutions and who is holding the toxic waste. Mark-to- market accounting at least imposes some discipline and transparency; moving away from it may further reduce the confidence of investors as it would lead to even less transparency.

Some suggest that the problem is not mark-to-market accounting but the pro-cyclical capital requirements of Basel II; that is correct. But even without such pro-cyclical distortions there is a risk that financial institutions – not just banks - would retrench leverage and credit too much and too fast during periods of turmoil when they become more risk averse. Thus, the issue remains open of whether there are forms of regulatory forbearance - that are not destructive of confidence - that can be used in periods of turmoil in order to avoid a cascading and destructive fall in asset prices. But certainly solutions should be symmetric, i.e applied both during periods of rising asset prices and bubbles (when market prices are above fundamentals) and when such bubbles go bust (and asset prices may fall below fundamentals). But so far there is no clear and sensible alternative to mark-to-market accounting.

Eighth, the recent financial markets crisis and turmoil has been partly caused by the fact that the – over the last few years – financial markets have become less transparent and more opaque in many different dimensions. The development of news exotic and illiquid financial instruments that are hard to value and price; the development of increasingly complex derivative instruments; the fact that many of these instruments trade over the counter rather than in an exchange; the fact that there is little information and disclosure about such instruments and who is holding them; the fact that many new financial institutions are opaque and with little or no regulation (hedge funds, private equity, SIV and other off-balance sheet special purpose vehicles) have all contributed to a lack of financial market transparency and increased opacity of such markets.

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But private financial markets cannot function properly unless there is enough information, reporting and disclosure both to market participants and to relevant regulators and supervisors. How much reporting and disclosure - and to whom - is appropriate is a difficult question. But it is clear that for the last few years financial market have become excessively opaque in ways that are destructive of investors’ confidence. When investors cannot prices appropriately complex new securities, when investors cannot properly assess the overall losses faced by financial institutions and when they cannot know who is holding toxic waste securities risk (that can be priced) turns into generalized uncertainty (that cannot be priced) and the outcome is an excessive increase in risk aversion, lack of trust and confidence in counterparties and a massive seizure of liquidity in financial markets. Greater transparency and information – including the use of fair value accounting (that, in spite of its shortcomings, is still the best way to value assets) – as well as prompt recognition by financial institutions of their exposures and losses are essential to restore the investors’ confidence in financial markets.

Some specific ideas on how to make new complex and exotic financial instruments more liquid and easier to price would be to make such instrument more standardized and have them traded in clearing house-based exchanges rather than over the counter. The benefits of standardization are clear as such standardization would allow to compare securities with similar characteristics and would thus improve their liquidity. Moreover, instruments that are exchange-traded through a clearing house would have much lower counterparty risk, would be subject to appropriate margin requirements and would be appropriately marked-to-market on a daily basis.

Ninth, what are the appropriate institutions of financial regulation and supervision and the system of such regulation and supervision in a world of financial innovation and globalization? There are many alternative models that have different pros and cons.

An increasingly popular model is the one of a unique and centralized financial regulator and supervisor, as in the case of the UK’s FSA where all financial policies – for banks, securities firms, other financial institutions, insurance companies, etc. – are under one umbrella. Another model is the US one where you have more than half a dozen or more of financial regulators and supervisors at the federal level and another layer of them at the state level. While some have argued that the US system because it foster beneficial competition about the best practices among different regulators the shortcoming of the US system, an incoherent set of overlapping regulators and a race to the bottom – rather than to the top – in terms of excessively deregulatory competition, have now become clear. One overall financial regulator may be too little but sixty plus of them is obviously way too many. A streamlining of such institutions and concentration of most regulatory and supervisory activities among a smaller number of institutions is certainly necessary.

Further, whether supervisory and regulatory power over banks – and possibly other systemically important financial institutions – should be kept within the central bank (as in the US) or whether it should be given to another regulator (as in the case of the UK FSA) is a difficult and controversial issue. Some worry that taking such powers away

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from the central bank – while maintaining its role as the lender of last resort - would reduce the ability of the central bank to oversee financial vulnerabilities in specific institutions and in the overall financial system (systemic risk). But as long as there is a proper exchange of information between the regulator and supervisor of banks and of other financial institutions and the central bank these informational issues can be properly managed. The UK debacle over Northern Rock was caused not by the existence of a single financial authority (the FSA) but rather – in part – by the lack of coordination and proper information exchange between the FSA, the Bank of England and the UK Treasury. Thus, the UK model of a single financial regulator/supervisor is – in principle – superior to a model where such powers are fragmented among many and different institutions. But proper coordination and information exchange is essential to make this system work.

Tenth, and finally, reforms of financial regulation and supervision cannot be done only at the national level as regulatory arbitrage may lead financial intermediation to move to jurisdictions with a lighter – and less appropriate - regulatory approach. Indeed, the recent US debate on reforming capital markets was driven – before the current market turmoil – by the concerns that a tighter regulatory approach in the U.S. (say the Sarbanes- Oxley legislation) was leading to a competitive slippage of New York relative to London in the provision of financial services.

In a world of financial globalization, mobile capital and lack of capital controls capital and financial intermediation may move to more lightly regulated shores. While the idea of a global financial regulator – or a global financial “sheriff” – is for the time being a bit far-fetched a much stronger degree of coordination of financial regulation and supervision policies is necessary to avoid a race to the bottom in financial regulation and supervision and to prevent excessive regulatory arbitrage. Such international coordination of financial policies is currently occurring on a very limited scale and will have to be seriously enhanced over time. Certainly within the Eurozone a system where bank supervision and regulation occurs only at the national level while only the ECB would be able to provide lender of last resort support in the case of a systemic banking crisis or when a major systemically important cross-border institution gets into trouble is an untested model. Over time financial supervision and regulation within the Eurozone will have to move from the national level to a Eurozone-wide level.

Finally, how do the U.S. Secretary Paulson proposals for the reform of the financial system compare with the principles and ideas for optimal financial regulation and supervision discussed above? An appropriate answer requires a detailed discussion that will be provided in the near future in this forum. But in brief summary, such proposals - while representing a step forward – have many shortcomings and they overemphasize the role of self-regulation, market discipline and reliance on principles rather than rules that have miserably failed to deliver an appropriate regulation and supervision of the financial system. Given that we are still in the midst of the worst U.S. financial crisis since the Great Depression, a crisis that has shaken the foundations of modern financial capitalism, the current US Treasury proposals have significant shortcomings that don’t address the core and structural financial risks and vulnerabilities that the current crisis has revealed.

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NBER WORKING PAPER SERIES

THE UNHOLY TRINITY OF FINANCIAL CONTAGION

Graciela L. Kaminsky Carmen M. Reinhart Carlos A. Vegh

Working Paper 10061 http://www.nber.org/papers/w10061

NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 October 2003

The authors wish to thank Laura Kodres, Vincent Reinhart, and Miguel Savastano for very useful comments and suggestions and Kenichi Kashiwase for excellent research assistance The views expressed herein are those of the authors and not necessarily those of the National Bureau of Economic Research.

©2003 by Graciela L. Kaminsky, Carmen M. Reinhart, and Carlos A. Vegh. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. 269

The Unholy Trinity of Financial Contagion Graciela L. Kaminsky, Carmen M. Reinhart, and Carlos A. Vegh NBER Working Paper No. 10061 October 2003 JEL No. F30, F31, F32

ABSTRACT Over the last 20 years, some financial events, such as devaluations or defaults, have triggered an immediate adverse chain reaction in other countries -- which we call fast and furious contagion. Yet, on other occasions, similar events have failed to trigger any immediate international reaction. We argue that fast and furious contagion episodes are characterized by "the unholy trinity": (i) they follow a large surge in capital flows; (ii) they come as a surprise; and (iii) they involve a leveraged common creditor. In contrast, when similar events have elicited little international reaction, they were widely anticipated and took place at a time when capital flows had already subsided.

Graciela L. Kaminsky Department of Economics George Washington University Washington, DC 20052 and NBER [email protected]

Carmen Reinhart University of Maryland School of Public Affairs and Department of Economics 4105 Van Munching Hall College Park, Maryland 20742 and NBER [email protected]

Carlos A. Vegh Department of Economics University of California, Los Angeles Los Angeles, CA 90095-1477 and NBER [email protected] 270 1

For reasons that are not always evident at the time, some financial events, such as

the devaluation of a currency or an announcement of default on sovereign debt

obligations, trigger an immediate and startling adverse chain reaction among countries

within a region and in some cases across regions. This phenomenon, which we dub “fast

and furious” contagion, was manifest after the floatation of the Thai baht on July 2, 1997,

as it quickly triggered financial turmoil across East Asia. Indonesia, Korea, Malaysia,

and the Philippines were hit the hardest—by December 1997, their currencies had

depreciated (on average) by about 75 percent. Similarly, when Russia defaulted on its

sovereign bonds on August 18, 1998, the effects were felt not only in several of the

former Soviet republics, but also in Hong Kong, Brazil, Mexico, many other emerging

markets, and the riskier segments of developed markets.1 The economic impact of these shocks on the countries unfortunate enough to be affected included declines in equity prices, spikes in the cost of borrowing, scarcity in the availability of international capital, and declines in the value of their currencies and in output.

Table 1 presents summary material for recent contagion episodes. The first column lists the country, the date that marks the beginning of the episode, the nature of the shock, and currency market developments in the crisis country, while the remaining columns include information on the existence and nature of common external shocks, the suspected main mechanism for propagation across national borders, and the countries that were most affected.

The challenge for economic researchers is to explain why the number of financial crises that did not have significant international consequences is far greater than those that did. It is no surprise that a domestic crisis (no matter how deep) in countries that are 271 2 approximately autarkic (either voluntarily or otherwise) will not likely have immediate repercussions in world capital markets. The countries may be large (China or India) or comparatively small (Bolivia and Guinea-Bissau.) More intriguing cases of “contagion that never happened” are where the crisis country is relatively large (at least by emerging market standards) and is reasonably well integrated to the rest of the world through trade or finance. Along with the fast and furious contagion episodes, these are the cases we focus on in this paper.

Some recent examples of financial crises with limited immediate consequences include Brazil’s devaluation of the real on January 13, 1999 and eventual flotation on

February 1, the Argentine default and abandonment of the Convertibility Plan in

December 2001, and Turkey’s devaluation of the lira on February 22, 2001. Given that

Brazil, Turkey, and Argentina are relatively large emerging markets, these episodes could have been–at least potentially--as highly “contagious” as the Thai and Russian crises.

Nonetheless, financial markets shrugged off these events, despite the fact that it was evident at the time that some of these shocks would have trade and real sector repercussions on neighboring countries over the medium term.2 Table 2 presents some summary material for these episodes, in a format parallel to Table 1.

This paper seeks to address the central question of why financial contagion across borders occurs in some cases but not others.3 Throughout the paper, we stress that there are three key elements—an abrupt reversal in capital inflows, surprise announcements, and a leveraged common creditor (the unholy trinity)--that distinguish the cases where contagion occurs from those where it does not. 272 3

First, contagion usually followed on the heels of a surge in inflows of international capital and, more often than not, the initial shock or announcement pricked the capital flow bubble, at least temporarily. The capacity for a swift and drastic reversal of capital flows—the so-called “sudden stop” problem—played a significant role. 4

Second, the announcements that set off the chain reactions came as a surprise to financial markets. The distinction between anticipated and unanticipated events appears critical, as forewarning allows investors to adjust their portfolios in anticipation of the event.

Third, in all cases where there were significant immediate international repercussions, a leveraged common creditor was involved—be it commercial banks, hedge funds, mutual funds, or individual bondholders—who helped to propagate the contagion across national borders.

Before turning to the question of what elements distinguish the cases where contagion occurs from those where it does not, however, we provide a brief tour of the main theoretical explanations for contagion and the most salient empirical findings on the channels of propagation.

What is Contagion?

Since the term “contagion” has been used liberally and taken on multiple meanings, it is useful to clarify how it will be used in this paper. We refer to contagion as an episode in which there are significant immediate effects in a number of countries following an event--that is, when the consequences are fast and furious and evolve over a matter of hours or days. This “fast and furious” reaction is a contrast to cases in which 273 4

the initial international reaction to the news is muted. The latter cases do not preclude the emergence of gradual and protracted effects that may cumulatively have major economic consequences. We refer to these gradual death by a thousand cuts cases as spillovers.

Common external shocks, such as changes in international interest rates or oil prices, are

also not automatically included in our working definition of contagion. Only if there is

“excess comovement” in financial and economic variables across countries in response to

a common shock do we consider it contagion.

Theories of Contagion

Through what channels does a financial crisis in one country spread across

international borders? Some models have emphasized investor behavior that gives rise to

the possibility of herding and fads. It is no doubt possible (if not appealing to many

economists) that such “irrational exuberance,” to quote Federal Reserve Chairman Alan

Greenspan, influence the behavior of capital flows and financial markets and exacerbates

the booms as well as the busts. Other models stress economic linkages through trade or

finance. This section provides a selective discussion of theories of contagion. The main

message conveyed here—consistent with our unholy trinity proposition--is that financial

linkages (i.e., cross border capital flows and common creditors) and investor behavior

figure the most prominently in the theoretical explanations of contagion.

Herding

Bikhchandani, Hirshleifer, and Welch (1992) model the fragility of mass behavior

as a consequence of informational cascades. 5 An information cascade occurs when it is 274 5 optimal for an individual, after observing the actions of those ahead of him, to follow the behavior of the preceding individual without regard to his or her own information. Under relatively mild conditions, cascades will almost surely start, and often they will be wrong.

In those circumstances, a few early individuals can have a disproportionate effect.

Changes in the underlying value of alternative decisions can lead to “fads,” that is drastic and seemingly whimsical swings in mass behavior without obvious external stimulus.

Banerjee (1992) also develops a model to examine the implications of decisions that are influenced by what others are doing. The decisions of others may reflect potentially important information in their possession that is not in the public domain.

With sequential decision making, people paying attention to what others are doing before them end up doing what everyone else is doing (i.e., herding behavior), even when one’s own private information suggests doing something different. The herd externality is of the positive feedback type: If we join the crowd, we induce others to do the same. The signals perceived by the first few decision makers–random and not necessarily correct-- determine where the first crowd forms, and from then on, everybody joins the crowd.

This characteristic of the model captures (to some extent) the phenomena of “excess volatility” in asset markets, or the frequent and unpredictable changes in fashions.

Another story suggests that the channels of transmission arise from the global diversification of financial portfolios in the presence of information asymmetries. Calvo and Mendoza (1998), for instance, present a model where the fixed costs of gathering and processing country-specific information give rise to herding behavior, even when investors are rational. Because of information costs, there are equilibria in which the marginal cost exceeds the marginal gain of gathering information. In such instances, it is 275 6

rational for investors to mimic market portfolios. When a rumor favors a different

portfolio, all investors “follow the herd.”

Trade Linkages

Some recent models have revived Nurkse’s (1944) classic story of competitive

devaluations (Gerlach and Smetts, 1996). Nurkse argued that since a devaluation in a one

country makes its goods cheaper internationally, it will pressure other countries that have

lost competitiveness to devalue as well. In this setting, a devaluation in a second country

is a policy decision whose effect on output is expected to be salutary, as it induces

expenditure-switching (i.e. reduces imports, increases exports, and improves the current

account.) An empirical implication of this type of model is that we should observe a high

volume of trade among the “synchronized” devaluers. As a story of voluntary contagion, this explanation does not square with the fact that central banks often go to great lengths to avoid a devaluation in the first place (often by engaging in an active interest rate defense of the existing exchange rate, as in Lahiri and Végh, 2003) or by enduring massive losses of foreign exchange reserves nor that devaluations have often been contractionary.

Financial Linkages

Other studies have emphasized the important role of common creditors and financial linkages. The “type” of the common creditor may differ across models but the story tends to remain consistent. 276 7

In Shleifer and Vishny (1997), arbitrage is conducted by relatively few specialized and leveraged investors, who combine their knowledge with resources that come from outside investors to take large positions. Funds under management become responsive to past performance. The authors call this Performance Based Arbitrage

(PBA). In extreme circumstances, when prices are significantly out of line and arbitrageurs are fully invested, PBA is particularly ineffective. In these instances, arbitrageurs might bail out of the market when their participation is most needed. That is, arbitrageurs face fund withdrawals, and are not very effective in betting against the mispricing. Risk averse arbitrageurs might chose to liquidate, even when they do not have to, for fear that a possible further adverse price movement may cause a drastic outflow of funds later on. While the model is not explicitly focused on contagion, one could see how an adverse shock that lowers returns (say, like the Mexican peso crisis) may lead arbitrageurs to liquidate their positions in other countries that are part of their portfolio (Argentina, Brazil, etc.), as they fear future withdrawals.

Similarly, Calvo (1998) has stressed the role of liquidity. A leveraged investor facing margin calls needs to sell asset holdings. Because of the information asymmetries, a “lemons problem” arises and the asset can only be sold at a firesale price. For this reason, the strategy will be not to sell the asset whose price has already collapsed, but other assets in the portfolio. In doing so, however, other asset prices fall and the original disturbance spreads across markets.

Kodres and Pritsker (2002) develop a rational expectations model of asset prices to explain financial market contagion. In their model, assets’ long run values are determined by macroeconomic risk factors, which are shared across countries, and by 277 8 country-specific factors. Contagion occurs when “informed” investors respond to private information on a country-specific factor, by optimally rebalancing their portfolio’s exposures to the shared macroeconomic risk factors in other countries’ markets. When there is asymmetric information in the countries hit by the rebalancing, “uninformed” investors cannot fully identify the source of the change in asset demand; they therefore respond as if the rebalancing is related to information on their own country (even though it is not). As a result, an idiosyncratic shock generates excess co-movement— contagion—across countries' asset markets. A key insight from the model is that contagion can occur between two countries even when contagion via correlated information shocks, correlated liquidity shocks, and via wealth effects are ruled out by assumption, and even when the countries do not share common macroeconomic factors, provided that both share at least one underlying macroeconomic risk factor with a third country, through which portfolio rebalancing can take place. Their model, like the rational herding model of Calvo and Mendoza (1998), has the empirical implication that countries with more internationally-traded financial assets and more liquid markets should be more vulnerable to contagion. Small, highly illiquid markets are likely to be under-represented in international portfolios to begin with and, as such, shielded from this type of contagion.

Kaminsky and Reinhart (2000) focus on is the role of commercial banks in spreading the initial shock. The behavior of foreign banks can exacerbate the original crisis by calling loans and drying up credit lines, but can also propagate crises by calling loans elsewhere. The need to rebalance the overall risk of the bank’s asset portfolio and 278 9 to recapitalize following the initial losses can lead to a marked reversal in commercial bank credit across markets where the bank has exposure.

Other Explanations

The so-called “wake-up call hypothesis” (a term coined by Morris Goldstein,

1998) relies on either investor irrationality or a fixed cost in acquiring information about emerging markets. In this story, once investors “wake up” to the weaknesses that were revealed in the crisis country, they will proceed to avoid and move out of countries that share some characteristics with the crisis country. So, for instance, if the original crisis country had a large current account deficit and a relatively “rigid” exchange rate, then other countries showing similar features will be vulnerable to similar pressures (see Basu,

1998, for a formal model).

Channels of Propagation: The Empirical Evidence

As discussed, some theoretical models emphasized trade linkages as a channel for the cross-border propagation of shocks, while most models have looked to financial markets for an explanation.

Perhaps because trade in goods and services has a longer history in the post World

War II period than trade in financial assets, or because of far better data availability, trade links have received the most attention in the empirical literature on channels of contagion. Eichengreen, Rose, and Wyplosz (1996) find evidence that trade links help explain the pattern of contagion in 20 industrial countries over 1959-1993. Glick and

Rose (1999), who examine this issue for a sample of 161 countries, come to the same 279 10 conclusion. Glick and Rose (1999) and Kaminsky and Reinhart (2000) also study trade linkages which involve competition in a common third market. While sharing a third party is a necessary condition for the competitive devaluation story, Kaminsky and

Reinhart (2000) argue it is clearly not a sufficient one. If a country that exports wool to the United States devalues, it is not obvious why this would have any detrimental effect on a country that exports semiconductors to the United States. Their study shows that third-party trade links is a plausible transmission channel in some cases but not for the majority of countries recently battered by contagion. For example, at the time of the

Asian crisis, Thailand exported many of the same goods to the same third parties as

Malaysia. This, however, does not explain all the other Asian crisis countries. Bilateral or third party trade also does not appear to carry any weight in explaining the effects of

Mexico (1994) on Argentina and Brazil. At the time of Mexico’s 1994 devaluation, only about 2 percent of Argentina’s and Brazil’s total exports went to Mexico. Similarly,

Brazil hardly trades with Russia, as only 0.2 percent of its exports are destined for

Russian markets; yet in the weeks following the Russian default Brazil’s interest rate spreads doubled and Brazil’s equity prices fell by more than 20 percent.

Kaminsky and Reinhart (2000) compare countries clustered along the lines of trade links versus countries with common bank creditors, and conclude that common financial linkages better explains the observed pattern of contagion. Mody and Taylor

(2002), who seek to explain the comovement in an exchange market pressures index by bilateral and third-party trade and other factors, also cast doubt on the importance of trade linkages in explaining the propagation of shocks. 280 11

Conversely, in many cases of crises without contagion, there are strong trade links. About 30 percent of Argentina’s exports are destined for Brazil, yet in the week following Brazil’s devaluation, the Argentine equity market increases 12 percent.

Similarly, nearly 13 percent of Uruguay’s exports are bound for the Argentine market.

Yet, the main reason why the crisis in Argentina ultimately affected Uruguay was the tight financial linkages between the two countries. Uruguayan banks have (for many years) been host to Argentinean depositors, who thought their deposits safer when these were denominated in U.S. dollars and kept across the Río de la Plata. At first, as the crisis deepened in Argentina, many deposits fled from Argentine banks and found their way to Uruguay. But when the Argentine authorities declared a freeze on bank deposits in December 2001, Argentine firms and households began to draw down the deposits they kept at Uruguayan banks. The withdrawals escalated and became a run on deposits amid fears that the Uruguayan central bank would either run out of international reserves or (like Argentina) confiscate the deposits.

