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 89º ANEXO V
Alvaro Espina Vocal Asesor 9 de Septiembre de 2009
BACKGROUND PAPERS:
1. Reserve status fear hits dollar, by Peter Garnham... 10 2. Hybrid EU Bank Capital: Will it be Battered by Burden- Sharing and Shift to Common Equity Requirement?, RGE Monitor... 11 3. Is There a Need for International Monetary Reform Through a Multilateral Exchange Rate Mechanism?, RGE Monitor... 13 4. Recession nears end but stagnation may follow, by Robert Lindsay... 15 5. The long-term consequences of Europe's lacklustre crisis management, by Wolfgang Munchau... 16 6. As Cheaper Chinese Tires Roll In, Obama Faces an Early Trade Test, by Peter Whoriskey... 18 7. Why some economists could see the crisis coming, by Dirk Bezemer... 31 8. ECB plans policy revamp to tackle bubbles, by Ralph Atkins... 23 9. Hedge funds show the way on bonuses, by Paul Marshal... 24 10. Judges’ Frustration Grows With Mortgage Servicers, by John Collins Rudolf... 26 11. Cerberus to bar withdrawals from two funds, by Francesco Guerrera and Sam Jones... 28 12. Regulatory Reform in the U.S.: Who Should Be the Systemic Risk Regulator?, RGE Monitor... 30 13. Comprehensive response to the global banking crisis, BIS... 32 14. Mortgage Market Bound by Major U.S. Role. Classes of Borrowers Cannot Find Loans as Publicly Backed Debt Mounts, by Zachary A. Goldfarb and Dina ElBoghdady... 34 15. South Korean Economy Seems Back on Track. Nation Now Faces Seoul Housing Bubble, by Blaine Harden... 38
1 16. No Getting Around This Guy, by Alec MacGillis... 40 17. In China and Spain, Deal Tightens Telecom Alliance, The New York Times by Kevin j O’Brien…45 18. G20 Finance Ministers’ Meeting: Pledges to implement regulatory commitments, address bankers’ pay structure, RGE Monitor…47 19. How to Negotiate a Severance Package, by Nancy Trejos... 20. G20 calls for better capital buffers at banks, FT.com by Norman Cohen …49 21. The wait for financial reform, The New York Times by Alan S Blinder …50 22. An early-warning system, run by the Fed, The New York Times by Alan S. Blinder…52 23. La política eocnómica: lo urgent y lo importante, El País by Oscar Fanjul …54 24. Europe’s failure of ambition stunts growth, FT.com by Wolfgang Munchau…59 25. How did economists get it so wrong?, The Yew York Times by Paul Krugman…61 26. A few notes on my magazine article…73 27. But the economists Didn’t get everything wrong, Time by Justin Fox…74 28. Eurozone stimulus: A myth, some facts, and impact estimates, by Volker Wieland... 29. Mistaking beauty for truth, Discover by Sean…75 30. Eurozone stimulus: A myth, some facts, and impact estimates, by Volker Wieland... 77 31. G20 agrees regulatory framework, FT.com by Norma Cohen …80 32. Text-G20 statement on strengthening financial system, Reuter …82 33. G20 draft agrees global stimulus to stay, FT.com …84
2 34. Timing is the soul of economic policy, FT.com …43 35. G20 rift opens on banking reform, FT.com by Ft reporters…87 36. Russia’s economic crisis –no cue for Perestroika 2.0, Open by Andrew Wilson…88 37. The long march to Scotland’s independence referendum, OurKingdom by Gerry Hassan…93 38. Macroprudencial illusions by Collegio Carlo Alberto by Axel Leijonhufvud…97 39. Insight: a matter of retribution, FT.com by Gillian Tett…99 40. El espejismo de los mercados, Cinco días,…100 41. High frequency firms set to benefit from Euroclear fee cut, FT.com by Jeremy Grant …101 42. High Frequency trading: Wall Street’s new rent-seeking trick by Martin Hutchinson…102 43. FSA launches a review of dark pools and high spedd trading, FT.com by Jeremy Grant…104 44. Michael Mackenzie, Joanna Chung and Aline van Duyn SEC to review flash orders july 26 2009, FT.com by Michael Mackenzie…105 45. Stock traders find speed pays, in Milliseconds, The New York Times by Charles Duhigg…107 46. Market manipulation …109 47. The G20 can lead the way to balanced growth, FT.com by Lee Myung-bak and Kevin Rudd…111 48. Lamy fears spillover between climate and trade talks, FT.com by James Lamont…113 49. Mark-to-make believe part 1: no accounting for the credit crisis, Collegio Carlo Alberto by Satyajit Das…115 50. Mark to make believe part 2: making time, Collegio Carlo Alberto by Satyajit Das…122
3 51. From financial crisis to debt crisis?, The Korea Times, by Kenneth Rogoff…127 52. Europe has mapped its monetary exit, Ft.com by Jean Claude Trichet…129 53. The politics of envy, Collegio Carlo Alberto…131 54. The Madoff files: a chronicle of SEC failure, The Washington Post by Zachary A Goldfarb…133 55. White house to propose big reserves at banks, The New York Times by Eric Dash …136 56. Financial stability depends on more capital, FT.com by Timothy Geithner…138 57. G20 plans for stimulus exit, FT.com by Ralph Atkins..140 58. Health care that works, The New York Times by Nicholas D Kristoff…142 59. Fed optimistic recovery is ahead –but unsure how far and how strong, The Washington Post by Neil Irwin…144 60. A reluctance to retire means fewer openings, The New Yor Times by Catherine Rampell and Matthew Saltmarsh…146 61. Spain’s unemployment problem, RGE Monitor, by Chris Mooney…149 62. G20 finance minister meeting: is the consensus for regulation fading? RGE Monitor…153 63. Lord turner tobin tax proposal: varied opinion emerges, Overview…155 64. Macro prudential regulation and the future of the global financial system: group of 30, NYU stern, CEPR reports…1156 65. EU wary on withdrawing fiscal stimuli, FT.com by Tony Barber…158 66. EU unites behind call for bank bonus cap, FT.com by Tony Barber…159 67. RGE monitor’s newsletter, RGE Monitor…1161
4 68. Manufacturing grows after 18 weak months, The New York Times, by Jack Healy…163 69. Low-wage workers are often cheated study says, The New York Times by Steven Greenhouse…165 70. Ian Bremmer and Nouriel Roubini: don’t expect the US and China to form a strategic alliance anytime soon WSF.com, The Wall Street by Ian Bremmer and Nouriel Roubini…167 71. Roubini: China won’t drive world out of recession, CNBC.com by Guy Adami…169 72. Banking crises and exports: lessons from the past, Vox by Leonardo Iacovone and Veronika Zavacka…170 73. A tale of two depressions, Vox by Barry Eichengreen and Kevin O’Rourke…174 74. Willem buiter forget tobin tax: there is a better way to curb financie, FT.com by Willem Buiter…178 75. What BP’s new oil strike means, BusinessWeek, by Stanley Reed…181 76. Madrid 2016 bid has strongest public support: repot, The Washington Post by Antonella Ciancio…184 77. The case against a super-regulator, The New York Times by Sheila C Bair…186 78. This woman might from eating cookie dough, The Washington Post, by Lyndsey Layton…187 79. Missing Richard Nixon, The New York Times, by Paul Krugman…190 80. Horse-race reporting, The Conscience of a Liberal…192 81. Some analysts see and end to market rally, The New York Times, by Jack Healy…193 82. Macro prudential regulation and the future of the global financial system: Group of 30, NYU stern, CEPR reports, RGE Monitor…195
5 83. Dumping Russia in 1998 and Lehman ten years later: triple time-inconsistency episodes, Vox, by Guillermo Calvo…197 84. International trade, offshoring, and US wages, Vox, by Ann Harrison…200 85. Shangai’s fall dents Japanese optimism, FT.com by Lindsay Whipp…206 86. Data highlight challenges faced by DPJ, FT.com by Robin Harding…208 87. Blue chip, white cotton: what underwear says about the economy, The Washington Post by Ylan Q Mui…209 88. Central banks can adapt to life below zero, FT.com by Wolgang Munchau…211 89. Time for a paradigm shiff to include credit: do we need a higher inflation target? A price level target?, RGE Monitor…213 90. Bankers watch as Sweden goes negative, FT.com by Andrew Ward …215 91. Back to 2007:fear of appreciation in emerging economies, Vox by Andrea Kiguel and Eduardo Levy- Yeyati…218 92. A case for (even) more transparency in the OTC markets, Voxeu.org, by Viral Acharya and Robert Engle…224 93. Transmission of the global recession through US trade, by Michael J Ferrantino and Aimee Larsen…227 94. Till debt does its part, The New York Times by Paul Krugman…234 95. Deficits, debt, and the economy, The Conscience of a Liberal…235 96. FDIC steps up scrutiny of new banks, FT.com, by Joanna Chung…240 97. US problem bank list hits 15 year high by Joanna Chung…240
6 98. Obama lucky to have Bernanke, ShanghaiDaily.com by J Bradford Delong…242 99. If you are so rich, why aren’t you smart?, by Greg Mankiw…243 100. The least susprising correlation of all time, NY Times…244 101. Heredity, environment, justice, The Conscience of a Liberal, by Grey Mankiw…245 102. Could Tobin tax reshape financial sector DNA?, FT.com by Gillian Tett…246 103. The Tobin tax explained, FT.com by Martin Sandbu…205 104. Treasury frowns on Tobin proposal, FT.com by George Parker…249 105. FSA backs global tax on transactions, FT.com by George Parker…250 106. The exit strategy from the monetary and fiscal easing: damned if you do, damned if you don’t, RGE Monitor, by Nouriel Roubini…251 107. The message from Jackson hole, Morgan Stanley, by Richard Berner…255 108. Jackson Hole 0, Jerusalem 1 by Joachim Fels…257 109. Beyond the inventory-Led Rebound…259 110. The case against Bernanke, FT.com by Stephen Roach…262 111. A comment on House prices by CalculatedRisk…264 112. House prices: reazl prices, price-to-rent and price to income by CalculatdRisk…265 113. FRBSF Economic Letter, Federal Reserve Bank of San Francisco …268 114. House prices and fundamental Value, FRBSF Economic Letter …268 115. Speech: Reflections on a Year of Crisis, by Chairman Ben S Bernanke…275
7 116. Speech: Bagehot's Dictum in Practice: Formulating and Implementing Policies to Combat the Financial Crisis, by Brian F Madigan…286 117. Krugman: some call it recovery, by CalcultadRisk…298 118. Some call it recovery, Paul Krugman…302 119. The answer is yes by Barara Kiviat…302 120. Wait a second, is this a recovery or isn’t it?, The Curious Capitalist by Barbara Kiviat…303 121. Postmoderns recessions, Calculated Risk by Krugman…304 122. Crackdown on naked short-selling’intesifies, FT.com by Brooke Masters…305 123. Sustaining a Global Recovery, FD by Olivier Blanchard…306 124. Looking beyond the crisis, blog-imfdirect.imf by John Lipsky in Jackson Hole…312 125. Fixing the financial system by john Lipsky in Jacson Hole…313 126. Jackson hole conference: A grand teton perspective by John Lipsky …315 127. Fully spend stimulus money to back crisis recovery, says IMF, Global economic crisis…318 128. Press release 19 august 2009 –euro area balance of payments (june 2009)… 320 129. Risks and rewards, Europe launches major push for new banker bonus rules, Spiegel International…328 130. Fed:Delinquency rates surged in Q2 2009 by CalculatdRisk…330 131. Whay this new crisis needs a new paradigm of economic thought, Vox by Keiichiro Kobayashi…331 132. Eliminate financial double-think, FT.com by Gillian Tett…2334
8 133. The swiss menace, The New York Times by Paul Krugman…336 134. Reversing the economic plunge by Moira Hersbst…338 135. Harbinger of change?, by Jump Brings Hope…340 136. Some executives didn’t hear bang, Germany Steinbruck warns of return of Casino Capitalism…341 137. School for scoundrels, The New York Times by Paul Krugman…3243 138. The Myth of the rational market , The New York Times by Justin Fox…346 139. Rewarding bad actors, The New York Times by Paul Krugman…348 140. China, new financial superpower, Brad Setser Follow the Money by Bsetser…350 141. China linkfest by Bsetser…351 142. The great preventer by Nouriel Roubini…354 143. Letter to the Queen: why no one predicted the crisis, Thomas Palley Economics for Democratic and Open Societies, by Buckingham Palace her Majesty The Queen…356 144. This is how we let the credit crunch happen, Ma’am, Guardian.co.uk by Heather Stewart …357 145. Private Confidencial.. 359 146. What the G2 must discuss now the G20 is over, by Martin Wolf…363 147. The timing of fiscal interventions: Don’t do tomorrow what you can do today, by Karel Mertens and Morten O. Ravn... 366
9
Reserve status fear hits dollar By Peter Garnham Published: September 8 2009 10:58 | Last updated: September 8 2009 17:26 The dollar slumped to its lowest level in almost a year on Tuesday rally in gold prices and concerns over its reserve status weighed on the US currency. Analysts said the dollar was suffering from the improvement in sentiment following data suggesting the global economy was recovering. The resulting rise in risk appetite dented haven demand. Derek Halpenny at Bank of Tokyo-Mitsubishi UFJ said the dollar’s near-term prospects did not look particularly encouraging. “Gold has just broken through the $1,000 level and this, along with the dollar index approaching its lows, may well encourage another wave of speculative dollar selling.” The dollar index, which tracks its progress against a basket of six leading currencies, fell to a low of 77.093, passing through the lows it hit in August to reach its weakest level since September 30 2008. The dollar also fell 1.3 per cent to a low for the year of $1.4518 against the euro, dropped 1.3 per cent to $1.6561 against the pound, lost 1 per cent to Y92.07 against the yen and fell 1.5 per cent to SFr1.0434 against the Swiss franc. Commodity-linked currencies advanced, with the Australian dollar climbing 1.1 per cent to a fresh one-year high of $0.8644 against its US counterpart, the New Zealand dollar rising 0.7 per cent to $0.6969 and the Canadian dollar gaining 0.6 per cent to C$1.0708. The dollar also suffered after a report from a UN agency rekindled concerns over the currency’s reserve status and raised fears that global reserve managers could diversify away from the US currency. The UN Conference on Trade and Development urged the creation of a new world reserve system using several currencies rather than just the dollar, and called for tough controls on cross-border financial flows. Unlike comments from countries such as China and Russia, Unctad did not call for a new artificial currency to replace the dollar as a reserve currency. It suggested an internationally agreed exchange rate system based on the principle of constant and sustainable real exchange rates of all countries, similar to multilateral frameworks such as Bretton Woods and the European Monetary System. Camilla Sutton at Scotia Capital said central bank reserve diversification was a long-term trend that would be played out over the coming decade and accordingly would be a weight on the dollar and not something that would see it collapse overnight. “We do not think the UN will prove to be the most important voice in the reserve currency debate, but do think that it adds yet another voice and one that is decidedly against the dollar,” she said. http://www.ft.com/cms/s/0/07c0bc30-9c56-11de-ab58-00144feabdc0.html
10 Sep 8, 2009 Hybrid EU Bank Capital: Will it be Battered by Burden-Sharing and Shift to Common Equity Requirement? Overview: After the G20 finance ministers call for higher capital requirements and for a larger share of common equity, European banks are in the spotlight in their role as large users of hybrid Tier 1 and Tier 2 capital. These debt-like instruments prevent the dilution of existing shareholders, but have shown inappropriate as loss-absorbing instruments during the crisis because they require interest payments at a time when earnings should be retained. FT: "Of the US$450 billion Tier 1 debt outstanding, European and UK banks account for $283bn and US banks $161bn. European banks are felt to be too dependent on hybrid debt which, as the crisis has unfolded, has not proved loss-absorbing enough to act as a buffer against shocks."(September 8, 2009) o Fitch: "Fitch Ratings has downgraded the ratings of hybrid securities at Lloyds Banking Group plc (LBS), Royal Bank of Scotland Group plc (RBS), ING Group, Dexia Group, ABN Amro, SNS Bank, Fortis Bank Nederland and BPCE and certain related entities. The downgrade reflects increased risk of deferral of interest payments after the European Commission (the "Commission") clarified its stance on bank hybrid capital, and in particular the application of the concept of "burden-sharing". The Commission's recent statements confirm Fitch's view that government support for banks may not extend to holders of subordinated bank capital." (August 21, 2009) o Lex: Santander is buying back its own hybrid debt at a discount, Deutsche Bank is re- tapping the market before others but pays a high yield. Natixis' parent bank may be forced to guarantee some of its subsidiaries losses. "That is because the European Commission increasingly believes banks should “burden share” any state aid by suspending not only stock dividends but also coupons on their hybrid debt, as the UK’s Northern Rock recently did." (August 26, 2009) o Dec 17, 2008 FT Alphaville: Deutsche Bank rattles the callable bond market (form of hybrid capital, see definitions below) by breaking with the convention to call these notes, at par, at the first available date (January 16 for €1bn worth of 3.875 per cent 2004/2014 subordinated bonds). That’s what banks do with such lower Tier 2 capital notes even if they are currently out of the money - redeem and re-issue on a regular basis in order to retain access to the market. On this occasion, Deutsche is allowing the bonds to turn into floating rate notes, preferring to pay a penalty rate of three month euribor +88bp because it deems re-issuing a new deal more costly--> The extra yield investors demand to buy financial company bonds climbed to a record 4.83 percentage points more than government debt, according to Merrill Lynch’s European Financial Corporate Index. That compares with a spread of 1.28 percentage points at the start of the year.
11 o Feb 3 Bloomberg: The market for securities with characteristics of both debt and equity (hybrids) that Citigroup Inc., Bank of America Corp. and other financial companies used to bolster their capital is in freefall on concern governments will stop banks that took public cash from paying interest. The hybrids, which typically count as regulatory Tier 1 capital to cushion against losses, fell 11 percent last month in the U.S., more than they did in all of 2008, according to Merrill Lynch & Co. index data. Citigroup and Bank of America bonds lost as much as 34 percent of their value. o European banks use the market for bonds with call dates rather than fixed maturities to meet regulatory reserve requirements, known as Tier 1 and 2 capital. The subordinated bonds rank after senior notes and loans for repayment. o Davies: More than $800bn hybrid bonds have been issued globally this decade, according to Dealogic, hitting a peak of $175bn in 2007 after raising common equity has become too expensive. Most of the issuance has come from banks. Their importance in supporting bank balance sheets during the crisis is shown in the $137bn of deals in the 2008. o Davies: When banks decide not to redeem the bonds at the earliest opportunity, the market value of the instruments falls, hurting investors. Analysts and bankers said such a scenario could see investors turn away from buying these deals in the future – further narrowing banks’ ability to raise new money. Analysts: "You have to ask two questions. One, can that capital be replaced at any price? Two, has the regulator told Deutsche it can only call the deal if it can replace it?” o Chen et al (U-Texas): Firms facing poorer future investment opportunities are more likely to issue callable bonds. In addition, firms with higher leverage ratio and higher investment risk are more likely to issue bonds. Finally, as firms call back their bonds, non-refunding calls are associated with poor performance and low investment activities, and refunding calls are associated with good performance and high investment activities. Firms with mediocre performance and investment activities tend to not call their bonds (see also Montier via InvestorsInsight) o Economist: Convertible bonds (fixed-income instruments that can be swapped for a company’s shares) have been battered in 2008. Traditionally, these were bought heavily by hedge funds (a specialist sector called convertible arbitrage) that hedged themselves by selling short (betting on a price fall) the shares of the company concerned. The trade has been almost impossible in recent weeks, thanks to the difficulty in getting leverage and restrictions on short-selling. Convertible bonds may look cheap but no one can take advantage of them. o Preferred shares - A hybrid security that are technically equities but behave more like bonds. Their share prices tend not to fluctuate as much as common shares. Payments from preferreds are taxed like dividends, which makes them a tax-effective holding in taxable portfolios. Unlike dividend stocks, preferreds usually have a fixed dividend and carry no voting rights. They have priority over common stocks in the case of bankruptcy and with regard to dividends. Only after the common share dividend has been suspended would preferred dividends be at risk. As opposed to common stockholders, preferred stockholders care more about the security of dividends than the size of dividends or capital appreciation o Acceler8now.com: Several different ways for listed banks to raise additional equity capital:
12
- Private placements: offer is privately presented to a limited number of investors, usually targeted at well-heeled investors, including fund managers and institutional investors--> low marketing costs and quiet way of testing markets. - Public offer: An already listed company sells shares to the wide public. [First time sale of shares to the public of a previously not listed company is called Initial Public Offering IPO.] - Rights Issue (popular in Europe and UK): close to a public offer, only with the limitation that only existing shareholders of the company can buy in order to limit ownership dilution--> Shares are usually offered at a discount to the currrent market price in order to limit the negative capital dilution effect for shareholders--> rights are now traded (sold and bought), meaning that the existing shareholders can still sell their rights to persons not previously shareholders. Rights are offered to shareholders in a certain proportion to what they already own (examples 1:2; 1:5). - Hybrid offers, i.e. a combination of public offer and rights issue, - Preferred shares and other “hybrid” securities with bond and equity like features are preferred by U.S. banks: Hybrids allow to replenish capital reserves without diluting existing shareholder base, but bond-like feature increases potential leverage which is watched closely by credit rating agencies (FT Alphaville) http://www.rgemonitor.com/10009/Europe?cluster_id=13366 Sep 8, 2009 Is There a Need for International Monetary Reform Through a Multilateral Exchange Rate Mechanism?
o In September 2009, the UN Conference on Trade and Development (UNCTAD) added its voice to those calling for a move away from the U.S. dollar as the primary reserve currency by suggesting that a new multilateral FX policy could be needed to rebalance global demand. Many economists have suggested that the increase in U.S. financing needs will lead key U.S. creditors to diversify their savings away from the dollar by increasing savings in euro, yen, SDR and eventually perhaps even currencies like the RMB.
o UNCTAD worried that the global stimulus is repeating "the earlier pattern in the distribution of global demand growth that led to the build-up of the global current account imbalances in the first place." The current system for adjustment, UNCTAD suggests, puts all onus for adjustment on the deficit countries, who either suffer currency depreciation or a sharp fall in domestic demand, rather than on surplus countries. The U.S., because of the dollar's central role, has not faced the same pressures as other deficit countries. Without major reforms, though, individual crisis responses could increase the incentive for undervalued currencies and surpluses. Steps taken on a regional basis including reserve pooling in Asia as well as currency swaps in Latin America are a key start. (UNCTAD)
o UNCTAD envisions a multilateral system based on stable and sustainable real effective exchange rates (that is the trade-weighted exchange rate adjusted by inflation differentials). It suggests the move would reduce speculative capital flows as the carry
13 trades would no longer be attractive as well as lowering the risk of currency crises, debt traps, reducing pro-cyclicality in times of crisis, fundamental imbalances and the need to build up reserves. Countries facing depreciation pressure would receive support through swaps or transfers once the currency reached a determined "sustainable" level. o RGE's Rachel Ziemba: Despite the potential benefits of such a system in terms of stability, getting political will for such a new system (and setting exchange rates) might be difficult. o The IMF seems to have officially abandoned its multilateral FX surveilance mechanism launched in 2007 to realign currencies and reduce global imbalances. IMF guidance to staff suggests that the institution no longer use the term "fundamentally misaligned" in its dealings with member states. It hopes the new guidance will increase the quality of collaboration with its members. o Chinese economic officials have also suggested that reserve currency issuers like the U.S. receive more scrutiny from the IMF and other institutions given the critical role they play in the global economy How effective was the IMF's surveillance mechanism? o The IMF mechanism was most effective in guiding the policies of countries receiving IMF funds, while the economies with the largest external balances like the U.S. and China resisted such labels. Divides over the language to be used regarding the currency contributed to a two year deferral of the Chinese Article IV consultation with the IMF. o IMF: The revised surveillance framework reaffirms promoting countries' external stability, guiding members on how they should run their exchange rate policies o IMF update on the FX Surveillance : "We [IMF] have not labeled any countries exchange rates as being fundamentally misaligned, nor found any member to be violating the principles. The idea is to bring the Board more closely into this process, not in the sense of putting pressure on countries, but to allow a broader international discussion of these issues. And we found the discussion we've had individually with countries on these matters about why it can be in their interest to make various changes in policies to have been very helpful" o Robert Lavigne, Bank of Canada:" The Surveillance Decision has significantly increased the quality of Article IV reports for emerging-market, advanced, and developing countries. Bilateral surveillance is more focused on external stability and core macroeconomic policies. Exchange rate analysis has improved significantly but the integration with multilateral surveillance remains relatively weak and cross-country spillovers still do not receive sufficient attention. Moreover, the link between domestic stability and external stability is not adequately analyzed. Implementation has been broadly similar across country income groups, though differences remain for specific aspects of the Decision." o Bretton Woods Project: External stability refers to a balance of payments position that does not, and is not likely to, give rise to disruptive exchange rate movements o IFI: " The amendment represents a diffident step for developing countries (including China) as the revised guidelines reduce the policy space needed for developing countries to successfully grow using a trade & export-led model" http://www.rgemonitor.com/41/IMF_and_other_Multilateral_Institutions?cluster_id=7795
14
September 8, 2009
Recession nears end but stagnation may follow Robert Lindsay
Britain’s economy grew for the first time over a three-month period since May last year, the National Institute of Economic and Social Research (NIESR) said today but warned that the end of recession could turn to a period of stagnation. NIESR's monthly estimate of economic growth suggests that gross domestic product (GDP) grew 0.2 per cent between June and August, after a 0.3 per cent fall in the three months to the end of July. The influential think-tank said: "This is the first time our GDP indicator has been higher over a three-month average since May of 2008 and reinforces our view that the recession ended in May of this year." However, NIESR added: "There may well be a period of stagnation now, with output rising in some months and falling in others; the end of the recession should not be confused with a return to normal economic conditions." The findings chime with other indicators in suggesting Britain’s economy is stabilising after suffering its sharpest contraction in decades. Britain’s services sector grew last month at its fastest pace in over two years, according to a survey last week, while official data earlier today showed manufacturing output rose in July at its fastest pace in one-and-a-half years. In a speech today, Chancellor Alistair Darling reiterated his opposition to reducing the Government’s fiscal stimulus package, which he said would risk damaging recovery. He said: “Cutting support now, as some are demanding, would run the real risk of choking off the recovery even before it started and prolonging the global downturn. “But in the medium-term we need to live within our means. Not to do so would be equally irresponsible and damage our country’s future.” Mr Darling set out the Government’s determination to “never risk the fiscal sustainability of our economy”. He said: “This will mean, as Gordon Brown and I have already made clear, hard choices on public spending. “We won’t flinch from these difficult decisions. But we will always be guided by our core values of fairness and responsibility.” NIESR specialises in estimating GDP ahead of official figures produced by the Office for National Statistics.
http://business.timesonline.co.uk/tol/business/economics/article6826196.ece
15
08.09.2009 The long-term consequences of Europe's lacklustre crisis management Wolfgang Munchau By: Wolfgang Munchau
One of the probable long-term consequences of the financial crisis is an acceleration of Europe’s economic decline. This is by no means an inevitable outcome, but I fear it is likely. No matter what we do, China and India will eventually displace the European Union as the world’s largest economies. What I mean by decline is a decline in living standards. The financial crisis has led to a fall in potential growth in the entire North Atlantic region. Both the US and Europe will go through an adjustment period, during which growth will be lower. The US will be first to recover: it is a more dynamic economy, has a more coherent framework for macroeconomic policy, and, unlike the EU, has a genuine internal market which is not unravelling. So what should the EU do? A good macroeconomic to-do-list for Europe came in an essay last week, published in Memos to the New Commission by the Bruegel think-tank in Brussels. It was co-authored by Professors Jürgen von Hagen and Jean Pisani-Ferry. They propose six points – not a complete list, but a sensible one. First, don’t all rush to exit from stimulus policies at once. Ensure a proper sequencing, with the goal of preventing a double-dip recession. Second, adopt a five-year growth programme. I would add that this is not to be confused with the competitiveness programmes the EU has been running for ages. This should be about policies specifically designed to raise the rate of potential growth in gross domestic product, without the usual long list of extra objectives. Third, move beyond a mechanistic, legalistic adherence to the stability and growth pact, the current framework for fiscal policy co-ordination. This should not only include binding commitments on deficits and medium-term strategies, but also institutional reform, which is probably necessary in several member states. Fourth, the crisis has shown that macroeconomic policy in the euro area needs to be better co-ordinated, especially when it comes to crisis and post-crisis management. Fifth, speed up the introduction of the euro in central and eastern Europe. The authors rightly point out that one membership criterion, the inflation rate, currently suggests everybody qualifies, while another – the deficit – suggests nobody does. A
16 bureaucratic application of the criteria is not a mature way to deal with eurozone enlargement. Finally, undertake some steps towards a common external representation of the eurozone. Unfortunately, most of this stands no chance of implementation. Adopting these policies would require that elusive quality of political leadership EU leaders lack. If you read the five-year action plan by José Manuel Barroso, the president of the Commission, also published last week, you would discover a shocking lack of imagination and ambition. Why is such lack of ambition a problem? Because the post-crisis policy response is in many ways more important than the crisis response itself. The crisis response was relatively straightforward. Guaranteeing the liabilities of the banking system and stimulating the economy were policies adopted in varying degrees by all governments. Most were national policies, with minimal co-ordination at EU level. The EU would have benefited from a greater degree of co-ordination. But the response was sufficient to prevent an all-out catastrophe. Post-crisis responses are not going to be so binary, and the Commission will need to play a much more prominent role because we are dealing with deep structural issues. Now, even with Mr Barroso in office, there will probably be some minimal action on a subset of those proposals, but don’t hold your breath. In the absence of action, there would be a reasonable chance that Mr Barroso could oversee the re-introduction of the escudo in Portugal, his own country. I do not believe that this will happen, because I would expect to see the minimum policy moves needed to prevent a fully-fledged catastrophe. But they will probably not sequence an exit strategy. As we learned last week on these pages, the European Central Bank will independently pull the interest rate trigger at the first sighting of the inflation fairy. As for fiscal policy, Germany and the Netherlands will be the first to exit, come what may, and France will be among the last. So the sequencing is partially given. There will be no growth programme; any programme will not target growth, but some lobbyist’s agenda. The Commission will desperately cling on to the stability pact, and will eschew any talk about a more flexible and strategic application of the rules; it will continue to ignore current account imbalances, since there is no treaty base for doing otherwise; and you can forget the last two points of the Bruegel memo. Prospective euro members will only be able to join if they fulfil criteria that no eurozone members would presently fulfil. Common external representation has been pushed right down the agenda. So the eurozone will probably survive. But it may wither, as potential growth and living standards are falling. Europe was always in danger of heading towards the “irrelevant but pleasant to live in” category of places. Now even the latter is no longer assured.
http://www.eurointelligence.com/article.581+M58a80590071.0.html#
17
As Cheaper Chinese Tires Roll In, Obama Faces an Early Trade Test By Peter Whoriskey Washington Post Staff Writer Tuesday, September 8, 2009 ALBANY, Ga. -- At the vast Cooper Tire plant here, workers heard for years about their rivals in Chinese factories. In meetings, managers urged employees to run production lines faster and more efficiently to help the company keep up. Overseas laborers were toiling for as little as 20 cents an hour, they were told, and working harder. Even more ominously, while browsing the aisles of Kmart and Wal-Mart, Cooper employees could see that, sure enough, the Chinese tires were cheapest. "They would have these meetings and say we're up against the Chinese," said Larry Burkes, 29, who worked at the plant, which rises on the city's outskirts just beyond a mobile-home park. "We'd hear it all the time: 'They work for less.' There was pressure." Now the plant that employed 2,100 people in this small south Georgia city is being shut down, and the troubles afflicting the U.S. tire industry are at the core of what many consider to be one of President Obama's first major decisions on trade policy. By Sept. 17, Obama must decide whether to slap a 55 percent tariff on tires imported from China, as recommended by a federal trade panel, or leave the matter alone, as a phalanx of lobbyists representing manufacturers in China and U.S. companies that import from them are urging. From 2004 to last year, the number of Chinese tires imported to the United States more than tripled, and their share of the U.S. market rose from 5 percent to 17 percent. Over the same period, the share of the U.S. market served by U.S. factories declined by a similar amount. More than 5,000 U.S. jobs were lost. Opponents of the tariff say the U.S. industry's shrinkage is unrelated to the surge in Chinese imports. The U.S. manufacturers, they say, have strategically moved into pricier, more profitable tires, shifting production of cheaper tires overseas. "We hope the U.S. government will refrain from taking action, for the long-term healthy and stable development of U.S.-Chinese relations," a Chinese deputy commerce minister, Fu Ziying, said at a news conference last month. "The case is neither supported by facts nor does it have valid legal grounds." The ballooning trade imbalance with China has provoked complaints that the relationship is crushing U.S. manufacturers. Critics of the relationship say China manipulates its currency and employs other protectionist policies that make it difficult for U.S. factories to compete. Congress passed legislation in 2000 that allows the United States to impose tariffs and other protections if a surge in Chinese imports damages a U.S. industry. China agreed to the provision while negotiating to join the World Trade Organization.
18 The general "safeguard" provisions of the law have never been invoked, however. The Bush administration was asked four times to impose measures to protect a U.S. industry, but it declined each time. The proposed tire tariff represents the first such case presented to Obama, and his action will be closely watched and weighed against his campaign promises to "crack down on China" and "work to ensure that China is no longer given a free pass to undermine U.S. workers," as his Web site put it. There are other political currents at work, as well. The United Steelworkers union, which represents many of the nation's tire workers and brought the complaint, helped Obama win the presidency. The other side, meanwhile, boasts the aid of several former U.S. trade officials, who are representing the Chinese manufacturers and U.S. companies that import from China. For the former plant employees here, however, the politics are a distant concern. They were not members of the union. They're trying to find jobs. Many of them made $18 to $21 an hour, and in the Albany area, it's difficult to match that wage -- even in ordinary times. These days, unemployment is just short of 11 percent. Larry Cannon, 37 and the father of three children, ages 13, 10 and 4, used to specialize in molds at the plant. Now, as he starts classes to become a biomedical technician, his wife has taken a job in the photo department at Wal-Mart. Joseph Roberts, previously a shift manager in curing and finishing, said he's just beginning to feel the pinch of unemployment. At 49, he said, he feels like "I'm starting all over again." Byron Botdorf, 59, is taking up welding at Albany Technical College. He'll be 61 when he's retrained for a new job. "My son got into welding -- it's a good trade," he said. "But here's the thing with this economy: Everything nowadays is made in China. Go to Wal-Mart. It's hard to find anything down there that isn't made in China. The last pair of boots I bought were made in China. I don't like buying China stuff -- but you kind of have to." Each of the 10 former Cooper employees interviewed expressed support for a tariff, though some wondered whether blocking Chinese tires might simply mean that the cheap imports would just arrive from other countries. Mark Burns, 43, who used to drive a forklift at the plant, has been through layoffs before. Fifteen years ago, he was briefly laid off from the local cotton mill, Flint River Textiles. That company eventually shut down, citing the cost pressures of Asian imports. He then took the job at Cooper Tire. Laid off again, he now plans to become a welder. "Welding is not something they could import very easily," he said. While workers lay some of the blame for the plant closure on Chinese tires, tire companies in the United States that import tires, as well as the manufacturers in China that supply them, argue that on the contrary, those imports make the U.S. companies more efficient and more profitable. They argue that the ability to import the cheapest tires from overseas enables U.S. manufacturers to focus on producing more expensive tires, which have a larger profit margin. Most major U.S. tire manufacturers have tire plants in China or import from there.
19 "When you are one of the guys who loses a job in the process, I know that's cold comfort -- but it's also a reality," said Marguerite Trossevin, who represents a coalition of U.S. tire companies that import Chinese tires to sell under their brands. Even if the tariff goes into effect and essentially bans Chinese tires from the United States, tariff opponents say, companies are unlikely to expand U.S. production because the competition from the world's low-cost countries is too strong. "You don't keep jobs here by forcing companies into unprofitable lines of business," Trossevin said. So far, the federal government has looked askance at the claim that the surge of Chinese tire imports is unrelated to the shrinkage in the U.S. industry, however. In a 4 to 2 decision released in July, the U.S. International Trade Commission, a quasi- judicial federal authority, ruled that the imports had damaged the domestic industry. They recommended the tariff that Obama is now considering. In announcing the closure of the plant here, Cooper officials cited "intense pressure in recent years from increased lower-priced imports." Today, 70 percent of the tires that Cooper sells in the United States are also manufactured in this country, a proportion that is larger than for any other major U.S. tire company, a spokesman said. Yet Cooper's corporate officials oppose the proposed tariff. It has built one plant and bought another in China in recent years, sometimes sending Albany workers there to help train the Chinese workforce. At one of the plants, the Chinese government stipulated that all of the production must be exported, a requirement that insulates Chinese manufacturers from competition. The proposed tariff would apply to Cooper Tire products manufactured in China and brought to the United States. It "could have significant negative impacts causing considerable market disruption" and "negative impacts on U.S. consumers," the company said in a statement. "Cooper Tire & Rubber Company believes in free and fair trade which allows markets to grow and be successful." Botdorf was surprised to learn that Cooper opposed the tariff but then said the company seems to have shifted its concern away from employees in order to satisfy shareholders. "Leaving things as they stand might be the right thing for American companies," he said. "But something has to be done for the workers, too. Otherwise we'll become a nation of retailers." http://www.washingtonpost.com/wp- dyn/content/article/2009/09/07/AR2009090702260_pf.html
20 COMMENT Why some economists could see the crisis coming By Dirk Bezemer Published: September 7 2009 19:34 | Last updated: September 7 2009 19:34 From the beginning of the credit crisis and ensuing recession, it has become conventional wisdom that “no one saw this coming”. Anatole Kaletsky wrote in The Times of “those who failed to foresee the gravity of this crisis” – a group that included “almost every leading economist and financier in the world”. Glenn Stevens, governor of the Reserve Bank of Australia, said: “I do not know anyone who predicted this course of events. But it has occurred, it has implications, and so we must reflect on it.” We must indeed. Because, in fact, many had seen it coming for years. They were ignored by an establishment that, as the former Federal Reserve chairman Alan Greenspan professed in his October 2008 testimony to Congress, watched with “shocked disbelief” as its “whole intellectual edifice collapsed in the summer [of 2007]”. Official models missed the crisis not because the conditions were so unusual, as we are often told. They missed it by design. It is impossible to warn against a debt deflation recession in a model world where debt does not exist. This is the world our policymakers have been living in. They urgently need to change habitat. I undertook a study of the models used by those who did see it coming.* They include Kurt Richebächer, an investment newsletter writer, who wrote in 2001 that “the new housing bubble – together with the bond and stock bubbles – will [inevitably] implode in the foreseeable future, plunging the US economy into a protracted, deep recession”; and in 2006, when the housing market turned, that “all remaining questions pertain solely to [the] speed, depth and duration of the economy’s downturn”. Wynne Godley of the Levy Economics Institute wrote in 2006 that “the small slowdown in the rate at which US household debt levels are rising resulting from the house price decline, will immediately lead to a sustained growth recession before 2010”. Michael Hudson of the University of Missouri wrote in 2006 that “debt deflation will shrink the ‘real’ economy, drive down real wages, and push our debt-ridden economy into Japan-style stagnation or worse”. Importantly, these and other analysts not only foresaw and timed the end of the credit boom, but also perceived this would inevitably produce recession in the US. How did they do it? Central to the contrarians’ thinking is an accounting of financial flows (of credit, interest, profit and wages) and stocks (debt and wealth) in the economy, as well as a sharp distinction between the real economy and the financial sector (including property). In these “flow-of-funds” models, liquidity generated in the financial sector flows to companies, households and the government as they borrow. This may facilitate fixed-capital investment, production and consumption, but also asset-price inflation and debt growth. Liquidity returns to the financial sector as investment or in debt service and fees. It follows that there is a trade-off in the use of credit, so that financial investment may crowd out the financing of production. A second key insight is that, since the economy’s
21 assets and liabilities must balance, growing financial asset markets find their counterpart in a growing debt burden. They also swell payment flows of debt service and financial fees. Flow-of-funds models quantify the sustainability of the debt burden and the financial sector’s drain on the real economy. This allows their users to foresee when finance’s relation to the real economy turns from supportive to extractive, and when a breaking point will be reached. Such calculations are conspicuous by their absence in official forecasters’ models in the US, the UK and the Organisation for Economic Co-operation and Development. In line with mainstream economic theory, balance sheet variables are assumed to adapt automatically to changes in the real economy, and can thus be safely omitted. This practice ignores the fact that in most advanced economies, financial sector turnover is many times larger than total gross domestic product; or that growth in the US and UK has been finance-driven since the turn of the millennium. Perhaps because of this omission, the OECD commented in August 2007 that “the current economic situation is in many ways better than what we have experienced in years . . . Our central forecast remains indeed quite benign: a soft landing in the United States [and] a strong and sustained recovery in Europe.” Official US forecasters could tell Reuters as late as September 2007 that the recession in the US was “not a dominant risk”. This was well after the Levy Economics Institute, for example, predicted in April of that year that output growth would slow “almost to zero sometime between now and 2008”. Policymakers have resisted inclusion of balance sheets and the flow of funds in their models by arguing that bubbles cannot be easily identified, nor their effects reliably anticipated. The above analysts have shown that this is, in fact, feasible, and indeed essential if we are to “see it coming” next time. The financial sector is just as real as the real economy. Our policymakers, and the analysts they rely on, ignore balance sheets and the flow of funds at their peril – and ours. *‘No One Saw This Coming’: Understanding Financial Crisis Through Accounting Models, MPRA (http://mpra.ub.uni-muenchen.de/15892/1/MPRA_paper_15892.pdf) The writer is a fellow at the economics and business department of the University of Groningen in the Netherlands Why some economists could see the crisis coming September 7 2009 http://www.ft.com/cms/s/0/452dc484-9bdc-11de-b214-00144feabdc0.html
22 BRUSSELS. Finance & Markets ECB plans policy revamp to tackle bubbles Ralph Atkins By Ralph Atkins in Frankfurt Published: September 7 2009 17:02 | Last updated: September 7 2009 23:56 The European Central Bank plans to revamp its system for guiding interest rate policy to take better account of credit and money supply data, as well as threats posed by asset price bubbles. The plan which it expects to unveil next year could see the ECB take a clear stance in the global debate over the factors that central banks take into account when setting official interest rates. It might, in theory, result in the Frankfurt-based institution acting earlier against financial market distortions. Jürgen Stark, an executive board member, told journalists at an “ECB watchers” conference in Frankfurt that he hoped early in 2010 “to be in a position to present concrete results about the enhancement of our monetary analysis”. Julian Callow, European economist at Barclays Capital, said: “They feel the tide is turning in their favour and want to surf a bit.” However, there are differences of emphasis about the importance of the project within the ECB’s 22-strong governing council. Since the launch of the euro in 1999, the ECB has attached much weight to money-supply indicators as indicators of longer-term inflation trends, a tradition it inherited from Germany’s Bundesbank. The ECB’s main aim is to control inflation. But the usefulness of the analysis was often questioned by economists. Meanwhile, Alan Greenspan, the former US Federal reserve chairman, famously argued that central banks had little power to stop bubbles from inflating and bursting – and should instead focus on mitigating the fallout. But the ECB believes events of the past two years – during which it has been overhauling its so-called “monetary pillar” – have justified its focus on data that could provide warnings about financial imbalances in asset markets. Jean-Claude Trichet, ECB president, told central banking counterparts at a gathering last month in Jackson Hole, Wyoming, that such a policy could allow it to, in effect, “lean against the wind” when it came to asset price bubbles. At last week’s Frankfurt conference, Mr Trichet said he believed the ECB’s approach was “the closest to what I could consider to be the best way to operate in this difficult time”. The ECB’s research has focused on improving economic models to take account of modern financial systems and the power of its monetary analysis to predict inflation rates. But financial markets are likely to remain sceptical. http://www.ft.com/cms/s/0/dde525aa-9bc3-11de-b214-00144feabdc0.html
23 COMMENT Hedge funds show the way on bonuses By Paul Marshall Published: September 6 2009 20:15 | Last updated: September 6 2009 20:15 The world’s finance ministers, meeting in London at the weekend, zeroed in on bonuses as the symbol of financial sector excess. They may be a convenient target, but we are in danger of some very bad law-making. Bonuses are a good thing: they are an instrument of alignment. They are the right way to align the interests of employee and employer, employer and shareholder, customer and service provider – and, yes, to curb excess by bankers. What should be vilified is not bonuses but their misuse. Many of the excesses of the past few years can be traced back to bonuses which encouraged the wrong sort of performance or were paid without any link to performance. Think of the skewed incentives of ratings agencies paid by the companies they rate; or how little bankers cared about default in packages of securitised mortgages they had offloaded. The way to make people behave responsibly is to create more, and better, alignment of interests. The recent moves by Morgan Stanley and UBS, the US and Swiss banks, to increase base salaries and cut bonuses are regrettable. Instead, banks need to behave more like hedge funds, at least in their proprietary trading desks, which caused so many of their troubles. Fund management has been transformed by incentive fees – bonuses for good performance are at the heart of the hedge fund business model. The alignment of hedge funds and their customers is not perfect. First, there can be a difference in the timing of incentive fees and terms of withdrawal, allowing managers to take bonuses before clients are able to realise profits. This is something customers need to police, as big investors such as Calpers and the state of Utah are, rightly, doing. A second problem is “performance hazard”: a plunge in performance after the manager has banked his fees, leaving him much richer than his clients. The solution is for those running hedge funds to have “skin in the game”; to co-invest in the fund alongside their clients. This is a well-established hedge fund tradition, which, again, investors must police. The final problem is that of transparency. Investors need to be sure they are paying for skill, not luck. Too many fund managers simply rode the bull market to leveraged riches; investors can and should demand information to assess the quality and persistence of returns. Properly aligning the bonuses of traders at a bank is much more complex. The essence of the problem is that there are two layers of obfuscation between traders and the shareholders who ultimately pay: the board and senior management. Traders typically do not have skin in the game and those whose money they deploy (the shareholders) do not have access to individual performance data.
24 In the UK, David Walker’s recent review rightly focused on this area, arguing for strengthened remuneration committees with a wider remit, plus a chief risk officer and a risk committee. I would take this approach a step further. Listed banks should be required to publish the amount spent on signing-on bonuses, on operating bonuses and on severance bonuses. Signing-on bonuses are an investment in people, and those responsible for paying them should be answerable for the return on investment. Severance bonuses should also be disclosed; these are contingent liabilities which the board should be required to review and justify. The most important piece of the equation is operating bonuses. These have the advantage that they can be tied directly to results. But the quality of trading profits varies enormously, depending on the amount of skill in returns, the risks taken to achieve them and the variety of sources of profit. Given the complexity of many strategies it is doubtful that boards will ever be in a position to make informed judgments. Hopefully Walker-style remuneration committees will be able to perform this task. If not, I suggest a more radical approach. Investment banks should prove to shareholders, whose money they are trading, that the trading business can punch its weight by raising at least some of the capital direct from outside investors – who can help keep bonuses in line. Or they could float these businesses off and let them run money from real investors, who can keep a better eye on the bonuses. The writer is chairman of Marshall Wace, a hedge fund manager http://www.ft.com/cms/s/0/6747053a-9b0f-11de-a3a1-00144feabdc0.html
25 Economy September 4, 2009 Judges’ Frustration Grows With Mortgage Servicers By JOHN COLLINS RUDOLF PHOENIX — Bobbi Giguere had no luck in securing a loan modification from her mortgage servicer, Wells Fargo. For months, she had sent the bank the financial documents it requested to process her modification. But each time she called to check on the request, she was told to send her paperwork again. “I submitted the paperwork three times, and nothing happened,” said Mrs. Giguere, 41, who has a high school education and worked as restaurant manager before losing her job. On Thursday, something happened. She questioned a Wells Fargo official about the bank’s lack of response — under oath. The spectacle of a high-ranking banking executive being grilled by an ordinary homeowner was the result of an unusual decision by Judge Randolph J. Haines of the United States Bankruptcy Court to summon a senior executive from Wells Fargo to appear in Mrs. Giguere’s bankruptcy case. At the hearing, Judge Haines made it clear that he was acting out of concerns about Wells Fargo’s mortgage modification practices generally. “This is certainly not an isolated case,” he said. “The kind of story I hear from this debtor is one that I and other bankruptcy judges around the country are hearing over and over and over again.” With consumers complaining about the difficulty of getting any response from their mortgage servicers, the effectiveness of the Obama administration’s plan to provide homeowner relief is being threatened. As they wait for an answer on whether they might qualify, homeowners are succumbing to foreclosure and bankruptcy proceedings and winding up in courts — at times in front of judges who are also frustrated. Ms. Giguere filed for bankruptcy protection as she was trying to keep her three-bedroom house in a Phoenix suburb, where she lives with her 15-year-old son. Representing the bank at her hearing on Thursday was Joseph Ohayon, senior vice president of Wells Fargo Home Mortgage Servicing. Under preliminary questioning by one of the bank’s lawyers, Mr. Ohayon stated that Mrs. Giguere had repeatedly failed to provide a financial worksheet, a critical document in processing a loan modification. Under cross-examination by Mrs. Giguere (who had a little assistance from Judge Haines), the bank’s defense withered. From her files, Mrs. Giguere produced a letter from Wells Fargo describing the paperwork that she needed to file for a loan modification. In the witness chair, Mr. Ohayon read the letter. “Mrs. Giguere is right,” Mr. Ohayon concluded. “The letter did not ask for a financial worksheet.”
26 Experts said the hearing in Phoenix reflected rising frustration by federal bankruptcy judges with mortgage servicers, which process payments for banks and the investors who own large pools of loans. In recent months, judges in Ohio and Pennsylvania have chastened mortgage servicers for failing to process payments properly and for errors in foreclosure filings, among other concerns. “The judges are seeing more and more of a pattern of indifference to record-keeping and good business practices,” said Robert Lawless, a law professor at the University of Illinois who specializes in bankruptcy law. One of the biggest complaints by homeowners has been poor communication by mortgage servicers on the status of their applications for loan modifications. In the case of Mrs. Giguere, Wells Fargo decided back in March shortly after she faxed the bank her application that she did not qualify for the Home Affordable Modification Program. She did not learn of the bank’s decision until Thursday. “When did you tell the debtors that their loan was no longer being considered for modification?” Judge Haines asked Mr. Ohayon. “We haven’t. They’ve never been told,” said Mr. Ohayon, adding: “Customer communication is something we’re taking a serious look at, your honor.” The hearing with Wells Fargo did not result in any sanctions against the bank for its failure to provide timely information to Mrs. Giguere about her mortgage modification application. But the bank did pledge to improve its communications with customers and to explore avenues for increasing the ease with which homeowners can seek loan modifications. Wells Fargo has also scheduled a three-day seminar at the Phoenix Convention Center, beginning on Tuesday, in which customers who have submitted loan modification applications can meet with a bank representative in person and learn whether their application has been approved or denied. Wells Fargo has been criticized for its slow pace in modifying mortgages under the Treasury Department’s foreclosure prevention initiative, which was begun in April. The bank has started trial modifications on about 20,000 home loans under the program, or 6 percent of those who meet the program’s guidelines. JPMorgan Chase, by comparison, has begun modifications on nearly 20 percent of such loans. The banks’ information was issued in a recent report from the Treasury on the progress of the program. At the hearing, Wells Fargo blamed a series of revisions in the program by the government for the slow pace. It has also pledged to renew negotiations with Mrs. Giguere over modifying her home mortgage. Yet difficult financial circumstances make it unclear whether she will ultimately be able to keep her home, mortgage modification or not. She has recently gone on food stamps and is receiving free state medical aid; her $240 weekly unemployment check is her main form of income. When her home shot up in value, she refinanced it several times, pulling out equity to pay off credit card debt and other expenses. She and her husband are divorcing, and he is no longer willing to help pay the mortgage. With little in savings, she has not made a full mortgage payment since November. “I’m not perfect, I’ll be the first to admit that,” Mrs. Giguere said. “I’ve fallen behind.” JOHN COLLINS RUDOLF Judges’ Frustration Grows With Mortgage Servicers September 4, 2009 http://www.nytimes.com/2009/09/04/business/economy/04wells.html?ref=business
27 COMPANIES Cerberus to bar withdrawals from two funds By Francesco Guerrera in New York and Sam Jones in London Published: September 2 2009 23:30 | Last updated: September 2 2009 23:30 Cerberus, the investment group, is barring investors in two new hedge funds from withdrawing money for three years in an effort to avoid a repeat of the large outflows that followed its lossmaking purchases of Chrysler and GMAC, the group’s executives said. The move to introduce a three-year “lock-up” is rare among hedge funds and could pave the way for other managers to follow suit. Hedge funds typically offer investors the chance to withdraw money every few months – a feature that contrasts with alternative asset classes such as private equity that require multi- year lock-ups. But after suffering more than $500bn in redemptions in the past year, hedge funds’ interest in longer-term investment structures – often accompanied by lower annual fees – is growing. They are keen to avoid fire sales when investors want out, while the latter are clamouring for a better alignment of their long-term goals with hedge fund managers’ rewards. Cerberus executives said the lock-up would apply to two multibillion-dollar funds to be raised later this year specialising in distressed investments. The funds, Cerberus Partners II and Cerberus International II, are successors to two vehicles that were hit by redemption requests as the financial crisis struck and Cerberus’s high-profile investments soured. Cerberus has suffered considerable losses on Chrysler, the carmaker that filed for bankruptcy in May and recently emerged from the process, and GMAC, General Motors’ former finance arm that had to be rescued by the US government. In 2008, it recorded a negative return of more than 20 per cent, the first time since its inception in 1992 that it did not make money for investors. Mark Neporent, chief operating officer, told the Financial Times that Cerberus was on its way to recoup those losses, saying its portfolio, excluding the two hedge funds, had recorded an 18 per cent return so far in 2009. The two funds were up between 1.5 and 3 per cent this year, he added. Cerberus officials said the new lock-ups are driven by a desire to avoid the situation they faced in December when they unilaterally halted redemption requests from the two hedge funds in order to avoid a fire sale of their assets. Cerberus has since relented. Mr Neporent said that investors controlling $4.77bn, or about 60 per cent of the funds’ total assets, had asked for their money back. Those funds will be placed in a wind-down vehicle that will sell assets and return money to investors over several years.
28 Mr Neporent stressed that those redemption requests totalled less than 20 per cent of Cerberus’s $24.3bn in assets under management and would not constrain its ability to operate its private equity and hedge funds businesses. “We still have lots and lots of money in our core business. We have ample liquidity to do what we want to do,” he said. However, he indicated that Cerberus, which abhors the public limelight and is run by the secretive financier Stephen Feinberg, would steer clear of takeovers of high-profile companies for some time. “We were naive in thinking that buying Chrysler would not have been high profile. But we have always tried to avoid publicity. We are happy making money for our investors and leaving the headlines to others,” Mr Neporent said. http://www.ft.com/cms/s/0/09f87c1a-9803-11de-8d3d-00144feabdc0.html Cerberus faces $5.5bn in fund withdrawals By Alan Rappeport in New York Published: August 28 2009 23:48 | Last updated: August 28 2009 23:48 Cerberus is facing a flood of withdrawal requests from investors in its core hedge funds, the Financial Times has learned. Investors are understood to be asking to withdraw more than $5.5bn, which would represent 71 per cent of the assets in the funds, which currently hold about $7.7bn in a domestic and foreign vehicle. The development was first reported by the Wall Street Journal. The hedge funds were restructured last month in response to initial withdrawal requests. Subsequently, more investors have sought to pull out their funds than the firm anticipated. Last year Cerberus’ investments lost nearly 25 per cent of their value, while hedge funds on average were down by 19 per cent. Stephen Feinberg, Cerberus chief executive, and William Richter, its co-founder, wrote in a letter to clients that investors were fleeing the fund because of a liquidity crisis and they were “surprised by this response”, according to the Wall Street Journal. A Cerberus spokesman said that he was not authorised to distribute the letter and declined to comment further. Investors in Cerberus’ funds have been disappointed by the group’s performance during the downturn, especially its investment in Chrysler, which required a bail-out by the US government, and GMAC, the financing arm of General Motors. In 2007 Cerberus used $7.4bn to take an 80 per cent equity stake in Chrysler.Earlier this year Cerberus, which specialises in cutting costs from struggling companies, was forced to turn the scalpel on itself by cutting 10 per cent of its workforce. Hedge funds started to recover in the second quarter of this year. According to Hedge Fund Research, the total assets invested in the industry have jumped by $100bn to $1,430bn in the second three months of the year and funds invested gained 9 per cent, the sharpest rise in a decade. Cerberus Partners is up by 3 per cent this year. The Cerberus hedge funds that are now facing pressure represent a third of the group’s assets. Cerberus is charging investors an annual management fee of 0.5 per cent for the new vehicle it has introduced to wind down the illiquid assets. http://www.ft.com/cms/s/0/ff3978d4-9423-11de-9c57-00144feabdc0.html
29 Aug 31, 2009 Regulatory Reform in the U.S.: Who Should Be the Systemic Risk Regulator?
Overview: June 17, Treasury's Comprehensive Plan for Regulatory Reform: : New framework includes the 1) Fed as systemic risk regulator and supervisor of too-big-to-fail institutions and creation of “council of regulators” 2) requires the originator, sponsor or broker of a securitization to retain a financial interest in its performance ('skin in the game'). Also regulate all financial derivatives for the first time; 3) Consumer Financial Protection Agency for strong investor protection and rules against predatory lending. 4) new resolution mechanism that allows for the orderly resolution of any financial holding company whose failure might threaten the stability of the financial system, including large hedge funds and major insurers such as AIG. 5) lead the effort to improve regulation and supervision around the world. Specifically:
o June 16 FT: According to proposal, the Fed will retain day-to-day supervision of the largest bank holding companies. The Fed will also directly supervise non-bank financial companies that reach a size and complexity comparable to these banks. Fed is given the final word on bank capital requirements, including a surcharge for the systemically important financial institutions. However, the Fed will have to consult with Treasury before extending emergency liquidity measures.
o FDIC may receive new non-bank/holding resolution authority but wants more teeth for council of regulators against the Fed.
o No federal insurance regulation but a national insurance office within the Treasury to gather information about the industry
o FT: Most likely securitizations will be subject to different rating scale.
Main Points of Contention in Congress:
o Baker, Wallison: Why expand the powers of an agency that sat idly by as the housing bubble took shape? March 6 Reuters: "Are any of you troubled with giving the Fed so much power?" asked Spencer Bachus, the top Republican on the full House Financial Services committee.
o WaPo: Another element likely to provoke fierce debate is the establishment of a Consumer Financial Protection Agency with a mandate to increase the availability of financial products in lower-income communities and other underserved areas
o CFTC and SEC still share regulation and supervision of derivatives: How to ensure consistency? 'Regulatory shopping' opportunity?
30
Opinions:
o Kenneth Rogoff: "The fact is that banks, especially large systemically important ones, are currently able to obtain cash at a near zero interest rate and engage in risky arbitrage activities, knowing that the invisible wallet of the taxpayer stands behind them. In essence, while authorities are saying that they intend to raise capital requirements on banks later, in the short run they are looking the other way while banks gamble under the umbrella of taxpayer guarantees."
o Nouriel Roubini: Overall proposal goes in right direction but the following is missing: - ensure risk-adjusted compensation: e.g. individual lenders and traders pushing toxic assets should be paid with toxic assets or receive compensation tied to it so that they receive both the up- and the downside (see e.g. recent Credit Suisse compensation package) - there are still too many regulatory bodies allowing for regulatory 'shopping' opportunities - Ensure that individuals at the helm of agencies are committed to use their powers: Fed could have acted before but leaders at the time did not deem it necessary.
o Hyun Song Shin; Joseph Mason: Require securitization originators to keep skin in the game is not going to solve anything: The very reason for this banking crisis is that banks actually held on to the economic risk while treating the securitized assets as sold for accounting purposes (see e.g. FAS 140)
o Paul Volcker: I do not believe hedge funds and private equity need to be so closely supervised and regulated as depository institutions. A presumption of government protection and support for financial institutions outside the [commercial banking] "safety net" should be avoided. Nor by the same token should hedge funds or private- equity funds indirectly benefit from official support by sponsorship or ownership by a banking institution--> Private Equity/ Hedge Fund Consortium Buys IndyMac: White Knights Or Indirect Access To Safety Net?
o March 10: Ben Bernanke (via FTAlphaville): "Suggestions for resolving systemic risk include: more supervision for financial institutions deemed ‘too big to fail’, tighter restrictions on the assets in which money market funds can invest, and, perhaps most significantly, modifying the accounting rules which cause pro-cyclicality for bank’s capital positions."
o Paul Volcker: "More broadly, strict mark-to-market accounting -- entirely appropriate for trading operations and investment banks -- may introduce a degree of volatility in reporting incompatible with the basic and essential business model of banks, which inherently intermediate maturity and credit risks" See Is There an Alternative to MtM Accounting? Regulatory Reform in the U.S.: Who Should Be the Systemic Risk Regulator? Aug 31, 2009 http://www.rgemonitor.com/10006?cluster_id=9221
31 7 September 2009 Comprehensive response to the global banking crisis
The Group of Central Bank Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, met on 6 September to review a comprehensive set of measures to strengthen the regulation, supervision and risk management of the banking sector. These measures will substantially reduce the probability and severity of economic and financial stress. President Jean-Claude Trichet, who chairs the Group, noted that "the agreements reached today among 27 major countries of the world are essential as they set the new standards for banking regulation and supervision at the global level".
Mr Nout Wellink, Chairman of the Basel Committee and President of the Netherlands Bank, stated that "central banks and supervisors have responded to the crisis by strengthening microprudential regulation, in particular the Basel II framework. We are working toward the introduction of a macroprudential overlay which includes a countercyclical capital buffer, as well as practical steps to address the risks arising from systemic, interconnected banks". The Central Bank Governors and Heads of Supervision reached agreement on the following key measures to strengthen the regulation of the banking sector: • Raise the quality, consistency and transparency of the Tier 1 capital base. The predominant form of Tier 1 capital must be common shares and retained earnings. Appropriate principles will be developed for non-joint stock companies to ensure they hold comparable levels of high quality Tier 1 capital. Moreover, deductions and prudential filters will be harmonised internationally and generally applied at the level of common equity or its equivalent in the case of non-joint stock companies. Finally, all components of the capital base will be fully disclosed. • Introduce a leverage ratio as a supplementary measure to the Basel II risk-based framework with a view to migrating to a Pillar 1 treatment based on appropriate review and calibration. To ensure comparability, the details of the leverage ratio will be harmonised internationally, fully adjusting for differences in accounting. • Introduce a minimum global standard for funding liquidity that includes a stressed liquidity coverage ratio requirement, underpinned by a longer-term structural liquidity ratio. • Introduce a framework for countercyclical capital buffers above the minimum requirement. The framework will include capital conservation measures such as constraints on capital distributions. The Basel Committee will review an appropriate set of indicators, such as earnings and credit-based variables, as a way to condition the build up and release of capital buffers. In addition, the Committee will promote more forward- looking provisions based on expected losses.
32 • Issue recommendations to reduce the systemic risk associated with the resolution of cross-border banks. The Committee will also assess the need for a capital surcharge to mitigate the risk of systemic banks. The Basel Committee will issue concrete proposals on these measures by the end of this year. It will carry out an impact assessment at the beginning of next year, with calibration of the new requirements to be completed by end-2010. Appropriate implementation standards will be developed to ensure a phase-in of these new measures that does not impede the recovery of the real economy. Government injections will be grandfathered. Mr Wellink emphasised that "these measures will result over time in higher capital and liquidity requirements and less leverage in the banking system, less procyclicality, greater banking sector resilience to stress and strong incentives to ensure that compensation practices are properly aligned with long-term performance and prudent risk-taking". The Group of Governors and Heads of Supervision endorsed the following principles to guide supervisors in the transition to a higher level and quality of capital in the banking system: • Building on the framework for countercyclical capital buffers, supervisors should require banks to strengthen their capital base through a combination of capital conservation measures, including actions to limit excessive dividend payments, share buybacks and compensation. • Compensation should be aligned with prudent risk-taking and long-term, sustainable performance, building on the Financial Stability Board (FSB) sound compensation principles. • Banks will be required to move expeditiously to raise the level and quality of capital to the new standards, but in a manner that promotes stability of national banking systems and the broader economy. Supervisors will ensure that the capital plans for the banks in their jurisdiction are consistent with these principles.
Comprehensive response to the global banking crisis 7 September 2009 http://www.bis.org/press/p090907.htm
33
Mortgage Market Bound by Major U.S. Role. Classes of Borrowers Cannot Find Loans as Publicly Backed Debt Mounts By Zachary A. Goldfarb and Dina ElBoghdady Washington Post Staff Writers Monday, September 7, 2009 Second in an occasional series In the go-go years of the U.S. housing boom, virtually anybody could get a few hundred thousand dollars to buy a home, and private lenders flooded the market, aggressively pursuing borrowers no matter their means or financial history. Now the pendulum has swung to the other extreme. Only one lender of consequence remains: the federal government, which undertook one of its earliest and most dramatic rescues of the financial crisis by seizing control a year ago of the two largest mortgage finance companies in the world, Fannie Mae and Freddie Mac. While this made it possible for many borrowers to keep getting loans and helped protect the housing market from further damage, the government's newly dominant role -- nearly 90 percent of all new home loans are funded or guaranteed by taxpayers -- has far-reaching consequences for prospective home buyers and taxpayers. The government has the power to decide who is qualified for a loan and who is not. As a result, many borrowers among both poor and rich are frozen out of the market. Nearly one-third of those who obtained home loans during the boom years of 2005 and 2006 couldn't get one today, according to mortgage industry analysts. Many of these borrowers were never really able to afford their homes and should not have gotten loans. But many others could, and borrowers like them are now running into tougher government standards. At the same time, taxpayers are on the hook for most of the loans that are still being made if they go bad. And they are also on the line for any losses in the massive portfolios of old loans at Fannie Mae and Freddie Mac, which own or back more than $5 trillion in mortgages. There is growing evidence that many loans being guaranteed by the government have a significant risk of defaulting. Delinquencies are spiking. And the Federal Housing Administration, another source of government support for home loans, is quickly eating through its financial cushion as losses mount. The outlay has already reached about $1 trillion over the past year and is rising. During that time, the government has pumped more money into the mortgage market than has been spent on Medicare or Social Security or the defense budget, more even than Washington has paid to bail out banks and other struggling companies. "Absent government intervention, there would be no lending," said Nicolas P. Retsinas, director of Harvard University's center for housing studies.
34 Government officials generally agree that it would be better for private lenders to resume their traditional role as major providers of finance for home loans. But policymakers now face some tough choices. They must decide how to reduce support for the mortgage market without letting it collapse. And they must decide what kind of support the government should provide in the long run. "The problem was a long time brewing, and the problems in our mortgage finance system will take a long time to repair," said Michael Barr, the Treasury's assistant secretary for financial institutions. Government Role Fannie Mae and Freddie Mac were chartered by Congress four decades ago to create a marketplace where mortgage lenders could sell the loans they made and use that money to make more loans. The two companies were owned by private shareholders and for a fee guaranteed investors in mortgage loans that they would get paid. After the government seized Fannie and Freddie, it offered them an unlimited line of credit and pledged to inject up to $400 billion to keep them solvent. But this is not the only form that government involvement in housing finance takes. The Federal Reserve is purchasing hundreds of billions of dollars of mortgages with the aim of ultimately owning $1.25 trillion worth. This buying spree has flooded the mortgage market with money, forcing down interest rates and assuring lenders they have somewhere to sell their loans. The Treasury Department has a similar, though smaller, program. The Federal Housing Administration, meantime, is dramatically increasing the amount of home loans it insures. Its share of new mortgages jumped from 1.8 percent in 2006 to 18 percent so far this year, according to Inside Mortgage Finance. It expects to insure about $400 billion this year. Several other agencies, such as the Department of Veterans Affairs, also provide mortgage guarantees. All told, the government now stands behind 86 percent of all new home loans, up from about 30 percent just four years ago, according to Inside Mortgage Finance. Fannie and Freddie had long played a dominant role in the mortgage market, providing traditional 30-year, fixed-rate loans. But earlier this decade, they faced competition from banks and other lenders promoting exotic mortgages, such as those that did not require proof of income or were available to people with checkered credit histories. With housing prices on the rise, these loans became ever more prevalent, and lenders figured that a struggling borrower could always get out from under a loan by selling or refinancing his home. For the first time in decades, the rate of home ownership ticked up, reaching 69.2 percent. Many first-time buyers were of lower income, and many such buyers were black or Hispanic. Fannie and Freddie, afraid of losing more market share, also began funding risky loans. Then, in 2006, the housing market began to tumble and many people couldn't or wouldn't pay their loans. Lenders and mortgage financiers suffered staggering losses. New loans dried up. Interest rates spiked. With investor confidence in Fannie and Freddie crumbling and the global economy at stake, the government seized the firms, nationalizing the U.S. housing finance system.
35
Niche Markets Many borrowers had been put into loans they could not afford, and when the mortgages failed the results were catastrophic, precipitating the financial crisis. The tighter market that emerged -- whether the consequence of stricter government standards or an industry retreat from risky practices -- now excludes some groups of aspiring home buyers. "People say, 'Well that's good because of lots of people who got loans in the past shouldn't have gotten those loans at all,' " said Keith Gumbinger, a vice president at research firm HSH Associates. "But there were tiny niche markets for whom those products were originally intended, and those people who legitimately need them now won't get them." Although Fannie and Freddie don't make loans, they effectively set standards for the mortgage industry by detailing what kind of loans they will purchase from lenders and at what cost. The companies, for instance, require documentation of income and have increased fees on loans for people who lack stellar credit and hefty down payments, especially those looking to buy condominiums. All but gone are subprime mortgages, initially meant to help people with blemished credit until they could get another loan. All but gone are the no-money-down mortgages used by four out of 10 first-time home buyers in 2005 and 2006. Those loans originally catered to wealthy borrowers with great credit who wanted to buy a home without having to liquidate their investments. And the advances in minority and low-income home ownership recorded earlier this decade have largely proved to be a mirage. The U.S. homeownership rate has declined to 67.4 percent. Some people who are no longer eligible for loans elsewhere have turned to FHA, which does not demand top-notch credit scores or sizable down payments. But for some consumers, such as Lisa McCracken of Stafford County, the FHA's minimum 3.5 percent down payment can be a stretch. McCracken, a traveling nurse, has been scrimping to raise the down payment, living with her parents to save money. "I think I can swing it, but it won't be easy," she said. "I'll be wiping out a lot of my savings to buy a house." The self-employed face difficulties because they tend to have a tough time documenting their income, as required by Fannie Mae, Freddie Mac and FHA loans. Donald Prieto, who owns a roof contracting business in San Diego, has shelved his plans to buy a new home. Five years ago, he and his wife purchased a small home without having to verify his income. They have made their payments on time, have maintained solid credit scores and have plenty of cash in the bank, he said. Now, they have three children. They want a larger home, but several lenders have turned them away because he does not have two years' worth of paychecks to show.
36 For that reason, Prieto has incorporated his company and started cutting himself formal paychecks. "No bank wants to take risks anymore, and I understand that," Prieto said. "I just have to wait." Other would-be buyers -- including investors, second-home and condo buyers, and people who need exceptionally large loans dubbed "jumbos" -- have fewer options than before. Earlier this summer, Philip Zanga, an investor, signed a contract on a $367,000 condo in Bethesda this summer and paid a $15,000 deposit. He planned to put down 60 percent, but his loan was rejected. Investors and loans for condos are both deemed risky by Fannie and Freddie. "Why turn away someone willing to put 60 percent down?" asked Avi Galanti, Zanga's real estate agent. "What's the risk in that?" Mountain of Debt Taxpayers could be hit with a staggering tab even if a small proportion of loans go bad. Fannie and Freddie now own or guarantee more than $5 trillion in home loans. (That equals two-thirds of the debt the U.S. government owes.) And many could be in trouble. Mortgages owned and backed by the companies often required down payments of no more than 10 percent. With housing prices down sharply, many borrowers are underwater, owing more than their home is worth, so they cannot sell or refinance to pay off troubled loans. As the economy has deteriorated, delinquencies are spiking and losses are mounting. In the past year and half, the companies have posted more than $150 billion in losses. Similar risks threaten to engulf FHA. Nearly 8 percent of FHA loans at the end of June were either 30 days late or in the process of foreclosure, according to the Mortgage Bankers Association. That compares with 5.4 percent of such loans a year ago. As a result, FHA has been exhausting much of its loss reserves, which are funded by premiums paid by borrowers. The reserves currently stand at an estimated 3 percent of all outstanding loans, half of what they were just a year ago. If the reserves fall below the 2 percent threshold set by Congress, they could require a taxpayer bailout. "Having the government this heavily into the mortgage market is inherently a dangerous thing for taxpayers," said Anthony Sanders, a finance professor at George Mason University. "We've already gone through one big bubble and burst, and right now the taxpayers are on the hook for a substantial amount of money." http://www.washingtonpost.com/wp- dyn/content/article/2009/09/06/AR2009090602033_pf.html
37
South Korean Economy Seems Back on Track Nation Now Faces Seoul Housing Bubble By Blaine Harden Washington Post Foreign Service Monday, September 7, 2009 SEOUL, Sept. 6 -- During the great financial swoon, confidence in South Korea's economy fell so far and so fast that the panicky government sacked the finance minister and arrested a financial blogger for excessive negativity. President Lee Myung-bak pleaded with currency traders to "refrain from greedily pursuing private interests." Less than a year later, that swoon is so over. Asia's fourth-largest economy has suddenly got its swagger back. Purchasing power surged between April and June at the highest rate in 21 years, rising 5.6 percent from the previous quarter, the Bank of Korea said last week. It said the gross domestic product jumped for the quarter at the fastest rate in five years, as South Korea benefited from lower oil prices, the depressed cost of raw materials and a weakened currency that made its cars and mobile phones cheaper on the world market. Fear of the poorhouse has been chased away by alarm over housing prices, which have risen sharply in response to record-low interest rates. The government plans on Monday to crack down on what has become a real-estate bubble in Seoul, the country's dominant city. It will limit the amount of money home-buyers can borrow to no more than 50 or 60 percent of their annual income. South Korean consumers, who lost their taste for foreign whiskey and imported cosmetics early in the year, are storming back into high-priced department stories, where luxury- goods sales spiked in August by as much as 18 percent compared with a year earlier. Sales of foreign cars in August were up 22 percent compared to a year ago and sales of video cameras were up nearly 60 percent, according to local press reports. The South Korean stock market has risen well above the levels it was at last September, when the bankruptcy of Lehman Brothers triggered a world economic crisis. Although they are up by more than 40 percent this year, stocks here remain a "sweet spot for investors" and are perhaps the best bargain in Asia, an analyst from Credit Suisse said last week. Banks also are happy, posting higher profits and sitting on relatively large amounts of capital. Foreign currency reserves in the Bank of Korea have jumped back to pre-crisis levels. Manufacturing is booming, and some South Korean conglomerates are devouring global market share. Samsung Electronics, the second-largest maker of mobile phones, has fattened its slice of the handset market to 19.2 percent from 15.4 last year. Hyundai Motor Co., South Korea's biggest carmaker, increased its share of the U.S. car market to 4.8 percent in August from 3.3 percent a year earlier.
38 "South Korea is, in the end, a country of manufacturers, and the reason we are recovering faster than other countries is that there is a reserve force of craftsmen in every corner of industry," Lee Jae-yong, the heir to the Samsung Group, told reporters last week while traveling in Canada. There is some concern among economists in Seoul that the economic recovery is outracing the government's stimulus strategy -- and that the result could be runaway inflation. Food prices are rising faster here than in most other developed countries. So far, however, the government is keeping its foot on the accelerator. It plans to use stimulus money that had been reserved for later in the year and early next year. "We need to keep an expansionary macroeconomic policy until signs of a solid global recovery materialize," Finance Minister Yoon Jeung-hyun said in London over the weekend during a meeting of finance ministers and central bankers from 20 wealthy and emerging nations. Shoppers in Seoul seemed to celebrate stimulus spending this weekend, as crowds choked department store aisles that six months ago were nearly empty. http://www.washingtonpost.com/wp- dyn/content/article/2009/09/06/AR2009090601097.html?wpisrc=newsletter
39
No Getting Around This Guy AFL-CIO's Richard Trumka Aims to Hold That Line on Health Care By Alec MacGillis Washington Post Staff Writer Monday, September 7, 2009 On the high school football fields of southwestern Pennsylvania -- the "cradle of quarterbacks" -- Richard Trumka was the monster man. Football fans will recognize the old-fashioned term for the defender who swings between the linebacker and safety positions, depending on whether the offense is set up to run or pass. But Trumka, who at 60 tends more to linebacker heft than safety leanness, would not mind if the monster tag were interpreted by the White House, Congress and corporate America as a metaphor for his primary goal as the next president of the country's largest labor federation, the AFL-CIO: Trumka wants to take a far more aggressive stance against anyone who stands in the federation's way, and that includes Democrats who beg for labor's support only to betray it on issues like health-care reform. Monday, he and the man he is succeeding, John Sweeney, will meet with President Obama at a Labor Day picnic in Cincinnati. In what could be a moment of high tension, they will have a chance to argue that, after being elected in part because the AFL-CIO's persuaded its more skeptical members to vote for him, Obama should not disappoint it by settling for half measures. "The labor movement is the best vehicle out there to make broad social change that creates an America where everyone gets a chance to win once in a while, not just the people on Wall Street but every American out there," Trumka said in his office overlooking Lafayette Park and the White House. "It's a big, big task, it's a big, big fight, and all the people that are arrayed against us are going to try to prevent us from changing anything. But with every fiber of my body I look forward to that fight." Truthfully, if there is a useful metaphor in Trumka's gridiron days, it is more nuanced than the evocation of brute force he might prefer. The monster man is defined by versatility, being able to stop the big fullback in the middle or pick up speedy receivers on the flank. Likewise, Rich Trumka is a mix of inside and outside man. He is a bulldog who, with his burly build and thick shoe-brush mustache, looks every bit the third-generation coal miner he is, one who led one of the few successful high-stakes strikes of the past half-century. But he is also a veteran Washington lawyer who consults with academics and keeps a well-thumbed copy of anti-globalization polemicist Naomi Klein's "The Shock Doctrine" close by. He is, in his own way, no less a theorist about the decline and fall of the house of labor than is the federation's rival, Andy Stern, the ambitious and exceedingly Beltway-minded leader of the Service Employees International Union who led his union and several others to break away from the AFL-CIO four years ago. "The only thing that is boilerplate about Trumka is what you see on the surface, which is iconic. The coal miner's background, his appearance. Well, that's deceptive," said Bob
40 Bruno, a labor relations professor at the University of Illinois-Chicago. "He's come to appreciate that the labor movement has to be about values and ideas, and he's grappling with those." Rose Ann DeMoro, the boisterous head of the California Nurses Association and a longtime Trumka friend, sees him the other way around. He may have operated inside the Beltway for 35 years, she said, but he does not show it. "He's lived there but he's not one of them," said DeMoro, whose husband often hunts with Trumka. "He won't go to Washington and cut a deal behind [our] backs. And I'm serious about that, because if he does, I'll shoot him." It was the convergence of the two Trumkas -- union-hall tub-thumper and spiritual ally of the metropolitan Starbucks liberal -- that produced his YouTube moment, surely the first YouTube moment in the history of the perpetually sepia-tinged American labor movement. On July 1, 2008, Trumka took the podium of a large convention hall in Las Vegas and vehemently told steelworkers that they, like other working-class whites, needed to get a grip. "There is not a single good reason for any worker, especially a union member, to vote against Barack Obama," Trumka told them, wagging his finger and glowering beneath his dark brows. "There's only one really bad reason to vote against Barack Obama. And that's because he's not white." He then related an encounter he'd had during the primaries with a woman in his home town of Nemacolin, a Democratic loyalist who said she was voting for Hillary Clinton because there was "no way that I'd ever vote for Obama." "I said, 'Why's that?' " he told the steelworkers. "And she said, 'Well, he's Muslim,' and I said, 'Actually he's Christian just like you and I, but so what if he's Muslim?' Then she shook her head and said, 'Well, he won't wear that American flag pin on his lapel.' I looked at my lapel and said, 'I don't have one and, by the way, you don't have one on either.' . . . 'Well, I don't trust him.' I said, 'Why's that?' She dropped her voice a bit and said, 'Because he's black.' I said, 'Look around this town. Nemacolin's a dying town. There's no jobs here. Our kids are moving away because there's no future here. And here's a man, Barack Obama, who's going to fight for us and you're telling me you're not going to vote for him because of the color of his skin?' " A pause before the punch. " 'Are you out of your ever- loving mind, lady?' " By summer's end, the speech had gone viral. And by Election Day, the worries about how Obama would fare with working-class whites had been largely laid to rest, thanks in part to his strong showing among union families. Obama and the Democrats' triumph, then, was organized labor's and Trumka's as well. For eight years, labor had been frozen out -- Sweeney had been invited to the White House only once by George W. Bush, when the pope asked that Sweeney be added to the list for his visit last year. Now, the federation had helped elect a Democratic majority and was poised to reap the rewards, and Trumka had solidified his standing within the AFL-CIO. But it has not worked out as hoped for the union, just as the first year has been tougher for Obama than many had imagined. The federation's top priority, a bill to make it easier for workers to unionize, bogged down amid a distinct lack of enthusiasm from Obama, and Democrats may drop its most controversial provision, which would let workers form unions by getting their colleagues to check cards instead of in secret-ballot elections.
41 Organized labor hopes that the bill will stem its decline, from representing a third of private-sector workers in the 1950s to 7.5 percent today. The federation is watching as Obama and congressional Democrats edge toward health- care concessions over the protests of organized labor, most notably on the question of whether to include a government-run insurance plan. On Tuesday, Trumka said the federation would not support a bill if the public option were dropped; a day later, the White House and Hill leaders gave out more signs they were doing just that. Into this fraught moment steps Trumka, who sees resistance to labor's agenda as just a sign of how entrenched the opposition is. "It's Wall Street. We're trying to change the status quo, and they liked the status quo. They've been benefiting from it by getting rich by it," he said. "Take health care. They have three lobbyists to every senator down there, that's what they've hired. The Capitol's awash in money. We're fighting that, and we'll continue to fight that, and ultimately we'll prevail." Trumka went into the mines at 19, following his grandfather, uncles and father. His father died of black lung disease in 1999, after he'd retired, and after the mine had been shut down by Jones & Laughlin Co., which like many other mine owners later tried to relieve itself of the health-care obligations of its retirees. "The new CEO said at the time that it allowed them to rid their company of the 'warts' that had grown on it," Trumka says. "When he talked about the warts, he was referring to my mom and dad and thousands of other people that were there." The mine's decline and the company's behavior were enough to send Trumka to college at Penn State and law school at Villanova in preparation for a career of union activism. After five years as a lawyer for the United Mine Workers, he became its president in 1982. Under him, the union took a leading role in the anti-apartheid movement and the boycott of Shell Oil. But his crowning moment was in 1989, when the union challenged the Pittston Co.'s refusal to contribute to a joint health-care and pension fund. Trumka sustained a nine-month strike in West Virginia that became a rallying cry for a beleaguered labor movement -- 4,000 workers submitted to arrest, hundreds came in solidarity from around the country, and all manner of civil disobedience was employed, including spreading bent-nail devices on roads to keep replacement workers from getting in. "It was one of the best-run strikes in the history of the country," says Cecil Roberts, the Mine Workers' current president. In 1995, Trumka was elected secretary-treasurer of the AFL-CIO, Sweeney's No. 2. A year later, he landed in hot water when he threw his weight behind Ron Carey in his bitter fight against James Hoffa Jr. for the Teamsters presidency. Federal investigators raised questions about whether Trumka improperly directed $150,000 in AFL-CIO funds to Carey's campaign; Trumka took the Fifth and was not charged. Since then, he has bided his time, lining up the chits as he prepared for when Sweeney, now 75, would retire. At the federation convention next week, Trumka will take the helm. Trumka's ascent represents a true changing of the guard, ushering in a tone of leadership that will be far more muscular than that of the avuncular Sweeney. Even Sweeney says the time has come for a more assertive approach. "It's true that he's more aggressive than Sweeney was," he said in his gentle Irish-via-New York lilt, referring to himself in the third person, "but I think that there is a time when you have to be aggressive and only can take so much, when you're getting it from people who
42 are not looking for a way to resolve a problem but are looking for a way to kill the labor movement." Trumka laid out the strategy last week in a speech to the Center for American Progress: The federation would do more to reach out to struggling younger workers, and would view its mission more in terms of speaking up for working-class Americans as a whole than merely for its 11 million members. What got everyone's attention, though, was his threat to Democratic congressmen and others who take labor's support for granted -- including those willing to compromise away key elements of health-care reform for the sake of token bipartisanship. "More than ever, we need to be a labor movement that stands by our friends, punishes its enemies and challenges those who, well, can't seem to decide which side they're on," he said. "I'm talking about the politicians who always want us to turn out our members to vote for them, but who somehow always seem to forget workers after the votes are counted." But are such threats just empty bluster, considering that the federation has been trying for years to keep Democrats in line with middling success, and given that so many of the Democrats who are giving organized labor fits come from relatively conservative states with low union membership? "We'll see," he says. "We'll see." The convention where Trumka will be anointed next week is in Pittsburgh, just up the Monongahela River from Nemacolin. He gets back there now and then to see his mother. Were people in town upset about the way it came across in the famous speech by its most famous son? Not really, he says. "I talked to some of my friends, and they were happy I gave the speech," he says. "It was the 500-pound gorilla no one wanted to talk about. I'd never seen any form of racism there, but there was this hesitancy I encountered [toward Obama], and I thought, if other people have that hesitancy and it doesn't go confronted, it could have some lasting effect. "It was just the natural thing to do."