Other studies focused primarily on financial channels of transmission. Frankel and Schmukler (1998) and Kaminsky, Lyons, and Schmukler (2000) show evidence to support the idea that US-based mutual funds have played an important role in spreading shocks throughout Latin America by selling assets from one country when prices fall in another – with Mexico’s 1994 crisis the being a prime example. Caramazza, Ricci, and

Salgado (1999), Kaminsky and Reinhart (2000), and Van Rijckeghem and Weder (2000) focus on the role played by commercial banks in spreading shocks and inducing a sudden stop in capital flows in the form of bank lending, especially in the debt crisis of 1982 and the crisis in Asia in 1997. Mody and Taylor (2002) link contagion to developments in the 281 12

US high yield or “junk” bond market. The common thread in these papers is that, without the financial sector linkages, contagion of the fast and furious variety would be unlikely.

Summing Up

Table 3 summarizes the some of the arguments about propagation of contagion among the five fast and furious cases emphasized earlier: Mexico in 1982, the European

Exchange Rate Mechanism crises of 1992, Mexico’s currency devaluation in 1994,

Thailand’s devaluation in 1997, and Russia’s devaluation in 1998. 6 In each case, we consider the possible trade channel, whether the affected countries shared similar characteristics with the crisis country and with each other, and whether a common creditor was present with the possible financial channel. Indeed, Table 3 lays the foundation for our unholy trinity of financial contagion proposition, which the next section discusses in greater detail. Several features summarized in Table 3 are worth highlighting. In all five cases, a common leveraged creditor was present, making it consistent with the explanations offered by Schleifer and Vishny (1997), Calvo (1998), and discussed in Kaminsky and Reinhart (2000). In three of the five cases, the scope for propagation via trade links is virtually nonexistent and in one of the two remaining cases

(Thailand) the extent of third party competition is with Malaysia, not the other affected

Asian countries. Lastly, with the exception of the countries that suffered most from

Russia/LTCM fallout, the affected countries tended to have large capital inflows and relatively fixed exchange rates.

282 13

The Unholy Trinity: Capital Inflows, Surprises, and Common Creditors

Having summarized some of the key findings of the literature on contagion, we now return to our central question of why contagion occurs in some instances but not in others.

The Capital Flow Cycle

Fast and furious contagion episodes are typically preceded by a surge in capital inflows which, more often than not, come to an abrupt halt or sudden stop in the wake of a crisis. The inflow of capital may come from banks, other financial institutions, or bondholders. The debt contracts typically have short maturities, which means that the investors and financial institutions will have to make decisions about rolling over their debts – or not doing so. With fast and furious contagion, investors and financial institutions are exposed to the crisis country and often highly leveraged. Thus, the investors can be viewed as halfway through the door, ready to back out on short notice.

This rising financial exposure to emerging markets is not present to nearly the same extent in the crises without major external consequences. Financial crises that have not set off major international dominos have usually unfolded against low volumes of international capital flows. Given lower levels of exposure, investors and institutions in the financial sector have a much lower need to adjust their portfolios when the shock occurs. In many instances, because the shock is anticipated, portfolios were adjusted prior to the event.

In all five of the examples from Table 1, the capital flow cycle has also played a key role in determining whether the effects of a crisis have significant international ramifications. For example, in the late 1970s, soaring commodity prices, low and 283 14 sometimes negative real interest rates (as late as 1978 real interest rates oscillated between minus two percent and zero), and weak loan demand in the United States made it very attractive for U.S. banks to lend to Latin America and other emerging markets—and lend they did. Capital flows, by way of bank lending, surged during this period, as shown in Figure 1. By the early 1980s, the prospects for repayment had significantly changed for the worse. U.S. short-term interest rates had risen markedly in nominal terms (the federal funds rate went from below 7 percent in mid 1978 to a peak of about 20 percent in mid-1981) and in real terms (by mid-1981 real short-term interest rates were around 10 percent, the highest level since the 1930s.) Since most of the loans made had either short maturities or variable interest rates, the effects were passed on to the borrower relatively quickly. Commodity prices had fallen almost 30 percent between 1980 and 1982, and many governments in Latin America were engaged in spending sprees that would seal their fate and render them incapable of repaying their debts. In 1981, Argentina’s public sector deficit as a percent of GDP was about 13 percent while Mexico’s was 14 percent; during 1979-80 Brazil’s deficit was of a comparable order of magnitude. Prior to

Mexico’s default in August 1982, one after another of these countries had already experienced currency crises, banking crises, or both. When Mexico ultimately defaulted, the highly exposed and leveraged banks retrenched from emerging markets in general and

Latin America in particular.

During the decade that followed, there were numerous crises in Latin America, including some severe hyperinflations (Bolivia in 1985, and Peru, Argentina, and Brazil in 1990) and other defaults. Yet, these crises had minimal international repercussions, as 284 15 most of the region was shut out of international capital markets. The drought in capital flows lasted until 1990.

Figure 1 shows net private capital flows for the contagion episodes of the 1990s, while Table 4 provides complementary information on capital flows and capital flight for the crisis country and those affected by it. Again, notice the common pattern of a run-up in borrowing followed by a crash at the time of the initial shock and much inflows of capital thereafter. Net private capital flows to Europe had risen markedly and peaked in

1992 before coming to a sudden stop after the collapse of the Exchange Rate Mechanism crisis, in which the attempt to hold exchange rates within preset bands fell apart under pressure from international arbitrageurs. The crisis in the European Monetary System in

1992-93 showed that emerging markets do not have a monopoly on vulnerability to contagion, although they certainly tend to be more crisis prone.

In the case of Mexico, as the devaluation of the peso loomed close late in 1994, capital flows were close to their 1992 peak after surging considerably. (As late as 1989,

Mexico had recorded net large capital outflows.) The rise in capital flows to the East

Asian Indonesia, Korea, Malaysia, the Philippines and Thailand (shown in Figure 1) was no less dramatic—especially after 1995, when Japanese and European bank lending to emerging Asia escalates.

The bottom right panel of Figure 1 shows the evolution of capital flows to all emerging markets and the progression of crises. The halcyon days of capital flows to emerging markets took place during the first half of the 1990s and held up at least for a short time after Mexican crisis and its contagious effects on Argentina. But the East

Asian crisis brings another wave of contagion along the marked decline in capital flows 285 16 in 1997. The Russian crisis of August 1998 delivers another blow from which emerging market flows never fully recover in the 1990s. As shown in the right bottom panel of

Figure 1, this crisis is associated with the second major leg of decline in private capital flows to emerging markets. Since Figure 1 is based on annual capital flow data, it significantly blurs the stark differences in capital flows during the pre- and post-Russia crisis. Figure 2, which plots weekly data on emerging market bond issuance before

(negative numbers) and after (positive numbers) the Russian default (dashed line) and, for contrast, the Brazilian devaluation on January 1999 (solid line). The vertical line marks the week of the crisis. It is evident that bond issuance collapses following the

Russian crisis and remains for over two months following the event; by contrast, the

Brazilian devaluation had no discernible impact on issuance, which actually increases following the devaluation.

As Figure 1 highlights, the next three crises--the Brazilian devaluation of January

1999, the Turkish devaluation of February 2001, and the Argentine default at the end of

2001—take place during the downturn of the cycle and at levels of net capital inflows that were barely above the levels of the 1980s drought. Indeed, the estimates of capital flows to emerging markets in recent years shown in Figure 1, indeed, may actually be overstated because total net flows include foreign direct investment, which held up better than portfolio bond and equity flows.

Surprise Crises and Anticipated Catastrophes

Fast and furious crises and contagion cases have a high degree of surprise associated with them while their quieter counterparts are more broadly anticipated. This 286 17 distinction appears to be critical when “potentially affected countries” have a common lender. If the common lender is surprised by the shock in the initial crises country, there is no time ahead of the impending crisis to rebalance portfolios and scale back from the affected country. In contrast, if the crisis is anticipated, investors have time to limit the damage by scaling back exposure or hedging their positions.

Evidence that quieter episodes were more anticipated than the fast and furious cases is presented in Table 5. Standard and Poor’s credit ratings had remained unchanged during the twelve months prior to of the Mexican and Thai currency crises. In the case of Russia, the credit rating is actually upgraded as late as June 1998 when the broader definition that includes Credit Watch (CW) status is used. The CW list lists the names of credits whose Moody’s ratings have a likelihood of changing. These names are actively under review because of developing trends or events which warrant a more extensive examination. Two downgrades eventually take place prior to the crises on

August 13, 1998 and again on the 17th, the day before the default. By contrast, Argentina has a string (five) of downgrades as it marched toward default, with the first one taking place in October 2000, over a year before the eventual default. Likewise, Brazil and

Turkey suffered downgrades well before the eventual currency crisis.

As further evidence that markets anticipated some of the shocks and not others,

Figure 3 plots of the domestic-international interest rate differential for the Emerging

Market Bond Index (EMBI) and the EMBI+ for two of the contagious episodes (Mexico and Russia, top panels) and for two crises without immediate international repercussions

(Argentina and Brazil, bottom panels). 7 The patterns shown in these four panels are representative of the behavior of spreads ahead of anticipated and unanticipated crises. 287 18

(The vertical axis is measured in basis points, so a measure of 1000 means a gap of 10

percentage points between the domestic borrowing rate and the international benchmark.)

If bad things are expected to happen, risk increases and spreads should widen. The

overall message is that fast and furious episodes are accompanied by sharp spikes in yield

differentials – reflecting the unanticipated nature of the news -- whereas other episodes

have tended to be anticipated by financial markets.

The top left panel of Figure 3, which shows the evolution of Mexico’s spread in

the pre-crisis period is striking. In Mexico, spreads are stable at around 500 basis points in the months and weeks prior to the December 21, 1994 devaluation. Indeed Mexico’s spreads remained below 1,000 until the week of January 6, 1995. Russian spreads, illustrated in the top right panel of Figure 3, show remarkable stability until a couple of weeks prior to the announcement and default. In the case of Russia, the devaluation of the ruble appears to have been widely expected by the markets, as evident on the spreads on ruble-denominated debt. One can conjecture that it was either the actual default or the absence of an IMF bailout (following on the heels of historically large bail-out packages for Mexico and Korea) that took markets by surprise.

The data presented in Figure 3 bottom panel illustrates the fact that markets foreshadowed turbulence in the cases of Argentina (2001) and Brazil (1999). The left bottom panel of Figure 3 presents evidence for interest rate spreads for Argentina and shows that the cost of borrowing began to rise steadily and markedly well before its default on December 23, 2001. In effect, since the week of April 22,spreads began to settle above 1,000 and since July 20 the never fell below 1,500. The bottom right panel of

Figure 3 shows Brazilian spreads. There is a run-up in spreads well before Brazil floats 288 19 the real on February 1,1999. This chart also reveals that Brazil—more so than

Argentina—was quickly and markedly affected by the Russian crisis.

In sum, we have provided suggestive evidence that anticipated crises are preceded by credit ratings downgrades and widening interest spreads before the crisis while for unanticipated crises the downgrades and widening of spreads come during the crisis or after the fact.

Common Creditors

As noted, international banks played an important role in the transmission of some of the crises of the 1980s and the 1990s. In the 1980s it was U.S. banks lending heavily to Latin America while in the 1990s it was European and Japanese bank lending to Asia, the transition economies and, in the case of Spanish banks, Latin America. In the remainder of this section, we discuss the role that commercial banks and mutual and hedge funds have played in the recent contagion episodes.

International bank lending to the Asian crisis countries grew at a 25 percent annual rate from 1994 to 1997 (or at a pace of about US$40 billion inflow per year.) At the onset of the crisis, European and Japanese banks’ lending to Asia was at its peak at

US$165 and US$124 billion, respectively, while the exposure of US banks was much more limited. Japanese banks had the highest exposure to Thailand, which also accounted for 26 percent of their total lending to emerging markets (the largest representation of any emerging market country in their portfolio.) Collectively, the Asian crisis countries

(excluding the Philippines, which did not borrow much from Japanese banks), accounted for 65 percent of the emerging market loan portfolio of Japanese banks. For European banks, the comparable share was 23 percent. Following the floatation of the Thai baht on 289 20

July 2, 1997, the exposed banks retrenched quickly and cut credit lines to emerging Asia.

The bank inflows quickly became outflows of about US$47 billion.

As with Asia, lending to transition economies had accelerated in the mid-1990s.

In the three years before the Russian crisis, international bank lending to the region grew at 14 percent per annum. German banks were more heavily exposed to Russia, with lending to Russia averaging about 20 percent of all their lending to emerging economies.

As with earlier fast and furious contagion episodes, bank flows to the region, which oscillated around US$28 billion per year in the years before the crisis, turned into a

US$14 billion dollar outflow in the year following the crisis. This retrenchment in lending helps explain why other transition economies were affected by the Russian crisis.

However, it fails to explain why Brazil, Hong Kong, and Mexico come under significant pressures at this time. To understand these and other cases, we need to turn our attention to non-bank common creditors.

Equity and bond flows also declined sharply in the aftermath of the fast and furious crises of the 1990s. For example, U.S.-based mutual funds specialized in Latin

America withdrew massively from the region following the Mexican crisis in 1994. As discussed in Kaminsky, Lyons, and Schmukler (2002), withdrawals from Latin America oscillated around 40 percent in the immediate aftermath of the crisis. The countries most affected were Argentina, Brazil, and (of course) Mexico, which were the countries to which the mutual funds were most heavily exposed to in Latin America at the time of the crisis. For example, if one examines the Latin American portfolio of mutual funds specialized in emerging markets at around the time of the crisis, Brazil, Mexico, and 290 21

Argentina account for 37, 26, and 14 percent of their portfolio, respectively (i.e., three countries accounted for 77 percent of the Latin American portfolio)!

The Thai crisis in 1997 also triggered equity outflows through mutual funds from

Asia. As discussed in Kaminsky, Lyons, and Schmukler (2002), the countries most affected by abnormal withdrawals were Hong Kong, Singapore, and Taiwan, the countries with the most liquid financial markets in the region. As was the case of the

Mexican crisis, these were the countries to which mutual funds were heavily exposed. Of the portfolio allocated to Asia, 30 percent was directed to Hong Kong, 7 percent to

Singapore, and 13 percent to Taiwan. They estimate that abnormal withdrawals (relative to the mean flow during the whole sample) oscillated at around 10 percent for the three economies.

Similarly, highly leveraged funds seem to have had an important role in the speculative attack against Hong Kong dollar in August of 1998 following the Russian crisis see Corsetti, Pesenti, and Roubini (2001). According to the Financial Stability

Forum 2000 Report of the Market Dynamics Study Group of the FSF Working Group on

Highly Leveraged Institutions (2000), large macro hedge funds appear to have detected fundamental weaknesses early and started to build large short positions against the Hong

Kong dollar. According to available estimates, hedge funds’ short positions in the HK$ market were close to 10 billion U.S. dollars (6 percent of Hong Kong’s GDP), but some observers believe that the correct figure was much higher. Several large hedge funds also took very large short positions in the equity markets, and these positions were correlated over time. As reported in the FSF study, among those taking short positions in the equity market were four large hedge funds, whose futures and options positions were equivalent 291 22 to around 40 percent of all outstanding equity futures contracts as of early August prior to the Hong Kong Monetary Authority (HKMA) intervention. Position data suggest a correlation, albeit far from perfect, in the timing of the establishment of the short positions. Two hedge funds substantially increased their positions during the period of the HKMA intervention. At end August, four hedged funds accounted for 50,500 contracts or 49 percent of the total open interest/net delta position; one fund accounted for one third. The group’s meetings suggested that some large highly leveraged institutions had large short positions in both the equity and currency markets.

Concluding Reflections

To date, what has distinguished the contagion episodes that happened from those that could have happened seems to have had little to do with more “judicious” and

“discriminating” investors—nor with any improvements to boast of in the state of the international financial architecture. If investors behaved in a more discriminating manner in the recent crises where contagion could have happened but did not, it is because: i) those crises tended to unfold in slow motion and were thus widely anticipated; and ii) the capital flow bubble had been pricked at an earlier stage, when those same investors were more “exuberant” and iii) hence, the “common creditor” we have stressed in our discussion was less leveraged in these episodes. When looking back into history, one is struck by an overwhelming sense of “déjà vu. It certainly seems a mystery why episodes of financial crises and contagion recur, in spite of the major costs associated with crises

(this would seem to provide a sufficient motivation for avoiding them.) But based on historical experience, there appears to be little hope that during the good times future 292 23

generations of sovereign borrowers or investors will remember that the four most

expensive words in financial history are “this time it’s different.”

If history is any guide, financial crises will not be eliminated—as Kindleberger

(1977) noted, they are hardy perennials. But it should be possible, based on the

understanding of what causes contagion and what does not, for countries to take steps to

reduce their vulnerability to international contagion.

Contagion appears to be linked to a substantial inflow of capital to a country. Of

course, the prospect of financial autarky as a way of avoiding fast and furious contagion

is not particularly attractive as a long run solution. In fact, it may not even be feasible

when countries have already liberalized the financial sector and the capital account. But

before turning to the issue of capital account restrictions, it is critical to remember that in

many crises (most of those discussed here and many others), the lead and largest

borrower in international capital markets during the boom periods are the sovereign

governments themselves. As Reinhart, Rogoff, and Savastano (2003) observe, it is the

most debt intolerant countries with a history of serial default that can least afford to

borrow that usually borrow the most. Often the outcome is default.

So, as a first important step, the risk of contagion would be reduced if

policymakers in countries that are integrated with world capital markets remember that

many a surge in capital inflows often ends in a sudden stop—whether owing to home- grown problems or contagion from abroad. As a consequence, prudent policymaking would at a minimum ensure that the government does not overspend and overborrow when international capital markets are all too willing to lend, as most of those episodes end in tears. In contrast, fiscal policy in emerging markets currently tends to be markedly 293 24 procyclical, with countries engaging in expansionary fiscal policy in good times and contractionary fiscal policy in bad times (Talvi and Végh, 2000). Fiscal reforms aimed at designing institutional mechanisms that would discourage such procyclical behavior

(particularly on the part of “provinces” or other autonomous entities) appear as an essential ingredient in preventing future crises from building up. Such consistent self discipline, however, on the part of governments has historically proved elusive.

As regards to curbing private borrowing from abroad, the issues are even more complex. The best case for restrictions on international financial inflows would seem to focus on debt contracts with short maturities that are denominated in a foreign currency– which have been the trigger in many modern contagion episodes. But although such policies may help in tilting the composition of capital flows toward longer maturities, their overall long-term effectiveness is unclear. Curbing capital outflows, once contagion and the ensuing sudden stop has occurred, is even more problematic.

Experience has shown that capital flight has been an endemic problem for countries that have tried to turn the clock back and re-introduce tight capital account and financial restrictions amidst economic turmoil. More fundamentally, pervasive capital controls hardly seem likely to be the solution in the medium and long run to the contagion and sudden stop problem.

As to new mechanisms in financial centers that could curb these periodic bouts of lending and “irrational exuberance” and lessen the likelihood of unpleasant future surprises, we remain very skeptical that there are easy or obvious solutions. Access to more information may not lessen surprises when borrowers and lenders have often shown themselves willing to downplay worrisome fundamentals that are in the public 294 25 domain in the late 1990s under the guise of having superior information. The economic historian Max Winkler wrote:

“The over-abundance of funds, together with the difficulty of finding the most profitable employment therefore at home has contributed greatly to the pronounced demand for and the ready absorption of large foreign issues, irrespective of quality...While high yield on a foreign bond does not necessarily indicate inferior quality, great care must be exercised in the selection of foreign bonds, especially today, when anything foreign seems to find a ready market...Promiscuous buying, however, is destined to prove disastrous.”

The New York Tribune, March 17, 1927

In 1929 a wave of currency crises swept through Latin America—it was quickly followed by a string of defaults on sovereign external debt obligations. At the time of this writing, with investors searching for high yields quickly snapping up emerging market bonds, Winkler’s warning rings as true now as it did then. 295 26

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Table 1 Financial Crises with Immediate International Repercussions: 1980-2000

Origin of the shock, Nature of common external Contagion mechanisms Countries affected country and date shock, if any

On August 1982 Between 1980 and 1985, U.S. banks, heavily With the exception of Mexico defaults on its commodity prices fell by exposed to Mexico, Chile, Colombia and external bank debt. By about 31 percent. US short retrenched from Costa Rica all countries in December, the peso term real interest rates rise emerging markets Latin America defaulted. had depreciated by 100 to about 10 percent, the percent. highest levels since the depression.

On September 8, 1992 High interest rates in Hedge funds. All the countries in the the Finnish markka is Germany. Rejection by European Monetary floated and the ERM Danish voters of the System except Germany. crisis unfolds. Maastricht treaty.

On December 20, 1994 From January 1994 to Mutual funds sell off Argentina suffered the Mexico announced a December, the Federal other Latin American most, losing about 20 15 percent devaluation Reserve raised the federal countries, notably percent of deposits in of the peso. It sparked funds rate by about 2 ½ Argentina and Brazil. early 1995. Brazil was a confidence crisis and percentage points. Massive bank runs and next, while losses in other by March 1995 the capital flight in countries in the region peso’s value had Argentina. limited to declines in declined by about 100 equity prices. percent.

On July 2 1997, The yen depreciated by Japanese banks, Indonesia, Korea, Thailand announces about 51 % against the US exposed to Thailand, Malaysia, and the that the baht will be dollar during April 1995 retrenched from Philippines were hit allowed to float. By and April 1997. Given the emerging Asia. As hardest. Financial January 1998 the baht Asian currencies link to the Korea is affected, markets in Singapore and had depreciated by US dollar, this translated European banks also Hong Kong also about 113 percent. into a significant withdraw. experienced some appreciation for their turbulence. currencies as well.