At a 2005 rally in Chicago, Richard Trumka is flanked by AFL-CIO Executive Vice President Linda Chavez-Thompson and President John Sweeney, whom Trumka will replace. (By Brian Kersey -- Associated Press) http://www.washingtonpost.com/wp- dyn/content/article/2009/09/06/AR2009090602292.html?wpisrc=newsletter
43
Global Busines September 7, 2009 In China and Spain, Deal Tightens Telecom Alliance By KEVIN J. O’BRIEN Telefónica, the Spanish telecommunications operator, and China Unicom, one of the largest mobile operators in the country, said Sunday that they would buy $1 billion worth of stock in each other to deepen a strategic alliance. The agreement was signed Sunday in Beijing by the Telefó- nica chairman, César Alierta, and the China Unicom chairman, Chang Xiaobing. After the transactions, Telefónica’s stake in China Unicom will increase to 8 percent from 5.4 percent, making the Spanish operator the largest single investor in the company. China Unicom will acquire a 0.88 percent stake in Telefónica, the former Spanish phone monopoly, which owns the European mobile operator O2 and is the largest mobile operator in Latin America. Together, the two companies have about 550 million customers. “We are fully committed to the alliance and will exploit the synergies offered by this far- reaching cooperation to benefit our shareholders and customers alike,” Mr. Alierta said in a statement. China Unicom and Telefónica operate fixed and mobile networks, including wireless networks based on WCDMA, the most prevalent third-generation technology standard. The companies said they would jointly buy infrastructure and equipment for customers and develop wireless service platforms and services for multinational companies. The agreement would also extend to network roaming and the sharing of technical research. Managers would also be swapped through an exchange program. “We think the partnership will help improve our capacities to provide extensive telecommunication and information application services and maximize shareholders’ return, making us bigger and more diversified so we can continue to compete globally,” Mr. Xiaobing said in a statement. The companies said the stock purchase price would be calculated using the 30-day average of the closing share prices of Telefónica and China Unicom shares through Aug. 28. Telefónica has been a financial investor in the Chinese telecommunications market since 2005, when it bought a 2.99 percent stake, which it later raised to 5.4 percent, in China Netcom, an operator that was merged into China Unicom last year. http://www.nytimes.com/2009/09/07/business/global/07phone.html?ref=business
44
How to Negotiate a Severance Package Nancy Trejos By Nancy Trejos Washington Post Staff Writer Sunday, September 6, 2009 As the national unemployment rate nears 10 percent, many Americans are doing something they had never imagined they would do: negotiate a severance package. It's a formidable task, more so now that employers, battered by the economic downturn, are offering smaller payouts when they let go of employees. Therefore, experts suggest doing research and soul-searching before walking into negotiations: Figure out what others have received and what you'd like to get. "There's a lot at stake here, and you really can make a difference in what you walk away with if you prepare," said Maury Hanigan, president of Layoff Coach. WHAT ARE YOUR RIGHTS? Many American workers have a misperception about what their employers are supposed to grant them when they are laid off. There is no law requiring employers to offer severance packages. Many top executives negotiate for severance agreements, sometimes known as golden parachutes, in their employment contracts. Average workers, however, don't have that specific an agreement. Still, it's important to review your initial letter of employment and your union contract, if you're covered by one, and to study the employee handbook. Look for anything that suggests a contract that guarantees severance or a company severance plan. "In the absence of those two things, there really is no right to severance," said Evan Fray-Witzer, a lawyer at Ciampa Fray-Witzer in Boston. "This is not something that is a guaranteed right. This is something you ask for." If you think you've been harassed, discriminated against or retaliated against, you might have a legal claim to a payout. In that case, check with a lawyer. THE ART OF NEGOTIATING Losing a job is traumatic. But don't make that obvious when you go into negotiations. "Try to maintain your composure, and don't act emotionally," said Jeff Gordon, a professional negotiator in Raleigh, N.C. "Don't key someone's car outside in the parking lot to feel like you got revenge. That really serves to diminish your own position." How do you put yourself in the best position? Try these steps: -- Gather information. Find out whether your company has given severance packages to others. If so, talk to your former colleagues to learn the details. -- Understand your leverage. What does the company want from you? Maybe you have a contact list it could use. Or maybe your boss needs you to train a replacement or complete a project. Also, if you've been with the company for several years and performed your duties well, point it out. But "you have to have facts to back it up," said Emory Mulling, chairman of Mulling Corp., a placement and career-transition coaching company in Atlanta. -- Act strategically. Prepare a prioritized list of what you plan to request. Also, consider to whom you should make your argument. Maybe that's your boss. Or maybe it's a human resources official.
45 -- Don't start off litigiously. Showing up at the negotiating table with a lawyer will set a hostile tone, experts said. Your company will then bring in its lawyer. "It gets very serious, very quickly," Mulling said. "You mention an attorney only as the last resort if you feel you have extenuating circumstances." -- Look for gotchas. Some employers will ask you to sign a non-compete clause, which would forbid you to work for a competitor. In some states, courts tend to rule against such clauses. Your employer could also ask you to sign a non-solicitation clause, which would bar you from wooing away anyone from your former company if you start a business. A non-disclosure clause would keep you from sharing confidential company information. Make sure you understand your rights. You might want to have an employment lawyer review any of these clauses in your severance agreement. -- Don't sign anything right away. Take the paperwork home. Have a friend or spouse look it over. If you don't understand it, have a lawyer study it. "You don't want to knee-jerk sign it because you are an emotional wreck," Gordon said. WHAT CAN YOU ASK FOR? The answer is anything. You've lost your job; what more do you have to lose? But be realistic. Don't expect to get everything you want. You will probably be most concerned about your salary and benefits. According to Hewitt Associates' review of 228 large U.S. companies, 51 percent offered a standard one to two weeks' pay for each year of employment. Thirty-three percent determined severance pay using a formula that combined years of service with salary or job level. Most companies provided at least one benefit, such as health-care coverage, retirement benefits or life insurance. Thirty percent provided full health-care coverage during the severance period. But think beyond the numbers. "Most people look at the number of weeks of severance and their benefits as the only pieces of the severance, and in truth those pieces are often the least negotiable," Hanigan said. "There's a whole world of things they might want to ask for." Here are a few: -- Electronics -- BlackBerry, cellphone, laptop. -- Home office furniture or equipment. -- The company car. -- A prorated bonus if you were laid off before the end of the year. -- Health-club membership. -- Employee discounts for the cellphone plan. -- Use of a day-care facility. More important, request things that will help you land your next job. Ask for a positive recommendation. Request outplacement services, such as training or résumé writing. "Anything you can negotiate to help you get employed faster becomes really important," Hanigan said. http://www.washingtonpost.com/wp- dyn/content/article/2009/09/04/AR2009090404232.html?wpisrc=newsletter
46 Sep 6, 2009 G20 Finance Ministers' Meeting: Pledges to Implement Regulatory Commitments, Address Bankers' Pay Structure Overview: The G20 finance ministers of industrialized and emerging nations met in London on September 4-5 in preparation for the G20 meeting in Pittsburg September 24- 25, 2009. The communique calls for the swift implementation of all the commitments reached on April 2, 2009 (see statement below.) No final deal was reached on formal pay caps which remains a focus, but leaders agreed to keep stimulus measures in place until the recovery is secured. They also agreed to put in place a "transparent, credible.. and coordinated" exit strategy from the fiscal and monetary surplus once recovery has been reached. The main conclusions in the communique issued on September 5, 2009 are as follows (G20, Sep 5, 2009) “We reiterated the need for swift and full implementation of all commitments made at the Washington and London summits and have agreed on further steps to strengthen the financial system as set out in the accompanying 6 points declaration" The six point plan addresses 1. Compensation; 2. Systemically important firms, 3. Prudential regulation, 4. Non-cooperative jurisdictions, 5. Implementation of international standards for actors outside the core bank system such as credit derivatives etc., 6. Convergence of international accounting standards “More needs to be done” on: 1. Increasing transparency; 2. Global standards on pay structure, including on deferral, effective clawback, the relationship between fixed and variable remuneration, and guaranteed bonuses, to ensure compensation practices are aligned with long-term value creation and financial stability. 3. We also ask the FSB (Financial Stability Board) to explore possible limits/approaches on total variable remuneration. 4. G20 governments will also explore ways to address non-adherence with the FSB principles.” The communique also calls for addressing excessive commodity price volatility though better functioning of physical and financial markets and producer-consumer dialogue and an orderly rebalancing of global demand.
Opinions On Financial Regulation o See Thomas Philippon's summary of the State of the Art proposals for Macro- Prudential Regulation and the Future of the Global Financial System: Group of 30, NYU Stern, CEPR Reports. (VoxEU, February 2009) o U.S. Treasury Secretary Tim Geithner: First priority is higher capital requirements for banks across the board with emphasis common equity. Also, capital rules should dampen pro-cyclicality in the system and be more forward-looking. Liquidity standards
47 will be an important addition next to improved risk management practices. (Sep 3, 2009) o Bloomberg: "France is proposing curbs on bonus pools as a percentage of a bank’s revenue, imposing a ceiling on payments or taxing them, a finance ministry official told reporters. UK Prime Minister Gordon Brown sees a cap as difficult to enforce." (September 2, 2009). See also Tobin Tax debate and France: Will Tighter Bonus Pay Rules Win International Approval? o French President Nicolas Sarkozy and German Chancellor Angela Merkel "want the G20 to limit the size of banks and tighten capital rules," Bloomberg reported on September 2, 2009. See EU Commission Faces Opposition On Derivative Reform and Time For Basel III: New BIS Rules Reduce Regulatory Arbitrage Via Trading Books. o NY Fed President William Dudley: "I think we can respond in a number of ways: First, we can do a better job understanding interconnectedness. This means changing how we oversee and supervise financial intermediaries. Second, we can change the system so that it is more self-dampening" instead of self-reinforcing. "Third, we can improve incentives" (e.g. mandate automatically equity-convertible debt instruments as a form of capital). "Fourth, we can increase transparency" (see e.g. the beneficial effect of U.S. stress tests). "Fifth, we can develop additional policy instruments. For example, we might give a systemic risk regulator the authority to establish overall leverage limits or collateral and collateral haircut requirements across the system. This would give the financial authorities the ability to limit leverage and more directly influence risk premia and this might prove useful in limiting the size of future asset bubbles" (July 2009). See Regulatory Reform in the U.S.: Who Should Be the Systemic Risk Regulator? o Paul McCulley (PIMCO): The most important elelments of macro-prudential, or systemic, regulation are "first, counter-cyclical capital/margin arrangements, replacing the pro-cyclical paradigm that has been in place; and second, a robust resolution regime, outside the disorderly bankruptcy process, for all systematically important financial institutions." (September 2009) G20 Statement, April 2, 2009 1) Leaders pledged an additional US$1.1 trillion of support for the world economy, tripling IMF resources to US$750 billion, supporting a new Special Drawing Rights allocation of US$250 billion, supporting at least US$100 billion of additional lending by the Multilateral Development Banks, ensuring US$250 billion of support for trade finance and using the additional resources from IMF gold sales for concessional finance for the poorest countries. 2) The fiscal stimulus measures adopted amounted to US$5 trillion, raising output by 4% and accelerating the transition to a green economy. 3) The leaders issued a declaration on Strengthening the Financial System, stating their intention to establish a new Financial Stability Board (FSB) with a strengthened mandate, as a successor to the Financial Stability Forum (FSF). The FSB would include all G20 countries, FSF members, Spain and the European Commission, which would collaborate as an early warning system with the IMF and extend regulation and oversight to all systemically important financial institutions, instruments and markets, including, for the first time, systemically important hedge funds. The FSB would also implement the FSF’s tough new principles on pay and compensation and improve the quality, quantity and international consistency of capital in the banking system. In the future, the declaration states, regulation must prevent excessive leverage and require the
48 build-up of resource buffers in good times. "The era of banking secrecy is over," the declaration asserts, calling on accounting-standard setters to work with supervisors and regulators to improve standards on valuation and provisioning and achieve a single set of high-quality global accounting standards. The leaders also agreed to extend regulatory oversight and registration to Credit Rating Agencies. 4) In the interest of strengthening global financial institutions, the leaders pledged to enhance the IMF's new US$750 billion of available funds with a Flexible Credit Line (FCL) and a reformed lending and conditionality framework. The leaders agreed to complete the next review of quotas by January 2011. 5) The leaders committed to resisting protectionism and promoting global trade and investment, including by striving for an ambitious and balanced conclusion to the Doha Development Round. 6) To ensure a fair and sustainable recovery for all countries from a crisis that has disproportionately affected the most vulnerable, resources from IMF gold sales and surplus income will provide US$6 billion of additional concessional and flexible finance for the poorest countries over the next two to three years.
G20 calls for better capital buffers at banks By Norma Cohen in London Published: September 6 2009 19:54 | Last updated: September 6 2009 19:54 European banks face pressure to issue far more shares in order to meet a tough new global regulatory framework outlined at the weekend by finance ministers of the G20 group of nations which calls for much bigger and better capital buffers against shocks, analysts warned on Sunday. The move follows criticism that some banks have relied too heavily on complex securities that have proved poor defences against big losses. Some banks have met up to more than half the existing regulatory requirements on capital buffers through the issuance of “hybrid” securities which are more like debt than equity, according to analysts. Huw Van Steenis, banking analyst at Morgan Stanley, said: “Over time this will reinforce banks raising more capital to replace government and other hybrids and reshape their balance sheet.” Hans Lorenzen, credit analyst at Citigroup, cited data from the International Monetary Fund showing that the average ratio of equity made up of issued ordinary shares to assets of European banks at the end of 2008 was 2.5 per cent against 3.7 per cent in the US. The G20 meeting agreed three main points: banks must raise much more capital once the financial crisis has passed; complex financial institutions should develop “living wills” to plan for their unwinding; and banks should be required to retain some portion of loans they repackage and sell as asset-backed securities. The group also made an implicit plea for banks to limit payouts to shareholders, saying: “We call on banks to retain a greater proportion of current profits to build capital, where needed, to support lending.” http://www.ft.com/cms/s/0/49d4be54-9b12-11de-a3a1- 00144feabdc0.html
49 Economy
September 6, 2009 ECONOMIC VIEW The Wait for Financial Reform By ALAN S. BLINDER BACK during the Obama transition, the newly designated chief of staff, Rahm Emanuel, enunciated what I’ll call the Emanuel Principle: “You don’t ever want a crisis to go to waste,” he said. “It’s an opportunity to do important things that you would otherwise avoid.” He was right. But I fear that the Emanuel Principle is about to be violated in the case of financial reform. We are barely emerging from the greatest financial crisis since the 1930s. From last September to March, it was downright frightening. Yet by the time Congress left town for its summer recess, financial reform appeared to be losing steam. Monday is Labor Day, the psychological end of summer. So, starting on Tuesday, it’s up to the administration and the Congressional leadership to breathe some life into what’s left of the reform concept. After all we’ve been through, and with so much anger still directed at financial miscreants, the political indifference toward financial reform is somewhere between maddening and tragic. Why is the pulse of reform so faint? I see five main reasons: IT’S YESTERDAY’S PROBLEM People have an amazing capacity to forget. Our financial system is now functioning much better than it was in March or last fall. So the Alfred E. Neuman Principle (“What, me worry?”) threatens to displace the Emanuel Principle. You can see public attention shifting elsewhere — to the budget, to health care, to torture, you name it — not to mention baseball and football. I want to scream, “Stop!” The financial regulatory system needs fixing, and to accomplish it, Congress will have to hold a lot of feet to a lot of fires. It’s not clear that many members have the stomach for that. LOST IN THE CROWD The problem of short attention spans has a first cousin: the overcrowded legislative agenda, which has spread the resources and time of Congress and the administration thinly over a vast array of issues. There is a budget to pass, health insurance to reform, energy to cap and trade, schools to overhaul, two wars to watch over and others to avoid — and more. Amid all of this, the Treasury has sent Congress 16 pieces of financial reform legislation, totaling 618 pages. What are the chances that these 16 bills will surface to the top of the legislative agenda? THE MOTHER OF ALL LOBBIES Almost everything becomes lobbied to death in Washington. In the case of financial reform, the money at stake is mind-boggling, and one financial industry after another will go to the mat to fight any provision that might hurt it. But your exercise instructor had it right: no pain, no gain. If we don’t inflict a modicum of pain on financial players — not out of spite, but because the system needs change — we will accomplish little.
50 BUREAUCRATIC INFIGHTING Industry lobbyists are not the only problem. Regulatory deck chairs need to be rearranged, and various government agencies are scrambling to maintain or expand their turfs. So, for example, other regulators don’t want to lose influence to the Federal Reserve, and the Fed doesn’t want to give up its consumer protection functions — two changes that Treasury proposes. The bureaucratic turf wars have grown intense, with Timothy F. Geithner, the Treasury secretary, reportedly berating regulators at a meeting last month. A LACK OF FOCUS Perhaps worst of all, it’s hard to keep the public engaged in something as complex, arcane and — frankly — as boring as financial regulation. We have a heavily checked-and-balanced political system. To get anything done, one must overcome both a strong status-quo bias and powerful lobbying. Normally, that requires constituents to pressure their elected representatives — hard. Today, the electorate has a vague sense that it has been ripped off and that change is needed. But the sentiment is unfocused and inchoate — with these two exceptions: People clearly want greater consumer protection and restrictions on executive pay. By no coincidence, those are the two pieces of financial reform that seem most likely to survive the Congressional sausage grinder. Don’t get me wrong; we need both. But the two don’t constitute the entirety of reform, or even its most important parts. I’d attach greater importance to at least three major Treasury proposals that may wind up on the cutting-room floor: First, we need a systemic risk monitor or regulator. A monitor just watches risks develop and issues warnings, while a regulator is empowered to take action. In my last column, I explained the reasons for wanting a systemic risk regulator, and why the Fed should get the job. Second, we need a new mechanism to euthanize or rehabilitate giant financial institutions whose failure could threaten the whole system. Lehman was put into Chapter 11, with catastrophic effects. A.I.G. was turned into an appallingly expensive ward of the state. There must be no more situations like these. As both Mr. Geithner and Ben S. Bernanke, the Fed chairman, have observed, we need a better way out. Third, something serious must be done to tame — though not to destroy — the derivatives markets. Today, virtually all derivatives trading remains unregulated and nontransparent. Much of it also has too little capital and, at crucial times, too little collateral behind it. The Treasury’s draft legislation proposes to fix these problems by standardizing many derivatives and pushing trading into clearinghouses or organized exchanges, where more capital would be required and collateral would have to be posted often. And there is a great deal more in those 618 pages. So let’s get on with the job, remembering the Emanuel Principle. There will never be a better time “to do important things” for our financial system. Alan S. Blinder is a professor of economics and public affairs at Princeton. He was an economic adviser to President Bill Clinton and vice chairman of the Federal Reserve. http://www.nytimes.com/2009/09/06/business/economy/06view.html
51 Economy July 26, 2009 ECONOMIC VIEW An Early-Warning System, Run by the Fed By ALAN S. BLINDER THE Federal Reserve has long been the odd man out in the American system of government — powerful, yet designed to be nonpolitical and neither checked nor balanced. Now two contradictory crosscurrents are swirling in Washington — one that would enhance the Fed’s powers and one that would curtail them. The Treasury’s recent white paper on financial regulatory reform would have the Fed “supervise all firms that could pose a threat to financial stability,” even if they are not banks, turning the Fed into what some people are calling the nation’s “systemic-risk regulator.” Doing so would expand the Fed’s reach — though, of course, it has reached into those places already. (Think Bear Stearns, A.I.G., etc.) On the other hand, some members of Congress are grumbling that the Fed has already overreached, usurping Congressional authority. Others contend that it has performed so poorly as a regulator that it hardly deserves more power. Representative Ron Paul, the Texas Republican, has even introduced a bill that would have the Government Accountability Office audit the Fed’s monetary policy — a truly terrible idea that could quickly undermine the Fed’s independence. Let’s break down the issue into three questions: Should the United States have a systemic-risk regulator? If so, should it be the Fed? And, if so, are there other powers the Fed might give up in return? My answers are yes, yes and yes. The main task of a systemic-risk regulator is to serve as an early-warning-and-prevention system, on the prowl for looming risks that extend across traditional boundaries and are becoming large enough to have systemic consequences. Can this job be done perfectly? No. Is it worth trying? I think so. Suppose such a regulator had been in place in 2005. Because the market for residential mortgages and the mountain of securities built on them constituted the largest financial market in the world, that regulator probably would have kept a watchful eye on it. If so, it would have seen what the banking agencies apparently missed: lots of dodgy mortgages being granted by nonbank lenders with no federal supervision. If the regulator saw those mortgages, it might then have looked into the securities being built on them. That investigation might have turned up the questionable triple-A ratings being showered on these securities, and it certainly should have uncovered the huge risk concentrations both on and off of banks’ balance sheets. And, unless it was totally incompetent, the regulator would have been alarmed to learn that a single company, American International Group, stood behind an inordinate share of all the credit-default swaps — essentially insurance policies against default — that had been issued. This counterfactual suggests that history might have been quite different — and much better. Some people would end the systemic-risk regulator’s role there, making it an investigative body and whistle-blower whose job is to alert other agencies to mounting hazards. But if systemic problems are uncovered, someone must take steps to remedy or ameliorate them. Under one model, the regulator would be like the family doctor, taking a holistic view of the patient, making a general diagnosis and then referring the patient to appropriate specialists for treatment: to the Securities and Exchange Commission for securities problems, to the banking agencies for safety and soundness issues, and to someone for problems with derivatives — once we figure out whom that someone is.
52 But if multiple agencies are involved, their actions would need coordination. Would a systemic-risk regulator become the field marshal of a well-coordinated army, or find itself herding cats? An alternative model would work more like a full-service H.M.O., where an internist refers patients to in-house specialists as necessary. To make that work, the systemic-risk regulator would need more power — not just to diagnose problems, but also to fix them. And it would need a huge range of in-house expertise. Crucially, when truly systemic problems arise, a lender of last resort is almost certain to be part of the solution — and that means the central bank. So if there is to be a systemic-risk regulator in the United States, it should be the Fed. Furthermore, unlike any other agency, the Fed would not be starting from scratch in performing these expanded regulatory duties. At least in theory, every central bank is its nation’s principal guardian of financial stability. The Fed already has the eyes and ears (though not enough of them) to do this job, and has the broad view (though, again, not broad enough) over the entire financial landscape. It must have such a view to handle monetary policy properly. I am also deeply skeptical that a consortium or a committee would succeed at systemic-risk regulation. Creating a hydra-headed regulator, as some have proposed, invites delays, disagreements and turf wars — and dilutes accountability. So the Treasury plan sensibly puts the Fed in the driver’s seat, with the others playing advisory roles. Now to the final question. Critics who worry about the Fed accumulating too much power have a point. But the Treasury proposal already clips the Fed’s wings by stripping away its authority over consumer protection, and further wing-clippings are possible. But when it comes to dealing with systemic risk, Treasury Secretary Timothy F. Geithner said last month, “I do not believe there is a plausible alternative.” Neither do I. Alan S. Blinder is a professor of economics and public affairs at Princeton and former vice chairman of the Federal Reserve. He has advised many Democratic politicians. http://www.nytimes.com/2009/07/26/business/economy/26view.html
53
TRIBUNA: ÓSCAR FANJUL La política económica: lo urgente y lo importante ÓSCAR FANJUL 06/09/2009 En un corto espacio de tiempo el mundo ha descubierto dos cosas. Primero, que es más frágil y vulnerable de lo que creía. En segundo lugar, que también es más pobre de lo que pensaba. Las dos cosas explican el colapso experimentado por la demanda agregada ante el que las empresas han reaccionado contrayendo la producción, y dando prioridad, sobre cualquier otro objetivo, a la gestión del balance y de la liquidez, recortando, para ello, planes de inversión y de todo tipo de gasto. Este comportamiento de la demanda ha provocado una caída generalizada en el precio de los activos y, como consecuencia de ello, una descapitalización de gran parte de la banca mundial, y una fuerte contracción del crédito. Como los problemas de contrapartida son mayores en el caso de las transacciones internacionales, la restricción crediticia ha propiciado una fuerte caída del comercio internacional, más intensa que la de cualquier período equivalente de los años 30, siendo un reflejo de ello, que los fletes marítimos cayeran más de un 90% en el año 2008. En definitiva, se ha producido una espiral contractiva de la demanda agregada -caída del precio de los activos, descapitalización bancaria, contracción del crédito, nueva caída de la demanda...-. Las actuaciones puestas en marcha globalmente han intentado cortar esta espiral, convirtiéndose el reflotamiento de la demanda agregada en el objetivo prioritario de la política económica. Todos los instrumentos de la política económica se han puesto al servicio de este objetivo, desde la política monetaria más agresiva que se recuerda, hasta el empleo de la política fiscal para recapitalizar el sistema bancario con objeto de restablecer el sistema de crédito. Por poner un ejemplo ilustrativo, hasta las ayudas al sector del automóvil han tenido una justificación macroeconómica, que no de política industrial. Ante políticas tan expansivas hay quienes comienzan a preguntarse si los Estados no han gastado ya demasiado, si los déficit públicos no son excesivos, si su financiación provocará inflación, o si las masivas intervenciones públicas de todo tipo no tendrán los efectos negativos y las consecuencias no esperadas de muchas actuaciones públicas y, en definitiva, si no es hora ya de recortar gastos, subir impuestos y de comenzar a practicar políticas de mayor austeridad. La experiencia muestra en estos casos que no es fácil para los responsables políticos y económicos resistir las presiones para cambiar la orientación de la política económica, particularmente cuando comienzan a aparecer indicadores de recuperación. Para contestar a las anteriores cuestiones es necesario distinguir entre aquello que es urgente y lo que puede ser importante. Al igual que para una empresa el gasto en investigación o una inversión de carácter estratégico pueden ser muy importantes, pero lo urgente es su supervivencia, y eso pasa por garantizar su tesorería, de igual manera, lo urgente hoy, desde el punto de vista macroeconómico es cortar la espiral de caída de la demanda agregada y propiciar su reflotamiento. Aunque pueda parecer paradójico, la corrección de los efectos del excesivo apalancamiento pasan a corto plazo por más deuda, esta vez pública, trasladando su amortización hacia el futuro, con objeto precisamente de
54 evitar que las caídas del producto y del precio de los activos continúen aumentando los ratios de endeudamiento. Además, con el aumento tan significativo que se ha producido en el ahorro privado y con los masivos excesos de capacidad existentes es improbable que los déficit públicos reduzcan hoy la demanda privada (el efecto crowding out de la jerga económica, un argumento tradicional contra los déficit). Al contrario, cabe esperar que en las presentes circunstancias el gasto público tenga un efecto expansivo sobre el gasto privado de consumo y de inversión, acabe cebando la bomba que finalmente arranque el motor de la economía, y genere una espiral ascendente de gastos y de renta. Relanzar la demanda agregada continúa siendo la prioridad pues si bien es verdad que comienzan a aparecer algunos datos positivos, estos apuntan, por ahora, más a una ralentización del deterioro o una estabilización de la demanda que a una recuperación sostenida, y aunque ha comenzado la corrección de los grandes desequilibrios globales, falta todavía mucho por hacer. Ha habido recomposición de existencias, pero la demanda final sigue siendo débil y no es fácil todavía ver qué componentes de la demanda privada impulsarán la recuperación, pues la recomposición de las existencias es algo temporal y el despegue de la inversión vendrá limitado por los fuertes excesos de capacidad. El rebote reciente debe mucho a impulsos públicos con objetivos muy específicos, por ejemplo sobre la demanda de automóviles, y es difícil prever lo que sucederá con la demanda cuando estos desaparezcan. Además, en este contexto de fragilidad cualquier débil shock o perturbación económica, o geopolítica, puede provocar otra fuerte recaída. Es también verdad que es siempre difícil anticipar las recuperaciones, pero aunque posiblemente ha pasado ya lo peor, es pronto para pensar que lo hemos dejado atrás. En España, por ejemplo, los consumidores están todavía lo suficientemente preocupados por desendeudarse y por perder su puesto de trabajo, como para que no pueda esperarse una próxima recuperación significativa del consumo privado y, mientras esto no ocurra, es difícil la vuelta al crecimiento sostenido. Por todo ello, es prematura la adopción de medidas restrictivas, tal como una subida generalizada de impuestos -a no ser aquellos que tengan como objetivo desincentivar consumos específicos como alcohol, tabaco, combustibles fósiles, o incentivar el uso de energías limpias....-, pues ello sólo contribuiría a reducir las rentas y a deprimir aún más el ánimo de los agentes económicos y de la todavía anémica demanda. - Los déficit fiscales: la necesidad de una estrategia de salida. El objetivo de la actuación pública debe ser conseguir tener el grado de libertad y autonomía suficiente como para poder elegir en qué momento cambiar el signo de la política económica, lo que no debería ocurrir antes de que el aumento del producto tienda a superar su tasa de crecimiento a largo plazo. Hay suficientes ejemplos -Estados Unidos en el año 37, Japón en el 97...- de cómo políticas prematuras de consolidación fiscal pueden abortar el comienzo de una recuperación y retrotraernos al punto de partida. Manejar adecuadamente el cambio de política es tarea más que suficiente para los responsables de la economía. Pero también es claro que políticas tan expansivas como las actuales no pueden continuar indefinidamente, siendo el problema fundamental financiar transitoriamente déficit públicos que previsiblemente supondrán pronto más del 10% del PIB, niveles no sostenibles a largo plazo y difíciles y costosos de manejar. Es verdad que hemos entrado en la recesión con una situación de las cuentas públicas comparativamente buena, pero también es verdad que vivimos un período extraordinario en el que se aplican políticas nunca antes experimentadas, y no conocemos bien cuáles pueden ser los efectos de políticas monetarias tan poco convencionales y de crecimientos tan masivos de los déficit y de los niveles de endeudamiento público.
55 Por ello, si bien hoy es el momento de políticas expansivas, la transmisión de confianza a la sociedad y a los mercados exige explicar, en primer lugar, cuál será la estrategia de salida que permitirá en su momento corregir los actuales déficit y, en segundo lugar, que el gasto público será empleado de forma eficiente, confiando en que las autoridades monetarias gestionarán adecuadamente el momento y la forma del cambio de signo de la política monetaria (conviene recordar que tras la gran recesión en Estados Unidos se tardó 30 años en volver a los niveles de tipos de interés de los años 20) Pero la única vía realista de reducción de los actuales niveles de déficit pasa necesariamente por recuperar las tasas de crecimiento. Sin esta recuperación no es posible la vuelta a los equilibrios financieros, ni del sector público ni tampoco del sector privado. Ni los recortes del gasto, ni las subidas de los impuestos permitirán la vuelta al equilibrio si no hay crecimiento. La reducción del grado del apalancamiento pasa por el crecimiento del producto nominal y del precio de los activos. Y si bien es verdad que nuestra recuperación depende de la recuperación mundial, esta la aprovecharemos con mayor o menor intensidad dependiendo de cuál sea nuestra competitividad productiva. Por ello, la financiación de los déficit exige también poder explicar a los mercados qué actuaciones tomaremos para mejorar nuestra competitividad y recuperar las tasas de crecimiento. De nuestra capacidad de convencer a los mercados de esta estrategia dependerá la capacidad de financiar nuestros desequilibrios. Este círculo se cierra pues si bien es verdad que sólo volviendo a crecer recuperaremos el equilibrio financiero, sólo con este último ese crecimiento podrá ser sostenible. La rapidez con que se han deteriorado nuestras cuentas públicas es una indicación de las mayores dificultades que para una economía como la española puede tener la gestión de los déficit durante el próximo periodo de ajuste. En definitiva, todo ello sólo reafirma la necesidad de tener un plan de consolidación fiscal que explique cómo transitaremos hacia una senda en que los niveles de déficit y de deuda sean sostenibles, que debe ser lo suficientemente flexible como para no impedir el principio de una recuperación, y que será más creíble cuanto más monitorizable sea su ejecución. Desde el punto de vista de esa estrategia de salida no son importantes sólo los niveles de los déficit sino también la naturaleza de los mismos. En efecto, no es lo mismo incurrir en gastos de naturaleza transitoria, que en compromisos que signifiquen aumentos permanentes de los mismos. Tampoco es igual financiar gasto público que ayude a aumentar la competitividad de la economía, que gasto improductivo. Siendo inevitable el aumento del gasto público es importante, por tanto, preguntarse por su estructura, por sus objetivos y por sus implicaciones en el sistema de incentivos de los agentes sociales ¿Es necesario impulsar aún más el gasto en infraestructuras o es más útil hoy gastar en educación o en políticas activas de empleo? Son estos ejemplos de preguntas que deberíamos contestar. Actuar sobre la estructura del gasto público puede no ser fácil, por las expectativas creadas, por las presiones y resistencias que generan los grupos organizados, pero la actual situación requiere nuevos planteamientos y prioridades, y exige, en definitiva, primar el rigor sobre el populismo, y tratar las causas y no sólo los síntomas de nuestros problemas. Hoy se habla mucho de la necesidad de grandes pactos sociales -¿no se plantean Pactos de Estado para demasiados temas?- pero esto quiere decir poco o nada si no se aclara sobre qué y para qué. Se ponen como ejemplo a los pactos de la Moncloa, pero estos tenían un objetivo y un instrumento muy claros, cortar la espiral de una inflación que superaba el 20% mediante un acuerdo de rentas. Pero, ¿cuál es hoy el objetivo y qué se propone para alcanzarlo, en definitiva, cuál es el contenido del Pacto?
56 - ¿Hacia un nuevo modelo de crecimiento? Se habla también de la necesidad de cambiar nuestro "modelo económico" y, en efecto, la introducción de determinados cambios en nuestras pautas de crecimiento es lo importante, pero siempre que no ponga en peligro la recuperación de la demanda agregada. Una parte de este cambio en el modelo ya ha comenzado. La participación de la construcción en el PIB, el doble de lo normal y la razón por la que hemos destruido más empleo que los países de nuestro entorno, perderá peso en los próximos años como consecuencia de la caída de la construcción residencial y, si bien esto es sano, el riesgo a corto plazo lo puede constituir la excesiva rapidez con que se producirá este ajuste. Cuando se habla de cambiar nuestro modelo económico, el discurso suele referirse a la parte fácil y obvia de este proyecto, como es ir hacia una economía con mayor peso en actividades con nivel de productividad y de contenido tecnológico superior. Sobre esto es difícil que no exista acuerdo, ha sido siempre nuestro objetivo, y, por ello, la discusión relevante no es hacia dónde ir sino el cómo hacerlo. El desarrollo de sectores de mayor valor añadido requiere, sobre todo, facilitar la movilidad de los factores de producción, capital y trabajo, de unos sectores y empresas a otros, lo que no es ni fácil ni rápido. ¿Qué estamos dispuestos a hacer para facilitar ese proceso? Existen políticas horizontales que pueden facilitar este tipo de transición, y que en cualquier caso deberíamos acometer, pero estas pueden tardar tiempo en manifestar sus impactos, o éstos son más intangibles y no son de explotación política fácil como la inauguración de una obra pública. Tal vez el ejemplo más claro sea el de la mejora de la educación escolar, uno de los factores más importantes a la hora de explicar el crecimiento económico, por encima incluso de los gastos en I+D. Son muchas las políticas a desarrollar en este campo, pero muchas también las resistencias que desarrollarán los grupos afectados. Muchos de los que hoy abogan por políticas de liberalización y de reforma del mercado de trabajo, se opondrán a este tipo de políticas en sus propios sectores, y siempre con nobles justificaciones. Pero es difícil imaginar un cambio de modelo sin cambios institucionales significativos. A veces, se propugna el desarrollo de sectores específicos desde el sector público y así, por ejemplo, se menciona mucho recientemente el de energías renovables como candidato a apoyar para generar empleo, para superar la crisis y como ejemplo del nuevo modelo de crecimiento. El desarrollo de las energías renovables es necesario para reducir las emisiones de CO2 -el 25% de las cuales son producidas por el sector eléctrico- y creo que hoy ya es difícil negar la importancia que tiene descarbonizar nuestro aparato productivo. Las inversiones en este sector tendrán, como cualquier otra inversión, un impacto positivo en el nivel de actividad, y en el potencial de crecimiento si el desarrollo de este sector va asociado a exportaciones y a actividad internacional, es decir, si nosotros somos también los suministradores de las políticas energéticas de otros. No es lo mismo convertirnos en suministradores y agentes de las políticas energéticas de otros que simplemente aumentar el peso de las energías renovables en nuestro sistema. Por ello, conviene distinguir entre el impacto de promocionar actividades empresariales relacionadas con mejoras de la eficiencia energética, sin duda con un gran futuro por delante, de otras que sólo encarecen el coste energético para el usuario. Conviene no olvidar que a corto y medio plazo el aumento de generación con renovables supone un encarecimiento del coste energético -si no fuera así, su desarrollo no necesitaría el apoyo que recibe y ha recibido- y, por ello, esto no constituye por sí un elemento de recuperación de la competitividad o lo hace un motor especialmente generador de empleo. Algunas de estas nuevas tecnologías son muy intensivas en capital y tienen un coste varias veces
57 superior a las convencionales. Que sea importante y necesario el desarrollo de este sector no significa que sea el más adecuado para la recuperación del crecimiento. Por otra parte, es importante no caer en la tentación de que sean las políticas públicas las que decidan qué sectores desarrollar, cuáles proteger, subsidiar, etc. Existen suficientes experiencias negativas en este sentido como para querer sustituir el papel del mercado y de los agentes individuales. Recordemos que el sector de la construcción residencial, origen de gran parte de nuestros actuales problemas, ha sido internacionalmente uno de los más protegidos e incentivados desde el sector público. Pero si hay algo claro es que, en el nuevo contexto internacional, el futuro modelo de crecimiento no podrá descansar tan intensamente como en el pasado en la expansión de la demanda interna, y en déficit exteriores tan elevados como para que nuestra cuenta corriente requiera una financiación exterior equivalente al 10% del PIB, uno de los ratios mayores del mundo. Estos déficit necesariamente se corregirán, pero ello podrá ser con mayor producción o, por el contrario, con menor demanda interna y más paro. El que la solución final sea de mayor y no de menor crecimiento depende de nuestro grado de competitividad internacional, es decir, de nuestra capacidad de exportar y del atractivo de la producción doméstica frente a las importaciones. Si hay algo claro de nuestro futuro modelo de crecimiento es que para que sea sostenible deberá estar basado más que en el pasado en exportaciones y en inversión productiva y menos en otros componentes de la demanda interna. Por encima de otras consideraciones es este el reto realmente importante de nuestro futuro modelo de crecimiento. Es difícil negar que hemos perdido competitividad relativa, consecuencia de la subida de los precios internos y del bajo crecimiento de la productividad, lo que se ha reflejado en la revaluación de nuestro de tipo de cambio real (y no sólo porque haya aumentado el peso de sectores con bajo nivel como el de la construcción, sino que es algo que se aprecia individualmente en diferentes sectores). Nuestro actual problema de competitividad es parecido al experimentado a primeros de los ochenta y que dio lugar a las llamadas políticas de reconversión. Hoy la competencia que sufre nuestra economía viene de un grupo más amplio de países, pues a los de siempre se han sumado un buen número de economías, China y la India entre otras, que en los ochenta no estaban incorporados a la competencia internacional y hoy compiten incluso con industrias con nivel tecnológico más avanzado que el nuestro. El proceso de reajuste llevado a cabo en los ochenta y noventa puede considerarse un éxito, la economía demostró sorprendente capacidad de reacción ante el desarme que supuso la incorporación a la Comunidad Económica Europea, y que permitió la configuración, y consolidación en los noventa, de las actuales multinacionales españolas. En el pasado, el acceso a la Comunidad Económica Europea, la creación del mercado único o la incorporación al euro constituyeron retos nacionales claros que, con convulsiones y dificultades, fueron entendidos como tales por la sociedad y explican los logros de la modernización de nuestra economía y el éxito de nuestra integración internacional. De aquellos procesos de ajustes y reformas deberíamos sacar lecciones. No deberíamos dejar pasar hoy la oportunidad que siempre ofrece una crisis. Óscar Fanjul, “La política económica: lo urgente y lo importante”, El País. Negocios, 6, 09, 2009: http://www.elpais.com/articulo/semana/politica/economica/urgente/importante/elpepuecon eg/20090906elpneglse_8/Tes
58 COLUMNISTS Europe’s failure of ambition stunts growth By Wolfgang Münchau Published: September 6 2009 20:11 | Last updated: September 6 2009 20:11 One of the probable long-term consequences of the financial crisis is an acceleration of Europe’s economic decline. This is by no means an inevitable outcome, but I fear it is likely. No matter what we do, China and India will eventually displace the European Union as the world’s largest economies. What I mean by decline is a decline in living standards. The financial crisis has led to a fall in potential growth in the entire North Atlantic region. Both the US and Europe will go through an adjustment period, during which growth will be lower. The US will be first to recover: it is a more dynamic economy, has a more coherent framework for macroeconomic policy, and, unlike the EU, has a genuine internal market which is not unravelling. So what should the EU do? A good macroeconomic to-do-list for Europe came in an essay last week, published in Memos to the New Commission by the Bruegel think-tank in Brussels. It was co-authored by Professors Jürgen von Hagen and Jean Pisani-Ferry. They propose six points – not a complete list, but a sensible one. First, don’t all rush to exit from stimulus policies at once. Ensure a proper sequencing, with the goal of preventing a double-dip recession. Second, adopt a five-year growth programme. I would add that this is not to be confused with the competitiveness programmes the EU has been running for ages. This should be about policies specifically designed to raise the rate of potential growth in gross domestic product, without the usual long list of extra objectives. Third, move beyond a mechanistic, legalistic adherence to the stability and growth pact, the current framework for fiscal policy co-ordination. This should not only include binding commitments on deficits and medium-term strategies, but also institutional reform, which is probably necessary in several member states. Fourth, the crisis has shown that macroeconomic policy in the euro area needs to be better co-ordinated, especially when it comes to crisis and post-crisis management. Fifth, speed up the introduction of the euro in central and eastern Europe. The authors rightly point out that one membership criterion, the inflation rate, currently suggests everybody qualifies, while another – the deficit – suggests nobody does. A bureaucratic application of the criteria is not a mature way to deal with eurozone enlargement. Finally, undertake some steps towards a common external representation of the eurozone. Unfortunately, most of this stands no chance of implementation. Adopting these policies would require that elusive quality of political leadership EU leaders lack. If you read the five-year action plan by José Manuel Barroso, the president of the Commission, also published last week, you would discover a shocking lack of imagination and ambition.
59 Why is such lack of ambition a problem? Because the post-crisis policy response is in many ways more important than the crisis response itself. The crisis response was relatively straightforward. Guaranteeing the liabilities of the banking system and stimulating the economy were policies adopted in varying degrees by all governments. Most were national policies, with minimal co-ordination at EU level. The EU would have benefited from a greater degree of co-ordination. But the response was sufficient to prevent an all-out catastrophe. Post-crisis responses are not going to be so binary, and the Commission will need to play a much more prominent role because we are dealing with deep structural issues. Now, even with Mr Barroso in office, there will probably be some minimal action on a subset of those proposals, but don’t hold your breath. In the absence of action, there would be a reasonable chance that Mr Barroso could oversee the re-introduction of the escudo in Portugal, his own country. I do not believe that this will happen, because I would expect to see the minimum policy moves needed to prevent a fully-fledged catastrophe. But they will probably not sequence an exit strategy. As we learned last week on these pages, the European Central Bank will independently pull the interest rate trigger at the first sighting of the inflation fairy. As for fiscal policy, Germany and the Netherlands will be the first to exit, come what may, and France will be among the last. So the sequencing is partially given. There will be no growth programme; any programme will not target growth, but some lobbyist’s agenda. The Commission will desperately cling on to the stability pact, and will eschew any talk about a more flexible and strategic application of the rules; it will continue to ignore current account imbalances, since there is no treaty base for doing otherwise; and you can forget the last two points of the Bruegel memo. Prospective euro members will only be able to join if they fulfil criteria that no eurozone members would presently fulfil. Common external representation has been pushed right down the agenda. So the eurozone will probably survive. But it may wither, as potential growth and living standards are falling. Europe was always in danger of heading towards the “irrelevant but pleasant to live in” category of places. Now even the latter is no longer assured. Write to [email protected] More columns at www.ft.com/wolfgangmünchau http://www.ft.com/cms/s/0/67aef208-9b0f-11de-a3a1-00144feabdc0.html
60
Magazine
September 6, 2009 How Did Economists Get It So Wrong? By PAUL KRUGMAN I. MISTAKING BEAUTY FOR TRUTH It’s hard to believe now, but not long ago economists were congratulating themselves over the success of their field. Those successes — or so they believed — were both theoretical and practical, leading to a golden era for the profession. On the theoretical side, they thought that they had resolved their internal disputes. Thus, in a 2008 paper titled “The State of Macro” (that is, macroeconomics, the study of big-picture issues like recessions), Olivier Blanchard of M.I.T., now the chief economist at the International Monetary Fund, declared that “the state of macro is good.” The battles of yesteryear, he said, were over, and there had been a “broad convergence of vision.” And in the real world, economists believed they had things under control: the “central problem of depression-prevention has been solved,” declared Robert Lucas of the University of Chicago in his 2003 presidential address to the American Economic Association. In 2004, Ben Bernanke, a former Princeton professor who is now the chairman of the Federal Reserve Board, celebrated the Great Moderation in economic performance over the previous two decades, which he attributed in part to improved economic policy making. Last year, everything came apart.
Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy. During the golden years, financial
61 economists came to believe that markets were inherently stable — indeed, that stocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year. Meanwhile, macroeconomists were divided in their views. But the main division was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful Fed. Neither side was prepared to cope with an economy that went off the rails despite the Fed’s best efforts. And in the wake of the crisis, the fault lines in the economics profession have yawned wider than ever. Lucas says the Obama administration’s stimulus plans are “schlock economics,” and his Chicago colleague John Cochrane says they’re based on discredited “fairy tales.” In response, Brad DeLong of the University of California, Berkeley, writes of the “intellectual collapse” of the Chicago School, and I myself have written that comments from Chicago economists are the product of a Dark Age of macroeconomics in which hard-won knowledge has been forgotten. What happened to the economics profession? And where does it go from here? As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess. Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation. It’s much harder to say where the economics profession goes from here. But what’s almost certain is that economists will have to learn to live with messiness. That is, they will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic “theory of everything” is a long way off. In practical terms, this will translate into more cautious policy advice — and a reduced willingness to dismantle economic safeguards in the faith that markets will solve all problems. II. FROM SMITH TO KEYNES AND BACK The birth of economics as a discipline is usually credited to Adam Smith, who published “The Wealth of Nations” in 1776. Over the next 160 years an extensive body of economic theory was developed, whose central message was: Trust the market. Yes, economists admitted that there were cases in which markets might fail, of which the most important was the case of “externalities” — costs that people impose on others without paying the price,
62 like traffic congestion or pollution. But the basic presumption of “neoclassical” economics (named after the late-19th-century theorists who elaborated on the concepts of their “classical” predecessors) was that we should have faith in the market system. This faith was, however, shattered by the Great Depression. Actually, even in the face of total collapse some economists insisted that whatever happens in a market economy must be right: “Depressions are not simply evils,” declared Joseph Schumpeter in 1934 — 1934! They are, he added, “forms of something which has to be done.” But many, and eventually most, economists turned to the insights of John Maynard Keynes for both an explanation of what had happened and a solution to future depressions. Keynes did not, despite what you may have heard, want the government to run the economy. He described his analysis in his 1936 masterwork, “The General Theory of Employment, Interest and Money,” as “moderately conservative in its implications.” He wanted to fix capitalism, not replace it. But he did challenge the notion that free-market economies can function without a minder, expressing particular contempt for financial markets, which he viewed as being dominated by short-term speculation with little regard for fundamentals. And he called for active government intervention — printing more money and, if necessary, spending heavily on public works — to fight unemployment during slumps.
It’s important to understand that Keynes did much more than make bold assertions. “The General Theory” is a work of profound, deep analysis — analysis that persuaded the best young economists of the day. Yet the story of economics over the past half century is, to a large degree, the story of a retreat from Keynesianism and a return to neoclassicism. The neoclassical revival was initially led by Milton Friedman of the University of Chicago, who asserted as early as 1953 that neoclassical economics works well enough as a description of the way the economy actually functions to be “both extremely fruitful and deserving of much confidence.” But what about depressions? Friedman’s counterattack against Keynes began with the doctrine known as monetarism. Monetarists didn’t disagree in principle with the idea that a market economy needs deliberate stabilization. “We are all Keynesians now,” Friedman once said, although he later claimed he was quoted out of context. Monetarists asserted, however, that a very limited, circumscribed form of government intervention — namely, instructing central banks to keep the nation’s money supply, the sum of cash in circulation and bank deposits, growing on a steady path — is all that’s required to prevent depressions. Famously, Friedman and his collaborator, Anna Schwartz, argued that if the Federal Reserve had done its job properly, the Great Depression would not have happened. Later, Friedman made a compelling case against any deliberate effort by government to push unemployment below its “natural” level (currently thought to be about 4.8 percent in the United States): excessively expansionary
63 policies, he predicted, would lead to a combination of inflation and high unemployment — a prediction that was borne out by the stagflation of the 1970s, which greatly advanced the credibility of the anti-Keynesian movement. Eventually, however, the anti-Keynesian counterrevolution went far beyond Friedman’s position, which came to seem relatively moderate compared with what his successors were saying. Among financial economists, Keynes’s disparaging vision of financial markets as a “casino” was replaced by “efficient market” theory, which asserted that financial markets always get asset prices right given the available information. Meanwhile, many macroeconomists completely rejected Keynes’s framework for understanding economic slumps. Some returned to the view of Schumpeter and other apologists for the Great Depression, viewing recessions as a good thing, part of the economy’s adjustment to change. And even those not willing to go that far argued that any attempt to fight an economic slump would do more harm than good. Not all macroeconomists were willing to go down this road: many became self-described New Keynesians, who continued to believe in an active role for the government. Yet even they mostly accepted the notion that investors and consumers are rational and that markets generally get it right. Of course, there were exceptions to these trends: a few economists challenged the assumption of rational behavior, questioned the belief that financial markets can be trusted and pointed to the long history of financial crises that had devastating economic consequences. But they were swimming against the tide, unable to make much headway against a pervasive and, in retrospect, foolish complacency. III. PANGLOSSIAN FINANCE
In the 1930s, financial markets, for obvious reasons, didn’t get much respect. Keynes compared them to “those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those that he thinks likeliest to catch the fancy of the other competitors.” And Keynes considered it a very bad idea to let such markets, in which speculators spent their time chasing one another’s tails, dictate important business decisions: “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”
64 By 1970 or so, however, the study of financial markets seemed to have been taken over by Voltaire’s Dr. Pangloss, who insisted that we live in the best of all possible worlds. Discussion of investor irrationality, of bubbles, of destructive speculation had virtually disappeared from academic discourse. The field was dominated by the “efficient-market hypothesis,” promulgated by Eugene Fama of the University of Chicago, which claims that financial markets price assets precisely at their intrinsic worth given all publicly available information. (The price of a company’s stock, for example, always accurately reflects the company’s value given the information available on the company’s earnings, its business prospects and so on.) And by the 1980s, finance economists, notably Michael Jensen of the Harvard Business School, were arguing that because financial markets always get prices right, the best thing corporate chieftains can do, not just for themselves but for the sake of the economy, is to maximize their stock prices. In other words, finance economists believed that we should put the capital development of the nation in the hands of what Keynes had called a “casino.” It’s hard to argue that this transformation in the profession was driven by events. True, the memory of 1929 was gradually receding, but there continued to be bull markets, with widespread tales of speculative excess, followed by bear markets. In 1973-4, for example, stocks lost 48 percent of their value. And the 1987 stock crash, in which the Dow plunged nearly 23 percent in a day for no clear reason, should have raised at least a few doubts about market rationality. These events, however, which Keynes would have considered evidence of the unreliability of markets, did little to blunt the force of a beautiful idea. The theoretical model that finance economists developed by assuming that every investor rationally balances risk against reward — the so-called Capital Asset Pricing Model, or CAPM (pronounced cap-em) — is wonderfully elegant. And if you accept its premises it’s also extremely useful. CAPM not only tells you how to choose your portfolio — even more important from the financial industry’s point of view, it tells you how to put a price on financial derivatives, claims on claims. The elegance and apparent usefulness of the new theory led to a string of Nobel prizes for its creators, and many of the theory’s adepts also received more mundane rewards: Armed with their new models and formidable math skills — the more arcane uses of CAPM require physicist-level computations — mild-mannered business-school professors could and did become Wall Street rocket scientists, earning Wall Street paychecks. To be fair, finance theorists didn’t accept the efficient-market hypothesis merely because it was elegant, convenient and lucrative. They also produced a great deal of statistical evidence, which at first seemed strongly supportive. But this evidence was of an oddly limited form. Finance economists rarely asked the seemingly obvious (though not easily answered) question of whether asset prices made sense given real-world fundamentals like earnings. Instead, they asked only whether asset prices made sense given other asset prices. Larry Summers, now the top economic adviser in the Obama administration, once mocked finance professors with a parable about “ketchup economists” who “have shown that two-quart bottles of ketchup invariably sell for exactly twice as much as one-quart bottles of ketchup,” and conclude from this that the ketchup market is perfectly efficient. But neither this mockery nor more polite critiques from economists like Robert Shiller of Yale had much effect. Finance theorists continued to believe that their models were essentially right, and so did many people making real-world decisions. Not least among these was Alan Greenspan, who was then the Fed chairman and a long-time supporter of financial deregulation whose rejection of calls to rein in subprime lending or address the
65 ever-inflating housing bubble rested in large part on the belief that modern financial economics had everything under control. There was a telling moment in 2005, at a conference held to honor Greenspan’s tenure at the Fed. One brave attendee, Raghuram Rajan (of the University of Chicago, surprisingly), presented a paper warning that the financial system was taking on potentially dangerous levels of risk. He was mocked by almost all present — including, by the way, Larry Summers, who dismissed his warnings as “misguided.”
By October of last year, however, Greenspan was admitting that he was in a state of “shocked disbelief,” because “the whole intellectual edifice” had “collapsed.” Since this collapse of the intellectual edifice was also a collapse of real-world markets, the result was a severe recession — the worst, by many measures, since the Great Depression. What should policy makers do? Unfortunately, macroeconomics, which should have been providing clear guidance about how to address the slumping economy, was in its own state of disarray. IV. THE TROUBLE WITH MACRO “We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time — perhaps for a long time.” So wrote John Maynard Keynes in an essay titled “The Great Slump of 1930,” in which he tried to explain the catastrophe then overtaking the world. And the world’s possibilities of wealth did indeed run to waste for a long time; it took World War II to bring the Great Depression to a definitive end. Why was Keynes’s diagnosis of the Great Depression as a “colossal muddle” so compelling at first? And why did economics, circa 1975, divide into opposing camps over the value of Keynes’s views? I like to explain the essence of Keynesian economics with a true story that also serves as a parable, a small-scale version of the messes that can afflict entire economies. Consider the travails of the Capitol Hill Baby-Sitting Co-op. This co-op, whose problems were recounted in a 1977 article in The Journal of Money, Credit and Banking, was an association of about 150 young couples who agreed to help one another by baby-sitting for one another’s children when parents wanted a night out. To ensure that every couple did its fair share of baby-sitting, the co-op introduced a form of scrip: coupons made out of heavy pieces of paper, each entitling the bearer to one half-hour of sitting time. Initially, members received 20 coupons on joining and were required to return the same amount on departing the group.
66 Unfortunately, it turned out that the co-op’s members, on average, wanted to hold a reserve of more than 20 coupons, perhaps, in case they should want to go out several times in a row. As a result, relatively few people wanted to spend their scrip and go out, while many wanted to baby-sit so they could add to their hoard. But since baby-sitting opportunities arise only when someone goes out for the night, this meant that baby-sitting jobs were hard to find, which made members of the co-op even more reluctant to go out, making baby-sitting jobs even scarcer. . . . In short, the co-op fell into a recession. O.K., what do you think of this story? Don’t dismiss it as silly and trivial: economists have used small-scale examples to shed light on big questions ever since Adam Smith saw the roots of economic progress in a pin factory, and they’re right to do so. The question is whether this particular example, in which a recession is a problem of inadequate demand — there isn’t enough demand for baby-sitting to provide jobs for everyone who wants one — gets at the essence of what happens in a recession. Forty years ago most economists would have agreed with this interpretation. But since then macroeconomics has divided into two great factions: “saltwater” economists (mainly in coastal U.S. universities), who have a more or less Keynesian vision of what recessions are all about; and “freshwater” economists (mainly at inland schools), who consider that vision nonsense. Freshwater economists are, essentially, neoclassical purists. They believe that all worthwhile economic analysis starts from the premise that people are rational and markets work, a premise violated by the story of the baby-sitting co-op. As they see it, a general lack of sufficient demand isn’t possible, because prices always move to match supply with demand. If people want more baby-sitting coupons, the value of those coupons will rise, so that they’re worth, say, 40 minutes of baby-sitting rather than half an hour — or, equivalently, the cost of an hours’ baby-sitting would fall from 2 coupons to 1.5. And that would solve the problem: the purchasing power of the coupons in circulation would have risen, so that people would feel no need to hoard more, and there would be no recession. But don’t recessions look like periods in which there just isn’t enough demand to employ everyone willing to work? Appearances can be deceiving, say the freshwater theorists. Sound economics, in their view, says that overall failures of demand can’t happen — and that means that they don’t. Keynesian economics has been “proved false,” Cochrane, of the University of Chicago, says. Yet recessions do happen. Why? In the 1970s the leading freshwater macroeconomist, the Nobel laureate Robert Lucas, argued that recessions were caused by temporary confusion: workers and companies had trouble distinguishing overall changes in the level of prices because of inflation or deflation from changes in their own particular business situation. And Lucas warned that any attempt to fight the business cycle would be counterproductive: activist policies, he argued, would just add to the confusion. By the 1980s, however, even this severely limited acceptance of the idea that recessions are bad things had been rejected by many freshwater economists. Instead, the new leaders of the movement, especially Edward Prescott, who was then at the University of Minnesota (you can see where the freshwater moniker comes from), argued that price fluctuations and changes in demand actually had nothing to do with the business cycle. Rather, the business cycle reflects fluctuations in the rate of technological progress, which are amplified by the rational response of workers, who voluntarily work more when the environment is
67 favorable and less when it’s unfavorable. Unemployment is a deliberate decision by workers to take time off. Put baldly like that, this theory sounds foolish — was the Great Depression really the Great Vacation? And to be honest, I think it really is silly. But the basic premise of Prescott’s “real business cycle” theory was embedded in ingeniously constructed mathematical models, which were mapped onto real data using sophisticated statistical techniques, and the theory came to dominate the teaching of macroeconomics in many university departments. In 2004, reflecting the theory’s influence, Prescott shared a Nobel with Finn Kydland of Carnegie Mellon University. Meanwhile, saltwater economists balked. Where the freshwater economists were purists, saltwater economists were pragmatists. While economists like N. Gregory Mankiw at Harvard, Olivier Blanchard at M.I.T. and David Romer at the University of California, Berkeley, acknowledged that it was hard to reconcile a Keynesian demand-side view of recessions with neoclassical theory, they found the evidence that recessions are, in fact, demand-driven too compelling to reject. So they were willing to deviate from the assumption of perfect markets or perfect rationality, or both, adding enough imperfections to accommodate a more or less Keynesian view of recessions. And in the saltwater view, active policy to fight recessions remained desirable. But the self-described New Keynesian economists weren’t immune to the charms of rational individuals and perfect markets. They tried to keep their deviations from neoclassical orthodoxy as limited as possible. This meant that there was no room in the prevailing models for such things as bubbles and banking-system collapse. The fact that such things continued to happen in the real world — there was a terrible financial and macroeconomic crisis in much of Asia in 1997-8 and a depression-level slump in Argentina in 2002 — wasn’t reflected in the mainstream of New Keynesian thinking. Even so, you might have thought that the differing worldviews of freshwater and saltwater economists would have put them constantly at loggerheads over economic policy. Somewhat surprisingly, however, between around 1985 and 2007 the disputes between freshwater and saltwater economists were mainly about theory, not action. The reason, I believe, is that New Keynesians, unlike the original Keynesians, didn’t think fiscal policy — changes in government spending or taxes — was needed to fight recessions. They believed that monetary policy, administered by the technocrats at the Fed, could provide whatever remedies the economy needed. At a 90th birthday celebration for Milton Friedman, Ben Bernanke, formerly a more or less New Keynesian professor at Princeton, and by then a member of the Fed’s governing board, declared of the Great Depression: “You’re right. We did it. We’re very sorry. But thanks to you, it won’t happen again.” The clear message was that all you need to avoid depressions is a smarter Fed. And as long as macroeconomic policy was left in the hands of the maestro Greenspan, without Keynesian-type stimulus programs, freshwater economists found little to complain about. (They didn’t believe that monetary policy did any good, but they didn’t believe it did any harm, either.) It would take a crisis to reveal both how little common ground there was and how Panglossian even New Keynesian economics had become. V. NOBODY COULD HAVE PREDICTED . . . In recent, rueful economics discussions, an all-purpose punch line has become “nobody could have predicted. . . .” It’s what you say with regard to disasters that could have been
68 predicted, should have been predicted and actually were predicted by a few economists who were scoffed at for their pains. Take, for example, the precipitous rise and fall of housing prices. Some economists, notably Robert Shiller, did identify the bubble and warn of painful consequences if it were to burst. Yet key policy makers failed to see the obvious. In 2004, Alan Greenspan dismissed talk of a housing bubble: “a national severe price distortion,” he declared, was “most unlikely.” Home-price increases, Ben Bernanke said in 2005, “largely reflect strong economic fundamentals.” How did they miss the bubble? To be fair, interest rates were unusually low, possibly explaining part of the price rise. It may be that Greenspan and Bernanke also wanted to celebrate the Fed’s success in pulling the economy out of the 2001 recession; conceding that much of that success rested on the creation of a monstrous bubble would have placed a damper on the festivities. But there was something else going on: a general belief that bubbles just don’t happen. What’s striking, when you reread Greenspan’s assurances, is that they weren’t based on evidence — they were based on the a priori assertion that there simply can’t be a bubble in housing. And the finance theorists were even more adamant on this point. In a 2007 interview, Eugene Fama, the father of the efficient-market hypothesis, declared that “the word ‘bubble’ drives me nuts,” and went on to explain why we can trust the housing market: “Housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.” Indeed, home buyers generally do carefully compare prices — that is, they compare the price of their potential purchase with the prices of other houses. But this says nothing about whether the overall price of houses is justified. It’s ketchup economics, again: because a two-quart bottle of ketchup costs twice as much as a one-quart bottle, finance theorists declare that the price of ketchup must be right. In short, the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place. Now that the undiagnosed bubble has burst, the true riskiness of supposedly safe assets has been revealed and the financial system has demonstrated its fragility. U.S. households have seen $13 trillion in wealth evaporate. More than six million jobs have been lost, and the unemployment rate appears headed for its highest level since 1940. So what guidance does modern economics have to offer in our current predicament? And should we trust it? VI. THE STIMULUS SQUABBLE Between 1985 and 2007 a false peace settled over the field of macroeconomics. There hadn’t been any real convergence of views between the saltwater and freshwater factions. But these were the years of the Great Moderation — an extended period during which inflation was subdued and recessions were relatively mild. Saltwater economists believed that the Federal Reserve had everything under control. Freshwater economists didn’t think the Fed’s actions were actually beneficial, but they were willing to let matters lie. But the crisis ended the phony peace. Suddenly the narrow, technocratic policies both sides were willing to accept were no longer sufficient — and the need for a broader policy response brought the old conflicts out into the open, fiercer than ever.
69 Why weren’t those narrow, technocratic policies sufficient? The answer, in a word, is zero. During a normal recession, the Fed responds by buying Treasury bills — short-term government debt — from banks. This drives interest rates on government debt down; investors seeking a higher rate of return move into other assets, driving other interest rates down as well; and normally these lower interest rates eventually lead to an economic bounceback. The Fed dealt with the recession that began in 1990 by driving short-term interest rates from 9 percent down to 3 percent. It dealt with the recession that began in 2001 by driving rates from 6.5 percent to 1 percent. And it tried to deal with the current recession by driving rates down from 5.25 percent to zero. But zero, it turned out, isn’t low enough to end this recession. And the Fed can’t push rates below zero, since at near-zero rates investors simply hoard cash rather than lending it out. So by late 2008, with interest rates basically at what macroeconomists call the “zero lower bound” even as the recession continued to deepen, conventional monetary policy had lost all traction. Now what? This is the second time America has been up against the zero lower bound, the previous occasion being the Great Depression. And it was precisely the observation that there’s a lower bound to interest rates that led Keynes to advocate higher government spending: when monetary policy is ineffective and the private sector can’t be persuaded to spend more, the public sector must take its place in supporting the economy. Fiscal stimulus is the Keynesian answer to the kind of depression-type economic situation we’re currently in. Such Keynesian thinking underlies the Obama administration’s economic policies — and the freshwater economists are furious. For 25 or so years they tolerated the Fed’s efforts to manage the economy, but a full-blown Keynesian resurgence was something entirely different. Back in 1980, Lucas, of the University of Chicago, wrote that Keynesian economics was so ludicrous that “at research seminars, people don’t take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another.” Admitting that Keynes was largely right, after all, would be too humiliating a comedown. And so Chicago’s Cochrane, outraged at the idea that government spending could mitigate the latest recession, declared: “It’s not part of what anybody has taught graduate students since the 1960s. They [Keynesian ideas] are fairy tales that have been proved false. It is very comforting in times of stress to go back to the fairy tales we heard as children, but it doesn’t make them less false.” (It’s a mark of how deep the division between saltwater and freshwater runs that Cochrane doesn’t believe that “anybody” teaches ideas that are, in fact, taught in places like Princeton, M.I.T. and Harvard.) Meanwhile, saltwater economists, who had comforted themselves with the belief that the great divide in macroeconomics was narrowing, were shocked to realize that freshwater economists hadn’t been listening at all. Freshwater economists who inveighed against the stimulus didn’t sound like scholars who had weighed Keynesian arguments and found them wanting. Rather, they sounded like people who had no idea what Keynesian economics was about, who were resurrecting pre-1930 fallacies in the belief that they were saying something new and profound. And it wasn’t just Keynes whose ideas seemed to have been forgotten. As Brad DeLong of the University of California, Berkeley, has pointed out in his laments about the Chicago school’s “intellectual collapse,” the school’s current stance amounts to a wholesale rejection of Milton Friedman’s ideas, as well. Friedman believed that Fed policy rather than changes in government spending should be used to stabilize the economy,
70 but he never asserted that an increase in government spending cannot, under any circumstances, increase employment. In fact, rereading Friedman’s 1970 summary of his ideas, “A Theoretical Framework for Monetary Analysis,” what’s striking is how Keynesian it seems. And Friedman certainly never bought into the idea that mass unemployment represents a voluntary reduction in work effort or the idea that recessions are actually good for the economy. Yet the current generation of freshwater economists has been making both arguments. Thus Chicago’s Casey Mulligan suggests that unemployment is so high because many workers are choosing not to take jobs: “Employees face financial incentives that encourage them not to work . . . decreased employment is explained more by reductions in the supply of labor (the willingness of people to work) and less by the demand for labor (the number of workers that employers need to hire).” Mulligan has suggested, in particular, that workers are choosing to remain unemployed because that improves their odds of receiving mortgage relief. And Cochrane declares that high unemployment is actually good: “We should have a recession. People who spend their lives pounding nails in Nevada need something else to do.” Personally, I think this is crazy. Why should it take mass unemployment across the whole nation to get carpenters to move out of Nevada? Can anyone seriously claim that we’ve lost 6.7 million jobs because fewer Americans want to work? But it was inevitable that freshwater economists would find themselves trapped in this cul-de-sac: if you start from the assumption that people are perfectly rational and markets are perfectly efficient, you have to conclude that unemployment is voluntary and recessions are desirable. Yet if the crisis has pushed freshwater economists into absurdity, it has also created a lot of soul-searching among saltwater economists. Their framework, unlike that of the Chicago School, both allows for the possibility of involuntary unemployment and considers it a bad thing. But the New Keynesian models that have come to dominate teaching and research assume that people are perfectly rational and financial markets are perfectly efficient. To get anything like the current slump into their models, New Keynesians are forced to introduce some kind of fudge factor that for reasons unspecified temporarily depresses private spending. (I’ve done exactly that in some of my own work.) And if the analysis of where we are now rests on this fudge factor, how much confidence can we have in the models’ predictions about where we are going? The state of macro, in short, is not good. So where does the profession go from here? VII. FLAWS AND FRICTIONS Economics, as a field, got in trouble because economists were seduced by the vision of a perfect, frictionless market system. If the profession is to redeem itself, it will have to reconcile itself to a less alluring vision — that of a market economy that has many virtues but that is also shot through with flaws and frictions. The good news is that we don’t have to start from scratch. Even during the heyday of perfect-market economics, there was a lot of work done on the ways in which the real economy deviated from the theoretical ideal. What’s probably going to happen now — in fact, it’s already happening — is that flaws- and-frictions economics will move from the periphery of economic analysis to its center. There’s already a fairly well developed example of the kind of economics I have in mind: the school of thought known as behavioral finance. Practitioners of this approach emphasize two things. First, many real-world investors bear little resemblance to the cool calculators of efficient-market theory: they’re all too subject to herd behavior, to bouts of irrational
71 exuberance and unwarranted panic. Second, even those who try to base their decisions on cool calculation often find that they can’t, that problems of trust, credibility and limited collateral force them to run with the herd. On the first point: even during the heyday of the efficient-market hypothesis, it seemed obvious that many real-world investors aren’t as rational as the prevailing models assumed. Larry Summers once began a paper on finance by declaring: “THERE ARE IDIOTS. Look around.” But what kind of idiots (the preferred term in the academic literature, actually, is “noise traders”) are we talking about? Behavioral finance, drawing on the broader movement known as behavioral economics, tries to answer that question by relating the apparent irrationality of investors to known biases in human cognition, like the tendency to care more about small losses than small gains or the tendency to extrapolate too readily from small samples (e.g., assuming that because home prices rose in the past few years, they’ll keep on rising). Until the crisis, efficient-market advocates like Eugene Fama dismissed the evidence produced on behalf of behavioral finance as a collection of “curiosity items” of no real importance. That’s a much harder position to maintain now that the collapse of a vast bubble — a bubble correctly diagnosed by behavioral economists like Robert Shiller of Yale, who related it to past episodes of “irrational exuberance” — has brought the world economy to its knees. On the second point: suppose that there are, indeed, idiots. How much do they matter? Not much, argued Milton Friedman in an influential 1953 paper: smart investors will make money by buying when the idiots sell and selling when they buy and will stabilize markets in the process. But the second strand of behavioral finance says that Friedman was wrong, that financial markets are sometimes highly unstable, and right now that view seems hard to reject. Probably the most influential paper in this vein was a 1997 publication by Andrei Shleifer of Harvard and Robert Vishny of Chicago, which amounted to a formalization of the old line that “the market can stay irrational longer than you can stay solvent.” As they pointed out, arbitrageurs — the people who are supposed to buy low and sell high — need capital to do their jobs. And a severe plunge in asset prices, even if it makes no sense in terms of fundamentals, tends to deplete that capital. As a result, the smart money is forced out of the market, and prices may go into a downward spiral. The spread of the current financial crisis seemed almost like an object lesson in the perils of financial instability. And the general ideas underlying models of financial instability have proved highly relevant to economic policy: a focus on the depleted capital of financial institutions helped guide policy actions taken after the fall of Lehman, and it looks (cross your fingers) as if these actions successfully headed off an even bigger financial collapse. Meanwhile, what about macroeconomics? Recent events have pretty decisively refuted the idea that recessions are an optimal response to fluctuations in the rate of technological progress; a more or less Keynesian view is the only plausible game in town. Yet standard New Keynesian models left no room for a crisis like the one we’re having, because those models generally accepted the efficient-market view of the financial sector. There were some exceptions. One line of work, pioneered by none other than Ben Bernanke working with Mark Gertler of New York University, emphasized the way the lack of sufficient collateral can hinder the ability of businesses to raise funds and pursue investment opportunities. A related line of work, largely established by my Princeton colleague Nobuhiro Kiyotaki and John Moore of the London School of Economics,
72 argued that prices of assets such as real estate can suffer self-reinforcing plunges that in turn depress the economy as a whole. But until now the impact of dysfunctional finance hasn’t been at the core even of Keynesian economics. Clearly, that has to change. VIII. RE-EMBRACING KEYNES So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics. Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: “There is always an easy solution to every human problem — neat, plausible and wrong.” When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly. The vision that emerges as the profession rethinks its foundations may not be all that clear; it certainly won’t be neat; but we can hope that it will have the virtue of being at least partly right. Paul Krugman is a Times Op-Ed columnist and winner of the 2008 Nobel Memorial Prize in Economic Science. His latest book is “The Return of Depression Economics and the Crisis of 2008.” This article has been revised to reflect the following correction: Correction: September 6, 2009 Because of an editing error, an article on Page 36 this weekend about the failure of economists to anticipate the latest recession misquotes the economist John Maynard Keynes, who compared the financial markets of the 1930s to newspaper beauty contests in which readers tried to correctly pick all six eventual winners. Keynes noted that a competitor did not have to pick “those faces which he himself finds prettiest, but those that he thinks likeliest to catch the fancy of the other competitors.” He did not say, “nor even those that he thinks likeliest to catch the fancy of other competitors.” http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?em
September 5, 2009, 4:22 pm A few notes on my magazine article So my big state-of-economics piece is out. Just a few notes, since I have to get to bed early: we have 27 miles over hills to do tomorrow. First, to anyone who wishes I’d given credit — yes, I was helped by reading many sources (especially Justin Fox), but it’s a magazine article, not a book with room for an acknowledgments page; I couldn’t even acknowledge the editing work done by my wife,
73 Robin Wells, which played a big role. Some fairly extensive sections had to be taken out — for example, I wanted to include material about Paul Samuelson’s 1948 textbook, which reads very well in the current crisis, but had to cut it. Hyman Minsky also got crowded out. Sorry. Second, on whether the pretty good response of policy-oriented economists in the crisis undercuts the thesis — I don’t think so. I mean, yes, my colleagues are smart people, and some of them are highly flexible and quick on their feet. But the fact remains that many of these responses have been completely ad hoc; there just wasn’t the theoretical development in advance there would have been if the profession hadn’t been chasing the neoclassical dream. Third, on an interesting point raised by Discover (via Mark Thoma): won’t we eventually have a true theory that’s as beautiful as the full neoclassical version? Well, one thing’s for sure: we don’t have that beautiful final theory now, so the current choice is between ideas that are beautiful but wrong and a much messier hodgepodge. But my guess is that even in the long run it won’t be all that neat. Discover suggests general relativity versus Newtonian physics; but a better model may be meteorology, which as I understand it starts from some simple basic principles but is fiendishly complex in practice. Actually, let me put it this way: the economy is a complex system of interacting individuals — and these individuals themselves are complex systems. Neoclassical economics radically oversimplifies both the individuals and the system — and gets a lot of mileage by doing that; I, for one, am not going to banish maximization-and-equilibrium from my toolbox. But the temptation is always to keep on applying these extreme simplifications, even where the evidence clearly shows that they’re wrong. What economists have to do is learn to resist that temptation. But doing so will, inevitably, lead to a much messier, less pretty view. So be it.
But the economists DIDN'T get everything wrong Posted by Justin Fox Friday, September 4, 2009 at 6:51 am 10 Comments • Trackback (4) • Related Topics: economics, economy, efficient market Paul Krugman has an epic, and really great, dissection of the state of economics in Sunday's New York Times Magazine—headlined "How Did Economists Get It So Wrong"—that has already gone up online (thanks to Daniel Lippmann for letting me know about it). For those who only know Krugman from his NYT columns, it's a wonderful glimpse of the expansive, unpredictable essayist whom my former boss Rob Norton (who disagreed with Krugman at least 60% of the time) called the best economics writer since Keynes. For me it's a little frustrating, since large swaths of the article parallel the story told in my book, which Krugman said was a "must-read" in the NYT Book Review a few weeks back, but it never actually mentions my book. I'm going to assume that Krugman did mention my book in the draft he turned in, but some editor at the NYT removed it for reasons of narrative flow. And considering that I make such decisions in my column all the time (in fact, I did it in this week's column; I'll explain later), I really can't complain too much. Beyond that, the one big issue I have with the piece is that, while economists certainly got lots of things wrong before the crisis (as did almost all of us), many members of the
74 profession have acquitted themselves pretty well since things turned really ugly last year. Krugman goes on and on about the "freshwater" economists (at the Universities of Chicago, Rochester and Minnesota) and their crazy ideas about perfect markets. But what's telling is that the hardcore freshwaterites have had almost no impact on economic policy for the past year—neither in the Bush months or the Obama ones. Sure, Nobelist Ed Prescott, a former freshwater economist who now teaches in Phoenix and thus should probably be described as a no-water economist, made the statement that: "I don't know why Obama said all economists agree on [the need for a stimulus bill]," Prescott said. "They don't. If you go down to the third-tier schools, yes, but they're not the people advancing the science." Unless you believe that pretty much anyplace other than Arizona State University is a third- tier school, this is patently untrue, evidence of the extreme isolation of the remaining true believers in rational expectations and real business cycles and other such elegant but profoundly unhelpful macroeconomic theories developed since the 1960s. Even some of the true believers seem far more aware than Prescott that the past year's events have challenged their theories—as the University of Chicago's Robert Lucas told me last fall, "everyone is a Keynesian in a foxhole." Among economists with actual influence on policy over the past year—Philip Swagel in the Paulson Treasury, Larry Summers and Christina Romer and Austan Goolsbee and etc. in the current White House—there's been a great willingness to experiment and accept that markets don't always deliver optimal results. The result: an economic recovery that seems to be gaining strength. So don't totally count the economists out. http://curiouscapitalist.blogs.time.com/2009/09/04/but-the-economists-didnt-get- everything-wrong/
Mistaking Beauty for Truth by Sean Everyone’s talking about this Paul Krugman essay on where economics, as a discipline, went wrong. Partly, “going wrong” means the failure to appreciate the risks in our financial system, and the corresponding failure to predict the crash we’re currently trying to deal with. But from an insider’s perspective, something else has happened: an uneasy consensus between two different approaches to economics has been shattered. One, which Krugman labels the “saltwater” approach, is associated (in the U.S.) with some variety of post- Keynesian analysis, generally identified with some willingness to have the government intervene in the economy over and above the Fed’s control of the money supply. The other, the “freshwater” approach favored by the Chicago School and other inland economists, is more purely free-market and non-interventionist. (Truth in advertising: I am not an economist.) These camps could more or less get along when everything was going fine, but have dramatically different reactions to a crisis. To the extent that you find freshwater economists claiming that unemployment is currently high, not because there aren’t many jobs, but because there are too many incentives for people not to work.
75 One of the reasons it’s a great essay is that it’s a wonderful example of popularizing science. You can debate all you like about whether economics counts as a science, but there’s little doubt that Krugman does an amazing job at explaining esoteric ideas in non- technical language, and is so smooth about it that you hardly realize difficult ideas are even being discussed. I wish I could write like that. One part of the essay worth commenting on, or at least musing about, is the punchline. Krugman thinks that a major factor leading to the failures of economics to understand the mess we’re currently in was the temptation to think that beautiful models must be right. As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess. Without knowing much of anything about the relevant issues, I nevertheless suspect that this moral might be a bit too pat. Sure, people can fall in love with beautiful theories, to the extent that they overestimate their relationship to reality. But it seems likely to me that the correct way of understanding all this, once it’s properly understood, will look pretty beautiful as well. General relativity is widely held up as an example of a beautiful theory — and it is, when understood in its own language. But if you put the prediction of GR in the Solar System into the language of pre-existing Newtonian physics (which you could certainly do), it would look ugly and ad hoc. Likewise, Newton’s theory itself is quite elegant, when phrased in the language of potentials on a fixed spacetime background; but if you express the theory in terms of differential geometry (which you could certainly do), it looks like a mess. Sometimes the beauty/ugly distinction between theoretical conceptions is more a matter of how well we understand them, and less about their intrinsic qualities. So my counter-hypothesis would be that it wasn’t beauty that was the problem, it was complacency. If you have a model that is beautiful and works well enough, you’re tempted to take pride in it rather than pushing it to extremes and looking for problems. I suspect that there is a very beautiful theory of economics out there waiting to be developed, one that understands perfectly well that individuals aren’t rational and markets aren’t perfect. One that has even more impressive-looking equations than the current favored models! Beauty isn’t always a cop-out. September 4th, 2009 10:53 AM in Science and Society http://blogs.discovermagazine.com/cosmicvariance/2009/09/04/mistakin g-beauty-for-truth/
76 vox Research-based policy analysis and commentary from leading economists Eurozone stimulus: A myth, some facts, and impact estimates Volker Wieland 5 September 2009
Eurozone governments have engaged in substantial fiscal stimulus. This column argues against further fiscal measures, claiming that forward-looking firms and households will cut their expenditure in response to governmental expansions. It warns that further fiscal efforts risk eroding financial and monetary policies that are combating the crisis.
Fact: Fiscal stimulus packages put together by Eurozone governments were much smaller than the US package (American Recovery and Reinvestment Act, ARRA). Announcements of discretionary fiscal measures by Eurozone governments only add up to about 1% of GDP in 2009 and a little less in 2010. The $787 billion stimulus by the US government amounts to over 5% of US GDP. Myth: It’s the fault of the German government. If only they had followed the example set by the Americans, the Eurozone economy would have enjoyed a big boost, and the recession would have been much smaller. This view still appears to be widely held. To give just one example, as recently as July 20, the German business daily Handelsblatt reported on an interview with Robert Shiller under the front-page heading “We need more stimulus” as follows: Handelsblatt: Nobel prize winner Paul Krugman accused the German government some months ago of "boneheadedness" in fighting the recession. How do you judge the crisis management in Germany? Shiller: My impression is that the stimulus program of the German government was weak. Though the money from the stimulus package in America was also flowing with some delay, it has at least strengthened confidence. In this regard the US was more active. Fact: The German government, which was heavily criticised in the fall of 2008 for not spending enough, quickly followed up with a second “Konjunkturpaket” in January 2009. The two fiscal packages, together, imply additional spending, transfers, and tax cuts of about 1.5% in 2009 and 2% in 2010. This is actually quite close to the US stimulus for those two years, since the ARRA measures are spread over five years. The German stimulus is about 50% of the Eurozone stimulus, quite a bit more than its share in Eurozone GDP. Given that Germany is a country with much more pronounced automatic stabilisers than the US, this is a strong sign of fiscal activism. Thus, the German government should get good grades from those who trust in the boosting power of fiscal stimulus.
77 How much of a boost to Eurozone GDP should we expect? Proponents of discretionary fiscal stimulus hope for a Keynesian multiplier effect. It follows from the national accounts spending identity when combined with the textbook Keynesian consumption function. The latter has current income as the main driver of consumption spending. A government-induced increase in total spending then raises income and boosts private consumption, which in turn raises total spending further. Does the multiplier work? The recent debate in the US indicates quite some disagreement even among Keynesian economists. President Obama’s advisers Christina Romer and Jared Bernstein estimate that 1% of government spending would generate a 1.6% increase in GDP. They give much weight to the type of traditional macro models used by some forecasting firms. As a result, they believe the ARRA stimulus is good for 3% to 4% additional growth by end of 2010. A robustness analysis with New-Keynesian models conducted by Cogan, Cwik, Taylor, and Wieland (2009) indicates only about one-sixth of this effect. Our analysis suggests government spending quickly crowds out private consumption and investment, because forward-looking households and firms will consider eventual increases in future taxes, government debt, and interest rates. New evidence on the multiplier In a recent paper, Tobias Cwik and I assess the magnitude of Eurozone stimulus and construct a range of impact estimates (Cwik and Wieland 2009). We use a database of macroeconomic models that includes several models developed and used at important policy institutions such as the ECB, the EU Commission, and the IMF. Our findings confirm the earlier analysis with models of the US economy. Once you allow for a significant role of forward-looking behaviour by households and firms, there is no multiplier. The expectation of future tax increases, or rising government debt and future interest rate increases leads to a reduction in private consumption and investment spending. This holds in particular for the three New Keynesian models developed by economists at the ECB, the IMF and the EU Commission (see Smets and Wouters 2003, Laxton and Pesenti 2003, and Ratto, Roeger and in’t Veld 2009). These models include extensive Keynesian features such as price and wage rigidities, but also employ up-to-date microeconomic foundations. The model of EU Commission researchers is especially interesting because it is recently estimated and one-third of its households do not care about the future and follow a traditional Keynesian consumption function. Broadly similar results are obtained in the multi-country model of Taylor (1993), a slightly older vintage of New Keynesian economics with price and wage rigidities and forward- looking households and firms. Only the ECB’s area-wide model delivers the desired multiplier effect. However, all its firms and households look backwards. Its developers therefore caution that it is adequate for short-term forecasts but not the evaluation of major policy changes (Fagan et al. 2005). Likely implementation lags make things worse. If anticipated, the initial effect of fiscal stimulus may even be negative. Monetary accommodation, of course, helps. For example, if the ECB puts off the usual interest rate increases for a year, the fiscal stimulus gets more play, but not enough to generate a substantial multiplier. Spillovers to Eurozone neighbours and a conclusion Additional spending may partly be diverted to imports. For this reason, proponents of fiscal stimulus in Europe have talked much about spillover effects and lobbied for coordinated
78 measures. As it turns out, Eurozone stimulus remained limited because most Eurozone members did not really follow the US example. Using Taylor’s multi-country model, we tried to estimate likely spillovers from the major stimulus package in Germany to France and Italy. This model exhibits significant direct demand effects for French and Italian exports. Nevertheless, the spillovers are negligible. Readers who remember the impact of the German unification spending boom on members of the European Monetary System in the early 1990s will not be surprised. The direct demand effects are offset by the upward pressure on the exchange rate with countries outside the Eurozone, as well as the expectation of somewhat higher future interest rates. Conclusion In light of these findings, European policy makers ought to ignore calls for further stimulus packages. Instead, they should carefully monitor the impact of decisions already taken on the burden imposed on future taxpayers. If governments exhaust their fiscal space in measures that have little aggregate effect, their continued capability to back up the financial system will be questioned. At the same time, the economy is likely to benefit more from the increases in base money engineered by the ECB than traditional Keynesians would tend to believe (see Orphanides and Wieland 2000). In addition, fiscal responsibility on behalf of Eurozone governments would help avoid a premature exit from unconventional measures by the ECB. References Cogan, John, Tobias Cwik, John B. Taylor and Volker Wieland (2009), “New Keynesian versus Old Keynesian Government Spending Multipliers”, CEPR Discussion Paper 7236, March. Cwik, Tobias and Volker Wieland, (2009), “Keynesian government spending multipliers and spillovers in the Eurozone, CEPR Discussion Paper 7389, August. Fagan, Gabriel, Jerome Henry and Ricardo Mestre, An area-wide model for the Eurozone, Economic Modelling, 2005. Laxton, Douglas and Paulo Pesenti, (2003), Monetary rules for small, open emerging economies. Journal of Monetary Economics, 50, 1109-1146. Orphanides, Athanasios and Volker Wieland, (2000), Efficient Monetary Policy Design Near Price Stability, Journal of the Japanese and International Economies, 14, 327-365. Ratto, Marco, Werner Roeger, and Jan in’t Veld (2009), Quest III, An estimated open- economy DSGE model of the Eurozone with fiscal and monetary policy, Economic Modelling 26(1), 222-233. Romer, Christina and Jared Bernstein (2009), “The Job Impact of the American Recovery and Reinvestment Plan”, January 8, 2009. Smets, Frank and Raf Wouters (2003), “An estimated dynamic general equilibrium model of the Eurozone”, Journal of the European Economic Assocation, 1, 11-23-1175. Taylor, John B. (1993), Macroeconomic Policy in a World Economy: From Econometric Design to Practical Operation, WW Norton, New York.