On August 18, 1998, With heavy exposure to Margin calls and Apart from several of the Russia defaults on its Russia and other high-yield leveraged hedge funds former Soviet republics, domestic bond debt. instruments, Long Term fueled the sell off in Hong Kong, Brazil, and Between July 1998 and Capital Management other emerging and Mexico were hit hardest. January 1999, the (LTCM) is revealed to be high yield markets. It But most emerging and ruble depreciated by bankrupt. is difficult to developed markets were 262 percent. On distinguish contagion affected. September 2, 1998, it from Russia and fear of became public another LTCM. knowledge that LTCM had gone bankrupt.

Sources: International Monetary Fund, International Financial Statistics, dates of the default or restructurings are taken from Reinhart, Rogoff, and Savastano (2003).

299 30

Table 2 Selected Financial Crises without Immediate International Repercussions: 1999-2001

Origin of the shock: Background on the run-up Spillover mechanisms Countries affected country and date to the shock

On January 13, 1999 The crawling peg exchange There is an increase in Significant and protracted Brazil devalues the rate policy (the Real Plan) volatility in some of effect on Argentina, as real and eventually that was adopted in July larger equity markets Brazil is Argentina’s floats on February 1. 1994 to stabilize and Argentina spreads largest trading partner. Between early January inflation is abandoned. widened. Equity and end-February the markets in Argentina real depreciates by 70 and Chile rallied. These percent. effects lasted only a few days.

Turkey, Facing substantial external There has been some February 22, 2001 financing needs, in late conjecture that the Devaluation and November 2000, rumors of Turkish crisis may have floatation of the lira the withdrawal of external exacerbated the credit lines to Turkish banks withdrawal of investors triggered a foreign exchange from Argentina but given outflows and overnight rates the weakness in soared to close to 2,000 Argentina’s fundamentals percent. at the time, it is difficult to suggest developments owed to contagion.

On December 23, Following several waves of Bank deposits fall by Uruguay and, to a much 2001, the president of capital flight, on December more than 30 percent in lesser extent, Brazil Argentina announces 1st capital controls are Uruguay, as Argentines intentions to default. introduced. withdraw deposits from Uruguayan banks. Significant effects on economic (trade and tourism) activity in Uruguay.

300 31

Table 3 Propagation Mechanisms in Episodes of Contagion

Episode Trade Common characteristic across Common creditor affected countries

Mexico, As the entire region was Large fiscal deficits, weak U.S. commercial banks. August 1982 affected, trade links are banking sectors, dependence on significant, even though commodity prices and heavy there are low levels of external borrowing. bilateral trade among most of the affected countries.

Finland, While bilateral exports to Large capital inflows, common Hedge funds. September 8, Finland from the affected exchange rate policy as part of 1992--ERM countries are small, there are the EMS. crisis substantial trade links among all the affected countries.

Mexico, No significant trade links. Exchange rate based inflation Primarily US December 21, Bilateral trade with stabilization plans. Significant bondholders, including 1994 Argentina and Brazil was real appreciation of the exchange mutual funds. minimal. Only 2 percent of rate and concerns about Argentina’s and Brazil’s overvaluation. Large capital exports were destined to inflows in the run-up to the Mexico. Little scope for third crisis. party trade story. Mexico’s exports to the United States were very different from Argentine and Brazilian exports.

Thailand, Bilateral trade with other Heavily managed exchange rates European and Japanese July 2 1997 affected countries was very and large increase in the stock of commercial banks limited. Malaysia exported short-term foreign currency debt. lending to Thailand, similar products to some of Korea, Indonesia, and the same third markets. Malaysia. Mutual Funds sell off Hong Kong and Singapore.

Russia/LTCM, Virtually no trade with the The most liquid emerging Mutual funds and hedge August 18, most affected countries markets, Brazil, Hong Kong and Funds 1998 (bilateral or third party.) Mexico were most affected. Exports from, Brazil, Mexico These three countries accounted and Hong Kong to Russia for the largest shares of mutual accounted for 1 percent or fund holdings. less of total exports for these countries.

301 32

Table 4 Capital Flows and Capital Flight on the Eve of Crises

Episode Capital flow background in crisis Capital flow background in other country relevant countries 1 Fast and furious episodes Exchange Rate Mechanism Net capital flows to Finland had In 1989 private net capital flows Crisis: risen from less than $2 billion in to the European Union (EU) were Finland September 8, 1992 1988 to $9 billion at their peak in about $11 billion (US dollars) in 1990. Portfolio flows, which 1992, on the eve of the crisis were about $3 billion in 1988, these had risen to $174 billion. however, hit their peak prior to the crisis in 1992 at $8 billion. Tequila Crisis: In 1990 private net capital flows Net flows to the other major Latin Mexico, December 21, 1994 were less than $10 billion (US American countries had also risen dollars) by 1993 flows had risen sharply, for Western Hemisphere to $35 billion. Estimates of as a whole it went from net capital flight showed a outflows in 1989 to inflows of repatriation through 1994. $47 billion in 1994. Asian Crisis: From 1993 to 1996 net capital Flows to emerging Asia had risen Thailand, July 2, 1997 flows to Thailand doubled to from less than $10 billion (US about $20 billion (US dollars). In dollars) to almost $80 billion in 1997 capital outflows amounted 1996. about $14 billion. Russian Crisis: August 18, 1998 While total flows into Russia Excluding Asia, which witnessed peaked in 1996, foreign direct a sharp capital flow reversal in investment peaked in 1998, rising 1997, capital flows to other from about $0.1 billion in 1992 to emerging markets remained $2.2 billion in 1998. buoyant through 1997 and early 1998, having risen from about $9 billion in 1990 to $125 billion in 1997. Cases without immediate international consequences Brazil Devalues and Floats: Repatriation of capital flight At about $54 billion (US dollars) February 1, 1999 amounted to about 3 percent of in 1999,capital flows to Western GDP in 1996. By early 1998 it Hemisphere well below their had reversed into capital flight. peak ($85 billion) in 1997. Yet net capital flows did not change much between 1997 and 1999, currency crisis notwithstanding. Turkey floats the lira While repatriation amounted to Following the successive crises in February 22, 2001 about 2 percent of GDP during Asia (1997) and Russia (1998) 1997-1999, capital flight began in private capital flows to emerging earnest in 2000. markets had all but dried up by 2001. At a meager $20 billion in 2001, flows were $200 billion off their peak in 1996. Argentina Defaults: Until 1998, capital abroad was (see Turkey commentary) December 23, 2001 being repatriated. By 1999, however, capital flight amounted to 5 percent of GDP. After several waves of bank runs, capital flight was estimated at 6 percent of GDP in 2001. 302 33

Table 5 Expected and Unexpected Crises: Standard and Poor’s Sovereign Credit Ratings Before and After Crises

Change in rating Country Crisis Date (including Credit Watch) Change in rating 12 months prior to the after the crisis crisis

Fast and Furious Contagion Episodes

Mexico December 21, 1994 None Downgraded two days after the crisis December 23, 1994

Thailand July 2, 1997 None Downgraded in August Russia August 18, 1998 1 upgrade and 1 further downgrade 2 downgrades (on the week of the crisis)

Crises with Limited External Consequences

Brazil February 1, 1999 2 downgrades No immediate change

Turkey February 22, 2001 1 upgrade and two I further downgrade downgrades the day after the crisis

Argentina December 23, 2001 5 downgrades between October 2000 and July 2001

Source: Standard and Poor’s, Sovereign Rating History Since 1975.

1 The international financial turmoil that followed Russia’s default was compounded in a significant manner by another negative surprise announcement: on September 2, 1998 it became public knowledge that Long Term Capital Management (LTCM), owing to its large exposure to Russia and other high-yield assets, had gone bankrupt.

2 As Brazil is Argentina’s largest trading partner, the sharp depreciation of the real

(about 70 percent between January and end February) left the Argentine peso overvalued. 303 34

Similarly, through its extensive financial and trade links, Uruguay’s economy (as it has through history) would be whiplashed by the Argentine crisis.

3 Of course, there are historical examples of fast and furious contagion before the last few decades. Commonly cited examples of contagion include the first Latin American debt crisis -- which began with Peru’s default in April 1826 -- and the international financial crisis of 1873. Going back even further in time, Neal and Weidenmeir (2002) also discuss the “contagion” dimension of the Tulip Mania of the 1630s and the

Mississippi and South Sea Bubbles of 1719-20. Two leading examples of financial crises that did not lead to contagion include the well-documented Argentina-Baring crisis of

1890, and the United States financial crisis of 1907. For detailed accounts of historical episodes of financial crises, see Bordo and Eichengreen (1999), Bordo and Murshid

(2000), Kindleberger (2000), and Neal and Weidenmier (2002.)

4 See Calvo and Reinhart (2000) for an empirical analysis of sudden stop episodes and

Caballero and Krishnamurthy. (2003) for a model that traces out the economic

consequences of sudden stops.

5 See Bikhchandani, Hirshleifer, and Welch (1998) for a thoughtful discussion of this

literature.

6 For a detailed discussion of the evolution of these contagion episodes, the interested

reader is referred to IMF World Economic Outlook (January 1993) for the ERM crisis,

IMF International Capital Markets (August 1995) for the more recent Mexican crisis,

Nouriel Roubini’s home page http://pages.stern.nyu.edu/~nroubini/ for an excellent

chronology of the Asian crisis, and IMF World Economic Outlook and International 304 35

Capital Markets Interim Assessment (December 1998) for Russia’s default and LTCM crisis. Diaz Alejandro (1984) provides a compelling discussion of the debt crisis of the early 1980s.

7 The Emerging Market Bond Index Plus (EMBI+) tracks total returns for traded external

debt instruments in the emerging markets. While the EMBI covers only Brady bonds, the

EMBI+ expands upon the EMBI, covering three additional markets: (1) Eurobonds, (2)

U.S. dollar local markets, and (3) loans. The country coverage of the EMBI+ varies over

time, currently including 19 members Current members are: Argentina, Brazil, Bulgaria,

Colombia, Ecuador, Egypt, Mexico, Malaysia, Morocco, Nigeria, Panama, Peru,

Philippines, Poland, Russia, Turkey, Ukraine, Venezuela, and South Africa. The selection

of countries and instruments follow four eligibility criteria imposed by JP Morgan Chase:

(1) a minimum balance in outstanding, (2) rating, (3) remaining maturity, and (4) ability

for international settlement. In order to construct the index of a specific country, a daily

total return of each instrument is first computed, and then aggregated by market-

capitalization-weight.

305

Figure 1. Net Private Capital Flows, 1985 - 2003

(Billions of U.S. dollars) European Union Western Hemisphere 1/ 200 50

150 40 Mexican crisis (1995) 100 30 50 20 0 10 -50 ERM crisis -100 (1992-93) 0

-150 -10 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

Asia 2/ Emerging Market Economies Asian 100 250 Mexican Turkey crisis crisis devaluation (1997) 80 (1995) (2001) Asian crisis 200 Russian (1997) 60 crisis (1998) Brazil 40 150 devaluation Argentine (1999) default 20 100 (2002) 0 50 -20

-40 0 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

1/ Includes Argentina and Mexico. 2/ Includes Indonesia, Malaysia, Philippines, South Korea, and Thailand. Source: IMF, World Economic Outlook.

Note: If the crisis occurred in the second half of the year, the vertical line is inserted in the following year.

306

Figure 2. Emerging Market: Bond Market Issuance Around Crises 1/ (In billions of U.S. dollars; weekly data, centered three-week moving average)

3.6 3.2 2.8 After Brazilian devaluation 2.4 2 1.6 1.2

0.8 After unilateral Russian 0.4 debt restructuring 0 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Weeks Relative to Crisis Week (Week 0)

1/ Data prior to Russian default exclude the July 1998 Russian debt exchange. Source: IMF staff calculations based on data from Capital Data.

307

Figure 3. Emerging Market Bond Yield Spreads, 1992 – 2002 1/

Russian Mexican 7000 crisis 2500 crisis Mexico 6000 Russia 2000 5000

1500 4000

3000 1000 2000 500 1000

0 0 92 93 94 95 96 98 99 00 01 02

8000 2500 Argentina Brazil Argentina Brazil 7000 crisis devaluation 2000 6000

5000 1500 4000 1000 3000

2000 500 1000

0 0 98 99 00 01 02 98 99 00 01 02

1/ Emerging market bond index plus (EMBI+) spreads are plotted. Source: JP Morgan Chase.

308

NBER WORKING PAPER SERIES

CRISES IN EMERGING MARKET ECONOMIES: A GLOBAL PERSPECTIVE

Guillermo A. Calvo

Working Paper 11305 http://www.nber.org/papers/w11305

NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 May 2005 Revised April 2007

This is a revised version of my paper for the Frank D. Graham Memorial Lecture, Princeton University, March 30, 2005. This paper greatly benefited from comments by Kevin Cowan, Enrique Mendoza, Carmen Reinhart and Ernesto Talvi. Special thanks go to Rudy Loo-Kung and John D. Smith for first-rate research assistance, and editing. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.

© 2005 by Guillermo A. Calvo. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. 309

Crises in Emerging Market Economies: A Global Perspective Guillermo A. Calvo NBER Working Paper No. 11305 May 2005, Revised April 2007 JEL No. F31,F32,F34,F41

ABSTRACT

The paper argues that global financial factors played an important role in the capital-inflow episode in Emerging Market economies (EMs), during the early part of the 1990s, and clearly in the Sudden Stop (of capital inflows) crises that took place after the 1998 Russian crisis. Moreover, the paper shows that recovery after crises that exhibit large output loss (more than 5 percent of GDP from peak to trough) occurs in a Phoenix-like fashion: little credit or investment is required. These results strongly suggest that: (1) deep financial crises can be prevented or at least largely alleviated and (2) global institutions and arrangements should be high on the policy agenda. The paper then discusses an Emerging Market Fund (EMF) charged with the task of lowering the incidence of contagion in EM bond prices. In addition, the paper analyzes domestic policies and concludes that they are critical and important in making EMs less vulnerable to shocks but are unlikely to succeed in fully shielding these economies from global financial shocks if not supported by arrangements like the EMF. Finally, two sections of the paper are devoted to discussing some current issues regarding applicable theory and econometrics.

Guillermo A. Calvo Professor of Economics, International and Public Affairs Columbia University School of International and Public Affairs New York, NY 10027 and NBER [email protected] 310

I. Introduction

This year (2005) marks the tenth anniversary of the “First Crisis of the Twenty-

First Century,” as Michel Camdessus, the former managing director of the IMF, called

Mexico’s 1994/5 Tequila crisis. The event is important not because it signaled a new environment (the Tequila was not that different from Mexico’s 1982 crisis), but because it was the beginning of a long series of financial crises in Emerging Market economies

(EMs). Their frequency and global span (Latin America, Asia, the Middle East and

Russia) set them apart from anything else that we have seen—at least since World War

Two. The key question that arises in this respect is as follows: Is higher frequency an indication that EMs have become sharply less creditworthy (e.g., by running unsustainably large fiscal deficits), or rather, does the higher frequency of EM crises show that greater access to the global capital market has made those economies more vulnerable to shocks coming from the capital market itself? In Calvo (2002) I referred to these capital market shocks as Globalization Hazard. The central point of this lecture is that empirical evidence strongly supports the view that EM crises exhibit an important degree of globalization hazard; consequently, policies aimed at attenuating the incidence and seriousness of these crises should contain significant global or systemic components.

Specifically, one is prompted to think of ways in which the international financial community can help to lower globalization hazard. Without new and effective global instruments, the old modus operandi in which IMF missions are sent to nurse the wounds of economies hit by crisis may still alleviate the pain, but it is unlikely to wipe out the plague.

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I begin my presentation in Section II by discussing a remarkable fact that has received little attention in the literature, namely, the persistent slowdown in EMs’ growth

(if not outright output collapse) and investment in the aftermath of the 1997 Asian and

1998 Russian crises, especially the latter.1 The negative shock cuts across various EMs, strongly suggesting the existence of systemic or global factors. This is further confirmed by evidence pointing to the fact that the capital inflow episode in EMs in the first half of the 1990s may also have global roots such as the rapid development of the US bond market and the creation of Brady Bonds. Finally, adding a touch of hope to global instability, the section closes by noting that these crises may have been preventable or significantly alleviated, albeit with new policies and institutions (some of which are later discussed in Section V).

Sections III and IV are relatively more technical and could be skipped on a first reading without loss of continuity. Section III outlines a model explaining shocks that emanate from a malfunctioning of capital markets. The section further explains why a shock in the international capital market could spread to EMs and how domestic vulnerabilities could help to magnify the external shock and give rise to higher domestic volatility and financial disorder. Section IV summarizes recent empirical and econometric findings, which further confirm the relevance of external factors and identify domestic vulnerabilities that might aggravate the impact of negative external shocks. In particular, empirical papers focus on Domestic Liability Dollarization or DLD (i.e., domestic banks’ loans denominated in foreign exchange as a share of GDP) and the

1 For a discussion of the Russian crisis in the context of Latin American economies, see Calvo and Talvi (2005).

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Current Account deficit (as a share of the absorption of tradables). Finally, Section V

discusses policy issues, emphasizing the global perspective.

II. The Asia/Russia Crisis and Its Aftermath

It always happens after a big crisis: people happily reveal their inchoate views.

Thus, for instance, after the 1982 Mexican crisis that inaugurated the so-called Debt

Crisis period, enemies of government intervention immediately concluded that the crisis

was due to the failure of Import Substitution. This conclusion stuck for many years, and

still does, as few bothered to question it.2 Likewise, after the Asia/Russia crisis, it has

become fashionable in Latin America to blame the reform process inspired by the

Washington Consensus (see Williamson (1994)), even though there is no thread of

evidence connecting reforms to crises in the region. However, if left unchallenged, this

view will soon become conventional wisdom (and an army of protection-hungry firms

and politicians will have good reason to celebrate!)

In this section, I will challenge that view in a somewhat indirect way. I will show

that there exists evidence strongly suggesting that what recently happened in EMs may

have a great deal to do with the global capital market. This does not deny, I hasten to

add, that local factors are relevant. Rather, it suggests that, without the existence of external disturbances, EMs would not have ridden the dizzying rollercoaster of recent years.3

2 For a different view stressing the catalytic role of the sharp rise in U.S. interest rates, see Borensztein and Calvo (1989), and Stiglitz (2003). Panagariya (2003) even shows that it is incorrect to characterize the 1960s and 1970s in Latin America as a period of Import Substitution. 3 See, for example, Calvo and Talvi (2005) where the sharp differences between Argentina and Chile after the Russian crisis are attributed to factors like Domestic Liability Dollarization and Openness to Trade.

4 313

Before starting, I should warn the reader that the discussion in this section is

highly impressionistic and would not pass a rigorous scientific test. The latter will have

to wait until Section IV. Instead, the main objective in this section is to show some key

stylized facts strongly suggesting that the 1997/1998 Asia/Russia crisis4 appears to have

had an inordinately strong impact on EMs, thus challenging the opponents of reform

while at the same time motivating the theoretical discussion in the next section.

The Asia/Russia Crisis

Let me begin by referring to Figure 1. Figure 1 plots monthly observations of J. P.

Morgan’s EMBI and EMs’ current account from January 1991 until the present. The

EMBI shows two episodes where this index sharply rises above 1,500 basis points (i.e.,

15 percent above U.S. treasuries), namely, shortly after the onset of (1) Mexico’s Tequila crisis in December 1994 and (2) the Russian crisis in August 1998. However, the impact on current account adjustment is quite different in the two episodes. While it is difficult to see much of an adjustment around the Tequila crisis (actually shortly after the Tequila

crisis the EM current account deficit widens until the Asian crisis in 1997), the combination of Asia and Russia set in motion an enormous current account adjustment

that completely reversed earlier current account deficits; large EM current account

surpluses are still the norm at present. Evidently, something very dramatic happened

around the Asia/Russia crisis.5 The impact of these crises on the real economy can be

seen in Figures 2 and 3.6 Again, the difference between the Tequila and Asia/Russia

4 I bunch them together because they happened in the span of about one year, but later I will argue that the Russian crisis likely was the most damaging. 5 Indeed, the drama or, rather, the tragedy also visited the North as LTCM (Long-Term Capital Management) collapsed on September 2, 1998 (see Kaminsky and Reinhart (2001)). 6 Quarterly data. Investment and output are unweighted averages across the corresponding regions. A similar pattern emerges if countries’ data are weighted by their relative GDPs.

5 314

crises is quite striking. While the Tequila crisis represents a minor bump in the road, even for Latin America, the Asia/Russia crisis is associated with major collapses in growth and investment. Even in Asia, where recovery begins immediately after the

Russian crisis, output does not return to its peak (prior to the Asian crisis) until 2002, and investment is still about 15 percent below its peak. Incidentally, notice that the

Asia/Russia crisis was much more benign in Latin America than in Asia, since in the former it brought about a slowdown in the growth rate, while in Asia output shows a precipitous decline.

Figure 1. The Asia/Russia 1997/8 Crisis: Effects on EMs.

150000 2500 Tequila As ian Russian Crisis Crisis Crisis

100000 2000

50000 1500

1000 -50000 EMBI spread (basispoints) 500

Current Account (millions USD) of Account Current -100000

-150000 0 Jul-91 Jul-92 Jul-93 Jul-94 Jul-95 Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jul-03 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Current Account Balance, last four quarters EMBI Sovereign Spread, bps over US Treasuries

Note: Includes Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Slovak Republic, South Africa, Thailand, Turkey and Venezuela. Source: J.P. Morgan and IMF Balance of Payments Statistics.

6 315

Figure 2. The Asia/Russia 1997/8 Crisis: Latin American Investment and Output.