This article may be reproduced with appropriate attribution. See Copyright (below).
“Eurozone stimulus: A myth, some facts, and impact estimates”, VOX, 5, septiembre 2009 http://www.voxeu.org/index.php?q=node/3949
79 Global Economy G20 agrees regulatory framework By Norma Cohen, Economics Correspondent Published: September 5 2009 11:28 | Last updated: September 5 2009 19:53 After two days of meetings in London, the Group of 20 finance ministers and central bankers agreed the broad outlines of a tough new regulatory framework for financial institutions that stops short of setting caps on bankers’ bonuses but leaves open the possibility that regulators will have a say on pay. In broad terms, the group agreed three major points about banking regulation: banks must raise much more capital once the financial crisis has passed, complex financial institutions should develop “living wills” to plan for their unwinding should that ever become necessary and banks should be required to retain some portion of loans they repackage and sell as asset-backed securities. The group also made an implicit plea for banks to limit payouts to shareholders, saying: “We call on banks to retain a greater proportion of current profits to build capital, where needed, to support lending.” The group also agreed that it is far too soon to begin unwinding the unprecedented amounts of fiscal, monetary and financial sector support which have been poured into the economies of member states, with US Treasury Secretary Tim Geithner saying that unemployment remains “unacceptably high”. The US unemployment rate reached 9.5 per cent last month according to figures released on Friday. In a press briefing following a full day of meetings, UK Chancellor Alistair Darling, said the group believes that although “decisive and concerted policy action has helped to arrest the decline and boost global demand,” stimulatory policies will need to remain in place “until recovery is secured.” But it is not too soon to discuss an orderly unwinding of that stimulus, Mr Darling added, saying that the G20 has agreed that what is needed is “a transparent and credible process for withdrawal of the stimulus.” In addition to the measures announced, Dominique Strauss-Kahn, the International Monetary Fund Managing Director, said that the IMF had raised $500bn in funding, which was promised at the April G20 summit. “We’ll be just over the $500bn figure,” Mr Strauss-Kahn said. “We have experienced an unprecedented level of cooperation among countries.” Members appear to have passed some of the thorniest issues surrounding reform of bank regulation and the matter of payouts to bankers into the arms of the Financial Stability Board, an international group of central bankers and regulators. The group stopped short of setting caps on bankers’ bonuses as some nations – France particularly – had pressed it to do. Instead, it has asked the FSB to help it draw up guidelines that incorporated the principles of transparency and improved corporate governance of banks including greater independence of remuneration committees.
80 It also agreed that compensation packages must have an element in which rewards are deferred for some time, clawback of payments is possible in cases where early profits lead to later losses and there are limits on guaranteed bonuses. Mr Darling said that banking regulators may have a role in limiting bonuses. “We agreed to look at the total amount set aside for the bonus pool,” he said. “A regulator could look at that in light of the strength of the institution,” he added, implying that banks with highly risky strategies or those facing large losses could be forced to scale back total bonus payments. The most important thing, Mr Darling said, was that any agreement on bonus structure must be embraced by all member states. “Quite clearly, you don’t want to get into a a situation where banks can play one country against another,” he said, adding that banks that do not adhere to the rules “will face sanctions.” “You have to balance the bonus payment against the health of the firm,” he said. He added that there was unanimity among finance ministers and central bankers that “every single banker has to realise that they would not be here except for actions that were underwritten by taxpayers.” On the much larger and more significant issue of bank reform, both Mr Darling and Mr Geithner sought to underscore a determination not to return to the pre-crisis world. “We cannot put the world in the position where things might go back to where they were at the start of the boom,” Mr Geithner said at a press briefing. And although some may argue that tough capital rules mean that banks will not be as profitable as they had been in the past, Mr Geithner said there are good questions about just how profitable these really were once risks were accounted for. “They created a mis-leading impression of profits,” he said. “People are worried that things are going to go back to where they were. That’s just not going to happen.” http://www.ft.com/cms/s/0/6a7de19c-9a06-11de-9c09-00144feabdc0.html
81
TEXT-G20 statement on strengthening financial system Sat Sep 5, 2009 11:20am EDT LONDON, Sept 5 (Reuters) - Finance ministers and central bank heads from the G20 nations met in London on Friday and Saturday to discuss the next steps in tackling the worst financial crisis since World War Two. Alongside the communique summarising their conclusions [ID:nL5238053], they issued the following "Declaration on further steps to strengthen the financial system": We, the G20 Finance Ministers and Central Bank Governors, reaffirmed our commitment to strengthen the financial system to prevent the build-up of excessive risk and future crises and support sustainable growth. We have made substantial progress in delivering our ambitious plan, which will ensure a robust and comprehensive framework for global regulation and oversight. The Financial Stability Board and the Global Forum on Transparency and Exchange of Information have expanded their mandate and membership. The regulatory bodies have agreed to more stringent capital requirements for risky trading activities, off-balance sheet items, and securitised products; they have developed proposals to address procyclicality, issued important principles on compensation and deposit insurance, and established over thirty supervisory colleges. But more needs to be done to maintain momentum, make the system more resilient and ensure a level playing field, including the following actions: 1. Clear and identifiable progress in 2009 on delivering the following framework on corporate governance and compensation practices. This will prevent excessive short- term risk taking and mitigate systemic risk, on a globally consistent basis building on and strengthening the application of the FSB principles: * greater disclosure and transparency of the level and structure of remuneration for those whose actions have a material impact on risk taking; * global standards on pay structure, including on deferral, effective clawback, the relationship between fixed and variable remuneration, and guaranteed bonuses, to ensure compensation practices are aligned with long-term value creation and financial stability; and, * corporate governance reforms to ensure appropriate board oversight of compensation and risk, including greater independence and accountability of board compensation committees. We call on the FSB to report to the Pittsburgh Summit with detailed specific proposals for developing this framework, which could be incorporated into supervisory measures, and closely monitoring its delivery. We also ask the FSB to explore possible approaches for limiting total variable remuneration in relation to risk and long-term performance. G20 governments will also explore ways to address non-adherence with the FSB principles.
82 2. Stronger regulation and oversight for systemically important firms, including: rapid progress on developing tougher prudential requirements to reflect the higher costs of their failure; a requirement on systemic firms to develop firm-specific contingency plans; the establishment of crisis management groups for major cross-border firms to strengthen international cooperation on resolution; and strengthening the legal framework for crisis intervention and winding down firms. 3. Rapid progress in developing stronger prudential regulation by: requiring banks to hold more and better quality capital once recovery is assured; introducing countercyclical buffers; developing a leverage ratio as an element of the Basel framework; an international set of minimum quantitative standards for high quality liquidity; continuing to improve risk capture in the Basel II framework; accelerating work to develop macro-prudential tools; and exploring the possible role of contingent capital. We call on banks to retain a greater proportion of current profits to build capital, where needed, to support lending. 4. Tackling non-cooperative jurisdictions (NCJs): delivering an effective programme of peer review, capacity building and countermeasures to tackle NCJs that fail to meet regulatory standards, AML/CFT and tax information exchange standards; standing ready to use countermeasures against tax havens from March 2010; ensuring developing countries benefit from the new tax transparency, possibly including through a multilateral instrument; and calling on the FSB to report on criteria and compliance against regulatory standards by November 2009. 5. Consistent and coordinated implementation of international standards, including Basel II, to prevent the emergence of new risks and regulatory arbitrage, particularly with regard to Central Counterparties for credit derivatives, oversight of credit ratings agencies and hedge funds, and quantitative retention requirements for securitisations. 6. Convergence towards a single set of high-quality, global, independent accounting standards on financial instruments, loan-loss provisioning, off-balance sheet exposures and the impairment and valuation of financial assets. Within the framework of the independent accounting standard setting process, the IASB is encouraged to take account of the Basel Committee guiding principles on lAS 39 and the report of the Financial Crisis Advisory Group; and its constitutional review should improve the involvement of stakeholders, including prudential regulators and the emerging markets. TEXT-G20 statement on strengthening financial system Sat Sep 5, 2009 http://www.reuters.com/article/marketsNews/idUSL566412820090905
83 Global Economy
G20 draft agrees global stimulus to stay LONDON, Sept 5 - G20 finance leaders pledged on Saturday to keep economic life- support packages in place until a recovery is firmly secured, but reached no deal on putting limits on bankers’ pay. Finance ministers and central bankers meeting in London agreed fiscal and monetary policy would stay ”expansionary” until recovery from the worst financial crisis since World War II was certain, a draft of their joint statement seen by Reuters showed. The global economic outlook is certainly a lot better since leaders last meet on the economic crisis in April, but policymakers are worried about derailing that recovery by pulling the plug too soon. ”We will continue to implement decisively our necessary financial support measures and expansionary monetary and fiscal policies consistent with price stability and long-term fiscal sustainability until a recovery is firmly secured,” the draft said. With politicians looking for someone to blame for the recession, the rhetoric leading up to the meeting had been directed firmly at bankers and their lavish multi-million dollar bonuses. But the ministers could not agree on putting an actual cap on bonuses as had been advocated by some countries and leading charities. Instead, they agreed to create a global structure for imposing tighter controls on pay at financial institutions to discourage bankers from making the kind of risky bets that started the crisis back in August 2007. These included deferring bonus payments over time and subjecting them to ”clawback” in case things went sour. The compromise was that the Financial Stability Board, a global regulatory council headed by Bank of Italy chief Mario Draghi, would study caps and the whole issue of pay further. ”Pay and bonuses cannot reward failure or encourage risk taking.” British Prime Minister Gordon Brown told the start of the meeting. ”It is offensive to the public whose taxpayers’ money in different ways has helped many banks from collapsing and is now underpinning their recovery.” The draft statement showed agreement that emerging nations like India and China should have a greater say in the running of the International Monetary Fund and World Bank but did not offer up any formula of how this should be achieved. It said only that their voice in global economic policymaking would grow ”significantly” and that it expected ”substantial progress” to be made on the issue at a summit of world leaders in Pittsburgh later this month. The BRIC group of leading emerging powers -- India, China, Russia and Brazil -- had laid out on Friday concrete targets for how much movement they wanted in IMF and World Bank quotas.
84 Nor was there much clarity yet on a U.S. proposal for increasing the capital that banks hold in order to prevent a rerun of the crisis that led to the collapse of some of the world’s biggest banks. While G20 countries agree that banks need more money set aside in reserves to cushion against losses, how much is needed and how that is calculated appears to be in dispute. Washington’s proposal has raised concerns that the United States is pulling back from the G20’s April pledge to tackle the issue within the existing framework, known as Basel II. French finance minister Christine Lagarde said on Friday she could not see the point of scrapping that framework, saying changes already made to it had dealt with the biggest issues. Key points from the draft communique Economic stimulus measures:: “We reiterated the need for swift and full implementation of all commitments made at the Washington and London summits and have agreed on further steps to strengthen the financial system as set out in the accompanying declaration.” Commodity prices: Pledges to “work to address excessive commodity price volatility.” Global imbalances: “Work to achieve high stable growth which will require orderly rebalancing of global demand.” Reform of International Monetary Fund: ”The voice and representation of emerging and developing economies, including the poorest, must be significantly increased” Accompanying statement called “Declaration on Further Steps to Strengthen Financial Institutions” with 6 points: 1. Compensation 2. Systemically important firms 3. Prudential regulation 4. Non-cooperative jurisdictions 5. Implementation of international standards for actors outside the core bank system such as credit derivatives etc. 6. Convergence of international accounting standards Statement says “More needs to be done” on: - Increasing transparency - “Global standards on pay structure, including on deferral, effective clawback, the relationship between fixed and variable remuneration, and guaranteed bonuses, to ensure compensation practices are aligned with long-term value creation and financial stability.” “We also ask the FSB (Financial Stability Board) to explore possible limits/approaches on total variable remuneration.” “G20 governments will also explore ways to address non-adherence with the FSB principles.” http://www.ft.com/cms/s/0/6a7de19c-9a06-11de-9c09-00144feabdc0.html
85 COMMENT Timing is the soul of economic policy Published: September 4 2009 20:09 | Last updated: September 4 2009 20:09 When the leaders of the Group of 20 nations met last spring, they were united by fear of a vicious world recession. As the G20 finance ministers now meet in London, ahead of a full national leaders’ summit in Pittsburgh later this month, they are finding it harder to agree about how to support a sustainable global recovery. In the first quarter this year, the Group of Seven major industrialised economies were contracting at an annualised rate of 8.4 per cent. Tremors from the financial sector crisis and the collapse in world trade volumes, which fell by 17 per cent between September and December, were felt across the world. Ministers now know that the first quarter was a one-off change in the level of world activity. Fewer banks are now reporting tightening credit. Corporate bond spreads remain elevated, but have retreated from their peaks. It is now clear that world trade volumes stabilised at the start of 2009. The export-reliant mercantilist economies have enjoyed sharp recoveries: Germany and Japan, which declined at annualised rates of 13.4 per cent and 11.7 per cent in the first quarter, bounced back to grow at annualised rates of 1.3 per cent and 3.7 per cent in the second. The big-spending nations have recovered some confidence. The US economy shrank in the second quarter, but the OECD expects it to return to growth in the third. The UK is likely to be the last major country to start growing again, but it should stop shrinking by the end of the year. It would, however, be dangerous to assume that steady growth will now resume. The US and UK are massively over-indebted: they should not be counted upon to return to being the world’s shoppers. Some historically frugal countries will need to boost spending permanently if growth is to continue for any reasonable length of time. It is not clear how much output is being stoked solely by stimulus packages. As a whole, these demand-boosting packages for the G20 now total almost 2 per cent of its output. In Germany, private consumption was boosted by around 1 per cent in the first half of this year, thanks to its popular “cash-for-clunkers” car trade-in scheme. As Dominique Strauss-Kahn, managing director of the International Monetary Fund, said on Friday, withdrawal of stimulus will need to be handled delicately, and not before households and companies are up to the task of “taking the baton” of supporting growth from the public sector. Divisions have appeared among the G20: Germany and France are treading hawkish lines about cutting borrowing. The UK, in particular, is urging flexibility. Britain is right to do so. Governments should only withdraw stimulus as quickly as the strength of the economy allows. If that means extending existing programmes, so be it. The G20 should provide political cover for that outcome, not make it more difficult. It should not set a plan in stone when the economic situation is so fluid. http://www.ft.com/cms/s/0/49e7d9c4-997f-11de- ab8c-00144feabdc0.html
86 Global Economy G20 rift opens on banking reform By FT reporters Published: September 4 2009 19:39 | Last updated: September 5 2009 01:52 Calls by the US and UK to introduce tougher capital rules for banks have met resistance from France ahead of Saturday’s meeting of G20 finance ministers in London. The rift over how some of the biggest banks in the world should be regulated and how they should cushion themselves against financial shocks could be an even bigger stumbling block to an international agreement on reforming the financial system than the contentious issue of bankers’ bonuses. Tim Geithner, the US Treasury secretary, this week set out eight principles for regulatory reform. These included one that could force banks to raise far more equity capital by issuing new shares. It would also set absolute limits on the amount of money a bank could borrow relative to its capital cushion.On Friday, Alistair Darling, chancellor, signalled broad support for Mr Geithner’s proposals, saying: “We agree with the Americans that, across the world, banks do need to strengthen their capital positions.” However, the proposals have caused disquiet in Paris. Christine Lagarde, the French finance minister, told a press conference in London that changes proposed to existing capital rules for banks – known as Basel II – should be enough to ensure lenders hold a satisfactory level of capital. “We need to have a good and sound explanation among ourselves concerning what Basel II is about. It has been significantly improved, amended over time ... and, as revised, I would have thought that addressed the issue,” she said. Instead, Ms Lagarde added, France would like to see the debate on bankers’ bonuses at the heart of discussions about reforms. France and Germany still favour a cap on bonuses or a targeted tax on excess remuneration, proposals the US and UK believe would be difficult to implement. On Friday night Ms Lagarde told BBC’s Newsnight she would be surprised if Britain failed to find a way of enforcing a cap on bonuses. “What happened 12 months ago was just horrible for our societies, it was horrible for our economies, and we are still suffering as a result,” she said. “Nobody wants this thing to happen again and if we want to avoid a recurrence of the crisis we need to change the rules.” On the economy, finance ministers are expected to agree to keeping policy accommodative for as long as needed.US joblessness surged to a 26-year high of 9.7 per cent in August, official data showed Friday. But the pace of job losses slowed to the lowest level in a year, fuelling hope that the worst of the recession is over. Reporting by Norma Cohen, Martin Arnold and Jean Eaglesham in London, Ben Hall in Paris and Alan Rappeport in New Yorkhttp://www.ft.com/cms/s/0/e54b7ec6-997e-11de-ab8c- 00144feabdc0.html
87 http://www.opendemocracy.net Russia’s economic crisis – no cue for ‘Perestroika 2.0’ By Andrew Wilson Created 2009-09-04 14:20 Russia is one of those countries for which the economic crisis ought to be a blessing in disguise. Over the last boom decade, high energy prices have excused a multitude of pathologies: corruption got worse because there was more to steal; Putin brokered the creation of giant inefficient ‘national champions' that are a deadweight on the more productive parts of the economy; even Russia's one copper-bottomed asset, oil and gas, will decline in the future, as its giant energy companies like Gazprom and Rosneft have simply failed to invest enough to meet supply commitments. Recession and lower energy prices, on the other hand, it is often argued, ought to prompt protest and/or reform. But, Russia is currently a land where all the predicted dogs are failing to bark. The idea of a new perestroika [1] - in itself an indication of how far Russia has moved backwards over the last twenty years - is a myth. Social unrest has been isolated and parochial. ‘Protest' has the flavour of the Khrushchev era: people petition local bosses, who then save factory jobs or build new roads because of the fear of retribution from the top. Putin is starting to behave like Yeltsin when he was Mayor of Moscow in the mid 1980s [2], making unannounced visits to city supermarkets to bemoan the price of pork. Nor, on the other hand, has there been any real crackdown to prevent protest - the regime seems capable of enduring without it. According to one of those who built the current system, the political fixer Gleb Pavlovsky [3], therefore, ‘the system has survived this crash-test - though there is no guarantee it will survive the next one'.[1] [3] Lord of the Rings One of Pavlovsky's mantras is that ‘Russia is an old country, but a new state'. [2] [3] Despite Russia's long history as an empire, the thinking of both elites and masses is over-determined by the experience of its traumatic birth as a state in 1991. The ‘twenty year crisis' under first Gorbachev and then Yeltsin has been overcome, but only just. According to Pavlovsky, ‘despite the mythology positing absolute control in Russia's politics', Russia ‘is in fact rather weakly governed, barely balancing on the very verge of stability - if not survival'.[3] [3] Whereas the West tends to compare the current economic crisis with 1929 and the social crisis that followed, Russians think more naturally in terms of their own most recent crash, in 1998. [4] Social breakdown had already happened in the early 1990s; the Putin regime has successfully mythologised 1998 as a crisis of statehood and therefore argues that preserving hard-won stability is the only way to prevent a reversal through 1998 back to the social chaos of the 1990s.
88 The first threat to stability comes from the ‘oligarchs' [5]. Putin originally came to power chillingly promising to ‘destroy the oligarchs as a class' - the same phrase that Stalin used in 1929 against the ‘kulaks' [6]. But Putin's real job is what he calls maintaining the ‘political configuration', which is code for keeping a lid on, and a balance between, the Hobbesian struggle between a whole universe of, in the Russian phrase, krugovaya poruka (‘circles of interest' - every so often the Russian press depicts as an actual universe, drawing a map of the pre-Copernican complex of planets and satellites in interlocking orbit around ‘planet Putin'). Even the infamous siloviki [7] (‘men of force', current and former KGB), are divided into rival clans. But there is a balance between those who play by the Kremlin rules. Those who don't, like the former king-maker Boris Berezovsky [8], or Russia's former richest man, the jailed Yukos boss Mikhail Khodorkovsky [9], are crushed. The choice of Dmitry Medvedev as Putin's superficial successor was part of this balancing act. ‘Project Medvedev' was originally a ‘prosperity project' with two aims. First was continuity in the guise of competition. Russia's traditionally top-heavy political system is not good at successions. The departure of the old leader tends to upset a highly personalised system of patrimony and privilege; there then tends to be a war of all against all until a new system of personalised authority is in place. On the eve of the last elections, the Russian elite was gripped by the fear of a form of oligarchic Trotskyism - not ‘permanent revolution', but the ‘permanent redistribution' of control of Russia's hard-won cash cows. Medvedev's second job was to sell the idea of Russia moving towards a rule of law, and legitimise the established distribution of assets. Plan A was extraordinarily successful. Plan B might have been. But the world economic crisis intervened. Ironically, it wasn't the expected succession crisis that threatened property, as many had feared, but the unexpected economic crisis. But Putin has kept the balance of the system remarkably well. There has been no feeding frenzy during the current crisis, unlike after 1991 or 1998. The idea of a ‘rescue list' for oligarchs mooted in the autumn of 2008 was quietly abandoned when it threatened to lead in that direction. Some have gained a little, but no one individual or group has grown strong enough to upset the balance or change the system's logic. Genady Timchenko [10] of the Swiss-registered oil trader Gunvor [11] has expanded his stake in Novatek [12], Russia's second largest gas producer after Gazprom. Deputy Prime Minister Igor Sechin [13], the head of Rosneft [14], has expanded his empire to include the state shipbuilding corporation OPK and consolidated control over the electricity industry. And Sechin and Timchenko have SUPPOSEDLY been linking up to increase their share of Russia's oil export trade. Individual oligarchs have received handsome subsidies: Sergey Chemezov's [15] Russian Technologies has received $7 billion, Oleg Deripaska [16] won a $4.5 billion loan to keep his 25% stake in Norilsk Nickel, Rosneft got $4.6 billion, and Roman Abramovich's Evraz $1.8 billion. But given the size of the ‘Stabilisation Fund' [17] built up during the boom years and now coveted by the troubled oligarchs - still $94.5 billion on 1 July 2009, down from a peak of $142.6 billion - this is relatively small beer. ‘Lord of the rings' is Putin's personal role - and he knows if he is too generous even to his own inner circle the system will collapse. He cannot transfer this role. Medvedev cannot do it, so Putin cannot retire. According to Masha Lipman [18] of the Moscow Carnegie Centre, ‘Putin's power as ring-master keeps him number one and keeps Medvedev number two'. [4] [18] Significantly, the number of Russians thinking that Medvedev runs the country has actually declined during his first year as president, from 25% to 12% in May/April 2009.
89 ‘Novocherkassk-2009' [19] A recent spate of articles - the first by the liberal economist Yevgeny Gontmakher - have addressed a second potential threat.[5] [19] Russia has hundreds of single employer ‘monocities', where there is a risk of unrest similar to that in the southern Russian town of Novocherkassk in June 1962, when panicky local authorities opened fire on crowds demonstrating against simultaneous increases in food prices and wage cuts. Twenty two were killed and another seven subsequently executed. But Russia in 2009 is a much more sophisticated regime than the USSR in 1962. The regime does not yet need repression. According to Dmitry Trenin [20] of the Carnegie Centre, ‘It has managed to manipulate people in a post-modern environment, without powerful political institutions or real political parties'. [6] [20] ‘Political technology' has been an alternative to traditional authoritarianism. Unlike China with its ‘great wall' of censorship, Russia regulates the internet with a lighter touch and enlists sympathetic bloggers rather than censors. Opposition parties were neutered long ago, but still exist to provide an outlet for protest. The Kremlin is adept at manipulating mini-crises to win popularity, with both internal and external enemies, though this is one reason why it is short of friends abroad. Cruder methods are of course used. Khodorkovsky is in jail. Contract killings of journalists and NGO activists are depressingly frequent. The youth movement Nashi [20] was set up to show anyone tempted to copy the tactics of the Orange Revolution in Russia that they would basically be beaten up. But, as Lipman points out, ‘people under fifty have no memory of a repressive state'. [7] [20] And as unpleasant as the dark side of Putinism may be, it is designed to be a lower-risk and lower-cost alternative to the nationalist authoritarianism advocated by many. If such voices grew louder, it is unclear whether Putin would swim with the tide or whether he would have the strength to pre-empt them. The longer term significance of the original Novocherkassk incident is also often missed. It was not just that people dared to demonstrate, or that the demonstrations were brutally suppressed. The Kremlin took fright at working class rebellion. Retrospectively, Novocherkassk marked the moment when the Soviet system moved from the rigid labour discipline of the Stalin era to the relatively comfortable, and ultimately unaffordable, ‘welfare state authoritarianism' of the Brezhnev years. Instead of a new Novocherkassk, Russia had the ‘Pikalyovo incident' [21] in early June, when Putin publically humiliated Oleg Deripaska, one of the ultimate symbols of Russia's ‘wild capitalism' of the 1990s, during a lighting visit to his cement factory to force him to pay wages and reopen the plant (after Deripaska signed the agreement, Putin demanded the pen back in case he stole it). But Pikalyovo does not mark the start of a populist spending spree, at least not yet. After Pikalyovo, according to Fyodor Lukyanov, editor of Russia in Global Affairs [22] , ‘liberals expected Putin to be everywhere, like Batman, solving all sorts of problems. But Putin understands better. It's only necessary to do it once. Like with the Khodorkovsky trial, people soon learn the new rules'. [8] [22] Pikalyovo was a signal to governors to deliver on ‘social responsibility' and to oligarchs not to rock the boat. According to Trenin, ‘populism is a strategy to preserve power'. [9] [22] And often fake - only days after Pikalyovo, Vneshtorgbank agreed another credit line for Deripaska. Nor did Pikalyovo mark the upsurge of anti-regime rebellion that the Kremlin's opponents have long hoped for. Recent protests have been a call to official action. They have not been revolutionary or nihilistic. There is as yet no threat of what Russians call bunt (atavistic rebellion). The aim of most protestors has not been to replace the authorities, but to get them
90 to turn up and deliver resources. According to Lipman, ‘it's like the Soviet era, when people would threaten not to vote until the Party got their roof mended'. [10] [22] But Pikalyovo did show that Russia is not responding to the economic crisis by joining some Western club - either the fiscal retrenchers or the new Keynesians. Russia is responding to its own recent history. In 1998, to put it crudely, the people got screwed by the sudden devaluation of the rouble, while the oligarchs were forewarned and colluded with the state to defraud their creditors, including the IMF who had just lent Russia $4.8 billion. In 2008-9 the state has allowed its reserves to dwindle by over $200 billion (from a pre-crisis peak of $598 billion to a low of $376 billion) to ensure a ‘soft landing'. This was a huge investment in social stability. The Russian system works on messages, and the message was that this time the state would look after the people, unlike in 1998 or with earlier confiscatory ‘redenominations' in 1991, 1961, 1947 and in the 1920s. (Though the step-by-step devaluation also meant big profits for the well-connected. With sufficient notice, the big banks and oligarchs simply used their bail-out cash to buy dollars or euros and then buy back the cheaper roubles a few days later - thereby also ensuring that few of the state's crisis subsidies actually reached the real economy). ‘Reverse Connection' Pikalyovo was also an attempt to address the inefficiencies in Putin's authoritarian project by creating what Russians call obratnaya sviaz' (‘reverse connection'). The system works, but only just. Russia still needs a modernisation project, albeit not the ‘prosperity project', backed by good finances and sound macroeconomics, which the Putin-Medvedev tandem was originally supposed to implement. Not only will Russia have to proceed with fewer resources, it will have to tackle the flip-side of a stronger state, what even Pavlovsky calls ‘severe monopolism in all social spheres', [11] [22] not just in government and the economy, but in the mass media and in society at large. The intermediary structures he helped set up are passive and inert - particularly ‘the party', now normally referred to in the singular as in the days of the CPSU [23], i.e. United Russia [24], which, unlike the CPSU, is mainly a vehicle for governors and lower bureaucrats to advertise their loyalty. Hardly anybody in the Kremlin belongs to it. Moreover, the stasis extends to society as a whole. After the ‘twenty year crisis' of the 1980s and 1990s, ‘all social spheres are static. There is a conservative mood, even in business. There are no risk takers. The atmosphere is against innovation'. [12] [24] Pikalyovo was supposed to spark an inert bureaucracy into life. The search for ‘reverse connection' has also led to some outreach to civil society, but one that will be very different to the kind of liberalisation advocated by Russia's surviving liberals, men like Gontmakher and Igor Yurgens [25], the head of the Institute of Contemporary Development [26], the think-tank currently favoured by Medvedev. Gontmakher has recently argued that the system needs ‘Khrushchev-isation' - like Khrushchev after Stalin, Medvedev (or Putin) needs to break with the system he helped create.[13] [26] In his first year in office, Medvedev has managed to maintain the impression that he is all-things-to-all-liberals, and that he might be willing to create a bigger tent, bringing in some survivors from the 1990s. In fact, Medvedev's job is to promote a ‘soft form of cooptation'. The new Kremlin- sponsored ‘liberal party' Right Cause and the new Civil Society Forum [27] are designed to prevent liberals reaching out and making common cause with protestors. Medvedev's job is to persuade civil society to play along, or it will be subject to re-control by real hardliners. The regime needs NGOs to improve the upward information flow, but the chief Kremlin ideologist Vladislav Surkov [28], who was responsible for the original law restricting the operation of NGOs in 2006, made the terms of the bargain crystal clear at the last meeting
91 of the Civil Society Forum in June. Civil society leaders are requested to provide concrete proposals on specific policy areas, but should not think of getting involved in politics and should not speculate about the system as a whole. Conclusion There is, as yet, no real sign of any second summer of perestroika. Medvedev has yet to prove that he is some kind of chrysalis liberal. The Institute of Contemporary Development, which has become the first port of call for Western visitors seeking to spot the first green shoots of reform, is in fact complaining it is starved of money, resources and influence. Russia's gamble is to keep with the system it has for now. It has run down its reserves, but kept most of its money in the bank, and is banking on oil price recovery to lift it off the rocks. The one thing Russia is not doing is using the crisis writ large as a new form of shock-therapy. Russia had had too many shocks recently. Senior Policy Fellow at the European Council on Foreign Relations
[1] [28] Author's interview [2] [28] Author's interview [3] [28] http://www.kreml.org/opinions/217126459 [4] [28] Author's interview [5] [28] http://www.vedomosti.ru/newspaper/article.shtml?2008/11/06/167542 [29], translated into English at http://www.robertamsterdam.com/2008/12/vedomosti_novocherkassk-2009.htm [6] [29] Author's interview [7] [29] Author's interview [8] [29] Author's interview [9] [29] Author's interview [10] [29] Author's interview [11] [29] Author's interview [12] [29] Author's interview [13] [29] http://www.specletter.com/obcshestvo/2009-08-25/revoljutsii-ne-budet-budet- bunt.html [30] ------Andrew Wilson is Senior Policy Fellow at the European Council on Foreign Relations http://www.opendemocracy.net/article/email/russia-s-economic-crisis-no-perestroika-2-0
92
The long march to Scotland’s independence referendum By Gerry Hassan Created 2009-09-04 14:18 The world of politics and history sometimes throws up by complete accident fascinating and revealing coincidences. So it proved on the 70th anniversary of Britain and France reluctantly declaring war on Nazi Germany after Hitler had taken the decision two days previously to unleash his war machine on Poland. On such a day laden with history the SNP administration fired the first official shots in the referendum on Scottish independence. Alex Salmond, First Minister, committed his administration to bring forward a bill to hold a referendum in the next year. More than the date of September 3rd connects these two separate events for they tell us something profound about the nature of Britain, what it became, the state it is currently in and what fate awaits it in the near-future. Britain’s declaration of war unleashed a whole set of events which have resonated down through the years. Neville Chamberlain’s announcement, after the shame of Munich and before that British ‘non-belligerence’ against Fascist aggression in the Spanish Civil War, led to ‘the Dunkirk miracle’, Britain’s decision to fight on in the summer of 1940 and spurn Nazi peace offerings, ‘the Battle of Britain’ and ‘our finest hour’. This period of British history – 1940-41 – is one of the defining set of stories of Britishness. It has been shaped and framed by Churchill’s rich, powerful rhetoric, which reached out and gave a voice and sense of hope to the British at their most beleaguered and lonely hour. In Max Hastings' words this gave ‘an elixir of hope’ which ‘anchored his people and their island’ at a time of gathering storms (Finest Years: Churchill as Warlord 1940-45, Harper Press 2009, p. 93; also see: Carlo d’Este, Warlord; Winston Churchill at War 1878-1945, Allen Lane 2008). At the same time this time contained within it the seeds of the slow, irreversible decline of the idea of ‘Britain’. For within the imperialist, all-powerful rhetoric of Churchill, with its belief in empire and the white races’ place on the planet, lay another idea, which Anthony Barnett appositely called ‘Churchillism’ (Iron Britannia: Why Parliament Waged its Falklands War, Allison and Busby 1982). This articulated the idea of Britain’s place in the world becoming the junior partner to the American imperial project – thus beginning the so- called ‘special relationship’ which has blighted and distorted British foreign policy and statecraft since.
93 Fast forward to the SNP proposals for a referendum on Scottish independence – in the words of The Herald editorial [1], ‘the political crux of the SNP’s legislative programme for the next year’. Alex Salmond [2] said that ‘the people of Scotland must be heard’, adding that ‘this Parliament should not stand in their way – let the people speak’. Yet it is widely known that the SNP have neither the numbers nor real desire for a referendum before the 2011 Scottish Parliament elections. The Nationalist strategy is to call the bluff of the unionist parties in the Scottish Parliament, and then go to the polls in 2011 claiming the moral high ground of the democratic argument. The unionist position here is an indefensible and even counter-productive one for if a vote were held tomorrow they would win easily. However, their nervousness displays a deeper unionist crisis of confidence about how the case for the British Union is made in a modern Scotland, and that the last story of Britain: the story of 1940-41 which led through ‘the people’s war’ to 1945 has been exhausted and is no longer the poignant, potent box office success it once was north of the border (or elsewhere for that matter). The crucial point from these parliamentary manoeuvrings is that an independence referendum is inevitable at some point. Serious politicians such as Michael (now Lord) Forsyth, the last Tory Secretary of State for Scotland, recognise this as did Wendy Alexander, Scottish Labour’s fourth leader, in her ‘bring it on’ phase. Independence is the pivotal faultline in Scottish politics in a post-socialist world. It is no accident that David Cameron and Gordon Brown have both at points briefly considered calling one – and shooting the Nationalists fox. And it is no accident, given this unionist crisis of confidence, that they have backed off from doing so. What is also illuminating is the lack of thinking and detail that has so far gone into looking into independence, in the Scottish Nationalists or elsewhere including the darkest recesses of the British state and establishment. Margo MacDonald, Nationalist heartthrob in the 1970s and now independent MSP and pain in the neck to the SNP leadership, got it bang on when she said [3] the party had ‘failed to explain the nuts and bolts of independence’, or deal with the reality that most Scots were ‘men and women who have grown up in a culture that can accommodate Britishness, no matter how Scottish they feel’. The Scotsman editorial [4] described the situation thus: In the draft referendum bill, the SNP government suggested that, under their proposals, Scots would be asked to state whether or not they agreed ‘that the Scottish Government should negotiate a settlement with the government of the United Kingdom so that Scotland becomes an independent state’. The Scotsman believes this is too soft a question to ask the people, asking as it does only to give the Scots Government the power to negotiate, missing, the editorial believes, the Constitution Unit report's view that the Scots need not one, but two referendums to gain independence – one to agree to negotiations, and one on their outcome (Jo Eric Murkens et al, Scottish Independence: A Practical Guide, Edinburgh University Press 2002). But this argument ignores the fact that none of the two dozen independent nations which emerged out of the shattering of the Soviet empire, of Yugoslavia, and of Czechoslovakia, required two referendums. Surely Scotland won't either. The coming of a Scottish independence referendum is a huge political event carrying waves and consequences far across the globe well beyond the reach of a small nation of five million people. And that is because an independence referendum carries with it a direct challenge to the geo-political nature of what Tom Nairn has termed the 'Ukanian' state and
94 Great British Powerism and its pretensions to power, influence and war through its asymmetrical alliance with the US. All political events have unintended consequences. The coming of the independence referendum changes the terms of reference and the terrain in which the UK operates and is understood. Politics is about power, legitimacy and voice and the long march to an independence referendum – by which I mean the next five to ten years – challenges the power, legitimacy and voice of the Ukanian state and its global position and pretentions. Which is why Westminster politicians and their journalistic acolytes hope against hope that the issue will just evaporate in the manner of many causes. But as The Scotsman [5] said, ‘Those who favour the United Kingdom remaining united are being short-sighted if they think the issue will go away’. A number of powerful forces have converged here on the anniversary of September 3rd; above all the slow decline of the traditional story of Britain, and within it the last great, powerful, progressive account of our strange ‘nationless state’ of Ukania, one many of us were brought up with as it was related to us with pride by our parents. And many of us saw that hope die in those who told us such stories. The progressive story of Britain is in deep, deep crisis, perhaps mortally so; it has been battered by the onslaught of Thatcherism which killed off the gentlemanly, benign Tory unionism which understood intuitively where to push and when to caress the strange hybrid that is the union. It was then brutalised by Blair’s twin track continuation of Thatcherism consolidated along with his grotesque application of the British state and foreign policy. This leaves us with the old but now emaciated parables of Tory unionism and a Labour version of Britain reduced to little more than flag-waving and barking at 'toffs' in the supposedly 'classless' accents of mid- Atlantic corporate efficiency - ‘the people’s story’, savaged, humiliated... and over. Events are moving fast here in Scotland. An incoming Conservative Government in Westminster in 2010 will have a scant to non-existent Scottish mandate. It will have to preside over massive public spending cuts much more savage than Thatcher in 1979-81. The Cameron Conservatives have barely begun to think anything about Scotland, and they are to put it mildly going to have their plate full next year, and will not want to be looking for avoidable northern troubles. It is highly probable that they will, along with the painful medicine offer the Scots a conciliatory gesture of going beyondthe proposals of the Calman Commission, to full fiscal autonomy, which could be presented well in the Tory shires as tackling the ‘subsidy junkie Scots’. When interviewed on Newsnight Scotland [6] last night on the independence referendum, I posed that this was a huge occasion for the Scots: a growing moment and one which offered us the chance to mature and have an adult debate. Within both the Scottish Nationalists and unionists there is a connivance which allows both of them to avoid debating the kind of society they want to bring about. This is because post- Thatcher they agree on the narrow, technocratic model of the bruised, discredited neo- liberal model. Instead of talking about the different values of society both talk in Armageddon-like terms of independence versus the union. This disguises that the political difference between a post-nationalist and post-unionist politics - seen in the writings of Neil MacCormick (Questioning Sovereignty: Law, State and Nation in the European Commonwealth, OUP 1999) and Michael Keating (Plurinational Democracy: Stateless Nations in a Post- sovereignty Era, OUP 2001) respectively - is small, both informed by the realities of post- sovereignty in an interdependent world. At the same time that difference between statehood
95 and less than full statehood matters given the nature of the UK (see Gerry Hassan (ed.), The Modern SNP: From Protest to Power, Edinburgh University Press 2009). This collusion by all the Scottish parties of cowardice and deception needs to be blown apart for the sake of radicals across these isles: an independence referendum has to be centred on the kind of Scotland and society we desire, and the posing of alternatives to the Anglo- American neo-liberal model. By doing so it will set off an equally wide debate south of the Scottish border that brings together the nature of the British state as a democracy, the kind of social regime it seeks to be, and therefore also its place in the larger European Union. The political class is terrified of any such debate. Which is why it is so hostile to an independence referendum irrespective of its outcome, and why the rest of us should welcome and support it. Gerry Hassan is a writer, commentator and policy analyst whose latest book is ‘The Modern SNP: From Protest to Power’ (Edinburgh University Press, October). He can be contacted at gerryhassan.com [7]
Source URL: http://www.opendemocracy.net/ourkingdom/gerry_hassan/scotlands_independence_referen dum Links: [1] http://www.theherald.co.uk/features/editorial/display.var.2528998.0.The_SNP_proposals.ph p [2] http://news.scotsman.com/leaders/Independence-question-should-be-put.5617617.jp [3] http://edinburghnews.scotsman.com/comment/-Margo-MacDonald-SNP- must.5608436.jp [4] http://news.scotsman.com/leaders/Independence-question-should-be-put.5617617.jp [5] http://news.scotsman.com/leaders/Independence-question-should-be-put.5617617.jp [6] http://www.bbc.co.uk/iplayer/episode/b00ml1hq/Newsnight_Scotland_03_09_2009/ [7] http://www.gerryhassan.com/ http://www.opendemocracy.net/ourkingdom/gerry_hassan/scotlands_independence_referen dum
96
04.09.2009 Macroprudential illusions By: By Axel Leijonhufvud
The sense of imminent crisis has abated for the time being. A debate is beginning on how to prevent a recurrence of the disaster. A variety of sensible reforms have been proposed with the aim to improve the transparency of recently innovated instruments and to ameliorate moral hazard in the markets for securitized products. The report by a group appointed by European Commission President Jose’ Manuel Barroso and headed by Jacques de Larosière, former president of the IMF, spells out an entire agenda of such measures. Among the recommendations of the Larosière Group was the proposal to create a system of macroprudential supervision, and perhaps regulation, on a European level. The proposal received the support of Nout Wellinck who, as head of the Basel Committee on Banking Supervision, also has formidable authority in international banking circles. At the end of May, the European Commission already moved ahead on these recommendations and proposed the creation of a European Systemic Risk Council. The duties of the Council would be to identify systemic risks, issue risk warnings and recommend what actions the authorities should take. It is true enough that the big banks of the world did not understand the risks they were incurring. The only person on Wall Street of whom we can say with confidence that he knew exactly what he was doing is Bernard Madoff. If we truly believed that the other great names of banking fully understood the system in which they were operating, we would think of them as ‘criminal’ too (even if not legally liable). Given these circumstances, it is a rather natural impulse to conclude that these people need to be watched so that we get warned in good time before they get themselves -- and all of us – into trouble again. Having bankers supervised by people who “know better” and who can take the measures needed to prevent another crash may seem a plausible notion at first. But second thoughts bring doubts and not only because people who know better may be in short supply. The need for yet another institution in this area is far from obvious. The Financial Stability
97 Forum hosted by the Bank of International Settlements has debated systemic risk for years. The IMF, the ECB and the Bank of England all produce regular Financial Stability Reports. Checking these reports for 2006 and 2007 one finds intelligent discussions of potentially dangerous weaknesses in the financial system but no strong forewarning of the enormous calamity about to happen. Can we expect a new European Systemic Risk Council to do better? The financial crisis has taught economists, bankers and politicians some hard lessons. But the next crisis will not be just a rerun of this one and the simple truth is that at present macroprudential analysis is far from being a science. Moreover, the Council will be a rather unwieldy body. Chaired by the ECB president, it will have permanent representatives from each of the EMU countries plus a few rotating members from the other European Union countries. The United Kingdom predictably (and somewhat understandably) has already objected to the proposed composition of the Council as militating against the interests of the non-Euro states. The Council will not be a likely source of unanimous, strong and timely policy recommendations. It had better be understood that the idea of ensuring financial stability by creating an early warning system that would trigger effective policy action is deeply flawed. Financial bubbles pose nasty dilemmas for policy. It is not possible in the early stages of a bubble to determine objectively that it poses serious systemic risks. Consequently, no agreement on policy action can be reached when it would still be feasible to deflate the bubble gently. By the time it is recognized as dangerous, any policy action will make it burst – and no one wants to be responsible for the crash. It was for this reason that former Federal Reserve chairman Alan Greenspan took the position (at one time shared by the present chairman, Ben Bernanke) that nothing should be done about suspected bubbles. If they happened, one could clean up after them – as the Greenspan Fed did rather successfully following the dot.com crash. Needless to say, this is no longer seen as a defensible position. The Systemic Risk Council is unlikely to do much good. It may not do much harm either unless responsible politicians and the general public come to believe that its creation has actually reduced the risk of future calamities. At this time, virtually nothing has been accomplished in this direction. If acting on early warnings of rising systemic risk is not a feasible stabilization strategy, what can be done? The answer is that the financial system has to be regulated so as to reduce its tendency to generate boom-and-bust cycles. Two issues have priority. One is how to lower the general level of leverage in the system and to reduce the cyclical amplitude of leverage movements. The other is what to do with the large complex and highly connected financial institutions that are too-big-to-fail. These issues have not been tackled on either side of the Atlantic.
Axel Leijonhufvud is professor emeritus at the University of California Los Angeles and professor at the University of Trento
http://www.eurointelligence.com/article.581+M5a1930101e5.0.html#
98 MARKETS. Insight Insight: A matter of retribution By Gillian Tett Published: September 3 2009 17:33 | Last updated: September 3 2009 17:33 How many financiers do you think ended up in jail after America’s Savings and Loans scandals? The answer can be found in a fascinating, old report from the US Department of Justice*. According to some of its records, between 1990 and 1995 no less than 1,852 S&L officials were prosecuted, and 1,072 placed behind bars. Another 2,558 bankers were also jailed, often for offenses which were S&L-linked too. Those are thought-provoking numbers. These days the Western world is reeling from another massive financial crisis, that eclipses the S&L debacle in terms of wealth destruction. Yet, thus far, very few prison terms have been handed out. For sure, there have been a few high-profile dramas. Bernie Madoff is one, obvious, example. But one reason why the Madoff drama has grabbed so much attention and already sparked a slew of books this month, is precisely because there are precious few other financiers behind bars, or facing momentous fines. Compared to the S&L days, the level of retribution so far seems almost non existent. Why? In part, it may be a matter of timing. The wheels of American justice often grind slowly, and many cases are now passing through the system. Navigant, a financial consultancy, for example, says that private investors have filed more suits against financial companies in the last two years than they did in the S&L days. And some are now seeing the light of day. Yesterday, an American judge rejected attempts to block a lawsuit lodged by Abu Dhabi Commercial Bank against Moody’s, Standard & Poor’s and Morgan Stanley – meaning that case, which involves structured notes, will soon get underway. Separately, federal investigators have opened inquiries into at least 25 companies, including Lehman, AIG, Fannie Mae, Freddie Mac and Wamu. Yet, in private many lawyers, and some government officials too, seem pretty cynical about just how many jail sentences or fines these initiatives will produce. In part that is because of the sheer complexity of the financial deals in the recent crisis, and the fact that these deals were often deliberately and cleverly constructed to “arbitrage” the law (ie skirt, but not break it). Another big issue is the sheer number of powerful parties that typically participated in complex finance deals. Few private law firms have the resources or desire to go head to head with numerous Wall Street banks at one time, particularly since the Supreme Court has made it harder to bring and win securities cases in the last couple of years. And government agencies are often short of resources too, partly because some, such as the FBI, have been forced to divert staff in recent years to terrorist financing issues.
99 However, another key problem is a lack of knowledge in Western courts about complex finance. That makes it time-consuming to hear cases. It also makes verdicts unpredictable. Some senior figures in the financial world are looking for solutions to this. Jeffrey Golden, a prominent lawyer who helped to create the modern derivatives world, for example, thinks there is an urgent need for a specialist, cross-border financial court (in much the same way, say, that there are specialist family or trade courts.) This, he argues, could be staffed by former derivatives experts and lawyers, since these not only understand finance but also have a vested interest in ensuring that their beloved derivatives business is built credible foundations. But there seems limited chance that Golden’s sensible suggestion will fly soon. Right now, in other words, the Western financial system is stuck with a legal structure that seems ill-equipped to cope. And that is worrying on several levels. On a personal level, I have little taste for seeing hordes of bankers heading for jail, or facing massive fines. Nor do I have any illusion that public or private prosecutions will resolve bigger structural flaws. A witch-hunt might be a media distraction. But, on the other hand, if there is no retribution against financiers, it will be very difficult to force a real change in behaviour. After all, no amount of twiddling with Basel rules or pious statements about bonuses will ever scare a financier as much as the thought of jail. Moreover, without some retribution it will also be hard to persuade voters that finance is really being reformed, or has any credibility or moral authority. That is bad for politicians and regulators. However, it is also bad for bankers too. So, in the months ahead, keep a close eye on what happens to the legal cases in the system and, above all, watch to see just how many do (or do not) quietly die, compared to those S&L days. *DoJ, Financial Institution Fraud special report, June 30 1995; cited in The Great Texas Savings and Loan Financial Debacle; By Tom S. King [email protected] Gillian Tett Insight: A matter of retribution September 3 2009 http://www.ft.com/cms/s/0/f197ed60-98a5-11de-aa1b-00144feabdc0.html http://www.cincodias.com/ El espejismo de los mercados 04/09/2009 Wall Street ha contemplado atónito cómo tres de las grandes compañías intervenidas por el Gobierno -la aseguradora AIG y las dos hipotecarias Fannie Mae y Freddy Mac- y principales causantes de la actual crisis han subido como la espuma en Bolsa. En 15 días, casi han duplicado su valor sin ningún motivo aparente. En el mercado se apunta que el causante del rebote no es otro que la entrada en acción de las plataformas de intermediación de alta frecuencia (high frequency trading), un negocio que domina el parqué neoyorquino y que genera jugosos beneficios. Se calcula que con estas operaciones se pueden ganar unos 21.000 millones de dólares al año. Algunos economistas ya han comenzado a criticar estas prácticas, a las que acusan de "destrozar el vínculo que existía entre los precios y los valores". http://www.cincodias.com/articulo/mercados/espejismo- mercados/20090904cdscdimer_1/cdsmer/
100
High frequency firms set to benefit from Euroclear fee cut By Jeremy Grant in London Published: September 4 2009 18:55 | Last updated: September 4 2009 18:55 High frequency trading firms are set to be among the main beneficiaries of a move by Euroclear, the post-trade service group, to cut its fees for users of the London Stock Exchange. However, many mid-tier traders on the exchange could find their post-trade costs going up as a result of the move, unveiled this week. Euroclear said on Wednesday it would in November cut a “netting fee” that is part of the overall clearing and settlement costs payable by traders using the LSE. The fee is charged by Euroclear for netting down trades at the end of the day. It comes on top of a clearing fee charged by LCH.Clearnet, the main clearer of trades done on the LSE. Traders using the LSE’s rivals, such as Chi-X Europe and other “multilateral trading facilities”, do not have to pay a netting fee since the clearing houses serving the MTFs carry out their own trade netting. Many users of the LSE have complained about the Euroclear netting fee, arguing that it adds to the overall cost of using the exchange, making it more expensive than using the MTFs. Euroclear said the average trade-netting fee would fall to 1.8p per trade, from 4.3p, with “most high volume clients paying 1p per transaction”. That represents a 58 per cent cut. Euroclear will also replace a long-standing discount scheme, where fee discounts are triggered once certain volume thresholds are met, with a standard monthly discount. Geoffrey Vander Linden, product manager at Euroclear in London, said: “Clearly, for large players like high frequency [traders] they will benefit. We know that their business is almost entirely based on volume growth activity. They don’t have any stock loans or settlement activity so it’s clearly a structure that benefits them.” High frequency trading firms that trade on the LSE include Chicago-based Getco, which has a London office, and Netherlands-based Optiver. Banks that are among the largest providers of orders to the LSE – such as Goldman Sachs, Credit Suisse, UBS and Nomura - will also benefit. Euroclear said that while the moves would clearly benefit large volume players, “some clients that do not increase their volumes could pay more”. But it added it believed the new fee structure was “an incentive for them to do more business with us”. Industry analysts say those likely to benefit most from the new Euroclear fee structure would have to be doing over 50,000 trades a day. The fee accounts for roughly half of total clearing and settlement costs for traders using the LSE, they said, assuming trading of up to 100,000 trades a day.
101 Under the new Euroclear scheme, this would fall to about 30 per cent. Mr Linden said the outgoing discount scheme was “quite complex, so that’s why we are trying to move away from it”. Euroclear said its new fee structure - which also affects trades done on the Irish Stock Exchange – would “improve transparency by charging separately for Mifid-related transaction reporting and UK and Irish stamp duty assessments for relevant trades”. Mifid is the Markets in Financial Instruments Directive, a European Commission directive that kick-started competition in European share trading in 2007. http://www.ft.com/cms/s/0/42068914-9973-11de-ab8c-00144feabdc0.html Investment News: Money Morning 14 Aug 2009 High Frequency Trading: Wall Street’s New Rent-Seeking Trick Martin Hutchinson Contributing Editor Money Morning Goldman Sachs Group Inc. (NYSE: GS) disclosed recently that it had 46 “$100 million trading days” in the second quarter of 2009. That was a record number, even for one of the biggest players on Wall Street. When the U.S. economy is facing collapse and merger and acquisition volume is way down, it seems odd that investment banks like Goldman had record quarters. Well, here’s the secret: They’ve found a new way to skim more of the cream off the top of U.S. economic activity. It’s called “High-Frequency Trading” (HFT). High-frequency trading uses the speed of supercomputers to trade faster than a human trader ever could. Human owners of the supercomputers program them to take advantage of information milliseconds faster than other computers, and whole seconds faster than ordinary human traders. This is not a minor development; HFTs now represent about 70% of the trading volume in the U.S. equity market. HFT computer servers are able to beat other computers because they are located at the exchanges. They take crucial advantage of the finite speed of light and switching systems to front-run the market. They also gain information on orders and market movements more quickly than the market as a whole. They operate not only on the New York Stock Exchange (NYSE), but also on the electronic trading exchanges such as the NYSE hybrid market. According to a paper “Toxic equity trading order flow on Wall Street” by the brokerage Themis Trading LLC, there are a number of different types of HFT. Liquidity rebate traders take advantage of volume rebates of about 0.25 cents per share offered by exchanges to brokers who post orders, providing liquidity to the market. When they spot a large order they fill parts of it, then re-offer the shares at the same price, collecting the exchange fee for providing liquidity to the market. Predatory algorithmic traders take advantage of the institutional computers that chop up large orders into many small ones. They make the institutional trader that wants to buy bid
102 up the price of shares by fooling its computer, placing small buy orders that they withdraw. Eventually the “predatory algo” shorts the stock at the higher price it has reached, making the institution pay up for its shares. Automated market makers “ping” stocks to identify large reserve book orders by issuing an order very quickly, then withdrawing it. By doing this, they obtain information on a large buyer’s limits. They use this to buy shares elsewhere and on-sell them to the institution. Program traders buy large numbers of stocks at the same time to fool institutional computers into triggering large orders. By doing this, they trigger sharp market moves. Finally, flash traders expose an order to only one exchange. They execute it only if it can be carried out on that exchange without going through the “best price” procedure intended to give sellers on all exchanges a chance at best price execution. The Securities and Exchange Commission (SEC) has now promised to ban this technique, and flash trading on the Nasdaq will stop on September 1. This toxic trading has caused volume to explode, especially in NYSE listed stocks. The number of quote changes has also exploded and short-term volatility has shot up. NYSE specialists now account for only around 25% of trading volume, instead of 80% as in the past. The bottom line for us ordinary market participants is that insiders are using computers to game the system, extracting billions of dollars from the rest of the market. While it is illegal to trade on insider knowledge about company financials, these people are trading on insider knowledge about market order flow. That’s how Goldman Sachs and the other biggest houses make so much from trading. By doing so they are rent-seeking, not providing value to the market. There are two ways to stop this: Ideally, the SEC will employ both. First, they can introduce a rule that all orders must be exposed for a full second. That will reduce the volume of HFT, but still doesn’t truly protect non-computerized outsiders. The second, and better, solution is to introduce a small “Tobin tax” on all share transactions. It could be tiny; maybe 0.1 cents per share. (The SEC would also need to ban “exchange rebates” to traders.) Such a tax would make the worst HFT types unprofitable without imposing significant costs on retail investors. It would also provide funds to help run the vast apparatus of regulation and control that seems to be necessary to run a modern financial system. Goldman Sachs, and other financial institutions of its ilk, have imposed huge costs on the U.S. public with their “too big to fail” status. Now they are adding to the problem by scooping out money from the stock market through HFT. It’s about time the government imposed some taxes to stop the worst of these scams and recover the public some of its money. http://www.moneymorning.com/2009/08/14/high-frequency-trading/
103
FSA launches a review of 'dark pools' and high- speed trading By Jeremy Grant in London Published: August 4 2009 03:00 | Last updated: August 4 2009 03:00 The City watchdog has launched a wide-ranging review of UK equity markets that will cover the controversial investing strategy of high-frequency trading and the use of alternative trading platforms, it emerged yesterday. The move by the Financial Services Authority, which follows similar steps by US regulators, comes amid growing questions about how the rise of sophisticated electronic trading in recent years may be affecting investors. The FSA study will also look at so-called "dark pools", a type of trading facility that allows large blocks of shares to be traded, the prices of which are not posted publicly until after trades are completed. The US Securities and Exchange Commission is also looking at whether any regulatory action is necessary for dark pools, given questions over their alleged lack of transparency. High-frequency trading, which is now believed to account for about half of daily dealing volume in the US, is done by traders with sophisticated computer programs that allow the rapid-fire purchase and sale of shares. The UK study is being conducted by FSA staff and Henry Knapman, a 15-year veteran of trading and equity market structures at UBS, the Swiss-based bank. Mr Knapman is on a year-long secondment to the FSA ending in March next year. He has spent the past month meeting about 10 asset managers and hedge funds to discuss whether changes to the way equity markets function in recent years have been beneficial or not. It is unclear what will emerge from the FSA review. The authority said yesterday: "We are talking to people in the market about market structure. It's not an investigation as such, it's just using market contacts to find out what's going on." The study is not expected to result in a formal report. "It's information-gathering," a spokesman said. Niki Beattie, a former Merrill Lynch trading expert and now managing director of The Market Structure Practice, a consultancy, said: "I think it's a pertinent time to start looking at this with things like high frequency trading emerging as an issue." London Stock ExchangeDeutsche Börse Euronext Separately yesterday, the Serious Fraud Office confirmed it has been investigating whether the failure of certain financial institutions in the US as a result of credit default swap trades, could provide any guidance for future fraud probes.
104
Michael Mackenzie, Joanna Chung and Aline van Duyn SEC to review ‘flash’ orders July 26 2009 By Michael Mackenzie, Joanna Chung and Aline van Duyn in New York Published: July 26 2009 20:30 | Last updated: July 28 2009 00:12 The Securities and Exchange Commission on Monday said it was examining “flash” orders – trades made at lightning speeds on electronic systems – after calls by a US senator to ban the practice. Officials are currently conducting a review that includes looking into flash orders by exchanges and automatic trading systems that disseminate information to select market participants, ‘’potentially disadvantaging investors,’’ said a SEC spokesman. The SEC staff is “specifically examining flash orders to ensure best execution and fair access to information for all investors,” he said. The practice of flashing orders across electronic platforms helps providers of market liquidity, many of whom are high-frequency traders with powerful computer systems, to attract “buy” and “sell” orders from investors. But critics, notably Charles Schumer, a senior Democrat on the Senate banking panel, contend that flash orders are not being shown to all investors at the same time, creating a two-tier market. This, they say, favours traders with faster and more powerful trading systems. The New York senator has called for a clampdown on how equity prices are displayed to investors on electronic systems. He sent a letter late last week to the SEC requesting that it curb the use of flash orders by Nasdaq OMX and the trading platforms Direct Edge and BATS. If the regulator fails to act, Mr Schumer said he planned to introduce legislation in the Senate seeking to prohibit the use of flash orders. Flash orders have come under increasing scrutiny recently as US securities regulators look for ways to regulate “dark pools”. These anonymous electronic trading venues, which do not display public quotes for stocks, have flourished in recent years. Last month, Mary Shapiro, the chairman of the SEC, raised concerns about the growth of dark pools. On Monday, Nasdaq OMX, which allows flash orders, wrote to Ms Schapiro, urging her to review the broader practices which now dominate equity markets. Exchanges like Nasdaq have lost market share to electronic rivals, including some which operate dark pools. Flash orders are but one symptom of the current evolving market structure,” wrote Bob Greifeld, chief executive of Nasdaq, in a letter. ”We have a unique opportunity at this time to take a hard look at dark order types and the underlying market structure issues that do not support public price formation. These include flash orders, internalised orders, enhanced liquidity providers, Block Talk orders and dark pools.” But calls to ban flash orders have met resistance from Direct Edge, a leading market provider. William O’Brien, chief executive of Direct Edge, said: “If these types of programs are banned, it will drive liquidity away from exchanges and perpetuate a two-tier
105 market.” The Direct Edge system was available to any brokerage that wished to participate, he said. BATS also said any trading firm could submit flash orders with its system and it was “ready to participate in an industry review of potential issues associated with them, including the possibility that they create a two-tier market”. NYSE Euronext does not allow flash orders and wants the practice stopped. “We are waiting to see how the regulatory landscape develops,” said Joe Mecane, NYSE Euronext’s chief administrative officer for US equities markets. “We have been vocal about our opposition to flashing orders.” In Europe, high-frequency trading firms have yet to attract the same level of regulatory attention as in the US. But they have been attracted to the region as a handful of new trading platforms, offering ultra-fast electronic trading, has sprung up in the wake of the Mifid reforms passed by the European Commission two years ago. The platforms, including Chi-X Europe, Turquoise and a European arm of BATS, also offer rebates to the firms to encourage them to post orders, making them the platforms’ largest customers. However doubts about the value of high-frequency firms have emrged at the London Stock Exchange, which this month abandoned similar rebates amid concern that it was alienating its biggest customers, the large banks that channel orders from so-called buy-side asset managers and pension funds. Michael Mackenzie, Joanna Chung and Aline van Duyn SEC to review ‘flash’ orders July 26 2009 http://www.ft.com/cms/s/0/039fc8f6-7a11-11de-b86f-00144feabdc0.html
106 Business
July 24, 2009 Stock Traders Find Speed Pays, in Milliseconds By CHARLES DUHIGG
It is the hot new thing on Wall Street, a way for a handful of traders to master the stock market, peek at investors’ orders and, critics say, even subtly manipulate share prices. It is called high-frequency trading — and it is suddenly one of the most talked-about and mysterious forces in the markets. Powerful computers, some housed right next to the machines that drive marketplaces like the New York Stock Exchange, enable high-frequency traders to transmit millions of orders at lightning speed and, their detractors contend, reap billions at everyone else’s expense. These systems are so fast they can outsmart or outrun other investors, humans and computers alike. And after growing in the shadows for years, they are generating lots of talk. Nearly everyone on Wall Street is wondering how hedge funds and large banks like Goldman Sachs are making so much money so soon after the financial system nearly collapsed. High-frequency trading is one answer. And when a former Goldman Sachs programmer was accused this month of stealing secret computer codes — software that a federal prosecutor said could “manipulate markets in
107 unfair ways” — it only added to the mystery. Goldman acknowledges that it profits from high-frequency trading, but disputes that it has an unfair advantage. Yet high-frequency specialists clearly have an edge over typical traders, let alone ordinary investors. The Securities and Exchange Commission says it is examining certain aspects of the strategy. “This is where all the money is getting made,” said William H. Donaldson, former chairman and chief executive of the New York Stock Exchange and today an adviser to a big hedge fund. “If an individual investor doesn’t have the means to keep up, they’re at a huge disadvantage.” For most of Wall Street’s history, stock trading was fairly straightforward: buyers and sellers gathered on exchange floors and dickered until they struck a deal. Then, in 1998, the Securities and Exchange Commission authorized electronic exchanges to compete with marketplaces like the New York Stock Exchange. The intent was to open markets to anyone with a desktop computer and a fresh idea. But as new marketplaces have emerged, PCs have been unable to compete with Wall Street’s computers. Powerful algorithms — “algos,” in industry parlance — execute millions of orders a second and scan dozens of public and private marketplaces simultaneously. They can spot trends before other investors can blink, changing orders and strategies within milliseconds. High-frequency traders often confound other investors by issuing and then canceling orders almost simultaneously. Loopholes in market rules give high-speed investors an early glance at how others are trading. And their computers can essentially bully slower investors into giving up profits — and then disappear before anyone even knows they were there. High-frequency traders also benefit from competition among the various exchanges, which pay small fees that are often collected by the biggest and most active traders — typically a quarter of a cent per share to whoever arrives first. Those small payments, spread over millions of shares, help high-speed investors profit simply by trading enormous numbers of shares, even if they buy or sell at a modest loss. “It’s become a technological arms race, and what separates winners and losers is how fast they can move,” said Joseph M. Mecane of NYSE Euronext, which operates the New York Stock Exchange. “Markets need liquidity, and high-frequency traders provide opportunities for other investors to buy and sell.” The rise of high-frequency trading helps explain why activity on the nation’s stock exchanges has exploded. Average daily volume has soared by 164 percent since 2005, according to data from NYSE. Although precise figures are elusive, stock exchanges say that a handful of high-frequency traders now account for a more than half of all trades. To understand this high-speed world, consider what happened when slow-moving traders went up against high-frequency robots earlier this month, and ended up handing spoils to lightning-fast computers. It was July 15, and Intel, the computer chip giant, had reporting robust earnings the night before. Some investors, smelling opportunity, set out to buy shares in the semiconductor company Broadcom. (Their activities were described by an investor at a major Wall Street firm who spoke on the condition of anonymity to protect his job.) The slower traders faced a quandary: If they sought to buy a large number of shares at once, they would tip their hand and risk driving up Broadcom’s price. So, as is often the case on Wall Street, they divided
108 their orders into dozens of small batches, hoping to cover their tracks. One second after the market opened, shares of Broadcom started changing hands at $26.20. The slower traders began issuing buy orders. But rather than being shown to all potential sellers at the same time, some of those orders were most likely routed to a collection of high-frequency traders for just 30 milliseconds — 0.03 seconds — in what are known as flash orders. While markets are supposed to ensure transparency by showing orders to everyone simultaneously, a loophole in regulations allows marketplaces like Nasdaq to show traders some orders ahead of everyone else in exchange for a fee. In less than half a second, high-frequency traders gained a valuable insight: the hunger for Broadcom was growing. Their computers began buying up Broadcom shares and then reselling them to the slower investors at higher prices. The overall price of Broadcom began to rise. Soon, thousands of orders began flooding the markets as high-frequency software went into high gear. Automatic programs began issuing and canceling tiny orders within milliseconds to determine how much the slower traders were willing to pay. The high-frequency computers quickly determined that some investors’ upper limit was $26.40. The price shot to $26.39, and high-frequency programs began offering to sell hundreds of thousands of shares. The result is that the slower-moving investors paid $1.4 million for about 56,000 shares, or $7,800 more than if they had been able to move as quickly as the high-frequency traders. Multiply such trades across thousands of stocks a day, and the profits are substantial. High- frequency traders generated about $21 billion in profits last year, the Tabb Group, a research firm, estimates. “You want to encourage innovation, and you want to reward companies that have invested in technology and ideas that make the markets more efficient,” said Andrew M. Brooks, head of United States equity trading at T. Rowe Price, a mutual fund and investment company that often competes with and uses high-frequency techniques. “But we’re moving toward a two-tiered marketplace of the high-frequency arbitrage guys, and everyone else. People want to know they have a legitimate shot at getting a fair deal. Otherwise, the markets lose their integrity.” CHARLES DUHIGG Stock Traders Find Speed Pays, in Milliseconds July 24, 2009 http://www.nytimes.com/2009/07/24/business/24trading.html?em Market Manipulation FRIDAY, JULY 24, 2009 This article from the New York Times does a nice job of giving an example of how high- speed trading algorithms can front run markets. It helps to explain why traders who only buy or sell after strength or weakness has been manifested are often the ones buying the high tick or selling the low one.
It seems to me that some of the traders who are most vulnerable to these machinations are very active traders (including prop houses) who frequently bid and offer for stocks. The algorithms are reading the order book ahead of others, which tips the hand of these traders.
Because the high-speed algos are buying and selling quickly as a rule, their effects on the markets longer-term are unclear. A stock may still travel from point A to point B, but the computers will affect the path from A to B. This may help explain why traders I work
109 with who are more selective in their intraday trades and who tend to hold for longer intraday swings on average have been doing better than very active daytraders. When up to half of all stock market volume consists of these algorithmic trades, one has to wonder about the edge of very active traders. Interestingly, those that are successful may be trading new patterns that have emerged since the onslaught of the high-frequency computers. My hunch is that these new patterns would involve a keen reading of order flow, catching the shift in the bidding/offering and the location (bid/offer) of transactions in real time. http://traderfeed.blogspot.com/2009/07/thoughts-on-high-frequency-trading-and.html
110
The G20 can lead the way to balanced growth By Lee Myung-bak and Kevin Rudd Published: September 3 2009 03:00 | Last updated: September 3 2009 03:00 Confronted by a financial and economic shock unmatched in the postwar era, leaders of the Group of 20 have been united in their commitment to take all necessary action to restore global growth. To date, the fiscal, monetary and financial policy response across the G20 countries has been unprecedented - amounting to the largest global stimulus the world has seen. Signs of renewed stability in global financial markets confirm that the G20 policy measures put in to place are working. China, South Korea and other Asian countries are leading the way, while in June France, Japan and Germany recorded their first quarter of growth since early 2008. While such positive news has helped restore confidence, a global recovery is not assured. This is no time to be complacent. The world faces several new challenges that will require leadership from the G20. The first is to follow through on existing commitments. In many countries, much of the announced fiscal stimulus is yet to be delivered. There is more work to do to implement G20 commitments to reform financial systems, modernise and resource the international financial institutions and support developing countries. The second global economic challenge is to manage the transition from crisis to recovery. While the extraordinary fiscal, monetary and financial policies implemented during the crisis have been necessary to support growth, governments will be required to execute a significant shift in policy settings as growth gradually returns or risk further damage to fiscal positions and a return of inflation. In the late 1930s, exit strategies were poorly managed, with fiscal and monetary policies undermining recovery and leading to a double-dip recession in many countries. This time it is important that we get it right. Unwinding the policies of the crisis will involve complex challenges of timing, co- ordination and credibility. The G20 needs to lead the process of communicating a transparent and clear way forward on the unwinding of fiscal, monetary and financial interventions, including bank guarantees. It can also play a role by facilitating international agreements on shared principles and implementing a global monitoring and "peer review" process. The transition towards more balanced global growth is the third major challenge. Meeting it will require both co-operation and flexibility from the G20. Flexibility, because each country will have its own national trajectory towards sustainable growth. Co-operation, because the crisis has taught us that national macroeconomic strategies developed in isolation can lead to dangerous imbalances. Developing a flexible framework for co-ordinated macroeconomic policy will be a central challenge for the G20. The Pittsburgh summit later this month is an opportunity for G20
111 leaders to launch a process to guide the global transition. At Pittsburgh, G20 leaders should agree to a three-stage process. First, national governments should develop their own national strategies for recovery. Second, they should agree to deliver these strategies to the International Monetary Fund before the end of the year and ask the IMF to report back on their consistency with balanced and sustained global growth. Third, G20 leaders should meet again in 2010 (when South Korea is the chair of the G20) to agree their responsibilities and actions to achieve this goal within the framework of post-crisis global economic management. This process should be consistent with, and an important input to, the development of a global framework of principles such as the current proposal from Germany for a charter for sustainable economic activity. It would also recognise that there is no one-size-fits-all approach. Each country must find its own development strategy tailored to its unique economic circumstances. But these strategies must be consistent and together they must be compatible with balanced global growth. Australia and South Korea are committed to work together and with other countries to develop and implement effective strategies at Pittsburgh and beyond to ensure that the recovery is sustained and economic and financial stability are maintained. As open and dynamic economies, we know that our own prosperity depends on strong global economic growth and stability. Lee Myung-bak is president of South Korea ; Kevin Rudd is prime minister of Australia Lee Myung-bak and Kevin Rudd The G20 can lead the way to balanced growth September 3 2009 http://www.ft.com/cms/s/0/fb1bf220-9821-11de-8d3d-00144feabdc0.html
112
Lamy fears spillover between climate and trade talks By James Lamont in New Delhi Published: September 3 2009 23:41 | Last updated: September 3 2009 23:41 Failure to find agreement at United Nations climate change talks in Copenhagen in December would threaten a much needed overhaul of the international trading system, Pascal Lamy, head of the World Trade Organisation, warned on Thursday. His comments highlighted concerns that a breakdown in discussions about reducing greenhouse gas emissions may spill into the trade arena – with devastating effect, as some countries seek to exclude goods from high emitters. India has already protested to Hillary Clinton, the US secretary of state, about the threat of carbon tariffs from environmental legislation proposed by the Obama administration. Speaking as trade ministers from 39 countries met in New Delhi to progress the WTO’s Doha round, Mr Lamy cautioned against adopting trade measures to force changes in environmental behaviour. “I sincerely hope that [agreement] will happen in Copenhagen. If it doesn’t happen, our job at the WTO will become more difficult,” Mr Lamy told the Financial Times. “Go-it-alone measures will not achieve the desired results. Relying on trade measures to fix global environmental problems will not work.” He said world leaders, who meet at the Group of 20 in Pittsburgh, US, later this month, had to prioritise agreement on tackling climate change, ahead of discussion of how trade policy might be used to deepen environmental protection. “I am of the firm conviction that the relationship between international trade and climate change would be best defined as a follow- up to a consensual international accord on climate change that successfully embraces all major polluters,” Mr Lamy said. Some developing countries have expressed concerns about environmentally linked tariffs on imports by developed nations, as the pressure to cut greenhouse gases intensifies. They claim such tariffs are in effect protectionist measures. The American Clean Energy and Security Act, passed by the House of Representatives in June, has fuelled concerns among developing countries that it may lead to punitive US border adjustment mechanisms, shutting out trade. At a time when the developed world is trying to persuade growing economies like China and India to agree greenhouse gas emissions cuts, some climate change experts say threats to resort to trade measures are “dangerous”. “The discussion of trade and climate is already out there,” said one expert. “That is a big risk for Copenhagen. Counter-measures are not a helpful dynamic. We have got to talk collaboratively.” Trade negotiators are hoping that a successful conclusion of this week’s meeting in New Delhi will help put the revival of the stalled Doha round firmly on the agenda of the G20
113 meeting in Pittsburgh. Many view a trade deal as an economic stimulus to help the global economy recover from its downturn. However, Mr Lamy said world leaders had to find the political will to embrace tougher global financial regulation to prevent a repeat of last year’s banking crisis and prepare the ground for the Copenhagen talks on climate change. Anand Sharma, India’s commerce minister, on Thursday played down the prospect of a swift conclusion of the Doha round in spite of calls by some of his counterparts to home in on a few outstanding issues. “Let’s be frank in acknowledging that even the unequivocal expression of political resolve has not been translated into action...... It has been suggested that most issues have been settled almost in ‘end-game’. However, it would be apparent that there are still a few gaps and a large number of unresolved issues.” http://www.ft.com/cms/s/0/8e32f0ba-98a7-11de-aa1b-00144feabdc0.html
114
01.09.2009 Mark-to-Make Believe – Part 1: No Accounting for the Credit Crisis! By: Satyajit Das
In 2007, as the credit crisis commenced, paradoxically, nobody actually defaulted. Outside of sub-prime delinquencies, corporate defaults were at a record low. Instead, investors in high quality (AAA or AA) rated securities, that are unlikely to suffer real losses if held to maturity, faced paper - mark-to-market (“MtM”) - losses. In modern financial markets, market values drive asset values, profits and losses, risk calculations and the value of collateral supporting loans. Accounting standards, both in the U.S.A. and internationally, are now based on theoretically sound market values that are problematic in practice. The standards emerged from the past financial crisis where the use of “historic cost” accounting meant that losses on loans remained undisclosed because they continued to be carried at face value. The standards also reflect the fact that many modern financial instruments (such as derivatives) can only be accounted for in MtM framework. MtM accounting itself is flawed. There are difficulties in establishing real values of many instruments. It creates volatility in earnings attributable to inefficiencies in markets rather than real changes in financial position. Alan Greenspan once noted that: “It has been my experience that competency in mathematics, both in numerical manipulations and in understanding its conceptual foundations, enhances a person's ability to handle the more ambiguous and qualitative relationships that dominate our day-to-day financial decision-making.” He may be the only one qualified to understand modern financial statements. MtM accounting falls well short of its objective - the provision of accurate, reasonably objective and meaningful information about financial position. In the present crisis, it has heightened uncertainty and confusion about the position of banks and investors.
115
MtM accounting requires financial instruments to be valued at current market prices. This assumes a market and a price. As Michael Milken (the progenitor of “junk bonds” at Drexel Burnham Lambert) once noted: “Liquidity is an illusion. It is always there when you don’t need it and rarely there when you do.” Mark-to-Market & Its Discontents In volatile times, liquidity becomes concentrated in government bonds, large well known stocks and listed derivatives. For anything that is not liquid, MtM means mark- to-model. This assumes universally accepted pricing methodologies with verifiable inputs. Valuation for all but the simplest instruments today requires a higher degree in a quantitative discipline, a super computer and a vivid imagination. For complex structured securities and exotic derivatives, the only available price is from the bank that originally sold the security to the investor. Prices available from the purveyor of the instrument (a concept known as mark-to-myself) strain reasonable concepts of independence and objectivity.
A current market price of 85% for a AAA security does not actually mean that you will lose 15% of the face value. It is only an estimate of likely losses. It may reflect the opportunity loss of being able to invest in the same or similar security at the time of valuation. In volatile markets, excessive uncertainty or risk aversion means that values deviate significantly from actually cash values.
MtM prices may be prone to manipulation. An often neglected element of the Enron scandal was the company’s ability to convince its auditors and the U.S. Securities and Exchange Commission (“SEC’) to allow MtM accounting to be used in the natural gas industry allowing the company to record current earnings based on the future value of long term contracts.
In dealings with hedge funds and structured investment vehicles (“SIVs”), banks have an incentive to mark positions at high prices thereby preventing complex and illiquid securities being sold at a discount and pushing down prices in the market. If these securities actually traded then the lower market price would have to be used to value positions increasing losses and margin calls on already cash strapped investors.
A lower price can be used to force margin calls and selling that may allow a dealer to buy the assets cheaply. Long Term Capital Management (“LTCM”) believed that the dealers brought about their downfall by moving the market values against their positions. In the current credit crisis, at one time markets resorted to barter – you exchange what you want to sell for something else – to avoid recording low prices for securities.
MtM prices, no matter how dubious, drive real investment and credit decisions. Holders of AAA rated securities may be forced to sell securities showing losses because MtM losses reach “stop loss” levels. Where investors have borrowed against these securities,
116 the falling MtM value supporting the borrowing means finding money to top up the collateral or selling the securities thus realizing the loss. In the case of SIVs, the MtM losses trigger breaches of tests that require selling securities to liquidate the structure.
MtM values are used to establish current portfolio values and allow investors to invest or withdraw funds. Errors in pricing lead to transfers in wealth between incoming and outgoing investors; for example, a low value punishes a redeeming investor but rewards the new investor. In 2007, difficulties in establishing MtM values caused some funds to suspend redemptions. Sound investments may be sold off to prevent further losses or realize earnings to cover other losses even where the market does not fairly value the asset penalizing investors. In the global financial crisis, with the capital markets virtually frozen, the extent of losses on bank inventories of hard-to-value products and commitments (structured debt and leveraged loans) was difficult to establish. Three Levels of Enlightenment Financial Accounting Standard Board (“FASB”) Standard 157 (“FAS157”), which became effective for fiscal years after November 2007, is designed to provide “clarity” to the issue of fair valuation of assets and liabilities. The centerpiece of FAS157 is the three level hierarchy of valuation (better referred to as the “three levels of enlightenment”). The Fair Value Hierarchy prioritizes the valuation inputs used to determine fair value into: · Level 1 – this requires observable inputs that reflect quoted prices for identical assets or liabilities in active markets and assumes that the entity can access the markets at the measurement date (known as Mark-To-Market). In practice, this means a liquid asset or instrument that is actively traded; for example, where two-way prices are readily available. · Level 2 – this requires inputs other than quoted market prices included within Level 1 that are observable either directly or indirectly (known as Mark-To-Model). In practice, this means instruments that cannot be priced based on trade prices but are valued using observable inputs; for example, comparable assets or instruments or using interest rates/ curves, volatility, correlation, credit spreads etc that can be put through an accepted model to establish values. · Level 3 – this relates to unobservable inputs reflecting the reporting entity's own assumptions used in pricing an asset or liability (known as Mark-To-Make Believe or Mark-to-Myself). In practice, this means that the asset or liability cannot be priced using observable inputs and requires the use of modeling techniques and substantially subjective assumptions. FAS157 valuations should be based on the exit price (the price at which it would be sold) regardless of whether the entity plans to hold or sell the asset. FAS157 emphasises that fair value is market-based rather than entity-specific. FAS157's fair value hierarchy ranks the quality and reliability of information used to determine fair values - market prices are regarded as reliable valuation inputs, whereas model values that include unobservable inputs are regarded less reliable. The lowest level of significant input drives placement in the hierarchy and the level within the
117 hierarchy drives financial statement disclosures. The objectives of FAS157 are laudable and unobjectionable. Unfortunately, the standard provides significant discretion to companies in determining the values of assets and liabilities, although detailed disclosure is required. It also may create significant uncertainty in the values of assets and liabilities and financial condition of the reporting entity. This is especially true of Level 3 assets. It is also relevant to the valuation of Level 2 assets. The problem is compounded by the fact that many major global financial institutions have increased their holdings of Level 3 assets in recent years. Major areas of valuation concern include: · Structured finance securities such securitised mortgages including subprime mortgages, securitised credit card obligations, asset backed commercial paper and collateralised debt obligations (“CDOs”). · Leveraged and private equity loans. · Distressed debt. · Principal investments by financial institutions in private equity, unlisted securities or physical assets for which there are no true market. · Complex derivative contracts including exotic options, structured products and credit default swaps. Exhibit 1 summaries of the holdings of Level 3 assets amongst major financial U.S. institutions as at the end of 2007 and 2008: Exhibit 1 Analysis of Level 3 Assets 2007
CitiGroup JP Goldman Merrill Morgan Lehman Morgan Sachs Lynch Stanley Brothers
Total Assets (U.S.$ bn) 2,167.63 1,562.15 1,119.98 1,020.05 1,045.41 691.06
Level 2 Assets 933.64 1,093.06 573.63 768.07 225.92 176.66 (U.S.$ bn)
Level 3 Assets 133.44 71.29 54.72 41.45 73.65 41.98 (U.S.$ bn)
Total Capital (U.S.$ 134.12 132.24 42.80 31.93 31.93 22.49 bn)
Level 3/ Total 6% 5% 5% 4% 7% 6% Assets
Level 3/ Total 99% 54% 128% 130% 231% 187% Capital
118 % Change in Level 101% 185% 78% 77% 43% 54% 3 Assets Needed to Eliminate Capital
% Change in Level 13% 11% 7% 4% 11% 10% 2 & 3 Assets Needed to Eliminate Capital
2008
BA CitiGroup JP Goldman Morgan Morgan Sachs Stanley
Total Assets (U.S.$ bn) 1817.94 1,938.00 2,175.05 884.55 658.81
Level 2 Assets (U.S.$ 1906.99 1,444.12 2,933.92 584.86 235.33 bn)
Level 3 Assets (U.S.$ 59.41 145.95 109.09 59.57 85.94 bn)
Total Capital (U.S.$ 177.05 142.00 166.88 64.37 50.83 bn)
Level 3/ Total Assets 3% 8% 5% 7% 13%
Level 3/ Total Capital 34% 103% 65% 93% 169%
% Change in Level 3 298% 97% 153% 108% 59% Assets Needed to Eliminate Capital
% Change in Level 2 9% 9% 5% 10% 16% & 3 Assets Needed to Eliminate Capital
Notes: All data is as at end 2007 and 2008 and based on published financial statements. The key issue is that a relatively small change in the values of these Level 3 assets has the potential to reduce the capital base of the entity significantly. The valuation of Level 2 assets may be more problematic than generally assumed especially under condition of market stress. This reflects the impact of model risk and lack of disclosure of the instruments treated as Level 2. Importantly, if market conditions deteriorate then some of these assets classified as Level 2 may need to be reassessed and treated as Level 3 assets.
It is not clear where in the Fair Value Hierarchy specific instruments are currently being
119 valued. The correlation between disclosed bank write-offs and Level 3 assets is imperfect. This may be because individual institutions are classifying assets within the three level hierarchy using different criteria. It may also mean that there is actually no correlation between the classification and “real” losses. The lack of correlation may also reflect behavior, such as new chief executives wishing to write-off assets to be able to “blame” previous management. The potential subjectivity in valuation of some of these securities can be illustrated. Exhibit 2 sets out the substantial differences in valuations. In fairness, CDO structures display significant heterogeneity and it is difficult to know if the quoted prices are fair or the proportion of the difference that is due to difference in product or structure or problems in valuation. Lack of detailed disclosure about valuations compounds the uncertainty. Exhibit 2 Values (%) of CDO Super Senior Tranches
Underlying High grade Mezzanine CDO squared Collateral
Minimum
Range 20.05 55.10 34.74
Maximum 84.00 80.14 57.77
Source: Bank of England (April 2008) Financial Stability Report No.23 at page 9 Level 3 securities and derivatives cannot be valued using observable prices in liquid public markets. Market values must be based on models and estimates. Where losses are reduced (substantially) by MtM “hedging” gains, the exact nature of the hedges is not disclosed. Some banks and hedge funds have indicated that some losses resulted from hedges that did not function as intended. The hedge counterparty is undisclosed. As the gains are unrealized, if the counterparty (a thinly capitalized hedge fund) is unable to perform, then the hedge gains would be illusory. The lack of disclosure around the value of the hedges, their nature and hedge counterparties makes it difficult to gauge whether they are truly effective in reducing losses. Being downgraded is now good for you! There are other oddities in current MtM accounting, such as the fair valuation of an entity’s own liabilities. FAS157 and Statement 159 (“Fair Value Option for Financial Assets and Financial Liabilities” issued in February 2007 by the FASB) allows the entity's own credit risk to be used in establishing the value of its liabilities.
120 Changes in the entity's credit standing are therefore reflected as changes in fair value. This results in gains for credit downgrades and losses for credit upgrades. For example, if a bank has $100 million of bonds that are subject to mark-to-market accounting and the market price drops to $80 (80%) then, it records a “gain”. As credit spreads increased, U.S. banks have taken substantial profits to earnings from revaluing their own liabilities. These MtM profits on liabilities have helped banks offset recent write-downs. But the revaluation of a bank’s liabilities is problematic. The face value of the liability must still be repaid. The gain from a higher credit spread is unlikely to result in cash profits. It is only if the entity can re-purchase its debt that the “theoretical” gain can be realised. The Federal Reserve, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency and Office of Thrift Supervision objected to Statement 159 prior to its passage. They argued that would the MtM of a bank’s liabilities in this way would “have the contrary effect” of increasing a bank’s net worth at the same time its “financial condition is deteriorating.” The revaluation of a bank’s liabilities may also create volatility of earnings. Major financial institutions have recently been forced to issue substantial amounts of debt to finance “involuntary asset growth” as assets returned onto their balance sheets. This debt has been issued at relatively high credit spreads reflecting current debt market conditions. This means that if the market conditions improve, these institutions may record the mark-to-market losses on their liabilities even as their credit condition improves. The International Accounting Standards Board (“IASB”) is understood to be considering the issue. Under proposals being considered, gains on falls in the value of an issuer’s own debt my no longer be allowed to be recognised. This would remove one of the most controversial elements of MtM accounting. © 2009 Satyajit Das All Rights reserved. Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
http://www.eurointelligence.com/article.581+M5130f769dce.0.html#
121
04.09.2009 Mark-to-Make Believe – Part 2: Marking Time By: Satyajit Das
Marking MtM to Market Proponents of MtM argue that basing values on current prices provides an accurate picture of a firm’s financial position. In particular, it is superior to the alternative – historical cost accounting – where assets and liabilities are valued at the price at the time the transaction was entered into. Recent research[1] indicates that MtM accounting may, in fact, distort the price of assets. Under historical accounting, if the market value of a bank’s loans increase above historical cost, then there is an incentive for management (who are judged on current profits) to sell the loans. This allows the profit to be realised irrespective of whether the market values the asset accurately. The sale is in the interest of the managers but not necessarily of the shareholders that may be better off if the loans were not sold (especially if the market value is below the “true” economic value of the asset). Under MtM accounting, in theory, the loans do not have to be sold as marking the assets to market value enables the gain to be realised. In a falling market, this process works perversely resulting in the uneconomic sale of long- term, illiquid assets. If observed market prices are low (below perceived value) due to lack of liquidity then firms may try to sell assets to try to establish higher observed prices. If all firms behave in this way, the resultant selling may drive prices down. This penalises shareholders that would have benefitted from the assets being held as in the absence of default they would receive face value rather than the (lower) market price. The research highlights that MtM accounting is pro-cyclical and creates volatility of asset values through complex positive and negative feedback loops. Under normal market conditions where asset markets are liquid, MtM accounting works benignly. In volatile markets, where behaviour becomes linked by a common factor such as disclosure required by MtM accounting, co-ordinated actions of market participants can easily lead to sharp movements in asset prices. The process distorts market prices and ultimately the firm’s
122 financial position and value. The effects of MtM accounting illustrate a fundamental economic principle where eliminating one market imperfection (poor information) magnifies other imperfection (illiquid markets). In the current crisis, MtM accounting has exacerbated uncertainty. Banks have constantly misjudged values of assets. This uncertainty has been destabilising to market confidence. The new accounting framework has actually been an impediment to dealing with the problem. In a pre-MtM environment, banks may have responded to the deterioration in asset quality by writing exposures to conservative values to remove uncertainty. This would then have allowed them to re-capitalise to an adequate level to restore confidence. In a MtM environment, there is less flexibility. Firms have been forced to mark assets to unreliable market prices causing them to progressively follow the market down. This has resulted in a “drip feed” of losses and a succession of capital raising measure that have increased uncertainty. Robert Kaplan, Robert Merton and Scott Richard writing in the Financial Times (17 August 2009)[2] asserted that: “Financial assets, even complex pools of assets, trade continuously in markets.” This would have been news to those in the real world that struggle daily to get meaningful prices for many securities and assets. The learned Professors, without a hint of irony or humour, went on to advocate the use of models for valuation: “Mutual funds in the US now use models, rather than the last traded price, to provide estimates of the fair values of their assets that trade in overseas markets. … In this way, the funds ensure that their shareholders do not trade at biased net asset values calculated from stale prices. Banks can similarly use models to update the prices that would be paid for various assets. Trading desks in financial institutions have models that allow them to predict prices to within 5 per cent of what would be offered for even their complex asset pools.” Sadly, many of the lessons of the current financial crisis for MtM accounting seem to be lost on some. Marking Time The emerging problems of MtM accounting have led to proposals for change. Accountants were stung by the criticism of the standards. One structured finance accountant noted that: "It's the market that needs to change, not the accounting." Officials and commentators have called for the accounting standards to be suspended with firms being allowed to revert to historic values adjusted for expected impairment. It seemed that MtM was acceptable when there were “gains”. However, everybody should be allowed to revert to historical or “adjusted” model prices when there were “losses”. Paul Craig Roberts, a former Reagan administration official, wrote that the mark-to-market rule "is imploding the U.S. financial system by requiring financial institutions to value subprime mortgages at their current market values." He proposed that financial institutions be allowed to “keep the troubled instruments at book value, or 85-90 percent of book value, until a market forms that can sort out values, and allow financial institutions to write down the subprime mortgages and other troubled instruments over time." Steve Forbes from Forbes suggested a 12-month “moratorium” of MtM in "exotic financial instruments (primarily packages of subprime mortgages)." In Forbes’ opinion: "It's preposterous to try to guess what these new instruments are worth in a time of panic." Going even further, the publisher and erstwhile presidential candidate, in a Wall Street
123 Journal op-ed piece wrote: “Mark-to-market accounting is the principal reason why our financial system is in a meltdown.” The International Institute of Finance (“IIF”) proposed resorting to historical price to facilitate “stable valuations” that “increase market confidence”. The IIF proposal was dismissed by Goldman Sachs as “Alice in Wonderland” accounting. The IIF, following hasty informal consultations with market participants, central banks, regulators and accountants, clarified their position: · MtM accounting will remain as it fosters transparency, discipline and accountability. · There is already latitude to use model approaches where observable market inputs are not available. · There is a need for clarification of pricing inputs in illiquid markets and the rules may need “refinement”. · New “techniques” or allowing “greater flexibility” risks that however well-framed the proposals the intentions of those advocating changes could be “misunderstood by investors at this stage”. Another alternative approach was suggested by a group of French accountants[3]. The Gallic thesis was that “market prices [had been] squeezed by a “crisis discount”. They proposed adjusting the valuation using an “upgraded fair value” model for serious crises where the “market” price was measured consistent with their intrinsic values. The proposal recommended that the accounting regulator in the country concerned would arbitrate that the “crisis discount” was abnormally high. Once this determination was made banks would be able to discontinue mark-to-market measurements of credit assets and switch to a fair value measurement. The “fair value” would be based on a “mark-to-model” approach using parameters set by the regulator. The proposal was reflective of French strengths as identified by Napoleon III: “We do not make reforms in France; we make revolution.” In March 2008, the SEC has clarified the application of SFAS 157. The SEC indicated that it is appropriate to use actual market prices, or observable inputs, even when the market is illiquid, unless those prices are the result of a forced liquidation or distress sale. Under political pressure, the U.S. SEC and the FASB were forced to further clarify FAS 157 in September 2008. The SEC also conducted a study into mark-to-market accounting - a condition of the Emergency Economic Stabilisation Act passed by the U.S. Congress in October 2008. The FASB and the IASB altered the accounting standards so that firms were not obligated to use market prices in distressed markets. The changes allowed the reporting firm to use its judgement about whether individual market transactions are forced liquidations or distressed sales. If it determined the market price is not reflective of ‘true’ value or if no observable inputs are available, then the reporting entity could use its own assumptions about future cashflows and risk-adjusted discount rates. The revised position introduces significant uncertainty about how MtM is to be applied. It is difficult to determine objectively whether prices are “distressed”. Proponents of the alternatives to MTM seems to have decided that in the final analysis it better to just manipulate the values and pretend that there are no losses using an arbitrary model with assumed inputs in preference to “inconvenient truths” about market prices and the extent of the losses. As Mr. Hazard aka hedge fund manager Jon Shayne sings on You Tube:
124 “It’s easier to patch and mend and temporize away; Immediate cost is tough, we favor gradual decay.” In July 2009, the IASB proposed a further change in MtM principles. Under the approach, reporting firms would need to value a financial investment as a long-term holding or as a trading position. Under the proposed rules, if the investment produces predictable cash flow like a bond, then it would be valued in accounts using an accounting mechanism that smooths out market fluctuations. If the investment’s cash flow is unpredictable, like derivatives, then it would be valued at current market levels. The proposals were an attempt to resolve the increasingly intense disputes about MtM accounting. The problem was that it now introduces subjectivity in how instruments should be classified. The amusing thing about the ‘radical’ proposals was that it was a return to exactly what the rules were before the entire MtM system was implemented. Firms valued hold to maturity instruments at book value (accrual accounting) adjusted for impairments and trading instruments at market. Value. In the words of Giuseppe di Lampedusa, author of “The Leopard”, the great Sicilian novel: “everything must change so that everything can stay the same.” Mark-to-Make Believe MtM accounting has theoretical advantages. The famed humorist Yogi Berra once opined that: “In theory there is no difference between theory and practice. In practice there is.” MtM and fair value accounting allowed banks to maximize short term returns by recognising profits up-front. Longer term risks of illiquid assets were hidden by the process. When the hidden risks emerged, central banks and regulators were left to solve the problems using public funds. If accounting is a mechanism for communicating financial information, then in the global financial crisis, MtM accounting has been a means for mis- communication. In a speech in September 2008 to the Institute of Chartered Accountants of Scotland[4], Sir David Tweedie, head of the IASB, spoke of accountants with “all the backbone of a chocolate éclair.” He spoke of an era of “creeping crumble” when “… auditors [were picked off] by investment bankers, selling a scheme that perhaps was just within the law to a client, persuading two major auditing firms to accept it whereupon it became accepted practice and QCs would tell a third auditor that he could not qualify [the company's financial report] as the scheme was now part of ‘true and fair’.” Sir David’s outlined his vision of the role: “The accountant is an artist, but he has to portray his subject faithfully…..If the reporting accountant lacks integrity; if raw economic facts are unpalatable and smoothing devices are sought; if he fails to support fellow professionals who have carefully documented their view of the principle, researched the literature and sought advice and made an honest judgment; if regulators demand one answer and one alone, not those within a range; or if the profession constantly seeks answers for all questions - the reporting accountant will paint by numbers and deserve the rule-based standards he has requested. This will be the profession of the search engine, not one of reasoned judgment." George Clemenceau, the former French Prime Minister, once noted that: “La guerre! C’est une chose trop grave pour la confier à des militaires.[War is too important a matter to be left to the military.]” Accounting may be simply too important to be left to accountants.
125 © 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
0 [1] See Guillaume Plantin, Haresh Sapra and Hyun Song Shin (12 August 2007) Marking to Market: Panacea or Pandora’s Box; Princeton University, working paper
1 [2] See Robert Kaplan, Robert Merton and Scott Richard “Disclose the fair value of complex securities” (17 August 2009) Financial Times
2 [3] See Jean-Francois Lepetit, Etienne Boris and Didier Marceau “How to arraive at fair value during a crisis” (28 July 2008) Financial Times
3 [4] See www.iasb.org
http://www.eurointelligence.com/article.581+M5fcbfe210e7.0.html#
126
Opinion. Friday, September 4, 2009
From Financial Crisis to Debt Crisis?
By Kenneth Rogoff CAMBRIDGE ― Everyone from the Queen of England to laid-off Detroit autoworkers wants to know why more experts did not see the financial crisis coming. It is an awkward question. How can policymakers be so certain that financial catastrophe won't soon recur when they seemed to have no idea that such a crisis would happen in the first place? The answer is not very reassuring. Essentially, there is still a risk that the financial crisis is simply hibernating as it slowly morphs into a government debt crisis. For better or for worse, the reason most investors are now much more confident than they were a few months ago is that governments around the world have cast a vast safety net under much of the financial system. At the same time, they have propped up economies by running massive deficits, while central banks have cut interest rates nearly to zero. But can blanket government largesse be the final answer? Government backstops work because taxpayers have deep pockets, but no pocket is bottomless. And when governments, particularly large ones, get into trouble, there is no backstop. With government debt levels around the world reaching heights usually seen only after wars, it is obvious that the current strategy is not sustainable. If the trajectory is unsustainable, how long can debt keep piling up? We don't know. Academic economists have developed useful tools to predict which economies are most vulnerable to a financial crisis. But, although we can identify vulnerabilities, getting the timing right is virtually impossible. Our models show that even an economy that is massively overleveraged can, in theory, plod along for years, even many decades, before crashing and burning. It all boils down to confidence and coordination of expectations, which depend, in turn, on the vagaries of human nature. Thus, we can tell which countries are most vulnerable, but specifying exactly where and when crises will erupt is next to impossible. A good analogy is the prediction of heart attacks. A person who is obese, with high blood pressure and high levels of cholesterol, is statistically far more likely to have a serious heart attack or stroke than a person who exhibits none of these vulnerabilities. Yet high-risk individuals can often go decades without having a problem. At the same time, individuals who appear to be ``low risk" are also vulnerable to heart attacks. Of course, careful monitoring yields potentially very useful information for preventing heart attacks. Ultimately, however, it is helpful only if the individual is treated, and perhaps undertakes a significant change in lifestyle.
127 The same is true for financial systems. Good monitoring yields information that is helpful only if there is a response. Unfortunately, we live in a world where the political and regulatory system is often very weak and shortsighted. Indeed, no economy is immune to financial crises, no matter how much investors and leaders try to convince themselves otherwise, as Carmen Reinhart and I show in our new book, ironically entitled ``This Time is Different: Eight Centuries of Financial Folly." Right now, the latest ``this time is different" folly is that, because governments are taking all the debt on their shoulders, the rest of us don't have to worry. We are constantly reassured that governments will not default on their debts. In fact, governments all over the world default with startling regularity, either outright or through inflation. Even the U.S., for example, significantly inflated down its debt in the 1970s, and debased the gold value of the dollar from $20 per ounce to $34 in the 1930s. For now, the good news is that the crisis will be contained as long as government credit holds up. The bad news is that the rate at which government debt is piling up could easily lead to a second wave of financial crises within a few years. Most worrisome is America's huge dependence on foreign borrowing, particularly from China ― an imbalance that likely planted the seeds of the current crisis. Asians recognize that if they continue to accumulate paper debt, they risk the same fate that Europeans suffered three decades ago, when they piled up U.S. debt that was dramatically melted down through inflation. The question today is not why no one is warning about the next crisis. They are. The question is whether political leaders are listening. The unwinding of unsustainable government deficit levels is a key question that G20 leaders must ask themselves when they meet in Pittsburgh later this month. Otherwise, Queen Elizabeth II and Detroit autoworkers will be asking again, all too soon, why no one saw it coming. Kenneth Rogoff is a professor of economics and public policy at Harvard University, and was formerly chief economist at the International Monetary Fund (IMF). For more stories, visit Project Syndicate (www.project-syndicate.org).
Kenneth Rogoff From Financial Crisis to Debt Crisis? September 4, 2009 http://www.koreatimes.co.kr/www/news/opinon/2009/09/137_51195.html
128 COMMENT Europe has mapped its monetary exit By Jean-Claude Trichet Published: September 3 2009 19:35 | Last updated: September 3 2009 19:35 Exceptional times call for exceptional measures. The European Central Bank, like other central banks, has introduced non-standard measures to tackle the financial crisis and cushion its impact on the economy – what I call “enhanced credit support”. These have contained the threats to the stability of the euro area’s financial system and supported the flow of credit to companies and households over and above what could be achieved through interest rate cuts alone. Because of their exceptional nature, these measures will have to be unwound once economic and financial conditions normalise. We at the ECB designed the non-standard measures with our exit strategy in mind, and we are ready to implement this strategy when the appropriate time comes. Stressing the importance of the exit strategy should not be confused with its activation: it is premature to declare the financial crisis over. Today is not the time to exit. Four issues will shape our approach to exiting the non-standard measures. First and foremost, should the non-standard measures trigger risks to price stability, we will immediately begin to unwind them and ensure the continued solid anchoring of inflation expectations. The timing and sequencing of our exit strategy depends on our real-time assessment of the economic outlook and the health of the financial system in line with our contribution to financial stability. Second, a degree of phasing out has been built into the exit through the design of our measures. In the absence of new policy decisions, several of these measures will unwind naturally. Given that the overwhelming majority of the liquidity has been provided through repurchase agreements, a new policy decision would be necessary in order to roll these operations over once they mature. Third, the ECB’s operational framework is well equipped to facilitate the unwinding of non-standard measures as the need arises. This framework comprises a varied and flexible set of instruments, including fine-tuning operations, allowing the absorption of surplus liquidity – promptly, if necessary. Moreover, with its interest rate corridor, the framework allows short-term interest rates to be changed while keeping some non-standard measures in place, should continued credit support be needed. The governing council can therefore choose the way in which interest rate action is combined with the unwinding of the non- standard measures. Fourth, the outright purchases of securities by the eurozone’s central banks have been measured in both scope and volume. They have focused on the market for covered bonds and have acted only as a catalyst. We opted for a purchase programme with a volume that was significant enough to improve the activity and functioning of the market, but not so large as to dominate the market or the balance sheets of eurozone central banks. The measured programme facilitates its future unwinding or its offsetting by other policy operations.
129 With regards to future actions, we are unrestricted in our ability to take decisions, given the strong institutional independence of the ECB. This reflects the clear dividing line in the euro area between the responsibilities of the central bank and those of the fiscal sphere. That the ECB has not purchased government bonds is in line with this institutional framework. The ECB has an exit strategy from its non-standard measures in place. Its implementation will build on three self-reinforcing elements: credibility, alertness and steady-handedness. These form the basis for the strong anchoring of inflation expectations in the euro area – our main asset. This strong anchoring is based on our determination and ability to act decisively whenever the need arises. The ECB’s governing council will continually assess whether policy adjustments are necessary and implement those adjustments to maintain price stability in the euro area over the medium and longer term. Our fellow citizens can have full confidence in the determination and ability of the ECB to deliver price stability. This confidence will, in turn, contribute to a sustainable recovery. The writer is president of the ECB http://www.ft.com/cms/s/0/c50df098-98b7-11de-aa1b-00144feabdc0.html
130
03.09.2009 The politics of envy
Sweden’s finance minister Anders Borg spoke a word of truth. It is the politics of envy that drives the EU to adopt a position to cap bankers’ pay ahead of the Pittsburgh G20 summit. And as La Repubblica among others reports the position among European finance ministers has been unanimous. As unemployment is expected to rise later this year and next, the politicians expect an outbreak of public anger, and feel the need to regulate bankers pay in response. The FT quotes Borg as saying “We will see social tensions in our societies, given that we’re in a precarious situation on the labour market,” he said. “It’s important that we as politicians should give a clear message that the old bonus culture must come to an end.” So this is not about finding an appropriate regulatory response, or let alone prevent another crisis. This is all about finding someone to blame. The decision to propose a joint EU position on bonus payment was taken at the Ecofin, and the issue will be taken up with the other G20 finance ministers. There are still differences within this unanimity, as Les Echos reports. The UK says it has it own proposals on bankers’ pay, but they do not include caps. (We guess it will ultimately boil down to a series of guideline to link pay to long-term performances of the banks, but will not necessarily reduced the size of the bonus.) FT Deutschland also said that it is very unlikely that the final decision will be a cap on bonuses. The paper quotes Jörg Asmussen, state secretary in the German finance ministry, that the goal should be to link bonus payments to long-term performance.
On exit strategies Also from the ECOFIN meeting Der Standard quotes Jean Claude Junker saying that while the worst might be over the economies will need extra government support well into 2010. Then, the exit strategy should be coordinated on an international and European level, emphasises EU Commissioner Joaquin Alumunia (also advocated by Bruegel in its memos
131 to the new Commission ).
Mr Brown goes to Washington The Financial Times has an editorial endorsing Gordon Brown’s agenda for the G20 summit, consisting of two principal points .The first is close policy co-ordination of monetary and fiscal policy, especially concerning exit strategies. The other consists of policies to reduce global imbalances, a reduced reliance on the US and a few other countries to generate global demand. The FT argues that these two points deserve a fair hearing at Pittsburgh.
Tourist slump hits Spain’s job market The FT has the story that Spanish employment suffered from a tourist slump, as the unemployment rate rose for for the first time in four months during August. The labour and immigration ministry said the number of jobless claimants rose by nearly 85,000 to 3.63m, 1.1m more than in August last year, with services and construction recording the heaviest job losses.
Volatility index hits another peak This is one of market afficionades, but the VIX index, a measure of market volatility, jumped to the highest level since July, as FT Deutschland reported on its home page – a reflection of renewed nervousness about the prospects of the financial sector. The increase in the VIX follows a bad week for stock as the S&P fell once against to under 1000, as the most recent market rally shows signs of petering out, or even reversing.
Karamanlis calls snap elections The Greek prime minister Costas Karamanlis called snap elections amid mounting economic problems and continous political struggles, reports the FT. Half way through his four year term in office, Karamanlis failed to push through structural reforms and lost popularity afer a series of political scandals. Opinion polls now predict a 6% lead by the Socialist party under George Papandreou, a former foreign minister, but who could still fall short of an outright majority. Kathemerini writes that elections might be held October 4 and 11 at the earliest. OECD recommends Island to join EMU In its latest country report on Island the OECD recommends the country to join the euro zone as fast as possible, once it becomes a member of the EU, reports Les Echos. With this wording the OECD hopes to remain outside the political controversy about whether or not to join the EU in the first place. But the authors do not shy away to put into question whether such a small economy really can continue to have its own independent currency (which essentially lends support to the EU entry, like it or not). Peter Ehrlich on the limits of a centre-right government Writing in FT Deutschland, Peter Ehrlich says politics is not going to change much no matter who wins the forthcoming German elections. Even a straight-centre right victory would not bring back the pro-market type legislatoin of the Kohl governments in the 1990s, as too much has changed, including majorities in the Bundesrat, and even views among conservatives themselves. Given the electoral timetable, the CDU can ill afford to
132 drift to the right, and adopt radical free-market policies.
The Madoff Files: A Chronicle of SEC Failure Over and Over, Agency Skipped 'Basic' Steps to Find Fraud, Report Says By Zachary A. Goldfarb Washington Post Staff Writer Thursday, September 3, 2009 Washington's top cop for Wall Street, hamstrung by bureaucracy and inexperienced investigators, failed to thoroughly pursue multiple warnings about Bernard L. Madoff's multibillion-dollar Ponzi scheme, according to a scathing new critique of the Securities and Exchange Commission by its internal watchdog. The report, issued Wednesday by the commission's inspector general, offers the first detailed examination of one of the agency's most public embarrassments. It says the SEC received repeated allegations that Madoff was probably cheating investors, including detailed road maps provided by outside businessmen, only to fail to discover the fraud. The SEC opened inquiries five times in a 16-year period. But in each instance, inexperienced officials, at times ignorant of other agency probes into Madoff, took his explanations at face value and did little to verify them. Madoff himself told the inspector general that he was "astonished" that the SEC did not verify whether he was carrying out the billions of dollars of trades he claimed to be making after he supplied the agency with account details. "The SEC never properly examined or investigated Madoff's trading and never took the necessary, but basic, steps to determine if Madoff was operating a Ponzi scheme," the inspector general, H. David Kotz, concludes in the report. The extensive number of contacts between the SEC and Madoff raises questions about whether the agency is capable of spotting and stopping other financial frauds. The SEC has said it doesn't have the resources necessary to oversee the exploding number of financial firms and can review many of them only once every few years. It became aware of Madoff's fraud only when he confessed to it in December. The financial crisis has exposed many breakdowns in regulation, but none has involved such a large fraud by a single person. The inspector general's report "makes clear that the agency missed numerous opportunities to discover the fraud," SEC Chairman Mary L. Schapiro said. "It is a failure that we continue to regret, and one that has led us to reform in many ways how we regulate markets and protect investors." Federal prosecutors say Madoff may have stolen up to $65 billion from his clients. He claimed that he engaged in a highly specialized trading strategy that persistently beat the market, but in fact, he did little trading and instead used proceeds from some investors to pay others.
133 His fraud left thousands of clients, including charities, retirees and celebrities, devastated. Madoff is serving a 150-year sentence in a federal prison in North Carolina. The inspector general's report concludes that the agency's failings were the result of misjudgments but not improprieties. It says that no SEC officials who worked on the review of Madoff's firm had "any financial or other inappropriate connection with Bernard Madoff or the Madoff family that influenced the conduct of their examination or investigative work." The report, in particular, exonerates Eric Swanson, a former SEC official who worked on a Madoff probe and later married Madoff's niece Shana, who was a compliance officer at his firm. The report issued Wednesday is a 22-page executive summary of a 450-page investigation likely to be released later this week. It contains a number of startling anecdotes recounting how the SEC bungled its Madoff probes since the first review in 1992. The inspector general found that SEC officials received detailed warnings but were generally not equipped to capitalize on them. In May 2003, for instance, the Office of Compliance Inspections and Examinations in Washington received a letter from a well-known hedge-fund manager identifying red flags at Madoff's firm. An SEC supervisor involved in the review called these "indicia of a Ponzi scheme." But it took seven months to launch the probe. One OCIE staffer said that "there was no training" and that "this was a trial by fire kind of job." Agency officials ignored several of the questions in the hedge-fund manager's letter that went to the heart of the fraud and focused on others, because, according to the associate director in charge of the review, "that was the area of expertise for my crew." The team prepared to ask Madoff for detailed information about trades but decided against it. Officials said such information "can be tremendously voluminous and difficult to deal with" and can take "a ton of time" to review. The Washington office stopped its probe as it shifted resources while public pressure mounted to review the mutual fund industry. At the same time, however, the SEC's New York office, unaware of the Washington probe, began its own review. It uncovered detailed concerns about Madoff's firm in the internal documents of another financial services company that had come under review. SEC officials arrived at Madoff's firm in Midtown Manhattan and learned that he would be their primary contact. He provided them with contradictory information. But when they sought to confront him about it, he said he had already given the information they wanted to investigators in Washington -- which was news to the SEC officials in New York. Shortly thereafter, they concluded their investigation without answering the questions that had spurred the review. In 2005, fraud analyst and onetime Madoff rival Harry Markopolos wrote a detailed letter to the SEC's Boston office warning, "The world's largest hedge fund is a fraud." The Boston office had worked with Markopolos before and found him credible. Boston sent the letter to the SEC's New York office, where officials viewed Markopolos skeptically and did not understand his reasoning, which was based largely on statistics. The team assigned to look into Madoff had little experience reviewing potential Ponzi schemes.
134 In May 2006, SEC investigators interviewed Madoff, who didn't bring along a lawyer. When asked how he consistently beat the market, he told the investigators, "Some people feel the market," the report recounts. Madoff told the inspector general that he expected to be exposed when he told the investigators that his trading was processed through the Depository Trust Co., an important financial intermediary. He gave the SEC his DTC account number, which they could have used to verify the trades he claimed to have made. "I thought it was the end, game over. Monday morning they'll call DTC, and this will be over," Madoff told the watchdog earlier this year. "And it never happened." The report calls the agency's decision to never verify Madoff's trading "the most egregious failure in the Enforcement investigation." That investigation was closed in August 2006. It took a single phone call to DTC after the Ponzi scheme was exposed in December 2008 to find out that he had not placed any trades with his investors' funds. Concerns about Madoff's firm continued to arrive. In March 2008, the office of then-SEC Chairman Christopher Cox received an e-mail from a source who had contacted the agency several times, urging investigators to look into secret files Madoff maintained on a computer he carried. Cox's aides sent the e-mail to the enforcement division. An enforcement staffer who had worked on the Madoff case replied: "[W]e will not be pursuing the allegations." http://www.washingtonpost.com/wp- dyn/content/article/2009/09/02/AR2009090203851.html?wpisrc=newsletter
135 Business
September 3, 2009 White House to Propose Big Reserves at Banks By ERIC DASH Many banks are finally back on their feet. The question now is how to keep them there for good. So after propping up lenders with billions of taxpayer dollars, the Obama administration is contemplating long-term measures aimed at preventing, or at least minimizing, any future financial crisis. The thrust of the plan is to have banks, particularly those deemed too big to fail, maintain larger capital cushions — a move bankers have traditionally opposed because it eats into their profits. The Treasury secretary, Timothy F. Geithner, is expected to outline the administration’s proposals Thursday in a letter to the finance ministers of the Group of 20 industrial and emerging nations, who are scheduled to meet in London this week. The measures are still under discussion and, if adopted, probably would not take effect for years. But capital levels, once the domain of academics and policy specialists, have quickly become Topic A in banking circles and underpin the administration’s proposals for overhauling financial regulation. Compelling banks to hold more capital could radically reshape the industry. Administration officials hope to reach a broad, international consensus on the issue and lay the groundwork for the rapid introduction of new capital guidelines after the Group of 20 summit meeting in Pittsburgh late this month. But agreeing on an outline is one thing. Getting down to the details is quite another. The last international capital standards were years in the making. Those guidelines rely on banks’ ability to assess risks, something most failed to do adequately in recent years, with disastrous results for the global economy. Yet few policy makers see an easy fix. While requirements for more capital generally make banks safer, albeit less profitable, they also impede banks’ ability to make the loans that fuel the economy and create jobs. The challenge is to strike a balance. At the center of the Obama administration effort are two of the biggest issues in banking. The first is how to deal with institutions that are so large and interconnected that their failure might threaten the entire financial industry and the broader economy. The second involves institutions that take outsize trading risks, potentially exposing them to devastating losses. Some banks, like Goldman Sachs, fall into both categories. Mr. Geithner is expected to propose that all banks maintain higher capital levels, with a big part in common stock. But so-called systemically important institutions — perhaps two dozen, mostly big banks, plus a handful of other financial institutions — would be held to even tougher standards. He is also expected to propose that institutions that engage in risky activities, like derivatives and proprietary trading, hold a larger buffer to guard against an industrywide shock. “This is a critical part of making the financial system safer in the future,” Mr. Geithner said in Washington on Wednesday. “This is not something we can take a long time to do.”
136 Administration officials hope to reach a global consensus and are wary about putting American banks at a competitive disadvantage by imposing tighter restrictions unilaterally. Mr. Geithner said his goal was to come out early with a proposal to shape the debate. It is unclear how regulators overseas will respond. European and Asian banks, which have typically held less capital than their American counterparts, might have to raise billions of dollars to comply with tough new global standards. The Obama administration will meet plenty of opposition at home. Businesses like trading, derivatives and private equity would become far less lucrative if capital levels were sharply raised. The industry is unlikely to accept new rules without a fight. Still, the failure of existing international standards, known as the Basel II accord, may prompt quick action. The health of banks has become a political issue as well as an economic one. Under the current international rules set by the Basel accord, a bank is “well capitalized” if it meets a so-called Tier 1 capital level of 4 percent and a total capital level of 10 percent of its risk weighted assets. Under American rules, banks must hold even larger cushions. Although no specific amounts have been settled on, it appears regulators now want more. In an interview on Tuesday, Sheila C. Bair, the chairwoman of the Federal Deposit Insurance Corporation, said there was already a consensus for a tougher international leverage ratio that would set consistent minimum capital levels around the world. “It needs to be a hard and fast simple measure to ensure adequate capital in good times and bad,” Ms. Bair said. Mr. Geithner is also expected to propose further measures intended to make banks less reliant on raising additional capital when the markets are under stress. One idea is to require banks to cut their dividends and stop buying back their own stock if their share price declines precipitously. Another is to encourage banks to issue preferred stock that automatically converts into equity in a severe downturn. Putting new measures into effect could take years. American and overseas regulators are reluctant to raise capital standards, curbing lending, during a global recession. ERIC DASH White House to Propose Big Reserves at Banks September 3, 2009 http://www.nytimes.com/2009/09/03/business/03bank.html?th&emc=th
137 COMMENT Financial stability depends on more capital By Timothy Geithner Published: September 3 2009 20:00 | Last updated: September 3 2009 20:00
A year ago, deep concerns about excessive leverage almost brought down the global financial system. The resulting panic severely damaged economies across the world and wiped out trillions of dollars in savings. Since at least the Great Depression, governments have recognised that financial breakdowns have devastating effects, and have put in place safety nets to limit the fall-out from instability. These safety nets have a cost, because they insulate financial institutions from the full consequences of their actions and can diminish market discipline. We have sought to contain this moral hazard through regulation. We require financial institutions to maintain reserves and capital buffers in proportion to their risk so that they can absorb losses at their own expense, not at the taxpayer’s. That regulatory framework failed last year. In the benign atmosphere before the crisis, government supervisors and those in the market underestimated risks building in the system. Major global financial institutions maintained capital levels that were too low, relied too heavily on unstable short-term funding, and their compensation plans rewarded excessive risk-taking. Larger banks often held less capital relative to their risks and used more leverage than smaller banks. The resulting distortions helped make our global financial system dangerously fragile. As that system grew in size and complexity, it became more interconnected and vulnerable to contagion when trouble occurred. This weekend, the Group of 20 will gather in London to move forward on reforms to put our global financial system on firmer ground. President Barack Obama has outlined a new regulatory framework that promotes stronger protections for consumers and investors and greater financial stability. Making the system safer requires a comprehensive approach
138 including tougher regulation of derivatives, securitisation markets and credit rating agencies, new executive compensation standards and, critically, more powerful tools for governments to wind down firms that fail. We are working with our partners to ensure similar reforms are put in place around the world. But at the core of our endeavour must be making capital standards for financial institutions stronger. In a recent paper sent to G20 finance ministers, I laid out my views on the principles that should shape a new international accord on capital standards. The fundamental principle is that capital and other regulatory requirements should be designed to ensure the stability of the system, not just the solvency of individual institutions. Such an approach requires a broad shift in the way capital and related regulations are designed. First, capital requirements for banks simply must be higher across the board. Bringing more capital into the banking system is vital. It is equally crucial to hold the largest, most interconnected institutions, whether or not they own banks, to tougher standards than others. Second, the regulatory framework also should put a greater emphasis on higher-quality forms of capital that best enable financial groups to absorb losses. Consistent with this principle, during good economic times, common equity should constitute a large majority of a bank’s Tier 1 capital. Third, capital requirements and accounting rules should be more forward-looking and should reduce the system’s pro-cyclicality. The capital regime should require banks to hold a larger buffer over their minimum capital requirements during good times, to be available in bad times. Fourth, banks should be subject to explicit liquidity standards designed to improve their resilience in the face of runs by creditors and prevent the build-up of liquidity risk in the financial system as a whole. Finally, we need to improve the rules used to measure risks embedded in banks’ portfolios and the capital required to protect against them, and put greater constraints on banks’ use of leverage to dampen volatility. Strengthening capital requirements is an essential part of a broader effort to modernise our regulatory framework so that the financial system is strong enough to withstand the failure of large, complex institutions. That is the most effective way to prevent the world from re- living the events of last autumn. And that is the challenge we must tackle in London, Pittsburgh and beyond. The writer is US Treasury secretary http://www.ft.com/cms/s/0/638b9eb2-98ba-11de-aa1b-00144feabdc0.html
139
G20 plans for stimulus exit By Ralph Atkins in Frankfurt and Norma Cohen in London Published: September 3 2009 19:51 | Last updated: September 3 2009 21:26 World leaders have set out the first steps toward withdrawing emergency support for the global economy even though they warned that the crisis was not over. On the eve of Friday’s meeting of G20 finance ministers to prepare for a summit on financial regulation later this month, the US, UK, France and Germany called for work to start “on exit strategies to be implemented in a co-ordinated manner as soon as the crisis is over”. Tim Geithner, US Treasury secretary, said finance ministers should start to spell out how the “very successful policy response” to the economic crisis could be reversed. Speaking at the US Treasury before flying to London to meet his counterparts from the Group of 20 nations, Mr Geithner said these exit strategies were “very important to [the] confidence” of the financial markets. The London meeting will be followed by a summit in Pittsburgh, hosted by President Barack Obama, on September 24-25. Up for discussion ● Bankers’ bonuses ● Bank capital adequacy and liquidity ● Accounting for bank assets and liabilities ● Exiting from massive fiscal and monetary stimulus ● Completion of the international aid package ● Reform of international financial institutions Jean-Claude Trichet, European Central Bank president, writing in Friday’s Financial Times, has outlined for the first time the principles the ECB would use to unwind the exceptional steps it has taken. The calls highlight how the policy debate has switched from crisis response to presaging a return to normal conditions. A recovery in the world’s economy now looks likely to come earlier than had been expected a few months ago, the Organisation for Economic Co-operation and Development said on Thursday. But it warned that a return to normal conditions would be slow and protracted. The OECD is forecasting that in 2009, the contraction in output among G7 nations will be 3.7 per cent, less severe than the 4.1 per cent decline forecast just a few months ago. The OECD downgraded the outlook for the UK, which will be the only G7 nation not to show growth in any single quarter of 2009. For 2009, UK gross domestic product is expected to contract at an annualised 4.7 per cent, an even sharper fall in output than the 4.3 per cent decline forecast in June, although the third and fourth quarter outlooks have been revised up marginally. The UK’s recovery was slower than the global recovery partly because of its heavy specialisation in financial services, said Jorgen Elmeskov, acting head of the OECD’s economics department. The global recovery was being led by the manufacturing sector.
140 Mr Elmeskov said the UK’s ability to stimulate demand had been constrained compared with other countries. Mr Trichet, in his FT article, stressed that it was “premature to declare the financial crisis over”. The ECB sees a bumpy road ahead for the eurozone and is wary about global prospects, especially if the US rebound disappoints. The ECB left its main interest rate unchanged at 1 per cent on Thursday. In a joint letter to European Union countries, Gordon Brown, prime minister, Nicolas Sarkozy, French president, and Angela Merkel, German chancellor, wrote: “While cyclical indicators point to economic stabilisation, the crisis is not over.” http://www.ft.com/cms/s/0/67bb6964-98b4-11de-aa1b-00144feabdc0.html
141 Opinion
September 3, 2009 OP-ED COLUMNIST Health Care That Works By NICHOLAS D. KRISTOF Here’s a paradox. Health care reform may be defeated this year in part because so many Americans believe the government can’t do anything right and fear that a doctor will come to resemble an I.R.S. agent with a scalpel. Yet the part of America’s health care system that consumers like best is the government-run part. Fifty-six to 60 percent of people in government-run Medicare rate it a 9 or 10 on a 10- point scale. In contrast, only 40 percent of those enrolled in private insurance rank their plans that high. Multiple surveys back that up. For example, 68 percent of those in Medicare feel that their own interests are the priority, compared with only 48 percent of those enrolled in private insurance. In truth, despite the deeply ingrained American conviction that government is bumbling when it is not evil, government intervention has been a step up in some areas from the private sector. Until the mid-19th century, firefighting was left mostly to a mishmash of volunteer crews and private fire insurance companies. In New York City, according to accounts in The New York Times in the 1850s and 1860s, firefighting often descended into chaos, with drunkenness and looting. So almost every country moved to what today’s health insurance lobbyists might label “socialized firefighting.” In effect, we have a single-payer system of public fire departments. We have the same for policing. If the security guard business were as powerful as the health insurance industry, then it would be denouncing “government takeovers” and “socialized police work.” Throughout the industrialized world, there are a handful of these areas where governments fill needs better than free markets: fire protection, police work, education, postal service, libraries, health care. The United States goes along with this international trend in every area but one: health care. The truth is that government, for all its flaws, manages to do some things right, so that today few people doubt the wisdom of public police or firefighters. And the government has a particularly good record in medical care. Take the hospital system run by the Department of Veterans Affairs, the largest integrated health system in the United States. It is fully government run, much more “socialized medicine” than is Canadian health care with its private doctors and hospitals. And the
142 system for veterans is by all accounts one of the best-performing and most cost-effective elements in the American medical establishment. A study by the Rand Corporation concluded that compared with a national sample, Americans treated in veterans hospitals “received consistently better care across the board, including screening, diagnosis, treatment and follow-up.” The difference was particularly large in preventive medicine: veterans were nearly 50 percent more likely to receive recommended care than Americans as a whole. “If other health care providers followed the V.A.’s lead, it would be a major step toward improving the quality of care across the U.S. health care system,” Rand reported. As for the other big government-run health care system in the United States, Medicare spends perhaps one-sixth as much on administration as private health insurers, although the comparison is imperfect and controversial. But the biggest weakness of private industry is not inefficiency but unfairness. The business model of private insurance has become, in part, to collect premiums from healthy people and reject those likely to get sick — or, if they start out healthy and then get sick, to find a way to cancel their coverage. A reader wrote in this week to tell me about a colleague of hers who had health insurance through her company. The woman received a cancer diagnosis a few weeks ago, and she now faces chemotherapy co-payments that she cannot afford. Worse, because she is now unable to work and has to focus on treatment, she has been shifted to short-term disability for 90 days — and after that, she will lose her employer health insurance. She can keep her insurance if she makes Cobra payments on her own, but she can’t afford this. In her case, her company will voluntarily help her — but I just don’t understand why we may be about to reject health reform and stick with a dysfunctional system that takes away the health coverage of hard-working Americans when they become too sick with cancer to work. On my blog, foreigners regularly express bewilderment that America may reject reform and stick with a system that drives families into bankruptcy when they get sick. That’s what they expect from the Central African Republic, not the United States. Let’s hope we won’t miss this chance. A public role in health care shouldn’t be any scarier or more repugnant than a public fire department.
http://www.nytimes.com/2009/09/03/opinion/03kristof.html?th=&emc=th&pagewanted=pr int
143
Fed Optimistic Recovery Is Ahead -- but Unsure How Far and How Strong By Neil Irwin Washington Post Staff Writer Thursday, September 3, 2009 Federal Reserve leaders have become more confident that the economy is stabilizing. But they are less sure about what the recovery will look like. At an Aug. 11-12 meeting of the central bank's policymaking committee, top Fed officials agreed that improving economic data had "strengthened their confidence that the downturn in economic activity was ending," according to minutes of the meeting released Wednesday. But that confidence did not extend to the shape of the recovery. The officials also expected the economy to improve "only slowly during the second half of this year, and all saw it as still vulnerable to adverse shocks," the minutes said. Ample evidence in the last few months has pointed to an economy that is expanding -- producing more goods and services. But the Fed minutes show that top officials at the central bank, like their private-sector counterparts, have simmering concerns about whether the improvement will be enough to steady the job market. "Conditions in the labor market remained poor, and business contacts indicated that firms would be quite cautious in hiring when demand for their products picks up," the minutes said. Underscoring that continued weakness in the job market, the payroll processing firm ADP on Wednesday estimated that private firms cut 298,000 jobs in August -- more than expected. A government report Friday is also expected to show continued job losses, though less steep than a few months ago. Also Wednesday, a Commerce Department report found that factory orders rose 1.3 percent in July, driven by a surge of orders for U.S.-made aircraft. The Labor Department said that productivity -- the amount of output produced for each hour worked -- rose 6.6 percent in the April through June quarter, more than the 6.4 percent originally estimated. At the August meeting of the Federal Open Market Committee, officials chose to leave their target for short-term interest rates at near zero, and to keep language in an accompanying statement suggesting that rates would be left at that level "for an extended period." They did take a first step toward unwinding the Fed's extensive interventions in the economy, indicating that an effort to buy $300 billion in Treasury bonds would be allowed to taper off by the end of October. In following up on that action, the Fed is likely to face a tightrope in the coming months: how to start to unwind other unconventional programs that support the economy while financial markets remain fragile and the unemployment rate remains high.
144 The minutes gave no real hints on the Fed's thinking about that issue. "They kind of kicked the ball down the field," said John Cannally, an economist at LPL Financial in Boston. The committee decided to wind down its Treasury bond purchases slowly "to help promote a smooth transition in markets." That could offer a hint of how the Fed will ultimately deal with its similar programs to buy mortgage-backed securities and the debt of Fannie Mae and Freddie Mac: tapering them off over time to try to avoid disrupting markets. "I think the stretching out of the Treasury program is likely to be a model for how the Fed ends the mortgage-backed and agency-debt buying programs," said Dean Maki, chief U.S. economist at Barclays Capital. Indeed, the Fed has particular reason to worry that ending the mortgage-purchase programs, which are scheduled to wind down by the end of the year, could pose risks to the economy. If closing the program goes poorly, mortgage rates would probably spike, potentially undoing the recent stabilization of the housing market. "I think they're a little more concerned about that lever than others," said Paul Ballew, a senior vice president at Nationwide Insurance, referring to the mortgage-related programs. "There's still a fragile element to real estate markets, and so there will be more of a weaning process that will take some time. I suspect that is almost a weekly debate in the halls of the Fed." Another outstanding question is how long and to what extent the Fed will continue its program to support business and consumer lending, the Term Asset-Backed Securities Loan Facility, or TALF. The minutes noted that the markets it is meant to support "showed improvement," owing in part to the program. The Fed extended the program into 2010, but has not expanded the types of lending it will support. http://www.washingtonpost.com/wp- dyn/content/article/2009/09/02/AR2009090202216.html?wpisrc=newsletter
145 Business
September 3, 2009 A Reluctance to Retire Means Fewer Openings By CATHERINE RAMPELL and MATTHEW SALTMARSH To the long list of reasons American companies aren’t hiring — business losses, tight credit, consumer retrenchment — add the fact that many of their older workers are unable, or afraid, to retire. In other parts of the developed world, people are retiring as planned, because of relatively flush state and corporate pensions that await them. But here in the United States, financial security in old age rests increasingly on private savings, which have taken a beating in the last year. Prospective retirees are clinging to their jobs despite some cherished life plans. As a result, companies are not only reluctant to create new jobs, but have fewer job openings to fill from attrition. For the 14 million Americans looking for work — a number expected to rise in Friday’s jobs report for August — this lack of turnover has made a tough job market even tougher. Consider Barbara Petrucci, a dialysis nurse who had expected to stop working soon, or at least scale back to part time. Now that her family savings have been depleted by market declines, she expects to stay on the job for a long, long time. “Retirement is kind of an elusive dream at this point,” says Ms. Petrucci, 58, who works at an Atlanta hospital while her retired husband, Ned, 61, interviews for jobs (unsuccessfully, so far). “We tease at work about someday having to go around at the hospital with our walkers.” The diverted life plans of families like the Petruccis are an unintended economic consequence of the nation’s sprawling 401(k) plans. These private retirement savings vehicles, designed 30 years ago as a supplement to traditional corporate pensions, have somewhat haphazardly replaced the old system, like an innocuous weed that somehow overgrew the garden. As is apparent in this downturn, the economic effects of such an ad hoc system can be perverse. In boom times, when companies need more workers, the most experienced employees may decide to retire, taking comfort in their bloated 401(k)s, whose values typically fluctuate with the financial markets. Today, the reverse is happening in the first deep recession since the new accounts became so pervasive. A Pew Research survey scheduled for Thursday release found that nearly four in 10 workers over age 62 say they have delayed their retirement because of the recession. (Though the data omits some people who have retired and includes some who are still working, the Social Security Administration said that about 2.3 million people that age started collecting benefits last year.) “One unappreciated side effect of the 401(k) system is that it’s a sort of reverse automatic stabilizer,” says Teresa Ghilarducci, an economics professor at the New School.
146 The recent retirement losses have prompted policy makers to discuss whether Americans need a stronger social safety net, not just in health care and unemployment benefits, but in retirement as well. Economists say there are advantages to reducing the financial risk for individuals. Pooling investments, in some cases, allows workers to switch jobs more easily and helps lower fees associated with investment decisions, for example. Alternatives include creating incentives for saving and for less risky investments through tax laws or other regulations. The Obama administration has proposed an opt-out retirement savings system, for example. And even before the crisis, some states developed plans for pooling private savings into voluntary, portable retirement accounts. Though their pension systems may be strained, people in many countries with stronger safety nets are still exiting the labor force in lockstep despite the global recession. Last year in the United States, almost a third of people ages 65 to 69 were still in the labor force; in France, just 4 percent of people this age were still working or looking for work. After all, Europe isn’t just the land of “socialized” medicine. It is also the land of “socialized” retirement plans, and like other automatic stabilizers, pensions help cushion the blow of an economic crisis. Retirement income typically comes from a combination of three buckets: state pensions, corporate pensions and individual arrangements. In many other industrialized countries, that first bucket — state pensions — supports a large amount of retirees’ income. The typical American receives just 45 percent of his preretirement wage through Social Security, according to the Organization of Economic Cooperation and Development. By contrast, a worker in Denmark, which has one of the most comprehensive and generous retirement arrangements in the world, can retire with a state pension that is 91 percent of his salary. “The financial crisis hasn’t affected me,” says Jens Erik Soerensen, a 63-year-old in Hellerup, Denmark, who works as a researcher at Chempilots, a Danish company that develops polymers for use in the medical device industry. Mr. Soerensen has calculated that when he retires, the combined disposable income that he has with his wife (Lone, also 63, who retired this year from her job in TV production) will fall by about 20 percent. The couple will also continue to benefit from universal health coverage. “I think we can survive without changing our lifestyle, at least until 75,” he said. After that, he might have to dip into personal savings. Of course, such a system comes with tradeoffs. To help pay for generous state pensions, Danish workers have one of the highest tax burdens. The population is also aging, meaning that there will be fewer working people to pay for the pensions and care of a graying society. In response, some nations have been trying to encourage people to stay at work longer. In France, suggestions to raise the retirement age above its current level of 60 have met fierce opposition from unions, although the government intends to push ahead. Britain has had a bit more success, announcing plans to raise the retirement age to 68, from 65 — in 2044. Along with raising the retirement age, some European countries have been shifting more financial risk to individuals.
147 In the United States, where the practice is decades old, the question is whether people can be freed from making their own financial decisions, an act they may not feel qualified to do and may not want to do. One study found that nearly a quarter of Americans ages 56 to 64 had more than 90 percent of their 401(k) balances invested in stocks instead of bonds, against financial advisers’ standard advice for people nearing retirement age. “Employees are just not capable of making these decisions,” said Rick K. Shapiro, a member of the army of financial planning professionals that America’s private retirement system (and private health care and college education financing systems) has spawned. “Maybe they can learn, but they’re distracted, and they’re not incented to learn until the thing blows up.” Even conscientious investors — like the Petruccis, who keep an updated spreadsheet of their investments — lose money. “We thought we were conservative,” said Mr. Petrucci, noting that he and his wife lost about 35 percent of their life savings in the crisis and have made only a little of it back. Still, the American preference for self-reliance, instead of more socialized financial protections, remains strong, even among those who lost big. “I don’t want to depend on anybody else in my retirement,” Mr. Petrucci said. “Not family members, not our children, and certainly not the government, for that matter.” http://www.nytimes.com/2009/09/03/business/03retire.html?_r=1&th&emc=th
148 Sep 2, 2009 Spain’s Unemployment Problem Chris Mooney | The Spanish unemployment rate hit 17.9% at the end of the Q2 2009, according to Spain’s National Statistics Institute (INE), the highest level in the eurozone and well above the 8.9% average of the 27 EU member states. In fact, Spain makes up over half of the past year’s increase in eurozone unemployment, with over 30% of the eurozone’s jobless living in Spain. The Organization of Economic Cooperation and Development (OECD) predicts that Spain’s jobless will reach 20% of the workforce during 2010, gradually edging closer to the historic high of 24% recorded in 1994. Youth unemployment is particularly severe, with one in three workers under 25 years old facing a prolonged period out of work. At the end of the Q2 2009, Spain’s GDP was down 4.1% y/y with domestic consumption expected to fall 4.5% by the end of 2009. The large number of unemployed not only presents obvious economic difficulties for Spain such as falling productivity and a heavy drag on demand but the social consequences are also being felt. Protests have erupted across Spain as citizens struggle to deal with the economic crisis. Jobs have become the primary concern for the electorate, overtaking terrorism at the start of the year. Every country across Europe has suffered from the economic contraction. Yet Spain’s catastrophic housing collapse and towering unemployment figures make its plight stand out. The downturn has been aggravated by Spain’s rigid, antiquated and embedded labor regulations. As Luis Garicano of the London School of Economics argues, “that the crisis has hit Spanish employment disproportionately is due to the catastrophic way the labor market works.” Unless action is taken to remedy the underlying causes of Spain’s unemployment crisis, the country faces a prolonged and dire recession.
149 Source: Eurostat One of Spain’s main problems is its two-tiered employment system, which was introduced in the 1980s, At the time, the structural rigidities of Spain’s economy, particularly in energy-intensive sectors, made it difficult for Spain to cope with rising oil prices. Unions opposed significant and wide-ranging reform, making the creation of the two-tiered system the only politically feasible solution. The changes liberalized temporary contracts, allowing them to be used to hire employees performing regular activities, something that had previously been prohibited. Temporary contracts also allow significantly lower dismissal costs. Termination cannot be appealed, offering sizeable advantages to employers who would otherwise face strict labor laws relating to the dismissal and severance pay of permanent employees. Temporary contracts act as a pro-cyclical factor, stimulating employment during a boom and exacerbating unemployment during a contraction. Since the system was introduced, a number of measures were taken to limit the occurrence of temporary contracts, such as lowering the hiring costs of permanent employees. However, there has not been enough reform enacted, and the widespread use of temporary labor continues. By the mid-2000s, temporary contracts made up 33.5% of all employment. Temporary contracts and the two-tiered labor system are by no means the only causes of high unemployment in Spain. While they are fundamental factors, academics and economists have identified three additional issues which lower the number of employed in Spain. Firstly, the high value of unemployment benefits in Spain is incentive to remain unemployed, and there is little pressure on the unemployed to find work. Secondly, the education system in Spain fails to teach students the technical skills needed by employers, and has created a mismatch between job openings and the educational backgrounds of the workforce. Increased demand for education has resulted in a weakly-structured education system with investment occurring at the high-end to the detriment of the low-end. As such, 30% of Spanish workers have an educational level that exceeds the requirements of their job. The result has been a substitution of high-skilled with unskilled labor, consequently increasing the unemployment of both types of labor as the economy contracts. Thirdly, wage rigidities within the labor market still exist, due to a high level of unionization and the process of indexation. As product prices fall due to lack of demand, wages remain rigid and heavily affect the cost of production, reducing competitiveness. The global economic crisis had a significant impact on the Spanish economy. In December 2008, Spain’s construction output was down 23.7% y/y, following a decade-long construction bubble. The construction industry had taken advantage of temporary labor, with a large proportion of the workforce employed on a short-term basis. This allowed for quick dismissals to occur in the struggling industry and stimulated a swift rise in unemployment. This was not and is still not the only sector suffering under the weight of the global recession: Banking and other service-sector jobs have disappeared. Industrial output has fallen dramatically, with a 48.1% fall in automobile production across the first three months of 2009. The severe labor market rigidities influence product markets, creating high costs of production with high levels of import penetration in Spain, signalling poor domestic competitiveness. The cost of dismissal has caused many firms to offer periods of reduced-pay leave to their permanent employees, a strategy used recently by Banco Bilbao Vizcaya Argentaria (BBVA) whose staff had been offered five years leave with the guarantee of keeping their job. The government has implemented a host of reforms including tax breaks for the self- employed and students; up to 60% in tax deductions on rental income; and the ”cash for
150 clunkers” incentive program. The government, backed by Socialist Prime Minister Zapatero, also implemented stimulus measures, known as “Plan E,” designed to curb job destruction and help the automobile and construction sectors while also promoting a more environmentally-friendly growth model. The package allocated some eight billion euros directly to town halls (i.e. local governments) for immediate expenditure, with the government claiming that the strategy helped create 280,000 jobs. Despite this stimulus, which amounts to almost 7% of GDP taking into account automatic stabilizers, it is unlikely to have the desired long-term effect. Unemployment has continued to rise and labor market rigidities continue to exist.
In short, quick-fix programs cannot alleviate Spain’s unemployment sickness. Only widespread and effective reforms to reduce wage indexation, equalize dismissal costs of temporary and permanent employees, and reduce the power of collective-wage bargaining can solve this entrenched problem. These reforms are essential under the conditions of a single currency to allow Spain to compete and avoid asymmetric shocks. Labor market policies are difficult to pass in Spain even though demand for reform is rife. At the start of 2009, a group of 95 economists wrote an open letter to Zapatero calling for imminent change. More recently, José Manuel González-Páramo, a prominent Spanish European Central Bank executive board member, called for urgent and widespread reform to prevent further job erosion and unemployment. Union resistance, however, is strong, with the General Workers Union claiming that the economic model which allowed the housing bubble to occur was the true cause of the crisis. Strikes have occurred across 70 Spanish cities with Zaragoza becoming a hot-spot of dissent. The unions wish to maintain the status quo as it provides extraordinary job security to permanent employees who make up the majority of union membership. According to existing data, the high number of permanent contracts allowed union members to become the median voter in the Spanish political system, thus holding significant power. This was reversed in the early 1990s, creating a window of opportunity for reform. The permanent workers held political power during 2000-2007 and this power has remained as rising unemployment has been the direct result of cutting temporary workers. As unemployment continues to rise, the political power of permanent workers is likely to fall, and a second window for reform could slowly appear. Zapatero’s real difficulty lies within the Spanish parliament. His minority government struggles to find allies, with left-wing parties especially unreliable on major issues. Reform
151 was not introduced during the boom period as opposition to such policies is vociferous and the weaknesses of the system are muted. The only possibility of reform is a joint effort between the Socialist incumbent party and its conservative opposition, which now leads in the polls. This is highly unlikely, though reform is in the interests of the Spanish economy. Institutions such as the IMF and the OECD are urging immediate reform, but the outlook looks weak. The majority of reforms introduced during the 1990s have maintained a two-tiered scenario as union pressure and political bargaining have reduced the effectiveness of enacted reforms. As the economy begins to stabilize in 2010, firms will still be able to re-hire temporary workers at low costs. However, this pro-cyclical device will only paper the cracks of a brutally inefficient two-tiered labor market (mercado de trabajo dual brutalmente ineficaz). http://www.rgemonitor.com/economonitor- monitor/257617/spains_unemployment_problem
[email protected] email address is being protected from spam bots, you need Javascript enabled to view it
Chris Mooney is an analyst at RGE Monitor focusing on European Monetary Union countries as well as the UK. His areas of expertise include monetary union economics, international economics and banking and finance. Prior to joining RGE Monitor, he worked for Citigroup Global Markets in London and Fleishman Hillard Financial Affairs in Brussels. He holds a bachelor’s degree in economics and government from the London School of Economics, and a master’s degree in European political economy from the European Institute at LSE.
152 Sep 2, 2009 G-20 Finance Minister Meeting: Is the Consensus for Regulation Fading? Overview: Group of 20 (G20) finance ministers of industrialized and emerging nations are meeting in London on September 4-5 in preparation for the G20 meeting on September 24- 25, 2009. As financial markets recovered strongly since the G-20 last met on April 2, and the signs of economic stabilization are multiplying, the sense of urgency to implement important regulatory reforms agreed during the last meeting is receding. See Thomas Philippon summary (VoxEU, Feb 2009) of State of the Art proposals for Macro-Prudential Regulation and the Future of the Global Financial System: Group of 30, NYU Stern, CEPR Reports On Financial Regulation
o William Dudley (NY Fed president): "I think we can respond in a number of ways: First, we can do a better job understanding interconnectedness. This means changing how we oversee and supervise financial intermediaries. Second, we can change the system so that it is more self-dampening instead of self-reinforcing. Third, we can improve incentives (e.g. mandate automatically equity-convertible debt instruments as a form of capital). Fourth, we can increase transparency (see e.g. the beneficial effect of U.S. stress tests). Fifth, we can develop additional policy instruments. For example, we might give a systemic risk regulator the authority to establish overall leverage limits or collateral and collateral haircut requirements across the system. This would give the financial authorities the ability to limit leverage and more directly influence risk premia and this might prove useful in limiting the size of future asset bubbles." (July 2009) See Regulatory Reform in the U.S.: Who Should Be the Systemic Risk Regulator?
o Bloomberg: "France will suggest curbing bonus pools as a percentage of a bank’s revenue, imposing a ceiling on payments or taxing them, a finance ministry official told reporters yesterday. U.K. Prime Minister Gordon Brown sees a cap as difficult to enforce, the Financial Times reported yesterday, citing an interview." (September 2, 2009) See also Tobin Tax debate and France: Will Tighter Bonus Pay Rules Win International Approval?
o Nicolas Sarkozy and Angela Merkel "want the G-20 to limit the size of banks and tighten capital rules." (Bloomberg, Sep 2, 1009)See: EU Commission Faces Opposition On Derivative Reform G20 Leaders Statement summary (April 2) 1) additional $1.1 trillion of support to the world economy: triple resources to the IMF to $750 billion, support a new SDR allocation of $250 billion, to support at least $100 billion of additional lending by the MDBs, to ensure $250 billion of support for trade
153 finance, and use the additional resources from IMF gold sales for concessional finance for the poorest countries, 2) fiscal measures adopted amount to $5 trillion, raise output by 4%, and accelerate the transition to a green economy. 3) Strengthening the Financial System Declaration: - establish a new Financial Stability Board (FSB) with a strengthened mandate, as a successor to the Financial Stability Forum (FSF), including all G20 countries, FSF members, Spain, and the European Commission, to collaborate as early warning system with IMF - extend regulation and oversight to all systemically important financial institutions, instruments and markets, including for the first time, systemically important hedge funds; -implement the FSF’s tough new principles on pay and compensation; - improve the quality, quantity, and international consistency of capital in the banking system. - In future, regulation must prevent excessive leverage and require buffers of resources to be built up in good times; - The era of banking secrecy is over. - call on the accounting standard setters to work urgently with supervisors and regulators to improve standards on valuation and provisioning and achieve a single set of high-quality global accounting standards - extend regulatory oversight and registration to Credit Rating Agencies 4) Strenghtening Global Financial Institutions: -enhance IMF's new $750bn available funds with Flexible Credit Line (FCL) and reformed lending and conditionality framework. -complete the next review of quotas by January 2011 5) Resisting protectionism and promoting global trade and investment remain committed to reaching an ambitious and balanced conclusion to the Doha Development Round 6) Ensuring a fair and sustainable recovery for all current crisis has a disproportionate impact on the vulnerable in the poorest countries. resources from sales of IMF gold, together with surplus income, to provide $6 billion additional concessional and flexible finance for the poorest countries over the next 2 to 3 years. http://www.rgemonitor.com/175/Risk_of_Systemic_Crises_and_Asset_Bubbles?cluster_id =14385
154 Sep 2, 2009 Lord Turner Tobin Tax Proposal: Varied Opinion Emerges Overview Following intense debate over UK banking bonuses, the head of the Financial Services Authority (FSA), Lord Adair Turner, has suggested the introduction of a tax on financial transactions. Such an idea, first put forward by Nobel laureate and economist James Tobin, is known as a Tobin Tax. Whether this proposal bears fruit remains to be seen--Chancellor Alastair Darling has dismissed suggestions that the idea be discussed in the Treasury. The Proposal Lord Turner: The ongoing debate on bankers’ bonuses is a “populist diversion,” and more drastic steps may be needed to cut the "swollen" financial sector down to size. This crisis "requires a very major reconstruct of the global financial regulatory system....If increased capital requirements are insufficient I am happy to consider taxes on financial transactions– Tobin taxes. Such taxes have long been the dream of the development economists and those who care about climate change–a nice, sensible revenue source for funding global public goods." (Prospect; August 27, 2009) The Guardian: "The scale of the crisis has brought Tobin out of the shadows. Indeed, Turner appears to be considering throwing the net wider than simply a tax on foreign exchange dealings." (August 17, 2009) Tobin Tax In 1972, Tobin proposed a small tax on currency transactions that would raise the cost of any financial transaction. He hoped that such a tax would reduce short-term speculation on currencies and "throw sand in the wheels of global finance," with reference to the U.S. dollar peg to gold. Tobin wanted to reduce the socially harmful effects of finance while keeping its benefits and does not agree with the idea of using the tax for revenue-raising purposes. In the foreword to his 1995 book, Tobin stated, "My main objectives for the tax are two. The first is to make exchange rates reflect to a larger degree long-term fundamentals relative to short-range expectations and risk. My second objective is to preserve and promote autonomy of national macroeconomic and monetary policies....Most disappointing and surprising, critics seemed to miss what I regarded as the essential property of the transactions–the beauty part–that this simple one-parameter tax would automatically penalise short-horizon round trips, while negligibly affecting commodity trade and long- term capital investments." Varied Opinion According to media reports from the FT and Bloomberg, Turner's Tobin tax proposal has drawn severe criticism from the financial sector. The main argument against such a proposal is London's loss of competitiveness as a major financial center. RGE's Salman Ahmed asserts that the Tobin tax has its merits, but it would take a global initiative to make it effective and to ensure that public costs associated with banking were properly internalized. Otherwise, the tax would only induce banks to shift centers and play regulatory arbitrage. In addition, tax policy is the remit of the Treasury.
155 Gordon Brown backed the idea of caps on bonuses, but stopped short of endorsing Lord Turner's idea. Brown affrimed that unilateral action in this area will not be fruitful. Darling's aides assert that no such taxes are under consideration and that Darling believes the banking industry in London should continue to play a leading role in global finance. Former Labor Welfare Minister Frank Field: "It looks like Adair Turner has fired the starting gun on thinking more seriously about the City and what it is for and what kind of pay people should expect. When the City has largely made money by moving money around and not by making anything, it is clear the pay is out of kilter." (Politics.co.uk; August 27) Liberal Democrat Treasury Spokesman Lord Oakeshott: "A Tobin tax is interesting but is unworkable without international agreement, which could take years and probably will never happen." (Politics.co.uk; August 27) British Bankers' Association: Banking sector was a main provider of jobs and tax revenues and could be undermined by the wrong kind of taxes or regulation. Mayor Boris Johnson: “Nobody in their right mind would want to do something that targeted London specifically. The City of London generates fantastic revenues for the government.”(FT; August 27) Willem Buiter: "The solution is clear, and it is not a tax on financial transactions: bring default risk back into the calculations of unsecured creditors and other counterparties of the financial sector. This would eliminate the capital subsidy to the industry. The obvious way to do this is through the creation of a “special resolution regime” as an alternative to bankruptcy for all systemically important financial institutions. This would permit their unsecured creditors and other counterparties to be forcibly and swiftly converted into shareholders, until the institutions are adequately capitalised." (FT; September 1) Centre for British Industry: The government and regulators should be very wary of undermining the competitiveness of the UK’s financial services industry. George Parker, FT: Turner’s suggestion of a Tobin tax to rein in excessive profits may turn out to be about as successful as Chirac’s failed initiative. The FSA chairman admits that a global agreement would be “very difficult to achieve.” (August 27) RGE: The Conservative Party's proposal to abolish the FSA after the next general election (which they are expected to win) waters down the nature of any initiatives or views put forward by the FSA in the interim period. http://www.rgemonitor.com/10000?cluster_id=14374 Aug 31, 2009 Macro-Prudential Regulation and the Future of the Global Financial System: Group of 30, NYU Stern, CEPR Reports Overview: Thomas Philippon (Vox): Column provides opinionated synthesis of Geneva Report, G30 Report, and NYU-Stern Report over most, if not all, areas of financial regulation. Column discusses also the capital insurance proposals of Kashyap, Rajan and Stein (2008), and the proposals of Zingales.
156 o Shin; Roubini/Pedersen: Today’s financial regulation is founded on the assumption that making each bank safe makes the system safe. This fallacy of composition goes a long way towards explaining how global finance became so fragile without sounding regulatory alarm bells. To do: introduce some form of systemic insurance to be paid by institutions as they grow bigger and more systemically important
o WEF: The Future of the Global Financial System: 1) An interventionist regulatory framework 2) Back to basics in banking 3) Restructuring in alternative investments 4) Potential winners/losers
o Group of 30, four core recommendations: 1) Gaps and weaknesses in the coverage of prudential regulation and supervision must be eliminated. All systemically significant financial institutions, regardless of type, must be subject to an appropriate degree of prudential oversight. 2) The quality and effectiveness of prudential regulation and supervision must be improved. This will require better-resourced prudential regulators and central banks operating within structures that afford much higher levels of national and international policy coordination. 3) Institutional policies and standards must be strengthened, with particular emphasis on standards for governance, risk management, capital, and liquidity. Regulatory policies and accounting standards must also guard against procyclical effects and be consistent with maintaining prudent business practices 4) Financial markets and products must be made more transparent, with better-aligned risk and prudential incentives. The infrastructure supporting such markets must bemade much more robust and resistant to potential failures of even large financial institutions.
o Peter Wallison (AEI): On Group of 30 proposal: Why extend bank regulation to other sectors when bank regulation clearly failed?
o Independent view from NYU Stern School of Business faculty: Reference summaries and recommendations on 18 key themes: Mortgage Origination and Securitization in the Financial Crisis; How Banks Played the Leverage “Game”? The Rating Agencies; What to Do About the GSEs?; Enhanced Regulation of Large Complex Financial Institutions; Hedge Funds in the Aftermath of the Financial Crisis; Corporate Governance in the Modern Financial Sector; Rethinking Compensation in Financial Firms; Fair Value Accounting; Derivatives – The Ultimate Financial Innovation; Centralized Clearing for Credit Derivatives; Short Selling; Regulating Systemic Risk; The Case for Conditionality in LOLR Facilities; The Financial Sector “Bailout”: Sowing the Seeds of the Next Crisis; Mortgages and Households; Where Should the Bailout Stop?; International Alignment of Financial Sector Regulation
o CEPR Geneva Report Series (Goodhart, Shin, Brunnermeier, Crocket, Persaud): Nature of Systemic Risk; Who Should be Regulated (by Whom); Counter cyclical Regulation; Regulation of Liquidity and Maturity Mismatches (e.g. Mark to Funding-A New Accounting Rule); Other Regulatory Issues; The Structure of Regulation; http://www.rgemonitor.com/175/Risk_of_Systemic_Crises_and_Asset_Bubbles?cluster_id =14385
157 BRUSSELS EU wary on withdrawing fiscal stimuli By Tony Barber in Brussels Published: September 2 2009 10:40 | Last updated: September 2 2009 12:24 European Union finance ministers were set to agree on Wednesday that the EU should not be too hasty in withdrawing fiscal stimuli and other extraordinary measures introduced in response to the worst economic crisis in Europe’s post-1945 history. “The time has not yet come to withdraw from the fiscal stimulus,” said Jean-Claude Juncker, chairman of the 16-member group of eurozone finance ministers. “We have to continue this effort in the course of this year and next year. Then we have to agree on an exit strategy.” The EU ministers were arriving in Brussels for an informal lunch meeting aimed at preparing the ground for a two-day session of G20 finance ministers on Friday and Saturday in London. High on their agenda was the question of how to organise a gradual, co-ordinated removal of the expansionary measures that the US, the 27-nation EU, China and other countries have implemented to avert a deep global recession. In Europe the measures include colossal injections of central bank liquidity, extra government spending that has pushed national budget deficits way beyond normal EU limits, and emergency state aid to the financial and car manufacturing sectors. Pressure is strong from countries such as Germany and the Netherlands, with their long tradition of fiscal and monetary self-discipline, to withdraw these measures as soon as it is safe to do so. “We will need to think about exit strategies, because in the end the huge deficits will threaten the euro,” said Wouter Bos, the Dutch finance minister. The ministers are aware, however, that the exit strategies, if not properly co-ordinated, risk turning into a self- defeating exercise. “A generalised rush to exit combining the mopping up of liquidity, interest rate increases, vigorous budgetary adjustment and the withdrawal of government guarantees would be a recipe for a double-dip recession,” Jürgen von Hagen and Jean Pisani-Ferry of the Brussels-based Bruegel think-tank wrote in a report this week on Europe’s economic priorities between 2010 and 2015. “Exit is bound to be gradual and because crisis management policies are interdependent, a proper sequencing of normalisation action by governments, the [European] Commission and central banks is essential for success,” they said. The EU ministers were also expected to discuss French proposals for capping bankers’ bonuses, ranging from a targeted tax to a legal maximum as a share of profits. France is hoping that a G20 summit of industrialised and emerging countries in Pittsburgh on September 24-25 will produce an agreement on limiting bonuses as strongly worded as a similar G20 accord on tax havens last April. http://www.ft.com/cms/s/0/bb763cc8-97a1- 11de-a927-00144feabdc0.html
158 Europe EU unites behind call for bank bonus cap By Tony Barber in Brussels Published: September 2 2009 10:40 | Last updated: September 2 2009 23:09
Christine Lagarde, French finance minister, after the meeting aimed at forging a common position on bankers’ pay and financial market regulation
European Union finance ministers will press for clearly defined restrictions on bonus pay for bankers when they hold talks with their US and other G20 counterparts this month. “The bankers are partying like it’s 1999, and it’s 2009,” said Anders Borg, finance minister of Sweden, which holds the EU’s rotating presidency. “Obviously, there’s a need for stronger muscles and sharper teeth. It won’t be satisfactory for Europe to end up with broad principles and guidelines.” Mr Borg was speaking on Wednesday after a meeting of the EU’s 27 finance ministers designed to forge common positions on bankers’ pay, financial market regulation and how to withdraw fiscal, monetary and other emergency measures adopted this year to prevent a deep global recession. Finance ministers from the G20 group of leading industrialised and emerging economies meet in London on Friday and Saturday, setting the stage for a full-blown G20 summit in Pittsburgh on September 24-25. The EU ministers agreed that recent signs that Europe’s recession was bottoming out were not sufficient to justify a rapid removal of the emergency measures. They include state aid
159 to the financial sector, injections of central bank liquidity, record low interest rates and government spending that has driven budget deficits far beyond normal EU limits. Wouter Bos, the Dutch finance minister, warned: “We will need to think about exit strategies, because in the end the huge deficits will threaten the euro.” Mr Borg said Europe would not suffer the worst effects of the recession, in terms of rising unemployment, until later this year and in 2010, and this made it all the more important to curb the bonuses of already well-paid bankers. “We will see social tensions in our societies, given that we’re in a precarious situation on the labour market,” he said. “It’s important that we as politicians should give a clear message that the old bonus culture must come to an end.” STIMULUS PLEA Indonesia said it would warn fellow G20 members at Friday’s finance ministers’ meeting against ending their fiscal and monetary stimuli, writes John Aglionby in Jakarta. Sri Mulyani Indrawati, Indonesia’s finance minister, accepted that the “extraordinary monetary and fiscal policies” introduced to combat the global finance crisis were unsustainable. But she warned that nations should not rush to implement a “crisis exit strategy”. “Although there are several statistics that are showing signs of improvement, it’s still too early to say that [the recovery] is on firm ground,” Mrs Sri Mulyani said. “We will say that a premature exit would be counterproductive.” Indonesia has implemented policies to stimulate its economy, which grew 4 per cent in the second quarter. Most EU governments are convinced of the need to break the perceived link between high bonuses and the risk-taking culture that they hold responsible for the near-meltdown of the western world’s financial sector a year ago. France has presented proposals for caps on bonuses such as a targeted tax and a legal maximum as a share of profits. But Gordon Brown, the UK premier, has declined to endorse the French ideas, saying that to impose mandatory limits “would be difficult in an international environment”. Governments in the 16-nation eurozone are conscious that actions on executive pay and bonuses will be less effective unless applied in the world’s biggest financial centres, notably London and New York. “We’ve put a lot of pressure on the other side of the Atlantic,” Mr Borg said. “We’ve seen very clear statements on this issue from President Obama.” “It is better to do it together,” said Didier Reynders, Belgium’s finance minister. “It is better to do it in all the eurozone countries and, if possible, also in the EU with our colleagues from Great Britain. And it may be useful to do it with our colleagues from the United States and other countries in the world.” The EU ministers also agreed to increase the bloc’s contribution to a special International Monetary Fund borrowing programme to €125bn from €75bn. http://www.ft.com/cms/s/0/bb763cc8-97a1-11de-a927-00144feabdc0.html
160
RGE Monitor's Newsletter miércoles 02/09/2009 9:00
Greetings from RGE Monitor!
This week we review the Q2 GDP releases of the four large Eurozone countries and the UK. Europe’s big surprise for the quarter was that Germany and France expanded again, each posting 0.3% quarterly growth. In Q1, by contrast, Germany’s economy contracted 3.5% and France’s shrank 1.3%, and over the past year the German and French economies have contracted 5.9% and 2.6%, respectively. While both countries were widely expected to lead the Eurozone recovery, given their proclivity for cyclical growth and their relatively small internal imbalances, the speed and scope of the turnaround caught economists by surprise. Contrary to forecasts that the Eurozone recovery would lag U.S. recovery, the Eurozone recorded a mere 0.1% q/q contraction in Q2, as compared to the -0.25% q/q (-1% SAAR) reading in the United States. It is important to keep in mind that the current growth drivers such as stimulus programs and restocking are temporary factors. Analysts point out that the signs of a sustained rebound in world trade volumes are still tentative. Germany: The breakdown shows that the rebound in Germany in Q2 was driven by public and especially private consumption, which was sustained by low inflation and the successful cash- for-clunkers program. A temporary work scheme also helped keep down the unemployment rate while supporting households’ purchasing power. Both support measures are set to expire during Q3, thus warranting a reassessment of the economy’s underlying strength going into 2010. Net exports were a major positive factor, but that effect was the result of imports contracting by more than exports. The latter still declined, but at a much slower pace compared to Q1, which reflects stabilizing world trade and positive prospects from new foreign orders. Investment also grew 0.8% q/q after a decline of 7.7% q/q in Q1. Importantly, aggressive inventory slashing continued in Q2, setting the stage for a likely round of restocking in the second half of 2009. The latest PMI indicators support this assessment. All in all, Germany’s tough cycle of supply side reforms, which started in 2003, as well as its budget balancing efforts at the time, introduced the necessary flexibility to adjust quickly to exogenous shocks given that its specialization pattern and economic growth model remains highly dependent on cyclical external demand. France: As mentioned in a previous newsletter on regional bright spots, France’s more balanced domestic demand-led growth model has served as a buffer during a synchronized global downturn. The large social safety net fully served its automatic-stabilizer purpose in a countercyclical manner. Fiscal measures were targeted to the short-term and included mostly non-recurring spending. This assessment is reflected in the Q2 GDP breakdown that shows a low but positive contribution of domestic demand (ex inventories) to GDP. The main contribution to France’s 0.3% q/q growth came from net exports, with exports expanding 1% q/q and imports continuing to contract, albeit at a slowing pace. Investment continued to decline in Q2, albeit also at a slowing pace. The still negative contribution of inventories to GDP sets the stage for a likely bounce in restocking in the coming quarters. France’s August composite PMI reading of above 50 supports the brighter outlook, although managers in the corporate sector recently forecast a sharp cut in investment expenditure. The weak spot in France’s economy remains the tough labor market situation and a likely decline in purchasing power
161 from higher inflation readings as the base effects from last year’s fall in energy prices start to reverse.
Spain: Spain’s structural imbalances and need to deleverage prevent it from participating in any cyclical upswing to the same degree as its larger Eurozone peers. The diverging pattern within the Eurozone is showing up in the August manufacturing PMI readings that see Germany and France improve from their respective July readings, and Spain and Italy basically stalling. Spain’s Q2 GDP recorded a 1.0% q/q (4.2% y/y) decline, driven by retrenching private consumption and investment on a yearly basis. Net exports contributed positively but the breakdown shows that this is due to imports declining faster than exports. Spain’s high unemployment rate reached 17.9% by the end of Q2 and is likely to put a drag on private consumption in the foreseeable future. Spain needs to regain it competitiveness within the Eurozone through productivity enhancement or face a protracted deleveraging effect. Italy: Italy’s GDP declined by 0.5% q/q in Q2 after contracting 2.7% q/q in Q1. From a year earlier, GDP is down 6.0% as of Q2. Although the final breakdown is not yet available, the growth pattern throughout this cycle corroborates a structural lack of dynamism that shields the economy from overextending itself in terms of private debt accumulation, but also prevents it from fully realizing its potential. As in other Eurozone countries, the government introduced consumption and investment support measures, but at a more modest scale due to fiscal constraints. In contrast to previous quarters, net exports are expected to have contributed positively in Q2. Although economic sentiment improved in August, the August manufacturing PMI reading shows a small setback, further corroborating Italy’s inability to fully participate in the stabilization and tentative reawakening of cyclical demand. United Kingdom: The UK economy witnessed it fifth consecutive q/q contraction, with GDP falling 0.7% in Q2. Compared to a year earlier, the economy shrank 5.5%, the largest fall since London started keeping track in 1955. Unemployment rose to a ten-year high of 7.6%, while producer prices fell 1.2% y/y at the end of Q2. Destocking appears to have ended in Q2, boosting manufacturing data and fuelling hopes of a recovery in GDP. Enterprises plan to hold stock levels well down on levels a year earlier. Retail sales grew 3.2% y/y at the end of Q2, boosted by warmer weather, so it is hard to conclude whether this improvement will continue into Q3.
162 Economy
September 2, 2009 Manufacturing Grows After 18 Weak Months By JACK HEALY
After 18 months of layoffs, plant shutdowns and other declines, the country’s manufacturing sector grew in August, offering another piece of evidence that the economy was pulling out of recession. The Institute for Supply Management’s survey of factories and industry had been edging higher this spring, as the blistering pace of economic declines began to level off. But last month, the group’s manufacturing index turned positive, rising to 52.9, from 48.9 in July. A reading above 50 indicates expansion and growth; a number below 50 means economic contraction. President Obama called the numbers “a sign that we’re on the path to economic recovery.”
Companies that make textiles, paper products, computers and electronics, appliances and chemicals were among 11 industry groups that said their business had grown in August. They said new orders were flowing in, production was ticking up and their prices were rising. “It is a big deal,” said John E. Silvia, chief economist at Wells Fargo. “It does suggest that manufacturing is recovering.” Bit by bit, the picture is improving for manufacturers like Allied PhotoChemical, a company in eastern Michigan that makes environmentally attuned ink, paint and coatings. Some 40 percent of its business disappeared last year as the economy swooned, but Allied’s president, Mike Kelly, said the company had gone after new customers and resisted the reflex to slash its work force. Mr. Kelly said Allied was now running at about 65 percent capacity, compared with a low of 40 percent early this year. “You could hear the crickets chirping,” he said. “Our suppliers were calling us, giving us automatic price reductions. They were panicking. Now they’re happy. They’re even beginning to have some product shortages.” Many factories slashed their output and idled assembly lines over the last year as demand for their products dried up and the turmoil of the housing market spilled into the broader economy. But now, after cutting their inventories to the quick, some businesses are starting to rebuild their stocks.
163 The Ford Motor Company has said that it would increase production by 10,000 vehicles to meet the higher demand generated by the government’s cash-for-clunkers program. “We’re at a very early stage of the upturn, and I think it’s going to gradually build steam,” said David Huether, chief economist of the National Association of Manufacturers. Still, most industries were not hiring, an indication that the labor market remained weak. The manufacturing employment index contracted again in August, although at a slower pace than in past months. Four industry groups said their payrolls were growing while nine reported decreases. Manufacturing jobs have been devastated by the recession, with some two million positions lost since the downturn’s official beginning in December 2007. In all, economists believe the economy lost 225,000 jobs last month, and they are expecting the unemployment rate to rise to 9.5 percent when the government releases its monthly snapshot of the labor market on Friday. While many economists expect the economy to grow during the summer quarter as businesses stir back to life, they are worried that sluggish consumer spending will weigh down the economy in the year ahead. Consumer spending fell at a rate of 1 percent in the second quarter of the year, even as tax credits from the stimulus began filtering through the economy. “What’s the sustainability going forward?” Mr. Silvia of Wells Fargo said. “So much of that depends on the consumer.” Also on Tuesday, a report on home sales that are under contract showed that buyers were flocking back to the housing market. The National Association of Realtors said its index of pending home sales surged on a seasonally adjusted basis to its highest levels since 2001, when the group began tracking the numbers. It was the sixth consecutive month of increases. “The recovery is broad-based across many parts of the country. Housing affordability has been at record highs this year with the added stimulus of a first-time buyer tax credit,” Lawrence Yun, the group’s chief economist, said in a statement. The government’s tax credit of up to $8,000 has been helping to entice first-time homebuyers into the market, and mortgage rates are about 5.25 percent nationwide, compared with more than 6 percent last year. Still, even if buyers are buying again, few builders are building. In another report, the Commerce Department said that construction spending fell 0.2 percent in July from a month earlier, and was 10.5 percent lower than it had been in July 2008. Although residential construction spending edged up for the month of July, it was down nearly 27 percent from a year earlier, a sign of the problems still facing builders as they compete with floods of foreclosed homes. Spending on office buildings, commercial projects and hotels all fell from June. http://www.nytimes.com/2009/09/02/business/economy/02economy.html?th&emc=th
164 U.S.
September 2, 2009 Low-Wage Workers Are Often Cheated, Study Says By STEVEN GREENHOUSE Low-wage workers are routinely denied proper overtime pay and are often paid less than the minimum wage, according to a new study based on a survey of workers in New York, Los Angeles and Chicago. The study, the most comprehensive examination of wage-law violations in a decade, also found that 68 percent of the workers interviewed had experienced at least one pay- related violation in the previous work week. “We were all surprised by the high prevalence rate,” said Ruth Milkman, one of the study’s authors and a sociology professor at the University of California, Los Angeles, and the City University of New York. The study, to be released on Wednesday, was financed by the Ford, Joyce, Haynes and Russell Sage Foundations. In surveying 4,387 workers in various low-wage industries, including apparel manufacturing, child care and discount retailing, the researchers found that the typical worker had lost $51 the previous week through wage violations, out of average weekly earnings of $339. That translates into a 15 percent loss in pay. The researchers said one of the most surprising findings was how successful low-wage employers were in pressuring workers not to file for workers’ compensation. Only 8 percent of those who suffered serious injuries on the job filed for compensation to pay for medical care and missed days at work stemming from those injuries. “The conventional wisdom has been that to the extent there were violations, it was confined to a few rogue employers or to especially disadvantaged workers, like undocumented immigrants,” said Nik Theodore, an author of the study and a professor of urban planning and policy at the University of Illinois, Chicago. “What our study shows is that this is a widespread phenomenon across the low-wage labor market in the United States.” According to the study, 39 percent of those surveyed were illegal immigrants, 31 percent legal immigrants and 30 percent native-born Americans. The study found that 26 percent of the workers had been paid less than the minimum wage the week before being surveyed and that one in seven had worked off the clock the previous week. In addition, 76 percent of those who had worked overtime the week before were not paid their proper overtime, the researchers found. The new study, “Broken Laws, Unprotected Workers,” was conducted in the first half of 2008, before the brunt of the recession hit. The median wage of the workers surveyed was $8.02 an hour — supervisors were not surveyed — with more than three-quarters of those interviewed earning less than $10 an hour. When the survey was conducted, the minimum wage was $7.15 in New York State, $7.50 in Illinois and $8 in California.