Investment Economic Growth

110 Russian Crisis 115 Rus s ian Cr is is Annualized Annualized grow th rate: 110 grow th rate: 2002.IV-2004-III: 2002.IV-2004-III: 100 Annualized 5.4% 10.6% 105 grow th rate: 1990.I-1998-II: 100 90 7.4% Annualized 95 grow th rate: 1990.I-1998-II: Annualized grow th rate: 4.4% 80 Annualized 90 1998.II-2002-IV: grow th rate: 0.2% 1998.II-2002-IV: 85 70 -4.1% 80

75 60 70

50 65 1990.I 1991.I 1992.I 1993.I 1994.I 1995.I 1996.I 1997.I 1998.I 1999.I 2000.I 2001.I 2002.I 2003.I 2004.I 1990.I 1991.I 1992.I 1993.I 1994.I 1995.I 1996.I 1997.I 1998.I 1999.I 2000.I 2001.I 2002.I 2003.I 2004.I

Note: s.a. Investment and s.a. GDP, 1998.II=100. Includes Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. Source: Corresponding Central Banks.

Figure 3. The Asia/Russia 1997/8 Crisis: Asian Investment and Output.

Investment Economic Growth

130 110 Asian Rus sian Asian Russ ian Annualized Crisis Crisis Crisis Crisis grow th rate: Annualized 1998.III-2004-III: 100 grow th rate: 120 5.3% 1993.I-1997-III: 9.1% Annualized Annualized 90 110 grow th rate: grow th rate: 1998.III-2004-III: 1993.I-1997-III: 5.3% 6.9% 80 100

Annualized grow th rate: 70 90 1997.III-1998-III: -35.9% Annualized 60 80 grow th rate: 1997.III-1998-III: -9.7% 50 70 1993.I 1994.I 1995.I 1996.I 1997.I 1998.I 1999.I 2000.I 2001.I 2002.I 2003.I 2004.I 1993.I 1994.I 1995.I 1996.I 1997.I 1998.I 1999.I 2000.I 2001.I 2002.I 2003.I 2004.I 1993.III 1994.III 1995.III 1996.III 1997.III 1998.III 1999.III 2000.III 2001.III 2002.III 2003.III 2004.III 1993.III 1994.III 1995.III 1996.III 1997.III 1998.III 1999.III 2000.III 2001.III 2002.III 2003.III 2004.III

Note: s.a. Investment and s.a. GDP, 1997.II=100. Includes Indonesia, Korea, Malaysia, Philippines and Thailand. Source: Corresponding Central Banks.

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Why was the Tequila crisis so mild, and the Asia/Russia crisis so severe? My conjecture is that the Tequila crisis was mild because the timely and large Mexican bailout orchestrated by the Fund succeeded in insulating the global capital market

(particularly Wall Street) from this crisis.7 The Asian crisis could have also been mild

(notice that the EMBI hardly budged during this episode), but it turned virulent when

combined with the Russian crisis. The latter showed investors that the EM asset class was

much more risky than they had originally believed in the early 1990s.

Capital Inflows in the Early 1990s

Thus far, the discussion has focused on crises, completely ignoring the capital inflow

period in the first part of the 1990s. While a full account of that period is outside the

purview of this lecture, it is nonetheless worth noting that explanations run the gamut

from domestic to external factors. During the capital inflow period, the official sector was quick to conclude that the surge in capital inflows reflected the end of the Debt

Problem (the debt crisis that involved several EMs and started with Mexico’s August

1982 financial crisis) and the onset of a pro-market reform period. This fit the facts in

Latin America, but not in Asia. By and large, Emerging Asia did not suffer from the

Debt Problem, and the 1990s was not a particularly active reform period (unless one counts as pro-market reform the opening up of Asian capital market). Thus, the domestic factors explanation is not terribly convincing.

In my opinion the external factors view has, once again, a better chance of hitting the bull’s eye. As shown in Figure 4, the U.S. private sector bond market exhibited

7 Some observers claim that the Mexican bailout is responsible for the Asian crisis, because it sent the signal that the public sector would bail them out in case of trouble. I do not find this moral hazard argument very persuasive. See Calvo (2002) and discussion in Section V.

8 317

almost a 211 percent expansion in the period from 1993 to 1997 as firms shifted from

bank loans to tapping the bond market. This represented a major technical change in

global financial markets, and the growth of the U.S. fixed-income market created an

expertise that could arguably be applied to other bond issuers. Moreover, the onset of

this expansion coincided with the creation of the so-called Brady Bonds, which

essentially meant taking sovereign loans out of banks’ balance sheets and placing them

on the bond market. This, combined with the large expansion of the U.S. bond market,

may have laid the groundwork for the EM bond market. These factors may have

additionally provided a platform for the initial wave of capital inflows in the 1990s,

especially for countries afflicted by the Debt Problem. Some evidence in that direction is

presented in Figure 4, which shows that in the 1993-1997 period private international bonds8 in LAC increased by 84 percent, while in Emerging Asia they did so by an impressive 365 percent. Notice, incidentally, that while the U.S. private sector bond market keeps growing at full steam after the Asia/Russia crisis, Emerging Asia shows a sharp retrenchment, while Latin America exhibits a marked slowdown (especially after the Russian crisis). Interestingly, the different nature of the Asian and Latin American private sector international bond stocks after the Asia/Russia crisis mirrors their output counterparts (recall Figures 2 and 3).

8 I focus on international debt for EMs because domestic debt is subject to tricky valuation problems, and considering them would unduly extend the discussion. However, tentative estimates including domestic EM debt provide a similar picture.

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Figure 4. Private Debt

17000 110 Asian Crisis Russian Crisis 100 15000 90

13000 80

70 11000 60

9000 50 Debt Securities

40 (International and Domestic) (International 7000 30 United States, Total Private Debt Securities Debt Private Total States, United

5000 20 International Private LAC-7 & Asia, Emerging 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 USA LAC-7 Emerging Asia

Note: Amounts Outstanding in billions of USD. Source: BIS.

An across-the-board increase in the supply of EM bonds may contain the seeds of

its own destruction, or at least of instability. This is argued in Calvo and Mendoza (2000)

by showing that such an expansion of the bond market may diminish investors’

incentives to collect information specific to each economy and induce them to make

portfolio decisions on the basis of general information (like ex ante first and second

moments).9 However, a slight change in expectations may bring about a sharp portfolio

repositioning. Thus, this theory helps to explain the occurrence of a single country’s

Sudden Stop episode, which, to the unsuspecting observer, would appear to have come from nowhere. As will be discussed in Section III, this type of shock may create confusion and make investors (especially the unsuspecting or uninformed ones) think that

9 A key assumption is that short sales are bounded (e.g., there are margin constraints).

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most EMs are subject to a negative shock, giving rise to an across-the-board increase in

interest-rate spreads, such as occurred during the 1998 Russian crisis.

The Phoenix Miracle

Another topic that deserves mention here is the nature of recovery after a Sudden

Stop (of capital inflows).10 In ongoing work with Alejandro Izquierdo and Ernesto Talvi

we examine the recovery process in all EM Sudden Stop episodes from 1980 to the

present, including all of those cases in which output fell by more than 5 percent from

peak to trough and exhibited a systemic nature. Economies in the sample underwent

Sudden Stops around the times of the 1982 and 1994/5 Mexican crises and the 1997/8

Asia/Russia crisis. In total we examined 14 cases. Among many interesting features, some of which will not be reported at this time (such as the remarkably similar V-shaped pattern of these crises), we find that the recovery took place under conditions in which (1) domestic bank credit, (2) current account deficit and (3) investment were only a fraction of the corresponding levels prior to Sudden Stop. This Phoenix Miracle or Rising from the Ashes phenomenon suggests that systemic Sudden Stops are preventable accidents.11

How to avoid them depends on how one interprets the reasons behind Sudden Stops. If

the triggering factor is external to EMs, then global solutions are called for. Our previous discussion shows that the Asia/Russia crisis could be a case in point. However, as the theoretical and econometric sections below will argue, domestic factors are also likely to play a critical role. Thus, policies to prevent Sudden Stops and attenuate their effects

10 These are episodes in which the flow of new international credit is sharply curtailed, and are central to recent financial crises in EMs. For a more formal definition, see Section IV below. 11 For an update of these results and formal empirical tests that confirm and extend them, see Calvo, Izquierdo and Talvi (2006).

11 320

must encompass both domestic and global components. This will be addressed in Section

V below.

The discussion above shows very clearly that the Asia/Russia crisis was

associated with a major and persistent collapse in EM growth and investment. This

empirical evidence should give pause to opponents of reform and at least make them

reconsider their dogmas. However, that is unlikely to happen unless they are faced with

well-structured theory and scientific empirical analysis. A summary of the first steps in

that direction will occupy us in the next two sections.12 However, readers less interested

in technical details are prompted to proceed directly to the policy discussion in Section V.

III. Insights from Theory

The first step is to rationalize the existence of a Sudden Stop stemming from a malfunctioning of international capital markets. Let the EM production function be given by f(k,θ), where k is capital per unit of a fixed factor (which one might interpret as entrepreneurial services, or home goods), and θ is a random shock.13

The representative firm is risk neutral and chooses k so as to maximize its quasi-

rent, i.e.,

( θ − − NrkkfEMaxEMax ii ),)(}/]),({[ (1) ∈Ii k where r is the international rate of interest or capital rental faced by the firm, E is the expectations operator, I is the set of information schemes (or σ-fields) available to the

12 The following discussion is heavily biased towards my own work, since I assume the objective of these lectures is to showcase different views rather than to offer a balanced survey of the literature. 13 As usual, I assume that function f is increasing and strictly concave with respect to k. A fixed factor is assumed, instead of allowing for a variable factor like labor, because at one point I will introduce a fixed

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firm, the forward slash stands for “conditional upon,” information scheme i is a member of I, and N(i) is the cost of information scheme i. Thus, given information scheme i, the firm is assumed to maximize its expected quasi-rent with respect to k, conditional upon information scheme i. The firm then chooses the information scheme i ∈ I that maximizes ex ante expected profits.

International shocks are transmitted through the interest rate faced by the firm, r.

Investors are risk neutral, but there are states of nature in which EM governments may impose a tax τ on interest income (in response to, for instance, a negative common real shock).14 Thus, letting R stand for the pure international interest rate, the no-arbitrage condition implies that

⎛ R ⎞ = Er ⎜ ⎟. (2) ⎝1−τ ⎠

Consider now a capital market mishap similar to the one that allegedly occurred during the Russian crisis, in which a set of key investors are subject to margin calls and therefore sharply lower their participation or dump a considerable share of their EM portfolios in the market.15 Upon observing such strange behavior on the part of margin- constrained but high-profile investors and firms, the non-margin-constrained agents would face a classical signal-extraction problem. What prompted margin-constrained investors to withdraw from the market? Was it because they are margin-constrained, or because they learned that EMs have been hit by a negative shock and, say, governments

cost and, as is well known, under those conditions variable factors and linear homogeneity are inconsistent with the existence of a competitive equilibrium. 14 The tax story is chosen for its simplicity. There is nothing especially “realistic” about it.

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will increase the tax τ on capital flows? Under those circumstances, unless there is a totally credible leak signaling that all is due to margin calls, rational non-margin- constrained agents (the only ones that would be able to extend fresh loans to EMs) will infer that EMs have been hit by a common negative shock. Consequently, expected interest income taxes will rise, leading to an increase in interest rates faced by firms, r.16

Therefore, a mishap in the international capital market that has nothing to do with EMs may result in an increase in r and have a negative impact on output.17

However, some degree of skepticism would be warranted here, because the argument above could apply to developed economies as well. Why, then, are EMs more likely to suffer devastating effects from capital market accidents? In my view, the key element that differentiates developed economies from EMs is in the very labeling of

EMs, namely, the adjective Emerging, especially if by Emerging one means that these economies operate under highly incomplete information due to, for example: (1) lack of a sufficiently long track record, and (2) weak economic and political institutions. These conditions make it more likely that, faced with a shock stemming from the international capital market, uninformed economic agents give more weight to the conjecture that the shock has a large EM component, and less weight to the alternative, i.e., that the shock comes from the international capital market.

Calvo (1999) discusses an example along these lines in which margin-call shocks and EM shocks are log-normally distributed and are mutually stochastically independent; in that context it is well known that the weight rational individuals give to domestic

15 Some investors buy financial securities by borrowing the attendant funds from a bank. Thus, upon a sharp fall in securities’ market values, the bank may decide that the original loan is too risky and demand a swift (partial) repayment. This is a salient characteristic of “margin calls.” 16 For a more rigorous discussion of this issue, see Calvo (1999).

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factors increases with the variance of domestic shocks relative to that of margin-call shocks. Thus, the larger the volatility of information about an economy, the bigger the weight uninformed (but rational) investors will put on domestic factors, which helps to explain why the same accident in the world capital market may have a bigger negative impact in EMs than in developed economies.

As argued in Calvo (1999), however, a Sudden Stop in capital inflows (provoked in this case by a sharp rise in r) may have negative effects that go beyond the decline in capital or investment. The existence of additionally negative effects is a standard feature in current macro models, and it goes by the name of adjustment costs. Typically, it is assumed that the larger the change in the rate of investment, the larger its associated adjustment cost. However, the standard assumption is that such costs result in lower net output but have no direct effect on marginal productivities and that, equally important, they are temporary. Relevant as the standard assumption may be for regular business- cycle shocks, it does not seem to capture the great disarray that follows a Sudden Stop in

EMs, in which shocks are so large and widespread that they radically change the business environment. Therefore, a more appropriate assumption seems to be that adjustment costs impinge on the marginal productivity of capital, θ, in our model and, in a dynamic extension, that the shocks are highly persistent (especially in the absence of sufficiently large and timely bailouts). Thus, at the very least one should assume that a

Sudden Stop temporarily lowers the unconditional expectation of θ. Since the Sudden

17 See Neumeyer and Perri (2005) for an analysis of the impact of international interest rates faced by EMs and their business cycle.

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Stop lowers the marginal productivity of capital, output will remain depressed even though interest rates go back to pre-crisis levels.18

The effect of a Sudden Stop on marginal productivities is likely to depend on the depth of the ensuing domestic financial turmoil. In some extreme cases, such as in

Argentina in 2002, even the domestic payments system may come to a sudden stop. In recent research with my collaborators, which will be summarized in Section IV, we have identified two factors that may contribute to deepening domestic crisis and, as a result, increase the probability of a Sudden Stop. These factors are Domestic Liability

Dollarization (DLD) and a large current account (of the balance of payments) deficit as a share of output of tradables. DLD is defined as domestic banks’ foreign exchange- denominated loans as a share of GDP, and it is a risk factor because Sudden Stops are associated with large real devaluations, increasing the chances that foreign exchange denominated loans will be defaulted on. On the other hand, the current account deficit

(as a share of the domestic production of tradables) is also a risk factor because a Sudden

Stop typically leads to a sharp current account adjustment which is likely to bring about large changes in relative prices (never a good omen in financial markets) when output of tradables is small. (If the economy produces only tradables, however, the current account adjustment would take place with hardly any change in the real exchange rate.)

As will be discussed in Section IV, empirical analyses also show that the volatility of relative prices sharply goes up during Sudden Stops, thus suggesting that Sudden Stops are also likely to lead to a higher variance of θ. This may stem from the fact that a

18 Mendoza (2004) studies a dynamic general equilibrium model in which Sudden Stops emerge exogenously, and when they occur the economy exhibits productivity effects on value added of the type discussed here. These effects are caused by changes in capacity utilization and demand for intermediate goods triggered by frictions in world credit markets.

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Sudden Stop increases the share of systemic as opposed to firm-specific shocks on individual θj, where j stands for firm j. Greater volatility, in turn, may increase firms’ incentives to learn more about the state of nature. Thus, as firms divert resources to knowledge activities, output in the short run is likely to fall further. Moreover, better knowledge about the state of nature may be reflected in even larger price volatility, as will be shown in the following example.

Relative-Price Volatility

To simplify the exposition, I will assume that there are only two polar information schemes: (a) No Information, NI, i.e., firms know the distribution of random variable θ, but not its realization, and (b) Full Information, FI, i.e., firms know the realization of θ.

Moreover, following Calvo, Izquierdo and Loo-Kung (2006), I will assume that function f can be approximated by the following quadratic form:

1 ),( −θ=θ kkkf 2 . (3) 2

Thus, in the no-information case, the maximization problem stated inside expression (1)

(i.e., after choosing the information scheme) yields, assuming interior solutions,

NI −θ= rk , (4) where kNI is the quasi-rent-maximizing capital stock under no information, and θ is the unconditional expectation of θ. Thus,

1 NI =π rkkfEMax ]),([ −θ=−θ r 2 ,)( (5) k θ 2

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where πNI stands for expected maximum quasi-rent in the no-information case.

Moreover, the ex post return to the fixed factor, wNI, is given by

1 NI NI rkkfw NI ))((),( −θ−−θ−θ=−θ= rrr 2 .)( (6) 2

Similarly, the quasi-rent-maximizing k in the full information case satisfies

FI −θ= rk , (7) and, expected quasi-rents associated with full information, denoted by πFI, satisfy

1 1 FI =π ]),([ rErkkfMaxE )( 2 var π+θ=−θ=−θ NI (8) θ k 2 θ 2

Equation (8) shows that expected quasi-rents under full information are larger than under no information, the difference being proportional to the volatility of θ. Clearly, given information cost, the higher the volatility of θ, the larger will be the incentives to acquire full information.

Furthermore, denoting the ex post return to the fixed factor under full information by wFI, we have

1 FI FI ),( rkkfw FI −θ=−θ= r 2 .)( (9) 2

Does more information entail higher relative-price volatility, as measured by w?

To answer this question in the present context, we could compute RVol defined as follows:

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var wFI 1 −θ r 2 ])var[( RVol = = , (10) var wNI −θ r)(2 var θ where the rightmost expression in (10) follows from equations (6) and (9). To obtain an explicit expression for RVol let us consider the case in which θ is log-normally distributed with natural log mean μ and natural log standard deviation σ, and assume r =

0. Then, one can show (see Appendix),

4σ2 1 σ2 e −1 = eRVol 2 > .1 (11) 2 eσ −1

Therefore, this example confirms the intuition that better information will result in higher relative-price volatility.19 This may not be welfare-reducing if its only effect is to generate an economy operating under better information. However, if firms are debt- ridden (as is likely to be the case after a capital-inflow episode), then the resulting higher relative-price volatility may bring about financial difficulties, which could more than offset the beneficial effects of better information.20

IV. Sudden Stop Probability and Price Volatility: Empirical Evidence

In this section I will summarize the main empirical findings on the Sudden Stop phenomenon based on Calvo and Reinhart (2000a), Kaminsky and Reinhart (2001),

Calvo, Izquierdo and Talvi (2004), Calvo, Izquierdo and Mejía (2004) and Calvo,

19 In Calvo, Izquierdo and Loo-Kung (2005) a similar result is shown in the case in which θ is uniformly distributed. However, we have not been able to establish the generality of this result for arbitrary distribution functions. 20 Notice that DLD is not a problem in the present context because firms are implicitly assumed to produce tradable goods.

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Izquierdo and Loo-Kung (2006). In these papers we employ various definitions of

Sudden Stop. However, much of the systematic empirical analysis defines Sudden Stop along the following lines:

• First, we define capital flows as of month t, as the accumulated capital flows in

the previous t – 11 months.

• We say that there is a Sudden Stop Episode at month t if capital flows in month t

are lower than its mean by more than 2 standard deviations, where mean and

standard deviation are computed from prior history.

• We define a Candidate Interval for Sudden Stop, as a time interval that contains a

Sudden Stop Episode, and for each month of the interval, capital flows are at least

1 standard deviation below the mean.

• Finally, we define a Sudden Stop Interval as a Candidate Interval for Sudden Stop

in which, in addition, output falls (see Calvo, Izquierdo and Mejía (2004)) or there

is at least 1 month in the interval in which the regional international interest-rate

spread exceeds its mean by at least 2 standard deviations (see Calvo, Izquierdo

and Loo-Kung (2006)).

These definitions of Sudden Stop try to capture situations in which the contraction of capital flows has a large “surprise” element, and is either associated with an output fall21 or takes place in an environment in which all EMs are undergoing financial stress.

21 The output contraction condition was assumed in order to exclude cases in which capital flows drop as a result of large terms of trade improvement, a phenomenon that has no connection to capital market difficulties, which is the focus of our analysis. Criticism of this criterion led us to the alternative definition in which the requirement is that global capital markets for EMs show signs of trouble.

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This definition is in line with the following setup. Sudden Stops stem mostly from a malfunctioning of the global capital market. A mishap in the latter leads investors to test all EMs. Thus, each EM is subject to an Incipient Sudden Stop. If the economy bounces back from this test, no (Full-Fledged) Sudden Stop takes place; otherwise, a

Sudden Stop (Interval) will take place. As discussed in Section III, whether or not a

Sudden Stop will occur is likely a function of domestic vulnerabilities. However, before turning to that issue, I would like to discuss two interesting features of Sudden Stops.

In the first place, Figure 5 shows that, for the case in which the definition of

Sudden Stops requires output contraction, Sudden Stops tend to bunch together, especially in EMs. This suggests that there is a systemic element in Sudden Stops (which is one reason why we changed the definition in Calvo, Izquierdo and Loo-Kung (2006), and required that Sudden Stops have a systemic characteristic), reinforcing the conjecture that Sudden Stops could have external roots.

Figure 5. Bunching of Sudden Stop Episodes in Emerging Market Economies.

6 Emerging Markets Developed Economies

0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Source: Calvo, Izquierdo and Mejía (2004).

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Second, as shown in Chart 1, more than 60 percent of large devaluations (which are typically associated with balance-of-payments, BOP, crises) in EMs are accompanied by a Sudden Stop, while for developed economies less than 20 percent exhibit that feature. This reveals a central difference between EMs and developed economies: BOP crises in EMs are more likely to be associated with a credit crisis than in developed economies. Thus, while purely monetary models like Krugman (1979) could be relevant for developed economies, Chart 1 suggests that for EMs one has to look deeper into the roots of credit disruptions.22 An implication of these facts is that, while simple policy actions like currency devaluation could be very effective in restoring equilibrium for developed economies, they may be ineffective or even counterproductive in EMs.23

Chart 1. Sudden Stop and Large Currency Depreciation In % of total Emerging Developed Markets Economies Devaluations associated with Sudden Stop 63 17 Of which: First Sudden Stop, then devaluation 42 9 First devaluation, then Sudden Stop 21 9 Devaluations not associated with Sudden Stop 37 83

Note: The total number of large devaluations is 19 in emerging markets and 23 in developed economies. Source: Calvo, Izquierdo and Mejía (2004).