165 Labor Secretary Hilda L. Solis responded to the report with an e-mail statement, saying, “There is no excuse for the disregard of federal labor standards — especially those designed to protect the neediest among us.” Ms. Solis said she was in the process of hiring 250 more wage-and-hour investigators. “Today’s report clearly shows we still have a major task before us,” she said. The study’s authors noted that many low-wage employers comply with wage and labor laws. The National Federation of Independent Business, which represents small- business owners, said it encouraged members “to stay in compliance with state and federal labor laws.” But many small businesses say they are forced to violate wage laws to remain competitive. The study found that women were far more likely to suffer minimum wage violations than men, with the highest prevalence among women who were illegal immigrants. Among American-born workers, African-Americans had a violation rate nearly triple that for whites. “These practices are not just morally reprehensible, but they’re bad for the economy,” said Annette Bernhardt, an author of the study and policy co-director of the National Employment Law Project. “When unscrupulous employers break the law, they’re robbing families of money to put food on the table, they’re robbing communities of spending power and they’re robbing governments of vital tax revenues.” When the Russell Sage Foundation announced a grant to help finance the survey, it said that low-wage workers were “hard to find” for interviews and that “government compliance surveys shy away from the difficult task of measuring workplace practices beyond the standard wage, benefits and hours questions.” The report found that 57 percent of workers sampled had not received mandatory pay documents the previous week, which are intended to help make sure pay is legal and accurate. Of workers who receive tips, 12 percent said their employer had stolen some of the tips. One in five workers reported having lodged a complaint about wages to their employer or trying to form a union in the previous year, and 43 percent of them said they had experienced some form of illegal retaliation, like firing or suspension, the study said. In instances when workers’ compensation should have been used, the study found, one third of workers injured on the job paid the bills for treatment out of their own pocket and 22 percent used their health insurance. Workers’ compensation insurance paid medical expenses for only 6 percent of the injured workers surveyed, the researchers found. http://www.nytimes.com/2009/09/02/us/02wage.html?th&emc=th
166 Ian Bremmer and Nouriel Roubini: Don’t Expect the U.S. and China to Form a ‘Strategic Alliance’ Anytime Soon - WSJ.com Nouriel Roubini | Sep 1, 2009 From the Wall Street Journal http://online.wsj.com/article/SB10001424052970204731804574384601554931882.html The Yin and Yang of U.S.-China Relations By Ian Bremmer and Nouriel Roubini American and Chinese officials said all the right things during this summer's inaugural round of their Strategic and Economic Dialogue. President Barack Obama pledged to "forge a path to the future that we seek for our children." Chinese State Councilor Dai Bingguo wondered aloud whether America and China can "build better relations despite very different social systems, cultures and histories." He answered his own question, in English, with a "Yes we can." They can, but they probably won't. Yes, Mr. Obama will visit China in November. But when it comes to international burden-sharing, Washington is focused on geopolitical headaches while China confines its heavy-lifting to geoeconomic challenges. The two sides have good reason to cooperate, but there's a growing gap between what Washington expects from Beijing and what the Chinese can deliver. Many of the issues that create conflict in U.S.-Chinese relations are well known: an enormous bilateral trade deficit, disputes over the value of China's currency, protections for U.S. intellectual property, the dollar's role as international reserve currency, conflicts over human rights, naval altercations, protectionist threats from both sides, and disagreements over how best to handle North Korea's Kim Jong Il. But there are other, less obvious obstacles to partnership.First, both governments remain largely focused on formidable domestic challenges. Mr. Obama knows his political fortunes depend largely on the resilience of the U.S. economy and its ability to generate jobs. He's occupied for the moment with a high-stakes poker game with lawmakers in his own party over ambitious health-care and energy-reform plans. China's leadership faces competing internal demands from those who want to stimulate the economy toward another round of export-driven growth and others who want to shift quickly toward greater dependence on domestic consumption. Given the trade deficit, Washington would like Beijing to focus on the latter, but China won't move as fast as the U.S. would like, in part because the leadership recognizes that the loss of millions of manufacturing and construction jobs in recent months could fuel further turmoil in a country that already sees tens of thousands of large-scale protests each year. Second, there's the bureaucratic problem. For the past several years, former U.S. Treasury Secretary Henry Paulson chaired a strategic dialogue with Chinese Vice Premier Wang Qishan. Washington and Beijing have now expanded the scope of talks to include the State Department and China's foreign ministry. Leaving aside the difficulties in building trust between U.S. and Chinese negotiators, State and Treasury don't coordinate well on strategy, and there's no guarantee that China's foreign and finance ministries will work seamlessly together either. The new formula for talks is bureaucratic infighting squared. The third reason the U.S. and China won't build a durable strategic partnership is that Beijing has little appetite for the larger geopolitical role Washington would like it to play. Why should Beijing accept the risks that come with direct involvement in conflicts
167 involving Iran and Iraq, Afghanistan and Pakistan, Israelis and Palestinians, Somalia and Sudan, and other sources of potential turmoil? It has more immediate problems at home. On many issues where the U.S. wants China's support—on Iran's nuclear program, for example—Beijing's interests don't coincide with Washington's. Even in East Asia, China has good reason to avoid the heavy lifting on security, because the U.S. naval presence limits the risk that Japan, India, and other states will spend much more money on their militaries. It's not as though Beijing is enjoying a free ride. China's more than $2 trillion in foreign currency reserves gives its leadership enormous clout as international lender of last resort. Its considerable contribution to global stability is mainly in financing Washington's spiraling debt. By righting its own economy, China can be the primary engine of near-term global growth. Isn't that service enough, Chinese officials ask, at a time when economic crises aggravate so many international problems? The one tangible result of this summer's Strategic and Economic dialogue, a "memorandum of understanding" on climate change, reveals the larger problem. It's valuable to have an agreement in principle, but there were no hard choices on the primary bone of contention— carbon emissions. That's a problem that will generate friction in months to come. Whenever U.S. and Chinese officials get together these days, they trigger a new round of speculation that the world's most important bilateral relationship might soon become its most valuable strategic alliance. It's wrong to entirely dismiss the value of effective speeches and positive political symbolism. But as U.S. and Chinese negotiators move from words to work, they're going to be pulling in different directions. Mr. Bremmer, president of Eurasia Group, is co-author of "The Fat Tail: The Power of Political Knowledge for Strategic Investing" (Oxford University Press, 2009). Mr. Roubini is a professor of economics at New York University's Stern School of Business and chairman of RGE Monitor.
168 CNBC.com Roubini: China Won't Drive World Out Of Recession GUY ADAMI, KAREN FINERMAN, PETE NAJARIAN, TIM SEYMOUR, "FAST MONEY". Posted By: Lee Brodie | Web Editor | 01 Sep 2009 | 06:05 PM ET In a Fast Money exclusive, widely followed market maven Nouriel Roubini reveals his latest market musings. As you may know Roubini, who is a professor of economics at NYU, is considered a sage by some investors after he accurately predicted the housing crisis, deep recession and more. His gloomy prognostications have also earned him the nickname Dr. Doom. Find out what Roubini says could drag us into a double dip recession -– and why China is too small to be the main engine of global growth. Roubini: Bank Balance Sheets Post Biggest Threat To Recovery Fast Money: What is the biggest threat to the recovery? Roubini: The debt ratios of banks and (individuals) are very high; (Individuals) have barely started saving. So what we’ve done is socialize these private losses and now we have a massive releveraging of the public sector with large and unsustainable budget deficits. (The deficits) are leading to accumulation of public debt - over $10 trillion over next 10 years. (That massive amount) of debt may lead to another crisis. Fast Money Insisghts I agree that we see bank failures going forward, says Guy Adami. And if that happens I expect it could spook the market. I also think the market has seen its high for a while. If you agree with Roubini I’d get long gold , counsels Joe Terranova. What do you think? We want to know! Roubini: China Is Not Big Enough To Drive Worldwide Economic Recovery Fast Money: Can China lead the world out of recession? Roubini: I don’t believe China can be the main locomotive of global growth – China GDP is only $3 trillion – the US is $15 trillion. Chinese total consumption is $1 trillion – the US is $10 trillion. So China is too small to be the main locomotive of engine of global growth, and there are excesses right now in China – like froth in the real estate and the stock market. And there is now the beginning of a correction. And if there was a sharp slowdown in China, that’s going to be again negative for the global economy. Fast Money Insights I agree with what Roubini is saying, reveals Tim Seymour. China alone can not do it. But also, I would not underestimate the strength of emerging markets. I don’t think we’re looking for China to be the locomotive, adds Pete Najarian. We’re just looking for a little push.
169 vox Research-based policy analysis and commentary from leading economists Banking crises and exports: Lessons from the past
Leonardo Iacovone, Veronika Zavacka 1 September 2009
Both financial turmoil and falling demand have hit exporters hard. This column confirms the importance of financing problems by showing that sectors relatively more dependent on external finance suffer larger export drops during banking crises. For most countries in the world, this is not a financial crisis – it is a trade crisis. For the first time since 1982, global trade flows will not grow. The latest IMF projections expect global trade in goods and services to drop 11% this year and stagnate next year. This collapse in trade has spread the global recession far beyond the couple dozen nations whose banks were involved in the financial wizardry that sparked the crisis. The size and synchronicity of the trade collapse raises new and pressing questions about the relationship between banking crises and exports growth (Freund 2009). Are the supply shocks due to the collapse in the banking system responsible for the falls in exports? Or is what we observe completely attributable to the demand side where we have also observed unprecedented drops particularly in developed countries? New research on supply-side effects Financial constraints arising during periods of banking crises are particularly relevant for exporters who, in addition to production costs, have to face additional expenses to penetrate foreign markets - a fact well documented by various firm-level studies (Roberts and Tybout 1997, Iacovone and Javorcik 2008, Muuls 2008). Previous industry-level studies have shown that countries with more developed financial systems can develop comparative advantages in industries that rely more on external finance or tend to have lower shares of tangible assets (Manova 2008, Beck 2003). The latter matters because the importance of collateral increases when financial markets are not sufficiently developed and industries with higher shares of tangible assets have a relative advantage in accessing finance. At the same time, it has been shown that in countries with less developed financial systems, sectors relying more on trade finance (as opposed to bank finance) tend to grow relatively faster (Fisman and Love 2003). Building on these studies and using data from 23 past banking crises episodes involving both developed and developing countries during 1980-2000, we treat a banking crisis as an adverse shock to financial development that reduces the availability of finance from private banks and increases the importance of providing collateral to access finance (Iacovone and Zavacka 2009). We compare how export growth changes during crises in industries highly dependent on bank finance with those able to finance their operations through internal cash flow. We expect that, when a crisis hits, the growth in industries
170 highly dependent on finance will fall while the growth of less dependent industries will be relatively unaffected. Figure 1 shows that this is exactly what we observe in the data. Our results show that, during a crisis, the export growth of a sector with a relatively high reliance on external finance, such as electric machinery, is reduced on average by four percentage points compared to a sector like footwear whose dependence is relatively low. We also find that exports of industries that tend to have more tangible assets grow relatively faster during a banking crisis, confirming the hypothesis about the importance of collateral in a context when access to finance becomes scarcer. Finally, using a proxy for trade credit dependence (Fisman and Love, 2003), we show that exports of industries relatively more reliant on inter-firm finance are not affected by a banking crisis more than others. A potential explanation for this finding is that if importers do not face a crisis themselves they might be willing to accept less favourable payment conditions and extend trade credit to their suppliers in order to allow them to overcome their temporary credit constraints. Figure 1. Financial dependence and export growth during banking crises
Impact of demand shocks during a financial crisis
171 In addition to the supply-side effects driven by credit crunch, we also find evidence that demand shocks operate in addition to the financial channel. In fact, when a banking crisis is simultaneously accompanied by a drop in demand, the exporters will be hit twice. Based on our results, Figure 2 simulates a situation in which a country simultaneously faces a banking crisis and a recession in its only importer. The drop of 2.8% that we choose for our simulation corresponds to the IMF projection for the US in 2009. As the figure shows, the effect of finance is amplified by the demand shock, and the latter is particularly pronounced in sectors producing durable goods (e.g. automobiles, domestic appliances) whose growth drops by as much as 10 percentage points. Our finding is in line with the recent Vox column by Caroline Freund, who finds that the impact of demand shocks on trade are particularly important in the context of global downturns. Figure 2. Export collapse in response to financial and demand shocks
Policy interventions Could these dramatic effects on exports be mitigated by policy interventions? Using a reduced sample of 14 out of the 23 periods, we are unable to find any positive impact on exporters arising from various policies including blanket depositor protection, forbearance, bank recapitalisations, and government-sponsored debt relief. Rather, it emerges that general economic and financial development and access to alternative sources of finance helps to reduce the adverse effect of a financial crisis. As shown in Figure 3, the differential effect of the crisis on export growth of highly and less dependent industries is less negative for richer countries, as well as for countries with a more developed financial system. When a crisis hits a country like Nepal, which has the lowest level of financial development in our sample, the export growth of its sectors highly dependent on banking finance drop by 7 percentage points more than that of sectors able to finance their investment using internal funds. In contrast, in a highly financially developed country, like Japan, there is almost no difference. A possible explanation for this result is that exporters in more advanced economies are relatively better established firms and are therefore more likely to have better access to finance from foreign sources. In addition, more developed economies tend to have a better diversified financial system, allowing firms to access financial instruments alternative to banking finance (e.g. leasing, factoring) that can help them to overcome temporary constraints in the context of a banking crisis. References Beck, T. (2003), “Financial Dependence and International trade”, Review of International
172 Economics, 11 (2), 296-316. Caprio, G., and D. Klingebiel (2002), “Episodes of financial and borderline financial crises”, pp. 31-49, no. 428. World Bank. Dell'Ariccia, G., E. Detragiache, and R. Rajan (2008), “The real effect of banking crises," Journal of Financial Intermediation, 17(1), 89-112. Fisman, R. and I. Love (2003), “Trade Credit, Financial Intermediary Development, and Industry Growth,” Journal of Finance, 58(1), 353-374. Freund, C.(2009), ”Demystifying the collapse in trade", VoxEU.org, . 3 July. IMF (2009), “World Economic Outlook: Crisis and Recovery”, April 2009. International Monetary Fund, Washington, D.C. Iacovone, L., and B.S. Javorcik (2008), “Multi-product exporters : diversication and micro-level dynamics," Policy Research Working Paper Series 4723, The World Bank, Washington, D.C. Iacovone, L. and V. Zavacka. (2009), “Banking Crises and Exports: Lessons from the Past.” Policy Research Working Paper Series 5016. The World Bank, Washington, D.C. Kroszner, R. S., l. Laeven, and D. Klingebiel (2007), “Banking crises, financial dependence, and growth," Journal of Financial Economics, 84(1), 187-228. Manova, K. (2008), “Credit Constraints, Equity Market Liberalizations and International Trade,” Journal of International Economics, 76, 33-47. Muuls, M. (2008), “Exporters and credit constraints. A firm-level approach," Research series 200809-22, National Bank of Belgium. Roberts, M. J., and J. R. Tybout (1997), “The Decision to Export in Colombia: An Empirical Model of Entry with Sunk Costs," American Economic Review, 87(4), 545-64. Figure 3. Impact of banking crisis on export growth: Effect of financial development and GDP
http://www.voxeu.org/index.php?q=node/3927
173 vox Research-based policy analysis and commentary from leading economists A Tale of Two Depressions Barry Eichengreen, Kevin H. O’Rourke 1 September 2009
This is an update of the authors' 4 June and 6 April 2009 columns comparing today's global crisis to the Great Depression. World industrial production, trade, and stock markets are now showing signs of recovery. Still – today's crisis remains dramatic by the standards of the Great Depression. Editor’s note: The original Vox column by Barry Eichengreen and Kevin O’Rourke shattered all Vox readership records (30,000 views in two days, over 100,000 in a week, now fast approaching 350,000). Here the authors provide updated charts, presenting monthly data up through June 2009 (or latest). What do the new data tell us? • Global industrial production now shows clear signs of recovering. This is a sharp divergence from experience in the Great Depression, when the decline in industrial production continued fully for three years. The question now is whether final demand for this increased production will materialise or whether consumer spending, especially in the US, will remain weak, causing the increase in production to go into inventories, leading firms to cut back subsequently, and resulting in a double dip recession. • Global stock markets have mounted a sharp recovery since the beginning of the year. Nonetheless, the proportionate decline in stock market wealth remains even greater than at the comparable stage of the Great Depression. • The downward spiral in global trade volumes has abated, and the most recent month for which we have data (June) shows a modest uptick. Nonetheless, the collapse of global trade, even now, remains dramatic by the standards of the Great Depression. Figure 1. World industrial production, now vs then
174 Figure 2. World stock markets, now vs then Figure 3. Volume of world trade, now vs then
Figure 5. Industrial output, four big Europeans, then and now
175
Figure 6. Industrial output, four non-Europeans, then and now
176 Figure 7. Industrial output, four small Europeans, then and now
http://www.voxeu.org/index.php?q=node/3421
177 COMMENT Willem Buiter Forget Tobin tax: there is a better way to curb finance By Willem Buiter Published: September 1 2009 20:19 | Last updated: September 1 2009 20:19
Lord Turner, chairman of the UK’s Financial Services Authority, has set the cat among the financial pigeons by making highly critical comments about the City of London and financial intermediation in general. He recommended some drastic remedies, and suggested considering a global tax on financial transactions – a generalised Tobin tax. James Tobin proposed a tax on foreign exchange transactions to stabilise floating exchange rates and achieve greater national monetary policy autonomy in a world of increasing financial integration. The Tobin tax was never implemented, which is just as well from the perspective of its declared objectives: it could have increased exchange rate instability and was unlikely materially to enhance national monetary policy autonomy. From a political perspective, it may be more surprising that it was never implemented. Even at a very low rate, the Tobin tax could have been a massive government revenue raiser. Distortionary taxes that raise large revenues, including transaction taxes on financial and real assets – such as the UK’s stamp duty on property – are, after all, a common feature of the political landscape. What problem would a Tobin tax on financial transactions solve? Lord Turner asserts, in an interview with Prospect magazine, that the UK financial sector has grown too big; that some financial sector activity is worthless from a social perspective; that the sector is destabilising the British economy; and that new taxes may be required to curb excessive profits and pay in the sector. “If you want to stop excessive pay in a swollen financial sector you have to reduce the size of that sector or apply special taxes to its pre-
178 remuneration profit,” he says. Even if all these assertions are correct, they do not imply the need for a Tobin tax. Economics teaches us that taxes and other public interventions to correct distortions and other market failures should be targeted directly at the distortion or failure in question. What distortion is a tax on financial transactions targeted at? The financial sector is too big throughout the overdeveloped world in part because much of it enjoys a free state guarantee against default on its unsecured debt. Retail deposits are explicitly insured, but at premiums that imply a taxpayer subsidy. Other counterparties of banks and other systemically important financial institutions also benefit from implicit default guarantees. The cost of capital to the banking sector is subsidised, causing the sector to be too large. The solution is clear, and it is not a tax on financial transactions: bring default risk back into the calculations of unsecured creditors and other counterparties of the financial sector. This would eliminate the capital subsidy to the industry. The obvious way to do this is through the creation of a “special resolution regime” as an alternative to bankruptcy for all systemically important financial institutions. This would permit their unsecured creditors and other counterparties to be forcibly and swiftly converted into shareholders, until the institutions are adequately capitalised. It must be possible to achieve such a mandatory recapitalisation by unsecured creditors and counterparties for any institution overnight, and without interrupting normal business. A regularly updated “will” for each systemically important financial institution would eliminate any remaining “too big, too interconnected, too complex and too international to fail” obstacles to the Darwinian discipline of the market, which has been sorely missed in the financial sector. I believe that efficient financial intermediation and a dynamic financial sector are essential for the proper functioning of any decentralised market economy; I also believe that too much financial sector activity is not only socially worthless, but actually harmful. Take financial derivatives. A financial derivative is a bet created by the issuer whose payoff depends on some aspect of the performance of an underlying financial instrument. If the bet pays out when the buyer of the derivative is worse off, we call it insurance. If the bet pays off when the buyer of the derivative is no worse off, we call it speculation. Speculation need not be a problem; it is a necessary feature of the efficient allocation of risk, as long as only one party to the transaction is engaged in it. To tame the rampant excessive speculation in the derivatives markets, it is sufficient to require that at least one of the parties involved in a derivatives transaction has an insurable interest. The Tobin tax does nothing to achieve this. An example: credit default swaps (securities that pay the holder when a bond defaults) can be issued in amounts much larger than the value of the underlying bonds. Anyone who owns CDS in excess of the value of the bonds he owns benefits when the debt defaults, creating obvious moral hazard. The issuer of CDS whose value is much larger than the underlying bonds has the opposite moral hazard: there is an incentive artificially to reduce or eliminate default risk. The simplest solution is to require that CDS pay out only if the same amount of the underlying bond is presented. “Churning” can be a problem for individual savers. Excessive transaction volumes can be caused by perverse incentive systems that link the remuneration of traders – acting as agents for owners of wealth – to trading volumes. Even here, the right solution is not transaction taxes but regulation restricting the undesirable features of these contracts directly. If excessive pay in the financial sector is a problem, tax pay. I agree with Lord Turner that the UK financial sector – too large to fail and possibly also too large to save – has become a destabilising force for the UK. Part of the solution to this
179 “Iceland problem” is for the UK to give up sterling and join the euro instead. A serious global reserve currency provides some protection against bank runs that could bring down a solvent but illiquid cross-border banking system when the country is stuck with a minor- league currency such as sterling. The euro would not help, of course, if the underlying problem is the insolvency of the banking sector and limited fiscal capacity. The only solution then is to limit the size of the banking sector, say by making capital requirements of individual banks a function not only of their own size, but of the size of the total banking balance sheet relative to the government’s capacity to raise taxes and cut spending. Again, a Tobin tax would not achieve this. Transactions are the wrong metric for size here. One can share Lord Turner’s diagnosis that the UK financial sector was allowed to grow too large and to get out of control – almost a law unto itself – without accepting the Tobin tax as part of the solution. Tobin was a genius, but the Tobin tax was probably his one daft idea. Creating a viable and socially useful UK financial sector does not require this unfortunate fiscal intervention. The writer is a professor at the London School of Economics. His Maverecon blog appears on FT.com http://www.ft.com/cms/s/0/76e13a4e-9725-11de-83c5-00144feabdc0.html
180 What BP's New Oil Strike Means A vast discovery in the Gulf of Mexico is the latest sign of success in a high-risk, high-reward strategy By Stanley Reed September 1, 2009, 10:10PM EST It may be one of the biggest oil finds of the year, if not the decade. In recent weeks, executives at BP (BP)'s exploration centers in Houston and London have been closely tracking the progress of a very deep well that BP contractors were drilling into the seabed of the western Gulf of Mexico. In late August the exploratory well, known as Tiber, was completed. On Sept. 2, BP announced that it had made a "giant oil discovery" in the gulf. BP's chief of exploration, Michael Daly, terms the Tiber find "very significant" and says it is even "better" than the Kaskida field, another huge BP property in the Gulf of Mexico, with an estimated 4 billion to 6 billion barrels of oil in place. BP has struggled recently, the result of highly publicized battles with its Russian partners and a series of accidents in the U.S. at its Texas refinery and on Alaska's North Slope. Now it is getting a shot in the arm from its gulf finds, which are just coming onstream with highly profitable oil. The London company's two-decade commitment to the gulf has also helped resurrect a region that was being dismissed as "the Dead Sea" in the early 1990s, after companies hit a series of dry holes. "With respect to the Gulf of Mexico, BP has done very, very well," says Richard Gordon, president of Gordon Energy Solutions, an Overland Park (Kan.) oil and gas consultancy. Tiber and Kaskida will take years to develop, and BP runs the risk of cost overruns, another crash in the price of oil, and unforeseen, expensive challenges in extracting all that crude. But when a field produces, the payoff can last for years. BP's star gulf property, a massive oil and gas field about 140 miles southeast of New Orleans called Thunder Horse, is already raking in cash for the company and for its minority partner in the project, ExxonMobil. Visitors to the BP production platform must first board a helicopter at an airstrip at Houma in the Louisiana bayou. Dodging thunderstorms, the chopper flies over a seascape that reveals the history of the gulf oil industry, as the platforms evolve from shack-like structures in shallow water to massive, deepwater drill ships farther out to sea. Finally, a monstrous gray platform floating on four red legs comes into view. The size of a sports stadium, the Thunder Horse platform is tethered to the ocean bottom by huge chains in 6,000 feet of water and is one of the biggest in the world. For Andy Inglis (pronounced Ingalls), BP's exploration and production chief and Daly's boss, Thunder Horse is worth all the snafus and delays the company had to overcome before it could coax oil from the seabed far below. The company and its suppliers had to devise dozens of new components and materials for the platform, such as valves and coatings to withstand the searing temperatures and intense pressures on wells that must go through four miles of seabed. In 2005 a hurricane left the platform listing to one side, and in 2007 a mass of equipment connecting up the wellheads on the sea floor had to be brought back to the surface to fix faulty welds. WORKING ON THE FRONTIER Now, the property is finally ramping up to its 300,000-barrels-per-day target—making it the No. 2 producer in the U.S. after Alaska's Prudhoe Bay. The oil from this gulf field is among the most profitable in BP's portfolio. Fadel Gheit, an analyst at Oppenheimer (OPY)
181 in New York, figures that at a price of $60 per barrel, BP will earn pretax profits in the mid-$20s per barrel from Thunder Horse, perhaps four times what it earns in high-tax Russia. Two other huge deepwater Gulf of Mexico fields, BP's Atlantis and Mad Dog, have also come onstream, making BP the lead producer in the gulf. Deepwater exploration has added about 1.2 million barrels per day to total U.S. output, arrested a long decline in American production, and decreased U.S. dependence on imported energy. The gulf is "one of the few bright spots in global oil production," says Bob MacKnight, an analyst at consultants PFC Energy in Washington. BP now reckons an additional 22 billion to 40 billion barrels of reserves are to be found there. Finds like Thunder Horse, Tiber, and Kaskida fit BP's high-risk, high-return strategy nicely. "We don't do simple things," Inglis says. "We are prepared to work at the frontier and manage the risks." BP wants to do big projects of a billion barrels or more because that's the only way to replace the huge volumes that it produces, and large scale translates into high returns. Unlike ExxonMobil (XOM) and Royal Dutch Shell (RDS), which have substantial refining and marketing operations, BP is largely an exploration and production company. BP wants to get the choice deals ahead of everyone else, even if that means courting trouble along the way. Witness TNK-BP, the company's turbulent though lucrative joint venture with a group of Russian oligarchs who forced the ouster of the venture's expatriate CEO last year. Then there's BP's lonely decision a few weeks ago to become the first big oil company to return to Iraq. ExxonMobil and Royal Dutch Shell, in contrast, balked at the Iraqis' tough terms. Exploration wells in the deepwater Gulf of Mexico take months to drill and cost up to $200 million. With an overall exploration budget of $600 million to $1 billion per year, BP goes to great lengths to make sure it is taking the right risks. Four times a year, exploration boss Daly gathers his 15 or so chief lieutenants from around the world, usually in Houston or London, to decide where to spend money next. The goal is to back the best ideas—not just spread the exploration budget evenly among various teams. The team that proposes a drilling prospect sets out in a few pages what it expects to find, including the amount of oil and gas and the cost of drilling. According to one participant, discussions can get quite tense, "because people are battling for projects they care about." BP's success rate on the 15 to 25 exploration wells it drills per year: about 60%. For the past eight years, BP has led its peers among the majors, in what's known as organic reserve replacement—additions to its reserve base that don't include any oil picked up through mergers. Says Irene Himona, the analyst at Exane BNP Paribas who ranked the companies according to their reserve replacement: "[BP] has created, through exploration, very large assets that go on producing for the next 20 to 30 years." Things weren't always so upbeat. BP got its feet wet in the deepwater of the gulf more than 20 years ago. But, along with other companies, it hit a dead end in the early 1990s, drilling a series of costly dry holes trying to replicate Shell Oil's deepwater success there. David Rainey, a dry-mannered Northern Irishman who now heads BP's gulf exploration team, recalls how other companies gave up, thinking the area was played out and too expensive, while the former Soviet Union, which was just opening up, looked more attractive than it turned out to be. Cindy A. Yeilding, a Southern Methodist University graduate who bids for BP at U.S. government auctions of gulf oil acreage, recalls fearing that BP's gulf group, too, would get the chop. But BP's brain trust looked at the pattern of the few discoveries that had been made in the deepwater and saw they were large and not trailing off in size, which is usually the case in a maturing area of production. The call: While the region was tricky, it still had
182 a world-class future. And since it was under the control of the U.S., rather than a developing-world dictator, the oil was more accessible. THINKING SMALL BP management told its explorers to go back to the drawing board. They had been drilling spots that looked good on seismic surveys, the maps generated by bouncing sound waves off the rocks below the earth's surface, but that approach had failed. So armed with new technology that allowed them to drill much deeper, the explorers went back to basic petroleum geology: Their aim was to figure out where in the gulf large amounts of oil, which is formed from the remnants of microorganisms that died millions of years ago, might have migrated up through the earth's crust and then hit a seal of rock and salt. "You have to learn to think like an oil molecule," Rainey says. One BP explorer, Neil Piggott, even went 2,000 feet down in a submarine to get a firsthand look at oil and gas seeping out of the sea bottom. There in the inky darkness he saw masses of bacteria feeding on the oil and bizarre 30-foot-long tube worms that in turn were eating the bacteria. The seeps were further evidence that there was more oil farther out in the gulf. The explorers soon identified Thunder Horse as a potential "elephant"—industry slang for a colossal find. But skeptics inside BP worried that the rocks bearing the oil were so deep and subject to such high temperatures that they would not be porous enough to let oil flow through. BP decided to drill an exploratory well to find out. In April 1999, the well hit oil. Recently, the company's exploration team has been locking up positions in even more difficult areas west of Thunder Horse. In August, BP led the bidding at the biannual lease auctions held by the Minerals Management Service of the Interior Dept. in New Orleans. BP bid about $50 million of the $145 million bid by all companies for about 40 tracts in the western gulf near Tiber. BP has also been coming up with new ways to see through the ancient salt layers, thousands of feet thick, that cover much of the oil and gas accumulations in the gulf and other deepwater regions. Oil companies had shied away from the salt because it distorts seismic waves, obscuring what's underneath. But BP's team has figured out how to look under the salt by employing new techniques, such as towing ribbons of seismic sensors behind boats over suspected fields to obtain sharper images of what lay below. "We stopped being afraid of the salt," says Yeilding, who has spent time in France and Canada studying rock formations like those at the gulf's bottom. Deepwater is now a favorite haunt of BP. The company is a major presence in the waters off Angola and is probing the Beaufort Sea in the Canadian Arctic. BP likes to apply what it has learned in the gulf and Alaska to other zones. One play it is beginning to scope out is the Gulf of Sirte off Libya, where prospective oil and gas deposits lie in the sands put down by ancient river systems. Outbid in open bid rounds, the company spent two years lobbying Muammar Qaddafi to grant BP a concession involving huge swaths of offshore and onshore acreage exceeding the size of Belgium. Daly says the next meeting of his explorers will give the green light to the first Libyan wells. The BP exploration group knows that no matter how many Thunder Horse and Tiber winners they hit, they had better not become smug. Two years ago they drilled a prospect in the gulf that had them so excited they called it Big Kahuna. As it turns out, they had the geology wrong and found nothing. "We try to stay humble," Rainey says. "When we don't, we get kicked in the behind. http://www.businessweek.com/print/magazine/content/09_37/b4146000578301.htm
183
Madrid 2016 Bid Has Strongest Public Support: Report By Antonella Ciancio Reuters Tuesday, September 1, 2009 1:10 AM MILAN (Reuters) - Spaniards stand united behind Madrid's bid for the 2016 Olympic Games while Tokyo has the weakest public support among the four potential host cities, a global study showed Tuesday. In an advance copy released exclusively to Reuters, "Sponsoring 21+" prepared by Germany-based sponsoring consultancy Sport+Markt, said 93 percent of Spanish respondents backed the Madrid bid, closely followed by Chicago and Rio de Janeiro. The International Olympic Committee (IOC) will announce the 2016 Olympic host city on October 2 in Copenhagen. "The population's passion for a sports event is the key to its success," said Hartmut Zastrow, executive director at Sport+Markt. Madrid, bidding for the second successive time, is banking on the legacy of the Barcelona 1992 Games and its Mediterranean climate to swing the vote but is widely seen as an outsider. "The Spanish enthusiasm for Madrid's bid is very remarkable. Madrid's chances are said to be low as the Summer Games in 2012 in London are already on European soil," Zastrow added. Tokyo, who topped the International Olympic Committee's (IOC) overall technical evaluation last June ahead of Madrid, ranks as the lowest bidder for local support. Just 72 percent of 1,000 people interviewed across Japan judged its proposal "good or very good," the report said. "The bid of Tokyo does not have enough support in its own country so far," Zastrow commented. "This weakens the Japanese bid immensely." Bookmakers' favorite Chicago comes second with 92 percent of public backing in the United States. Rio, promoting the city's friendly atmosphere and the hosting of the 2007 Pan American Games as key reasons for holding a successful Games, has 89 percent of nationwide support, the report added. (Reporting by Antonella Ciancio; Editing by John Mehaffey) © 2009 Reuters http://www.washingtonpost.com/wp- dyn/content/article/2009/09/01/AR2009090100067_pf.html
184
Opinion
September 1, 2009 OP-ED CONTRIBUTOR The Case Against a Super-Regulator By SHEILA C. BAIR Washington THE Obama administration has proposed sweeping changes to our financial regulatory system. I am an active supporter of the key pillars of reform, including the creation of a consumer financial protection agency and the administration’s plan to consolidate the supervision of federally chartered financial institutions in a new national bank supervisor. This consolidation would improve the efficiency of federally chartered institutions while not undercutting our dual system of state and federally chartered banks. But some are advocating even more drastic changes, like the creation of a single regulator for all banks (and bank holding companies). We clearly need to streamline the system, but a single regulator is not the solution. Calls for consolidation beyond the administration’s plan fail to identify the real roots of last year’s financial meltdown. The truth is, no regulatory structure — be it a single regulator as in Britain or the multiregulator system we have in the United States — performed well in the crisis. The principal enablers of our current difficulties were institutions that took on enormous risk by exploiting regulatory gaps between banks and the nonbank shadow financial system, and by using unregulated over-the-counter derivative contracts to develop volatile and potentially dangerous products. Consumers continue to face huge gaps in personal financial protections. We also lack a credible method for closing large financial institutions without inflicting severe collateral damage on the economy. The creation of a single regulator for all federal- and state-chartered banks would not address these problems. Rather, it would endanger a thriving, 150-year-old banking system that has separate charters for federal and state banks. Within this system, state-chartered institutions tend to be community-oriented and very close to the small businesses and consumers they serve. They provide loans that support economic growth and job creation, especially in rural areas. Main Street banks also are sensitive to market discipline because they know that they’re not too big to fail and that they’ll be closed if they become insolvent. Concentrating power in a single regulator would inevitably benefit the largest banks and punish community ones. A single regulator’s resources and attention would be focused on the largest banks. This would generate more consolidation in the banking industry at a time when we need to reduce our reliance on large financial institutions and put an end to the idea that certain banks are too big to fail. We need to shift the balance back toward community banking, not toward a system that encourages even more consolidation. A single-regulator system could also hurt the deposit-insurance system. The Federal Deposit Insurance Corporation currently supervises state banks. The loss of a significant
185 regulatory role would limit its ability to protect depositors by identifying and assessing risks in the financial system. We can’t put all our eggs in one basket. The risk of weak or misdirected regulation would be increased if power was consolidated in a single federal regulator. We need new mechanisms to achieve consensus positions and rapid responses to financial crises as they develop. I have advocated the creation of a strong council of federal financial regulators. This council would monitor the financial system to help prevent the accumulation of systemic risks and would also have the authority to close even the largest institutions. But we don’t need — and can’t afford — to depend on one supreme regulator to have sole decision-making authority in times when our entire financial system is in flux. One advantage of our multiple-regulator system is that it permits diverse viewpoints. The Federal Deposit Insurance Corporation voiced strong concerns about the Basel Committee on Banking Supervision’s relatively relaxed rules for determining how much capital banks should have on hand. In a single-regulator system, it’s very likely that these rules would have been put into effect much more quickly and with fewer safeguards, and our largest banks would have faced the current crisis with much smaller buffers of capital. This is not about protecting turf. This is about protecting consumers and the safety of our financial system. Working with Congress, we need to draw on the best ideas available to plug regulatory gaps as outlined in the administration’s proposal. We may never have a better opportunity to address the root causes of this crisis — and prevent it from ever happening again. Sheila C. Bair is the chairman of the Federal Deposit Insurance Corporation. SHEILA C. BAIR The Case Against a Super-Regulator September 1, 2009 http://www.nytimes.com/2009/09/01/opinion/01bair.html?th&emc=th
186
This Woman Might Die From Eating Cookie Dough Severe Case Gives Context to Issue of Food Safety By Lyndsey Layton Washington Post Staff Writer Tuesday, September 1, 2009 LAS VEGAS -- In Room 519 of Kindred Hospital, Linda Rivera can no longer speak. Her mute state, punctuated only by groans, is the latest downturn in the swift collapse of her health that began in May when she curled up on her living room couch and nonchalantly ate several spoonfuls of the Nestlé cookie dough her family had been consuming for years. Federal health officials believe she is among 80 people in 31 states sickened by cookie dough contaminated with a deadly bacteria, E. coli O157:H7. The impact of the infection has been especially severe for Rivera and nine other victims who developed a life-threatening complication known as hemolytic uremic syndrome. One, a 4-year-old girl from South Carolina, had a stroke and is partially paralyzed. The E. coli victims are among millions -- one in four Americans -- sickened by food-borne illnesses each year. As waves of recalls have caused the public to lose confidence in the safety of food, lawmakers are scrambling to respond. In July, the House approved legislation that would give the Food and Drug Administration broad new powers and place new responsibilities on food producers. The bill would speed up the ability of health officials to track down the source of an outbreak and give the government the power to mandate a recall, rather than rely on food producers to voluntarily pull tainted products from the shelves. The Senate is expected to take up its version in the fall, and the issue has become a high priority for the White House. It is impossible to say whether new laws and tougher enforcement would have prevented the contamination of the Nestlé cookie dough, which the company voluntarily pulled from stores hours after the government linked it to the outbreak. Last week, chilled packages of the chocolate-chip cookie dough returned to supermarkets after a two-month absence as company executives tried in vain to find the cause of the contamination. They scrubbed their production plant, bought new ingredients and started making dough again. Linda Rivera has just been trying to stay alive. Her cascading problems started about seven days after she ate the dough when her kidneys shut down and she went into septic shock. Then doctors had to remove part of her colon, which had become contaminated. Soon, her gallbladder was inflamed and had to be excised. Shortly after, her liver stopped functioning. It is unclear exactly what is causing her loss of speech, although the toxin produced by the E. coli O157:H7 bacteria can attack the brain. Of all the victims, Rivera has spent the most time in hospitals -- about 120 days since May. She was recovering well enough at one point to go home for nine days but, during that reprieve, she had to be rushed to the emergency room three times. Her case is unusual because E. coli O157:H7 tends to most seriously affect the very young and old. At 57, Linda Rivera is not part of either vulnerable group. Her situation is also unique for the number of major organs that have been injured. Her family and one of her physicians said she had no underlying health problems that would have exacerbated the infection. "Once these patients get into a downward spiral, it's hard to pinpoint why things go wrong," said Michael Gross, a kidney specialist who has treated Rivera. "The chances of her coming out of the hospital and getting into a normal life cycle are low."
187 The Rivera family never gave much thought to food-borne illness. "You watch a commercial, you go into a store and you just assume it's okay to eat," said Linda's husband, Richard, a sales manager for a Web site. "I assume if it's on a shelf, it's safe. But this whole thing has changed the way I look at food." Among the pathogens that can harm human health, E. coli O157:H7 is one of the most lethal, and there is no known cure. The Centers for Disease Control and Prevention estimates about 70,000 people are infected annually with E. coli O157:H7, but the actual number is unknown because many illnesses go unreported. "People just don't really understand how horrible food-borne illness is," said William Marler, a prominent Seattle-based food-safety lawyer who is representing the Rivera family and 23 other victims in the cookie dough outbreak. "They think food-borne illness is a tummy ache and diarrhea." E. coli O157:H7 is typically associated with beef because the bacteria lives in the intestines of cows, goats and other ruminants. But in recent years, the bacteria has turned up in unexpected places, such as spinach and other leafy greens, and, now, cookie dough. Linda Rivera was a high school teacher's aide who was always in motion, cheering her sons at their soccer games and wrestling and track meets, ferrying her twin teenage boys across town to playing fields and skate parks. Now she struggles to hold up her head. Her communication is reduced to shaky hand signals; she turns her right thumb up or down slightly in answer to her husband's questions. Richard Rivera's eyes well up when he contrasts the exhausted, gaunt woman lying askew in the hospital bed with the bubbly blonde he married 12 years ago. It was a second marriage for both, and they each brought three children to the union. "We called ourselves the Brady Bunch," he said. A bearish man in sneakers, shorts and a baseball cap, he spends his days and nights in Room 519, rubbing Linda's feet, dabbing her eyes with a cool washcloth and trying to spoon-feed her medication. He sleeps fitfully in a chair by her bed. He holds up both sides of the conversation. "Are you hot?" he asked Friday. "Give me a thumbs up if you're hot." He watched as Linda shakily turned her right thumb upward. "Okay, baby, do you want the blanket off your leg? Linda, you're turning red. Are you breathing? Okay, I just wanted to make sure." Linda Rivera is so weak, she can't suck on a straw long enough to draw liquid out of a cup. She is being fed nutrients intravenously. Once the CDC made the link between the outbreak of E. coli illness and Nestlé cookie dough in June, Nestlé immediately recalled about 3.6 million packages at a cost of $30 million to $50 million, according to Laurie McDonald, a company spokeswoman. The company and FDA investigators focused on Nestlé's Danville, Va., plant, which produces all its refrigerated cookie dough. E. coli O157:H7 was not found in the plant or on equipment but was detected among the samples of dough that Nestlé routinely sets aside for analysis. However, the contaminated dough had a different genetic fingerprint than the strain that caused the national outbreak, puzzling company officials. In consultation with the FDA, Nestlé bought new supplies of flour, eggs and margarine and restarted production July 7, McDonald said. The revived product, which is packaged with a "New Batch" label and a prominent warning against eating raw cookie dough, went on sale last week. It is too early to track sales, McDonald said. Nestlé "is aware of Mrs. Rivera's illness and our thoughts and prayers are with her and her family," McDonald said. She said the company has been in contact with the Rivera family through Marler and "we have offered support to the family." She declined to elaborate.
188 Neither Richard Rivera nor Marler would say whether Nestlé has made any payments. Linda Rivera has not filed a lawsuit against Nestlé, although three of Marler's clients have. In the three months since she fell ill, Linda Rivera missed her 18-year-old son J.J.'s high school graduation. She missed Mother's Day. Her stepsister unexpectedly died last week, but Richard hasn't told Linda, not wanting to add to her stress. When friends or family relieve him from his post inside Room 519, Richard stands in the 107- degree heat outside the hospital and takes deep drags on Marlboro Lights. At twilight Friday, one of those friends, Greg Van Houten, joined him on the sidewalk. "What do you think, Greg?" Richard asked. "I think she's dying," Van Houten said. Richard nodded. His eyes filled with tears. Moments passed. The two men went back inside the air-conditioned hospital. In Linda's room, her husband, her sons, neighbors and friends formed a small circle around her bed. In yellow hospital gowns and face masks, they clasped hands and prayed for her return to health. "You made it this far -- don't give up on us, Mom," said Tony, one of her 17-year-old twin boys, who sniffled beneath his face mask. "You've done everything for me in my life." Since May, there have been several moments when Richard thought he might lose his wife. Each time, she rebounded, and then relapsed. "That's how it's been through this whole thing," he said. "You feel like you're taking five steps forward and then three steps backward." He is hoping for another, final rebound. http://www.washingtonpost.com/wp- dyn/content/article/2009/08/31/AR2009083103922.html?wpisrc=newsletter
189
Opinion
August 31, 2009 OP-ED COLUMNIST Missing Richard Nixon By PAUL KRUGMAN Many of the retrospectives on Ted Kennedy’s life mention his regret that he didn’t accept Richard Nixon’s offer of a bipartisan health care deal. The moral some commentators take from that regret is that today’s health care reformers should do what Mr. Kennedy balked at doing back then, and reach out to the other side. But it’s a bad analogy, because today’s political scene is nothing like that of the early 1970s. In fact, surveying current politics, I find myself missing Richard Nixon. No, I haven’t lost my mind. Nixon was surely the worst person other than Dick Cheney ever to control the executive branch. But the Nixon era was a time in which leading figures in both parties were capable of speaking rationally about policy, and in which policy decisions weren’t as warped by corporate cash as they are now. America is a better country in many ways than it was 35 years ago, but our political system’s ability to deal with real problems has been degraded to such an extent that I sometimes wonder whether the country is still governable. As many people have pointed out, Nixon’s proposal for health care reform looks a lot like Democratic proposals today. In fact, in some ways it was stronger. Right now, Republicans are balking at the idea of requiring that large employers offer health insurance to their workers; Nixon proposed requiring that all employers, not just large companies, offer insurance. Nixon also embraced tighter regulation of insurers, calling on states to “approve specific plans, oversee rates, ensure adequate disclosure, require an annual audit and take other appropriate measures.” No illusions there about how the magic of the marketplace solves all problems. So what happened to the days when a Republican president could sound so nonideological, and offer such a reasonable proposal? Part of the answer is that the right-wing fringe, which has always been around — as an article by the historian Rick Perlstein puts it, “crazy is a pre-existing condition” — has now, in effect, taken over one of our two major parties. Moderate Republicans, the sort of people with whom one might have been able to negotiate a health care deal, have either been driven out of the party or intimidated into silence. Whom are Democrats supposed to reach out to, when Senator Chuck Grassley of Iowa, who was supposed to be the linchpin of any deal, helped feed the “death panel” lies? But there’s another reason health care reform is much harder now than it would have been under Nixon: the vast expansion of corporate influence. We tend to think of the way things are now, with a huge army of lobbyists permanently camped in the corridors of power, with corporations prepared to unleash misleading ads
190 and organize fake grass-roots protests against any legislation that threatens their bottom line, as the way it always was. But our corporate-cash-dominated system is a relatively recent creation, dating mainly from the late 1970s. And now that this system exists, reform of any kind has become extremely difficult. That’s especially true for health care, where growing spending has made the vested interests far more powerful than they were in Nixon’s day. The health insurance industry, in particular, saw its premiums go from 1.5 percent of G.D.P. in 1970 to 5.5 percent in 2007, so that a once minor player has become a political behemoth, one that is currently spending $1.4 million a day lobbying Congress. That spending fuels debates that otherwise seem incomprehensible. Why are “centrist” Democrats like Senator Kent Conrad of North Dakota so opposed to letting a public plan, in which Americans can buy their insurance directly from the government, compete with private insurers? Never mind their often incoherent arguments; what it comes down to is the money. Given the combination of G.O.P. extremism and corporate power, it’s now doubtful whether health reform, even if we get it — which is by no means certain — will be anywhere near as good as Nixon’s proposal, even though Democrats control the White House and have a large Congressional majority. And what about other challenges? Every desperately needed reform I can think of, from controlling greenhouse gases to restoring fiscal balance, will have to run the same gantlet of lobbying and lies. I’m not saying that reformers should give up. They do, however, have to realize what they’re up against. There was a lot of talk last year about how Barack Obama would be a “transformational” president — but true transformation, it turns out, requires a lot more than electing one telegenic leader. Actually turning this country around is going to take years of siege warfare against deeply entrenched interests, defending a deeply dysfunctional political system. http://www.nytimes.com/2009/08/31/opinion/31krugman.html
191
August 30, 2009, 4:49 pm Horse-race reporting The WaPo ombudsman hits on a pet peeve of mine from way back: reporting that focuses on how policy proposals are supposedly playing, rather than what’s actually in them. Back in 2004 I looked at TV reports on health care plans, and found not a single segment actually explaining the candidates’ plans. This time the WaPo ombud looks at his own paper’s reporting, and it’s not much better. Why does this happen? I suspect several reasons. 1. It’s easier to research horse-race stuff. To report on policy, a reporter has to master the policy issues fairly well. That’s not easy, especially for journalists who have specialized in up close and personal rather than wonkery — and policy issues change from year to year. To do a horse-race piece, you just call up the usual suspects on your Rolodex, and have a bunch of “one Democratic insider said” quotes. That’s also, I suspect, why many policy stories just consist of dueling quotes from supposed experts. 2. It’s easier to write horse-race stuff. Even if you know the policy issues, writing them so you don’t totally lose your audience is really tricky — I’ve spent years trying to learn the craft, and it still often comes out way too dry. On the other hand, horse-race stuff can be full of personal details. 3. It’s safer to cover the race. If you cover policy, and go beyond dueling quotes, you have to make some factual assertions — and people who prefer to believe otherwise will get mad. Newsweek’s Sharon Begley wrote a piece about what actually is and isn’t in Obamacare, and got mail from readers denouncing her and wishing her an early death. As I pointed out the other day, I’m getting a lot of hate mail — and I mean obscenities, death wishes, and all that, not strongly worded disagreements — for writing about Swiss health care and budget arithmetic. Much safer to report on ups and downs in the conventional wisdom. The upshot, of course, is that we’re having a crucial national policy debate in which the great bulk of the news coverage tells people nothing at all about the policy issues. August 30, 2009, 4:24 pm Getting stucco I liked this article on Florida’s bust. But this isn’t the first time the Sunshine State has suffered from a big real estate bubble and crash: You can have any kind of a home you want. You can even get stucco. Oh, how you can get stucco.
192 Business
August 31, 2009 Some Analysts See an End to Market Rally By JACK HEALY It’s been a blockbuster summer for the bulls on Wall Street. Shares are up more than 15 percent since mid-July, investors are feeling optimistic, and once-idle money is pouring back into equities. But as Wall Street heads into September, historically its worst-performing month, the party may be winding down. Some of the analysts and investors who called a bottom in March, when the markets hit their worst levels in more than a decade, now say they are detecting a peak in share prices, and they warn that stocks could be headed for a sharp pullback. Markets drifted over the last week as investors shrugged at more signs the economy was slowly turning around. Stock prices are not such bargains anymore. And corporate insiders, including executives and board members, are starting to sell, suggesting that some of the smarter money is heading for the door. “The people who know are getting out early,” said Art Cashin, the director of floor operations at UBS, who said his “gut feeling” about the markets prompted him to sell some stocks last week. “This rally’s a little long in the tooth.” On Friday, the research firm TrimTabs reported that insider selling had grown to $6.1 billion in the month of August through last Thursday, its highest levels since May 2008 — when the Dow Jones industrial average was floating above 12,000, compared with just over 9,500 at Friday’s close. The ratio of insider selling to insider buying also soared in August, to about 30 to one, its highest levels since the firm started keeping numbers in 2004. “You have a classic case of greed stampeding investors into believing that nirvana is at hand,” said Charles Biderman, chief executive of TrimTabs. “We just don’t see how the market’s going to last.” Of course, insiders are not always right. Many of the country’s smartest investors got clobbered during the downturn last year, and analysts say it is normal for investors to cash in some gains. And betting against Wall Street’s momentum has not been a smart move lately. The Dow and the Standard & Poor’s 500-stock index closed on Friday near their highest levels of the year. The Dow is up 45 percent from its March lows, and the S.& P. 500 is more than 50 percent higher. Analysts say that financial stocks are looking even frothier as trading in a handful of big banks has come to dominate the action on Wall Street. The KBW Bank Index, which tracks two dozen national and regional lenders, has surged more than 150 percent since early March.
193 Shares of the troubled insurance giant American International Group have quadrupled. And Citigroup, Bank of America and Wells Fargo, while still down sharply from their record highs, have been some of the rally’s biggest winners. For months, the cautious and pessimistic voices on Wall Street kept saying the rally would end as investors realized the extent of problems facing the economy — that the financial system was still on life support, companies were struggling to generate new revenue, and nearly 15 million people in the United States were unemployed. But the markets defied their warnings and chugged higher. The investors now waiting for Wall Street to lose its footing see a big “sell!” sign flashing in the confidence that has accompanied the gains. Just before stocks turned around in early March, only 2 percent of investors were optimistic, according to the Daily Sentiment Index, which measures the mood of small traders and is run by Jake Bernstein, an independent market analyst. Now, the index shows that about 89 percent are feeling bullish. Investors were equally cheery when the Dow hit its record high in October 2007. Robert Prechter, president of Elliott Wave International, a technical analysis firm in Gainesville, Ga., cut his negative outlook on stocks in late February. “Now,” he wrote in an e-mail message, “we are firmly back on the bear side.” Investors might be embracing greed once again, but Mr. Prechter said he doubted the stock indexes could replicate the remarkable gains of the past five months. Others see signs of trouble in volatile market swings in China, in the American commercial real estate sector, or in just the sheer amount of time that has passed without a major drop in stocks. “I think everyone’s pretty bearish,” said Thomas J. Lee, the chief United States equity strategist at JPMorgan Chase. “People I talk to think there’s a 10 percent correction coming.” Jeremy Grantham, chairman of the investment firm GMO, was another investor who began encouraging others to buy during Wall Street’s darkest days. But when the S.& P. 500 rose above 1,000 this summer, his firm started taking money off the table. “We said that’s enough above fair value that you want to do something,” said Ben Inker, GMO’s director of asset allocation. “And we made a move.” So far, it is just a small one. The firm cut its equity holdings by about two percentage points, to 63 percent, which is still up substantially from last year, and it is focusing on “big stable blue chips.” The hedge fund manager Doug Kass, who declared in March that stocks had skidded to a “generational bottom,” said last week the rally had run its course. Like other investors who expect the markets to falter, Mr. Kass said he believed the economy was not heading toward a quick or easy recovery. Companies have made themselves look profitable by slashing costs, but he said they are not going to rake in more money in the months ahead as long as weakened consumers stay in hiding. “I think we’ve seen the high for the year,” he said. “There’s a time to hold ’em and a time to fold ’em. And I think we’re at that point.” http://www.nytimes.com/2009/08/31/business/31markets.html?th&emc=th
194 Aug 31, 2009 Macro-Prudential Regulation and the Future of the Global Financial System: Group of 30, NYU Stern, CEPR Reports Overview: Thomas Philippon (Vox): Column provides opinionated synthesis of Geneva Report, G30 Report, and NYU-Stern Report over most, if not all, areas of financial regulation. Column discusses also discusses the capital insurance proposals of Kashyap, Rajan and Stein (2008), and the proposals of Zingales. o Shin; Roubini/Pedersen: Today’s financial regulation is founded on the assumption that making each bank safe makes the system safe. This fallacy of composition goes a long way towards explaining how global finance became so fragile without sounding regulatory alarm bells. To do: introduce some form of systemic insurance to be paid by institutions as they grow bigger and more systemically important o WEF: The Future of the Global Financial System: 1) An interventionist regulatory framework 2) Back to basics in banking 3) Restructuring in alternative investments 4) Potential winners/losers o Group of 30, four core recommendations: 1) Gaps and weaknesses in the coverage of prudential regulation and supervision must be eliminated. All systemically significant financial institutions, regardless of type, must be subject to an appropriate degree of prudential oversight. 2) The quality and effectiveness of prudential regulation and supervision must be improved. This will require better-resourced prudential regulators and central banks operating within structures that afford much higher levels of national and international policy coordination. 3) Institutional policies and standards must be strengthened, with particular emphasis on standards for governance, risk management, capital, and liquidity. Regulatory policies and accounting standards must also guard against procyclical effects and be consistent with maintaining prudent business practices 4) Financial markets and products must be made more transparent, with better-aligned risk and prudential incentives. The infrastructure supporting such markets must bemade much more robust and resistant to potential failures of even large financial institutions. o Peter Wallison (AEI): On Group of 30 proposal: Why extend bank regulation to other sectors when bank regulation clearly failed?
195 o Independent view from NYU Stern School of Business faculty: Reference summaries and recommendations on 18 key themes: Mortgage Origination and Securitization in the Financial Crisis; How Banks Played the Leverage “Game”? The Rating Agencies; What to Do About the GSEs?; Enhanced Regulation of Large Complex Financial Institutions; Hedge Funds in the Aftermath of the Financial Crisis; Corporate Governance in the Modern Financial Sector; Rethinking Compensation in Financial Firms; Fair Value Accounting; Derivatives – The Ultimate Financial Innovation; Centralized Clearing for Credit Derivatives; Short Selling; Regulating Systemic Risk; The Case for Conditionality in LOLR Facilities; The Financial Sector “Bailout”: Sowing the Seeds of the Next Crisis; Mortgages and Households; Where Should the Bailout Stop?; International Alignment of Financial Sector Regulation o CEPR Geneva Report Series (Goodhart, Shin, Brunnermeier, Crocket, Persaud): Nature of Systemic Risk; Who Should be Regulated (by Whom); Counter cyclical Regulation; Regulation of Liquidity and Maturity Mismatches (e.g. Mark to Funding-A New Accounting Rule); Other Regulatory Issues; The Structure of Regulation; http://www.rgemonitor.com/175?cluster_id=14385
196 vox Research-based policy analysis and commentary from leading economists Dumping Russia in 1998 and Lehman ten years later: Triple time-inconsistency episodes
Guillermo Calvo, 31 August 2009
This column introduces "triple time-inconsistent" episodes. First, a public institution is expected to cave in and offer a bailout to prevent a crisis. Then, in an attempt to regain credibility, it pulls back. Finally, it resumes bailing out the survivors of the wreckage caused by the policy surprise. This column characterises the 1998 Russian crisis and the current crisis as triple time-inconsistency episodes and says that a financial crisis may simply be a bad time to try to build credibility.
In the last decade we have witnessed two major systemic financial crises, namely, the 1998 Russian crisis and the current crisis, the latter initially associated with the subprime mortgage market (henceforth, subprime crisis). A critical event in the subprime crisis was the Lehman Brothers’ episode in September 2008. Lehman’s collapse, coming on the heels of the sell-off of Bear Stearns, took the market by surprise. The ensuing about-face regarding AIG was perhaps less surprising but still added a heavy dose of policy uncertainty. Many observers have been critical of that erratic policymaking and see it as directly responsible for the worldwide collapse of stock markets and near panic that took place soon afterwards. Repeated bouts of time inconsistency – as I will characterise this type of episode – have also been argued to have triggered the spreading of the Russian crisis across most emerging market economies in August 1998. As the argument goes, the market was aware that Russia was facing an unsustainable fiscal deficit before August but it was expecting that if a run against Russian public debt obligations materialised, the IMF and other multilateral institutions would rise to the occasion and bail them out. One often-heard reason for this was that Russia was “too nuke to fail.” However, the bailout did not happen, Russia was forced to default and, as if coordinated by a magic wand, the JP Morgan EMBI for all emerging markets went through the roof, with the average interest spread exceeding 1500 basis points. This episode raised fears that Brazil – Latin America’s kingpin – would follow suit and collapse, and apparently led the IMF to soften its stance and extend a very generous standby loan to Brazil on the basis, according to rumour, of skimpy fiscal account information – likely lowering IMF’s credibility as enforcer of market discipline.1 These episodes are cases of what one might call “triple time inconsistency”. First, a public institution is expected to depart from earlier statements and offer a bailout to prevent a major crisis (this is the first round of time inconsistency); then, in an attempt to regain credibility, the bailout is pulled back (the second round) and, finally, having witnessed the wreckage caused by the policy surprise, it resume bailouts of the still-standing dominoes (third round). This seesaw policymaking cannot be right. The initial refusal to continue offering bailouts can only be justified as a warning signal to market players against getting
197 involved in situations in which they will need a bailout. But this “investment in credibility” goes to waste as the policymaker chickens out and bailouts resume. The example below aims at making these intuitions more precise. I think the effort is worth it, given that the similarity between the episodes highlighted above suggests that the phenomenon is likely to repeat itself unless we better understand it and develop ways to prevent it. I would like to point out, however, that the example focuses on the costs of different rounds of time inconsistency but stops short of addressing the policy uncertainty generated by policies that are not in line with private-sector expectations. The latter is a major task that requires more substantive research. A simple model of “triple time-inconsistent” actions Consider an economy with a two-period time span: today and tomorrow. Individuals have an output endowment today that they could consume or allocate to capital accumulation. This is the only decision that they have to make today. Tomorrow’s output can be produced by two independent technologies: (1) output proportional to the capital stock (which is predetermined as of tomorrow) and (2) output proportional to labour supply (which individuals will choose tomorrow as a function of the wage rate net of taxes). Net (consumable) income is output minus taxes. Taxes are of two types: (1) a tax proportional to capital holdings and (2) a tax proportional to wages. The government collects taxes in order to pay back outstanding debt. In a fully conventional way, I will assume that social welfare depends on today’s consumption, tomorrow’s consumption, and tomorrow’s leisure. From today’s perspective, the two taxes are distorting. The capital tax distorts allocation between consumption today and tomorrow, and the wage tax distorts the allocation between consumption and leisure tomorrow. Therefore, it is intuitive that there should be a robust set of cases in which optimal taxation from the perspective of today calls for setting positive taxes on capital and wages. However, if a benevolent government is free to reset taxes tomorrow, it will set the wage tax equal to zero and finance government expenditure entirely out of capital taxes (assuming that government expenditure does not exceed the value of the capital stock). This is because tomorrow the capital accumulation decision has already been taken and there is no output or welfare cost (i.e., no distortion) involved in changing the tax on capital. Thus, there are solid grounds for individuals to expect that a benevolent government will be time inconsistent and that government expenditure will be fully financed from capital taxes. This outcome, of course, is suboptimal from today’s perspective but, unless institutional constraints bar a benevolent government from engaging in time inconsistency, once tomorrow arrives, the best available policy will take that form (This suboptimality of time-inconsistent policy is well known; see Kydland and Prescott 1977 and Calvo 1978). Let us consider the case in which the private sector has reached the conclusion that the government will follow the time-inconsistent optimal policy (in the above-mentioned episodes this would correspond to the cases in which, counterfactually, the IMF bailed out Russia in 1998, and the Fed/Treasury bailed out Lehman Brothers in 2008) and suppose that, contrary to those expectations, the government decides to stick to today’s announcement and avoid the first round of time inconsistency. Notice that tomorrow’s economy is already exhibiting the effects of expected time inconsistency. Therefore, in that context, from the private sector’s point of view, the government not behaving in a (first round) time-inconsistent way boils down to a second round of time inconsistency. Could this be optimal? The second round of time inconsistency takes place tomorrow when the cost of lower capital accumulation (as a result of expected first round of time
198 inconsistency) has already been incurred. Thus, the best policy from tomorrow’s perspective is to eliminate wage taxation; in other words, to behave as expected by the private sector. In this simple model, the second round of time inconsistency pointlessly reduces welfare. In a richer and more realistic model, though, the second round of time inconsistency may have some redeeming value because it could send a strong signal that the government is prepared to incur severe costs to ensure the credibility of time-consistent policy. But the third round of time inconsistency (corresponding to the about-face after failing to bailout Russia and Lehman Brothers) destroys the credibility investment in one fell swoop. Improving public policy responses It is far from me to chastise or ridicule those involved in triple time inconsistency. There are always good reasons why bright and well-intentioned public officials make serious mistakes during major crises. The two cases singled out in this note took place in arguably “unprecedented” circumstances. In situations like these, “shooting from the hip” becomes the rule, and errors are to be expected. However, I believe that there are at least two lessons that we could draw from these episodes, which could help to lower the incidence of triple time inconsistency and other inefficiencies: • A financial crisis is not the best time for reform or building credibility, especially if those actions go against the private sector’s expectations. Policymakers should focus their attention on putting out the fires and minimise the short-run social costs. • Policymakers should spend more time discussing worst-case scenarios before crises occur. These discussions should be carried out with some regularity (much like fire drills) and involve a wide spectrum of public officials that might eventually have to be involved in rescue operations during crisis. This will ensure a better understanding of the involved risks and tradeoffs, and improve the effectiveness of policies that need to be implemented in the spur of a moment. References Calvo, G. (1978), “On the Time Consistency of Optimal Policy in a Monetary Economy,” Econometrica 46, pp. 1411-1428. Calvo, G. (2005), Emerging Capital Markets in Turmoil, Cambridge, MA: MIT Press, Chapters 5 and 12. Kydland, Finn E. and Edward C. Prescott (1977), “Rules Rather than Discretion: The Inconsistency of Optimal Plans,” Journal of Political Economy, 85, 3, June, pp. 473-492.
http://www.voxeu.org/index.php?q=node/3919
199 vox Research-based policy analysis and commentary from leading economists International trade, offshoring, and US wages Ann Harrison, 31 August 2009
This column revisits the heated debate over international trade, offshoring, and US wages using new data. It says that increased international exchange with low-income countries has depressed US wages. That effect only arose during the 1990s, suggesting a different conclusion about trade, offshoring, and income inequality than the previous round of debate. Over the last two decades, the US economy experienced a boom in offshoring and a doubling of imports of manufactured goods from low-wage countries. Over this same period, roughly 6 million jobs were lost in manufacturing and income inequality increased sharply. These parallel developments led many critics of globalisation to conclude that “good” manufacturing jobs were being shipped overseas at the expense of the domestic labour force, putting downward pressure on wages of American workers. Concern over these developments led the US Congress to pass the American Jobs Creation Act of 2004. Yet whether these changes in the US labour market are a result of rising import competition or relocation by multinationals to other countries (known as “offshoring”) is not clear. In a recent study prepared for the Brookings Institution, Paul Krugman (2008) claims that we will never know. He asks “How can we quantify the actual effect of rising trade on wages?”, and then answers: “The answer, given the current state of the data, is that we can’t.” Yet Krugman suspects that the dramatic increase in manufactured imports from developing countries since the early 1990s has contributed to increasing income inequality. Earlier studies explained rising inequality as a result of technological change which favours skilled workers, a falling minimum wage, or weaker unions (Autor, Katz and Kearney 2008). Larry Katz and David Autor agree with Krugman, arguing that international trade and offshoring will be increasingly important drivers of wages in the future. They predict that this will be due rapid growth in competition from developing countries (where wages are low) and dramatic reductions in the cost of computer and communications technology. Trends in employment, wages, offshoring, and trade In recent research (Ebenstein, Harrison, McMillan and Phillips 2009), my coauthors and I use new data to confirm that globalisation forces have had a bigger impact on US wages than previously believed. We show that while some US workers have been adversely affected by global competition, others have benefited from these changes. We combine data on individual workers with information on international trade and offshoring to measure globalisation’s impact on US wages and employment. We begin by showing that over the last twenty years, employment in US manufacturing has declined, wage inequality has increased, and the role of international trade has grown. Figure 1 shows the sharp fall in US manufacturing employment between 1979 and 2002. Total manufacturing employment fell from 22 to 17 million during the sample period, with rapid declines at the beginning of the 1980s and in recent years. However, the effects were
200 uneven across different types of workers. For workers without a college degree, there were significant declines in manufacturing employment over the entire period. The opposite was true for workers with a college degree. Within manufacturing, the labour force has become increasingly well educated, as college graduates replaces workers with high school degrees. Figure 1. US manufacturing employment by education level, 1979-2002
Note: Author’s calculations based on the Current Population Survey’s Outgoing Rotation Group, 1979-2002. Figure 2 shows the trends in hourly real wages. While wages fell for the least educated workers, they increased for workers with at least some years of college. The biggest wage gains were for manufacturing workers with an advanced degree. The decline in wages for high school dropouts and the steep wage increases at the upper end of the income distribution indicate a sharp increase in wage inequality. Figure 2. US manufacturing real wages by education level, 1979-2002
Note: Author’s calculations based on the Current Population Survey’s Outgoing Rotation Group, 1979-2002. Earnings weights, equal to the product of CPS sampling weights and hours worked in the prior week, are used in all calculations. Hourly wages are the logarithm of reported hourly earnings for those paid by the hour and the logarithm of usual weekly earnings divided by usual weekly hours. Overtime, tips, and commissions are included in wages, and top-coded wages are imputed by assuming a log-normal distribution for weekly earnings as described by Schmitt (2003). The calculated nominal hourly wage is converted to a real wage using the 2006 CPI and then trimmed to values between $1-100 per hour. We then ask whether falling manufacturing employment and rising wage inequality are related to trends in offshoring activities and international trade. One measure of the
201 increase in offshoring activities for US companies is the number of workers employed “offshore” by US multinationals (firms which account for most of US manufacturing employment). Figure 3 shows that the number of workers employed by US multinationals in low-income countries nearly doubled over the last 25 years, while such employment in high-income countries remained roughly constant. One implication is that any employment costs at home of offshoring activities abroad are likely to be concentrated in low-income countries (a result our research confirms). Figure 3. Domestic and foreign employment US-based multinationals
Note: Author’s calculations based on the most comprehensive data available from firm- level surveys of US direct investment abroad, collected each year by the Bureau of Economic Analysis. We compute number of employees hired abroad by counter by year and aggregate them by World Bank country income classifications. Figure 4 presents a visual summary of increasing international trade for US manufacturing during the sample period. The solid line in Figure 4 plots the ratio of imports to imports plus shipments over time and the dashed line plots the ratio of imports from developing countries to imports plus shipments. Unlike offshoring, the trends in import penetration were already evident throughout the 1980s. Both imports from developed and developing countries increased steadily between 1982 and 2002, with the most dramatic increase occurring for developing countries. Figure 4. Import penetration
202 Note: Data from Bernard, Jensen, and Schott. (2006). We aggregated industry-level data using employment weights calculated from the Current Population Survey’s Outgoing Rotation Group, 1979-2002. Statistical tests for employment impacts of trade and offshoring Next, we statistically test whether trade and offshoring has forced workers out of the manufacturing sector. We find that there has been a big movement of workers out of sectors with a lot of import competition. We also look for the impact of offshoring on US manufacturing employment, finding small effects on employment that depend on the location of offshore activities. A 10 percentage point increase in offshoring to low-wage countries reduces employment in manufacturing by 0.2% while offshoring to high-wage countries increases employment in manufacturing by 0.8%. The beneficial effect of offshoring activities in high-income countries by US firms on their home employment is one of the most surprising findings of the study. The surprising positive effect of offshoring to high income countries on US wages is consistent with some new theories developed by Gene Grossman and Esteban Rossi-Hansberg (2008). They argue that offshoring activities can actually increase wages for workers remaining at home by cutting costs for the companies that employ them. Did the negative effects of international trade and offshoring activities on US wages increase in the 1990s relative to earlier decades? We find that they did, and that the negative impact of offshoring to low-wage countries on both US wages and employment only became important in the 1990s. The wages of older workers appear to have been disproportionately hurt by offshoring activities. Statistical tests for wage effects of trade and offshoring We then test for the impact of competition from international trade and offshoring activities on US manufacturing wages. Because the US labour market is very flexible, we argue that most workers can easily move across different industries. Our results show that there is a lot of movement of workers across different industries in response to competition from imports. This means that there is no visible impact of import competition on wages within highly affected industries since those workers may relocate to another industry. However, it is much more difficult to switch occupations. Consequently, we introduce the concept of an occupation-specific measure of offshoring, import competition, and export activity. Table 1 shows that some occupations experienced enormous increases in exposure to international trade during the sample period. These included shoe machine operators, for whom occupation-specific import penetration increased from 37% in 1983 to 77% in 2002. Table 2 shows those occupations where export activity increased the most. However, many individuals were in occupations where there was no exposure at all. These occupations included teachers, therapists, sales workers, judges, dancers, and many others. Table 1. Exposure to international trade across selected occupations 1983 2002 Tool and die makers 0.097 0.189 Patternmakers, lay-out workers, and cutters 0.092 0.19 Miscellaneous textile machine operators 0.071 0.192 Miscellaneous precision woodworkers 0.061 0.195 Lathe and turning machine set-up operators 0.109 0.197 Precision assemblers, metal 0.084 0.201
203 Assemblers 0.1 0.203 Tool and die maker apprentices 0.104 0.204 Knitting, looping, taping, and weaving machine 0.046 0.205 operators Production testers 0.072 0.206 Numerical control machine operators 0.103 0.207 Solderers and brazers 0.094 0.218 Electrical and electronic equipment assemblers 0.09 0.219 Textile cutting machine operators 0.085 0.226 Textile sewing machine operators 0.136 0.304 Shoe repairers 0.182 0.379 Shoe machine operators 0.372 0.774 Table 2. Sectors with large increases in export shares 1983 2002 Assemblers 0.091 0.171 Miscellaneous textile machine operators 0.033 0.171 Winding and twisting machine operators 0.037 0.174 Metal plating machine operators 0.084 0.176 Patternmakers and model makers, metal 0.107 0.177 Lathe and turning machine set-up operators 0.089 0.178 Drilling and boring machine operators 0.112 0.184 Tool programmers, numerical control 0.116 0.185 Lathe and turning machine operators 0.112 0.188 Miscellaneous precision workers 0.118 0.191 Tool and die makers 0.097 0.191 Mechanical engineering technicians 0.126 0.193 Production testers 0.108 0.2 Aerospace Engineers 0.18 0.219 Milling and planing machine operators 0.132 0.219 Precision assemblers, metal 0.152 0.223 Knitting, looping, taping, and weaving machine 0.027 0.224 operators Solderers and brazers 0.105 0.225 Numerical control machine operators 0.116 0.23 Tool and die maker apprentices 0.113 0.232 Electrical and electronic equipment assemblers 0.113 0.241 Shoe machine operators 0.023 0.261 What we find is that a one percentage point increase in occupation-specific import competition is associated with a 0.25 percentage point decline in real wages. While some occupations have experienced no increase in import competition (such as teachers), import competition in some occupations (such as shoe manufacturing) have increased by as much as 40 percentage points. The contrasting experiences of workers in textiles and apparel- related sectors compared to many service sector employees such as teachers helps to explain why some parts of the US economy have been deeply affected by globalisation while others have not.
204 We also examine the impact of increased offshoring by US multinational firms on wages of workers in the US. We find that when US companies increase their offshoring activities to low-income countries, this hurts US wages, but that more offshoring to high-income countries is associated with an increase in US wages. Policy implications There are several policy implications of this research. • Policies designed to help displaced workers should be targeted at occupations, not industries. Since the research shows that some types of workers, such as those who work in shoe manufacturing, have been disproportionately hurt while other types of workers (such as teachers) have been unaffected, trade adjustment assistance needs to be appropriately targeted. • Policies (such as those proposed by the Obama administration) designed to curb the negative effects of offshoring on US jobs need to distinguish between offshoring to rich and poor countries. Since the negative effects are restricted to lowincome destinations, any policies which discourage offshoring in high-income regions (such as Ireland or France) will have the unintended effect of hurting the very workers they are designed to protect. References Autor, David H., Lawrence F. Katz and Melissa S. Kearney (2008), “Trends in US Wage Inequality: Revising the Revisionists”, Review of Economics and Statistics 90 (May), 300-23. Bernard, Andrew, J. Bradford Jensen and Peter Schott (2006), “Survival of the Best Fit: Exposure to Low- wage Countries and the (uneven) growth of U.S. Manufacturing”, Journal of International Economics 68:219-237. Ebeinstein, Avraham, Ann Harrison, Margaret McMillan and Shannon Phillips (2009), “Estimating the Impact of Trade and Offshoring on American Workers Using the Current Population Surveys”, NBER Working Paper 15107, June. Feenstra, Robert (2008), “Ohlin Lectures”, manuscript. Grossman, Gene M. and Esteban Rossi-Hansberg (2008) “Trading Tasks: A Simple Theory of Offshoring”, forthcoming American Economic Review. Krugman, Paul (2008), “Trade and Wages, Reconsidered”, draft for Brookings Papers on Economic Activity, February. Schmitt, John (2003). “Creating a consistent hourly wage series from the Current Population Survey's Outgoing Rotation Group, 1979-2002”.
http://www.voxeu.org/index.php?q=node/3920
205 MARKETS.- Asia-Pacific Shanghai’s fall dents Japanese optimism By Lindsay Whipp in Tokyo Published: August 31 2009 06:07 | Last updated: August 31 2009 17:46 The worst plunge in Shanghai equities in more than a year on Monday pulled the rest of the region’s stock markets lower. Investor optimism over a rare change in Japan’s government was not strong enough to keep the benchmark Nikkei 225 index in positive territory. The Shanghai Composite index sank 6.7 per cent to 2,667.75 points, its sharpest one-day decline since June 2008. The index is now trading at its lowest level since the end of May. In Shenzhen, the market dropped 7.1 per cent to 904.70 points. Investors remained concerned about the tightening of lending, which has helped fuel the country’s stock market rally this year. Glenn Maguire, chief Asia economist at Société Générale in Hong Kong, said: “The Chinese market is very much a buy the fact, sell the rumour market. “There’s lots of rumours of tightening of policy, regulation and corporate governance but there’s been very, very little factual backdrop to that. Whilst you see negative rumours persist, the market is more likely to be vulnerable to the downside.” Most stocks were affected with the banking sector and industrials all declining. Shanghai Pudong Development Bank slid 6.1 per cent to Rmb17.84 while Citic fell 7.5 per cent to Rmb24.50. Baoshan Iron & Steel lost 7 per cent to Rmb6.42 after it reported a decline in profit and Sinopec dropped its daily 10 per cent limit to Rmb11.13. The Nikkei rallied 2.2 per cent after the opposition Democratic Party of Japan secured a landslide victory against the Liberal Democratic party in a historic shift in political power. But as Shanghai tumbled and investors became risk averse, the yen started to gain, causing exporters to underperform. The Nikkei lost 0.4 per cent to 10,492.53 points; the broader Topix also fell 0.4 per cent to 965.73 points. Toyota fell 1.2 per cent to Y3,990 while Honda lost 1.8 per cent to Y2,935 and Nissanfell 1.4 per cent to Y650. Sony dropped 1.4 per cent to Y2,515 and Canon fell 3.3 per cent to Y3,570. Chipmakers and related companies outperformed throughout the region, benefiting from Intel’s Friday announcement that it raised its financial guidance for the current quarter. In Japan, Shinko Electric, which makes semiconductor packages, gained 1.5 per cent to Y1,736 while Elpida gained 0.8 per cent to Y1,455 and Dainippon Screen Manufacturing gained 1.3 per cent to Y321. Toshiba rose 2.4 per cent to Y478.
206 In Korea, Samsung rose 0.9 per cent to Won771,000 while Hynix Semiconductor gained 2.8 per cent to Won21,950. The Kospi index lost 1 per cent to 1,591.85 points. Taiwanese chipmakers gained, helping the overall market outperform the region. The Taiex Weighted index gained 0.2 per cent to 6,825.95 points. Nanya Technology gained 6.3 per cent to T$17 while Transcend Information gained 1.9 per cent to T$109.50. In Hong Kong, the Hang Seng index closed 1.9 per cent lower at 19,724.19 points. The sub-index of mainland Chinese shares traded in the territory lost 1.4 per cent to 11,278.26 points. Banks were under pressure with HSBC losing 1.1 per cent to HK$82.20 while Hang Seng Bank lost 1.5 per cent to HK$110.10. In Australia, the S&P/ASX 200 lost 0.2 per cent to 4,479.10 points. ANZ Banking Group announced its earnings for the 10 months to June. Its shares gained 4.1 per cent to A$21.29 after it said retail and commercial lending grew and impaired loan increases were slower than the previous two quarters. http://www.ft.com/cms/s/0/da1dae48-95e6-11de-90e0-00144feabdc0.html?nclick_check=1
207 Asia-Pacific Data highlight challenges faced by DPJ By Robin Harding in Tokyo and Justine Lau in Hong Kong Published: August 31 2009 05:58 | Last updated: August 31 2009 17:06 An array of data released on Monday showed the challenge ahead for the Democratic Party of Japan as it seeks to shift the focus of Japan’s economy towards domestic consumption. Industrial production recovered further in July, up by a seasonally-adjusted 1.9 per cent on the previous month. However, production was still 22.9 per cent lower than a year ago, and retail sales, real wages, and new housing starts similarly trailed their 2008 levels. The increase in industrial production, driven by higher output of cars, adds to evidence that Japan will enjoy another quarter of growth between July and September. Manufacturers expect production to increase by 2.4 per cent in August and 3.2 per cent in September, according to a Ministry of Economy, Trade and Industry’s survey released at the same time. The slow recovery in manufacturing and exports, however, is in contrast to the economy’s domestic weakness. According to data released on Monday, retail sales were down by 2.5 per cent on a year earlier in July; real wages were down by 2.2 per cent on the previous year; and new housing starts were 32.1 per cent fewer than in July 2008. In a speech on Monday, Masaaki Shirakawa, the governor of the Bank of Japan, said that he expected a gradual recovery from the autumn, but its pace was likely to be moderate. “Against a backdrop of excessive capital stock and the severe employment and income situation, business fixed investment and private consumption are likely to remain relatively weak for the time being,” Mr Shirakawa said. Japan’s combination of falling prices, falling real wages and rising unemployment will make it hard for the DPJ to persuade consumers to spend, because workers have less money in their pockets, greater fear of losing their jobs, and also the prospect that deflation will make goods cheaper if their purchases are delayed. “If overhauling the [government] spending structure acts to relieve the public’s anxieties, the resulting increase in permanent consumption should sustainably bolster economic growth,” wrote BNP Paribas economist Ryutaro Kono in a note to clients, but he emphasised the need for the DPJ to properly fund its spending promises. The DPJ’s policies to increase household incomes include a Y26,000 monthly allowance per child, free public high school education and the abolition of motorway tolls, although these will be offset by the withdrawal of tax allowances. “We will increase the disposable income of households and encourage consumption...These measures will change the Japanese economy to one centred on domestic demand, and will make stable economic growth possible,” the DPJ pledged in its election manifesto. http://www.ft.com/cms/s/0/14e34e58-95dc-11de-90e0-00144feabdc0.html
208
Blue Chip, White Cotton: What Underwear Says About the Economy By Ylan Q. Mui Washington Post Staff Writer Monday, August 31, 2009 For one answer to the nation's most pressing economic question -- when will the recession end? -- just take a peek inside the American man's underwear drawer. There may be some new pairs there, judging by recent reports from retailers and analysts, and that could mean better days ahead for everyone. Here's the theory, briefly: Sales of men's underwear typically are stable because they rank as a necessity. But during times of severe financial strain, men will try to stretch the time between buying new pairs, causing underwear sales to dip. "It's a prolonged purchase," said Marshal Cohen, senior analyst with the consumer research firm NPD Group. "It's like trying to drive your car an extra 10,000 miles." The growth in sales of men's underwear began to slow last year as the recession took hold, according to Mintel, another research firm. This year, Mintel expects sales to fall 2.3 percent, the first drop since the company started collecting data in 2003. But the men's underwear index -- or, conveniently, MUI -- may also have a silver lining. Mintel predicts that next year, men's underwear sales will fall by 0.5 percent, and as with many economic indicators, a slowing of a decline can be welcomed as a step in the right direction. Retailers are reporting encouraging signs in the men's underwear department. Sears spokeswoman Amy Dimond said stores are beginning to see more sales. At Target, spokeswoman Jana O'Leary said sales of men's underwear have been stronger over the past two months and multi-pair packs are moving. No less an oracle than former Federal Reserve chairman Alan Greenspan has given this theory credence, as described in a report on NPR two years ago. But you don't have to take his word for it. Just ask Kenneth Sanford, 59, of Capitol Heights, about his underwear. He said he usually buys new boxers every three months or so in maroon, black or white. But he had to stop working for medical reasons, and now he's having a hard time finding a new job. To save money, he doesn't go out for ribs with his friends and family as much anymore. And when he indulges, he gets one piña colada instead of two. He hasn't bought a new pair of underwear in at least eight months. "It's been a while now," Sanford said. "I just don't ever go shopping." Of course, there are more conventional indicators of the nation's economic health. The gross domestic product fell 1 percent during the second quarter. Consumer spending and consumer confidence have been on a roller coaster this year. Home sales show some signs of bottoming out. But sometimes it is the little things that can be the most telling. Leonard Lauder, chairman of the cosmetics company Estee Lauder, famously looked to lipstick sales as a barometer of consumers' mind-set during the last downturn. He believed
209 that women were looking for small indulgences to lift their spirits during a tough economic time, though that theory has not held up in this recession, as sales of lipstick at mass retailers fell 8 percent over the past year, according to the research firm Information Resources. Others look to a reported rise in prescriptions of anti-depressants and sleep aids last year as a sign of consumers' fragile state.
But perhaps no other purchase is as intimate as underwear. Few, if any, other people see it, so it's an easy place to skimp. According to Mintel, men buy an average of 3.4 pairs of underwear in a year. But from 2004 to 2008, the proportion of men buying single pairs at a time increased from 5 percent to 8 percent, while the share of men opting for packs of four or more fell slightly, from 68 to 66 percent -- indicating that shoppers may be trying to save money by buying only when necessary. "People still need underwear," said Michael Kleinmann, president of FreshPair.com, an online underwear retailer. "They just have less money to spend." The company sells high-end men's underwear that can run as much as $30 per pair, along with brands that cost less than $10. Kleinmann said that such less expensive pairs have had double-digit-percentage sales growth recently, while demand for pricier pairs is slowing. Cohen, of NPD, said he hopes the recent positive signs in men's underwear will spill over into other need-based purchases. With the recession nearing two years, shoppers are at the stage where their stuff is simply beginning to wear out, providing an incentive to return to the stores. "The consumers may be down, but they're not out," said Cohen, who is bullish on an economic recovery. "If this were a true, deep, long, embedded recession, they wouldn't even be buying underwear."