Third, in Calvo, Izquierdo and Mejía (2004), and Calvo, Izquierdo and Loo-Kung

(2006), we tested the hypothesis that the probability of a Sudden Stop increased with

DLD (defined as local banks’ foreign-exchange denominated loans as a share of GDP and current account deficit as a share of output of tradables (denoted by 1 – ω). The

22 This establishes a connection with Section III, since credit disruptions are at the heart of the theoretical framework discussed there.

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rationale for these variables was discussed in the previous section. In all cases we find that DLD and ω are significant at conventional levels. Terms of Trade come out significant and with the right sign (i.e., negative) in some cases but, by far, not in all.

Moreover, other a priori relevant macro variables like fiscal deficit and total debt are not significant. It is worth noting that in our interpretation this does not imply that the probability of a Sudden Stop is independent of past “bad” policy but, rather, that the conditional probability of a Sudden Stop may exclusively depend on DLD and ω. DLD, in particular, could reflect past monetary and fiscal mismanagement, driving individuals to protect themselves by adopting a more stable foreign currency. Once DLD is placed on the right-hand side of the estimation equation, however, past history becomes irrelevant.

Figure 6 is based on panel probit estimates in Calvo, Izquierdo and Mejía (2004).

The left-hand side in Figure 6 corresponds to the standard random effects probit estimation, while the right-hand side corresponds to estimates that adjust for endogeneity

à la Rivers and Vuong (1988). Clearly, the probability of Sudden Stop falls with 1 - ω and rises with DLD. It is worth noting that the probability of a Sudden Stop is highly sensitive to DLD values in the sample. This sensitivity is even greater when we adjust for endogeneity.

23 This issue will be further discussed in the next section.

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Figure 6. Probability of Sudden Stop.

Not controlling for the Controlling for the endogeneity of w endogeneity of w (A) (B)

1.00 1.00

Low dollarization

Average dollarization

High dollarization 0.75 0.75

0.50 0.50 Probability of a sudden stop

0.25 0.25

0.00 0.00 0.75 1 1.25 1.5 0.75 1 1.25 1.5 Omega Omega Source: Calvo, Izquierdo and Mejía (2004).

Relative-Price Volatility

Another issue worth exploring is volatility. The theoretical model in Section III suggests that volatility may change during Sudden Stops. That is precisely what we find in Calvo, Izquierdo and Loo-Kung (2006).24 In our sample, the ratio of the variance of relative prices (measured by the ratio: Wholesale/Consumer prices indexes) is around 3 times larger during Sudden Stop than during Tranquil (i.e., non-Sudden Stop) periods for

EMs, while for developed economies that ratio is around 2. This suggests that the variance of random shocks like θ in the model of Section III increases during a Sudden

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Stop, possibly leading to further volatility and output costs as a result of firms’ investment in information. Furthermore, Figure 7 shows that conditional volatility can also exhibit large changes, especially for EMs. Notice that the two big spikes there occur around the Tequila and Asia/Russia crises but, once again, the Asia/Russia crisis dominates the scene. In Calvo, Izquierdo and Loo-Kung (2006) we estimate ARCH models with DLD, 1 - ω, and a dummy for Sudden Stop as independent variables, given that arguments similar to those suggesting that they may have a role in determining expected changes in relative prices could be utilized to justify their possible effect on relative-price volatility.

Figure 7. WPI/CPI Conditional Variance for the Average Emerging and Developed economy.

Tequila Crisis Asia/Russia Crisis 12

0 Jan-01 Jan-00 Jan-99 Jan-98 Jan-97 Jan-96 Jan-95 Jan-94 Sep-01 Sep-00 Sep-99 Sep-98 Sep-97 Sep-96 Sep-95 Sep-94 May-01 May-00 May-99 May-98 May-97 May-96 May-95 May-94 Average Emerging Market Average Developed Economy

Source: Own calculations based on estimations from Calvo, Izquierdo and Loo-Kung (2006).

24 See also Kaminsky and Reinhart (2001).

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Our conjecture was confirmed. We found that the coefficient for Sudden Stop and DLD are always significant (at conventional levels) and positive, showing that conditional relative-price volatility increases with DLD and during Sudden Stop. On the other hand, the significance of 1 - ω does not always hold, although it does so in a good number of cases, and its point estimate is always negative, i.e., relative-price conditional volatility is an increasing function of the current account deficit (as a share of output of tradables). Thus, variables that help to enhance the probability of a Sudden Stop also seem to contribute to higher relative-price volatility. Volatility is not necessarily a negative factor, especially if it reflects better information, but it could be dangerous in a context of, for example, high DLD.

In sum, econometric studies do not reject the hypothesis that Sudden Stops are largely prompted by external factors but, at the same time, strongly suggest that the probability of Sudden Stops reflects domestic characteristics. Moreover, Sudden Stops are periods of higher conditional volatility, which may cause financial disorder if contracts are not made state-conditional.

V. Policy Issues

The evidence discussed in Section II strongly suggests that EMs could be subject to external shocks that combined with domestic vulnerabilities, result in major crises.

Moreover, the Phoenix Miracle reported at the end of that section suggests, in addition, that one may be dealing with preventable accidents. Therefore, one is left with the feeling that there must be room for policies and institutions that help to reduce the incidence of Sudden Stops and attenuate their consequences. In this section I will discuss

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domestic and global policies that relate to the previous sections, although no attempt is made to provide comprehensive coverage of the many issues involved here.25

Domestic Policies

Sudden Stops happen in the best of families (see Calvo and Talvi (2005)). In order to avoid Sudden Stops and/or attenuate their effects, the empirical research summarized in Section IV suggests that it is essential to reduce financial vulnerabilities.

Among them, it is particularly important to maintain low exposure to foreign- denominated debt, especially DLD. Since DLD involves the domestic payments system, financial crises under high DLD may entail serious systemic consequences. It should be noticed that these concerns involve both public and private sectors; this is so because experience shows that the government is likely to be called upon as lender of last resort if the private sector runs into financial trouble. Thus, for example, public debt in Korea was around 10 percent before the July 1997 crisis and quickly rose to about 40 percent as a result of the mechanisms put in place to ameliorate the effects of the crisis in the private sector. Contingent public debt is hard to control, precisely because government bailouts are effective instruments for attenuating the impact of financial crises. Thus, stern statements to the effect that the government will not be a lender of last resort will enjoy little credibility.

An alternative policy would be to discourage large private debt in terms of foreign exchange by levying a tax on total borrowing (not just international borrowing) denominated in foreign exchange. This is not easy to implement, however, and it may have a negative impact on growth.

25 For a complementary policy discussion, see Calvo (2002) and Calvo and Talvi (2005).

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Another way to discourage foreign-exchange-denominated borrowing is allowing the exchange rate to undergo large fluctuations. However, this policy is likely to result in a highly volatile real exchange rate, which may have negative effects on trade and output

(see Calvo and Reinhart (2000b)). Moreover, if the economy initially exhibits large

DLD, real exchange rate volatility may cause serious financial distress, as noted above.

Incidentally, forcing de-dollarization has proven not to be very effective, since there are many examples where dollarization returns with a vengeance. On the other hand, spontaneous de-dollarization cases are few and far between (see Reinhart, Rogoff and

Savastano (2003)). At present, however, a small window of opportunity may be opening up. The U.S. dollar, the currency of choice for denominating financial transactions in

EMs (until now), is undergoing persistent devaluation vis-à-vis several currencies, including EM currencies. This appears to have increased the appetite of international investors for debts denominated in terms of EM currencies. Countries like Colombia,

Mexico and Peru are taking advantage of the situation and issuing public debt denominated in their own currencies, which is being acquired by both domestic and foreign investors.

The previous discussion was heavily colored by my conjecture that global crises entail major financial difficulties that prevent the effective use of standard countercyclical monetary and fiscal policies. There are exceptions, though, and Chile in

1998 is possibly one of them. Chile was hit by the largest Sudden Stop in Latin America

(equivalent to more than 7 percent of GDP; see Calvo and Talvi (2005), and Cowan and

De Gregorio (2005)).26 However, Chile did not display a high level of Liability

26 Chile never lost access to credit markets. However, this is not incompatible with suffering an externally- driven Sudden Stop. To be sure, Chile’s spread was low compared to the rest of Latin America. However,

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Dollarization, its current account deficit (relative to output of tradables) was not large, and public debt was tiny. Why, then, did Chile experience such a large Sudden Stop? An interesting conjecture is that, in response to the 1998 Russian crisis shock wave, Chile chose the wrong policy mix, sending the wrong signal to the market. As this view goes,

Chile, like every other EM, was tested by the markets after the Russian crisis. In response, Chile narrowed the exchange-rate band (the previously large headroom of the exchange rate was virtually eliminated) and sharply tightened monetary policy, sending interest rates to record-high levels. This policy response revealed to the market that the monetary authority was worried about balance-sheet currency-denomination mismatch

(i.e., Liability Dollarization). This signal was wrong because Liability Dollarization was apparently a problem only for firms providing public services, involving multinationals who most likely would have been bailed out by their headquarters. Thus, this argument that that this type of policy could have put Chile, in the eyes of investors, in the same basket as Argentina and other Liability Dollarized economies—helping to explain the full-fledged Sudden Stop that followed. Expansive monetary and fiscal policy may have been a better policy response.27

It should be noted, however, that expansionary policy may be counterproductive if the government is also subject to Sudden Stop. Clearly, under those circumstances, lowering taxes or raising public expenditure is out of the question unless the government resorts to some kind of capital levy, like debt repudiation or a higher inflation tax.

Although one can think of costless capital levies, in practice costs could be quite high.

it increased by a factor of three in 1998 like the rest of the region. A large relative increase in interest rates could provoke sizable contraction in the value of loan collaterals, even though the increase is small in absolute terms. For a discussion of this and related topics, see Calvo and Talvi (2005). 27 This view was put forward by my IADB colleague and frequent collaborator Alejandro Izquierdo.

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Necessary conditions for a capital levy to be costless are that (1) it is largely unanticipated and (2) it does not seriously affect the credit or payments system. These conditions are unlikely to be satisfied in practice. Condition (1) generally does not hold, unless capital levies are automatically triggered by Sudden Stop.28 On the other hand, condition (2) is also hard to satisfy in practice, as collateral constraints play a key role in credit markets.29 Thus, capital levies would lower collateral values, bringing about a sudden contraction of bank loans, for example, unless the levy falls entirely on nonresidents. The latter is unlikely because bonds are subject to legal clauses that prevent unequal treatment of bondholders, thus making it difficult to discriminate in favor of domestic residents.30

Could lowering domestic interest rates help after a Sudden Stop that dries up credit to both private and public sectors? Under fixed exchange rates, lower interest rates are possible only if effective controls on capital outflows can be implemented (as in

Malaysia in 1997). This is not easy, especially in economies in which there is a long history of capital flight: underground institutions and fake transactions (e.g., underinvoicing of exports) are quickly put in place. On the other hand, under floating exchange rates, the low-interest-rate policy may be helpful if price/wage downward inflexibility delays reaching “full employment” equilibrium. However, since easy money results in a large devaluation, such policy may wreak financial havoc in Liability

28 Automatic mechanisms are interesting policy options but will not be explored in this paper. 29 For a discussion in the context of EMs, see Caballero and Krishnamurthy (2002), and Izquierdo (2000). 30 Moreover, it is hard to know who is a resident and, finally, even if that were possible and there were no clauses explicitly protecting bondholders from discrimination, the international financial institutions are much against unequal treatment of creditors in case of default (as recently revealed in the context of Argentina’s debt-default negotiations).

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Dollarized economies; or sharply raise inflationary expectations in economies that have a long history of high inflation.31

In closing this section, I would like to say a few words about Full Dollarization, i.e., the adoption of a foreign or regional currency for all financial and commercial transactions (except, possibly, for “small change” like the balboa in an otherwise fully dollarized economy like Panama). It is not an ideal system if the economy is subject to large fluctuations in relative prices and financial contracts are very rigid (e.g., non-state contingent). However, in economies addicted to dollars, to use the expression in

Reinhart, Rogoff and Savastano (2003), Full Dollarization may dominate a system that stubbornly sticks to high Domestic Liability Dollarization. Moreover, Full Dollarization considerably lowers the complexity of macroeconomic assessment, given that an easily manipulable variable like the nominal exchange rate will no longer be subject to policy decisions (or, at least, the exchange rate would be much more difficult to manipulate because it would involve a radical change in the policy regime).32

Global Policies

The above discussion shows that EMs have a very limited set of policies for preventing Sudden Stops and attenuating their effects, especially when they originate in a malfunctioning of the global capital market. This prompts us to think about policies that are directly aimed at the global capital market. In Calvo (2002) I proposed the creation of an Emerging Market Fund (EMF) whose main activity would be to stabilize an EM bond price or spread index, like J. P. Morgan’s EMBI, whenever it is judged that

31 For a complementary discussion about domestic policies, including controls on capital inflows, see Calvo and Talvi (2005). 32 See Calvo (2001) and Mendoza (2005).

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the latter undergoes unduly large fluctuations. A motivation for the EMF was the large and persistent increase in the EMBI following the 1998 Russian crisis (see Figure 1).

Russia traded little with the other EMs, and its output and debt were minuscule on a global scale. Therefore, its large impact on the EMBI was arguably evidence of shocks coming from the global capital market, as discussed in Section II. The two leading conjectures in this respect are that the large impact on the EMBI were due to: (1) margin calls triggered by the Russian crisis (a conjecture discussed in Sections II and III above), and (2) Reverse Moral Hazard, caused by Russia not being bailed out by the IMF. The latter may have sent a signal that other large EMs, like Brazil, would receive the same treatment—thus decreasing the expected return on EM bonds.33 Whatever explanation one finds most persuasive, the point remains that the shock had a global origin.

Institutions like the EMF play the role of Lenders of Last Resort and would thus, be close relatives of national central banks. A salient characteristic of central banks is that they are able to relieve the symptoms at the source, which in this case is the global capital market, not the individual countries. Thus, it appears that something like the EMF is needed to attenuate globalization hazards. The question that naturally arises in this connection, however, is why the EMF would have better information than the capital market which, after all, is in the business of finding arbitrage opportunities. There are two types of answers to this question. The first one is institutional. The capital market is subject to regulations, such as collateral constraints, that prevent it from taking full advantage of arbitrage opportunities. Mendoza (2004) discusses a dynamic general equilibrium example along these lines. The second type of answer goes to the heart of

33 I am not very enthusiastic about the Reverse Moral Hazard conjecture, because soon after the Russian crisis Brazil got a generous package from the IMF (in January 1999). However, it took several years for

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how the capital market is supposed to operate, even if there were no institutional or principal-agent constraints. As noted in Grossman and Stiglitz (1980), for example, asset market prices convey information about other market participants’ information, and the authors provide an example in which prices costlessly transmit all relevant information across the market. This is, of course, an extreme case, but it sharply illustrates the fact that market participants can benefit from costly information collected by others without having to pay for it. Thus, capital market information has features in common with externalities or public goods and, consequently, capital market information is likely to be undersupplied in equilibrium. This market failure implies that a Lender of Last Resort put in charge of collecting better EMs’ information may result in a Pareto-enhancing equilibrium. Why, then, should there be an EMF and not just a Global Bureau of

Economic Research (GBER) that freely provides information to the market? This is an important question, and a valid objection to setting up a Fund that may possibly result in large losses for the international community.34 My favorite answer is that one advantage of the EMF over the GBER is that the former would “put its money where its mouth is,” thus better aligning incentives with public pronouncements.35 In addition, if market failure is partly due to institutional constraints, the EMF would help to relieve those constraints by infusing the market with a larger liquidity chest.

A word of caution is in order, however, as international arrangements like the

EMF require full and credible support by the involved sovereign countries. This is not a

the EMBI to get back to the levels prevailing prior to the Russian crisis. See Figure 1. 34 Durdu and Mendoza (2005) examine the possible moral hazard implications of asset price guarantees, a close relative of the EMF. It should be noted, however, that the EMF is supposed to “lean against the wind” in order to lower contagion, not to give price guarantees. See Calvo (2002). 35 In fact, experience at the IMF and other multilaterals shows that the information that these institutions make available to the public is heavily tinted by political opportunism. Do they put their money where

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minor complication, and may represent an impassable roadblock. Nevertheless, even if the EMF and similar global financial institutions are not feasible at present, a thorough understanding of why and how these institutions would operate is useful, because we would be much better prepared to set them up when the time comes.

The discussion above was biased in favor of stabilizing and expanding the EM bond market. However, an entirely different conclusion emerges if Reverse Moral

Hazard is seen as the main driving force behind the 1997/1998 events, particularly the

Russian crisis. Reverse Moral Hazard implies that too much money was flowing to EMs.

Thus, if anything, one should devise policies that make it more difficult for EMs to borrow in international markets. Interestingly, therefore, even though the margin call and

Reverse Moral Hazard views both imply that external shocks are relevant, their policy implications are diametrically opposed. However, Reverse Moral Hazard is just one possible story of how the market read the news that the Fund left Russia twisting in the wind. Another interpretation is that, as the Fund jettisoned its role as Lender of Last

Resort, the market became more apprehensive about lending to EMs. There is nothing optimal about this retrenchment if, on the basis of prior discussion, one concludes that informational/frictional considerations call for the existence of a Lender of Last Resort.

In summary, both domestic and global policies are called for to increase the stability of EMs while allowing them to reap the benefits of financial globalization.

Success in this area would likely rely on improving both the domestic and global fronts.

Traditional fiscal and monetary stabilization policies do not seem very effective and need to be complemented with structural policies that help to lower domestic financial

their mouths are? Yes, but to a limited extent, because those institutions are senior creditors: they are supposed to be paid back before everyone else! This would not be the case with the EMF.

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vulnerability, especially in economies suffering from a high incidence of foreign- exchange denominated domestic bank loans.

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APPENDIX

I will derive equation (11) in the text. Variable θ is log-normally distributed with natural log mean μ and natural log standard deviation σ. Thus (see Maddala (1977)),

2 22 =θ e )2/1( σ+μ and, var =θ 2 ee σσ+μ − ).1( (A1)

Moreover, it follows that θ2 is log-normally distributed with natural log mean 2μ and natural log standard deviation 4σ. Thus,

2 2 var =θ ee 4)(42 σσ+μ − ).1( (A2)

By equation (6) in the text and (A1), setting r = 0,

22 var wNI 2 var =θθ= 24 ee σσ+μ − ).1( (A3)

Moreover, from equation (9) in the text, and setting r = 0,

1 2 2 var FI = eew 4)(4 σσ+μ − ).1( (A4) 4

Equation (11) in the text follows from equation (10) in the text, (A3) and (A4).

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Do Credit Rating Agencies Add Value? Evidence from the sovereign rating business

Eduardo Cavallo Inter‐American Development Bank

Andrew Powell Inter‐American Development Bank

Roberto Rigobon Massachusetts Institute of Technology

This draft: August 11, 2008.

Abstract

If rating agencies add no new information to markets their actions are not a public policy concern. But as rating changes may be anticipated, testing whether ratings add value is not straightforward. We argue ratings and spreads are both noisy signals of fundamentals and suggest ratings add value if, controlling for spreads, they help explain other variables. We analyze the different actions (ratings and outlooks) of the 3 leading agencies for sovereign debt, also considering the differing effects of more or less anticipated events. Our results are consistent across a wide range of tests. Ratings do matter and hence how the market for ratings functions may be a public policy concern.

JEL Codes: F37, G14, G15, C23

Keywords: Ratings, Spreads, Information Economics, Event Studies.

Disclaimer: the paper represents the views of the authors and do not necessarily reflect the views of any institution including the IDB, its Executive Directors or the countries they represent. We thank Jeromin Zettelmeyer, John Chambers, Eduardo Fernandez Arias and seminar participants at the XXVII Meeting of the Latin American Network of Central Banks and Finance Ministries for very useful comments and Francisco Arizala for superb research assistance. All remaining errors are our own.

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I. Introduction

Recently, rating agencies have come under fire for their role in assessing risks of structured products. Here we focus on something they have been doing for a longer period of time; rating sovereign debt. Debt instruments are actively traded in secondary markets, thereby providing up‐to‐date information on prices, yields and spreads over riskless debt. Credit ratings are often mapped into default probabilities but bond spreads may also be mapped onto the same scale. Credit ratings and spreads appear then to be capturing the same thing; the question we consider in this paper is what can rating agencies tell us that we cannot learn simply from looking at the price of debt?

One potential answer is that rating agencies and investors may have different information sets. Take the case of a small investor who wishes to have a diversified portfolio. It would generally not be in the interests of each such investor to have a large research department focusing on the fundamentals of each country. Rather the investor will rely on a central information source such as a rating agency. Some larger investors may of course have research departments, and brokers that service many investors are also a source of a great deal of analysis. A second answer is that investors and rating agencies with the same information may have different opinions. Indeed, as we detail below, different rating agencies frequently have different views on sovereigns. Roughly, and using standard mappings between the agencies, they disagree about as much as they agree on ratings. Another way to state the potential role of rating agencies is then to suggest that ratings and spreads are both noisy signals of the true and perhaps unknowable deep economic fundamentals. The question we address in this study is then, given the signals provided by markets, do the rating agencies add information?

This is an important topic, not only as an academic issue to understand how markets, including the market for information on how to value assets, functions, but also an important policy issue. If rating agencies do not add information, then their opinions do not matter and it is difficult to argue that there is any policy concern regarding their activities. On the other hand if it is found that they do add information, their opinions matter and is important to know that the credit rating market is working well.