Ylan Q. Mui Blue Chip, White Cotton: What Underwear Says About the Economy August 31, 2009 http://www.washingtonpost.com/wp- dyn/content/article/2009/08/30/AR2009083002761.html?wpisrc=newsletter
210 COLUMNISTS. Wolfgang Munchau Central banks can adapt to life below zero By Wolfgang Münchau Published: August 30 2009 19:48 | Last updated: August 30 2009 19:48 The zero lower bound is one of the great myths of monetary economics. It is the statement that interest rates cannot fall below zero, for otherwise people would hoard cash. Generations of central bankers have treated it as the equivalent of zero degrees Kelvin, the lowest theoretically possible temperature. The Swedish Riksbank last week took the unusual step for a central bank of breaching the zero bound when it set a small negative deposit rate. The decision raises two questions. Should it be done? Can it be done? The answer to both is yes. It should be done simply because real interest rates are presently not consistent with most central banks’ inflation or price stability targets. Inflation is very likely to undershoot official inflation targets for some time to come. The reason is that interest rates are too high, because central banks feel trapped by an imaginary zero lower bound. This brings us to the second and harder question. Can it be done, given the problem of cash hoarding? First, modern central banks have more than one interest rate at their disposal. The Riksbank did not cut all its interest rates to below zero, only the deposit rate – the rate banks receive for their deposits with the central bank. The idea of a negative deposit rate is to discourage banks to hoard their surplus liquidity in the form of central bank deposits, as opposed to lending it to customers. By cutting only the deposit rate below zero, the Riksbank only partially transgressed the zero lower bound. It used negative interest rates for the purpose of a highly targeted operation. Negative interest rates are therefore not an all-or-nothing proposition. Second, even if we accept the existence of a lower bound, it might not be zero. The traditional argument for the zero bound is that people simply move out of deposits into cash. But they have to store the cash somewhere and to protect it. This costs money. A US central banker once told me his estimate for the actual storage cost was somewhere between 1 and 2 per cent of the cash value. This means that negative interest rates of minus 1 or 2 per cent would probably not trigger a serious dash for cash. At those rates, people and banks would still prefer to hold their surplus cash in deposits rather than take the trouble to put it under a mattress and hire round-the-clock security guards. The storage costs still imply a lower bound, but one below zero. Third, central banks could deploy policies to discourage cash hoarding. One extreme possibility would be to stamp cash, putting an expiry date on banknotes that would force their holders to pay a fee equivalent to the negative interest rates. Given the two previous arguments, this is probably not necessary, as the current economic situation does not require interest rates to be extremely negative. But it is good to know that such policies exist and can be deployed when necessary.
211 So why do central banks remain in awe of the zero bound? There are several explanations. The first is that central bankers are a risk-averse lot and do not like to tread where no one has gone before. It takes a small central bank such as the Riksbank to take the first step. Furthermore, it is no accident that Lars Svensson, the deputy governor of the Riksbank, who pushed hard for this policy change, is also one of the world’s best known monetary economists. Academics are generally less troubled by the notion of a negative interest rate than practitioners, who tend to be overawed by technical arguments. I have heard the case made that computers would probably not be able to cope with negative interest rates. Some central bankers have also argued that negative interest rates would kill the business model of money market funds. While that may be true, it is astonishing that its advocates prioritise the welfare of individual fund managers and their clients over the general goal of price stability. This is the argument of central bankers whose function is reduced to financial centre lobbyists. A third argument is that zero or negative interest rates might lure investors into purchasing risky assets, in the full knowledge that those policies will sooner or later have to be reversed once the economy recovers. The latter is really an argument for a non-activist monetary policy, the kind that is generally preferred in continental Europe. But if non- activist policies result in large swings in inflation rates, they, too, might produce financial instability and unfair wealth distribution. So it is generally best for central banks to set interest rates to stabilise inflation expectations around a desired level, even if that requires vigorous policy action at times. But there is one prerequisite for any such policy to be credible and successful, and this is my main ground for concern: the central bank must act symmetrically. When the economy recovers and inflationary pressures build up, central banks must raise interest rates just as vigorously. So if you believe that interest rates should be negative now, you should also accept that they might be strongly positive in a few years’ time. While I have full confidence in the Riksbank, I doubt whether all central banks will have the nerve. Write to [email protected] More columns at www.ft.com/wolfgangmünchau http://www.ft.com/cms/s/0/d69a0a48-9594-11de-90e0-00144feabdc0.html
212 Aug 29, 2009 Time for a Paradigm Shift to Include Credit: Do We Need a Higher Inflation Target? A Price Level Target? Overview In a July 16, 2009, report, Morgan Stanley (MS) asserts that the pre-crisis period showed that "stabilizing consumer price inflation does not automatically stabilize asset prices. On the contrary." Moreover, the OECD notes that several nations have hit the zero bound of nominal interest rates, which highlights the shortcomings of the low-inflation-targeting framework. Among the possible options to reduce the downside risks of deflation are increasing inflation targets and "target[ing] a price level path instead of an inflation rate because a credible price-level targeting regime can practically eliminate the risk that policy rates may be constrained by the zero floor" (June 24, 2009). Too Much Debt and Leverage
o Anja Hochberg, Credit Suisse: "The carefree granting of credit to consumers and the interest in securitized loans on the investor side were phenomena that could only have occurred under specific conditions: a long period of historically low interest rates." (August 18, 2009)
o Daniel Gros, Stefano Micossi, Jacopo Carmassi (Vox-EU): "Without lax money and excessive leverage, reckless bets on asset price increases would have been much reduced. A repeat of this instability could be avoided in the future by correcting those two policy faults. By and large, there is no need for intrusive regulatory measures constraining non-bank intermediaries and innovative financial instruments." (August 13, 2009)
o Jan Schildbach (Deustsche Bank): "Banks' net interest income has been boosted for the past 30 years by a structural decline in interest rates that fueled an exceptional lending boom. Falling interest rates are beneficial for banks as the pass- through of interest rate changes differs on the asset and liability side of the balance sheet."
o Hyun Song Shin, Tobias Adrian (Princeton U./NY Fed): "Aggregate liquidity can be seen as the rate of change of the aggregate balance sheet of the financial intermediaries. We document evidence that marked-to-market leverage is strongly procyclical as financial institutions seem to target a fixed leverage ratio throughout the cycle."
o Nassim Nicholas Taleb and Mark Spitznagel, Universa Investments: "The core of the problem, the unavoidable truth, is that our economic system is laden with debt, about triple the amount relative to GDP that we had in the 1980s. The only
213 solution is the immediate, forcible and systematic conversion of debt to equity. There is no other option." (FT; July 13, 2009) o Keiichiro Kobayashi: "The existing theoretical structure of macroeconomics is incapable of addressing macroeconomic performance and the stability of the financial system in an integrated context." The author proposes a paradigm shift. See also Luigi Spaventa, CEPR, reaching similar conclusions. o see also the evolving Tobin Tax debate set in motion by the FSA's Adair Turner. Higher Inflation Target? o Thomas Palley, Director of the Globalization Reform Project, Open Society Institute: Financial innovation and deregulation increase the elasticity of private money creation. The optimal monetary policy and financial stability framework in this setting includes two components. One is an inflation target at the Minimum Unemployment Rate of Inflation (MURI), somewhere between 2% and 5% instead of an a priori "low" level based on the Non-Accelerating Inflation Rate of Unemployment (NAIRU) framework. The second are countercyclical, asset-based reserve requirements that prevent the build-up of credit overextension in the first place (off-balance-sheet items need to be taken into account.) Both MURI and NAIRU are unobservable, but the MURI concept errs on the side of steering clear of deflation traps in the face of easy debt creation, whereas the NAIRU concept errs on the side of structural unemployment and a permanent demand deficit trap--the flip-side of "awash with liquidity" (see the July 19, 2009, Joseph Stiglitz lecture). See Liquidity Trap Revisited. o Stephen Cecchetti, BIS Chief Economist: Adding "leaning against the wind" and macro-prudential systemic risk provisions in monetary policy "does not mean forsaking central banks’ price stability objectives, as it is not aimed at changing long- term targets or goals." (July 17, 2009) See Systemic Risk Supervision around the World Price Level Targeting o FT: "Under a price-level target regime, rather than aiming for an annual inflation rate of 2%, for example, a central bank would target a CPI index of 100 in the first year, 102 in the second year, 104 in the third and so on. While inflation targeting is forward looking and does not attempt to correct for past undershoots or overshoots, a price-level target takes into account past performance–so if the central bank overshoots its target one year it will aim to undershoot in subsequent years in order to bring the price index back on track, and vice versa." (August 26, 2009) o Joachim Fels & Spyros Andreopoulos, MS: "The major advantage of PT is that, if credible, long-term inflation expectations are actually more stable than under IT. During the Gold Standard, which implicitly was a price level-targeting regime, the long-run price level was given by the quantity of gold in the international monetary system. Periods of inflation were followed by periods of deflation because there was a built-in automatic stabilizer, and the price level was stable over the long term." (July 16, 2009) o see Will Inflation Targeting Give Way to Price Level Targeting? http://www.rgemonitor.com/175/Risk_of_Systemic_Crises_and_Asset_Bubbles?cluster _id=14180
214 Currencies Bankers watch as Sweden goes negative By Andrew Ward in Stockholm and David Oakley in London Published: August 27 2009 19:48 | Last updated: August 27 2009 22:41 For a world first, the announcement came with remarkably little fanfare. But last month, the Swedish Riksbank entered uncharted territory when it became the world’s first central bank to introduce negative interest rates on bank deposits. Even at the deepest point of Japan’s financial crisis, the country’s central bank shied away from such a measure, which is designed to encourage commercial banks to boost lending. But, as they contemplate their exit strategies after the extraordinary measures of the past two years, central bankers will be monitoring the Swedish experiment closely.
Mervyn King, the Bank of England governor, has hinted he may follow the Swedish example as the danger of a so-called liquidity trap, where cash remains stuck in the banking system and does not filter out to the wider economy, is an increasing concern for the UK. Hoarding is exactly what happened in Japan earlier this decade when the Bank of Japan implemented quantitative easing between 2001 and 2006. Japanese banks refused to lend, in spite of central bank stimulus, because of fears over the dire state of the economy. If this continues to happen in other economies, central bankers may be left with little choice but to follow the Swedish example. John Wraith, head of sterling rates product development at RBC Capital Markets, says: “The success of the UK’s quantitative easing
215 experiment hinges a lot on whether the banks will use the extra money they are getting for lending to individuals and businesses. “If there is no sign of this over the next few months, then the Bank of England might consider a negative interest rate. In essence, it is a fine on banks that refuse to lend.” In the UK, for example, nearly £140bn has been injected into the economy through central bank purchases of government bonds and corporate assets, mainly from the commercial banks. Quantitative easing explained Our interactive feature explains how quantitative easing works and how this policy may stimulate the economy. However, since the QE project was launched on March 5, a lot of this money, which in theory should be used by the commercial banks for lending to businesses and individuals, has ended up at the Bank of England in reserves. Commercial bank deposits have risen from £31bn in early March to £152bn at the end of July – the latest figure. This in itself is not a problem as the banks could be using this big increase in their reserves to step up their lending to the private sector. The more the banks have in reserves, the more they are allowed to lend. However, there is no sign yet that they are using their much bigger reserves to lend on. The latest money supply figures for lending are still fairly anaemic. It is why Mr King did not rule the possibility of negative interest rates when asked about the Riksbank model this month following the unveiling of the quarterly inflation report. “It’s an idea we will certainly be looking at, whether the effectiveness of our asset purchases could be increased by reducing the rate at which we remunerate reserves,” he said. His comments are one reason why yields on short-dated UK government bonds have fallen to record lows and why sterling has been under pressure in the currency markets. Initially, Mr King gave QE six months before it would start taking effect. That time limit is up next week. If there are no signs in the money supply numbers, particularly in the key M4 lending excluding financial institutions, then the policy may start to look a distinct possibility. In Europe, the European Central Bank is considered less likely to introduce negative interest rates.This is because it has maintained higher official rates than other banks and used money market operations to act as a stimulant instead. For example, it offered commercial banks unlimited funds for one year at the end of June. But it does have the same problem as the Bank of England in assessing the success of its policy. Like the UK, commercial bank deposits at the ECB have shot up in the past few months. At this stage, the US also seems unlikely to introduce the policy as there has been little debate on the matter and no hints from policymakers about it being an option. At the Riksbank, which now has a deposit rate of minus 0.25 per cent, the most vocal advocate of the policy is deputy governor Lars Svensson, a world-renowned expert on monetary policy theory and a close associate of Ben Bernanke, chairman of the US Federal Reserve, since they worked together at Princeton University.
216 According to the minutes of the Riksbank’s July meeting, Mr Svensson dismissed the “zero interest rate mystique” that had “exaggerated the problems” associated with zero or sub- zero rates. “There is nothing strange about negative interest rates,” he said. Henrik Mitelman, chief fixed income strategist at SEB, the Swedish bank, said that the negative deposit rate, combined with a cut in the repo rate to an historic low of 0.25 per cent, sent a powerful signal to the market that the Riksbank intended to keep rates close to zero until economic recovery was well under way. “What the Riksbank did was very brave. They decided to see if markets could cope with it and the markets have.” Carl Milton, fixed income analyst at Danske Bank in Stockholm, cautions that the Riksbank decision was not as pioneering as some have portrayed. The Bank routinely keeps its deposit rate 50 basis points lower than the repo rate to regulate liquidity in the market, he says. When the repo rate was cut to 0.25 per cent, the deposit rate was automatically forced into negative territory. “It was not something put in place to punish banks or to force them to lend,” he says. Moreover, Swedish banks make relatively little use of the central bank deposit facility, limiting the impact of negative rates. But by breaking the taboo surrounding sub-zero rates, the Riksbank may have set an important precedent that others could use to greater effect. Don Smith, economist at Icap, says: “Sweden’s policy is certainly very interesting. We will have to wait and see what happens there. This is certainly a very unusual policy, but these are very unusual times.” Copyright The Financial Times Limited 2009. Print a single copy of this article for personal use. Contact us if you wish to print more to distribute to others.
Banks pay price for policy Sweden’s decision to introduce negative interest rates on deposits at the Riksbank means that commercial banks have to pay for the privilege of saving their money at the central bank, writes David Oakley. The new rate of minus 0.25 per cent forces banks to pay 0.25 per cent to the Riksbank. Normally, banks would be paid interest on these deposits. It is thought to be the first time that negative rates have been introduced. Central banks usually shy away from such a drastic policy because it is in effect a tax or fine on the commercial banks and could hurt their balance sheets. However, the Riksbank hopes that by charging banks for saving their money, rather than paying them, it will encourage them to increase their lending to individuals and businesses, boosting the economy. It also hopes that it might encourage them to divert the money into other assets, such as government bonds or even highly rated corporate bonds. This would bring down bond yields and act as an stimulant. In the UK, there have been signs that banks are switching cash into short- dated government bonds following hints from Mervyn King, Bank of England governor, that the policy could be introduced there. http://www.ft.com/cms/s/0/5d3f0692-9334-11de-b146-00144feabdc0.html
217 vox Research-based policy analysis and commentary from leading economists Back to 2007: Fear of appreciation in emerging economies Andrea Kiguel Eduardo Levy-Yeyati 29 August 2009
After a crisis-induced hiatus, the exchange rate landscape seems to be moving back to a situation that resembles 2007. This column says that fear of appreciation is part of a leaning-against-the-wind exchange rate policy that promises to be the norm for emerging economy currencies for years to come. That may pose difficulties for global rebalancing. In recent years, many developing countries have joined the group of economies that officially run inflation targeting regimes in the context of freely floating exchange rates (Rose 2007). While this has been heralded as the triumph of floating regimes, most emerging economies are still pursuing active exchange rate policies. Prior to the Lehman Brothers bankruptcy meltdown, international reserves in most developing countries (including all four BRICs) had reached historic highs (in terms of both external debt and GDP) and, even among inflation targetters, central banks were active in foreign exchange markets, cushioning the effect of portfolio flows and accumulating reserves. This “fear of floating” in reverse could be labelled, for lack of better alternatives, fear of appreciation (Levy Yeyati and Sturzenegger, 2007). The crisis by no means has put the policy debate to rest. On the contrary, central bank intervention was critical to limiting exchange rate overshooting during the currency selloff in the last quarter of 2008 and the first quarter of 2009.1 Encouraged by the insurance benefits of liquid reserves during the meltdown, most central banks in emerging economies are already rebuilding reserve stocks and talking down (and selling) the domestic currency to slow down the rise of their currencies. After a one-year crisis-linked hiatus, the post- crisis exchange rate landscape seems to be moving “back to the future”, i.e. a situation that resembles 2007.2 The remarkable synchronicity of the currency rally Since 9 March 2009, emerging-market currencies have been moving in tandem, a reflection of the strong incidence of common and highly correlated global factors (dollar weakness, equity and commodities strength) that have themselves been driven by a growing conviction that a global recovery is on the way (and the associated increase in the market’s appetite for risk). A simple two-step exercise illustrates the point. • First, we can reduce the dimensionality of the global backdrop by computing the principal components of the log weekly changes in equity prices, commodity prices, and the dollar (proxied by the S&P 500 equity index, the CRB commodity index, and the DXY dollar index, respectively), since March 9 to date.3 The fact that the first principal component (PC) explains 70% of the series’ variability – with each individual series highly correlated with the principal component (Table 1) – indicates that the three variables were to a large extent three sides of a single global story.
218 • Second, we can measure the sensitivity of individual currencies to global factors by estimating the 15-week rolling elasticities of log FX changes with respect to the principal component (their “betas” to the global context, so to speak). Not surprisingly, those betas were persistently high during the rally (Figure 1), illustrating the dominant role of common global factors.4 Table 1. The remarkable synchronicity of the crisis: Principal component analysis
S&P DXY CRB
Weights 0.58 0.57 0.59
Correlation with PC 0.84 0.81 0.84
Note: The first principal component explains 70% of the series’ variability. Source: Barclays Capital Figure 1. Synchronicity: 15-week rolling betas to global drivers
Note: Betas are computed with respect to changes in global factors, as captured by the first principal component of the log changes in DXY, S&P and CRB. Source: Barclays Capital There are hints, however, of an imminent regime switch that promises to bring the exchange rate debate in emerging economies back to where it ended in 2007. On the one hand, the co-movement of the US dollar with equity and commodity prices – a key aspect behind the synchronicity of the past few months – may be fading as Figure 2 suggests. The safe haven allure of the dollar may be fading and country fundamentals may be moving to centre stage. More to our point, the surprisingly strong intervention by the Bank of Israel in early August suggests that fear of appreciation may be returning as the defining feature of exchange rate policy in emerging markets. Figure 2. Back to the past: The dollar negative premium may be gone
219
Source: Bloomberg, Barclays Capital Fear of appreciation (and the road of less resistance) Central bank exchange rate intervention, the flipside of reserve accumulation, has been attributed alternatively to precautionary hoarding of liquid dollar assets after the dollar liquidity crises in the 1990s and to the “fear of appreciation” related to a mercantilist attempt to keep the currency undervalued (either to foster the competitiveness of exports or to detract from the competitiveness of imports).5 Ultimately, both are likely to be intertwined, as a depreciated currency, to the extent that it contributes to a current account surplus, both allows the accumulation of foreign assets and preserves some slack on the external front. Figure 3. Reserves back on track
Source: Haver Analytics, Barclays Capital Renewed demands for reserves Lessons from the recent crisis do not suggest that the motives underlying global imbalances
220 are self-correcting. If anything, experience since September 2008 may have revived the prudential motive for reserve accumulation. If the panic late last year taught central bankers anything about reserves, it is that when panic strikes, you just can’t have enough on hand. And, despite the IMF’s valuable attempts to present itself as an international lender of last resort to substitute for precautionary reserve hoarding, the evidence indicates that all large developing countries with the exception of Mexico have chosen to go their own way. More generally, a quick look at the evolution of foreign exchange reserves confirms that the crisis was merely a brief detour from the accumulation path (Figure 3). At this stage, the relevant question is no longer whether the dollar will continue to weaken but rather by how much and against what. As fundamentals and central bank policy regain their influence on exchange rate behaviour, any remaining dollar adjustment would tend to reflect economic fundamentals as much as the path of less central bank resistance. Dollar correction, but against what? The potential for dollar correction against emerging market currencies is not obvious. Eastern European countries continue to sort out their own currency imbalances, and should mirror the economic fate of the Eurozone. Asian currencies are unlikely to lead the way insofar as the Chinese renminbi, against which many Asian currencies are implicitly anchored, remains stable. And Latin America is likely to struggle to reconcile (and possibly redefine) the inflation-targeting paradigm with its intervention pattern. Thus, while a casual look at global capital flows points to currencies in emerging Asia and Latin America as the natural candidates to appreciate vis-à-vis the dollar, the undoing of global imbalances may fall disproportionately on more flexible G10 commodity currencies like the Australian and New Zealand dollars and the euro. Figure 4. Devaluation expectations and implied volatilities close to pre-Lehman levels
In this sense, regardless of its normative aspects, fear of appreciation has important implications. Against a constructive macroeconomic backdrop, intervention is bound to limit upward moves. By postponing appreciation, this policy will preserve appreciation expectations and thus reduce the tail-risk of unexpected currency depreciation (Figure 4).6 However, this combination of growing appreciation expectations and declining volatility should feedback into the demand for emerging market currencies and the need to intervene to keep them down – a typical central bank conundrum during capital inflow episodes since the mid-1990s. This in turn is likely to lead to an accelerating accumulation of high grade, US dollar-denominated assets by emerging market governments. Ultimately, this feedback
221 loop may condition monetary policy and postpone or derail the pending global rebalancing process. At any rate, the recent crisis has showed that fear of appreciation is more than a one-off upshot of the bonanza of the early 2000s. It seems to be a part of a more general two-way, leaning-against-the-wind exchange rate policy that promises to be the norm for emerging economy currencies for years to come. References Aizenman, J. and Lee, J. (2007), “International Reserves: Precautionary Versus Mercantilist Views, Theory and Evidence”, Open Economies Review, Vol. 18, issue 2. Levy-Yeyati, E. and Sturzenegger, F. (2007), “Fear of Appreciation”, KSG Working Paper 07-047, Harvard University. Levy-Yeyati, E. and Sturzenegger, F. (2009), “Monetary and Exchange Rate Policies and Economic Development”, forthcoming, Handbook of Development Economics, 5, Chapter 64 (M. Rosenzweig and D. Rodrik, eds.), Elsevier. Pontines, V. and Rajan, R. (2008), “Asian exchange rate asymmetry,” Vox EU.org, 19 November. Rose, Andrew (2007). “Are international financial crises a relic of the past? Inflation targeting as a monetary vaccine,” VoxEU.org, 31 May.
1 Indeed, as one of us argues elsewhere (in work in progress with Federico Sturzenegger for Economic Policy), fear of appreciation could be seen as one aspect of more general leaning-against-the-wind exchange rate policy that combines standard monetary policy tools with discretionary reserves purchases and sales to counter the market’s often amplified response to the cyclical pattern of exchange rates. 2 2007 appears a better reference date than mid-2008, when many emerging currencies recorded historic highs at the peak of the commodity bubble.
3 Principal component analysis is a method for choosing the weights of y = a1x1 + a2x2 + … + akxk so that y will capture as much of the variance in the group of variables x1, x2, …, xk as possible. 4 Note that, given the synchronicity of global drivers, the betas to any of these global factors in isolation would exhibit the same pattern – focusing on individual betas would erroneously attribute the rally to equities, commodities, or the dollar, while in fact it was the self-reinforcing combination of the three that was at play. 5 Aizenmann and Lee (2007) make a case for the prudential motive, and Levy Yeyati and Sturzenegger (2009) for a survey of the evolution of de facto exchange rate policies in emerging economies. In a recent Vox EU column, Pontines and Rajan (2008) highlight the incidence of fear of appreciation in Asian currencies. 6 Risk reversal refers to similar (in the sense of having the same delta) out-of-the-money call and put options. A positive risk reversal means the volatility of the call is greater than the volatility of the put, which implies a skewed distribution of expected spot returns, consistent with expectations of a large upward dollar movements (in other words, a currency selloff).
222
Figure 5. Central bank intervention: Leaning against the wind
Andrea Kiguel Eduardo Levy-Yeyati Back to 2007: Fear of appreciation in emerging economies29 August 2009http://www.voxeu.org/index.php?q=node/3917
223 http://www.voxeu.org/index.php?q=node/3913 A case for (even) more transparency in the OTC markets Viral Acharya y Robert Engle, 29 August 2009
Over-the-counter (OTC) markets produced most of the toxic assets that played a prominent role in the ongoing crisis. This column advocates further transparency in OTC markets regulation, arguing that it would make participants apply appropriate risk controls, lower systemic risk, and better situate regulators to address failures of large institutions. Though over-the-counter (OTC) markets have successfully exchanged financial contracts for decades, they played a prominent role in causing and aggravating the ongoing crisis. After all, most of the toxic assets plaguing financial institutions were purchased in OTC markets. Regulatory reforms proposed in the US in March 2009 by Treasury Secretary Geithner for approval by Congress involve significant changes to legislation governing derivatives trading, especially the trading infrastructure of OTC markets. The objective of these reforms appears to have been to reduce systemic risk in the financial sector and improve overall regulatory oversight. Under the proposed reforms, mature and standardised derivatives such as credit default swaps (CDS) will be traded with a centralised counterparty (CCP) or an exchange. Trades in such derivatives will thus be recorded on a timely basis. Regulators will gain unfettered access to information on prices, volumes, and exposures from the centralised counterparties, but it is unclear if the proposals will require that such information be made public. While some aggregate information will likely be disseminated to all market participants, such as the recent data published by the Depository Trust and Clearing Corp (DTCC) on all live CDS positions, full transparency is being required only for regulatory usage. Since the announcement of the reform plans, index and single-name CDS trades have moved to centralised counterparty (ICE Trust) and clearing (DTCC). The terms of the standard single-name CDS contract have also been altered so that a fixed premium (100bps for investment grade names and 500bps for junk names) will be paid during the life of the contract, regardless of the fair market premium, and any residual premium will be settled through an upfront exchange between the buyer and the seller. This “big-bang” protocol will enable the CCP to close out otherwise equivalent long and short positions with counterparty by simply exchanging cash up-front and leave no residual counterparty risk. Indeed, such protocol had always existed for index CDS trades and worked seamlessly. While the industry has embraced these changes fully, it continues to resist regulatory calls to move the CDS on to exchange-traded platforms, arguing that these products do not yet have sufficient participation outside of the inter-dealer market to succeed on an exchange. Exchange trading might also reduce dealer margins in the CDS market. Why more transparency is needed in OTC markets: Counterparty risk Overall, we applaud these proposals and changes and the stated objectives of limiting systemic risk, opacity, manipulation and fraud in the derivatives business. But we urge the Treasury to push for even further transparency in the OTC markets, recognising that many financial products, such as the customised or “bespoke” collateralised debt and loan
224 obligations (CDOs and CLOs), will not be amenable to centralised clearing or exchange trading. The OTC markets will surely exist if only to trade these remaining contracts. It might seem that these bespoke products can be ignored from a risk point of view, but nearly all the problem legacy assets are of this type and these we now know are extremely risky systemically. To explain why further transparency is required, let us first understand the key role played by counterparty risk in creating systemic risk. Most financial contracts are arrangements between two parties to deliver goods or cash in amounts and at times that depend upon uncertain future events. Designed appropriately, financial contracts facilitate risk-sharing in the economy. There may be many risks in such contracts, but one additional risk to be evaluated at the time of contracting is the risk that the counterparty will not fulfil its future obligations. This counterparty risk is difficult to evaluate because the exposure of the counterparty to various risks is generally not public information. This opacity of exposures leads to an important risk spillover – an “externality” in the language of economists – that the counterparty risk on one contract will be increased if the counterparty agrees to the same contract with another agent because the second contract increases the probability that the counterparty will be unable to perform on the first one. Put simply, the risk on one deal depends on what else is done but in OTC markets it is not at all transparent what else is being done. This makes it likely that excessively large positions will be built by some institutions without the full knowledge of other market participants. If these institutions were to default, their counterparties would also incur significant losses, creating systemic risk in the economy. For example, in September 2008, it became known that AIG’s liquidity position was inadequate given that it had written credit default swaps (bespoke CDS) for many investors guaranteeing protection against default on mortgage-backed products. Each investor realised that the value of AIG’s protection was dramatically reduced on its individual guarantee. Investors demanded increased collateral – essentially posting of extra cash – which AIG was unable to provide and the Treasury had to take over AIG. The counterparty risks were so widespread globally that a default would probably have spurred many other defaults generating a downward spiral. The AIG example illustrates well the cost that large OTC exposures can impose on the system. But, more importantly, it also raises the question of whether AIG’s true risk as a counterparty was reflected by investors in prices and risk controls – such as collateral or margining arrangements – for protections they purchased from AIG. The opacity of the OTC markets in which these credit derivatives trade was primarily responsible for allowing the build-up of such large exposures in the first place. While positions in derivatives that are moved to exchange trading will naturally be subject to capital requirements, the real risk is that inadequately capitalised positions might build up in derivatives that continue to trade in opaque OTC markets. Transparency for all derivatives To prevent systemically important exposures from building up again in the future, we suggest that regulators should extend the push for transparency to all derivatives. In particular, all OTC markets should be subject to minimum levels of transparency. Transactions should be public information. Suppose every trade was posted on a particular internet site within a reasonable time of execution – as required by the NASD for all OTC trades in corporate bonds which must be reported on the TRACE. Counterparties could then verify the accuracy of the contract. Those interested could determine the volume of contracts of any form and by any counterparty. Vendors would presumably make a profitable business compiling, analysing and selling the complex data from this source.
225 Counterparty risk could be more accurately priced and collateral arrangements could be based on this information. Counterparties who sold excessive protection would find their prices falling for both old and new contracts. Counterparties would have incentives to limit exposures and to advertise this to other market participants. Although the risk spillover is not as completely eliminated as with a centralised counterparty, it would be substantially reduced by this type of transparency. Investors, regulators, and even the financial institutions themselves would have a much better way to analyse and hedge the true risk of their exposures. An alternate scheme is to impose higher capital requirements on OTC derivative positions. In principle, this would also safeguard against systemic risks building up in OTC markets. On balance, we prefer the transparency legislation laid out above for two reasons. First, OTC contracts are inherently complex as they are customised for specific purposes. Putting the entire burden of figuring out the right capital requirements for complex contracts on regulators, rather than providing the necessary information to market participants to correctly price the counterparty risk, and thereby, the OTC contract itself, seems unfortunate. Second, being able to charge capital requirements on OTC contracts implicitly assumes a certain level of transparency of these positions, at least to the regulator, through a centralised registry or disclosure requirement; the incremental cost of providing that information to market participants seems small. Of course, some capital requirements would be warranted even with the transparency legislation in place. Transparency regulation and the future of financial innovation Large players will naturally resist such transparency legislation. They will argue that it inhibits financial innovation, as they have repeatedly done in the past. But such resistance needs to be balanced against the systemic losses when large players fail. Centralised counterparty or exchange trading of standard derivative products is an important step forward. But regulators must look to fighting the next war, not just the last one. Such transparency requirements would discourage players from cloning OTC varieties of standard products just to reduce capital requirements. Furthermore, when some OTC market becomes large and suitable for exchange trading, transparency standards would enable smooth migration to centralised trading. And, finally, huge losses announced by the Royal Bank of Scotland and State Street earlier this year suggest that even now we do not know exactly what toxic assets are held by which banks. With legislation in place that requires transparency also in the remaining, less standardised OTC markets, we would eventually know these positions. Market participants would apply appropriate risk controls in OTC trades, systemic risk would be lower, and even if it were to materialise, regulators would be less compromised in dealing with failures of large institutions. Overall, we would have a smoothly functioning financial market capable of actively developing – and robustly managing – the next financial innovation. Note: adapted from Chapter 11 “Centralizing Clearing of Credit Derivatives” from the NYU-Stern book, Restoring Financial Stability: How to Repair a Failed System, edited by Mr. Acharya and Matthew Richardson, John Wiley & Sons, March 2009.
226
Transmission of the global recession through US trade Michael J. Ferrantino Aimee Larsen 29 August 2009
International trade has transmitted demand contractions across national boundaries throughout the crisis. This column analyses the transmission of the recession through US trade flows at the sectoral level. US imports of housing construction inputs peaked before many other popular housing indicators. International trade has played a major role in the global recession especially in transmitting demand contractions across national boundaries (Freund 2009). According to standard trade-linkages reasoning, countries “catch” recessions from their major export partners while transmitting recessions to their major import suppliers. This simple economic logic directs attention to a set of facts that has heretofore attracted little attention in the global debate. • US exports are disproportionately sold to the EU and Canada; US imports are disproportionately sourced from China, Japan, and the rest of Asia. • Imports from China dominated the US (real) import decline, while exports to Canada figured disproportionately in US export declines. • US imports peaked in October 2007, with a secondary peak in October 2008, and a trough in February 2009. US exports, by contrast, continued to rise until much later in June 2008. • The timing of US import peaks by sector is markedly different from that of US export peaks by sector. The export peaks cluster around the general peak in mid- 2008. The import peaks, by contrast, both came much earlier (end of 2007) and show a great deal of sectoral dispersion. • US imports related to housing construction – especially wood and construction equipment – showed relatively early downturns. • The downturn in US imports of motor vehicles and parts has been particularly deep; it began in March 2007 when oil prices were still rising sharply. These facts suggest that the transmission of the recession to the US (via declines in US exports) is mediated by a very different set of goods than the transmission from the US to other nations (via US imports). Table 1. Changes in real US trade, not seasonally adjusted
227 Source: Authors’ calculations. For comparison with the disaggregated data, seasonally adjusted data show peaks for real imports in April 2008, real exports in August 2008, a trough for both exports and imports in May 2009, and a slight uptick in both series in June. Detailed trade data analysis Using a new dataset on disaggregated real trade and trade prices, we identify features of the current business cycle visible in US trade data.1 High-frequency trade data must be used with caution in an environment of price instability, such as the current recession, which was preceded by a sharp run-up of commodity prices followed by a sharp deflation. Thus, it is important to distinguish between nominal and real trade data (Francois and Woerz 2009; Ferrantino 2009). Sectoral timing The timing of US real import peaks by sector is markedly different from that of US real export peaks by sector. US export peaks tend to cluster around the general peak, reflecting the synchronisation of the global peak in GDP in mid-2008. US import peaks, by contrast, show a great deal of sectoral dispersion, with some sectors turning down much earlier than others. This suggests that the decline in US import demand, as well as its depth, was significantly influenced by particular sectoral weaknesses in the US economy, in particular the timing of the housing and oil bubbles. These facts are summarised in Figure 1, in which each colour-coded bubble represents a sector. The horizontal location of the bubbles represent the timing of the peak, the vertical location represents the cumulative decline in real trade since the peak. Bubble size represents the dollar value of trade in 2008. Figure 1. US trade decline by sector
Most notably, the demand for imported motor vehicles and parts peaked in March 2007, well before the peak in aggregate imports. This suggests some response to rising gasoline prices. Inputs into autos and/or construction, including aluminium, iron and steel, and plastics, also began to show real import declines in 2005 and early 2006. By contrast, US
228 imports of computers and industrial machinery and crude and refined fossil fuels) did not decline until relatively late in the cycle. Country-specific linkages The particular linkages through which global declines in demand are transmitted across countries are driven by pre-existing geographic and sectoral trading patterns, as well as by the particular structural weaknesses in each country and its trading partners. One would expect countries to “catch” recessions from the countries to which they disproportionately export and transmit recessions to the countries from which they disproportionately import. The pre-existing patterns of specialisation with these trading partners will in part determine the sectoral distribution of the transmission of the business cycle though trade. Overlaid on these patterns are contractions in the specific sectors for which disequilibria were particularly important in triggering the downturn and the upstream and downstream linkages of those sectors. Geographically, US exports go disproportionately to the EU and Canada, while US imports come disproportionately from China, Japan, and the rest of Asia. More precisely, from 2006-2008, the EU and Canada accounted for 42.9% of US exports and 34.0% of US imports on a nominal basis, while Asia accounted for 35.5% of US imports and only 25.9% of US exports. China alone accounted for 16.1% of US imports and only 5.9% of US exports. Table 2. Largest real US import declines, July 2008-February 2009
Source: Authors’ calculations. The transmission of the recession to and from the US is mediated by a very different set of goods. From July 2008 to the trough, we identify 13 categories of goods for which US real imports fell by $1 billion or more, and 10 categories of goods for which US real exports fell by $500 million or more. They are largely non-overlapping categories. For example, US import declines are dominated by electronics, crude oil, and other consumer goods, while US export declines are concentrated in intermediate and capital goods. There are large two-way declines in US trade in passenger cars, motor vehicle parts, and organic
229 chemicals. Goods imported from China dominated US import declines, while goods exported to Canada figured disproportionately in US export declines. Table 3. Largest real US export declines, July 2008-January 2009
Source: Authors’ calculations. Stories of the current cycle – construction, automotive, and petroleum The collapse of US housing associated with the financial crisis shows up clearly in US construction imports, which began to decline much earlier than US imports in general and have fallen more deeply. US real imports of sawn or chipped wood, of the type used in construction, peaked in May 2005 and declined by 62.9% through May 2009. This peak is 29 months earlier than the general peak in US imports. The corresponding price series peaked earlier, in March 2005, and has declined by a cumulative 32.5% through May 2009. A simultaneous decline in prices and quantities is a clear indicator of a decline in import demand, induced by the declining demand for construction. Similarly, US real imports of equipment such as bulldozers, graders, and shovel loaders, which have multiple uses but are important for construction, peaked in May 2006, 19 months before the general peak, and declined by 81.5% in the subsequent three years. Import prices and quantities for inputs related to housing turned down relatively early compared to more direct indicators of the state of the housing market, such as new housing starts (peaking in May 2005), housing units under construction (September 2005), the Case-Shiller Composite-20 home price index (July 2006), and prices of new one-family homes under construction (March 2007). Construction firms anticipated the bubble, restricting their purchases of imported wood inputs at least as early as their construction activity and well before the decline in housing prices. Since construction plays an important role in the business cycle (Leamer 2007), this suggests that import data on construction inputs may be an important tool in anticipating the business cycle. The impact of the decline in US construction on US trading partners was highly geographically concentrated. In a typical year, about 80% of US imports of sawn wood come from
230 Canada, while about 50% of US imports of bulldozers and similar equipment come from Japan. Figure 2. Prices of sawn wood imports and the Case-Shiller housing index
Price shifts for oil are often responsible for big swings in nominal trade data. These shifts were particularly sharp in the run-up to the current recession. Prices of US imports and exports of crude and refined mineral and petroleum products peaked in mid-2008 and bottomed early in 2009. In real terms, trade in mineral fuels has been relatively resilient, consistent inelastic demand. In the year ending in May 2009, US real exports of mineral fuels rose 47.6%, while US real imports declined only 10.3%. These represent different stages of the production process – US imports consist about half of crude petroleum and half of refined products, while US exports consist largely of refined products. Real trade in motor vehicles and parts has decreased more sharply than trade as a whole. US real imports for the category have fallen by 55.1% since their peak in March 2007, while US real exports have fallen by 60.4% since June 2008. This fits in with the general pattern observed above – US imports were reduced by the increase in gasoline prices prior to the recession, while the decline in US exports corresponds to the general drop in global demand and the emerging crises of GM and Chrysler. US real imports of passenger cars have recovered slightly since February 2009. This is unlikely to be a seasonal effect, since prior to the recession the seasonal peak for US auto imports was usually in the fourth quarter and could possibly be related to anticipation of the “cash-for-clunkers” program under which US consumers received government financial incentives in the summer of 2009 to trade in low-mileage vehicles for more fuel-efficient ones.
231
Figure 3. Real US imports and exports of vehicles
Figure 4. Collapse of vehicle imports and exports, Feb 2008 – Feb 2009
Conclusions We analyse the mechanism of transmission of the global recession to and from the US using real monthly merchandise trade data. The channels of transmission arise both from historical patterns of comparative advantage and peculiar features of the US and global recessions. The US's import decline was a major vector for transmitting the recession to Asia, as this drop in demand came well before the official recessions began in Asia. Peaks in US imports show a higher degree of sectoral dispersal than peaks of US exports, reflecting the particular patterns of weakness in the US, such as imports of inputs into construction and the relatively synchronous timing of the recession in US trading partners. In particular, contractions of US imports of wood and construction equipment, used as inputs into housing, showed relatively early downturns. The downturn in US imports of
232 motor vehicles and parts, which began when oil prices were still rising sharply, has been particularly deep but appears to have reversed in recent months. The downturn in US auto exports was related both to the global contraction and to the situation immediately preceding the bankruptcies of General Motors and Chrysler. By contrast, large nominal swings in exports of mineral fuels were largely price-induced, and mask relatively stable US demand for crude oil and foreign demand for US refined products. Disclaimer: This piece reflects solely the views of the authors and does not reflect the views of the US International Trade Commission or any of its Commissioners. References Freund, C. (2009). “Demystifying the collapse in trade”, VoxEU.org, 3 July. Francois, J. and J. Woerz (2009). “The big drop: Trade and the Great Recession”, VoxEU.org, 2 May. Ferrantino, M. J. (2009). “The global trade contraction: How much is 2008-09 like 1929- 33?”, USITC Executive Briefings on Trade, April. Leamer, E. (2007). “Housing IS the Business Cycle”, NBER Working Paper 13428.
1 Specifically, we have applied the BLS indices for US export and import prices indices to the US trade data released by Census. Cf. Census' monthly release on real U.S. trade, aggregated to six end-use, and the multicountry aggregate real trade data produced by CPB. 2 Principal suppliers and markets are defined as the top two, plus any others with a 10% market share, in 2008. http://www.voxeu.org/index.php?q=node/3914
233 Opinion
August 28, 2009 OP-ED COLUMNIST Till Debt Does Its Part By PAUL KRUGMAN So new budget projections show a cumulative deficit of $9 trillion over the next decade. According to many commentators, that’s a terrifying number, requiring drastic action — in particular, of course, canceling efforts to boost the economy and calling off health care reform. The truth is more complicated and less frightening. Right now deficits are actually helping the economy. In fact, deficits here and in other major economies saved the world from a much deeper slump. The longer-term outlook is worrying, but it’s not catastrophic. The only real reason for concern is political. The United States can deal with its debts if politicians of both parties are, in the end, willing to show at least a bit of maturity. Need I say more? Let’s start with the effects of this year’s deficit. There are two main reasons for the surge in red ink. First, the recession has led both to a sharp drop in tax receipts and to increased spending on unemployment insurance and other safety-net programs. Second, there have been large outlays on financial rescues. These are counted as part of the deficit, although the government is acquiring assets in the process and will eventually get at least part of its money back. What this tells us is that right now it’s good to run a deficit. Consider what would have happened if the U.S. government and its counterparts around the world had tried to balance their budgets as they did in the early 1930s. It’s a scary thought. If governments had raised taxes or slashed spending in the face of the slump, if they had refused to rescue distressed financial institutions, we could all too easily have seen a full replay of the Great Depression. As I said, deficits saved the world. In fact, we would be better off if governments were willing to run even larger deficits over the next year or two. The official White House forecast shows a nation stuck in purgatory for a prolonged period, with high unemployment persisting for years. If that’s at all correct — and I fear that it will be — we should be doing more, not less, to support the economy. But what about all that debt we’re incurring? That’s a bad thing, but it’s important to have some perspective. Economists normally assess the sustainability of debt by looking at the ratio of debt to G.D.P. And while $9 trillion is a huge sum, we also have a huge economy, which means that things aren’t as scary as you might think. Here’s one way to look at it: We’re looking at a rise in the debt/G.D.P. ratio of about 40 percentage points. The real interest on that additional debt (you want to subtract off inflation) will probably be around 1 percent of G.D.P., or 5 percent of federal revenue. That doesn’t sound like an overwhelming burden.
234 Now, this assumes that the U.S. government’s credit will remain good so that it’s able to borrow at relatively low interest rates. So far, that’s still true. Despite the prospect of big deficits, the government is able to borrow money long term at an interest rate of less than 3.5 percent, which is low by historical standards. People making bets with real money don’t seem to be worried about U.S. solvency. The numbers tell you why. According to the White House projections, by 2019, net federal debt will be around 70 percent of G.D.P. That’s not good, but it’s within a range that has historically proved manageable for advanced countries, even those with relatively weak governments. In the early 1990s, Belgium — which is deeply divided along linguistic lines — had a net debt of 118 percent of G.D.P., while Italy — which is, well, Italy — had a net debt of 114 percent of G.D.P. Neither faced a financial crisis. So is there anything to worry about? Yes, but the dangers are political, not economic. As I’ve said, those 10-year projections aren’t as bad as you may have heard. Over the really long term, however, the U.S. government will have big problems unless it makes some major changes. In particular, it has to rein in the growth of Medicare and Medicaid spending. That shouldn’t be hard in the context of overall health care reform. After all, America spends far more on health care than other advanced countries, without better results, so we should be able to make our system more cost-efficient. But that won’t happen, of course, if even the most modest attempts to improve the system are successfully demagogued — by conservatives! — as efforts to “pull the plug on grandma.” So don’t fret about this year’s deficit; we actually need to run up federal debt right now and need to keep doing it until the economy is on a solid path to recovery. And the extra debt should be manageable. If we face a potential problem, it’s not because the economy can’t handle the extra debt. Instead, it’s the politics, stupid. PAUL KRUGMAN Till Debt Does Its Part August 28, 2009 http://www.nytimes.com/2009/08/28/opinion/28krugman.html?_r=1&pagewanted=print
August 25, 2009, 2:38 pm Deficits, debt, and the economy So the CBO and OMB mid-session reviews are out; not much difference, but there’s more information in the OMB report (big pdf). So let me go with that. It turns out that I was a little over-pessimistic in my assessment, mainly because the $9 trillion includes this year’s deficit, so we start from debt at 40% of GDP, not 50%. Overall, the OMB puts debt in 2019 at 76.5% of GDP; that figure is slightly exaggerated, however, because various financial rescues get counted as additions to the deficit even though taxpayers end up with additional assets. Net of these assets, the debt in 2019 is 68.9% of GDP. As I’ve pointed out, that’s bad, but it’s not horrific either by historical or international standards. On a comparable basis, federal debt hit 109 percent of GDP at the end of World
235 War II, and hit a second peak of 49 percent at the end of the Reagan-Bush years. And a number of European countries have hit substantially higher debt levels without crisis. The only reason to fear these numbers is if you believe that our political system is broken, and that markets will soon come to see it that way. Then we could become a debt-intolerant country, and all bets are off. So it’s not really the debts per se, or even the economy; it’s the politics, stupid. Meanwhile, what everyone should be focused on is the sheer awfulness of the economic projections. OMB has unemployment still at 9.7% at the end of 2010; still at 8% at the end of 2011. These numbers cry out for a more aggressive economic policy. If that’s politically impossible, we’re really in terrible shape. August 27, 2009, 11:01 am A note on the Bush fiscal legacy Right now, the OMB is projecting a debt/GDP ratio of 77 percent by 2019 — 69 percent if you net out financial assets acquired via the TARP and all that. This may be somewhat over-optimistic, but stay with it for a bit. As I’ve been pointing out, the projected debt/GDP ratio will be high by US historical standards, but within a range that a number of advanced countries have entered without catastrophe in the past. Still, it’s not good. And I had a thought that I haven’t seen anyone else explore (apologies if someone has already done this.) Namely, what would things look like if we hadn’t had 8 years of gross fiscal irresponsibility from the Bush adminstration? There were two big-ticket Bush policies. One was the tax cuts, which cost around $1.8 trillion in revenue; add in interest costs, and we’re presumably talking about more than $2 trillion in debt. The other was the Iraq War, which has cost at least $700 billion, and will cost more before we finally extract ourselves. Without these gratuitous drains on the budget, it seems fair to assert that we’d be coming into this economic crisis with a federal debt around 20 percent of GDP ($2.8 trillion) smaller than we are. And that, in turn, means that we’d be looking at projected net debt in 2019 of around 50 percent of GDP, not 70. And that would definitely not be a scary number. Net federal debt was 49 percent of GDP in 1993, at the end of the Reagan-Bush years; Bill Clinton did move to reduce that number, and succeeded, but the nation wasn’t facing imminent crisis. The bottom line, then, is this: the irresponsibility of the Bush years has left us poorly positioned to deal with the current crisis, turning what should have been an easily financed economic rescue into a more difficult, anxiety-producing process. August 27, 2009, 3:28 pm A further note on debt and deficits So I see that commenters on this piece want to know why I’m blaming Obama’s deficits on Bush, and why I think Obama deficits are good, while Bush deficits weren’t. So, in order: First of all, I wasn’t blaming Bush for future deficits: I was blaming him for debt — debt that was incurred on Bush’s watch. If you don’t think that’s fair, let me echo Barney Frank and ask on what planet you spend most of your time.
236 Second, now that you mention it, surely much of the current deficit can be attributed to the previous administration’s policies. I mean, we’re all of seven months into the Obama administration; nearly all federal spending, all federal taxes, are dictated by laws that were in effect before Obama took office. Both Bush and before him Reagan spent years blaming all their problems on the failures of their predecessors; I think we can give Obama a few months. Finally, about the stimulative effects of deficits: as I’ve explained a number of times, it’s the zero bound that makes all the difference. There was a case for temporary fiscal stimulus in 2002, when the economy was close to the zero bound, but most of the Bush tax cuts took effect during a period in which interest rates were well above zero, in fact during which the Fed was raising rates to keep the economy from overheating. This means that fiscal expansion wasn’t needed. Now, by contrast, we’re hard up against zero and have run out of monetary ammunition. I don’t know if this helps, or whether I’m just (Barney Frank) arguing with a dining room table (/Barney Frank). But anyway, that’s the underlying logic. August 28, 2009, 10:59 am The burden of debt I respect Jim Hamilton a lot, so I take his criticism seriously — and he raises questions that others raise too about my relatively sanguine assessment of the debt situation. Yet I think that he and others are quite wrong, on several counts. First off: the assertion that the post-World War II debt was sui generis, that it offers no guidance on what we can afford. It’s true that right after the war it was possible to get a drastic reduction in spending easily, since we didn’t have to fight the Axis any more. But let’s take a slightly later start date: in 1950, federal debt in the hands of the public was 80 percent of GDP, which is in the ballpark of what we’re looking at for 2019. By 1960 it was down to 46 percent — and I haven’t heard that anyone considered America a debt-crippled nation when JFK took office. So how was that possible? Was it through drastic cuts in defense spending? On the contrary: we’re talking about the height of the Cold War (with a hot war in Korea along the way), and federal spending actually rose as a share of GDP. So yes, it wasn’t entitlement programs, but it wasn’t exactly discretionary either. How, then, did America pay down its debt? Actually, it didn’t: federal debt rose from $219 billion in 1950 to $237 billion in 1960. But the economy grew, so the ratio of debt to GDP fell, and everything worked out fiscally. Which brings me to a question a number of people have raised: maybe we can pay the interest, but what about repaying the principal? Jim gets scary numbers about the debt burden by assuming that we’ll have to pay off the debt in 10 years. But why would we have to do that? Again, the lesson of the 1950s — or, if you like, the lesson of Belgium and Italy, which brought their debt-GDP ratios down from early 90s levels — is that you need to stabilize debt, not pay it off; economic growth will do the rest. In fact, I’d argue, all you really need to do is stabilize debt in real terms. So where Jim Hamilton has us paying $1 trillion a year to service $9 trillion in debt, I have us paying $225 billion — 2.5% real interest on that sum.
237 Now, how does that compare with the tax base? Hamilton rather mysteriously compares debt service only with current personal income taxes. If we use the overall tax take, and talk about what that tax take will be a decade from now, things look much less severe. So: in 2008, with revenues already depressed by the recession and housing bust, the federal government took in $2.5 trillion in revenues. If we assume 2.5% real growth* and 2% inflation, by 2019 that would rise to $4 trillion. So debt service costs due to the next decade’s deficits would be less than 6 percent of revenue under current law. So, to review: to make the debt look scary, you have to dismiss the post-World -War II experience, even though it turns out that the 50s offer a quite good lesson; assume that in the future the federal government will have to amortize debt over a quite short period, even though it never had to in the past; compare this inflated debt burden with a narrow piece of the federal tax base; and ignore the likely growth in the tax base over the next decade. I’m not convinced. *Contrary to what some think, we’d actually expect growth over the next decade to be somewhat above trend, as the economy picks up some of the current slack. That’s what the historical record tells us actually happens. August 29, 2009, 10:09 am Summer of hate A curious personal observation: I’m getting more crazy hate mail than I have in years, maybe since 2004. But this time the character of the hate mail has changed. Back then I was a traitor for questioning Dear Leader’s motives in invading Iraq. These days, I’m a socialist piece of, um, stuff because I assert that we might have something to learn from the Swiss health care system, or that debt projections aren’t quite as awful as you may have heard. It’s not too hard to understand. Presumably it’s coming from talk radio; I assume the ranters are furious with anyone who questions their vision of Obamanite tyranny. Still, it’s odd to get such violent reactions to what are basically dry, wonkish columns. August 29, 2009, 10:20 am 1945 I guess I should say something about claims that looking at debt at the end of World War II is irrelevant, because so much of the spending back then was on the war, and therefore fell rapidly once the war was over. Yes, it’s true that it was relatively easy to cut spending after World War II. However, during the war the United States ran massive deficits — more than 20 percent of GDP for three years. What the big cuts in defense spending after the war did was mostly to close those deficits; big defense spending during the war didn’t somehow make it easier to pay down debt after the war was over. The fact is that the war left America with a big debt — bigger, relative to our resources, than we’re likely to face when the economic rescue is over. We dealt with it. August 30, 2009, 10:13 am
238 A couple of notes on the 40s and 50s Many commenters on my 1945 post have raised two objections: (1) didn’t rapid population growth make it easier to deal with debt? (2) didn’t the fact that the rest of the world was in ruins help? Let me explain why both objections are off point. On (1), I think people are collapsing their history, projecting back to the 40s and 50s things that didn’t actually happen until much later. Thus, there was indeed a baby boom after the war, which led to a rapid rise in the population. However, the baby boomers didn’t enter the work force for a couple of decades! Their impact on economic growth didn’t begin until the late 1960s, long after debt levels had fallen a long way. And the great surge of women into the paid labor force was also a much later event. Rosie the Riveter basically went back to being a housewife; it was her daughter who became an office worker. You can see all this in the labor force data. The US labor force (defined as those working or looking for work) rose only 13 percent from 1947 to 1957. It didn’t really take off until the 70s: the labor force grew 30 percent from 1969 to 1979. The point is that our ability to deal with WWII debt had nothing to do with unusually favorable demography. What about the way the war left our competitors in ruins? Well, yes it did — but it also left our markets in ruins. This goes back to stuff I wrote way back, about the fallacy of thinking about a country as if it were a company; basically, there’s no reason to believe that economic growth in the rest of the world necessarily makes us poorer. Oh, one last thing: some commenters say that it’s not reassuring to compare America to Italy. I think they’re missing the point — if even Italy can handle debt/GDP ratios of 100 percent, we should be able to do it too.
239 US. Economy & Fed FDIC steps up scrutiny of new banks By Joanna Chung in Washington Published: August 28 2009 22:37 | Last updated: August 28 2009 22:37 New banks will be kept under strict supervision for a longer period of time because they are failing at a higher rate than more established lenders, US regulators said on Friday. The new policy from the Federal Deposit Insurance Corporation comes as regulators try to cope with a rising number of bank failures as the recession takes its toll. New lenders – those who have been insured less than seven years – have been ‘’over represented’’ on the list of institutions that failed during 2008 and 2009 and they pose an ‘’elevated risk’’ to the fund that protects depositors, the FDIC said in a letter to banks. So far this year, 82 banks have failed in the US. But the number of so-called ‘’problem’’ banks at risk of failing has jumped to 416, a 15-year high. Meanwhile, the FDIC’s deposit insurance fund, which insures up to $250,000 per depositor in each bank, has fallen to $10.4bn, a level not seen since 1993 when the US was in the midst of the savings and loans crisis. Currently, new lenders face more frequent examinations and higher capital requirements during the first three years, but they will now be subject to such scrutiny for a seven-year period. They will also have to get prior approval from the FDIC if they want to make ‘’material changes’’ to their business plans. That is because newly insured institutions “have pursued changes in business plans during the first few years of operation, which, in some cases, have led to increased risk and financial problems where accompanying controls and risk management practices were inadequate,” the FDIC said in the letter. In particular, new lenders have suffered from rapid growth, over-reliance on volatile funding, including brokered deposits, significant deviations from approved business plans, and weak risk management practices, the FDIC said. http://www.ft.com/cms/s/0/23710fd6-9416-11de-9c57-00144feabdc0.html US ‘problem’ bank list hits 15-year high By Joanna Chung in Washington and Francesco Guerrera in Pittsburgh Published: August 27 2009 16:08 | Last updated: August 27 2009 20:38 The number of US banks at risk of failure is at a 15-year-high while the fund protecting depositors is at its lowest level since 1993, according to figures that highlight the spread of the crisis to the lower reaches of the financial system. The Federal Deposit Insurance Corporation, a banking regulator, on Thursday said the number of “problem banks” had risen from 305 to 416 during the second quarter. The
240 FDIC does not name the lenders on the “problem list” but said that total assets of that group had increased from $220bn to $299.8bn in the three months through June. That relatively low figure suggests that after hitting large institutions which traded complex securities, the financial crisis and the recession are taking a toll on smaller banks that lend to businesses and consumers. Sheila Bair, the FDIC chairman, said on Thursday that while earlier losses in the industry were related to troubled residential loans and complex mortgage-related assets, there were now problems with more conventional types of retail and commercial loans that have been hit hard by the recession. “These credit problems will outlast the recession by at least a couple of quarters,’’ she said. The FDIC’s total asset figure indicates that Citigroup is not on the “problem list”, in spite of fears among executives and investors that its financial problems and regulators’ concerns over the management team could prompt an inclusion. Citi declined to comment. Thursday’s news of a sharp fall in the FDIC’s deposit insurance fund, which insures up to $250,000 per depositor in each bank, underscored the problems faced by regulators when contemplating the rescue or wind-down of institutions with trillions of dollars on their balance sheets. The agency said its fund had fallen to just $10.4bn from $13bn in the quarter, the lowest level since March 1993 when the US was in the middle of the savings and loans crisis. The fund has been depleted by bank failures: regulators have shut 81 banks this year. “In many important respects, financial markets are returning to normal,’’ said Ms Bair. “Combined with the positive economic news in recent weeks, we’re hopeful that this will lead to a moderation in credit problems in coming quarters. But, as our report shows, cleaning up balance sheets is a painful process that takes time.’’
241
Obama lucky to have Bernanke Created: 2009-8-28 0:19:02
J. Bradford DeLong WILLIAM McChesney Martin, a Democrat, was twice reappointed chairman of the United States Federal Reserve by Republican President Dwight D. Eisenhower. Paul Volcker, a Democrat, was reappointed once by the Reagan administration (but not twice: there are persistent rumors that Reagan's treasury secretary, James Baker, thought Volcker too invested in monetary stability and not in producing strong economies to elect Republicans). Alan Greenspan, a Republican, was reappointed twice by Bill Clinton. And now Barack Obama has announced his intention to renominate Republican appointee Ben Bernanke to the post. The Fed chairmanship is the only position in the US government for which this is so: it is a mark of its unique status as a non or not-very-partisan technocratic position of immense power and freedom of action - nearly a fourth branch of government, as David Wessel's recent book "In Fed We Trust" puts it. The reason American presidents are so willing to reappoint Fed chairmen from the opposite party is closely linked to one of the things a president seeks: The confidence of financial markets that the Fed will pursue non-inflationary policies. If financial markets lose that confidence - if they conclude that the Fed is too much under the president's thumb to wage the good fight against inflation, or if they conclude that the chairman does not wish to control inflation - then the economic news is almost certain to be bad. Capital flight, interest-rate spikes, declining private investment, and a collapse in the value of the dollar - all of these are likely should financial markets lose confidence in a Fed chairman. And if they occur, the chances of success for a president seeking re-election - or for a vice president seeking to succeed him - are very low. By reappointing a Fed chairman chosen by someone else, a president can appear to guarantee to financial markets that the Fed is not too much under his thumb. But US presidents seek more than just a credible commitment to financial markets that the Fed chairman will fear and fight inflation. They seek intelligence, honor, and a keen sense of public interest and public welfare. Presidents' futures - their ability to win re-election, to accomplish other policy goals, and to leave a respectable legacy - hinge on the economy's strength. It may or may not be true, especially these days, that what is good for General Motors is good for America and vice versa, but certainly what is good economically for America is good politically for the president. It is here that Obama has lucked out. Ben Bernanke is a very good choice for Fed chairman because he is intelligent, honest, pragmatic and clear-sighted in his vision of the economy. He has already guided the Fed through two very tumultuous years with only one major mistake - the bankruptcy of Lehman Brothers. http://www.shanghaidaily.com/sp/article/2009/200908/20090828/article_411986.htm
242 If You Are So Rich, Why Aren't You Smart? A correspondent emails me a link to http://gregmankiw.blogspot.com/2009/08/least- surprising-correlation-of-all.html... Greg Mankiw looks at:
And says: The Least Surprising Correlation of All Time: [S]o what? This fact tells us nothing about the causal impact of income on test scores.... Suppose we were to graph average SAT scores by the number of bathrooms a student has in his or her family home. That curve would also likely slope upward.... But it would be a mistake to conclude that installing an extra toilet raises yours kids' SAT scores. It would be interesting to see the above graph reproduced for adopted children only. I bet that the curve would be a lot flatter. And he drops it there. But merely saying that correlation is not always causation and dropping the issue is, I think, profoundly unhelpful--and shows a... lack of work ethic as well. Off the top of my head... IIRC, the age-adjusted correlation between log income and IQ is 0.4: take someone with a log income higher by one standard deviation than average--these days someone with a middle-age-adjusted family income of $100,000-$120,000 rather than $60,000-$80,000-- and their IQ is likely to be 0.4 standard deviations (6 points) above average. The individual
243 heritability of IQ is about 0.5: take an individual with a IQ 6 points above average and their children will be expected to have an IQ 3 points above average. SAT scores have a mean of 500, a standard deviation of 100, and a high but not a perfect (0.7) correlation with IQ. So if we compare people whose parents have an income of $100,000-$120,000 to those with an income of $60,000-$80,000 we would expect to see 1 x 0.4 x 0.5 x 0.7 x 100 = 14 points. The actual jump in the graph Mankiw refers to is twice as large. The rule of thumb, I think, is that half of the income-test score correlation is due to the correlation of your test scores with your parents' IQ; and half of the income-test score correlation is coing purely from the advantages provided by that component of wealth uncorrelated with your parents' (genetic and environmental!) IQ. The curve is less steep, but there is definitely a "what" here to be thought about. The masters at explaining this, of course, are (Googles) Samuel Bowles and Herbert Gintis, "The Inheritance of Inequality" http://www.umass.edu/preferen/gintis/intergen.pdf... Friday, August 28, 2009 The Least Surprising Correlation of All Time
The NY Times Economix blog (http://economix.blogs.nytimes.com/2009/08/27/sat-scores- and-family-income/) offers us the above graph, showing that kids from higher income families get higher average SAT scores. Of course! But so what? This fact tells us nothing about the causal impact of income on test scores. (Economix does not advance a causal interpretation, but nor does it warn readers against it.) This graph is a good example of omitted variable bias, a statistical issue discussed in Chapter 2 of my favorite textbook. The key omitted variable here is parents' IQ. Smart parents make more money and pass those good genes on to their offspring. Suppose we were to graph average SAT scores by the number of bathrooms a student has in his or her family home. That curve would also likely slope upward. (After all, people with more money buy larger homes with more bathrooms.) But it would be a mistake to conclude that installing an extra toilet raises yours kids' SAT scores. It would be interesting to see the above graph reproduced for adopted children only. I bet that the curve would be a lot flatter. http://gregmankiw.blogspot.com/2009/08/least-surprising-correlation-of-all.html August 28, 2009, 11:14 am
244
August 28, 2009, 11:14 am Heredity, environment, justice Oh, Kay. Greg Mankiw looks at a graph showing that children of high-income families do better on tests, and suggests that it’s largely about inherited talent: smart people make lots of money, and also have smart kids. But, you know, there’s lots of evidence that there’s more to it than that. For example: students with low test scores from high-income families are slightly more likely to finish college than students with high test scores from low-income families. It’s comforting to think that we live in a meritocracy. But we don’t. http://krugman.blogs.nytimes.com/2009/08/28/heredity-environment-justice/#comments
245 COLUMNISTS Could ‘Tobin tax’ reshape financial sector DNA? By Gillian Tett Published: August 27 2009 11:26 | Last updated: August 27 2009 11:26 Does the world need a global “Tobin tax”? That is the question buzzing around London’s financial circles this week. Some three decades ago, James Tobin, the economist, first proposed introducing a tax on financial transactions to deter short-term currency speculation. Few policymakers have dared air that idea in the intervening years, since it seemed wildly unfashionable. But earlier this month Adair Turner, the chairman of the Financial Services Authority, participated in a round table organised by Prospect magazine and suggested a new debate about the old “Tobin” idea. Unsurprisingly, this has grabbed attention, particularly in a quiet August. However, the really interesting thing about Lord Turner’s suggestion is the wider intellectual impetus behind it. For, as the FSA chairman surveys the financial crisis, he is increasingly convinced that western policymakers are at a crucial intellectual watershed. In recent years, he argues, “the whole efficient market theory, Washington consensus, free market deregulation system” was so dominant that it was somewhat like a “religion”. This gave rise to “regulatory capture through the intellectual zeitgeist”, enabling the banking lobby to swell in size and power. But now, he says, there has been “a very fundamental shock to the ‘efficient market hypothesis’ which has been in the DNA of the FSA and securities and banking regulators throughout the world”. Hence, “the idea of that more complete markets were good and more liquid markets are definitionally good” is no longer trusted. “[This crisis] requires a very major reconstruct of the global financial regulatory system, [not] a minor adjustment,” he concluded during the Prospect discussion (in which I also participated). Reflect on those words for a moment. Lord Turner previously worked at McKinsey, the management consultant group that has recently been a key evangelist for the creed of shareholder value, free-market competition and financial capitalism. Yet he now thinks that the intellectual compass-cum-bible that has guided the FSA – and McKinsey – has been wrong. Now a cynic might attribute some of this to mere political posturing. The FSA, after all, has faced criticism for failing to get tougher in curbing banking bonuses, and in also fending off proposals to put it under the Bank of England. Yet, if nothing else, Lord Turner’s comments are a striking sign of the times. And they raise a crucial question: namely what type of intellectual framework should western regulators now use, if their prior bible – or compass – has now turned out to be so flawed? Sadly, Lord Turner does not offer any pat answers. He has a long list of ideas he thinks politicians and regulators should debate. Aside from the Tobin tax, he would like to consider more curbs on financial innovation, and a review of market dominance and
246 pricing activity in the wholesale finance sector. But those ideas are not really a manifesto. Instead, he stresses that regulators are “still trying to work out” what to do “after a fairly complete train wreck of a predominant theory of economics and finance”. No doubt, this agnostic stance will infuriate some, or confirm the impression that regulators are toothless. But that may be the wrong response. After all, the real problem with finance in the past few decades is not simply that policymakers and investors were using flawed economic and financial theories, but using them in such a blind way that they often disengaged their brains. Bodies such as the FSA, for example, were so wedded to ideas of market efficiency that they only intervened when there was a clear case of market failure. Similarly, investors were so obsessed with narrow, short-term definitions of shareholder value that they, like regulators, often appeared to be acting on autopilot. However, the unpleasant truth is that there is never going to be any complete intellectual system to explain how financial systems should work. After all, as I wrote last week, ideologies are always rooted in shifting power structures and struggles. And just as the old intellectual model proved imperfect, any new “theory” that might yet replace it – with or without a Tobin tax – will have limitations too. What is needed now, in other words, is not so much a new creed, or magic-wand policies, but policymakers, politicians, investors and bankers who are willing to engage their brains, and keep remaking policy, as the world evolves. That is not an easy idea to sell to politicians, voters or even regulators. After all, as Lord Turner points out, a world without a reliable compass is frightening, exhausting and time- consuming to navigate: “For the regulators of the world, once you have accepted that you don’t have an intellectual framework of ‘more market is always better’ you’re in a much more worrying space, because you don’t have an intellectual system to refer each of your decisions.” It is unclear whether Lord Turner will ever be able to actually turn any of his rhetoric into policies, given the scale of backlash that his comments will undoubtedly spark from the banking world. But I, for one, reckon he is to be applauded for at least trying to think the unthinkable again and move away from a crude reliance on creeds. The only question now is whether other regulators will follow, not just in Europe but, above all, in the US, where so many of the free-market dogmas first sprang to life. http://www.ft.com/cms/s/0/980e9ec8-92f2-11de-b146-00144feabdc0.html
247
The Tobin tax explained By Martin Sandbu Published: August 27 2009 14:46 | Last updated: August 27 2009 14:46 The “Tobin tax” was originally proposed in the early 1970s by James Tobin, an influential American macroeconomist and recipient of the Nobel prize for economics. His idea was prompted by the collapse of the Bretton Woods system in 1971, which replaced an arrangement of fixed exchange rates ultimately based on the US dollar’s peg to gold with a period of volatile floating exchange rates. Tobin proposed to reduce this volatility with a small tax – for instance 0.1 per cent – levied on every amount exchanged from one currency into another. He wanted to discourage short-term currency speculation, which makes it difficult for countries to implement independent monetary policies by moving money quickly back and forth between countries with different interest rates. Tobin’s goal was to “throw sand in the wheels” of global finance with a simple tax that would be small enough to make short-term purely financial movements uneconomical – without being a burden on trade. The proposal never caught on in the 1970s but received renewed attention during the Asian financial crisis in the late 1990s when it became a cause celèbre for the anti-globalisation movement. A number of organisations, such as France-based Attac, sprang up to campaign for a Tobin tax long after the economist had died in 2002. The original purpose of putting the brakes on currency speculation has been somewhat eclipsed among activists who have increasingly seen the Tobin tax as a good way of raising revenue for economic and social development. Some have suggested that a Tobin tax should be introduced to finance the money needed to meet the UN’s Millennium Development Goals of reducing poverty and ill health. Governments have been at best lukewarm to the idea, although former French president Jacques Chirac expressed interest in it. Tobin himself disowned activists’ adoption of his proposal for revenue-raising purposes, which he thought missed the point of the proposal: which was to reduce the socially harmful effects of finance while keeping its benefits. In this respect, FSA chairman Adair Turner’s broaching of the Tobin Tax as a method for regulating the financial sector may be more in line with the original idea. http://www.ft.com/cms/s/0/6210e49c-9307-11de-b146-00144feabdc0.html
248 UK
Treasury frowns on ‘Tobin’ proposal By George Parker, Political Editor Published: August 27 2009 00:01 | Last updated: August 27 2009 00:01 When Jacques Chirac, the former French president, proposed in 2005 a “Tobin tax” on financial transactions to address the excesses of “liberal globalisation” his ideas were scorned by Britain. Times have changed since then. Today the man charged with regulating the City of London makes exactly the same suggestion, arguing that such a tax might help to curb excessive pay, profit and activity in a “swollen” financial sector. Lord Turner, chairman of the Financial Services Authority, is highly regarded in the Treasury, but the idea of imposing new global taxes on a sector struggling out of its deepest hole in the postwar period was not well received. “This isn’t on the table,” said one government official. “If Adair Turner has views on tax policy, perhaps he should go and work in the Treasury.” Lord Turner’s comments in the pages of Prospect magazine represent the views of someone who believes the City has simply become too big for society or for the British economy. He argues that parts of the financial industry have grown “beyond a socially reasonable size” and that London’s competitive position should not be defended at any cost. To illustrate his point he looks at growth in the share of gross domestic product made up of wholesale financial services and considers “what percentage of highly intelligent people from our best universities went into financial services”. “Now, unless you’ve got a theory that explains why financial intermediation suddenly needs all this extra resource, there is something of a conundrum,” he says. “Is it really the case that financial intermediation today is a more complex thing than a decade or two back?” Lord Turner’s suggestion of a Tobin tax to rein in excessive profits may turn out to be about as successful as Mr Chirac’s failed initiative. The FSA chairman admits that a global agreement would be “very difficult to achieve”. But his stark warning illustrates a wider fear among some regulators that the easing of the financial crisis has bred complacency and that tough measures still need to be implemented.World leaders will consider the progress made in tightening up banking regulation next month at the Group of 20 summit in Pittsburgh. Some bankers privately suspect Lord Turner has ulterior motives and that his tough message might be designed to appeal to George Osborne, who hopes to be the Conservative chancellor of the exchequer within nine months. The Tories refused to be drawn on Lord Turner’s suggestion of a globally negotiated Tobin tax, but Mr Osborne will have been pleased with some of his comments. Notably Lord Turner is agnostic over Mr Osborne’s plan to scrap the FSA and merge its regulatory functions with the Bank of England. “You can argue this either way,” he says. He argues that Spain rode out the crisis reasonably well with a bank supervisory system allied to its central bank; Canada’s apparently sound banking system was overseen by a regime that separated central bank and bank supervision.
249 “You can’t do a split like that without some risks of transition management – and I don’t think George Osborne would deny that,” he says. “But that’s a challenge to be dealt with if the electorate decides to go in that direction.” http://www.ft.com/cms/s/0/f37bd90e-9286- 11de-b63b-00144feabdc0.html
UK FSA backs global tax on transactions By George Parker in London Published: August 27 2009 00:01 | Last updated: August 27 2009 00:01 The head of Britain’s top banking watchdog supports the idea of new global taxes on financial transactions, warning that a “swollen” financial sector paying excessive salaries has grown too big for society. Adair Turner, chairman of the Financial Services Authority, says the debate on bankers’ bonuses has become a “populist diversion” and that more drastic measures may be needed to cut the financial sector down to size. He also says the FSA should “be very, very wary of seeing the competitiveness of London as a major aim”, claiming the city’s financial sector has become a destabilising factor in the British economy. His comments, floated in an interview in Prospect magazine published on Thursday, may be read in other financial centres, including New York, as a sign that Britain is becoming increasingly sceptical about the perceived advantages of being a leading financial centre. Lord Turner’s suggestion that a “Tobin tax” – named after the economist James Tobin – should be considered for financial transactions is also likely to reverberate around the world. The proposed tax, which has previously been championed by development economists and the French government as a means of funding the developing world, has been fiercely opposed by the finance industry. Lord Turner appears worried about a return to “business as usual” in the banking sector, suggesting that new taxes may be necessary to curb excessive profits and pay in the financial sector. “If you want to stop excessive pay in a swollen financial sector you have to reduce the size of that sector or apply special taxes to its pre-remuneration profit,” he says. Lord Turner says higher capital requirements will be the FSA’s main tool to eliminate excessive activity and profit, but that a tax on transactions on a global level may be an additional option. Aides to Alistair Darling, chancellor, said no such taxes were under consideration. Mr Darling insists that the banking industry in London should continue to play a leading role in global finance. Angela Knight, chief executive of the British Bankers’ Association, also defended the financial industry’s role in the economy saying the sector was a main provider of jobs and tax revenues and could be undermined by the wrong kind of taxes or regulation.
250 The FSA chairman also claims that parts of the financial services sector had grown “beyond a socially reasonable size”, including derivatives and hedging and aspects of the asset management industry and equity trading. http://www.ft.com/cms/s/0/08943b5a-926a- 11de-b63b-00144feabdc0.html
The Exit Strategy from the Monetary and Fiscal Easing: Damned If You Do, Damned If You Don’t Nouriel Roubini| Aug 24, 2009 In the last few months the world economy has been saved from a near depression. That feat has been achieved by a range of extraordinary government stimulus measures: In the U.S. and in China, and to a lesser extent in Europe, Japan and other countries, governments have pumped liquidity, slashed policy rates, cut taxes, primed demand and ring-fenced and back-stopped the financial system. All of this has worked, but it has worked at a cost. Governments have been spending and borrowing like never before. The question now is: how do they stop? This is not a simple problem. Restore normality too soon and the risk is that a weak recovery will double dip into a second and deeper recession. Restore it too late and inflation will already be ingrained. Consider how much has been committed, and how much has been spent. In the U.S. alone, when you add up the government’s liquidity support measures, its re-capitalizations of banks, its guarantees of bad assets, its extension of deposit insurance and guarantees of unsecured bank debt, at least US$12 trillion has been committed, and a quarter of that has already been spent. Along with the rise in spending there has also been a very large fiscal stimulus, pushing the federal budget deficit to 13% of GDP this year (next year on current plans the deficit will fall back, but still amount to 10% of GDP). Not all the measures adopted appear on the budgetary bottom line. As well as monetary easing and fiscal stimulus, the U.S. and other governments have resorted to unconventional measures to ease monetary conditions. In the U.S., Japan and the UK, real interest rates have been pushed down to zero, and governments have resorted to buying long-dated securities, the goal of which - only partially achieved - was to hold down long-term interest rates. The Fed, for example, has committed to spending US$1.8 trillion on longer-dated treasury bonds and other securities, but most of this spending is money the government has printed itself, simply by creating central bank monetary base. It doesn’t add to the budget deficit, although it does add to the long-term risk profile of the government doing the spending as monetization of fiscal deficit can eventually be inflationary.
251 This massive escalation of central government spending and borrowing was necessary. For most of last year governments lagged well behind the curve of the unfolding crisis. For too long policymakers continued to believe that the house price bubble was an isolated aberration that would self-correct without impacting the wider economy, and that the unprecedented growth in household indebtedness was not a matter of concern. By the final quarter of last year, however, the global economy was in freefall with industrial production, private demand, employment and broad GDP all contracting at a rate indicating something close to depression at hand. Policymakers suddenly went into corrective overdrive in late 2008, and not a moment too soon. The second quarter GDP estimates for the U.S. show just how significant this aggressive front-loaded policy stimulus has been. While total GDP growth was sharply negative in the first quarter – around -5.6% - the rate of decline in the second quarter had moderated to around -1.5%. Credit this relative improvement to governmental monetary, fiscal and financial stimulus. The private components of GDP, private demand and capex, were actually still very weak. But government spending rose by 5.6%, breaking what otherwise would have been another quarter of headlong GDP contraction. Necessary as the stimulus has been, it cannot go on indefinitely. Governments cannot run deficits of 10% or more of GDP, and they cannot go on doubling the monetary base, without eventually stoking inflation expectations, pushing up long term interest rates and eventually eroding their very viability as sovereign borrowers. Not even the U.S. can do that. The fiscal implications of the current policy package are particularly serious. For the time being fiscal policy has been put at the service of survival, but the current price of survival is that net public debt is going to double as a share of GDP between 2008 and 2014. Even using the very optimistic forecasts of the Congressional Budget Office which anticipate growth of around 4% over the next few years, the net debt burden will rise from 40% of GDP to 80% - that’s an increase in the debt stock of about $9 trillion. The interest charge alone on that increased debt will be in the region of $300 billion to $400 billion a year, which in turn may mean more borrowing to pay the interest if primary deficits are not reduced. When governments reach the point where they are borrowing to pay the interest on their borrowing they are coming dangerously close to running a sovereign Ponzi scheme. Ponzi schemes have a way of ending unhappily. To get out of the Ponzi trap governments will have to raise taxes, or cut spending, or monetize the debt – or most likely do some combination of all three. Monetization is already happening. This is where a government effectively prints money by allowing the central bank to create base money that is used to buy government debt, thereby increasing liquidity and holding down long-term interest rates (because the additional demand for these securities pushes up bond prices, thereby lowering the real interest rate the securities pay, as well as putting money into the pockets of the investors who have sold the securities). Over time, monetization is inflationary, but the inflationary effect is insidious because it is not immediately visible. In the short run deflation will outplay inflation. In most developed countries today there is so much slack in economies, with weak demand and high unemployment, that prices cannot rise. The velocity of money is also weak, as financial institutions are receiving liquidity from central banks and hoarding it to rebuild their balance sheets, instead of lending it out. But as the economy recovers these effects will abate, and the growth of the monetary base caused by monetization will eventually drive
252 expected and actual inflation. And once markets start to anticipate that scenario, it may already be too late to avert an inflationary surge. Simply issuing debt in the form of treasury bonds offers no escape. The more debt a government issues, the higher the risk it will eventually face refinancing problems and/or default on that debt. Accordingly investors will demand a higher return for investing in that debt, and that in turn will push up rates. Independent rating agencies have already downgraded the sovereign risk rating of countries like Greece and Ireland, and it cannot be ruled out that core economies of the OECD, including the US, could eventually be downgraded. As it happens there is little sign today of investors demanding a significantly higher risk premium on US government debt. That is partly because private savings are increasing: those savings have to be invested somewhere and investors are cautious about alternative investments. Foreign demand for US bonds also remains so far robust. But this demand is unlikely to survive another big round of government-financed stimulus and bailout spending. And unfortunately, just such a spending round is rather likely. Consider that by the end of 2010 most of the tax cuts legislated by the Bush administration in 2001 and 2003 are due to expire. This means that there will be a sharp tax hike, including income taxes, capital gains taxes, and taxes on dividends and estates. This hike – equivalent to around 1.5% to 2% of GDP – is already factored in to future calculations of government indebtedness. So if by next year the recovery proves as anemic as I expect, and if unemployment is around 10.5-11% as I also expect, then the pressure for another stimulus round early in 2010 will be strong. A rough calculation goes like this: stimulus money to keep the lid on rising unemployment is likely to be around $200 billion. Add to that the likely temporary partial extension of the Bush tax cuts and funding of the current administration’s plans for universal healthcare (an additional bill of around $1.5 trillion over ten years) and you get deficits close to12% of GDP. This amounts to a fiscal train wreck. For the US, it means that deficits could remain over 10% of GDP for years. Bond issuance will remain enormous, and it will mean that the Fed will almost certainly have to monetize a proportion of the debt by buying even more government or government backed securities. A combination of higher official indebtedness and monetization has the potential to yield the worst of all worlds, pushing up long-term rates and generating increased inflation expectations before a convincing return to growth takes hold. An early return to higher long-term rates will crowd out private demand, as lending rates on mortgages, personal and corporate loans rise too. It is unlikely that actual inflation will emerge this year or even next, but inflation expectations as reflected in long-term interest rates could well be rising later in 2010. This would represent a serious threat to economic recovery, which is predicated on the idea that the actual borrowing rates that individuals and businesses pay will remain low for an extended period. Yet the alternative – the early withdrawal of the stimulus drug that governments have been dispensing so freely – is even more serious. The present administration believes that deflation is a worse threat than inflation. They are right to think that. Trying to rebuild public finances at a deflationary moment – a time when unemployment is rising, and private demand is still contracting – could be catastrophic, turning recovery into renewed recession.