Several recent papers have considered the role of rating agencies in the sovereign debt market. Cantor and Packard (1996) and Afonso (2007) show that ratings can be modeled fairly successfully by economic fundamentals. Several papers show that ratings affect spreads but the real question is whether ratings affect spreads controlling for fundamentals. Eichengreen and Mody (1998) and Dell’Ariccia, Schnabel and Zettelmeyer (2006) regress ratings on fundamentals and interpret the error as the rating agencies’ “opinion”. They then show that this residual is highly significant in explaining spreads. Powell and Martinez (2007) replicate these analyses; they also employ a system of

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equation approach and further argue that the rating agencies’ differences in opinion are informative. In other words, when one agency changes a rating and the others do not, then this is associated with a change in spreads.

Despite these efforts, it is not yet possible to argue that the case is closed. Each methodology employed to date has its particular drawbacks. In the case of the technique used by Eichengreen and Mody (1998) and Dell’Ariccia et al. (2006), it is a heroic assumption that the error of the ratings equation represents the rating agencies’ opinion and not that this equation is simply mis‐specified. In the system approach favored by Powell and Martinez (2007) a different but also heroic assumption is needed to identify the system. In the approach employing rating agencies’ differences of opinions, one rating agency may follow a spread change rather than actually affect the spread. Moreover, there may be more information in markets than captured in these models. The above approaches do not control for the current information in markets but only current fundamentals and/or ratings. This paper raises the bar with respect to the papers cited by testing if credit ratings influence spreads over and above the information that is already aggregated in market variables.

Another tack would be to attempt an event study as in the corporate finance literature – see Campbell, Lo and Mckinlay (1997) for a discussion. However, rating agencies appear to try to signal when rating changes may occur. Sovereign debt is either given a positive or negative outlook (suggesting an upgrade or a downgrade may be the next change respectively) and additionally may be placed on a “rating watch” (indicating that a decision may be about to be made). Moreover, agencies publish what a particular sovereign would have to do to improve its rating and while targets may not be precise, the information required to make a judgment is generally public and indeed may become a focus of market research and analysis. All this implies that the classic event study methodology may not be appropriate as rating changes may be anticipated.

This means that it is a real challenge to answer the question as to whether ratings agencies add value. If rating agency actions are fully anticipated then we would see no effects on spreads. But seeing no effects on spreads of a rating change would not mean that rating agencies do not add value. In our view outlined above, that both ratings and spreads are noisy signals of fundamentals, it just implies that whatever effect ratings had on spreads may have already been incorporated into spreads. We suggest therefore that we need to seek other methods to tackle this question.

For this purpose, we first devise a simple specification test to evaluate whether or not ratings are informative. We conclude that they are. Next, we consider a type of horse race between ratings and spreads as to how well they are correlated to other macroeconomic

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variables using high frequency data. We suggest that, given the possibility of full anticipation, this is a better method to evaluate if rating agencies add value.

However, we also argue that outlook changes give interesting information on how anticipated rating changes have been. If the outlook is changed just a few days before the rating, then it seems reasonable to suggest that the rating change is largely unanticipated before that date. We exploit this and other further details of the process in our analysis below.

We also conduct tests on whether certain rating changes are more important that others. In particular if a debt issue obtains an “investment grade” rating this may allow different classes of investors to purchase those issues and hence the instrument may be said to have changed “asset class”. We test below whether rating changes in and out of investment grade are more important than other changes.

Our results across several methods and for the three main credit rating agencies are strong and highly consistent. We find that we cannot reject the view that rating agencies add value. We find that this is true for both changes in asset classes and other rating changes, and we find that less anticipated rating changes have even more significant effects. We conclude that rating agencies do matter and hence that there is a public policy concern regarding whether these agencies are doing a good job.

II. Organizing framework

The question we are interested in answering is to evaluate the informational content that the rating has in addition to the observed spread on marketable sovereign debt (henceforth spread).1 In other words, the null hypothesis that all the information in the rating is already reflected in the spread is equivalent to say that the spread is a sufficient statistic. The alternative hypothesis, on the other hand, implies that spreads and ratings are imperfect measures of the unobservable fundamentals of the economy; and therefore ratings provide information above and beyond what spreads reflect.

In this section we organize our thoughts regarding ratings and spreads in a simple error‐in‐ variables framework. The goal is to devise a simple specification test to evaluate whether or not ratings are informative.

1 We focus the analysis on sovereign bonds spreads, which are computed as the difference of the yield‐to‐maturity of a bond, minus the yield‐to‐maturity of a comparable riskless bond (i.e., US treasuries). These are the most widely used proxies of risk by market observers.

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A. Preliminary considerations

Some considerations are necessary to clarify before devising an empirical strategy. First, this paper is studying sovereign ratings, and in this context, rating agencies are concerned with evaluating countries’ probability of default, or countries risk. This is important because in this environment, if the spread of the sovereign debt is observed, then it is reasonable to assume that the spread and the rating are supposedly capturing the same aspect.

It is impossible to evaluate the informational content in the rating only using ratings and spreads – we need other variables. Fortunately, the country risk not only affects the spread, but also impacts other macroeconomic variables. For instance, an increase in the probability of default of a country should have a negative impact on all asset prices – and in particular – stock prices. Therefore, if we observe a downgrade we should expect a drop in the stock market index. If the spread is a sufficient statistic for the rating, then if we were to run a regression where the spread and the rating are included on the RHS, the rating should be insignificant after controlling for the spread. In fact, we study three macro variables: the spread one period ahead, the stock market prices, and the nominal exchange rate.

The second consideration is that we concentrate in high frequency data – daily. This explains our choice of macro variables. The main reason why we look at daily data is that if ratings have any informational content beyond the spread, we expect this information to be incorporated into macro variables within days; and therefore, monthly data will be unable to disentangle the spread and the ratings informational components.

Third, if ratings and spreads are imperfectly measuring the fundamental – default probability – then we can interpret them as noisy versions of an unobservable fundamental. However, the rating, because of its discrete nature, is then a version of the fundament whose noise is not of classical form. In other words, the rating can be interpreted as a discretization of the fundamental, and the noise implied in this measure is serially correlated, and correlated with the fundamental – hence, making it a non‐classical error‐in‐variables problem. Our methodology testing for the informational content has to be robust to this property of the data. Furthermore, ratings are very sticky, in the sense they change very infrequently when observed daily. This means that the error‐in‐variables (EIV) problem in the rating is probably more severe than in the spread estimation. Therefore, in horse race estimations between the spread and the rating we have to be careful to take into account the possibility that the EIV biases are different across the two variables.

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Fourth, exchange rates, spreads, stock prices, and ratings are all endogenous. The methodology we devise has to take into consideration that linear regressions might be misspecified. The test has to be meaningful even in the presence of other forms of misspecification (not just the error‐in‐variable interpretation). More importantly, a crucial form of endogeneity is the fact that credit rating changes are indeed anticipated by market participants. This not only affects the interpretation but also how to implement the estimation. We return to the point of anticipation later in the results section.

B. Specification test

With these four considerations at hand, let’s proceed to explain our empirical strategy. We

assume that spreads (it ) and ratings ( rt ) are noisy versions of an unobserved fundamental.

t 0 θxii ++= ε tt

t 0 += xfrr ηtt ),(

Where the idea is that xt is the unobserved fundamental that not only affects the probability of default of the country (and its spread) but also affects the exchange rate, stock markets, and future spreads. We assume that the rating is a non‐linear function of the fundamental – trying to emphasize the discreteness of the variable. We assume a simple linear function for the spread, although, that is not restrictive.

Assume that another macroeconomic variable yt (which for expositional simplicity let’s assume it is the stock market) is affected by the same fundamental.

t 0 βxyy ++= μtt

The null hypothesis is that the spread is a sufficient statistic –that the rating does not add information beyond what the spread already captures. In a well specified regression we could test for this by just running a horse race between spreads and rating. However, if the variables are endogenous or they are measured with error, then this simple procedure might not produce the correct inference.

To resolve this problem we take several steps in the estimation procedure. First, we concentrate on the relationship between macro variables, spreads and ratings around the periods in which the rating changes. Our preferred specification looks at the window 10 days before and after a credit rating is modified. Second, we compute the cumulative return on all the variables over the events windows. This means that if the movement in the rating is anticipated, spreads and macro variables will adjust before the rating actually changes. Hence, all will be endogenously determined. Third, in this environment, we regress the

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cumulative change in the macro variables on the spread, and compare the estimates when the spread is instrumented by the rating. If the spread is a sufficient statistic for the rating, the two coefficients should be similar. If the spread and the rating summarize different sets of information – both are imperfect measures of the fundamentals – then the two coefficients will be statistically different.

This procedure is robust to misspecification of the macro variable on the spread regression. In other words, when we say that the spread is a sufficient statistic for the rating, technically what we are saying is that the change in the rating is captured by the movement of the spread, and everything else in the rating is just noise. Instrumenting the spread with the rating around the window in which the rating is changing, therefore, implies that both capture the same change in fundamentals. By concentrating on the window around the rating change we are minimizing the EIV in the rating measure and providing the best chance to the rating to provide additional information.2

What means that the spread is a sufficient statistic for the rating? The simple model below highlights a case in which the spread is indeed a sufficient statistic.

t 0 += θxii t

t 0 += xfrr ηtt ),(

t 0 βxyy ++= μtt

1. Uncorrelated errorinvariables, and exogenous fundamentals

Let us start by studying the case when all the residuals are uncorrelated. Because the spread captures the information in the fundamental perfectly, when we estimate the regression:

t 0 bicy ++= ϕtt

The OLS estimate is consistent. Because the rating is a noisy version of the same fundamental, and its noise is uncorrelated with the residual in the stock market equation, then if we instrument the spread with the rating we also estimate a consistent coefficient.

2 In other words, when the rating isn’t changing it is possible to argue that the default probability is changing little as well. And therefore, no change in ratings is imperfectly measuring small changes in fundamentals. However, when the rating is indeed changing, we expect in those windows for the fundamental to cross some threshold, and therefore, the increase in the rating indeed reflects an improvement in the fundamental.

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Importantly, the instrumental variable estimate is inefficient under the null hypothesis, and OLS is efficient.

Under the alternative hypothesis the spread is a noisy version of the fundamental. This means that the OLS estimate is inconsistent and biased – the bias comes exactly from the noise. This estimate can be improved. The rating is a perfect instrument to do so. First, it is correlated with the spread because both are measures of the same fundamental. Second, their noises are different and such noises are uncorrelated with the fundamentals. This means that the rating is uncorrelated with the residual in the stock market regression. In other words, the rating is a valid instrument for the spread and the IV estimates are going to be a consistent estimate of the true parameter.

This is a standard specification test. Under the null hypothesis, OLS is consistent and efficient, while IV is consistent but inefficient. On the other hand, under the alternative hypothesis, OLS is inconsistent, but IV continues to be consistent (see Hausman, 1978).

2. Uncorrelated errorinvariables, and endogenous fundamentals

The most important source of possible misspecification in this model is when the

fundamentals are not exogenous. In other words, when x μtt ≠ 0),cov( .

The methodology we have described has no problems dealings with this form of misspecification. Let us assume that the measured fundamental and the residual in the stock market equation are correlated. The implication of this assumption is that OLS is

biased, but because in our window the rating is proportional to the fundamental xt , then the IV will be equally biased if and only if the spread is a sufficient statistic. In other words, if the spread is a sufficient statistic but the fundamentals are correlated with the residual in the macro equation, OLS and IV are equally biased. On the alternative hypothesis, when the spread is not a sufficient statistic, then both coefficients are biased, but they are biased differently.

The simplest way to understand the intuition behind this test is to assume that both the spread and the rating are linear functions of the fundamental.

t 0 += θxii t

t 0 αxrr ++= ηtt

t 0 βxyy ++= μtt

The OLS estimate of the stock market on the spread is equal to

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ˆ yi tt βθ xt + x μθ tt ),cov()var(),cov( β x μtt ),cov( bOLS = = 2 += it )var( θ xt )var( θθ xt )var(

Where, just for clarification, the bias arises from the correlation between the fundamental and the residual in the stock market regression. It is needless to say that the OLS estimate – β when consistent – is an estimate of the ratio between . θ

In this environment, the IV estimate is (using the rating as the instrument)

ˆ rt yt βα xt + x μα tt ),cov()var(),cov( β xt μt ),cov( bIV = = += it )var( θα xt )var( θθ var xt )(

Where the source of the misspecification x μtt ≠ 0),cov( , is exactly the same in both regressions. Notice that both estimates are numerically the same.

Under the alternative hypothesis the two estimators are going to differ from each other. The OLS estimator has two forms of bias: the one from the misspecification, and the one coming from the error‐in‐variables. On the other hand, the IV estimate will have only the bias from the misspecification. In the end, the test is roughly the same: the coefficients should be the same under the null hypothesis but different in the alternative hypothesis. The main difference is the interpretation of the coefficients, but not the validity of the test.

This is an important characteristic of our design because, certainly, changes in ratings, spreads, and financial variables are endogenous, they are driven by common shocks that are unobservable, and rating changes might be anticipated.3 Our test will be able to deal with these aspects.

This example highlights the form of specification that we can solve analytically. It is the one in which the fundamental and the residual of the economy are correlated, but the error‐in‐ variables are still orthogonal to everything else. In other words, this solves the most basic (and possibly important) form of misspecification; the fact that the fundamentals and the residuals in the stock market are correlated. For instance, this covers omitted variable biases, and endogeneity. In particular, this includes the anticipation of rating changes.

3 In fact, anticipation of improvements in fundamentals implies that x μtt ≠ 0),cov( .

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3. Correlated errorinvariables

Assume that the errors in the rating equation are also correlated with the fundamental – non classical – then the estimate of the IV is slightly different from the OLS

ˆ r ytt ),cov( β{}α t + xx tt + x μαη tt ),cov(),cov()var( β α cov(x μtt ), bIV = = += ir tt ),cov( {}αθ t + xx ηtt ),cov()var( {}αθθ t + xx ηtt ),cov()var(

In this case, the estimates (IV and OLS) will be different, because the noise of the rating is correlated with the fundamental. Interestingly, in this case, the rating is indeed providing information above and beyond the one contained in the spread, and therefore, a rejection should be found. However, in this case, the information is not necessarily contained in the actual change in the rating but in its noise. This is important because we will be able to conclude with our method whether or not the rating contains information, although we do not know – or will be able to disentangle – its source.

In summary, if the spread is a sufficient statistic, then it captures all the relevant fluctuation of that is contained in the rating. Because the stock market (or exchange rate) equation is likely to be mis‐specified, the test can be performed, but the coefficients cannot be interpreted – structurally speaking. If the spread is a noisy measure of the rating (add a noise to the first equation of our model) or the noise of the rating is correlated with the fundamental or the residual, then the rating is indeed providing information beyond the one contained in the spread, and we have shown that the estimation of the OLS and IV coefficients will differ from each other. 4

C. Errorinvariables

Finally, before discussing the estimation and results we devote our attention to the error‐ in‐variables interpretation we are providing to the spread and the rating.

In the figure 1 we have depicted the fundamental, the spread, and the rating. In general we assume that the spread differs from the fundamental, and that those differences can be captured with a standard classical error‐in‐variables. A priori, there is no reason to have a different view on the discrepancy between the fundamental and the spread. In fact, most will argue that there is no difference and that the spread indeed captures the fundamental.

The difference between the fundamental and the rating is what we interpret as the error‐ in‐variables. The idea is that the rating is trying to capture the fundamental, but it is a

4 The test described here has discussed mostly the linear case, but the non‐linear case is exactly the same. For instance, take a non‐linear model and linearize it. The residuals in that model will be correlated with the unobservable fundamental exactly in the way we discussed cases 2 and 3.

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discretized version of it. If the fundamental increases, the rating increases, but it does so in a “sticky” way. This implies that the error‐in‐variables in the rating clearly is non‐classical.

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Figure 1: Errors in Variables

In other words, the error‐in‐variables are serially correlated. When the rating is below the fundamental, it is very likely to continue to be below the fundamental the following period. A classical error is serially uncorrelated. Second, and probably more importantly, when the rating remains the same and the fundamental increases, the error‐in‐variable increases, this means that the error‐in‐variables is correlated with the fundamental. Finally, around the credit rating changes, the error‐in‐variables are serially negatively correlated. The reason is that if there is a trend in the fundamental, and the rating moves up, then the errors prior to the change in the rating were negative, and they are likely to be positive afterwards.

When the spread is a sufficient statistic, we are assuming that the spread measures the fundamental without error, and therefore, the spread captures xt perfectly, while the rating doesn’t. When the spread is not a sufficient statistic, we assume that the error‐in‐ variables for the spread is classical, while the one for IV is not.

One question that should arise immediately is what are the assumptions for the IV strategy to be valid. This is very simple; we just need the error‐in‐variables of the rating to be uncorrelated with the error‐in‐variables of the spread – which we assume it is trivially satisfied under the null hypothesis (given that the error is exactly zero for the spread under the null).

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III. Data

A. Dataset and methodology

The raw data for this study comes from Bloomberg database and from rating industry sources. From Bloomberg, we collected daily information available for 32 emerging market economies between January 1st 1998 and April 25th 2007.5 In particular, we collected data on the following macroeconomic variables: sovereign spreads, nominal bilateral exchange rates (domestic currency units’ vis‐à‐vis the US$); and local stock market indices.6 We also collected data on the so‐called volatility index (VIX), a widely used measure of market risk.7 From the three main rating agencies (Fitch, Moody’s and Standard & Poor's), we collected data on ratings and outlooks for the same dates and we tabulated the days of rating and outlook changes.8 The resulting dataset is an unbalanced panel with 77760 observations.

The ratings from the three agencies are transformed into a numeral scale (between 1 – lowest— and 21 –highest—) using the scale proposed by Afonso et al. (2007).

5 The list of countries is in the appendix.

6 Some countries have multiple stock market indices. The list of indices used in this study is in the appendix.

7 The VIX is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward‐looking and is calculated from both calls and puts.

8 One contribution of this paper is to assemble a consistent dataset with precise dates for rating and outlook changes that have been cross‐checked with industry sources.

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Table 1: Rating Scale

Fitch Rating Number Moodys Rating Number S&P Rating Number AAA 21 Aaa 21 AAA 21 AA+ 20 Aa1 20 AA+ 20 AA 19 Aa2 19 AA 19 AA- 18 Aa3 18 AA- 18 A+ 17 A1 17 A+ 17 Investment A 16 A2 16 A 16 Grade A- 15 A3 15 A- 15 BBB+ 14 Baa1 14 BBB+ 14 BBB 13 Baa2 13 BBB 13 BBB- 12 Baa3 12 BBB- 12 BB+ 11 Ba1 11 BB+ 11 BB 10 Ba2 10 BB 10 BB- 9 Ba3 9 BB- 9 B+ 8 B1 8 B+ 8 B 7 B2 7 B 7 B- 6 B3 6 B- 6 CCC+ 5 Caa1 5 CCC+ 5 Speculative CCC 4 Caa2 4 CCC 4 Grade CCC- 3 Caa3 3 CCC- 3 CC 2 Ca 2 CC 2 C 2 C 1 SD 1 DDD 1 D 1 DD 1 D 1 Source: Afonso et al. (2007) The next step consisted in re‐arranging the master dataset to make it amenable to the analysis. For this purpose, first we defined “events” as changes in the ratings for each of the three rating agencies. Rating changes are either upgrades or downgrades of one notch or more. Table 2 summarizes the resulting events per rating agency

Table 2: Number of Events by Rating Agency

Number of events Downgrades Upgrades Standard & Poor's 145 62 83 Fitch 111 44 67 Moody's 90 39 51 For each one of these events we defined a 21‐day window,9 centered on the day of event. Thus, the rating becomes a step variable within each window: it has a starting value for the

9 Alternatively, for robustness checks purposes, we defined 41‐day and 11‐day windows around the event.

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first 10 days, then jumps on day 11 (either upgrade or downgrade), and then remains at the new value for the subsequent 10 days.10

Next, in order to make the rest of the data comparable across countries and events, we normalized the variables so that the starting point for every series in each event window is the same. The normalization consists of taking, for every day “t” in the window, the following transformatio n:

yt (X t −= X 0 )log()log

Where X is, alternatively: the sovereign spread, the stock market index, the nominal

exchange rate, and the VIX; X 0 is the value of the corresponding variable on the first day of

the window; and yt is the transformed variable, which is simply the cumulative return.

Thus, the initial value for these variables in each event window ( yo ), is normalized at zero.

Table 3 below reports the summary statistics for the normalized variables grouped by rating agencies.

10 In the cases where there are multiple rating changes within the same event window, we treat each rating change as an independent event. We alternatively drop these events from the sample for robustness checks purposes, but the results remain unchanged.

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Table 3: Summary Statistics

Standard & Poor's Variable Obs Mean Std. Dev.

Rating 3045 8.51 3.80 Spread 2533 0.01 0.17 Stock Market 2438 -0.01 0.10 Exchange Rate 2996 0.01 0.06 VIX 3045 -0.01 0.13

Fitch Variable Obs Mean Std. Dev.

Rating 2331 9.14 3.36 Spread 2159 0.03 0.16 Stock Market 1768 0.00 0.10 Exchange Rate 2265 0.02 0.09 VIX 2331 0.00 0.13

Moody's Variable Obs Mean Std. Dev.

Rating 1890 9.13 3.31 Spread 1718 0.03 0.18 Stock Market 1582 -0.02 0.11 Exchange Rate 1832 0.01 0.07 VIX 1890 0.02 0.14 The first panel shows that for the case of S&P ratings, where we have 145 events, we end up with 3045 observations for the rating (i.e., 145 events x 21 days per event). We report the mean and the standard deviation of the rating for all the events. In the rows below, we report the summary statistics for the other variables of interest, where, for example, a value of 0.01 for the “mean” indicates that the average value of the corresponding variable for all the available days, across all events, is 1% higher than the average value on the first day of the window. The other two panels replicate the same exercise but for events based on the data from the other two rating agencies.