253 History offers more than one example of this error. It happened in Japan in the late 1990s, when the Japanese government feared the effects of fiscal deficits and of an increase in inflation as the economy was beginning to recover after almost a decade of deflation. Consumption taxes were raised too soon and the ‘zero interest rate policy’ was abandoned. Within a year the economy was back in recession. It also happened in the US in the 1930s. President Roosevelt instituted a massive stimulus package when he came to office in 1933, to push the US economy out of the depression, but by 1937 the administration was worrying that inflation was returning and that deficits were too large; so it cut spending and raised rates and the Fed tighten monetary policy. By 1938 the economy was heading back into double-dip near depression. So policy makers are between a rock and a hard place. Stop spending now and risk renewed recession and deeper deflation (stag-deflation). Keep spending now and risk renewed recession amid rising inflation expectations (stagflation). Yet there is a space between the rock and the hard place. It is not a big space, but it is there. Governments will have to manage perceptions. Today investors remain willing to bankroll federal spending without any clear or firm indication of how the fiscal crisis – and it is a crisis of extraordinary proportions – is going to be dealt with. That won’t last. Clear indications will soon be needed as to how and when public finances will be repaired. That doesn’t have to be accomplished soon – but it does have to be communicated soon. Monetary policy can most likely remain looser for longer (in the developed economies at least) so long as there is a clear commitment to fiscal consolidation. But a credible fiscal commitment to medium terms fiscal sustainability is vital, because that is what will open up the very narrow window that is the exit route from our current and unsustainable spend- and-borrow economy. http://www.rgemonitor.com/roubini- monitor/257551/the_exit_strategy_from_the_monetary_and_fiscal_easing_damned_if_you_do _damned_if_you_dont
254
United States The Message from Jackson Hole August 27, 2009
By Richard Berner | New York The Grand Tetons' timeless beauty once again provided a relaxed backdrop in which to debate and reflect on the state of the global economy and financial markets at the Kansas City Federal Reserve's annual Monetary Policy Symposium this weekend in Jackson Hole, Wyoming. Gone were last year's gloomy acceptance by policymakers and market participants that continued downside risks for the global economy and financial markets would persist, along with the huddled meetings to deal with the gathering storm. In their place was relief that the worst of the crisis was now past and that economies were stabilizing or showing early signs of recovery, and hope that the outlook for recovery was good. Sunny markets, cautious policymakers. Nonetheless, there is a significant disconnect between market sentiment and policymakers' moods. Risky asset markets are celebrating early signs of economic recovery, but policymakers at Jackson Hole were far more cautious about the outlook. While we continue to think that the recovery will ultimately be sustainable, we agree with most policymakers that it is still reliant on forceful policy support; that a self-sustaining recovery is far from a sure thing; and that downside risks to inflation persist. Ironically, continued caution from policymakers is a key ingredient encouraging investors to take on more risk, as low rates help to finance carry and other risky asset trades. Against this backdrop, debate at the symposium focused on four areas of uncertainty: the success of policies to jump-start recovery, what comes next, when and how to exit from extraordinary policy support, and how to reform the policymaking and regulatory structure. Aggressive monetary policy support for financial markets and economic activity has clearly contributed to healing in both, but there is still uncertainty about policy effectiveness and thus the outlook. Most agree that aggressive use of monetary policy's broader tool kit has mitigated the financial crisis and stabilized economic activity. While this is not the same thing as jump-starting recovery, most agreed that ‘tapering' some policy supports - for example, winding down and possibly extending the termination of the Fed's asset purchase programs - is now appropriate to signal the end of easing. There is also consensus that commitments to maintain the current highly accommodative policy stance should be conditional on the outlook for inflation. Whether expressed in terms of the calendar, like the Bank of Canada's pledge to maintain the policy rate at 0.25% until 2Q10, or the Fed's ‘extended period', the goal of policy is to prevent deflation. Indeed, US policymakers were quick to emphasize that there is no inconsistency between currently low interest rates and stable inflation. With US markets apparently pricing in the first tightening around the turn
255 of the year, officials clearly wanted to express a more cautious stance, and their caution was echoed by many others. Little consensus on exit strategy. There was little consensus at Jackson Hole about how to prosecute exit strategies even when they become appropriate: Should uncertainty dictate a gradual Brainard/Kohn approach, one that allows officials to correct small mistakes? Or should exiting from accommodation and moving to renormalize rates mirror the aggressive stance of easing in the crisis? 20 years ago this month, then-Secretary to the FOMC Don Kohn articulated the logic behind the gradualist approach: Small but frequent adjustments to the funds rate in the context of a larger policy strategy may be optimal. Two decades later, Vice-Chairman Kohn gave no hint that today's circumstances warranted a departure from gradualism. Yet the logic for adopting a more aggressive exit strategy is not without merit: Policy is extremely accommodative, so just to normalize rates will require sizeable moves. And while even normalization seems a distant prospect, no policymaker wants to overstay his or her welcome. Activist fiscal policy: Uncertain effects, risky legacy. Most agreed that the depth of the crisis warranted aggressive use of fiscal policy, especially given concerns about monetary policy traction in the credit crunch. But there is widespread uncertainty about the bang-for- buck and fiscal policy multipliers from either the 2008 or 2009 stimulus packages, and little if any consensus about their current benefits. Some estimates of fiscal policy multipliers were significantly less than one. Moreover, participants at Jackson Hole unanimously wanted a credible commitment to reducing deficits to head off a potentially damaging rise in real interest rates. We couldn't agree more. Expanding the policy mandate. Financial stability is now a key goal for monetary policy, but how to achieve that expanded policy mandate and whether it complements or conflicts with the traditional goals of price and economic stability are still open questions. As Bank of Canada Governor Carney noted, "a prolonged, benign macroeconomic environment can encourage ...complacency...as risk taking adapts to the perceived new equilibrium..." and changes the monetary transmission mechanism. "Indeed", Carney noted, "risk appears to be at its greatest when measures of it are at their lowest". In other words, achieving price stability can encourage excessive risk taking and leverage that will breed, Minsky-like, financial and ultimately economic instability. Policy ideally should not contribute to such instability; it should lean against it. However, defining this expanded mandate and deciding how much would go to central banks, the scope, the techniques and how to communicate the objectives and strategy are still evolving. As the first line of defense, many central bankers recognize the need for better regulation, for example through improved macroprudential supervision and regulations that reduce procyclicality in financial markets and credit availability. Time- varying capital buffers, discussed at last year's symposium, and their funding-market cousins - through-the-cycle margins and haircuts - are on most policymakers' lists. However robust, no regulatory framework will eliminate panics resulting from financial shocks. The debate extended to how to institutionalize liquidity provision to quell such panics in a way that fits Bagehot's dictum to "lend early and freely (i.e., without limit) to solvent firms, against good collateral, and at ‘high rates'" - especially when it comes to evaluating ‘good' collateral. When and where to draw the line between liquidity support for a solvent firm from the central bank and a rescue from the taxpayer for one requiring restructuring requires both principles and judgment. And what if such improved regulation fails to prevent a credit or asset boom? In contrast with the US view of a few years ago, central bankers today increasingly believe that policy
256 should lean against the wind of such booms. Critical to that judgment is work suggesting that small changes in funding costs (either through actual change in policy rates or in adjustments to margins or haircuts) can have a significant effect. Announcing their intentions to do so does not preclude flexibility in deciding whether exuberance is going too far and could reduce the now-infamous ‘put' that developed when central bankers took a hands-off approach. Whether institutionalized in the ECB's ‘two pillar' approach to policy or in some other credible fashion, policymakers must develop the right framework for allowing them to achieve financial stability, as well as the flexibility to accommodate deviations from it. Spectacular weather no metaphor for investor uncertainty. The ever-changeable weather in the Tetons is often the proverbial pathetic fallacy, a metaphor for the conference. Not so last year or this: Last year's weather was ideal, but the cloudy litany of economic, financial and policy concerns was widespread. I shared those concerns, noting then, "With global growth slowing, there is reason to worry that the adverse feedback from the economy to credit quality will trigger more financial dislocations that will require tough choices - choices that involve trade-offs between moral hazard and real economic hazards, potentially setting lasting and uncomfortable precedents for the future". This year, the spectacular weather seemed to fit investors' moods, contrasting with the still- cautious disposition of policymakers. An improving economic outlook and still-low interest rates are providing a sweet spot for investors. A scenario of rising earnings and sustainable growth now seems more plausible than at any time in the last two years. And low rates provide fuel for leveraging high-beta, cyclical investment opportunities. But there is a lot of good news in the price, and market participants will for now have to grapple with the uncertainty surrounding the outlook and the prospects for an eventual exit from policy support. Investors also face uncertainty about the ways that policies to achieve the goal of financial stability will reduce leverage, prospective returns and growth. Finally, they face uncertainty of how elected officials will respond to the financial crisis by reshaping the Fed.
Global Jackson Hole 0, Jerusalem 1 August 27, 2009
By Joachim Fels | London Shekeling the tree: Until very recently, central banks around the globe stood united in their quest for easing monetary conditions through interest rate cuts or, where the lower bound for rates had been reached, unconventional policies. Moreover, at their annual gathering in Jackson Hole this past weekend, most central bankers signalled that an early tightening in the major economies is not on the cards. However, at least one central bank chose to differ this week: the Bank of Israel in a surprise move broke ranks and raised rates by 25bp on August 24, thus becoming the first central bank in the EM and non-EM space to tighten policy in this cycle. While we do not believe that this move alters the outlook for the big central banks, it does have two important ramifications. First, markets will increasingly focus on who's next to raise rates (Norway, we think). Second, with policies starting to diverge as some central banks, especially in Central and Eastern Europe, are still cutting rates, differentiation between countries is likely to become a bigger theme again for markets.
257 Cautious consensus at Jackson Hole: The main message that our colleague Richard Berner brought back from this past weekend's gathering of central bankers at Jackson Hole is that an early policy tightening in the major countries is definitely not on the cards, in line with our global team's forecasts. In Dick's own words (see The Message from Jackson Hole, August 24): "Risky asset markets are celebrating early signs of economic recovery, but policymakers at Jackson Hole were far more cautious about the outlook...Most agreed that ‘tapering' some policy supports - for example, winding down and possibly extending the termination of the Fed's asset purchase programs - is now appropriate to signal the end of easing. There is also consensus that commitments to maintain the current highly accommodative policy stance should be conditional on the outlook for inflation. Whether expressed in terms of the calendar, like the Bank of Canada's pledge to maintain the policy rate at 0.25% until 2Q10, or the Fed's "extended period", the goal of policy is to prevent deflation. Indeed, US policymakers were quick to emphasize that there is no inconsistency between currently low interest rates and stable inflation. With US markets apparently pricing in the first tightening around the turn of the year, officials clearly wanted to express a more cautious stance, and their caution was echoed by many others". In fact, the Fed, The Bank of Japan, the ECB and the Bank of England are all still engaged in their various unconventional easing programmes and are all forecasting inflation to remain below their respective targets in the foreseeable future. An early policy reversal thus remains unlikely for now - in this sense, there was nothing new from Jackson Hole (for more detail on other issues discussed, please refer to Dick Berner's piece). From the trumpets of Jerusalem: Notwithstanding the cautious Jackson Hole consensus, the Bank of Israel became the first central bank to tighten policy in this cycle by nudging up its policy rate by 25bp to 0.75%. As justification, the policy statement points out that headline inflation is currently above the target range and that, even excluding non-recurring factors (increased tax rates, including VAT, and water prices), inflation is close to the upper limit of the target range. Also, the Bank of Israel notes a "turnaround" in real activity, even though there is "great uncertainty regarding the expected rate of growth". Looking ahead, our Israel watcher Tevfik Aksoy writes: "While the current statement gives limited guidance on what the next move could be, we would be surprised if the bank kept the tightening at merely 25bp this year. This might not only prove ineffective (from an inflation perspective) but could also result in confusion in the market. Prior to the interest rate decision, we had pencilled in a 150bp hike for 2010, and we maintain our view, albeit with different timing. The minutes of the BoI rate-setting meeting are expected to be made public on September 7, after which we will revisit our rates outlook. The next rate-setting meeting will be held on September 24." Why the Israeli situation is different: In a global context, the important thing to note about the Bank of Israel rate hike is that Israeli inflation has recently been uncomfortably high while interest rates have been extremely low. This differs from the situation in most other countries, which fall into two broad groups: First, as our Inflation Target Monitor on page 4 of The Global Monetary Analyst (August 26) illustrates, countries where policy rates are very low typically have inflation at or below target at this stage. Second, in countries where inflation is above target (mostly in Central and Eastern Europe and parts of Latin America), policy rates are typically much higher than in Israel. Thus, Israel looks like an outlier on the interest rate/inflation map and is thus unlikely to find many followers in hiking rates in the near future.
258 Next? Norges Bank? The most likely candidate for the next rate hike after the Bank of Israel is the Norwegian central bank, in our view. In its August policy statement, Norges Bank noted that "New information may also suggest that production and employment may slow less sharply than expected. These tendencies are still uncertain and new figures may change the picture, but should these developments continue, it may be appropriate to increase the interest rate earlier than projected in the previous Monetary Policy Report (our italics)". Thus, our Norway watcher Spyros Andreopoulos writes: "Our central case is for the first rate increase to come in the December meeting. We think the urgency with which Norges Bank communicated a change in posture - effectively shredding the Monetary Policy Report which forecast rates on hold until the 2Q10 only one meeting after its publication - is telling. 2Q09 GDP data, published recently, show that the consumption-led recovery Norges Bank was forecasting is underway: household consumption posted the first sequential increase since 1Q08 at a 0.6% quarterly rate. With government spending also increasing strongly, all indications are that the substantial monetary and fiscal policy stimulus is succeeding in buoying the Norwegian economy. That said, we think Norges Bank will want to proceed at a measured pace, given the risks to the outlook and for fear of generating too strong an exchange rate. After the opening salvo in December, we have pencilled in a 25bp hike in every other meeting from then on, with the pace picking up in 4Q10 where we expect a hike in both meetings for that quarter. This would leave rates at 2.75% for 4Q10 in our estimates." Or perhaps the RBA? Another country where the central bankers sound more hawkish recently is Australia. Helped by significant rate cuts, fiscal stimulus, exchange rate depreciation and Chinese recovery, the economy has avoided recession and the Reserve Bank of Australia (RBA) raised its outlook for growth and inflation in the early August policy statement. While the statement noted that "the present accommodative setting of monetary policy is appropriate", it also indicated that "with the cash rate at an unusually low level and the global economy stabilising, movement towards a more normal setting of monetary policy could be expected at some point if further signs of a durable recovery emerge". While our Australia watcher Gerard Minack's central base is that the cash rate will remain on hold until 2Q10, he acknowledges the clear risk of an earlier move. Bottom line: Notwithstanding the surprise rate hike by the Bank of Israel this week, we continue to believe that the major central banks will keep rates on hold until well into 2010, a view that we feel was confirmed by central bankers at Jackson Hole. Israel is in a special situation, given that it has an unusual combination of extremely low policy rates and uncomfortably high inflation. We think that the next central bank to hike rates is Norges Bank (in December), with the RBA being another candidate to watch (though this is not our main case). In any case, with some countries now embarking on monetary tightening while others are still easing, differentiation between countries is likely to become a bigger theme for markets again. Malaysia Beyond the Inventory-Led Rebound August 27, 2009
By Deyi Tan, Chetan Ahya & Shweta Singh | Singapore An Inventory-Led Rebound Like other economies in ASEAN such as Singapore and Thailand, 1Q09 marked the bottom in terms of percentage year-on-year GDP trajectory for Malaysia. 2Q09 data show
259 that the economy declined at a slower pace of 3.9%Y (versus -6.2%Y in 1Q09). Seasonally adjusted sequential data are not published. However, our calculation shows that Malaysia emerged from a two-quarter-long recession in 2Q09. A few cross-currents are at work in terms of GDP components. The slower pace of decline in 2Q09 was predominantly driven by an inventory snapback. Destocking shaved only 1.9pp from headline GDP in 2Q09, while it shaved off a massive 9.7pp in 1Q09. Meanwhile, domestic demand (excluding inventories) also showed a slightly slower pace of decline at -2.3%Y (versus -2.9%Y in 1Q). However, external demand still saw further deterioration at -17.3%Y (versus -15.2%Y in 1Q09). Taking Stock of Trends at the Margin A restocking rebound would ultimately have to give way to a firmer turnaround in real demand for the uptick to sustain. The macro framework that we have when looking at the Malaysian economy is that it is essentially a three-legged growth model: first, it is dependent on manufacturing exports; second, it is dependent on commodity exports, given that Malaysia is the largest net commodity exporter within Asia; and third, it is dependent on fiscal pump-priming, as Malaysia possibly has the largest public sector economy in Asia and commodity revenue is recycled back into the economy via the political machinery. In this regard, we look at high-frequency macro indicators from a C+I+G+X-M framework to assess how each of these growth legs as well as the broader economy is faring at the margin, heading into 3Q09. Private Consumption: Sentiment Picked Up Much More than Actual Spending The reaction on the consumer side this time round has been worse than in the 2001 cycle (low of +2.1%Y in 3Q01 and no contractions) but not as bad compared to 1998 (low of - 12.3%Y in 3Q98 and six quarters of negative percentage year-on-year growth) when the slowdown was relatively more home-grown. Indeed, GDP data on consumption show only one quarter of a shallow decline in 1Q09 (-0.7%Y) in this cycle. In terms of how strong the recovery in consumer spending will be, recent retail spending proxies still look like a mixed bag in terms of direction, suggesting that the near-term spending recovery could still be somewhat hesitant. Specifically, declines in passenger car sales (-11.1%Y, 3MMA in June 2009) and motorcycle sales (-17.7%Y) are holding somewhat steady while contractions in consumption imports have deepened (-8.2%Y). On the other hand, sentiment has rebounded strongly in 2Q09, attesting to reflexivity from asset markets, which could translate into incremental spending willingness in 2H09. Quality of labor market data for Malaysia is less than ideal, but retrenchment figures have tapered off recently. Anecdotally, we have heard of manufacturers who over-fired during the downturn and are now rehiring at the margin. Fixed Capex: No Excesses Mean a Lesser Adjustment Period The capacity utilization rate rebounded somewhat in 2Q09 to 78.2 from 72.0 in 1Q09. With capacity utilization mapping fixed capex trends fairly well, we believe that the trajectory turnaround for the latter will continue into 2H09 amid the tepid global recovery. Indeed, unlike in Singapore where corporates were aggressively undertaking capacity expansion plans right up until the Lehman episode, Malaysia's capex cycle post the Asian currency crisis has been fairly moderate. The fixed capex share of the economy has remained steady at around 20%. To the extent to which there were no excesses in this cycle, we believe that the adjustment period for capacity normalization will also be correspondingly shorter.
260 Fiscal Pump-Priming: Execution Underway June data showed that fiscal execution is underway, with fiscal expenditure (12-month trailing sum, percentage of GDP) continuing to trend up, reaching a high of 28.5% of GDP from a recent low of 23.3% (February 2008). Consequently, the budget deficit widened to 5.3% of GDP (12-month trailing sum) from 2.8% in February 2008. Going forward, we believe that government expenditure is likely to pick up further on a sequential basis, as spending tends to be back-loaded in the second half of the fiscal year in the case of Malaysia. Initial comments by government officials suggest that fiscal policy from a deficit perspective, while still accommodative, could be less expansionary in 2010 compared to 2009. Yet, we note that, among the ASEAN economies, Malaysian policymakers have generally been among the more accommodative ones. Trade Trends: A Mixture of Price Effects and Cyclicality Commodity-related exports are still reflecting price changes, with exports of mineral fuels and edible oils still showing unabated declines at -42.4%Y, 3MMA in June (versus - 37.8%Y in May), given the peak of the oil price cycle in mid-2008. However, declines in other non-commodity exports have somewhat stabilized at -20.3%Y (versus -18.9%Y in May). Going forward, the US ISM New Orders index (which leads ASEAN exports by roughly four months) points to a more evident turnaround in 2H09, and we believe that such a turnaround is in the pipeline. More specifically, trade would likely be dominated by two trends. Commodity exports would be buoyed by the bounce-back in commodity prices and such positive base effects would be most pronounced in 1H10. On the other hand, manufactured exports would receive cyclical support from the tepid global recovery. Yet, to the extent to which Malaysia's manufactured exports have been gradually losing market share over the years, the tailwind on this front could be correspondingly weaker. Deflation and a Dovish Central Bank On CPI, deflation in Malaysia (-2.4%Y in July versus -1.4%Y in June) is still primarily driven by the transport segment rather than demand destruction per se. Retail fuel constitutes about 7.3% of the CPI basket, and administered fuel prices have been revised downwards by 33-35% since mid-2008. We believe that Malaysia will come out of deflation territory by end-2009 or early 2010 as base effects get washed out. Yet, whether Malaysia would see cost-push pressures from commodities in 2010 depends a lot on whether policymakers are likely to change the fuel subsidy system. Our base case assumption using the oil futures curve is for oil to average about US$75/bbl in 2010. If the current subsidy system is maintained, we suspect that policymakers will be unlikely to hike retail fuel prices. In this case, inflation will likely rise from 0.2%Y this year to only 1.5%Y in 2010. On policy response, further easing is unlikely as the central bank (BNM) is keen to keep a balance between reducing the cost of capital for debtors and maintaining the interest income for saving households. Malaysia is after all a net saving economy. On exit strategy, we think BNM will be closely watching for second-round inflation pressures instead of ‘first-round' policy-induced inflation from base effects. In this regard, we believe that BNM is unlikely to be anxious with the initial uptick in headline inflation simply on fuel price base effects, and monetary policy normalization is likely to start only in 2H10, which would bring policy rates from 2% to 3%. Bottom Line The percentage year-on-year GDP trajectory bottomed out in 1Q09, primarily on the back of an inventory snapback. Beyond the inventory-led rebound, a firmer turnaround in real
261 demand is required for an uptick to sustain. Structural weaknesses not withstanding (see Malaysia Economics: Where Are the Structural Gaps? April 23, 2009), looking at Malaysia via the three-legged growth framework of manufacturing exports, commodity exports and fiscal pump-priming suggests that the economy is likely to receive cyclical support going forward, with GDP growth expected to go from -3.5%Y in 2009 to +3.8%Y in 2010. Meanwhile on the policy front, deflation is likely to persist until late 2009 or early 2010, and we believe that monetary policy renormalization will take place in 2H10. http://www.morganstanley.com/views/gef/print.html
COMMENT The case against Bernanke By Stephen Roach Published: August 25 2009 16:02 | Last updated: August 25 2009 16:02 Barack Obama has rendered one of his most important post-crisis verdicts: Ben Bernanke will be nominated for a second term as chairman of the Federal Reserve. This is a very shortsighted decision. While America’s head central banker deserves credit for being creative and courageous in orchestrating an unusually aggressive monetary easing programme, it is important to remember that his pre-crisis actions played an equally critical role in setting the stage for the most wrenching recession since the 1930s. It is as if a doctor guilty of malpractice is being given credit for inventing a miracle cure. Maybe the patient needs a new doctor. Mr Bernanke made three critical mistakes in his pre-Lehman incarnation: First, and foremost, he was deeply wedded to the philosophical conviction that central banks should be agnostic when it comes to asset bubbles. On this count, he stood with his predecessor – serial bubble-blowing Alan Greenspan – who argued that monetary authorities are best positioned to clean up the mess after the bursting of asset bubbles rather than to pre-empt the damage. As a corollary to this approach, both Mr Bernanke and Mr Greenspan drew the wrong conclusions from post-bubble strategies earlier in this decade put in place after the bursting of the equity bubble in 2000. In retrospect, the Fed’s injection of excess liquidity in 2001-2003, which Mr Bernanke endorsed with fervour, played a key role in setting the stage for the lethal mix of property and credit bubbles. Second, Mr Bernanke was the intellectual champion of the “global saving glut” defence that exonerated the US from its bubble-prone tendencies and pinned the blame on surplus savers in Asia. While there is no denying the demand for dollar assets by foreign creditors, it is absurd to blame overseas lenders for reckless behaviour by Americans that a US central bank should have contained. Asia’s surplus savers had nothing to do with America’s irresponsible penchant for leveraging a housing bubble and using the proceeds to fund consumption. Mr Bernanke’s saving glut argument was at the core of a deep-seated US denial that failed to look in the mirror and pinned blame on others. Third, Mr Bernanke is cut from the same market libertarian cloth that got the Fed into this mess. Steeped in the Greenspan credo that markets know better than regulators, Mr Bernanke was aligned with the prevailing Fed mindset that abrogated its regulatory authority in the era of excess. The derivatives’ explosion, extreme leverage of regulated and shadow banks and excesses of mortgage lending were all flagrant abuses that both Mr
262 Bernanke and Mr Greenspan could have said no to. But they did not. As a result, a complex and unstable system veered dangerously out of control. Notwithstanding these mistakes, Mr Obama may be premature in giving Mr Bernanke credit for the great cure. No one knows for certain as to whether the Fed’s strategy will ultimately be successful. The worst of the US recession appears to have been arrested for now – a fairly typical, but temporary, outgrowth of the time-honoured inventory cycle. But the sustainability of any post-bubble recovery is always dubious. Just ask Japan 20 years after the bursting of its bubbles. While financial markets are giddy with hopes of economic revival – in part inspired by Mr Bernanke’s cheerleading at the Fed’s annual Jackson Hole gathering – there is still good reason to believe that the US recovery will be anaemic and fragile. US consumers are in the early stages of a multi-year retrenchment as they cut debt and rebuild retirement saving. The unusual breadth and synchronicity of the global recession will restrain US export demand from becoming a new growth engine. It would be the height of folly to reward Mr Bernanke for the recovery that never stuck. Yet Mr Bernanke’s apparent reward is, unfortunately, typical of the snap judgments that guide Washington decision-making. In this same vein, it is hard to forget Mr Greenspan’s mission-accomplished speech in 2004 that claimed “our strategy of addressing the bubble’s consequences rather than the bubble itself has been successful”. Eager to declare the crisis over, the Obama verdict may be equally premature. The Bernanke reappointment is a welcome chance for a broader debate over the conduct and role of US monetary policy. Mr Obama has made sweeping proposals that give the Fed broad new powers in managing systemic risks. I argued in the Financial Times 10 months ago that the Fed should not be granted these powers without greater accountability as required by a “financial stability mandate” – in effect, forcing the Fed to shape monetary policy with an aim towards avoiding asset bubbles and imbalances. Without a revamped policy mandate, it is conceivable that we could face another destabilising crisis. Ultimately, these decisions boil down to the person – in this case, Mr Bernanke – who is being charged with the awesome responsibility as America’s chief economic policymaker. As a student of the Great Depression, he should have known better. Yes, he reacted strongly after the fact in taking actions to avoid the pitfalls highlighted by his own research. But he lacked the foresight and courage to resist the most reckless tendencies of the era of excess. The world needs central bankers who avoid problems, not those who specialise in post-crisis damage control. For that reason, alone, he should not be reappointed. Let the debate begin. The writer is chairman of Morgan Stanley Asia and author of The Next Asia to be published next month http://www.ft.com/cms/s/0/a2ba2378-9186-11de-879d-00144feabdc0.html
263 Tuesday, August 25, 2009 A comment on House Prices by CalculatedRisk on 8/25/2009 09:39:00 PM I've seen story after story today suggesting the bottom is in for house prices. This isn't like 2005 when it was almost certain that prices would fall, and fall sharply. Now we are much closer to the bottom than to the top in prices (for some metrics, see House Prices: Real Prices, Price-to-Rent, and Price-to-Income) In some areas prices have probably already hit bottom - like some non-bubble areas, and some bubble areas with significant foreclosure activity. But I think many areas, especially the mid-to-high priced bubble areas, there will be further price declines. I'm not as certain as I was in 2005, but I think these price declines will drag down the Case-Shiller indexes - and I don't think the price bottom is in. I do not have a crystal ball, but ... It seems there are many more foreclosures coming. Some of this depends on the success of the modification programs, but the Q2 MBA delinquency report shows a growing number of homeowners in the problem pipeline. And the Fitch report yesterday suggests few of these delinquent homeowners will cure. That seems to mean rising foreclosures, and more distressed inventory. The MBA Chief Economist Jay Brinkmann thinks foreclosures will peak at the end of 2010. Historically prices bottom about the same time as foreclosure activity peaks. Maybe it will be different this time - maybe the modification programs will significantly reduce foreclosures - maybe prices will bottom before foreclosures peak ... but I'll go with the normal pattern. And on the demand side, there has been a surge in first-time homebuyer activity. There was significant pent up demand from potential first-time buyers who were priced out of the market in 2004-2006, and then were afraid to buy as prices fell. But demand from these buyers will probably wane later this year, even if another tax credit is enacted. Just like the "cash-for-clunkers" demand declined after the initial burst. For mid-to-high priced homes, there are few move-up buyers (or so it would seem since so many low end homes were distress sales). Right now the months-of-supply in many of these areas is well into double figures, suggesting further price declines. And on unemployment: most forecasts are for unemployment to rise into next year some time. Historically house prices do not bottom until after unemployment peaks. That seems especially likely now since so many homeowners are underwater. Once again I'll go with the normal pattern. Also looking back at previous housing busts (like I did earlier today looking at the early '90s) there are usually some months during the bust with increasing prices. So no one should expect every month to be negative during the bust ... especially are prices get closer to the bottom. I could be wrong - this isn't as certain as in 2005 - but I don't think house prices have bottomed. If I'm proven wrong, I'll be the first to admit it. Best to all. http://www.calculatedriskblog.com/2009/08/comment-on-house- prices.html
264 TUESDAY, AUGUST 25, 2009 House Prices: Real Prices, Price-to-Rent, and Price-to-Income by CalculatedRisk on 8/25/2009 10:01:00 AM Here are three key measures of house prices: Price-to-Rent, Price-to-Income and real prices based on the Case-Shiller quarterly national home price index. Price-to-Rent In October 2004, Fed economist John Krainer and researcher Chishen Wei wrote a Fed letter on price to rent ratios: House Prices and Fundamental Value. Kainer and Wei presented a price-to-rent ratio using the OFHEO house price index and the Owners' Equivalent Rent (OER) from the BLS. Here is a similar graph through Q2 2009 using the Case-Shiller National Home Price Index (SA):
Click on image for larger graph in new window.
This graph shows the price to rent ratio (Q1 1997 = 1.0) for the Case-Shiller national Home Price Index. For rents, the national Owners' Equivalent Rent from the BLS is used. Looking at the price-to-rent ratio based on the Case-Shiller index, the adjustment in the price-to-rent ratio is mostly behind us as of Q2 2009 on a national basis. However this ratio could easily decline another 10% or so. It is important to note that rents are now falling and this has not shown up in the OER measure yet. The OER lags REIT rents, and I expect OER to declines later this year. And declining rents will impact the price-to-rent ratio.
265 Price-to-Income: The second graph shows the price-to-income ratio:
This graph is based off the Case-Shiller national index, and the Census Bureau's median income Historical Income Tables - Households (and an estimate of 2% increase in household median income for 2008 and flat for 2009). Using national median income and house prices provides a gross overview of price-to- income (it would be better to do this analysis on a local area). However this does shows that the price-to-income is still too high, and that this ratio needs to fall another 10% or so. A further decline in this ratio could be a combination of falling house prices and/or rising nominal incomes. Real Prices
T his graph shows the real and nominal house prices based on the Case-Shiller national index. (Q1 2000 = 100 for nominal index) Nominal prices are adjusted using CPI less Shelter. The Case-Shiller real prices are still significantly above prices in the '90s and perhaps real prices will decline another 10% to 20%. Summary
These measures are useful, but somewhat flawed. These measures give a general idea about house prices, but there are other important factors like inventory levels and credit
266 issues. All of this data is on a national basis and it would be better to use local area price- to-rent, price-to-income and real prices.
It appears that house prices - in general - are still too high. However prices depend on the local supply and demand factors. In many lower priced bubble areas supply has declined sharply (as banks are currently slow to foreclose), and demand is very strong (first-time home buyer frenzy, and cash flow investors). This is pushing up low end prices.
However in the mid-to-high end of the bubble areas - with significant supply and little demand - prices are probably still too high. http://www.calculatedriskblog.com/2009/08/house-prices-real-prices-price-to- rent.html
267
FRBSF Economic Letter 2004-27; October 1, 2004 House Prices and Fundamental Value • Fundamental value and the price-rent ratio • What moves the price-rent ratio? • Conclusions • References
Download and Print PDF Version (67KB)
The performance of the residential housing market over the last ten years has been remarkable. According to the Office of Federal Housing Enterprise Oversight (OFHEO), house prices have appreciated at an annual rate of 5.4% on average (68.9% over the whole time period). Perhaps even more remarkable is that the performance was strong even when economic activity overall was weak. Average annual appreciation rates have been 7.4% (26% in total) since the collapse of the Nasdaq in 2000 and 7.1% (20% in total) since 2001:Q1, the beginning of the 2001 recession. In contrast, since the start of the 2001 recession, the S&P 500 and Nasdaq have averaged negative annual returns of –2.43% and – 1.42% respectively. These kinds of statistics have generated an enormous amount of commentary along with suspicions of a house price bubble. At first glance, housing would appear to be just the type of market that is susceptible to systematic mispricings. Most market participants have little experience, making transactions only infrequently. Asymmetric or incomplete information between buyers and sellers about demand and prices is acute. Even with the advent of new technologies, the matching of buyers with sellers remains cumbersome and slow. And unlike other markets, there are no good ways to “short” the housing market if prices get too high. This Economic Letter describes one of the measures commonly used to gauge the fundamental value of housing—the price-rent ratio. We describe the kinds of forces that cause the ratio to move over time and document which forces appear to be most important. We document the way that the housing market typically adjusts to changes in economic fundamentals. Fundamental value and the price-rent ratio Th i f h i i d t i d b th f
268 We borrow from the finance literature to take a different approach. The finance paradigm holds that an asset has a fundamental value that equals the sum of its future payoffs, each discounted back to the present by investors using rates that reflect their preferences. For stocks, the payoffs requiring discounting are the expected dividends. This approach can extend to housing by recognizing that a house yields a dividend in the form of the roof over the head of the occupant. The fundamental value of a house is the present value of the future housing service flows that it provides to the marginal buyer. In a well- functioning market, the value of the housing service flow should be approximated by the rental value of the house. A bubble occurs—in either the stock market or the housing market—when the current price of an asset deviates from its fundamental value. Right away we see that bubbles are difficult to detect because fundamental value is fundamentally unobservable. No one knows for sure what future dividends are going to be, or what discount rates investors will require on assets. Despite this obstacle, analysts still find it helpful to construct measures of fundamental value for comparison to actual valuations. One popular measure is the price-dividend ratio, which corresponds to a price-rent ratio for houses. The price-rent ratio for the U.S. housing market is in Figure 1. The price series is the existing home sales price index published by OFHEO; this index is a repeat sales index, meaning that index changes are compiled from the price changes on individual houses that turn over during the sample period. One of its drawbacks is that it does not fully differentiate between pure house price appreciation and price changes due to depreciation or home improvement. The rent series is the owner’s equivalent rent index published by the Bureau of Labor Statistics (BLS); this series is intended to measure changes in the service flow value of owner-occupied housing. The figure suggests that current prices are high relative to rents. More precisely, house prices have been growing faster than implied rental values for quite some time: currently, the value of the U.S. price- rent ratio is 18% higher than its long-run average. It is tempting to identify a bubble as a large and long-lasting deviation in the price-rent ratio from its average value, just like the one that we see in Figure 1. But exactly how large and how long-lasting a deviation must be to resemble a bubble is far from obvious. There is no reason to believe that a price-dividend ratio should be constant over time, even in the absence of bubbles; in particular, Campbell and Shiller (1988) showed that the value of the ratio today can increase only if there are expected future increases in dividends, expected future decreases in returns, or both. This simple model of the price-dividend ratio is based on a simple identity and the definition of a return as the sum of a dividend yield and a capital gain/loss. To make the implications of this simple model more concrete for our housing application, imagine a real estate market near a military base that has just been scheduled to close five years from now. The inevitable job loss associated with the closure is an adverse shock to the demand for housing. This should cause a decrease in the future value of the housing dividends on houses in the area, driving house prices down immediately. Current rental contracts, however, should be relatively unaffected because the closure is so far off in the future. Thus, the price-rent ratio should decline. Alternatively, suppose the government could
269 credibly promise to reduce taxes on real estate and keep them low forever. This change would probably lead to a higher demand for housing; at the margin, households would have the incentive to shift savings from financial assets to housing. In addition, the elimination of uncertainty about future tax rates would imply that houses are safer assets, requiring lower future returns. In this case, the price-rent ratio should increase. What moves the price-rent ratio? Given a notion of the sources of variability in the price-rent ratio, it is natural to wonder which sources are most important. Cochrane (1991) conducts this exercise for the case of stocks and finds that most of the most variation comes from changes in returns. We conduct Cochrane’s experiment for houses. To construct the price-rent ratios we use OFHEO’s existing home sales index and the owner’s equivalent rent index published by the BLS. We use quarterly data, ranging from 1982:Q4 to 2003:Q1. The constraint on the sample period is that the owner’s equivalent rent series does not begin until 1982. We could extend the rental series back further by using a pure rent series, but only at the cost of severing the link between an owner-occupied price in the numerator of our ratio and an approximation to an owner-occupied service flow value in the denominator. The basic insight of the empirical research on price-dividend ratios is that movements in the price-dividend ratio can be decomposed into two parts: movements relative to future expected dividend growth rates, and movements relative to future expected returns. In theory, these future variables are unknown to the investors when they set prices. In this application, we set the expected future dividend growth rates and returns equal to the actual values that occurred. Also in theory, we should assume all “future” dividend growth rates and returns to mean those extended to infinity. Obviously, this is not possible, so we study how the price-rent ratio moves relative to the next 15 quarters of rental growth rates and returns. (We experimented with other horizons, and found that the results did not change much.) Note also that we are unable to incorporate the current episode of price appreciation. We run out of observations before we can say anything definitive about the recent house price appreciation. The main result from this decomposition is that the behavior of the price-rent ratio for housing mirrors that of the price-dividend ratio for stocks. The majority of the movement of the price-rent ratio comes from future returns, not rental growth rates. This will not comfort everyone, as it implies that price-rent ratios change because prices are expected to change in the future, and seemingly out of proportion to changes in rental values. A more comforting conclusion, however, is that, despite the well-known frictions in real estate markets, the dynamics of a common valuation measure are still similar to those observed in a near- frictionless market like the stock market. It may appear that returns are quite volatile relative to changes in rental values, but this is true for stock prices as well and only serves to underscore our inability to understand how expectations and required rates of return on assets are formed. Another result is that almost all of the movement in the aggregate U.S. price-rent ratio was accounted for by two factors—the proxy for future growth in rents and the proxy for future returns. Put another way, other factors, such as bubbles, do not appear to be empirically important for explaining the behavior of the aggregate price-rent ratio. At the same time,
270 overstatement of volatility is caused by a much stronger comovement between the price-rent ratio and future returns than the comovement between price-rent and future rent growth. The excess of the price-rent ratio volatility (the difference between the movement predicted by the model and the actual movement) can be traced to the volatility of house prices in local markets. Most recently, local housing markets that historically have had “excess” volatility in future returns also exhibit high house prices compared to fundamentals. This is shown in Figure 2, where the vertical axis measures the excess volatility in percent terms; zero corresponds to the case in which the model and our implementation explain the actual price-rent ratio precisely. The horizontal axis measures the price-rent ratios normalized to have the value of one in 1995:Q4. The figure shows that in some markets, such as Dallas and Chicago, the combination of future growth in rents and future returns account for most of the variation in the price-rent ratio. Price-rent ratios in these markets appear to behave as do those in the national market. Other markets, such as Boston, Los Angeles, and San Francisco, have return streams that are much more variable than the price-rent ratios they are supposed to be tied to. Perhaps not coincidentally, these markets are thought to be ones where the supply constraint on new construction is particularly tight. Also, these are markets that now appear to be most highly valued. Conclusions The price-rent ratio for the U.S. and many regional markets is now much higher than its historical average value. We used a model from the finance literature to describe how the price-rent ratio can move over time. We found that most of the variance in the price-rent ratio is due to changes in future returns and not to changes in rents. This is relevant because it suggests the likely future path of the ratio. If the ratio is to return to its average level, it will probably do so through slower house price appreciation. John Krainer Economist Chishen Wei Research Associate References Campbell, J., and R. Shiller. 1988. “The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors.” Review of Financial Studies 1, pp. 195–227. Cochrane, J. 1991. “Explaining the Variance of Price-Dividend Ratios.” Review of Financial Studies 5(2), pp. 243–280. McCarthy, J., and R. Peach. 2004. “Are Home Prices the Next ‘Bubble’?” FRBNY Economic Policy Review. http://www.newyorkfed.org/research/epr/forthcoming/mccarthy.pdf http://www.frbsf.org/publications/economics/letter/2004/el2004-27.html
271
Friday, August 21
Session I: Chair, MARIO DRAGHI Governor, Bank of Italy
Opening Remarks BEN S. BERNANKE Chairman, Board of Governors of the Federal Reserve System
The Origins and Nature of Financial Crises
Author: RICARDO J. CABALLERO Professor, Massachusetts Institute of Technology
Discussant: KENNETH S. ROGOFF Professor, Harvard University
Financial Crises and Economic Activity
Authors: STEPHEN G. CECCHETTI Economic Adviser and Head of the Monetary and Economic Department, Bank for International Settlements
CHRISTIAN UPPER Head of Financial Markets, Bank for International Settlements
Discussant: MARK GERTLER Professor, New York University
Policies to Stabilize Financial Markets
Panelists: CHARLES GOODHART Professor, London School of Economics
272 BRIAN F. MADIGAN Director, Division of Monetary Affairs, Board of Governors of the Federal Reserve System
JEAN-CHARLES ROCHET Professor, University of Toulouse
STANLEY FISCHER Luncheon Governor, Bank of Israel Address
Saturday, August 22
Session II Chair, ALAN BOLLARD Governor, Reserve Bank of New Zealand
Monetary Policy to Stabilize Economic Activity
Author: CARL E. WALSH Professor, University of California, Santa Cruz
Discussant: MARK J. CARNEY Governor, Bank of Canada
Fiscal Policy to Stabilize Economic Activity
Authors: ALAN J. AUERBACH Professor, University of California, Berkeley
WILLIAM G. GALE Vice President and Director, Economic Studies, The Brookings Institution
Discussants: R. GLENN HUBBARD Dean, Columbia Business School, Columbia University
KLAUS SCHMIDT-HEBBEL Professor, Catholic University of Chile
The International Policy Response to Financial Crises
273 Panelists: JAIME CARUANA General Manager, Bank for International Settlements
MASAAKI SHIRAKAWA Governor, Bank of Japan
JEAN-CLAUDE TRICHET President, European Central Bank
Adjournment
HTTP://WWW.KC.FRB.ORG/HOME/SUBWEBNAV.CFM?LEVE L=3&THEID=11163&SUBWEB=10660
274
Speech Chairman Ben S. Bernanke At the Federal Reserve Bank of Kansas City's Annual Economic Symposium, Jackson Hole, Wyoming August 21, 2009 Reflections on a Year of Crisis By the standards of recent decades, the economic environment at the time of this symposium one year ago was quite challenging. A year after the onset of the current crisis in August 2007, financial markets remained stressed, the economy was slowing, and inflation--driven by a global commodity boom--had risen significantly. What we could not fully appreciate when we last gathered here was that the economic and policy environment was about to become vastly more difficult. In the weeks that followed, several systemically critical financial institutions would either fail or come close to failure, activity in some key financial markets would virtually cease, and the global economy would enter a deep recession. My remarks this morning will focus on the extraordinary financial and economic events of the past year, as well as on the policy responses both in the United States and abroad. One very clear lesson of the past year--no surprise, of course, to any student of economic history, but worth noting nonetheless--is that a full-blown financial crisis can exact an enormous toll in both human and economic terms. A second lesson--once again, familiar to economic historians--is that financial disruptions do not respect borders. The crisis has been global, with no major country having been immune. History is full of examples in which the policy responses to financial crises have been slow and inadequate, often resulting ultimately in greater economic damage and increased fiscal costs. In this episode, by contrast, policymakers in the United States and around the globe responded with speed and force to arrest a rapidly deteriorating and dangerous situation. Looking forward, we must urgently address structural weaknesses in the financial system, in particular in the regulatory framework, to ensure that the enormous costs of the past two years will not be borne again. September-October 2008: The Crisis Intensifies When we met last year, financial markets and the economy were continuing to suffer the effects of the ongoing crisis. We know now that the National Bureau of Economic Research has determined December 2007 as the beginning of the recession. The U.S. unemployment rate had risen to 5-3/4 percent by July, about 1 percentage point above its level at the beginning of the crisis, and household spending was weakening. Ongoing declines in residential construction and house prices and rising mortgage defaults and foreclosures continued to weigh on the U.S. economy, and forecasts of prospective credit losses at financial institutions both here and abroad continued to increase. Indeed, one of the nation's largest thrift institutions, IndyMac, had recently collapsed under the weight of distressed mortgages, and investors continued to harbor doubts about the condition of the
275 government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, despite the approval by the Congress of open-ended support for the two firms. Notwithstanding these significant concerns, however, there was little to suggest that market participants saw the financial situation as about to take a sharp turn for the worse. For example, although indicators of default risk such as interest rate spreads and quotes on credit default swaps remained well above historical norms, most such measures had declined from earlier peaks, in some cases by substantial amounts. And in early September, when the target for the federal funds rate was 2 percent, investors appeared to see little chance that the federal funds rate would be below 1-3/4 percent six months later. That is, as of this time last year, market participants evidently believed it improbable that significant additional monetary policy stimulus would be needed in the United States. Nevertheless, shortly after our last convocation, the financial crisis intensified dramatically. Despite the steps that had been taken to support Fannie Mae and Freddie Mac, their condition continued to worsen. In early September, the companies' regulator placed both into conservatorship, and the Treasury used its recently enacted authority to provide the firms with massive financial support. Shortly thereafter, several additional large U.S. financial firms also came under heavy pressure from creditors, counterparties, and customers. The Federal Reserve has consistently maintained the view that the disorderly failure of one or more systemically important institutions in the context of a broader financial crisis could have extremely adverse consequences for both the financial system and the economy. We have therefore spared no effort, within our legal authorities and in appropriate cooperation with other agencies, to avert such a failure. The case of the investment bank Lehman Brothers proved exceptionally difficult, however. Concerted government attempts to find a buyer for the company or to develop an industry solution proved unavailing, and the company's available collateral fell well short of the amount needed to secure a Federal Reserve loan of sufficient size to meet its funding needs. As the Federal Reserve cannot make an unsecured loan, and as the government as a whole lacked appropriate resolution authority or the ability to inject capital, the firm's failure was, unfortunately, unavoidable. The Federal Reserve and the Treasury were compelled to focus instead on mitigating the fallout from the failure, for example, by taking measures to stabilize the triparty repurchase (repo) market. In contrast, in the case of the insurance company American International Group (AIG), the Federal Reserve judged that the company's financial and business assets were adequate to secure an $85 billion line of credit, enough to avert its imminent failure. Because AIG was counterparty to many of the world's largest financial firms, a significant borrower in the commercial paper market and other public debt markets, and a provider of insurance products to tens of millions of customers, its abrupt collapse likely would have intensified the crisis substantially further, at a time when the U.S. authorities had not yet obtained the necessary fiscal resources to deal with a massive systemic event. The failure of Lehman Brothers and the near-failure of AIG were dramatic but hardly isolated events. Many prominent firms struggled to survive as confidence plummeted. The investment bank Merrill Lynch, under pressure in the wake of Lehman's failure, agreed to be acquired by Bank of America; the major thrift institution Washington Mutual was resolved by the Federal Deposit Insurance Corporation (FDIC) in an assisted transaction; and the large commercial bank Wachovia, after experiencing severe liquidity outflows, agreed to be sold. The two largest remaining free-standing investment banks, Morgan
276 Stanley and Goldman Sachs, were stabilized when the Federal Reserve approved, on an emergency basis, their applications to become bank holding companies. Nor were the extraordinary pressures on financial firms during September and early October confined to the United States: For example, on September 18, the U.K. mortgage lender HBOS, with assets of more than $1 trillion, was forced to merge with Lloyds TSB. On September 29, the governments of Belgium, Luxembourg, and the Netherlands effectively nationalized Fortis, a banking and insurance firm that had assets of around $1 trillion. The same day, German authorities provided assistance to Hypo Real Estate, a large commercial real estate lender, and the British government nationalized another mortgage lender, Bradford and Bingley. On the next day, September 30, the governments of Belgium, France, and Luxembourg injected capital into Dexia, a bank with assets of more than $700 billion, and the Irish government guaranteed the deposits and most other liabilities of six large Irish financial institutions. Soon thereafter, the Icelandic government, lacking the resources to rescue the three largest banks in that country, put them into receivership and requested assistance from the International Monetary Fund (IMF) and from other Nordic governments. In mid-October, the Swiss authorities announced a rescue package for UBS, one of the world's largest banks, that consisted of a capital injection and a purchase of assets.1 The growing pressures were not limited to banks with significant exposure to U.S. or U.K real estate or to securitized assets. For example, unsubstantiated rumors circulated in late September that some large Swedish banks were having trouble rolling over wholesale deposits, and on October 13 the Swedish government announced measures to guarantee bank debt and to inject capital into banks.2 The rapidly worsening crisis soon spread beyond financial institutions into the money and capital markets more generally. As a result of losses on Lehman's commercial paper, a prominent money market mutual fund announced on September 16 that it had "broken the buck"--that is, its net asset value had fallen below $1 per share. Over the subsequent several weeks, investors withdrew more than $400 billion from so-called prime money funds.3 Conditions in short-term funding markets, including the interbank market and the commercial paper market, deteriorated sharply. Equity prices fell precipitously, and credit risk spreads jumped. The crisis also began to affect countries that had thus far escaped its worst effects. Notably, financial markets in emerging market economies were whipsawed as a flight from risk led capital inflows to those countries to swing abruptly to outflows. The Policy Response Authorities in the United States and around the globe moved quickly to respond to this new phase of the crisis, although the details differed according to the character of financial systems. The financial system of the United States gives a much greater role to financial markets and to nonbank financial institutions than is the case in most other nations, which rely primarily on banks.4 Thus, in the United States, a wider variety of policy measures was needed than in some other nations. In the United States, the Federal Reserve established new liquidity facilities with the goal of restoring basic functioning in various critical markets. Notably, on September 19, the Fed announced the creation of a facility aimed at stabilizing money market mutual funds, and the Treasury unveiled a temporary insurance program for those funds. On October 7, the Fed announced the creation of a backstop commercial paper facility, which stood ready to lend against highly rated commercial paper for a term of three months.5 Together, these steps helped stem the massive outflows from the money market mutual funds and stabilize the commercial paper market.
277 During this period, foreign commercial banks were a source of heavy demand for U.S. dollar funding, thereby putting additional strain on global bank funding markets, including U.S. markets, and further squeezing credit availability in the United States. To address this problem, the Federal Reserve expanded the temporary swap lines that had been established earlier with the European Central Bank (ECB) and the Swiss National Bank, and established new temporary swap lines with seven other central banks in September and five more in late October, including four in emerging market economies.6 In further coordinated action, on October 8, the Federal Reserve and five other major central banks simultaneously cut their policy rates by 50 basis points. The failure of Lehman Brothers demonstrated that liquidity provision by the Federal Reserve would not be sufficient to stop the crisis; substantial fiscal resources were necessary. On October 3, on the recommendation of the Administration and with the strong support of the Federal Reserve, the Congress approved the creation of the Troubled Asset Relief Program, or TARP, with a maximum authorization of $700 billion to support the stabilization of the U.S. financial system. Markets remained highly volatile and pressure on financial institutions intense through the first weeks of October. On October 10, in what would prove to be a watershed in the global policy response, the Group of Seven (G-7) finance ministers and central bank governors, meeting in Washington, committed in a joint statement to work together to stabilize the global financial system. In particular, they agreed to prevent the failure of systemically important financial institutions; to ensure that financial institutions had adequate access to funding and capital, including public capital if necessary; and to put in place deposit insurance and other guarantees to restore the confidence of depositors.7 In the following days, many countries around the world announced comprehensive rescue plans for their banking systems that built on the G-7 principles. To stabilize funding, during October more than 20 countries expanded their deposit insurance programs, and many also guaranteed nondeposit liabilities of banks. In addition, amid mounting concerns about the solvency of the global banking system, by the end of October more than a dozen countries had announced plans to inject public capital into banks, and several announced plans to purchase or guarantee bank assets. The comprehensive U.S. response, announced on October 14, included capital injections into both large and small banks by the Treasury; a program which allowed banks and bank holding companies, for a fee, to issue FDIC- guaranteed senior debt; the extension of deposit insurance to all noninterest-bearing transactions deposits, of any size; and the Federal Reserve's continued commitment to provide liquidity as necessary to stabilize key financial institutions and markets.8 This strong and unprecedented international policy response proved broadly effective. Critically, it averted the imminent collapse of the global financial system, an outcome that seemed all too possible to the finance ministers and central bankers that gathered in Washington on October 10. However, although the intensity of the crisis moderated and the risk of systemic collapse declined in the wake of the policy response, financial conditions remained highly stressed. For example, although short-term funding spreads in global markets began to turn down in October, they remained elevated into this year. And, although generalized pressures on financial institutions subsided somewhat, government actions to prevent the disorderly failures of individual, systemically significant institutions continued to be necessary. In the United States, support packages were announced for Citigroup in November and Bank of America in January. Broadly similar support packages were also announced for some large European institutions, including firms in the United Kingdom and the Netherlands.9
278 Although concerted policy actions avoided much worse outcomes, the financial shocks of September and October nevertheless severely damaged the global economy--starkly illustrating the potential effects of financial stress on real economic activity. In the fourth quarter of 2008 and the first quarter of this year, global economic activity recorded its weakest performance in decades. In the United States, real GDP plummeted at nearly a 6 percent average annual pace over those two quarters--an even sharper decline than had occurred in the 1981-82 recession. Economic activity contracted even more precipitously in many foreign economies, with real GDP dropping at double-digit annual rates in some cases. The crisis affected economic activity not only by pushing down asset prices and tightening credit conditions, but also by shattering household and business confidence around the world. In response to these developments, the Federal Reserve expended the remaining ammunition in the traditional arsenal of monetary policy, bringing the federal funds rate down, in steps, to a target range of 0 to 25 basis points by mid-December of last year. It also took several measures to further supplement its traditional arsenal. In particular, on November 25, the Fed announced that it would purchase up to $100 billion of debt issued by the housing-related GSEs and up to $500 billion of agency-guaranteed mortgage-backed securities, programs that were expanded substantially and augmented by a program of purchases of Treasury securities in March.10 The goal of these purchases was to provide additional support to private credit markets, particularly the mortgage market. Also on November 25, the Fed announced the creation of the Term Asset-Backed Securities Loan Facility (TALF). This facility aims to improve the availability and affordability of credit for households and small businesses and to help facilitate the financing and refinancing of commercial real estate properties. The TALF has shown early success in reducing risk spreads and stimulating new securitization activity for assets included in the program. Foreign central banks also cut policy rates to very low levels and implemented unconventional monetary measures. For example, the Bank of Japan began purchasing commercial paper in December and corporate bonds in January. In March, the Bank of England announced that it would purchase government securities, commercial paper, and corporate bonds, and the Swiss National Bank announced that it would purchase corporate bonds and foreign currency. For its part, the ECB injected more than €400 billion of one- year funds in a single auction in late June. In July, the ECB began purchasing covered bonds, which are bonds that are issued by financial institutions and guaranteed by specific asset pools. Actions by central banks augmented large fiscal stimulus packages in the United States, China, and a number of other countries. On February 10, Treasury Secretary Geithner and the heads of the federal banking agencies unveiled the outlines of a new strategy for ensuring that banking institutions could continue to provide credit to households and businesses during the financial crisis. A central component of that strategy was the exercise that came to be known as the bank stress test.11 Under this initiative, the banking regulatory agencies undertook a forward- looking, simultaneous evaluation of the capital positions of 19 of the largest bank holding companies in the United States, with the Treasury committing to provide public capital as needed. The goal of this supervisory assessment was to ensure that the equity capital held by these firms was sufficient--in both quantity and quality--to allow those institutions to withstand a worse-than-expected macroeconomic environment over the subsequent two years and yet remain healthy and capable of lending to creditworthy borrowers. This exercise, unprecedented in scale and scope, was led by the Federal Reserve in cooperation with the Office of the Comptroller of the Currency and the FDIC. Importantly, the
279 agencies' report made public considerable information on the projected losses and revenues of the 19 firms, allowing private analysts to judge for themselves the credibility of the exercise. Financial market participants responded favorably to the announcement of the results, and many of the tested banks were subsequently able to tap public capital markets. Overall, the policy actions implemented in recent months have helped stabilize a number of key financial markets, both in the United States and abroad. Short-term funding markets are functioning more normally, corporate bond issuance has been strong, and activity in some previously moribund securitization markets has picked up. Stock prices have partially recovered, and U.S. mortgage rates have declined markedly since last fall. Critically, fears of financial collapse have receded substantially. After contracting sharply over the past year, economic activity appears to be leveling out, both in the United States and abroad, and the prospects for a return to growth in the near term appear good. Notwithstanding this noteworthy progress, critical challenges remain: Strains persist in many financial markets across the globe, financial institutions face significant additional losses, and many businesses and households continue to experience considerable difficulty gaining access to credit. Because of these and other factors, the economic recovery is likely to be relatively slow at first, with unemployment declining only gradually from high levels. Interpreting the Crisis: Elements of a Classic Panic How should we interpret the extraordinary events of the past year, particularly the sharp intensification of the financial crisis in September and October? Certainly, fundamentals played a critical role in triggering those events. As I noted earlier, the economy was already in recession, and it had weakened further over the summer. The continuing dramatic decline in house prices and rising rates of foreclosure raised serious concerns about the values of mortgage-related assets, and thus about large potential losses at financial institutions. More broadly, investors remained distrustful of virtually all forms of private credit, especially structured credit products and other complex or opaque instruments. At the same time, however, the events of September and October also exhibited some features of a classic panic, of the type described by Bagehot and many others.12 A panic is a generalized run by providers of short-term funding to a set of financial institutions, possibly resulting in the failure of one or more of those institutions. The historically most familiar type of panic, which involves runs on banks by retail depositors, has been made largely obsolete by deposit insurance or guarantees and the associated government supervision of banks.13 But a panic is possible in any situation in which longer-term, illiquid assets are financed by short-term, liquid liabilities, and in which suppliers of short-term funding either lose confidence in the borrower or become worried that other short-term lenders may lose confidence.14,15 Although, in a certain sense, a panic may be collectively irrational, it may be entirely rational at the individual level, as each market participant has a strong incentive to be among the first to the exit. Panics arose in multiple contexts last year. For example, many financial institutions, notably including the independent investment banks, financed a portion of their assets through short-term repo agreements. In repo agreements, the asset being financed serves as collateral for the loan, and the maximum amount of the loan is the current assessed value of the collateral less a haircut. In a crisis, haircuts typically rise as short-term lenders attempt to protect themselves from possible declines in asset prices. But this individually
280 rational behavior can set off a run-like dynamic: As high haircuts make financing portfolios more difficult, some borrowers may have no option but to sell assets into illiquid markets. These forced sales drive down asset prices, increase volatility, and weaken the financial positions of all holders of similar assets, which in turn increases the risks borne by repo lenders and thus the haircuts they demand.16 This unstable dynamic was apparent around the time of the near-failure of Bear Stearns in March 2008, and haircuts rose particularly sharply during the worsening of the crisis in mid-September.17 As we saw last fall, when a vicious funding spiral of this sort is at work, falling asset prices and the collapse of lender confidence may create financial contagion, even between firms without significant counterparty relationships. In such an environment, the line between insolvency and illiquidity may be quite blurry. Panic-like phenomena occurred in other contexts as well. Structured investment vehicles and other asset-backed programs that relied heavily on the commercial paper market began to have difficulty rolling over their short-term funding very early in the crisis, forcing them to look to bank sponsors for liquidity or to sell assets.18 Following the Lehman collapse, panic gripped the money market mutual funds and the commercial paper market, as I have discussed. More generally, during the crisis runs of uninsured creditors have created severe funding problems for a number of financial firms. In some cases, runs by creditors were augmented by other types of "runs"--for example, by prime brokerage customers of investment banks concerned about the funds they held in margin accounts. Overall, the role played by panic helps to explain the remarkably sharp and sudden intensification of the financial crisis last fall, its rapid global spread, and the fact that the abrupt deterioration in financial conditions was largely unforecasted by standard market indicators. The view that the financial crisis had elements of a classic panic, particularly during its most intense phases, has helped to motivate a number of the Federal Reserve's policy actions.19 Bagehot instructed central banks--the only institutions that have the power to increase the aggregate liquidity in the system--to respond to panics by lending freely against sound collateral.20 Following that advice, from the beginning of the crisis the Fed (like other central banks) has provided large amounts of short-term liquidity to financial institutions. As I have discussed, it also provided backstop liquidity support for money market mutual funds and the commercial paper market and added significant liquidity to the system through purchases of longer-term securities. To be sure, the provision of liquidity alone can by no means solve the problems of credit risk and credit losses; but it can reduce liquidity premiums, help restore the confidence of investors, and thus promote stability. It is noteworthy that the use of Fed liquidity facilities has declined sharply since the beginning of the year--a clear market signal that liquidity pressures are easing and market conditions are normalizing. What does this perspective on the crisis imply for future policies and regulatory reforms? We have seen during the past two years that the complex interrelationships among credit, market, and funding risks of key players in financial markets can have far-reaching implications, particularly during a general crisis of confidence. In particular, the experience has underscored that liquidity risk management is as essential as capital adequacy and credit and market risk management, particularly during times of intense financial stress. Both the Basel Committee on Banking Supervision and the U.S. bank regulatory agencies have recently issued guidelines for strengthening liquidity risk management at financial institutions. Among other objectives, liquidity guidelines must take into account the risks that inadequate liquidity planning by major financial firms pose for the broader financial system, and they must ensure that these firms do not become excessively reliant on liquidity support from the central bank.
281 But liquidity risk management at the level of the firm, no matter how carefully done, can never fully protect against systemic events. In a sufficiently severe panic, funding problems will almost certainly arise and are likely to spread in unexpected ways. Only central banks are well positioned to offset the ensuing sharp decline in liquidity and credit provision by the private sector. They must be prepared to do so. The role of liquidity in systemic events provides yet another reason why, in the future, a more systemwide or macroprudential approach to regulation is needed.21 The hallmark of a macroprudential approach is its emphasis on the interdependencies among firms and markets that have the potential to undermine the stability of the financial system, including the linkages that arise through short-term funding markets and other counterparty relationships, such as over-the-counter derivatives contracts. A comprehensive regulatory approach must examine those interdependencies as well as the financial conditions of individual firms in isolation. Conclusion Since we last met here, the world has been through the most severe financial crisis since the Great Depression. The crisis in turn sparked a deep global recession, from which we are only now beginning to emerge. As severe as the economic impact has been, however, the outcome could have been decidedly worse. Unlike in the 1930s, when policy was largely passive and political divisions made international economic and financial cooperation difficult, during the past year monetary, fiscal, and financial policies around the world have been aggressive and complementary. Without these speedy and forceful actions, last October's panic would likely have continued to intensify, more major financial firms would have failed, and the entire global financial system would have been at serious risk. We cannot know for sure what the economic effects of these events would have been, but what we know about the effects of financial crises suggests that the resulting global downturn could have been extraordinarily deep and protracted. Although we have avoided the worst, difficult challenges still lie ahead. We must work together to build on the gains already made to secure a sustained economic recovery, as well as to build a new financial regulatory framework that will reflect the lessons of this crisis and prevent a recurrence of the events of the past two years. I hope and expect that, when we meet here a year from now, we will be able to claim substantial progress toward both those objectives.
Footnotes 1. Of course, these interventions were not the first of the crisis. For example, in July and August of 2007, two German banks that had relied heavily on market funding through asset-backed commercial paper (ABCP) conduits--IKB and Sachsen LB--received assistance from public-sector owners to cope with severe funding pressures. In September 2007, Northern Rock, a large mortgage lender that relied heavily on securitizations for funding, was nationalized by U.K. authorities after experiencing a run by retail depositors. In February 2008, West LB--another German bank with large ABCP conduits--received protection against losses from its owners, including the state of North Rhine-Westphalia. And in March 2008, the U.S. Treasury and the Federal Reserve facilitated the acquisition of the investment bank Bear Stearns by JPMorgan Chase & Co. Return to text 2. Throughout these remarks, where examples are given, they represent only a selection of instances, not an exhaustive list of all the relevant cases. Return to text
282 3. Prime money funds hold a variety of instruments, with commercial paper and bank obligations typically accounting for the majority of their assets. Return to text 4. For example, most financing of automobile purchases was provided through nonbank channels, and such channels began shutting down in September and October of 2008. Return to text 5. More precisely, in the Commercial Paper Funding Facility (CPFF), the Fed lends to a special purpose vehicle that, in turn, purchases highly rated three-month commercial paper directly from eligible issuers. On October 21, the Fed also announced the creation of the Money Market Investor Funding Facility, or MMIFF, which was intended to provide a source of backup liquidity to U.S. money market mutual funds and certain other money market investors. Given the improvement in short-term markets brought about by the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), the CPFF, and the Treasury guarantee of money market funds, the MMIFF never had to be tapped. Nonetheless, market participants reported that the facility's existence helped reassure investors that ample liquidity would be available in case of further disruptions in the money markets. Return to text 6. A crucial feature of these lines is that the Federal Reserve's counterparties are the foreign central banks, which are governmental entities, not the private-sector entities to which those central banks might lend in turn. Accordingly, the Fed bears little risk through these arrangements. Return to text 7. Notably, these commitments were reaffirmed on October 11 in communiqués issued by the International Monetary and Financial Committee of the Board of Governors of the IMF and by the Group of Twenty finance ministers and central bank governors. Return to text 8. The FDIC's guarantee program complemented a temporary increase in the deposit insurance limit, from $100,000 to $250,000 per account, passed by the Congress as part of the Emergency Economic Stabilization Act, the bill that created the TARP. Return to text 9. On January 26, the Dutch government announced that it would provide ING Group, a large banking and insurance firm, with loss protection on some of its assets, following up a €10 billion capital injection on October 19. Shortly afterward, the U.K. Treasury announced packages for the Royal Bank of Scotland (RBS) and for Lloyds Banking Group that included loss protection on assets and, in the case of RBS, a capital injection. Return to text 10. In March, the Federal Reserve announced that it would purchase up to $300 billion of longer-term Treasury securities and raised the caps on other purchases to $200 billion for the direct debt of the housing-related GSEs and $1.25 trillion for agency-guaranteed mortgage-backed securities. Return to text 11. Officially, it was called the Supervisory Capital Assessment Program, or SCAP. Return to text 12. See Walter Bagehot ([1873] 1897), Lombard Street: A Description of the Money Market (New York: Charles Scribner's Sons). Return to text 13. The Northern Rock episode in the United Kingdom may be seen as a counterexample, but in that case deposit insurance coverage was only partial. Return to text 14. To be sure, there are good economic reasons for a maturity mismatch between assets and liabilities in the financial system, including allowing households flexibility in when to consume (see Douglas W. Diamond and Philip H. Dybvig (1983), "Bank Runs, Deposit
283 Insurance, and Liquidity," Journal of Political Economy, vol. 91 (June), pp. 401-19). Moreover, short-term creditors can help to impose market discipline on financial institutions (see Charles W. Calomiris and Charles M. Kahn (1991), "The Role of
Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, vol. 81 (June), pp. 497-513; and Douglas W. Diamond and Raghuram G. Rajan (2001), "Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of
Banking," Journal of Political Economy, vol. 109 (April), pp. 287-327). Return to text 15. Also, during a panic, financial firms concerned about funding are likely to hoard liquidity, further exacerbating the situation. See Douglas W. Diamond and Raghuram G.
Rajan (2009), "Fear of Fire Sales and the Credit Freeze," NBER Working Paper Series 14925 (Cambridge, Mass.: National Bureau of Economic Research, April); and
Zhiguo He and Wei Xiong (2009), "Dynamic Debt Runs (385 KB PDF)," unpublished paper, June 30, Princeton University, Princeton, N.J. Return to text 16. See Markus K. Brunnermeier (2009), "Deciphering the Liquidity and Credit Crunch
2007-2008," Journal of Economic Perspectives, vol. 23 (Winter), pp. 77-100. This dynamic differed from the standard bank run in that investors did not completely withdraw funding. The reason for the difference lies in the nature of the lending contract. In a standard bank deposit contract, the price of deposits in terms of currency is fixed, and so depositors have no alternative to withdrawal when the value of deposits falls below the value of currency. For similar reasons, many investors in money market mutual funds withdrew all their funds when the redemption value exceeded the value of holding the fund. In contrast, in the case of repo lending, lenders have the alternative to withdrawal of varying the haircut they demand. There is a close analogy to the discounting of bank notes during the U.S. free banking era, as discussed by Gorton (see Gary Gorton (1996),
"Reputation Formation in Early Bank Note Markets," Journal of Political Economy, vol. 104 (April), pp. 346-97). In either case, however, variations in the liquidity premium play an important role in the amount of funding that lenders are willing to provide against a given set of assets. Return to text 17. See Gary B. Gorton and Andrew Metrick (2009), "Securitized Banking and the Run on
Repo," Yale International Center for Finance Working Paper No. 14, July. Return to text 18. See Daniel M. Covitz, Nellie Liang, and Gustavo Suarez (2009), "The Evolution of a Financial Crisis: Runs in the Asset-Backed Commercial Paper Market," unpublished paper, Board of Governors of the Federal Reserve System, Division of Research and Statistics, August. Moreover, the scale of these conduits and their vulnerability to runs contributed importantly to the liquidity panics globally as many of these programs were sponsored by non-U.S. banks (see Carlos O. Arteta, Mark Carey, Ricardo Correa, and Jason Kotter (2009), "Revenge of the Steamroller: ABCP as a Window on Risk Choices," unpublished paper, Board of Governors of the Federal Reserve System, Division of International Finance, May). Return to text
284 19. See Brian F. Madigan (2009), "Bagehot's Dictum in Practice: Formulating and Implementing Policies to Combat the Financial Crisis," speech delivered at this symposium, sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyo., August 21-23. Return to text 20. See Bagehot, Lombard Street. Return to text 21. See Ben S. Bernanke (2009), "Financial Reform to Address Systemic Risk," speech delivered at the Council on Foreign Relations, Washington, March 10. Return to text http://www.federalreserve.gov/newsevents/speech/bernanke20090821a.htm
285
Speech Brian F. Madigan, Director, Division of Monetary Affairs At the Federal Reserve Bank of Kansas City's Annual Economic Symposium, Jackson Hole, Wyoming August 21, 2009 Bagehot's Dictum in Practice: Formulating and Implementing Policies to Combat the Financial Crisis As a result of the developments of the past two years, the appropriate scope of central bank policy actions in a crisis is now a matter of significant public discussion, one that is taking place in the context of a wider debate over financial regulatory reform. For central bankers, however, the essential principles guiding their actions are long-standing and well established. In considering the appropriate central bank response to a financial crisis, monetary economists have long appealed to the insights that Walter Bagehot set forth in Lombard Street.1 Paul Tucker, for example, recently summarized Bagehot's dictum as follows: "[T]o avert panic, central banks should lend early and freely (ie without limit), to solvent firms, against good collateral, and at 'high rates.' "2 Bagehot's dictum is well founded: By lending freely, the central bank may be able to quell powerful panic-driven demands for liquidity and their potentially untoward effects on the economy. Providing a virtually unlimited source of liquidity to institutions can avert the fire sales that can lead to decreases in asset values, reductions in wealth, and ultimately to a costly contraction in economic activity. And providing liquidity can enable a continuation of the lending by financial institutions that is necessary to support activity at the economy's potential. We might call this the macroeconomic rationale for Bagehot's dictum--promoting the full employment of resources. At the same time, Bagehot's dictum can be viewed as having a sound foundation in microeconomics--one directed at promoting the efficient allocation of resources. By lending only to solvent firms, by lending only against good collateral, and by charging a penalty rate, central banks can limit the moral hazard and other distortionary effects of government intervention in private financial markets that can impair the efficiency of the economy. Specifically, lending only to sound institutions and lending only against good collateral sharpens firms' incentive to invest prudently in order to remain solvent. And lending only at a penalty rate preserves the incentive for borrowers to obtain market funding when it is available rather than seeking recourse to the central bank.3 Maintaining these incentives to the greatest extent possible helps promote the efficient allocation of society's resources. However, these principles need to be interpreted and applied in the real world in which central banks actually operate, one with grey areas and practical considerations. My remarks are intended to articulate some of the challenges that the Federal Reserve has faced in the current crisis as it has struggled to apply established principles of central banking and use its available tools to support economic growth and avoid distortions in the allocation of resources. I also draw lessons from that experience that can be applied toward the formulation of policies relevant to future crises. Of course, the standard disclaimer
286 applies: The views that I am about to express are not necessarily shared by the Board, the Federal Open Market Committee, or other staff members at the Federal Reserve.4 Federal Reserve Liquidity Actions during the Crisis: Traditional Central Banking? One of the key questions that surfaced in the financial crisis is, To whom should central banks lend? According to the quote I cited a minute ago, Paul Tucker's interpretation of Bagehot's view is fairly broad: Central banks are to lend to solvent firms. What is notable about Tucker's formulation is that it is not restricted to banks. In this respect, Tucker's characterization seems to be true to Bagehot. A typically pithy passage from Bagehot makes his perspective quite clear. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to 'this man and that man,' whenever the security is good.5 Quite evidently, Bagehot saw few limitations on the appropriate counterparties of a central bank in a financial crisis. In the modern era, central banks in market economies generally do not engage in routine lending to institutions that do not have a banking charter. When financial markets and institutions are functioning normally, a central bank has no need to extend credit to nonbank institutions. Extending credit to nonbank firms is held in normal times to be the job of commercial banks and other private lenders. In contrast, the task of a central bank in such circumstances is to ensure that short-term interest rates and the aggregate quantity of money and credit are suitable to promote macroeconomic objectives such as maximum employment and stable prices, primarily using market-based tools like open market operations. Central banks can accomplish this task by restricting their usual lending operations to banks, leaving the allocation of credit across banks and in the broader economy to market mechanisms. However, the absence of a routine reason for lending to nonbank institutions does not mean that central banks never need the authority to lend to such entities. Bagehot clearly saw this point. His remark that central banks must be prepared to lend to "this man and that man" implies that he drew no sharp distinctions among potential recipients of central bank funding in a panic. And indeed, from the very beginning of this crisis, events have demonstrated the potential for losses among nonbank firms to lead to systemic disruptions. For example, large redemptions from three funds operated by BNP Paribas, coupled with illiquid conditions in the markets for their assets, prompted the bank to shutter those funds on August 9, 2007, a development that was the immediate cause of intense money market pressures on that first day of the crisis. Over the course of the crisis, many other nonbank entities, including money market funds, conduits, structured investment vehicles, investment banks, and other financial firms experienced what amounted to bank runs. The resulting strains were felt immediately in bank funding markets as well, with rising rate spreads and sharply reduced liquidity, especially for term borrowing, as counterparty credit concerns mounted. Lending to Commercial Banks and Other Depository Institutions The Federal Reserve and other central banks initially responded to the panic through the most traditional channels, by stepping up the provision of reserves to banks through open market operations and by increasing the availability and decreasing the cost of liquidity
287 made available to banks through discount mechanisms. However, those steps appeared to have only limited success in stemming the panic, in part because banks were reluctant to use central banks' lending facilities. Indeed, one of the important practical difficulties that confronted the Federal Reserve early in the crisis--and one that appears not to have been anticipated by Bagehot--was the unwillingness of many banks to draw discount window credit because of concerns about stigma. That unwillingness threatened to undermine the effectiveness of central bank action to combat the crisis. And it was an important motivation behind the decision of the Federal Reserve to establish the Term Auction Facility (TAF) as a means of providing a large volume of term funding to banks through an auction mechanism. The Federal Reserve expected that providing funds through an auction, in which no individual institution can have any assurance of winning funds and where settlement takes place with a lag, would have much less stigma than a standing facility. Other central banks took similar actions in association with the Federal Reserve's establishment of the TAF, importantly by lending dollars obtained through swap lines arranged with the Federal Reserve. Various researchers have investigated the effectiveness of the TAF, but the econometric results have been diffuse because of thorny econometric identification problems.6 However, it is difficult to believe that meeting bank demands for more than $1 trillion in dollar funding through the TAF and comparable foreign arrangements, in conjunction with the broad range of other central bank and government interventions, did not play an important role in stabilizing the financial system.7 Lending to Primary Dealers and Investment Banks Although the TAF and related actions were successful in overcoming some banks' concerns about stigma and increasing the availability of term funding to the banking system, particularly over the critical period at year-end 2007, economic conditions continued to weaken, asset prices kept declining, and market volatility stayed elevated. By early 2008, the pressures on financial institutions began to have a distinct adverse effect on primary dealers--highly leveraged firms many of which hold a substantial volume of relatively illiquid, long-term assets financed largely through the market for short-term repurchase (repo) agreements. In the environment of volatile and declining asset values, the required "haircuts" on repo agreements were ratcheting higher, putting pressure on dealers to delever quickly through fire sales of assets; but the fire sales only exacerbated market illiquidity, volatility, and price declines. The failure of a major primary dealer could have meant substantial losses for repo investors, such as money market funds and securities lenders, a development that, in turn, could have led to broader difficulties in the money markets, such as disruption of the commercial paper market, and thus ultimately to serious economic consequences. In mid-March 2008, Bear Stearns became unable to secure adequate market financing, and some other primary dealers were approaching a similar condition. To address what was rapidly becoming a very unstable situation, the Federal Reserve provided credit to support the acquisition of Bear Stearns by JPMorgan Chase and created two facilities for lending to primary dealers more broadly, the Primary Dealer Credit Facility (PDCF) and the Term Securities Lending Facility (TSLF). Because these facilities involved the extension of credit to nondepository institutions, their establishment required the Federal Reserve Board to invoke its authorities under section 13(3) of the Federal Reserve Act, and in particular to make a determination that "unusual and exigent circumstances" were present-- the first time in decades that the section 13(3) authority had been used.8
288 In lending under the PDCF and the TSLF, the Federal Reserve's actions are quite consistent with the principles attributed to Bagehot. The Fed lends to firms that are judged to be solvent; by applying haircuts to the market value of securities, it ensures that it is lending against good collateral; and, particularly under the PDCF, the Fed extends credit at interest rates that would be above-market in more routine circumstances. As under the TAF, TSLF funding is provided through an auction mechanism and at an auction- determined price, a structure that seems to have greatly reduced the problem of stigma. Rather than lending directly to primary dealers, why couldn't the Federal Reserve maintain its routine lending practices and rely on the usual separation principle under which it lends to commercial banks, and commercial banks in turn lend to nonbank firms such as solvent broker-dealers? After decades of lending only to depository institutions, why did the Federal Reserve suddenly find it necessary in March 2008 to begin lending to broker- dealers? Very simply, it was because the financial system and the economy experienced a huge-- perhaps unprecedented--adverse shock that exposed numerous weaknesses in the financial system. The aggregate value of the housing stock and other assets was in the process of declining by trillions of dollars from peak levels, implying massive losses for financial intermediaries that had lent against such collateral, especially for those that had large exposures to poorly underwritten loans. Given the extent of such losses, and the uncertainty about their exact incidence, concerns about counterparty credit risk and lending firms' own solvency and liquidity increased dramatically. As a result, lending, arbitrage, and, more generally, market functioning broke down across a broad front. Without a liquidity provider of last resort, that breakdown in market functioning likely would have implied the disorderly failure of a number of primary dealers. Given their large size and interconnections within the financial system, that development would probably have cascaded across markets and institutions, with attendant severe adverse effects on credit availability and the economy. It is also worth recalling that over the first seven months of the crisis, the Federal Reserve responded using essentially its traditional arsenal; but that arsenal eventually proved inadequate given the magnitude of the current shock and the way that it was being transmitted through the entire financial system. The scope for rapid and unchecked transmission of the shock was increased by changes in financial structure that had developed gradually over preceding years. In particular, investment banks and other primary dealers on the one hand and commercial banks on the other had become more similar. For example, investment banks had moved away from a model under which their assets were primarily an inventory of relatively liquid securities to one in which they held an appreciable amount of relatively illiquid assets such as structured notes and loans they had originated or purchased. At the same time, they continued to finance themselves primarily through deposit-like short-term repo agreements and used substantial amounts of leverage. The model of financing relatively illiquid, longer-term assets with short-term borrowing is, of course, the commercial banking model. Meanwhile, some larger commercial banks had adopted business approaches--more specifically, the originate-to-distribute model--that resembled the operation of investment banks; this business strategy involved relatively less reliance on traditional retail deposit funding and a greater dependence on securitization markets. Moreover, the funding of AAA-rated tranches of securitizations was often provided by conduits that were supported by the originators of the underlying securities. When securitization markets came under increasing strain and ultimately ceased to function altogether, all entities that relied on such markets for funding were exposed. With the relevant economic characteristics of large commercial banks and large investment banks more similar than different, it made
289 little sense to draw sharp distinctions between commercial banks and investment banks in terms of their access to central bank liquidity during the crisis. Still, the Federal Reserve recognized that differences in the supervisory regimes applied to commercial banks and investment banks raised greater issues of moral hazard in lending to investment banks. As I have noted, the Federal Reserve's initial response to the crisis was consistent with the traditional model of bank-centered intermediation--in effect, it was driven by the Federal Reserve's statutory authority that governs its routine operations and by its established practice. In the wake of a smaller shock, that response might have been sufficient. But the financial system was broadly dysfunctional. And because of their own credit, capital, and liquidity problems, commercial banks simply were unable to act as the channel through which the central bank could provide liquidity sufficient to support the entire financial system. In these circumstances, the choice was stark: Lend to nonbank financial firms, something that had not been undertaken in decades, with the hope and expectation that such action would be sufficient to stave off financial collapse; or refuse to lend and accept almost certain systemic failure. Terms of Central Bank Lending Bagehot instructs us to lend at a high rate, and central banks generally seek to lend at a penalty rate in their standing facilities. The motivation that Bagehot had in mind was to avoid unnecessary draws on a limited stock of central bank liquidity, which is not a consideration in modern central banking. But pricing the facilities at a penalty rate has the added virtue of building an "exit strategy" into the structure of the programs. In pricing the PDCF, the Federal Reserve followed Bagehot's instruction by setting the interest rate on PDCF credit at the primary credit rate charged to depository institutions. As financial markets have improved and that rate has come increasingly to represent a penalty relative to rates available in the market, the usage of the PDCF has fallen to zero. Despite Bagehot's advice to lend broadly, practicability requires that central banks not lend to all firms, or even all financial institutions, either in routine circumstances or in a crisis. Rather, central banks generally need to establish eligibility for their facilities using some sharply defined criteria--for example, a banking charter, designation as a primary dealer, and so on--in order to avoid an untenable situation in which it may appear that individual firms are arbitrarily allowed or denied access. But because firms are heterogeneous, central banks also have to accept that, as a practical matter, any set of potential borrowers defined on the basis of institutional features will comprise firms with a range of financial characteristics, so that what is a penalty rate for one firm may not be for another. Partly for this reason, the setting of an above-market rate for a standing facility is not as simple as it might first appear. The heterogeneity of firms, particularly with respect to their size and thus their access to open market sources of funds, implies that either the rate needs to be set a level that represents a stiff penalty for the firms with the lowest marginal cost of funds or that the central bank may need to administratively restrict borrowing by the individual banks that have relatively high marginal costs of funds. A desire to minimize the need for such administrative restrictions is the principal reason that the Federal Reserve has set a relatively wide, 100 basis point spread of the primary credit rate over the target federal funds rate in routine circumstances. With a narrower spread, some banks with relatively high marginal costs of funds would find regular dependence on the discount window to be a cost-minimizing strategy. Over the course of the crisis, the primary credit spread was lowered to 25 basis points in order to encourage institutions to use the window and thus support overall credit availability. When market conditions
290 normalize, a wider spread of the primary credit rate over the funds rate may be needed to provide incentives to all banks to seek market sources of funds. Actually, the pricing of a collateralized loan is multidimensional, and terms other than the interest rate are relevant. In particular, the terms on which collateral for a discount window loan is taken constitute an important additional dimension, and the haircut applied to the collateral is one of the most salient aspects. In establishing haircuts for the PDCF, the Federal Reserve sought to provide financing on terms that were less onerous than could be obtained in the markets during the crisis but also less attractive than those available in the markets in more routine circumstances. Thus, the haircuts set on the primary dealer facilities represented a generalization of the dictum to "lend at a high rate." This generalization has been applied to the Federal Reserve's other liquidity facilities as well. The fact that usage of the Federal Reserve's liquidity facilities has declined markedly--in several cases to zero--as market conditions have improved suggests that the Federal Reserve has been successful in pricing these programs at terms that represent penalties in more normal circumstances. Illiquidity and Insolvency Traditional central banking principles also tell us to lend only to solvent institutions and only against good collateral, but complying with these standards in a crisis is not entirely straightforward. For instance, the difference between solvency and liquidity is not sharp-- insolvency can cause illiquidity and vice versa--and the distinction blurs further in a financial panic.9 Unless markets are quite liquid, any firm that is forced to sell assets in order to obtain liquidity will see some erosion of its economic capital. In a financial panic, when markets for financial assets may be extremely illiquid, enlarged liquidity premiums can absorb so much of a firm's economic capital that its solvency can be called into question if it needs to engage in a fire sale of assets, even though in more placid conditions the solvency of the firm may not be in doubt. Thus, the reduction in market liquidity during a panic can reduce the margin of solvency of financial firms. A key responsibility of central banks is to provide the liquidity to sound banks that is necessary to help them survive bouts of market illiquidity in order to preserve the functioning of the financial system and support economic activity. However, assessing the solvency of financial firms can be difficult, especially in strained market circumstances. Large financial institutions tend to be opaque, but in routine conditions, given enough time, a central bank can conduct a careful review of the financial condition of the firm seeking liquidity and obtain reliable market quotes for the collateral being tendered to obtain reasonable assurance that the central bank is lending only to sound institutions and with adequate security. In contrast, in a financial crisis, markets may be dysfunctional and price quotes volatile or even unavailable, adding to the uncertainty in assessing firms' solvency. As a result, the decision as to whether to lend to a given firm can entail a significant measure of judgment--judgment both about the firm's solvency and about the possible market effects of the failure of the firm. Indeed, the ramifications of a possible default of a large financial firm in conditions of financial stress may be unclear--and, typically, time is short. Consequently, it is essential for a central bank to have the capability to assess the firm's condition and the quality of its collateral, on the basis of incomplete information, rapidly and effectively. It is also essential to be able to make quick and sound judgments as to the likely market effects of the possible failure of such a firm. The experience of the Federal Reserve in this episode illustrated very convincingly that the ability of a central bank to make such determinations in short order is substantially enhanced by the availability of the in-house expertise that
291 comes from having responsibility for conducting bank supervision and from a practice of ongoing monitoring and analysis of a wide range of financial markets and institutions. Lending to Money Market Mutual Funds and Commercial Paper Issuers .Although the Federal Reserve's lending to primary dealers helped stabilize financial markets over the spring and summer of 2008, the Federal Reserve was again confronted with severe difficulties at nonbank financial firms in the early fall. At that time, money market mutual funds, among many other entities, came under intense liquidity pressures. The U.S. money fund industry is huge; with more than $3-1/2 trillion in assets, it is close to one-third the size of the U.S. commercial banking system. Moreover, money funds are major investors in the large and critical commercial paper and repo markets. Certain characteristics of money funds make them vulnerable to runs, like banks in the absence of deposit insurance. First, money funds engage in maturity transformation: They offer shares that are payable on demand but hold assets that typically mature in several weeks. Last fall, secondary markets for those assets came under considerable strain, and as a result funds had difficulty disposing of assets to meet redemptions without experiencing capital losses. Second, investors have come to expect--and demand--an unwavering money fund share price of $1, in part because money funds have regulatory authority to maintain, within limits, a stable price in the face of fluctuating market values of their assets. When the market value of money fund shares is expected to fall below their price, investors have an incentive to run. But money funds, unlike banks, do not have regular access to the discount window and do not have a permanent share insurance arrangement that would neutralize the incentive to run. Furthermore, the short-term nature of money funds' assets means that any broad-scale disruption to their investment poses an immediate threat to firms whose economic activity depends on access to financing in the money markets--especially when the availability of funding from alternative sources, such as commercial banks, is diminished. The fact that money funds are subject to runs was a significant contributor to the enormous increase in financial stress that occurred in the fall of 2008. On September 16, the Reserve Primary Fund announced that it "broke the buck" as a result of losses on its holdings of Lehman paper. That announcement was an unpleasant wake-up call for the many investors who had assumed that their investments in money market funds were, for all practical purposes, absolutely safe. Still, the money fund industry is quite competitive, with hundreds of funds in operation, and even in the highly stressed conditions during the fall of 2008, no single fund was large enough to be critical to the continued functioning of the financial system. Nonetheless, a substantial number of funds--in particular, many of the so-called prime funds that usually invest mainly in private debt securities--were seen by investors as having exposures potentially similar to that of the Reserve Primary Fund. A severe run on much of the industry ensued, with withdrawals totaling hundreds of billions of dollars and more than 100 funds losing a substantial volume of assets in the span of just a few weeks. As a result, many money funds were forced to dump assets on the market and cease buying new paper. Consequently, the commercial paper market nearly ground to a halt, preventing many businesses and investment vehicles from rolling over their liabilities beyond very short terms and leaving them potentially unable to finance their operations. In addition, banks had provided lines of credit to many issuers of unsecured paper as well as ABCP programs; as a result, banks faced additional pressures on their balance sheets though their commitments to provide loans under such lines.