B. Relationship between spreads and ratings

As discussed in the introduction, several recent papers consider the relationship between spreads and ratings. Eichengreen and Mody (1998) argue that ratings are important in explaining spreads. They regress ratings on fundamentals and then introduce the residual of that regression together with fundamentals in a regression to explain spreads. They argue the residual reflects the rating agency opinion and find that it is highly significant. Gonzalez Rozada and Levy Yeyati (2007) suggest that a large component of individual

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country spreads is driven by global factors such as the overall EMBI spread or the US high yield spread. In one specification they include the rating as a control for country fundamentals and find it to be significant with the expected sign. Powell and Martinez (2006) start with a simple regression of spreads against ratings and suggest that a simple log‐log relationship works reasonably well to capture how an improvement in the rating may lead to a reduction in spreads. They suggest though that the reduction in spreads to June 2007 is only partially explained by the improvement in ratings. They replicate the results of Eichengreen and Mody (1998) and also suggest a system of equation with similar results, suggesting that ratings may matter. They also exploit the differences between rating agencies opinion and show that those differences may be informative in explaining spreads.

The differences in opinions between rating agencies can be represented in various ways. In this paper we focus on rating changes as events. Below, we present a Venn diagram that summarizes the distribution of events across the three rating agencies, and their overlap. As explained, in the baseline each event has a 21‐day window. Thus, an overlap (or a potential agreement) occurs when rating changes for the different agencies happen within the same window. For example, out of 141 events for S&P,11 21 overlap with events of Fitch, 12 with events of Moody’s, and 15 with the two rating agencies concurrently. The general message that emerges from figure 2 is that the overlap is relatively small across the three rating agencies. This suggests that the rating agencies don’t always act concurrently, and hence that disagreements between agencies persist. In turn, this suggests that the informational content of the events across the agencies might be different. In particular, if the credit ratings are not perfectly correlated then they all three cannot be fully explained by the exact same statistic (in this case, the spread). In other words, given how uncorrelated the actions of the ratings agencies are, it should be a priori clear that they provide different information among themselves. And if one of these ratings is perfectly explained by the spread, then the other two can not. Therefore, in the analysis that follows, we consider these differences, and test the validity of our results using the data from the three rating agencies.

11 We use 141 events, rather than the total of 145 events in table 2, because there are 4 events that happen within the window of a previous event. Thus, we drop these to avoid double counting when comparing with the other rating agencies. We do the same for Moody’s and Fitch, where we drop 4 and 5 events respectively.

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Figure 2: Venn Diagram

21 12

IV. Results

A. Specification Test

We apply a standard Hausman specification test. This is performed in two steps. First we estimate the following models:

OLS Model

y ,ti α ,tiOLS θ VIXi ,ti +×+×= κ i + ε ,ti ; i = events, and t =days

Where y ,ti is, alternatively: i ti +1, (i.e., the spread one day forward); s ,ti (i.e., the stock market

index); and ner ,ti (i.e., the nominal exchange rate); κi is an event‐fixed effect, and ε ,ti is the error term. The VIX is included to control for the effect of global factors.

We also run instrumental‐variables version of this regressions, where the only variant is that we instrument spreads with ratings:

IV‐Model

y ,ti α IV ×= ,ti θ VIXi , κ ++×+ ε ,tiiti

j = ri ,, titi

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Where j is, alternatively: S&P, Moody’s or Fitch ratings.

For robustness checks purposes, we also run an error‐correction model for the case when the dependant variable is the spread. In this case, the estimated equation is as follows:

Error‐Correction Model

i α ×=Δ ,ti θ VIXi ,ti +×+ φ VIX +Δ× κ + ε ,tii

Where

+ −=Δ iii ,1, titi , and

VIXVIX ti +1, −=Δ VIX ,ti

In the IV‐variant of the error correction model, we simply instrument the spread with the rating.

The second step consists of applying a specification test using the estimates from these models. Hausman (1978) proposes a test where a quadratic form in the differences between two vectors of coefficients, scaled by the matrix of the difference in the variances of these vectors, gives rise to a test statistics (chi‐squared). Under the null hypothesis, OLS is consistent and efficient, while IV is consistent but inefficient. On the other hand, under the alternative hypothesis, OLS is inconsistent, but IV continues to be consistent.

Table 4 summarizes the results we obtain when we apply this test to our baseline specification (i.e., using all the events—upgrades and downgrades— from S&P, and a window of 21‐days per event).12 Every column in the table is a different dependant variable, and the last column is the error‐correction model. In the first two rows, we report 13 αOLS and αIV. respectively. Thus, the coefficient reported in the first row under the first column, is the OLS estimate for the effect of the current spread on the spread one day forward.

The OLS results suggests that increases in the spread have a positive effect on the spread forward (first and fourth columns), are related to decreases in the stock market index (second column), and are also related to depreciations of the nominal exchange rate vis‐à‐

12 For this purpose, we stack all the events (i.e., both upgrades and downgrades) together and run the regressions for the full sample of S&P events.

13 We omit to report the coefficient for the VIX in the standard OLS and IV regressions, and the rest of the coefficients in the error correction model, as they are not essential to explain the test we perform in this section.

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vis the US dollar (third column). The IV results (i.e., instrumenting spreads with ratings) are qualitatively similar. What the Hausman specification test reveals is, in essence, if these coefficients are also quantitatively the same.14 If they are statistically different, the null hypothesis is rejected –i.e., OLS is inconsistent —. Quite importantly for our purposes, that the null hypothesis be rejected is evidence that the spread is not a sufficient statistic.

In the next two rows of table 4, we report the Hausman statistic (chi‐squared) and the corresponding p‐value. The results are that the null hypothesis is rejected at standard confidence levels (10 percent or less) in 3 out of 4 cases. This suggests that, for these selected macro variables, the spread is not a sufficient statistic. In other words, not all the information in the rating is reflected in the spread, and thus, the rating explains some of the variation in these macro variables. It is worth re‐emphasizing here that the test is valid even if the OLS regression is misspecified, at least for the most common forms of misspecification.

The next step consists of checking the robustness of these results: we want to evaluate if we get a high number of rejections for the specification test across different possible variants. In table 5 we summarize the results of a series of robustness checks. The first set of checks consists of splitting the sample of events into upgrades and downgrades and running the regressions separately. Next, we repeat the same exercise for both, the full and the split samples, using the events of Fitch and Moody’s. Then, we go back to the S&P data and change the event window to 11‐day per event (i.e., 5 day around the rating change), and also to 41‐day per event (i.e., 20 days around each rating change). Finally, we drop the few events that occur within the same 21‐day window (contemporaneous events). 15

For each of these alternative specifications we run the OLS, IV and error correction models, and perform the corresponding Hausman test. In table 5 we report the p‐values. For comparability purposes, in the first row we report the p‐values from the previous regressions (table 4). The last row and the last column in the table are the “rejection rates,” i.e., the percentage of rejections of the null hypothesis for each row or column.

The results are very telling: the rejection rate varies between 56 and 75 percent in every column, which means that we reject a lot across many possible permutations of the dependant variable and also the estimation model. In the case of the rows, the rejection rate is below 50% only once: i.e., Fitch upgrades and downgrades. The high rejection rates across the board reinforce the conclusion that the spreads are not a sufficient statistic. In

14 This is not technically correct, as the Hausman procedure uses all the estimated coefficients, and their variance matrix, to perform the test.

15 In the case of S&P, these are 4 events that happen within the window of a previous event.

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other words, there seems to be some informational content in ratings that is not captured by the spreads. 16

At this point we can also evaluate the robustness of the test to the misspecifications that we are not fully able to solve analytically. In particular, recall from the methodological section, that if the errors in the rating equation are also correlated with the fundamental – non classical – then the estimate of the IV is slightly different from the OLS. In this case, the estimates (IV and OLS) will be different under the null hypothesis. If this form of misspecification is significant, we expect more rejections the bigger the windows are. The reason is that the error in variables implied in the rating grows with the window in which the rating isn’t changing. We do not find this in our tests. On the contrary, if anything, focusing on the case of the full sample (upgrades and downgrades for S&P) we find that the rejection rate is smaller when the width of the event window is increased to 20 days around the event.17 Despite this, and even if we this particular form of misspecification is significant and we don’t find more rejections when we expand the window simply because widening the window weakens the power of the test (because the instrument becomes noisier, and hence weaker), the reader should rest assured that the validity of the test is not invalidated because, as explained in section II, we still expect to find rejections if the rating is providing information above and beyond the one contained in the spread. The only difference is that we can not disentangle whether this information comes from the rating change itself or from the noise.

At the same time, if the rating is a non‐linear function of the fundamental, then the non‐ linearity can be interpreted as a non‐classical EIV which means that the larger the window, the more severe the non‐linearity and the higher the chance of rejecting the specification test. Thus, some of the rejections that we get with larger windows might be spurious. Despite this possibility, our results are also robust to defining the windows very tightly. The rejection rate for the cases when the width of the event window is only 5 days around the event is 75% ‐‐the same as the baseline—, hence, indicating that the EIV introduced by the non‐linearity is not significantly large.

16 We also run the same tests including a time trend in the regressions for each event window. We find somewhat lower rejection rates, although in most cases they remain over 50%. It is hardly surprising that the rejection rates fall when we include a time trend, as many events are anticipated (more on this below) and the effect of the anticipation may be precisely a trend over the event window for the macro variables. Thus, we find it reassuring that we still find a high number of rejections even when we include a trend.

17 We reject 3 out of 4 times when the window is 10 days around the event, and only 2 times when the window is expanded.

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Having established that spreads and ratings are different, in the next section we run a horse race between these variables. If ratings have informational content as we suggest, then we expect that when we run a regression where both variables are included on the RHS, the rating should be significant after controlling for the spread.

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Table 4: OLS vs. IV

Spread t+1 Stock Market Exchange Rate Spread t+1 (Error Correction) OLS 0.906*** -0.217*** 0.100*** -0.095*** [0.010] [0.009] [0.007] [0.010] IV 1.008*** -0.280*** 0.109*** 0.008 [0.025] [0.024] [0.017] [0.025] Hausman Test (Ch^2) 20.13 8.03 0.33 20.48 P-value 0.001 0.018 0.848 0.001 S&P ratings are used for these regressions. To perform these estimations the data is arranged to allow a 21-day window around the day of the change in the rating. The OLS coefficient is the estimated effect of the change in spread on the corresponding dependent variable. The IV is the coefficient obtained when the spread is instrumented by the rating. All these regressions include event fixed effects and the Volatility Index (VIX) as controls. The null hypothesis in the Hausman test is that the OLS estimator is more efficient.

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Table 5: Hausman Test, P‐values

Spread (Error Rejection Spreadt+1 Stock Market Exchange Rate t+1 Correction) rate1 Standard & Poor's (downgrades + upgrades) 0.001 0.018 0.848 0.001 75% Standard & Poor's (downgrades) 0.010 0.800 0.436 0.018 50% Standard & Poor's (upgrades) 0.001 0.140 0.001 0.015 75% Fitch (downgrades + upgrades) 0.430 0.600 0.001 0.700 25% Fitch (downgrades) 0.960 0.001 0.001 0.960 50% Fitch (upgrades) 0.190 0.001 0.031 0.420 50% Moodys (downgrades + upgrades) 0.066 0.061 0.082 0.160 75% Moodys (downgrades) 0.355 0.053 0.001 0.725 50% Moodys (upgrades) 0.078 0.009 0.001 0.154 75% Standard & Poor's - 5 day window (all) 0.001 0.078 0.771 0.001 75% Standard & Poor's - 5 day window (downgrades) 0.001 0.770 0.018 0.021 75% Standard & Poor's - 5 day window (upgrades) 0.100 0.017 0.001 0.235 75% Standard & Poor's - 20 day window (all) 0.001 0.660 0.850 0.001 50% Standard & Poor's - 20 day window (downgrades) 0.001 0.001 0.670 0.001 75% Standard & Poor's - 20 day window (upgrades) 0.001 0.068 0.001 0.001 100% Standard & Poor's - Without contemporanous change in rating 0.000 0.091 0.953 0.002 75% 2 Rejection rate 75% 69% 63% 56% 1 Corresponds to number of rejections of the null hypothesis in the Hausman test over the total regressions run per dependent variable 2 Corresponds to number of rejections of the null hypothesis in the Hausman test over the total regressions run per specification Every cell is the P-value of the Hausman test in the correspondent OLS versus IV regressions.

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B. Horse Race

Having established that spreads are not a sufficient statistic, we turn now to estimating a new model in which we exploit the informational content of ratings in order to explain the variation in three macro variables using high frequency data.

We estimate the following OLS model:

y × i j θβα ×+×+= VIXr ++ εκ ; i = events, and t =days ,ti i,t ,ti , ,tiiti

Where y ,ti is, alternatively: i ti +1, ; s ,ti ; ner ,ti ; κi is an event‐fixed effect, and ε ,ti is the error term. The VIX is included to control for the effect of global factors.

For robustness checks purposes, we also run an error‐correction model for the case when the dependant variable is it . In this case, the estimated equation is as follows:

Error‐Correction Model

i α ×=Δ j θβ ×+×+ VIXri φ VIX ++Δ×+ εκ ,ti ,ti ,ti ,tii

Where

+ −=Δ iii ,1, titi , and

VIXVIX ti +1, −=Δ VIX ,ti

It is clear from the previous discussion on misspecification, that we cannot interpret the magnitude of these coefficients in a structural way. Therefore, in what follows we just focus on the sings and statistical significance. We want to test if ratings explain part of the variation in the cumulative returns of the macro variables over the selected event windows after we control for spreads, and also if rating and spreads are correlated to these macro variables in ways that make intuitive sense.

The results are reported in table 6. The table is organized slightly different than the previous ones. The panel on the upper LHS has the results for the baseline regressions: S&P, all events, and a 21‐day window for each event. Every row is a different regression; either a different dependant variable, or the error correction model. Every column is the estimated coefficient for the corresponding RHS variable. The standard errors are reported in parenthesis below every point estimate. In order to make the interpretation easier, we

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put stars next to the coefficient if it is statistically significant. 18 Thus, the first row shows the results of estimating the model by OLS for the case in which the dependant variable is the spread one‐day forward. We find that, as expected, α is positive and statistically significant, meaning that increases in the spread today (i.e., a higher perceived probability of default) are correlated with increases in the spread tomorrow.

Interestingly, β enters with a negative sign and is also statistically significant, meaning that an increase in the rating (i.e., an upgrade) is correlated with a decrease in spreads one day forward. The fact that the rating is significant after controlling for the spread is additional evidence in favor of the hypothesis that spreads are not a sufficient statistic. The third RHS variable included in the regression, the VIX, is positive, but not statistically significant.

Next, we change the LHS variable to the stock market index. In this case we find that increases in the spread are associated to decreases in the stock market indices, while, an increase in the rating, controlling for the spread, is correlated to a statistically significant increase in the stock market. Finally, in this case, the coefficient estimate for the VIX is negative and statistically significant.

The next row presents the results for the case in which the LHS variable is the nominal exchange rate vis‐à‐vis the US dollar. The results are that increases in the spread are associated to nominal exchange rate depreciations, a result that we find consistent to what we would expect for emerging market economies: higher probability of default is oftentimes associated to capital flight and a weakening of the domestic currency. At the same time, the estimated effect for changes in the rating, in this case, is not statistically significant. Note, incidentally, that this is the one case for which we did not reject the Hausman test for the baseline specification in table 4. This is additional evidence in favor of the power of the test: in the case where we do not reject the specification test, we find that the rating is insignificant after controlling for the spread (i.e., the rating provides no additional information). Finally, we find that the coefficient estimate for the VIX is also positive and statistically significant.

In the last row, we report the results of the error correction model.19 The results are reassuringly similar to those in the first row, which are based on the same dependent variable. The only difference is that the coefficient estimate for the VIX, while still positive, is now statistically significant at the 10% level.

18 *: significant at ten percent, **: significant at five percent, and ***: significant at one percent.

19 We omit the coefficient estimates for φ , as they are not essential.

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Next, we rerun the baseline specification splitting the sample between upgrades and downgrades. The results for the case of downgrades are reported in the upper‐center panel, while for the downgrades are reported in the upper‐right panel. The results are very similar to the previous ones, with only a couple of differences. When we focus on downgrades, we find that the estimated effect of changes in the rating is no longer statistically significant when the LHS variable is the stock market. In the case of upgrades, the coefficient estimate for the effect of changes in rating on the nominal exchange rate is now positive and significant.

The middle panels of table 6 report the results for the same exercise, but for the case of the events from the other two rating agencies. For concreteness, we concentrate only in the cases of the full sample (upgrades and downgrades stacked together). We find that in all cases, the coefficient estimate for α, enters the regressions with the expected sign and is statistically significant: increases in the spread today are associated with higher spreads tomorrow; decreases in the stock market; and nominal exchange rate depreciations. In the case of β, the estimated effect of changes in the rating, we find that for Fitch events, they typically have no explanatory power, except in the case when the macro variable is the exchange rate: in that case, we find that increases in the ratings (i.e., upgrades) are associated to nominal appreciations. This is interesting because this is the one case where we find an insignificant estimate for S&P. Also, it is consistent with the results of the specification test: in the case of Fitch, full sample, we reject the null hypothesis only when the dependant variable is the nominal exchange rate. Instead, in the case of Moody’s, the rating always enters the regressions with the expected sign and is statistically significant: upgrades are associated with decreases in the spread forward, increases in the stock market, and nominal appreciations. In the case of the VIX, the coefficient estimates are always significant in both samples, and have the same signs: increases in the VIX are associated to higher spreads forward, lower stock market indices, and more depreciated nominal exchange rates.

Finally, in the lower panels of table 6 we report the results for the cases in which we narrow the width of the event window to 5 days around the event, and, alternatively, expand it to 20 days. We report the results based on the S&P sample only (upgrades and downgrades). The results are reassuringly similar to those of the baseline specification with one exception. For the case of the expanded window, the effect of rating changes on the stock market is not statistically significant.

In summary: there are a few important takeaways from this section. First, the results from the horse race exercise suggest that ratings usually enter these regressions with a statistically significant sign after controlling for the spread. In the case of S&P ratings, this is true in 3 out of the 4 regressions, in the case of Moody’s sample, it is always true, and in the case of Fitch ratings, it is true in just one case (which is incidentally the case when it is

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not true for S&P). This is consistent with the results from the specification tests (i.e., we reject less for Fitch). At the same time, the high rate of rejections across the board suggests that spreads are not a sufficient statistic for the rating. Second, the additional robustness checks show that these results are consistent when we split the sample between upgrades and downgrades, and also to expanding and narrowing the event window.

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Table 6: OLS with event fixed‐effects

S&P upgrades & downgrades S&P downgrades S&P upgrades Spread Rating VIX Spread Rating VIX Spread Rating VIX Spreadt+1 0.884*** -0.006*** 0.006 0.894*** -0.006*** 0.013 0.876*** -0.007*** -0.003 [0.011] [0.0014] [0.015] [0.014] [0.001] [0.017] [0.017] [0.001] [0.022] Stock Market -0.205*** 0.004*** -0.104*** -0.484*** -0.002 -0.067*** -0.018** 0.002** -0.085*** [0.011] [0.014] [0.001] [0.020] [0.002] [0.025] [0.008] [0.001] [0.012] Exchange Rate 0.098*** -0.0005 0.045*** 0.196*** -0.003 0.089*** 0.007** 0.002*** -0.006 [0.008] [0.0009] [0.010] [0.018] [0.002] [0.022] [0.003] [0.0003] [0.005] Δ Spread -0.117*** -0.006*** 0.029* -0.109*** -0.006*** 0.030* -0.124*** -0.006*** 0.027 [0.011] [0.001] [0.015] [0.014] [0.001] [0.018] [0.017] [0.0019] [0.024]

Fitch upgrades and downgrades Moodys upgrades & downgrades Spread Rating VIX Spread Rating VIX Spreadt+1 0.863*** -0.002 0.036*** 0.855*** -0.004** 0.040*** [0.010] [0.001] [0.011] [0.013] [0.002] [0.015] Stock Market -0.404*** 0.002 -0.132*** -0.297*** 0.005** -0.140*** [0.016] [0.002] [0.017] [0.014] [0.002] [0.016] Exchange Rate 0.225*** -0.009*** 0.033** 0.190*** -0.003** 0.046*** [0.013] [0.002] [0.014] [0.010] [0.0014] [0.012] Δ Spread -0.139*** -0.001 0.064*** -0.147*** -0.004** 0.070*** [0.010] [0.001] [0.012] [0.013] [0.002] [0.015]

S&P 5 day window S&P 20 day window Spread Rating VIX Spread Rating VIX Spreadt+1 0.742*** -0.005*** 0.013 0.941*** -0.005*** 0.021*** [0.019] [0.001] [0.019] [0.006] [0.0009] [0.007] Stock Market -0.234*** 0.003** -0.040** -0.271*** 0.001 -0.173*** [0.018] [0.001] [0.017] [0.009] [0.002] [0.011] Exchange Rate 0.048*** -0.0007 0.026* 0.168*** -0.0006 0.093*** [0.013] [0.001] [0.013] [0.007] [0.001] [0.009] Δ Spread -0.257*** -0.005*** 0.029 -0.060*** -0.005*** 0.037*** [0.019] [0.001] [0.021] [0.006] [0.0009] [0.008]

These regressions include event fixed effects as controls.

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One interesting feature of the data is that the events are oftentimes anticipated by the market several days before to the rating change. We show this in the figures below (figures 3 and 4) in which we plot the cumulative returns of spreads, stock market, and the nominal exchange rate around the days of the change in the rating. To facilitate the interpretation of the graphs, we separate between upgrades and downgrades. We present the results for the S&P sample only.

In the case of upgrades, we observe that the average change across all events is a one notch increase in the rating (right scale, from 9 to 10). While the rating change happens on day 11, by the time of the change, the stock market has already accumulated a 1 percent increase, and the spreads have fallen by approximately 4 percent. In both cases, this is roughly one half the cumulative changes over the entire event window. In the case of the nominal exchange rate, there are no noticeable effects, either before or after the rating change (recall that, for the S&P sample, the rating is not statistically significant in the regressions where the nominal exchange rate is the dependent variable).

Figure 3

S&P UPGRADES (Ratings)

Stock Market Spread Exchange Rate Rating Ratings

4% 10.5

10.3 2%

10.1

0% 9.9 123456789101112131415161718192021

9.7 -2%

9.5

-4% 9.3

9.1 -6%

8.9

-8% 8.7

-10% 8.5

Rating Change occurs on day 11

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In the case of downgrades, the results are very similar. The average downgrade is 1.5 notches (from approximately 7.7 to 6.2). By the time the rating changes, the stock market has already declined, in this case, by almost the entirety of the total cumulative decline in the window. This might explain why, in the previous regressions, the coefficient estimate for β, in the case S&P downgrades, was not statistically significant for the stock market equation. Instead, spreads are on the rise before the downgrade, but they accumulate only about one‐half of the total increase by day 11. Final ly, the nominal exchange rate appears to depreciate over the event window. Figure 4

S&P DOWNGRADES (Ratings)

Stock Market Spread Exchange Rate Rating Ratings

15% 8

7.8

10% 7.6

7.4

5% 7.2

0% 6.8 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21

6.6

-5% 6.4

6.2

-10% 6

Rating Change occurs on day 11

All in all, these results suggest that exchange rates, spreads, stock prices, and ratings are endogenous variables. Thus, as explained in section II, the methodology we devise has to take into consideration that linear regressions might be mis‐specified. We have already explained how the specification test is robust to this particular form of endogeneity. At the same time, this also affects how to implement the estimation and interpret the results. We return to the point of anticipation later, as we devote an entire section of the paper to this issue. Before that, we do some additional robustness checks.

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1. Asset class shift

In this subsection, we check if the results are robust to the introduction of nonlinearities for the case of rating changes. In particular, we want to explore if rating changes that happen between asset classes (i.e., investment to non‐investment grade and vice‐versa) explain more of the variation in the macro variables than rating changes that happen within the same asset class. For this purpose we create a dummy variable that takes the value one if the rating change is between asset classes, and zero otherwise. We interact the new variable with the rating, and include the interaction in the regression. The results, for the case of the S&P sample, are reported in table 7 below. Perhaps surprisingly, we find that rating changes between asset classes have no additional explanatory power vis‐à‐vis all the other rating changes: the interaction term is insignificant in all but 1 of the 12 regressions in table 7. Despite this, it is possible that we find no effect because there are relatively few events that represent changes in asset class in our sample. For example, for the S&P sample, only 9 of the 145 events are changes between asset classes.

We also tried creating two dummy variables: one for changes between asset class, and another for changes within one of the asset classes only –for example, investment grade to investment grade—, and including the two interactions in the regression. In this case we check if there are significant differences when rating changes happen in either one of these categories vis‐à‐vis the omitted one. The results (not reported) are not significant either.

Similarly, the results we obtain when we use the data form the other rating agencies are also weak. All in all, we do not find evidence that the effect of changes in ratings is different if they represent a shift in asset class.

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Table 7: Interaction with dummy variable of change in asset class

S&P upgrades & downgrades S&P downgrades S&P upgrades 1 Spread Rating Rating*(Δ Asset Class) VIX Spread Rating Rating*(Δ Asset Class) VIXSpread Rating Rating*(Δ Asset Class) VIX Spreadt+1 0.812*** -0.004*** -0.014 -0.009 0.894*** -0.005*** -0.016 0.012 0.875*** -0.006*** -0.005 -0.004 [0.015] [0.001] [0.008] [0.013] [0.014] [0.002] [0.012] [0.017] [0.017] [0.002] [0.012] [0.022] Stock Market -0.101*** 0.003** 0.001 -0.039*** -0.485*** -0.002 0.011 -0.065*** -0.021** 0.003** -0.023*** -0.088*** [0.015] [0.001] [0.008] [0.013] [0.021] [0.003] [0.019] [0.025] [0.008] [0.001] [0.006] [0.012] Exchange Rate 0.018 0.002* 0.002 0.036*** 0.196*** -0.003 0.012 [0.022] 0.007** 0.002*** -0.004 -0.006 [0.013] [0.001] [0.007] [0.011] [0.018] [0.002] [0.014] -0.003 [0.003] [0.001] [0.002] [0.004] Δ Spread -0.187*** -0.004*** -0.011 0.013 -0.109*** -0.006*** -0.015 0.029 0.875*** -0.006*** -0.005 -0.004 [0.015] [0.001] [0.009] [0.014] [0.014] [0.002] [0.011] [0.018] [0.017] [0.002] [0.012] [0.022]

These regressions include event fixed effects as controls. 1 Corresponds to the interaction between the rating and a dummy that takes the value of 1 if the change inchange the rating between implies investment a and non-investment grade, and zero otherwise.

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2. Change in outlook

Rating agencies publish outlooks alongside with ratings. In particular, rating changes are typically preceded by changes in outlooks: either a positive outlook before and upgrade, or a negative outlook before a downgrade. These outlook changes usually happen well in advance of the actual rating change.20 The graph below is the plot of the distribution of the number of days between a change in the outlook and a change in the rating for the S&P sample. The distribution is highly skewed and, while the minimum number of days the outlook is changed before a rating change is 2, the mode is 98 and the mean of the number of days is a staggering 311. In other words for most rating changes the outlook was altered at least one year before.

Figure 5: Frequency Distribution, S&P ratings

.004 .003 .002 Density .001 0 0 500 1000 1500 time

time= Number of days between outlook change and the subsequent change in the rating. Mean = 311 days.

20 This is not surprising as normally the outlook change means the rating upgrade/downgrade will be made between 6 and 12 months after. For example, according to Standard & Poor's, a rating outlook assesses the potential direction of a rating change over the intermediate term (typically six months to two years). In determining a rating outlook, consideration is given to any changes in the economic and/or fundamental business conditions. An outlook is not necessarily a precursor of a rating change.

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In the next section we exploit the discrepancies between outlook and rating changes to build a measure of the degree of anticipation of events. In this section we take a different approach: we replace ratings with outlooks in the horse race regressions and check whether changes in the outlook also have explanatory power once we control for spreads.

We proceed as follows: we re‐define “events” as episodes when there are changes in outlook, and re‐arrange the data accordingly. The “outlook” is a step variable that can take only three values in every event window: “‐1” if there is a negative outlook; “0” if the outlook is stable; “+1” if the outlook is positive. Next, we rerun the baseline regressions using “outlook” as a RHS variable. The results for the baseline specification are reported in table 8.

We find that changes in the outlook have very similar effects to changes in ratings. For the full sample (upgrades and downgrades together) we get that improvements in the outlook are associated to lower spread forward (although the coefficient estimate is not statistically significant), increases in the stock market, and appreciations of the exchange rate. The results are very similar when we split the sample between upgrades (i.e., favorable changes in the outlook) and downgrades, although the estimates tend to be more significant in the sub‐sample of upgrades.

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Table 8: Benchmark regressions replacing ratings with outlooks

S&P upgrades & downgrades S&P downgrades S&P upgrades Spread Outlook VIX Spread Outlook VIX Spread Outlook VIX Spreadt+1 0.856*** -0.0005 0.022** 0.876*** 0.002 0.02 0.808*** -0.003* 0.024* [0.009] [0.002] [0.009] [0.013] [0.002] [0.014] [0.016] [0.001] [0.012] Stock Market -0.363*** 0.007*** -0.009 -0.400*** -0.001 -0.017 -0.283*** [0.002] 0.0159*** [0.011] [0.002] [0.010] [0.013] [0.002] [0.013] [0.020] 0.015*** [0.0023] Exchange Rate 0.083*** -0.005*** 0.015*** 0.090*** -0.007*** 0.020** 0.054*** -0.002*** 0.009** [0.006] [0.0008] [0.005] [0.009] [0.002] [0.009] [0.004] [0.001] [0.003] Δ Spread -0.148*** -0.0009 0.0536*** -0.128*** 0.002 0.059*** -0.195*** -0.004** 0.045*** [0.009] [0.002] [0.0097] [0.013] [0.002] [0.014] [0.016] [0.0018] [0.013] These regressions include event fixed effects as controls.

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Interestingly, changes in the outlook also seem to be anticipated by the market. This is shown in the next two graphs (figures 6 and 7). In the case of upgrades to the outlook, the markets seem to anticipate it only partially, as spreads continue to fall, and the stock market to increase, after the day of the change in the outlook. In particular, the cumulative change in these variables up to day 11 is roughly one half of the cumulative change over the entire window.

Figure 6

S&P UPGRADES (Outlooks)

Stock Market Spread Exchange Rate Outlook Outlooks

4% 0.6

0.4

1% 0.2

0% 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 0

-1%

-2% -0.2

-3%

-0.4

-4%

-5% -0.6

Outlook change occurs on day 11

In the case of downgrades, the anticipation is even stronger, as we do not observe any discernible pattern in the spreads or the stock market after day 11.

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Figure 7

S&P DOWNGRADES (Outlooks)

Stock Market Spread Exchange Rate Outlook Outlooks

8% 0.6

6% 0.4

4% 0.2

0% 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21

-0.2 -2%

-0.4 -4%

-6% -0.6

Outlook change occurs on day 11

C. Anticipation and Rating Agency Value Added

We now return to the outlook changes as an indicator of the degree of anticipation of a rating change. As graphed above the distribution of the number of days that outlooks change before ratings is skewed and has extremely wide dispersion. We suggest here that if the outlook change precedes the rating change by only a reasonably small number of days then the rating change may not be fully anticipated. If the outlook change precedes the rating change by more than that, then it is likely that the rating change is fully anticipated. We also suggest that if the outlook change precedes the rating change by a very large number of days then again the outlook change gives very little information on the rating change – or at least the timing thereof.

To motivate this analysis, in figure 8 below, we plot the change in spreads around rating changes dividing the sample into those where outlook changes occurred less than 60 days before the rating change, between 60 and 220 days before the rating change and more than

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220 days. We normalize upgrades and downgrades to plot them on the same scale. 21 We also rescale the series so that they are centered at zero on the day of the rating change. In order to allow for more variation in the graph, we plot the results for the case of the expanded window (i.e., 41‐day per event). The graph is highly suggestive. As can be seen when the outlook change was between 60 and 220 days before the rating change there appears to be no reduction in the spread after the change in rating suggesting the rating change was entirely anticipated. However, when the outlook change was more than 220 days before the rating change, and especially if it was less than 60 days before the change in rating, there is a reduction in spreads after the rating change. In these cases it seems that the change in rating was only partially anticipated (as spreads decline before the event too) and that the rating change appears add information .

Figure 8

S&P - Outlook Anticipation to Change in Rating (Rating Changes on day 21)

20%

15%

10%

0% 1357911131517 19 21 23 25 27 29 31 33 35 37 39 41

-5%

-10% Spread less than 60 days Spread between 60 and 220 days Spreads more than 220 days -15%

-20%

Outlook change occurs on day 21

21 Thus, all the observations corresponding to downgrades are multiplied by ‐1 so they can be mapped into the same scale as upgrades.

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The graphs for the other macro variables used in this study show similar patterns for more and less anticipated events respectively. These graphs are reported in the appendix. However, a graph does not constitute a statistical significance. We therefore run regressions as above but we add an additional term. Our first hypothesis is that the further the outlook change precedes the change in rating then the more anticipated the rating change is. However we doubt the relationship is linear. In particular we suggest that the further the outlook change precedes the rating change, then the less the timing of the outlook change matters. We thus use the logarithm of the number of days the outlook was altered before the rating as an indicator of the potential lack of anticipation. We interact this variable with the rating.

A second approach is to simply add a dummy interacted with the rating where the dummy takes the value of one if the outlook change precedes the rating change by more than a fixed number of days. We used the value of 60 days as this gave us a reasonable number of observations of rating changes that might be less than fully anticipated.22 The results are given in the tables 9 and 10 below.

We find that both if these additional terms are significant and with the expected signs for virtually all of the cases detailed ‐ across the different dependent variables and for upgrades and downgrades and all changes. In particular, note that when the interaction term is significant, its sign is usually the opposite to the one of the coefficient for rating itself. This suggests that, whatever the impact of rating changes is on these macro variables; the more anticipated the event, the smaller is the effect. We conclude therefore that when the outlook change is closer to the rating change, then the rating change tends not to be fully anticipated and the rating change has a significant correlation with country variables. We suggest that this is further evidence that ratings matter.

22 Alternatively, we use a dummy variable that takes value one if the outlook change precedes the rating change by more than 60 days, but also less than 220 days. The results are unchanged

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Table 9: Benchmark regressions with anticipation effect: first variant

S&P upgrades & downgrades S&P downgrades S&P upgrades

1 Spread RatingRating*[Log(number)] of daysVIX Spread RatingRating*[Log(number of days)]VIX Spread RatingRating*[Log(number of days)]VIX Spreadt+1 0.940*** 0.008 -0.002** 0.021** 0.932*** -0.018***0.003** 0.032*** 0.930*** 0.054*** -0.010*** 0.008 [0.007] [0.005] [0.001] [0.008] [0.010] [0.007][0.001] [0.010] [0.009] [0.013][0.002] [0.013] Stock Market -0.178*** 0.136*** -0.022*** -0.125*** -0.516*** 0.053*** -0.010*** -0.014 -0.056*** 0.044*** -0.007*** -0.119*** [0.008] [0.007] [0.001] [0.010] [0.018] [0.011][0.002] [0.019] [0.007] [0.011][0.002] [0.011] Exchange Rate 0.086*** -0.137***0.023*** 0.064*** 0.216*** -0.130***0.022*** 0.102*** -0.001 0.011*** -0.002*** -0.007** [0.006] [0.005] [0.001] [0.008] [0.016] [0.011][0.002] [0.017] [0.002] [0.003][0.001] [0.003] Δ Spread -0.062*** 0.008 -0.002** 0.036*** -0.072*** -0.019***0.003** 0.045*** -0.071*** 0.056*** -0.010*** 0.027** [0.006] [0.006] [0.001] [0.009] [0.010] [0.007][0.001] [0.011] [0.009] [0.013][0.002] [0.013]

These regressions include event fixed effects as controls. 1 Corresponds to the number of dayse daybetween of the th change in the outlook and the change in the rating. Table 10: Benchmark regressions with anticipation effect: second variant

S&P upgrades & wdongrades S&P downgrades S&P upgrades

1 Spread Rating1 Rating*TVIX Spread Rating1 Rating*TVIX Spread Rating1 Rating*TVIX Spreadt+1 0.933*** -0.013*** 0.008** 0.019** 0.924*** -0.015*** 0.014*** 0.030*** 0.934*** -0.008 0.001 0.007 [0.007] [0.003] [0.003] [0.009] [0.010] [0.003] [0.003] [0.010] [0.009] [0.013] [0.013] [0.013] Stock Mar ket -0.140*** 0.103*** -0.106*** -0.120*** -0.437*** 0.059*** -0.072*** -0.016 -0.052*** 0.002 0.002 -0.120*** [0.007] [0.004] [0.004] [0.009] [0.018] [0.005] [0.005] [0.017] [0.007] [0.010] [0.011] [0.011] Exchange Ra te 0.066*** -0.085*** 0.085*** 0.058*** 0.217*** -0.061*** 0.057*** 0.092*** 0.0005 0.005* -0.006** -0.007** Δ Sp [0.006] [0.003] [0.003] [0.007] [0.017] [0.005] [0.005] [0.017] [0.002] [0.003] [0.003] [0.003] read -0.069*** -0.013*** 0.008** 0.035*** -0.079*** -0.015*** 0.014*** 0.043*** -0.066*** -0.007 0.0001 0.025* [0.007] [0.003] [0.003] [0.009] [0.010] [0.003] [0.003] [0.011] [0.009] [0.013] [0.013] [0.013]

Thesegressions re include event fixed effects as controls. 1 Corresp onds to the interaction between the rating and a dummy that takes the valueore thanof 1 if60 the days change before in thethe changeoutlook inocurred the rating, m and zero otherwise.

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V. Conclusions

In order to facilitate the investment decisions of its clients, credit rating agencies monitor countries’ fundamentals and assign individual (subjective) ratings and outlooks to sovereign debt. Given that they probably have more information than the average investor, it is conceivable that these subjective ratings end up determining the level of sovereign spreads. What it is not clear, and where there is considerable debate in the literature, is whether the opinion of rating agencies matter for the level of sovereign spreads even after controlling for countries’ fundamentals. Whether they do or not is a very important policy question, and one of great interest for policy makers who need to make decisions on how to improve access to finance. In particular, if rating agencies add no new information to markets, it is difficult to argue that their actions are a public policy concern.

The rating agencies’ business has come to the forefront of the debate since the US financial crisis erupted in the summer of 2007. While the focus of that debate has been on their role in rating corporate bonds, the results in this paper suggest that the scrutiny is probably warranted, as ratings do matter, and hence, how the market works is an important concern for regulators.

The objective of this paper was to devise a test to evaluate the informational content that ratings have over what is already observed in bond’s spread. We develop a simple Hausman specification test that is motivated in an error‐in‐variables framework. The proposed test has the virtue of being robust to the most typical forms of misspecification, for instance omitted variable bias, endogeneity, and in particular, the anticipation effect of rating changes that is observed in the data. The null hypothesis is that the spread is a sufficient statistic –that the rating does not add information beyond what the spread already captures—. We apply this test to various alternative specifications and conclude that we can reject the null hypothesis. In other words, there seems to be some informational content in ratings that is not completely captured by spreads.

Next, we consider a type of horse race between ratings and spreads as to how well they are correlated to other macroeconomic variables using high frequency data. We suggest that given the possibility of full anticipation of rating changes, this is a better method to evaluate if rating agencies add value. We find that they do, as the ratings typically explain part of the variation in the selected macro variables, even after controlling for the spread.

We also perform a battery of sensitivity tests, including using different windows for the regressions, using data from different rating agencies, using alternative estimation models, and also conducting tests on whether certain rating changes (i.e., changes in asset class, or

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changes that are more anticipated) are more important that others. These additional tests reinforce the main conclusion that ratings matter.

VI. References

Afonso, A., P. Gomes and P. Rother. 2007. “What ‘Hides’ behind Sovereign Debt Ratings?” Working Paper 711. Frankfurt, Germany: European Central Bank.

Campbell, Lo and Mckinlay, 1997. “The Econometrics of Financial Markets.” Princeton University Press. Princeton, New Jersey.

Cantor, R., and F. Packer. 1996. “Determinants and Impact of Sovereign Credit Ratings.” Economic Policy Review 2(2): 37‐53. New York, United States: Federal Reserve Bank of New York.

Dell’Ariccia, G., Schabel, I., and J. Zettelmeyer. 2006. How Do Official Bailouts Affect the Risk of Investing in Emerging Markets? Journal of Money, Credit, and Banking, Vol. 38, No. 7

Eichengreen, B., and A. Mody. 1998. “What Explains Changing Spreads on Emerging‐Market Debt: Fundamentals Or Market Sentiment?” NBER Working Paper 6408. Cambridge, United States: National Bureau of Economic Research.

Gonzalez‐Rozada, Martin and Eduardo Levy‐Yeyati (2006) “Global Factors and Emerging Market Spreads”, IDB Working Paper N 552, May 2006.

Hausman, J. 1978. “Specification Tests in Econometrics” Econometrica, Vol. 46, No. 6. (Nov., 1978), pp. 1251‐1271

Lo, A. and McKinlay, A. 1988. “Stock market prices do not follow random walks: evidence from a simple specification test.” Review of Financial Studies 1 (1988), pp. 41–66.

Powell, A. and Martinez J. 2007. “On Emerging Economy Sovereign Spreads and Ratings.” Research Department Working Paper 629. Washington, DC, United States: Inter‐ American Development Bank.

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VII. Appendix

Less anticipated events have a bigger impact on macro variables ex‐post than events that are more anticipated. In the text we presented the case of changes in the spread. Here, we report the cases of the stock market and the nominal exchange rate.

Figure 9

S&P - Outlook Anticipation to Change in Rating (Rating Changes on day 21)

15% Stock Market less than 60 days Stock Market Between 60 and 220 days Stock Market more than 220 days

10%

0% 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41

-5%

-10%

Outlook change occurs on day 21

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Figure 10

S&P - Outlook Anticipation to Change in Rating (Rating Changes on day 21)

10%

0% 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41

-5% Exchange Rate less than 60 days Exchange Rate Between 60 and 220 days Exchange Rate more than 220 days

-10%

-15%

Outlook change occurs on day 21

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Table 11: Countries and stock markets indices used

Country Stock Market Index Argentina Argentina Merval Index Bulgaria Sofix Index Brazil Brazil Bovespa Chile Chile Stock Market General China,P.R.: Mainland Shanghai Stock Exchange Composite Index Colombia Colombia General Index - Bogota Stock Market Index Dominican Republic Not available in Bloomberg Ecuador Ecuador Guayaquil Sotck Exchange Bolsa Egypt Egypt Hermes Index Croatia Croatia Zagreb Crobex Hungary Budapest Stock Exchange Index Indonesia Jakarta Composite Index Korea Kospi Index Lebanon Blom Stock Index Morocco Madex Free Float Index Mexico Mexico Bolsa Index Malaysia Kuala Lumpur Composite Index Nigeria Nigeria Stock Exchange Pakistan Karachi All Share Index Panama Panama Stock Exchange General Peru Peru Lima General Index Philippines Philippine Stock Exchange Index Polony Wse Wig Index Russia Russia Stock Market Index El Salvador Not available in Bloomberg Thailand Stock Exchange of Thaiindex Tunisia Tunise Stock Exchange Tunindex Turkey Ise Industrials Ukraine Ukraine Pfts Index Uruguay Not available in Bloomberg Venezuela, Rep. Bol. Venezuela Stock Market Index South Africa Africa All Share Index