292 Given the direct threat to economic activity and the scope for exacerbating the liquidity crunch, these circumstances were clearly unusual and exigent and warranted extending central bank credit to money funds even though, once again, the entities needing liquidity did not have regular access to the discount window. Had Bagehot been a member of the Federal Reserve Board, he most certainly would have approved such action. However, several factors potentially impeded the Federal Reserve's ability to lend to such entities. For example, representatives of the money fund industry advised the Federal Reserve that money funds would be unwilling to borrow, partly because investors would recognize that leverage would amplify the effects of any fund losses on remaining shareholders and intensify their incentive to run. Indeed, the Federal Reserve Board approved the establishment of a Direct Money Market Mutual Fund Lending Facility but left it on the shelf after being informed that money funds would be unwilling to use it.10 The unwillingness of money funds to borrow led the Federal Reserve to implement several facilities in support of money funds and money markets that did not involve direct lending to money funds. For example, under the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), the Federal Reserve lends not to money funds, but rather to commercial banking organizations, which can pledge as collateral just one type of asset--top-rated asset-backed commercial paper (ABCP)--that they purchase at amortized cost from the money funds. Tight constraints in designing the program--in particular, the need to lend to banking organizations rather than directly to the money funds--as well as the narrow spread of good quality ABCP over the federal funds rate meant that the credits had to be structured as nonrecourse loans, and also that it was impossible to charge a penalty rate for this facility; thus the design of the facility diverges modestly from Bagehot's principles. Partly to ensure that the absence of a penalty rate does not encourage funds to rely inappropriately on the facility, the Federal Reserve recently imposed certain constraints on use of the program that ensure it is used only for liquidity reasons. Given the limitations on the AMLF, the Federal Reserve saw some risk that this facility would not provide sufficient support to the money market and economic activity dependent on money market financing. So, even as the AMLF was being launched, the Federal Reserve intensively considered other mechanisms. It is essential to recall the circumstances under which this problem was being addressed. Several large financial institutions had failed or were close to failure. Large banks were extremely concerned about losses, capital adequacy, and continued access to liquidity, and thus were rapidly tightening terms and standards for credit extensions rather than seeking new lending opportunities; indeed, the situation was so serious that the government was designing mechanisms for injecting capital into major banking institutions and cleansing them of troubled assets. Under these conditions, it was highly unlikely that an effective mechanism could be engineered for increasing the availability of short-term financing through normal channels to nonfinancial businesses and to the conduits and other vehicles that relied on commercial paper. Issuance of paper with terms of more than a few days was nearly impossible, so the volume of paper maturing each day was in the hundreds of billions of dollars and mounting steadily, indicating that addressing the problem quickly was essential. Banking organizations themselves had issued large amounts of commercial paper, and thus the problems in the commercial paper market exacerbated banks' own liquidity problems. The serious impairment of two major sources of funding to the business sector--commercial banks and money funds--implied that prospects were dim for buoying the extension of
293 credit to firms and households by providing additional liquidity to any existing financial intermediary. In order to support the continued availability of short-term credit to the economy, the Federal Reserve established the Commercial Paper Funding Facility (CPFF). Under the CPFF, the Federal Reserve in effect lends directly to nonfinancial as well as financial issuers of commercial paper.11 Although the details of the CPFF stand in some contrast to standard central bank liquidity facilities--in particular, its security comes from fees rather than from collateral--in its broad structure, the facility is still in keeping with Bagehot's view of appropriate central bank actions in a crisis. Indeed, as I noted earlier in my remarks, Bagehot exhorted central bankers dealing with a panic to lend even "to merchants." Ultimately, the AMLF and the CPFF, in combination with a range of other Federal Reserve and government programs and facilities, proved successful in stemming the run on money funds and stabilizing the money markets.12 Over the course of the fourth quarter of 2008, flows to prime money funds resumed, the runoff of commercial paper slowed, and usage of the AMLF and CPFF began to decline. In retrospect, it is clear that the broad suite of actions taken by central banks and governments in the fall of 2008 was key to arresting the broadening liquidity panic. Lending to Investors in Asset-Backed Securities The crisis of fall 2008 disrupted not only the money markets but also other key financial markets. In particular, activity in the asset-backed securities (ABS) markets, in which more than one-third of consumer lending had been financed in recent years, abruptly halted in the fourth quarter. Of the markets providing longer-term credit to the economy, the ABS market was especially hard-hit because leverage was no longer available from the conduits, securities lenders, and other entities to the traditional investors in the higher- rated tranches of ABS who customarily relied heavily on leverage to achieve their desired risk-return combinations. Without a functioning ABS market as an outlet for originations of loans, the availability of auto, credit card, and student loans, as well as other types of financing, was likely to become even more impaired, further undermining economic activity. In response, the Federal Reserve in late 2008 announced that it was establishing the Term Asset-Backed Securities Loan Facility (TALF). Under the TALF, the Federal Reserve lends on a nonrecourse basis, at interest rates and with haircuts that would ordinarily be less attractive than those available in the market, to investors in the AAA-rated tranches of ABS. Both the significant haircuts on the collateral and backing from the Treasury afford the Federal Reserve substantial protection from credit risk. At first blush, the TALF appears very different from the traditional discount mechanisms of central banks. The Federal Reserve is intervening in a specific market for longer-term credit. But, in most of its essential elements, the TALF fits neatly into standard central bank approaches for addressing financial crises. Under the TALF, the Federal Reserve lends to investors against collateral--again, with substantial haircuts and additional credit protection provided by the Treasury--and at penalty rates.13 And the program lends against a broad range of asset-backed collateral to minimize distortions to credit allocation. Encouragingly, activity in the ABS market has picked up so far this year, suggesting that the TALF has been successful in helping to buoy the availability of credit to firms and households and thus in supporting economic activity.
294 Some Lessons Let me conclude with several lessons that can be drawn from the Federal Reserve's experience in extending credit in this episode. First, Bagehot's dictum continues to provide a useful framework for designing central bank actions for combating a financial crisis. However, that framework needs to be interpreted in the context of the modern structure of financial markets and institutions and applied in a way that observes both legal constraints and a broad range of practical considerations. The experience of the crisis shows that, in extraordinary circumstances, central banks may well need to take measures to prevent systemic collapse that are unprecedented in their details; but such measures may still be quite congruent with established central banking principles. Second, the problem of discount window stigma is real and serious. The intense caution that banks displayed in managing their liquidity beginning in early August 2007 was partly a result of their extreme reluctance to rely on standard discount mechanisms. Absent such reluctance, conditions in interbank funding markets may have been significantly less stressed, with less contagion to financial markets more generally. Central banks eventually were able to take measures to partially circumvent this stigma by designing additional lending facilities for depository institutions; but analyzing the problem, developing these programs, and gathering the evidence to support a conclusion that they were necessary took valuable time. Going forward, central banks and other policymakers need to avoid measures that could further exacerbate the stigma of using central bank lending facilities. And they should consider whether some now-existing arrangements, such as the Term Auction Facility and similar mechanisms, need to be adapted and made permanent, or new facilities established, so that the stigma of using central bank credit is minimized, especially in future crises. Third, the severe difficulties encountered by primary dealers in this crisis, and the evident consequences for broader effects on the financial system and the economy, illustrate a broader point: Any financial system that includes systemically important nonbank financial firms with significant amounts of illiquid assets and short-term liabilities--in other words, any system that includes important nonbank financial firms subject to bank-like runs--requires a mechanism for lending to such firms at least in crisis situations. Even though those firms may not be banks de jure, they are banks de facto in the risks that they pose to the broader financial system and the economy. Like banks, their interconnectedness with other parts of the financial system, as well as their similarities to one another and to other types of financial institutions, makes contagion possible and, in some circumstances, likely. The experience of this episode underscored once again the severe consequences that can result from the disorderly failure of one or more major financial institutions and the need for liquidity and resolution mechanisms to prevent such failures. Fourth, the run on money funds implies that individual nonbank "firms" do not necessarily have to be systemically important in themselves to warrant access to centralized liquidity. Rather, if the difficulties of one or a few such firms pose the risk of contagion to similar entities or to other parts of the financial system, a run on an entire set of firms, atomistic in themselves but not in the aggregate, can ensue, potentially disrupting economic activity. Thus, a means of lending in contingency situations even to nonbank firms that may not be systemically critical in themselves would seem necessary to promote a suitable degree of financial stability. Finally, experience suggests that a workable regulatory system must incorporate a mechanism to extend central bank credit to entities that are not normally eligible to borrow
295 from the central bank; no reasonable system of regulation can draw a bright line that cannot be crossed between banks and nonbanks. Absent very onerous regulation, there will always be a continuum in the degree to which financial firms pose systemic risk. Subjecting systemically risky firms to enhanced supervision and regulation is certainly warranted. But practical considerations will always require that only a well- specified set of institutions subject to a specific supervisory regime have regular access to central bank credit, and that firms outside the boundary do not have such access. Lending to some firms without routine access to central bank credit will occasionally be appropriate to prevent severe systemic disruptions. Thus, it would seem that authority similar to that provided by section 13(3) will continue to be necessary. In summary, the recent financial crisis provides considerable evidence in support of what Bagehot knew more than 135 years ago from the experience of his era. To cushion the adverse effects of a financial panic on economic activity, a central bank must be ready to lend freely, potentially to a broad range of counterparties, in a crisis. Although the need for a modern central bank to lend in normal times may be quite limited, it is not prudent to severely circumscribe the potential scope for central bank lending in a financial panic. Rather, as Bagehot recommended, we should look to the restrictions of lending only to solvent firms, only against good collateral, and only at high rates to limit distortionary effects on markets and to protect the fisc while allowing central bank credit to prevent financial panics from having excessively adverse effects on economic activity and employment. Bagehot's precepts need to be interpreted and applied in light of practical considerations, and that application is not necessarily straightforward. In a crisis, the solvency of firms may be uncertain and even dependent on central bank actions; the value of collateral may be depressed to an uncertain degree by liquidity rather than credit premiums; and the extent to which the terms of a central bank facility represent a penalty rate may depend on the circumstances and vary across firms. Nonetheless, Bagehot's dictum effectively addresses key economic objectives of society and thus continues to provide a useful framework for the formulation of central banks' policy actions in a crisis.
Footnotes 1. Walter Bagehot ([1873] 1897), Lombard Street: A Description of the Money Market (New York: Charles Scribner's Sons). Return to text 2. Paul Tucker (2009), "The Repertoire of Official Sector Interventions in the Financial System: Last Resort Lending, Market-Making, and Capital (90 KB PDF)," remarks at the Bank of Japan 2009 International Conference on the Financial System and Monetary Policy Implementation, Bank of Japan, Tokyo, May 27-28, p. 5. Return to text 3. Chairman Bernanke has noted that a desire to minimize moral hazard was not Bagehot's principal motivation for recommending that the central bank should lend at a penalty rate; rather, the high rate was intended to discourage unnecessary draws on limited liquidity. (See Ben S. Bernanke (2008), "Liquidity Provision by the Federal Reserve," remarks at the Federal Reserve Bank of Atlanta Financial Markets Conference, Sea Island, Georgia (via satellite), May 13.) Still, reducing moral hazard is one potentially important benefit of following Bagehot's precepts. Prudential supervision and regulation are also important mechanisms to ensure that financial institutions appropriately manage their liquidity. Return to text 4. Nonetheless, I thank, without implicating, members of the Board of Governors and members of the Board's staff for comments and suggestions. Return to text
296 5. Bagehot, Lombard Street, p. 51. Bagehot goes on to say (pp. 51-2), "The way in which the panic of 1825 was stopped by advancing money has been described in so broad and graphic a way that the passage has become classical. 'We lent it,' said Mr. Harman, on behalf of the Bank of England, 'by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount[,] in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice....' After a day or two of this treatment, the entire panic subsided, and the 'City' was quite calm." Return to text 6. See, for instance, John B. Taylor and John C. Williams (2008), "A Black Swan in the Money Market (339 KB PDF)," Working Paper 2008-04 (San Francisco: Federal Reserve Bank of San Francisco, February (revised April 2008)); and Tao Wu (2008), "On the Effectiveness of the Federal Reserve's New Liquidity Facilities (300 KB PDF)," Working Paper 0808 (Dallas: Federal Reserve Bank of Dallas, May). Return to text 7. To be sure, the fundamental problems of the banking system stemmed from losses and erosion of capital, and the situation was not adequately stabilized until governments contributed capital and provided guarantees to the banking system. Nonetheless, the TAF and comparable actions surely acted as at least a palliative by addressing panic-driven demands for liquidity. Return to text 8. Although the Federal Reserve found it necessary, in the interest of financial stability, to lend to support the acquisition of Bear Stearns and later to prevent the disorderly failure of AIG--in both cases with the full support of the Treasury Department--the Federal Reserve and the Treasury have both noted that a superior arrangement would be for the Congress to establish by statute a regime for the resolution of systemically important nonbank financial firms. Under such a regime, the central bank presumably would need to lend to a failing systemically important institution at most only for a brief period before responsibility was assumed by the resolving authority.Return to text 9. See Ben S. Bernanke (2009), "Reflections on a Year of Crisis," speech delivered at a symposium sponsored by the Federal Reserve Bank of Kansas City, held in Jackson Hole, Wyo., August 21-23. Return to text 10. The creation of the Direct Money Market Mutual Fund Lending Facility is reported in Minutes of Meeting of Federal Reserve Board, "Financial Markets--Proposal to Provide Liquidity Directly to Money Market Mutual Funds through the Direct Money Market Mutual Fund Lending Facility (103 KB PDF)," October 3, 2008, pp. 11-12, available on the Board's website. Return to text 11. The CPFF purchases commercial paper directly from issuers and finances those purchases through loans from the Federal Reserve. The loans are secured by fees paid by the issuers and by the accumulation of an excess spread in the facility. Return to text 12. Among other key government actions during the fall of 2008, the Treasury established a Temporary Guarantee Program for Money Market Funds, and the FDIC implemented a Temporary Liquidity Guarantee Program to insure certain bank debt, including commercial paper issued by banks. Return to text 13. The fact that credit is extended on a nonrecourse basis means that the third element of Bagehot's dictum--lending only to sound institutions--is of little direct relevance. Return to text http://www.federalreserve.gov/newsevents/speech/madigan20090821a.htm
297 SATURDAY, AUGUST 22, 2009 Krugman: Some call it recovery by CalculatedRisk on 8/22/2009 09:02:00 PM Excerpt from Paul Krugman: Some call it recovery The real problem here is that the standard language doesn’t make much allowance for the kind of gray zone we’re now in; that’s because in the pre-1990 era recessions tended to be V- shaped, so that jobs snapped back as soon as GDP turned around. I don’t think what we’re going through is good news — but GDP is almost surely rising, so the recession, as normally defined, is over. ... But the economy is not recovering in the most crucial area, job creation ... Excerpt from The Economist: U, V or W for recovery The world economy has stopped shrinking. That’s the end of the good news ... a rebound based on stock adjustments is necessarily temporary, and one based on government stimulus alone will not last. Beyond those two factors there is little reason for cheer. America’s housing market may yet lurch down again as foreclosures rise, high unemployment takes its toll and a temporary home-buyers’ tax-credit ends (see article). Even if housing stabilises, consumer spending will stay weak as households pay down debt. In America and other post-bubble economies, a real V-shaped bounce seems fanciful. It does appear the cliff diving is over, and that the U.S. economy will grow in the 3rd quarter. But there are still more problems ahead for consumer spending and housing (I think housing is still the key - and I'll discuss this soon). An immaculate recovery seems remote. Inland Empire: "The gold mine was construction" by CalculatedRisk on 8/22/2009 06:40:00 PM Here is a followup story on the Inland Empire in California, from the NY Times: “A Cul-de-Sac of Lost Dreams, and New Ones” This quote caught my eye:
298 "You have to think of it like a gold-mining town in a Clint Eastwood movie,” Mr. [John Husing, an economist whose expertise is Southern California] said. “Money comes to a place where there has never been any, and next there are tool stores, a saloon, a general store and so on. But the saloon doesn’t exist without the gold mine, and the gold mine here was construction.” Exactly. And the gold mine closed a few years ago. Here is how I saw it in 2006 for the Inland Empire: As the housing bubble unwinds, housing related employment will fall; and fall dramatically in areas like the Inland Empire. The more an area is dependent on housing, the larger the negative impact on the local economy will be.
So I think some pundits have it backwards: Instead of a strong local economy keeping housing afloat, I think the bursting housing bubble will significantly impact housing dependent local economies. Failed Banks and the Deposit Insurance Fund by CalculatedRisk on 8/22/2009 08:34:00 AM As a companion to the Problem Bank List (unofficial), below is a list of failed banks since Jan 2007. But first a few graphs ...
Click on graph for larger image in new window. The graph shows the cumulative estimated losses to the FDIC Deposit Insurance Fund (DIF) and the quarterly assets of the DIF (as reported by the FDIC). Note that the FDIC takes reserves against future losses in the DIF, and collects fees and special assessments - so you can't just subtract estimated losses from assets to determine the assets remaining in the DIF.
299
The FDIC closed four more banks on Friday, and that brings the total FDIC bank failures to 81 in 2009. The following graph shows bank failures by week in 2009.
Note: Week 1 on graph ends Jan 9th. The FDIC is seizing about 4 to 5 banks per week recently, and with over four months to go in 2009, this suggests close to 150 bank failures this year.
At the current pace there will be more failures in 2009 than in the early years of the S&L crisis. From 1982 thorough 1984 there were about 100 failures per year, and then the number of failures really increased as the 2nd graph shows.
The 2nd graph covers the entire FDIC period (annually since 1934). For a graph that includes the 1920s and early '30s (before the FDIC was enacted) see the 3rd graph here. Of course the number of banks isn't the only measure. Many banks today have more branches, and far more assets and deposits. Failed Bank List Deposits, assets and estimated losses are all in thousands of dollars.
300 Losses for failed banks in 2009 are the initial FDIC estimates. The percent losses are as a percent of assets. See description below table for Class and Cert (and a link to FDIC ID system).
The table is wide - use scroll bars to see all information! NOTE: Columns are sortable - click on column header (Assets, State, Bank Name, Date, etc.) FRIDAY, AUGUST 21, 2009 Meredith Whitney: 300 Banks to Fail by CalculatedRisk on 8/21/2009 09:01:00 PM From Bloomberg at Jackson Hole: (ht km4) We are up to 81 bank failures this year, and 109 since the crisis started. With 391 banks on the unofficial problem bank list (and more to come), I think 300 is probably low. I'll take the over ...
301
Krugman August 22, 2009, 5:27 pm Some call it recovery Reading comments, I see that some readers think that by saying that we may be in a recovery by the usual definition, even though jobs are still being lost, I’m either (a) shilling for Obama (b) radically changing my views. Um, no. I didn’t invent the standard definitions of recession and recovery. The real problem here is that the standard language doesn’t make much allowance for the kind of gray zone we’re now in; that’s because in the pre-1990 era recessions tended to be V-shaped, so that jobs snapped back as soon as GDP turned around. I don’t think what we’re going through is good news — but GDP is almost surely rising, so the recession, as normally defined, is over. And the current situation is no better — actually, worse — that I thought it would be when arguing that the Obama economic plan was inadequate. Read this, and bear in mind that the unemployment rate is now 9.4%. The stimulus has helped, and the conventional recession is over. But the economy is not recovering in the most crucial area, job creation, and the stimulus won’t be enough to restore prosperity.
August 21, 2009, 3:44 pm The answer is yes Barbara Kiviat asks, is this a recovery or isn’t it? The answer is yes. I’ve been pointing out for a long time — well before the crisis hit full steam — that recoveries ain’t what they used to be. Basically, the standard definition of a recovery is that it’s when GDP starts to rise; but “jobless recoveries”, in which unemployment keeps worsening long after GDP has turned around, have become the new normal. Bill Clinton was able to run on the economy, stupid, well into an alleged economic recovery; the 2001 recession formally ended in Nov. of that year, but it didn’t feel like a recovery until the second half of 2003. I really don’t understand why anyone is surprised that it’s happening again. PS: I’m also surprised that Ben Bernanke’s Jackson Hole remarks, which basically stated the current conventional wisdom — the output decline is over, but jobs are a big problem — made headlines.
302 The Curious Capitalist Commentary on the economy, the markets, and
business Wait a second, is this a recovery or isn't it? Posted by Barbara Kiviat Thursday, August 20, 2009 at 11:05 am 7 Comments • Trackback (3) • Related Topics: economy, jobs
This morning the Conference Board became the latest economy-watching group to call an end to recession. As you can see in the graph above, its index of leading economic indicators—which includes things like stocks prices, building permits and manufacturers' orders—increased for the fourth month in a row. Its index of coincident economic indicators—such as industrial production, personal income and manufacturing sales—held flat, the first time it didn't slide since October 2008. The group's economists think that index will be turning positive before we know it. And yet the jobs market—the way people most feel a recession—is showing renewed weakness. In another data release this morning, the Labor Department reported that weekly jobless claims are heading back up. That's something of a surprise to economists, who broadly thought the figure would be lower. For the week ending Aug. 15, initial claims for unemployment insurance came in at 576,000, up from 561,000 the week before. Since that weekly number jumps around a lot, it's good to look at a four-week moving average. That grew, too, hitting 570,000 weekly claims, up from 565,750. Continuing claims also edged up (as of Aug. 8), though the four- week moving average fell slightly. What gives? Well, to put those jobs numbers into context, consider that in a healthy economy there are normally 325,000 or fewer initial claims a week. We're obviously a long
303 way from that sort of figure. But on the upside, initial claims are holding below 600,000, which is one of those psychologically significant Dow 10,000 sorts of numbers. For the entire first half of 2009, we were above the 600,000 threshold. The first week of July we fell below it, and even though there's been a little bouncing around, we haven't recrossed that mark. Does that mean the jobs numbers aren't as bad as they look? Certainly not for the people being laid off. This could simply be an indication that we're heading for yet another jobless recovery. That's what the folks at the San Francisco Fed, among others, have been saying. And that makes me wonder—if this is going to be our third jobless recovery in a row (1992 kicked off the trend)—what exactly we mean anymore when we talk about "economic recovery." If having more jobs, and ones that pay livable salaries, isn't one of the conditions for proclaiming economic health, then I'm not sure I completely understand what conversation we're having. Barbara! http://curiouscapitalist.blogs.time.com/2009/08/20/wait-a- second-is-this-a-recovery-or-isnt-it/ Krugman February 10, 2008, 5:08 pm Postmodern recessions Calculated Risk says much of what I’d say about housing and the prospects for quick economic recovery. But I’d like to offer a bit more analysis. A lot of what we think we know about recession and recovery comes from the experience of the 70s and 80s. But the recessions of that era were very different from the recessions since. Each of the slumps — 1969-70, 1973-75, and the double-dip slump from 1979 to 1982 — were caused, basically, by high interest rates imposed by the Fed to control inflation. In each case housing tanked, then bounced back when interest rates were allowed to fall again. Since the mid 1980s, however, we’ve had the “Great Moderation,” with inflation quiescent. Post-moderation recessions haven’t been deliberately engineered by the Fed, they just happen when credit bubbles or other things get out of hand. And while they haven’t been as deep as the older type of recession, they’ve proved hard to end (not officially, but in terms of employment), precisely because housing — which is the main thing that responds to monetary policy — has to rise above normal levels rather than recover from an interest-imposed slump. That’s why I think our current problems will last a long time. CR says 2009; I say 2010.
304 COMPANIES Financial Services Crackdown on ‘naked short-selling’ intesifies By Brooke Masters in New York Published: August 5 2009 23:40 | Last updated: August 5 2009 23:40 The crackdown on ‘naked short-selling’ intensified on Wednesday as the Securities and Exchange Commission brought its first enforcement cases against the practice – betting that a stock will fall while failing to borrow the underlying shares. In its filing, the SEC said options traders at Hazan Capital Management and TJM Proprietary Trading of Chicago had improperly claimed to be exempt from rules requiring them to locate the stocks they had been shorting, and then had used complicated options transactions to avoid settling their trades as required. The firms and their employees have agreed to pay a total of $4.7m in fines, but neither admitted nor denied liability. A lawyer for HCM said the firm had concluded that the costs of fighting the SEC charges would be equivalent to paying the penalty. These cases may be just the tip of the iceberg. Wednesday’s action “is part of a larger effort and there are a number of other firms we are investigating”, said Scott Friestad, associate director of enforcement. Short-selling has come under regulatory scrutiny in the aftermath of the financial crisis, with some critics saying it exacerbated the troubles of weak banks. US, UK and European Union regulators have all proposed increased disclosure of short positions. In the US, naked short-selling has drawn particular opprobrium and the SEC recently sought to weed out the practice by reducing the timeframe for locating stock to cover a short trade. Brokers must now close out positions within four days instead of 13. “Naked short selling potentially dilutes shareholders influence and potentially creates a misleading impression of the market,” said Leslie Kazon, the SEC assistant regional director on the HCM case. The two cases predate the tighter rules. HCM’s trades occurred from 2005 to 2007 and TJM traded in 2007. In both cases, the SEC said, the traders had become involved with naked short-selling through transactions known as “reverse conversions”, in which a trader uses options to replicate a long position while simultaneously hedging himself by selling the same stock short. Borrowing stock to cover the short position can be expensive and cut into returns. TJM and HCM claimed to be acting as marketmakers. http://www.ft.com/cms/s/0/b8ddc2bc-820f-11de-9c5e-00144feabdc0.html
305 Vol 46, 3, Septiembre 2009 Sustaining a Global Recovery Olivier Blanchard The recovery has started. Sustaining it will require delicate rebalancing acts, both within and across countries In normal recessions, however disruptive they are to businesses and jobs, things turn around predictably. The current global recession is far from normal. Usually, to fight a recession, the central bank lowers interest rates, which results in increased demand and output. People resume buying durable goods such as appliances and cars. Firms start delayed investment projects. Often, an exchange rate depreciation gives a boost to exports by making them cheaper. The lower-than-normal growth during the recession gives way to higher-than-normal growth for some time, until the economy has returned to its normal growth path. But the world is not in a run-of-the mill recession. The turnaround will not be simple. The crisis has left deep scars, which will affect both supply and demand for many years to come. Supply-side problems
Olivier Blanchard: "Some parts of the economic system have broken." Some parts of the economic system have broken. Some firms went bankrupt that would not have in a normal recession. In advanced countries, the financial systems are partly dysfunctional, and will take a long time to find their new shape. Meanwhile, financial intermediation—and, by implication, the process of reallocation of resources that is central to growth—will be impaired. In emerging market countries, capital inflows, which decreased dramatically during the crisis, may not fully come back in the next few years. Changes in the composition of world demand, as consumption shifts from advanced to emerging economies, may require changes in the structure of production. In nearly all countries, the costs of the crisis have added to the fiscal burden, and higher taxation is inevitable. All this means that we may not go back to the old growth path, that potential output may be lower than it was before the crisis.
306 How much has potential output decreased? It is very hard to tell: we do not see potential output, only actual output. The historical evidence is worrisome, however. The IMF’s forthcoming World Economic Outlook presents evidence from 88 banking crises over the past four decades in a wide range of countries. While there is large variation across countries, the conclusion is that, on average, output does not go back to its old trend path, but remains permanently below it. The possible good news is that the trend itself appears to be unaffected: on average, crises permanently decrease the level of output, but not its growth rate. So, if past is prologue, the world economy likely will return to its past growth rate. But, especially in advanced countries, the period of above-average growth, characteristic of normal recoveries, may be short-lived or nonexistent. Demand-side issues Just achieving "normal" growth, however, may be hard because of demand problems. The forecasts now predict that growth will be positive in most countries, including advanced countries, for the next few quarters. But there are two caveats to this news: • Growth will not be quite strong enough to reduce unemployment, which is not expected to crest until some time next year. • These positive growth forecasts are largely predicated on a combination of a fiscal stimulus and inventory rebuilding by firms, rather than on strong private consumption and fixed investment spending. Sooner or later, the fiscal stimulus will have to be phased out. And inventory adjustment will also naturally come to an end. The question, then, is what will sustain the recovery. Two rebalancing acts will have to come into play. First, rebalancing from public to private spending. Second, rebalancing aggregate demand across countries, with a shift from domestic to foreign demand in the United States and a reverse shift from foreign to domestic demand in the rest of the world, particularly in Asia. Rebalancing public and private spending The fiscal response to the crisis was to increase government spending, lower taxes, and accept much larger fiscal deficits. Given the collapse of private demand, and the inability to reduce interest rates below zero, governments clearly chose the right response. But large deficits lead to rapid increases in debt, and, because debt levels were already high in many countries, such increases cannot go on for long. As large deficits continue debt sustainability comes increasingly into question. And with this comes the risk of higher long-term interest rates, both because of anticipated crowding out of private borrowers by government borrowers and because of a higher risk of default. How much longer can the fiscal stimulus continue? On its own, in most advanced countries, probably not very long. The average ratio of debt to gross domestic product (GDP) for the G-20 advanced economies was high before the crisis, and is forecast to exceed 100 percent in the next few years. (The situation is substantially different in a number of emerging market countries, where debt was much lower to start, and where there is more room for deficit spending.) An important qualifier is "on its own." The stimulus can be prolonged if, at the same time, structural measures are taken to limit the future growth of entitlement programs—whether from rising health care costs or from the effect of aging populations on retirement costs.
307 The trade-off is fairly attractive. IMF estimates suggest that the fiscal cost of future increases in entitlements is 10 times the fiscal cost of the crisis. Thus, even a modest cut in the growth rate of entitlement programs can buy substantial fiscal space for continuing stimulus. Eventually, however, the fiscal stimulus will have to be phased out, and private demand must replace it. The source of that demand—whether consumption or investment—is a crucial issue. Rebalancing demand across countries The United States was not only at the origin of the crisis, it is central to any world recovery. Consumption represents 70 percent of total U.S. demand, and its decline was the main near-term cause of the fall in output in this crisis. The ratio of U.S. household saving to disposable income, which was close to zero in 2007, has increased to about 5 percent. Will the saving rate go back to its 2007 level? That would not be desirable, and is unlikely. On the one hand, some of the increase in saving in the last year probably reflected a wait- and-see attitude on the part of consumers, an attitude that will go away as the smoke clears. On the other hand, the saving rate tends to go up as output and income expand. And even if financial wealth returned to its pre-crisis level—be it in housing (which seems undesirable and unlikely) or in stocks—and output returned to its trend path, U.S. consumers would still probably save more. The reason is that the crisis has made them more conscious of tail risks —events that are unlikely to occur but, when they do, have devastating consequences. Before the crisis, it was an article of faith that housing prices rarely, if ever, decreased (a belief that was a main contributor to the crisis). Another article of faith, one backed by stronger historical evidence, was that investors could count on stocks yielding an annual rate of return of 6 percent. Last year’s decline in the stock market showed that those yields cannot be taken for granted, and that more saving may be needed to ensure a safe retirement. Thus, U.S consumers are likely to save more, at least until they forget the lessons of the crisis. The best guess (and there is little more to go on) is that the U.S. household saving rate will remain at least at its current level. That means a 5 percentage point decline in the ratio of consumption to disposable income relative to the pre-crisis period, or about a 3 percentage point drop in the ratio of consumption to GDP. Put simply, 3 percent more of U.S. aggregate demand will have to come from something other than consumption. Will it be from investment? This also seems unlikely. Housing investment, as a percentage of GDP, was too high in the years preceding the crisis, and it will take a long time to get rid of the backlog of houses. Until that happens, housing investment will be low. Will fixed investment, again as a percentage of GDP, be higher after the crisis than it was before? Probably not. Capacity utilization is at a historical low, and will take a long time to recover. While banks may be solvent now, they are still tightening credit, and tight lending standards are likely to last a while. Less-efficient financial intermediation will affect not only the supply side, but also the demand side. Again, historical evidence from "creditless" recoveries suggests that investment will be weak for a long time. Can low interest rates help? It is likely that, at any given interest rate, U.S. private domestic demand will be weak for a long time, weaker than it was before the crisis. Note however the qualifier "at any given
308 interest rate." This appears to offer room for some optimism. The short-term riskless rate is lower now than it was in the pre-crisis years. Over the three years before the crisis, the average nominal U.S. treasury bill rate was 4 percent, while the average inflation rate was 3 percent. That resulted in a real—that is, after-inflation—rate of 1 percent. Today, the treasury bill rate is roughly zero and inflation expectations appear anchored around 2 percent. That implies a real rate of around –2 percent—that is, 3 percentage points below its pre-crisis level. The Federal Reserve can leave the policy rate—the federal funds rate—at zero if it needs to, and, because inflation expectations are more likely to increase than to decrease, real rates are likely to remain negative. An old rule of thumb is that a 1 percentage point lower real rate that is expected to remain so for some time leads roughly to a roughly 1 percent increase in aggregate demand. A decrease in the real rate of 3 percentage points would seem sufficient to offset the caution of consumers and firms and sustain the recovery. But it may not be. What matters for demand is the rate at which consumers and firms can borrow, not the policy rate itself. As was clear during this crisis, the rate at which consumers and firms borrow often is a lot higher than the policy rate. Risk premiums on U.S. BBB-rated bonds, for example, are nearly 3 percentage points higher than before the crisis. This higher risk perception may well be an enduring legacy of the crisis. (The Great Depression led to a large increase in the risk premium on stocks, which lasted for the better part of four decades. But the Depression lasted a long time, and this crisis appears unlikely to have the same psychological impact.) Higher risk premiums, then, could undo, at least in part, lower policy rates. U.S. policymakers cannot count on low interest rates alone to deliver a sustained U.S. recovery. Can Asia help? If the U.S. recovery is to take place, if the fiscal stimulus must be phased out, and if private domestic demand is weak, then U.S. net exports must increase. In other words, the U.S. current account deficit must decrease. That means that the rest of the world, now in substantial surplus, must reduce that current account surplus. Where should this reduction come from? It is natural to look first at the countries with large current account surpluses. Among them, most prominently, are Asian countries. And most prominent among them is China. From the point of view of the United States, a decrease in China’s current account surplus would help increase demand and sustain the U.S. recovery. That would result in more U.S. imports, which would help sustain world recovery. Why might China be willing to go along? Because it may well be in its own interest: China’s growth has been based on an export-led growth model that relies on a high saving rate, leading to low internal demand, and a low exchange rate, leading to high external demand. The model has been highly successful, but is leading to the accumulation of extremely large reserves and pressure is building to increase consumption. The high rate of saving reflects the lack of social insurance and the resulting high precautionary saving by households, limited access of households to credit, and governance issues in firms that lead them to retain too high a proportion of their earnings. Providing more social insurance, increasing household access to credit, and improving firms' governance are all desirable on their own, and would lead both to lower saving and higher internal demand. If such an expansion of demand runs into supply-side constraints, this higher internal demand would have to be partly offset by lower
309 external demand, meaning an appreciation of the Chinese renminbi (RMB) at least in real terms. Both higher Chinese import demand and a higher RMB will increase U.S. net exports. Other emerging market Asian countries also run large current account surpluses. Their motivations vary—some want to accumulate reserves as insurance, others chose an export- led growth strategy that incidentally affects the current account and reserve accumulation. Many of these countries could decrease saving, public or private (as the dramatic decline in household saving in Korea since the 1990s demonstrates), and allow their currency to appreciate. That would lead to a shift from external to internal demand and to a reduction in their current account surplus. Their incentives, however, are weaker than China’s. Having substantial reserves has proved very useful in the crisis. Swap lines from central banks, and multilateral credit lines—such as the "flexible credit line" created by the IMF during the crisis—could reduce the demand for reserves. But swap lines and credit lines might not be renewed, and so do not offer quite the same degree of safety as reserves. (Establishing arrangements to substantially reduce reserve accumulation would also be both highly desirable in the long run and would help to sustain the recovery in the short and the medium run.) Thus, countries that have adopted an export-led growth model may reassess that policy and give more weight to internal demand, but any change is likely to be gradual. To get a sense of magnitudes, another rough computation is useful. The GDP of emerging Asia is roughly 50 percent of U.S. GDP (with the ratio projected to increase to 70 percent in 2014). So, if all its trade was with the United States, Asian countries would have to lower their current account position by 4 percent of GDP to improve the U.S. current account by, say, 2 percent of GDP (which represents a 3 percent shortfall in the ratio of consumption to GDP less the 1 percent increase in U.S. demand coming from lower real interest rates). Since emerging Asia’s trade is not all with the United States, the adjustment would likely have to be even larger. This raises the question of whether other countries can and should play a role. What role for non-Asian countries? A number of other countries, including some advanced countries, also have current account surpluses. For example, Germany’s surplus for 2008 is half that of China’s (although it is shrinking fast); Japan’s surplus is one-third of China’s. Should Germany, for example, reduce its surplus? It cannot follow the same route as that suggested for China—that is a currency appreciation accompanied by a decrease in saving. Because it is part of the euro area, Germany cannot engineer an appreciation on its own. And, on the demand side, it suffers largely from the same problem as the United States: it has limited room on the fiscal side, and it is not clear that it is either desirable or feasible to get German consumers to save less. Germany could, however, improve productivity in its nontradable sector, which would be in its interest. This would, in time, lead to a reallocation of demand toward non tradables and reduce its current account surplus. The same argument applies to Japan. But, because such structural reforms are politically difficult, and because their effects take place slowly, it is likely to be a slow process—too slow to provide substantial support to the recovery over the next few years. So, if rebalancing is to come soon, it probably has to come largely from Asia, through a decrease in saving and an appreciation of Asian currencies vis-à-vis the dollar. What if rebalancing does not happen?
310 This tour of the world suggests three conclusions: • First, the crisis is likely to have led to a decrease in potential output. One should not expect very high growth rates in the recovery. • Second, sustained recovery in the United States and elsewhere eventually requires rebalancing from public to private spending. • Third, sustained recovery is likely to require an increase in U.S. net exports and a corresponding decrease in the rest of the world, coming mainly from Asia. One can question all three conclusions. On the supply side, the effect of potential output is highly uncertain. After all, despite the pessimistic historical evidence, some countries have emerged from banking crises without experiencing a visible impact on potential output (on the other hand, though, some countries have seen a long-lasting negative impact not only on the level of GDP, but also on its growth rate). On the demand side, the fiscal space in advanced countries may be larger than expected, allowing the United States to sustain longer-lasting deficits and a higher debt level than currently forecast without raising market concerns about debt sustainability. If this is the case, rebalancing private and public spending can be phased in more slowly if needed, allowing more time to achieve a rebalancing of world demand. Alternatively, private demand in the United States may be stronger: U.S. consumers could return to their old ways and save less. That would help the recovery and avoid the need for a major adjustment of net exports, although it would recreate in the longer run some of the problems that caused the current crisis. Or it could be that the world decouples—that Asia, for example, is able to return to high growth, while recovery in advanced countries falters. But the crisis, and the strong export links that turned a U.S. shock into a world recession, suggests that decoupling, although possible, is unlikely. If, however, one accepts the argument that both rebalancing acts are likely to be necessary for a sustained recovery, the next question is whether they will take place. It is clear that they may not, at least not on the scale needed. If, for example, Asia is unwilling to reduce its current account surplus and U.S. net exports do not substantially improve, weak U.S. private demand may lead to an anemic U.S. recovery. In that case, there would likely be strong political pressure to extend the fiscal stimulus until private demand has recovered. Were that to happen, one can imagine various scenarios: political pressure may be resisted, the fiscal stimulus could be phased out, and the U.S. recovery would then be very slow. Or fiscal deficits might be maintained for too long, leading to issues of debt sustainability and worries about U.S. government bonds and the dollar, and causing large capital flows from the United States. Dollar depreciation may take place, but in a disorderly fashion, leading to another episode of instability and high uncertainty, which could itself derail the recovery. Sustaining the nascent recovery is likely to require delicate rebalancing acts, both within and across countries. An understanding of the issues and the dangers, and some coordination across countries, is likely to be as crucial during the next few years as it was during the most intense part of the crisis. Olivier Blanchard is Economic Counsellor and Director of the IMF’s Research Department. http://www.imf.org/external/pubs/ft/fandd/2009/09/blanchardindex.htm
311 http://blog-imfdirect.imf.org/ Looking Beyond the Crisis Posted on August 27, 2009 by iMFdirect By John Lipsky in Jackson Hole In my first two Jackson Hole blogs, I addressed some of the key challenges to restoring growth. Yet whatever shape the recovery takes once the Great Recession ends, several significant long-term problems will have to be faced if a solid expansion is to be sustained. In particular, the principal sources of growth in many economies will shift, structural hurdles to growth will have to be overcome, the legacy of anti-crisis fiscal policies will have to be dealt with, and the governance of global economic policy will have to adjust to new realities. In other words, the agenda will be packed for many Jackson Hole Symposiums well into the future. At present, growth in the principal economies is being restarted with the help of massive fiscal and monetary stimulus. As has been noted widely, a sustained expansion will require a shift back to private demand. Yet the U.S. recession has been marked by a significant increase in U.S. household saving out of current income that has been associated with the substantial losses in household net worth suffered during the past two years. An immediate result has been weak consumption spending, and a significant decline in the U.S. current account surplus. Not only did these shifts appear to be inevitable even before the current crisis, but they almost certainly are going to be long-lasting. In other words, it was the case prior to the crisis that sustaining a global expansion will require strengthened demand growth outside the United States, an aspect that the current crisis has served to make clear to all. This premise already underpinned the IMF- sponsored Multilateral Consultations on Global Imbalances that took place in 2006/07. The aim of that exercise was to develop mutually consistent policies that would support sustained growth while reducing global imbalances by facilitating an appropriate shift internationally in the sources of growth, especially in economies that have relied on export-led growth. Whether the current crisis might have been moderated if the agreed policy programs had been fully implemented is moot, but the Consultation’s broad policy goals will remain relevant in the post-crisis period. Moreover, IMF research indicating that the current crisis likely will leave a legacy of reduced potential growth was echoed by other Jackson Hole presentations. One implication of this analysis is that prospects for productivity-boosting restructuring and other reforms will assume heightened importance in coming years, as they will be crucial in helping to compensate for the expected dampening impact of the crisis on growth potential. This consideration applies to advanced economies like Japan and those in core Europe, as well to emerging market economies. While the formal program at Jackson Hole this year addressed the impact of fiscal stimulus on economic performance, the participants were well aware of the longer-term fiscal policy challenges that will have to be faced in the coming years, especially in economies with aging populations. Moreover, the large anti-crisis increases in fiscal deficits will leave a leagcy of substantially increased public debt outstanding.
312 As IMF research has underscored, reversing the crisis-related increases in the debt-to-GDP ratio in the G-20 countries will require a substantial and sustained strengthening in budget performance. For example, for advanced economies with debt above 60 percent of GDP, an improvement in the primary balance by a projected 5½ percentage points from 2014 would be needed to reduce the debt-to-GDP ratio back to that benchmark over 15 years. When the anticipated spending increases associated with population aging are taken into account, it is clear that the coming decade will be accompanied by acute budget challenges. The breadth and scope of the evident post-crisis challenges—and the shifting relative roles of advanced and emerging economies—has created an obvious need to reassess the institutions of global governance. The creation of the G-20 Leaders Summit as a new and effective venue for addressing economic and financial issues has been an important crisis- inspired innovation. The upcoming Pittsburgh Leaders Summit no doubt will mandate new efforts to adjust existing institutions, in anticipation of the need to deal decisively with the set of post-crisis challeneges that loomed over the horizon at this year’s Jackson Hole Symposium. Next week, this Blog will explore how the crisis is affecting low-income countries and the IMF’s response. Fixing the Financial System Posted on August 25, 2009 by iMFdirect By John Lipsky in Jackson Hole Despite tentative signs that the global recession is ending, it’s clear that a full recovery will remain inhibited until financial markets are restored to health. While financial market conditions have improved—reflecting among other things massive public sector support— key credit channels remain strained, creating a drag on growth. One of the keys to strengthening financial markets will be to put securitization markets on a sounder footing, an issue I discuss below. Rebuilding active and innovative financial systems will be critical for sustaining a new global expansion. After being propped up by government intervention, a recovering economy increasingly will need to rely on private capital. As confidence and trust are restored, government guarantees will be rolled back gradually, and the crisis-driven expansion in central bank balance sheets will be unwound. The latest financial market developments have provided positive signals. Most markets have strengthened in recent months, and some asset prices are higher today than prior to last September’s severe turmoil. Equity prices have risen notably, while investment grade corporate and sovereign emerging market debt spreads have narrowed, mainly in response to reduced risk perceptions, but in the case of corporate debt also reflecting better-than- expected economic data. However, banks’ willingness and ability to lend remain weak in the euro area, the United Kingdom, and the United States. Credit standards are still being tightened—albeit at a slowing pace—and bank credit growth is meager. At the same time, the increased issuance of corporate bonds largely has been motivated by refinancing and debt restructuring. Thus, the overall deleveraging process does not appear to have reached an end.
313 Regarding banks, the healing process inevitably will involve raising additional capital and writing down impaired assets. This process appears to be further along in the United States than in Europe. However, the stress-testing process under way in the euro area should help to move the healing process forward. Nonetheless, no important acceleration in overall bank credit is expected anytime soon. Reviving securitization markets Securitization markets are still impaired, as issuance remains anemic despite narrower spreads. Gross issuance of securitized instruments by private-sector companies soared from almost nothing in the early 1990s to peak at almost $5 trillion in 2006, before dropping off sharply as the crisis escalated. Issuance is picking up in some specific market segments, but mostly those supported by public intervention. Structured credit markets remain essentially shut. Operations by key central banks—the Federal Reserve, the European Central Bank, and the Bank of England—have helped to support and calm these markets, but the prospects for a rapid return to adequate functionality remains cloudy. Mobilizing otherwise illiquid assets and transferring credit risk away from the banking system to a more diversified set of holders is the underlying justification for securitization. Of course, this market has acquired something of a bad name following the subprime debacle. One of the key problems of the current financial crisis was that several major financial institutions didn’t follow basic tenets of the “originate-to-distribute” model. Not only did underwriting standards deteriorate severely in many key market segments, but many originators didn’t distribute and retained far more risk than was prudent, often in opaque off-balance sheet entities whose relationship to the sponsoring institution was frequently misunderstood. The result was disastrous. In this sense, the market discipline that implicitly should underpin the securitization model simply failed. In restarting these markets, therefore, it will be important that the right balance is struck between allowing financial intermediaries adequate flexibility to create the intended benefits from securitization, while protecting the financial system from the instability that may arise from inadequate risk monitoring and control. There is little doubt that key market participants will have learned brutal lessons about risk management from the events of the past two years, and they are unlikely to simply repeat recent missteps. At the same time, financial regulators and supervisors are working together in various national and international fora on measures that can be taken to make securitized markets more reliable. Regardless of remaining problems, a key point shouldn’t be missed: Securitization markets have become such an important component of the credit creation process, especially in the United States, that restarting them would represent a major contribution to restoring the credit channel. Overhauling regulation Part of the discussion at Jackson Hole this year focused on the extent to which central banks should be involved in financial market regulation. While views differ on this aspect, it is agreed almost universally that the regulation of financial markets and institutions needs to be overhauled. The principal goals are to broaden the regulatory perimeter in order to bring all systemically important institutions under regulatory oversight, to establish more effective tracking of systemic risks, and to promote more robust risk management.
314 In other words, traditional regulation—that focuses almost exclusively on individual institutions and specific financial instruments—should be supplemented by a macroprudential approach that would take account of systemic and cyclical factors. This would create awareness of overall systemic leverage and interconnections and mitigate potential pro-cyclical effects of regulation. Market discipline will need to be strengthened through improved transparency, better governance structures, and more incentive- compatible compensation structures. To maintain a level playing field and alleviate risks of regulatory arbitrage, strengthened international cooperation and coordination will be essential. Some steps are being taken already: • Recent proposals by the United States to bring under stronger supervision large, systemically important firms, such as insurance companies and other financial institutions that are not banks, break new ground. The IMF has also strongly endorsed the ambitious reform of the European Union’s financial stability architecture that was agreed in June. • Institutional arrangements for dealing with impaired assets are being put in place (notably in the United States and the United Kingdom), but difficult operational issues relating to the valuation and disposal of these assets still need to be addressed. • Following rigorous stress tests of balance sheets, viable banks should be quickly recapitalized, if necessary. Insolvent institutions should be promptly intervened, and either closed or merged. The creation of the Financial Stability Board—of which the IMF is a key member—has energized international cooperation regarding regulatory reform. The FSB, working together with member country authorities, standard-setting bodies, and other international institutions —including the IMF—aim to produce concrete proposals in the coming months that would improve systemic stability and market efficiency. This process will not be simple, but there was complete agreement at Jackson Hole that it is critically important. In my next post, I’ll explore the need for rebalancing in the global economy as we emerge from this crisis. Jackson Hole conference: A Grand Teton Perspective. . . Posted on August 24, 2009 by iMFdirect By John Lipsky Every year at this time, senior Federal Reserve officials and central bank heads from around the world gather in Jackson Hole, Wyoming—together with leading economists from universities and the private sector—to hear presentations on key policy topics and to discuss the challenges facing the global economy. The spectacularly beautiful setting at the foot of the Grand Teton mountains provides calm and perspective. Last year’s gathering took place on the eve of historic financial turmoil and subsequent economic downturn. One year later, it is clear that progress is being made to overcome the crisis, but also that many fundamental changes will flow from the past year’s challenges, even though the exact nature and course of these changes remain far from certain. The mountains’ grandeur remains unaltered, of course, providing inspiration while insinuating an appropriate sense of humility.
315 The story of the past year is well known: Faced with the very real possibility of a global financial meltdown, and the reality of the sharpest global economic downturn of the post- World War II period, policymakers around the world responded with a series of unprecedented actions—including massive monetary and fiscal stimulus, plus new governance initiatives. One year later, the signs are clear—if still tentative—of renewed growth, although opinions are divided regarding how effective specific policy actions have been, or about how soon the global economy will regain the pre-crisis level of output, or reestablish pre-crisis trend growth rates. This year’s gathering naturally provided a welcome opportunity to review what has been done, to take stock of where things stand and to assess upcoming challenges. The timing is especially fortuitous, coming just weeks ahead of the Pittsburgh Leaders Summit, and of the IMF-World Bank Annual Meetings in Istanbul. In my blogs this week, drawing among other things on my discussions with colleagues during the Jackson Hole Symposium, I’ll be covering three main topics: • The near term challenges: While the worst has been avoided, the healing process is far from complete. Positive growth prospects for the coming year rest on the assumed implementation of a set of substantial policy actions and on private sector follow-through. Are those assumptions realistic? • Restoring the financial sector: The recovery will remain inhibited until financial markets return to more normal functionality. While there are positive signs—such as the rapid improvement in some emerging market debt and equity markets—many key securitization markets are still impaired. Moreover, public sector aid to financial markets and institutions remains very large, but it is intended that this support will be temporary. What needs to be done to restore markets, and how soon can that occur? • Addressing structural issues: Most important, structural changes in public policies and private markets will be needed in order to resume the unprecedented global growth of the past two decades—the so-called Great Moderation—and to protect against future turmoil. Among other things, this will require an assessment of the anti-crisis actions undertaken during the past year or so. At the same time, the fiscal policy challenges that will face all the advanced economies in the coming years will have to be dealt with, one way or another. What needs to be done in order to address these structural issues? The past year has been notable for both the scale and breadth of the challenges, but also for the speed and scope of the response. As Fed Chairman Ben Bernanke pointed out in his Jackson Hole address, “the world has been through the most severe financial crisis since the Great Depression…. Unlike the 1930s…during the past year monetary, fiscal, and financial policies around the world have been aggressive and complementary.” This aspect has been powerfully reflected in the G-20 Leaders process: Financial turmoil became acute in mid-September, and only two months later, the unprecedented Washington Leaders Summit laid out a detailed action plan. The London Leaders Summit in April underscored the G-20 authorities’ determination to act decisively and cooperatively to reverse the global downturn. More upbeat Without any doubt, the mood in Jackson Hole was more upbeat than it would have been even a few months ago. Policymakers and central bankers can see that global growth
316 prospects are reviving, and they sense that their actions are bearing fruit. Second quarter data for the largest advanced and emerging economies show either positive GDP growth or moderating rates of decline. Financial markets reflect a sharply improved assessment of overall risks. At this point, the global economy appears to be on a track consistent with the Fund’s World Economic Outlook (WEO). The WEO forecast anticipates a return to moderate global growth of around 2.5% in 2010, following a contraction of about 1.5% this year. Considering the risks faced a year ago, this is not a small achievement. However, even this moderate outcome can’t be taken for granted. As the IMF’s recent Fiscal Monitor, “The State of Public Finances: A Cross-Country Fiscal Monitor,” points out, a substantial proportion of the discretionary spending measures pledged as part of the G20 support efforts—and assumed in the WEO forecast—are still to come. At the same time, a revival of private sector spending—including both consumption and business investment—will be essential for the recovery to take hold. That will require the normal cyclical incentives of profitable prospects and attractive financing. With inflation threats distant, there is little doubt that central bankers intend to keep policy interest rates very low for some time to come: one takeaway from Jackson Hole this year was policymakers’ consensus to sustaining the current monetary stimulus, and to stand ready to act further, if needed. This is true regardless of the uncertainty about the potency of accommodative monetary policy under current circumstances. Moreover, opinions diverge about the efficacy of so-called unconventional measures. Forging consensus Over the past thirty years, the Jackson Hole Symposium played a notable role in forging a consensus among monetary authorities on the conduct of monetary policy, as the Taylor Rule and inflation targeting approaches supplanted an earlier focus on monetary aggregates. The current crisis has raised questions about whether a classic Taylor Rule or inflation targeting regimes are sufficient (if augmented by reformed financial regulation) to avoid future financial instability. For sure, there is virtually unanimous support for an overhaul of financial regulation. As always in these matters, however, the devil is in the details, and much work remains to be done. In my next post, I’ll discuss the efforts under way to restore the banking sector and financial markets, particularly securitization markets, without which any rebuilding effort will be incomplete. Looking ahead, additional hurdles will have to be faced. As the Fund’s Economic Counselor Oliver Blanchard has discussed recently in the IMF’s Finance & Development magazine, the crisis may leave a painful legacy of reduced potential growth. At the same time, the inevitable renormalization of the U.S. household saving rate implies that domestic demand gains elsewhere—particularly in emerging Asia—likely will be required in order to reestablish and sustain a strong global expansion. Moreover, the past year’s events has brought into higher relief the fiscal policy challenges facing the advanced economies in the coming years as a result of the prospective buildup of public indebtedness. I’ll address these issues in a subsequent post.
317 Global economic crisis Fully Spend Stimulus Money to Back Crisis Recovery, Says IMF IMF Survey online June 26, 2009 • Signs of recovery need to be supported by continued stimulus • IMF sees advanced economies still struggling to recover • Lipsky urges governments to ensure planned spending is fully implemented The IMF is urging governments to fully implement the spending measures they have announced to combat the global economic crisis and not to relax in supporting an incipient recovery. “The latest economic news from around the world gives some reason for cautious optimism,” said John Lipsky, the IMF’s First Deputy Managing Director, in a speech in Paris on June 26. “Tentative signs are emerging that the rate of decline in global output is moderating and that financial conditions are improving.” Speaking at an IMF-organized conference, Lipsky said it was far too early to draw firm conclusions. But he said this news “offers positive reinforcement for the unprecedented efforts under way to resist the unprecedented challenge. After all, the breadth and severity of the financial crisis and economic slowdown are the most serious experienced since the 1930s.” Nevertheless, he said that ongoing policy support would be crucial in laying down firmer foundations for renewed growth, including the restoration of financial sector health. Caution warranted Lipsky said policymakers around the world had responded with flexibility and ingenuity, using all the weaponry available in their arsenal, including large-scale fiscal stimulus, very accommodative monetary policy, plus strong and often innovative support for the financial sector. “The speed and magnitude of the policy response no doubt played a key role in beginning to turn around market sentiment, in slowing the decline in economic activity, and in truncating the downside risks,” he told the conference. But while clear signs of recovery are visible in some emerging markets, particularly in Asia, the recovery still appears to be struggling to become established in most advanced economies, Lipsky stated. Countries should not relax their fiscal stimulus measures. “Regarding fiscal policy, the implementation of the announced stimulus measures is an incomplete challenge.” Actual spending falls short Lipsky said that although experience varied across countries and programs, actual spending of announced stimulus measures was relatively low in many cases. In the United States, for example, while payroll tax cuts had been implemented relatively quickly, only $46 billion or 11 percent of authorized spending measures, had taken place through mid-May, concentrated in health and human services. “It is straightforward to conclude that the spending measures already announced must be implemented if they are to support the incipient recovery. Moreover, if the signs of
318 recovery turn out to be a false dawn, consideration may need to be given to providing additional stimulus,” he added. The IMF, which has forecast an end to the recession later this year, with a recovery in 2010, will give its latest projections for global economic growth on July 7. Boosting lending Lipsky said that on the monetary front, despite some normalization of inflation expectations, monetary policy should remain accommodative for the time being, including through “unconventional measures” where needed. Together with budgetary support, low policy interest rates and steeper yield curves help strengthen financial institutions’ earnings and balance sheets, which would hopefully boost lending to the private sector. “Monetary policy has been relatively successful in normalizing conditions in money markets, but has had less influence over longer term interest rates. Similarly, efforts to stimulate bank lending and restart securitization markets must contend with a more fundamental lack of confidence among creditors,” he added. Start thinking about exit strategies Lipsky raised the issue of how to unwind the stimulus measures once they have been effective in reviving growth. “As the danger of a total financial system collapse has ebbed, we need to avoid new vulnerabilities further down the road. We also need to start preparing a clear exit strategy for government intervention in both the fiscal and monetary areas,” he said. “The deployment of numerous instruments to stimulate demand and support the financial sector, together with the operation of automatic stabilizers—all essential to avoid a much more serious crisis—leave at the same time a legacy of fast growing government liabilities and bring us to uncharted territory,” Government debt is now projected to grow at a rapid pace for several years, and in the case of several advanced economies, approach the highest level since World War II. Policymakers must navigate skillfully between avoiding a premature withdrawal of fiscal stimulus that would nip the recovery in the bud, and, on the other hand, allowing debt to increase to levels that would cause concerns about fiscal sustainability, Lipsky added. Comments on this article should be sent to [email protected] http://www.imf.org/external/pubs/ft/survey/so/2009/POL062609A.htm
319 PRESS RELEASE 19 August 2009 - Euro area balance of payments (June 2009) In June 2009 the working day and seasonally adjusted current account of the euro area recorded a deficit of EUR 5.3 billion. In the financial account, net inflows of EUR 37 billion (non-seasonally adjusted) were observed in combined direct and portfolio investment. Current account The working day and seasonally adjusted current account of the euro area recorded a deficit of EUR 5.3 billion in June 2009 (corresponding to a deficit of EUR 0.3 billion in non- adjusted terms). This reflected deficits in current transfers (EUR 5.2 billion) and income (EUR 2.8 billion), which were partly offset by surpluses in goods (EUR 2.2 billion) and services (EUR 0.5 billion).
Preliminary results for the second quarter of 2009 show a deficit of EUR 11.5 billion in the seasonally adjusted current account (corresponding to a deficit of EUR 21.5 billion in non- adjusted terms). The 12-month cumulated, working day-adjusted current account recorded a deficit of EUR 122.6 billion (around 1.3% of euro area GDP) in June 2009, compared with a deficit of EUR 34.5 billion a year earlier. This increase was due to the goods account shifting from a surplus (EUR 24.7 billion) to a deficit (EUR 9.6 billion), increases in the
320 deficits in income (from EUR 15.8 billion to EUR 43.6 billion) and current transfers (from EUR 94.9 billion to EUR 98.3 billion), and a decrease in the surplus in services (from EUR 51.4 billion to EUR 28.9 billion). Financial account In the non-seasonally adjusted financial account, net inflows were observed in June 2009 in combined direct and portfolio investment (EUR 37 billion), as the net inflows in portfolio investment (EUR 45 billion) significantly exceeded the net outflows in direct investment (EUR 9 billion). The net outflows in direct investment resulted mainly from net outflows in other capital (mostly inter-company loans) (EUR 10 billion) , which were partly offset by net inflows in equity capital and reinvested earnings (EUR 2 billion). Looking at the subcomponents of portfolio investment, net inflows were recorded in debt instruments (EUR 45 billion), mainly reflecting non-residents’ net purchases of euro area bonds and notes (EUR 55 billion), which were only partly offset by non-residents’ net sales of euro area money market instruments (EUR 10 billion). Financial derivatives recorded net inflows of EUR 9 billion. Other investment recorded net outflows of EUR 53 billion, mainly as a result of net outflows for the Eurosystem (EUR 46 billion) and other sectors (EUR 7 billion). Reserve assets were close to balance (excluding valuation effects). The Eurosystem’s stock of reserve assets stood at EUR 382 billion at the end of June 2009. In the 12-month period to June 2009 cumulated net inflows of EUR 439 billion were observed for combined direct and portfolio investment, compared with net outflows of EUR 55 billion for the preceding 12-month period. This shift resulted mainly from a substantial rise in net inflows in portfolio investment (from EUR 90 billion to EUR 599 billion), largely reflecting a shift from net outflows (EUR 60 billion) to net inflows (EUR 287 billion) in money market instruments. The rise in net inflows in portfolio investment was, to a limited extent, offset by an increase in net outflows in direct investment (from EUR 144 billion to EUR 160 billion). Data revisions In addition to the balance of payments for June 2009, this press release incorporates revisions for May 2009. These revisions have not significantly altered the figures published previously.
321 Additional information on the euro area balance of payments and international investment position A complete set of updated euro area balance of payments and international investment position statistics is available in the “Statistics” section of the ECB’s website under the headings “Data services”/“Latest monetary, financial markets and balance of payments statistics” . These data, as well as historical euro area balance of payments time series, can be downloaded from the ECB’s Statistical Data Warehouse (SDW) . Data up to June 2009 will also be published in the September 2009 issues of the ECB’s Monthly Bulletin and Statistics Pocket Book. A detailed methodological note is available on the ECB’s website. The next press release on the euro area monthly balance of payments will be published on 18 September 2009. Annexes Table 1: Current account of the euro area – working day and seasonally adjusted data Table 2: Monthly balance of payments of the euro area – non-seasonally adjusted data European Central Bank Directorate Communications Press and Information Division Kaiserstrasse 29, D-60311 Frankfurt am Main Tel.: +49 69 1344 7455 , Fax: +49 69 1344 7404 Internet: http://www.ecb.europa.eu Reproduction is permitted provided that the source is acknowledged. PRESS RELEASE 19 August 2009 - Euro area balance of payments (June 2009)http://www.ecb.int/press/pr/stats/bop/2009/html/bp090819.en.html
322 Table 1: Current account of the euro area (EUR billions; transactions; working day and seasonally adjusted data) Cumulated figures for the 12-month 2008 2009 period ending June 2008 June 2009 July Aug. Sep. Oct. Nov. Dec. Jan. Feb. Mar. Apr. May June CURRENT ACCOUNT -34.5 -122.6 -6.3 -9.8 -7.5 -10.2 -18.1 -15.0 -21.7 -12.7 -10.0 -6.1 -0.1 -5.3
Credit (exports) 2,767.5 2,494.5 232.2 232.9 231.3 227.2 220.6 206.0 197.1 194.2 190.1 187.6 190.1 185.2
Debit (imports) 2,802.0 2,617.1 238.5 242.7 238.7 237.4 238.7 221.0 218.8 206.9 200.1 193.7 190.2 190.5
Goods 24.7 -9.6 -0.7 -2.2 0.1 3.1 -4.0 -2.9 -8.1 -1.1 -1.1 2.5 2.9 2.2
Credit (exports) 1,570.4 1,401.6 135.2 135.0 133.3 130.9 120.9 114.8 107.3 106.9 105.2 104.1 103.5 104.6
Debit (imports) 1,545.7 1,411.2 135.9 137.2 133.3 127.8 124.9 117.7 115.4 108.0 106.3 101.7 100.6 102.4
Services 51.4 28.9 2.8 4.2 2.2 1.8 2.5 4.2 2.3 1.6 0.8 3.0 2.9 0.5
Credit (exports) 505.4 485.7 40.5 43.0 42.3 42.5 42.8 40.4 41.5 39.4 39.2 38.7 38.6 36.9
Debit (imports) 454.0 456.8 37.7 38.8 40.0 40.7 40.3 36.2 39.2 37.8 38.3 35.7 35.6 36.4
Income -15.8 -43.6 -1.0 -3.2 -2.8 -5.8 -8.1 -7.5 -5.6 -5.9 0.1 -3.0 2.0 -2.8
323 Credit (exports) 600.7 525.9 49.5 49.6 48.7 46.3 49.6 43.0 42.3 40.0 39.3 38.6 41.7 37.3
Debit (imports) 616.6 569.5 50.5 52.8 51.5 52.1 57.7 50.5 47.9 45.9 39.1 41.5 39.7 40.1
Current transfers -94.9 -98.3 -7.3 -8.5 -7.0 -9.2 -8.5 -8.8 -10.2 -7.2 -9.8 -8.6 -7.9 -5.2
Credit (exports) 90.9 81.3 7.0 5.3 7.0 7.4 7.3 7.7 6.0 7.9 6.6 6.2 6.4 6.4
Debit (imports) 185.7 179.6 14.3 13.8 13.9 16.7 15.8 16.5 16.2 15.1 16.4 14.8 14.3 11.6 Source: ECB. http://www.ecb.int/press/pr/stats/bop/2009/html/bp090819_t1.en.html
324 Table 2: Monthly balance of payments of the euro area (EUR billions; transactions; non−seasonally adjusted data) Cumulated figures for May 2009 June 2009 the 12-month period ending (revised) June 2008 June 2009
Net Credit Debit Net Credit Debit Net Credit Debit Net Credit Debit Source: ECB. ( 1 ) Financial account: inflows (+); outflows (−). Reserve assets: increase (−); decrease (+). ( 2 ) Direct investment: assets refer to direct investment abroad and liabilities to direct investment in the euro area. CURRENT -33.0 2,768.1 2,801.2 -116.5 2,494.4 2,610.8 -11.9 184.3 196.2 -0.3 192.8 193.1 ACCOUNT Goods 26.6 1,572.2 1,545.6 -9.1 1,400.8 1,409.9 2.2 99.2 97.1 4.7 107.7 102.9 Services 50.9 505.2 454.4 29.2 485.4 456.3 3.6 37.3 33.7 2.8 39.1 36.3 Income -16.9 599.3 616.2 -39.0 524.5 563.5 -11.4 42.0 53.4 -5.0 39.7 44.7 Current transfers -93.6 91.4 185.0 -97.6 83.6 181.2 -6.2 5.8 12.0 -2.9 6.3 9.2
CAPITAL 16.0 29.5 13.5 6.9 18.5 11.6 0.2 0.9 0.7 0.3 1.1 0.9 ACCOUNT
325
Balance Assets Liabilities Balance Assets Liabilities Balance Assets Liabilities Balance Assets Liabilities FINANCIAL 136.7 352.6 26.6 -7.4 ACCOUNT1) DIRECT -144.1 -441.6 297.5 -160.4 -304.6 144.3 4.8 -14.3 19.0 -8.5 -15.6 7.1 INVESTMENT2) Equity capital and -125.5 -299.9 173.8 -59.1 -195.6 137.0 -2.7 -7.7 5.0 1.7 -8.4 10.0 reinvested earnings Other capital (mostly inter- -17.6 -141.7 123.7 -102.2 -109.0 7.2 7.5 -6.6 14.1 -10.2 -7.2 -3.0 company loans) PORTFOLIO 89.5 -338.9 428.4 599.4 283.3 316.0 58.0 -8.9 66.9 45.2 -2.2 47.5 INVESTMENT Equity 2.3 -26.3 28.6 -1.8 130.2 -132.0 8.5 -3.0 11.5 0.4 -4.8 5.3 Debt instruments 87.2 -312.6 399.8 601.2 153.1 448.1 49.5 -5.9 55.4 44.8 2.6 42.2 Bonds and notes 146.9 -222.2 369.1 314.0 91.7 222.3 56.1 0.1 55.9 54.6 -1.1 55.8 Money market -59.7 -90.4 30.6 287.2 61.4 225.8 -6.6 -6.0 -0.5 -9.8 3.8 -13.6 instruments MEMO ITEM: COMBINED DIRECT AND PORTFOLIO INVESTMENT -54.7 -780.5 725.8 439.0 -21.3 460.3 62.8 -23.2 86.0 36.7 -17.8 54.5 FINANCIAL -75.5 16.6 10.4 9.2 DERIVATIVES (NET) OTHER INVESTMENT 271.6 -490.2 761.8 -107.5 564.4 -671.9 -44.4 153.5 -197.9 -53.0 29.6 -82.6 Eurosystem 103.2 -7.8 111.0 57.6 10.0 47.6 -20.2 -0.0 -20.2 -45.6 -5.3 -40.2 General government 11.1 15.7 -4.6 11.9 5.8 6.1 -3.6 -3.8 0.1 -4.4 -1.8 -2.6 of which: currency and 9.9 9.9 6.4 6.4 -3.7 -3.7 -1.2 -1.2 deposits
326 MFIs (excluding the 198.1 -247.1 445.3 -168.5 463.5 -632.0 -2.1 64.6 -66.7 4.3 56.8 -52.5 Eurosystem) Long-term -182.3 -197.4 15.1 -188.4 -107.9 -80.5 -15.4 -3.8 -11.6 -21.5 -17.1 -4.4 Short-term 380.4 -49.8 430.2 19.8 571.4 -551.5 13.4 68.4 -55.0 25.9 74.0 -48.1 Other sectors -40.8 -251.0 210.1 -8.4 85.2 -93.6 -18.5 92.8 -111.2 -7.4 -20.1 12.7 of which: currency and 48.1 48.1 30.4 30.4 21.2 21.2 -4.9 -4.9 deposits RESERVE ASSETS -4.8 -4.8 4.5 4.5 -2.3 -2.3 -0.3 -0.3 Errors and omissions -119.6 -243.0 -15.0 7.4
Address encoded for mobile use http://www.ecb.europa.eu/press/pr/stats/bop/2009/html/bp090819_t2.en.html http://www.ecb.int/press/pr/stats/bop/2009/html/bp090819_t2.en.html
327 SPIEGEL International 26/08/2009 01:06 PM Risks and Rewards Europe Launches Major Push for New Banker Bonus Rules France, Germany and the EU are launching a major offensive to change the system of bonuses paid out to bank employees. Knowing that it won't work anywhere if it isn't implemented everywhere, they are hoping to make it a major issue at the upcoming G-20 summit in Pittsburgh. The debate surrounding bankers' bonus payments has finally reached Brussels. In an interview with the daily Hamburger Abendblatt, European Commissioner for Enterprise and Industry Günter Verheugen said that the European Union will reach an agreement very soon on limiting the income of bank managers. Verheugen also told the paper that the European Commission believes that, when it comes to a bank's system of compensation, there should be "no direct relation with a company's short-term profits." Instead, he is confident that the EU's member states and parliament will be able to reach a swift agreement on the issue. Likewise, Verheugen also voiced his support for measures to impose high taxation rates on the bonuses of bankers whose companies receive state support. "What we're really talking about here," Verheugen told the paper, "is figures arising when a company has been kept alive by the state for a long time." Enter Sheriff Sarkozy France, in particular, has joined Germany as one of the countries trying to impose the toughest restrictions on executive compensation. On Tuesday, French President Nicolas Sarkozy announced that Paris will impose strict controls on the bonuses banks pay to their employees. Following a meeting with France's leading bankers and the French Banking Federation, Sarkozy said that bank employees should also be held accountable for poor performance by having their bonus payments reduced. Sarkozy stressed, however, that the system would only work if it were implemented on the international stage. "Everyone understands that these limits can only be international," Sarkozy said. "If we just decided to limit them to France, everyone would leave." Sarkozy is pushing for an international agreement on the issue at the Group of 20 meeting of industrialized and developing countries to be held in Pittsburg on Sept. 24-25. France's plan calls for Michel Camdessus, the former managing director of the International Monetary Fund (IMF), to review the bonuses paid out to stockbrokers and, in particular, those on a list of the 100 highest-paid traders at each French bank. In the future, a large part of bonus payments will be withheld and paid out over three years. The system also envisions a "malus" element, which would penalize traders by reducing the amount of the withheld bonus for investments that turned out to be money-losers. Sarkozy also warned that, "We will not work with banks that do not apply these rules," meaning that banks that prefer to not play by these rules will be shut out from state- sponsored financing opportunities.
328 Even France's banks have welcomed the plans so far. Baudouin Prot, the incoming head of the French Banking Federation and the chief executive of France's largest bank, BNP Paribus, said after the meeting that the banks would implement the malus system for brokers who caused losses and that the banks needed to strengthen both controls and transparency. Prot stressed, however, that such a system could not be put into effect "in just one country" because it would encourage banks to take their business elsewhere and thereby only benefit others. Reducing Risky Business Through a spokesman, Sarkozy stressed that he wanted to bring a "strong message" to the G-20 summit that France wants to have "more regulation of the international financial markets and limits placed on payments" to bank employees. In a meeting with his cabinet, according to Housing Secretary Benoist Apparu, Sarkozy underlined that it shouldn't be possible for "bankers to stuff their pockets" in an era when the global financial crisis has cost thousands of people their jobs. "No one has forgotten that the financial sector is at the origin of this crisis," Sarkozy said in his meeting Tuesday with bankers, according to the Associated Press. The controversy surrounding bank bonus payments was rekindled in early August when reports surfaced claiming that BNP Paribas was setting aside €1 billion ($1.43 billion) for investment-banker bonuses despite the fact that it had received €5 billion in state support. However, France's central bank has declared that the bonus plan did not violate the regulations G-20 nations agreed to at a summit held in February in London. In February, French banks had already agreed to extend bonus payments over longer periods of time and to put limits on so-called guaranteed bonuses, which are paid out irregardless of performance. Germany 's Position The French proposals have found a cheerleader in Germany in the form of Finance Minister Peer Steinbrück. In a statement released earlier in the month, Steinbrück noted that: "There shouldn't be any more excessive pay and false incentives for exaggerated risk. So it's right for banking regulators to be putting the spotlight on payment rules." On Wednesday, he told the business daily Handelsblatt that he will be joining France in pushing to get the issue on the agenda for the G-20 meetings. Steinbrück went on to tell the paper that several bankers have "just not gotten the message." "When even those who were involved," he said, "don't think that they share some responsibility for the safety and legitimacy of the system of the social market economy, then they can't be helped." At the same time, Steinbrück did note that he did not think putting direct caps on bonus payments was the right approach and that, instead, he preferred to use taxes as a means of influencing such payments. "I am for tax-related limits," he said, "but I am also aware that there might be certain legal issues related to how such additional claims might not be allowed by private contract law." wal/jtw - with wire reports URL: http://www.spiegel.de/international/business/0,1518,645044,00.html
329 MONDAY, AUGUST 17, 2009 Fed: Delinquency Rates Surged in Q2 2009 by CalculatedRisk on 8/17/2009 02:42:00 PM The Federal Reserve reports that delinquency rates rose in Q2 in all categories.
Click on graph for larger image in new window . http://3.bp.blogspot.com/_pMscxxELHEg/Somk5uC1ISI/AAAAAAAAGHw/ 3pn4mWZB_H0/s1600-h/DelinquencyRatesQ22009.jpg
This graph shows the delinquency rates at the commercial banks for residential real estate, commercial real estate and consumer credit cards.
Commercial real estate delinquencies (7.91%) are rising rapidly, and are at the highest rate since the early '90s (as delinquency rates declined following the S&L crisis). Residential real estate (8.84%) and consumer credit card (6.7%) delinquencies are at the highest levels since the Fed started tracking the data (since Q1 '91). Although there is credit deterioration everywhere, the rise in these three categories is especially significant. There was also a significant increase in C&I delinquencies (commerical & industrial) and Agricultural loans.
Note: The Fed defines commercial as "construction and land development loans, loans secured by multifamily residences, and loans secured by nonfarm, nonresidential real estate", and many of the problems are probably in the C&D loans. These are the loans that will lead to the closure of many more regional banks. Also check out the charge-off rates. The charge-off rate for residential real estate increased from 1.81% to 2.34%, and for consumer credit cards from 7.64% to 9.55%! Ouch!!! http://www.calculatedriskblog.com/2009/08/fed-delinquency-rates-surged-in- q2-2009.html
330 vox Research-based policy analysis and commentary from leading economists Why this new crisis needs a new paradigm of economic thought
Keiichiro Kobayashi, 24 August 2009
Do the US and Europe risk repeating Japan’s lost decade? This column warns that if the US or European financial clean-ups falter, they will be vulnerable to recurring financial crises. It argues that macroeconomic models should not treat finance as an innocuous veil and calls for a new approach that places financial intermediaries at the centre of its models. The policies being debated in the US and Europe today are almost identical to those that played out in Japan a decade or so ago. Japan experienced the collapse of its colossal property bubble in 1990 and then a series of crises as major banks and securities companies were overwhelmed by rapidly rising non-performing debts. The conventional wisdom among economists and politicians throughout the 1990s was that massive public expenditure and extraordinary monetary easing would give the necessary boost to market sentiments and prompt an economic recovery. Public opinion in the US and Europe today seems to be the same. And indeed, throughout the 1990s, Japan did introduce major public works projects and tax cuts, yet the economy failed to stabilise, asset prices continued to fall, and the volume of non-performing debts continued to climb. Far from being dispelled, the sense of insecurity that had permeated the markets actually increased throughout the 1990s, ultimately leading to the collapse of several major financial institutions in 1997 and sparking an outbreak of panic. Even after this, recovery efforts continued to be channelled through large-scale public expenditure, while the disposal of non-performing debts became bogged down. Only around 2001 did Japanese public opinion finally turn away from the belief that reductions in bad debt and financial system stability would follow an economy recovery. The public came to understand that the financial system had to be stabilised and market insecurity dispelled before any recovery could occur. Special inspections were conducted repeatedly by financial regulators and Japanese megabanks were forced to accept massive capital increases and a new round of mergers. Meanwhile, the Resolution and Collection Corporation and the Industrial Revitalisation Corporation of Japan restructured companies that had collapsed under enormous debt burdens and finally broke the back of the non-performing debt problem. This sparked a recovery of market confidence, and Japan enjoyed a period of economic expansion from 2002 to 2007. Japan redux? Mainstream opinion in the US and other countries today appears to be similar to the thinking that dominated Japan during the 1990s. The general public, for the most part, have not bought into the theory that stabilising the financial system through means such as temporarily nationalising banks and rehabilitating debt-ridden borrowers is a necessary prerequisite for achieving an economic recovery. In a VoxEU column published on 1
331 April, I emphasised that there is a danger in expecting too much from fiscal policy. Rehabilitating the US financial system through the disposal of non-performing assets is essential for a global economic recovery. Princeton University Professor Paul Krugman commented on my column at his New York Times blog, claiming that the belief that stabilising the financial system is a necessary precondition for economic recovery is questionable. He said that if bank reform were the major factor in Japan’s economic recovery, capital investment should have increased, yet the Japanese data shows no increase in capital investment during the recovery period. My response is that stabilising the financial system alleviated the funding constraints that were making it difficult for companies to meet their working capital needs. As several recent studies show (see, for example, Chari, Kehoe and McGrattan 2007), loosening financial constraints on working capital causes productivity to rise and enables an increase in output and employment, but it does not necessarily result in higher capital investment. There is no contradiction between the Japanese data showing non-increasing capital investment and the hypothesis that stabilising the financial system was a factor behind Japan's economic recovery. The challenge for macroeconomics The essence of the debate is whether economic recovery and stabilisation of the financial system are two distinct and unconnected events. The prevailing view is something like – the framework within which we need to engineer a global economic recovery is macroeconomics. Since current macroeconomic theory deals only with Keynesian policy (fiscal and monetary policy), the only tools we have are fiscal and monetary expansion. The disposal of non-performing assets and injection of capital are necessary steps in stabilising the financial system, but to the best of our knowledge there is no clear link between this and a macroeconomic recovery. However, if we achieve an economic recovery through fiscal and monetary policy, the volume of non-performing assets will ease, eliminating the need for policies specifically designed to dispose of bad assets. The experience of Japan in the 1990s would seem to indicate that these expectations are misplaced. Further evidence is provided by Sweden, which experienced its own asset bubble collapse around the same time that Japan did, but recovered much more quickly after Swedish policymakers designed a surgical bad-asset restructuring. Signs of economic recovery are now emerging and fears of the crisis overwhelming the world economy are starting to fade. Yet if the policy responses of US and European governments toward the disposal of non-performing assets begin to falter, the financial systems of Europe and the US will once again be vulnerable to recurring financial crises, which Japan experienced repeatedly in the 1990s. There have been those who have recognised that cleaning up banks’ balance sheets and rehabilitating debtors are necessary preconditions for an economic recovery, but this recognition has been based purely on empirical principles. The existing theoretical structure of macroeconomics is incapable of addressing macroeconomic performance and the stability of the financial system in an integrated context. For example, in the standard New Keynesian or Neoclassical macroeconomic models, the economic agents are the household, corporate, and government sectors, and the financial sector is simply treated as an innocuous veil between these three sectors. The issue of non- performing assets is invariably viewed as a microeconomic issue related to the banking industry.
332 In fact, the crisis we are currently experiencing may call for a change in the theoretical structure of macroeconomics. In my view, a macroeconomic approach that encompasses financial intermediaries and places them at the centre of its models is necessary. The new approach should satisfy three requirements: • The focus should be on the function of financial institutions as media of exchange and the conditions that might cause payment intermediation to malfunction. Perhaps this kind of macro model can be built on the framework of the monetary theory of Lagos and Wright (2005), which explicitly considers the role of money as a medium of exchange. • The new macroeconomic approach should provide a unified framework for discussing the cost and effectiveness of various policy responses to the current global crisis in an integrated context, in which fiscal policy, monetary policy, and bad asset disposal can be compared and relative weightings can be given to all three. • To provide a unified framework for policy analysis, the new approach should make it easy to embed a model of financial crises into the standard business cycle models (i.e., the dynamic stochastic general equilibrium models). I have elsewhere attempted to construct a theoretical model that satisfies these requirements, in which I assume that assets such as real estate now function as media of exchange given the development of liquid asset markets but are unable to fulfil this function during a financial crisis (see Kobayashi 2009a). With a model like this, we can regard a financial crisis as the disappearance of media of exchange, which triggers a sharp fall in aggregate demand. In this case, both macroeconomic policy (fiscal and monetary policy) and bad asset disposals can be understood as responses targeting the same goal – restoring the amounts of media of exchange (inside and outside monies). Thus we can compare and analyse these policies in an integrated context. Bad asset disposal should not be left to financial community insiders If macroeconomic policy and financial stabilisation through bad asset disposals are designed to eradicate the same externality, financial stabilisation is not just a problem for the financial community – it is crucial for the recovery of the overall economy. Therefore, the design and execution of policies capable of disposing of non-performing assets are not tasks that should be left to financial community insiders. We need to openly discuss what financial stabilisation policies should look like (for practical lessons on the policy package from Japan’s experience, see Kobayashi 2008, 2009b). Bad asset disposals including capital injections for financial institutions (or temporary nationalisation) and the rehabilitation of debt-ridden borrowers must be considered alongside fiscal stimuli and monetary easing, with a new awareness that they also constitute macroeconomic policies. Perhaps, we need to adopt a new paradigm of economic thought. References Chari, V. V., P. J. Kehoe, and E. R. McGrattan (2007). "Business Cycle Accounting," Econometrica, vol. 75(3), pages 781-836, 05. Kobayashi, K. (2008). “Financial Crisis Management: Lesson from Japan’s Failure.” VoxEU.org, 27 October 2008. Kobayashi, K. (2009a). “Financial Crises and Assets as Media of Exchange.” Mimeo. Kobayashi, K. (2009b). “Some Reasons Why a New Crisis Needs a New Paradigm of Economic Thought.” RIETI Report No.108 July 31, 2009 Lagos, R., and R. Wright (2005). “A unified framework for monetary theory and policy analysis.” Journal of Political Economy 113 (3): 463–484. http://www.voxeu.org/index.php?q=node/3897
333 MARKETS Eliminate financial double-think By Gillian Tett Published: August 20 2009 15:17 | Last updated: August 20 2009 15:17 A decade ago, it was fashionable for western consultants, bankers and business people to decry Japan’s domestic service industry. For Japanese business sectors, ranging from milk production to financial broking, have long been plagued by complex distribution chains and numerous middlemen. So, Anglo-Saxon consultants – such as McKinsey – would regularly urge the Japanese to reform their distribution chains, and flourish data showing how much more “efficient” the US was than Japan in sectors such as retailing. Back then, I was working in Tokyo as a reporter. So I dutifully reported those studies- cum-sermons on the evils of middlemen. However, amid all that debate about American efficiency, one point that western commentators almost never discussed was the proliferation of middlemen in America’s financial world. If you were to sketch a map of how credit has been sliced and diced in 21st century banking, for example, there would be so many stages – and commission-hungry middlemen – in that process, the Japanese dairy industry might seem positively rational. Yet, for many years the apparent contradiction went almost entirely unnoticed, by western politicians, bankers, and consultants alike. Middlemen were regarded as bad in Japan; but they were somehow overlooked in America’s financial world. Why? The obvious answer is that the banking sector has been very powerful. Three decades ago, Pierre Bourdieu, a French sociologist, observed that elites in a society typically maintain their power not simply by controlling the means of production (ie money), but by dominating the cultural discourse too (ie a society’s intellectual map). And what is most important in relation to that cognitive map is not what is overtly stated and discussed – but what is left unstated, or ignored. Or as he wrote: “The most successful ideological effects are those which have no need of words, and ask no more than a complicitous silence.” The western financial system is a powerful case in point. For the first seven years of this decade, most politicians, voters (and journalists) effectively ignored the extraordinary revolution brewing in the debt and derivatives world, because these areas of finance were widely (and wrongly) believed to be very boring, or so complex they could only be understood by a tiny technocratic elite. That essentially left bankers free to operate with minimal external scrutiny. It also meant there was little discussion about the inconsistencies that plagued the free-market rhetoric – or intellectual map – that ruled the day. And these paradoxes were numerous. One of the founding principles of free market theory, for example, is the idea that markets work best when there is a free flow of information.
334 Yet, some of those bankers who have been promoting free market rhetoric in recent years have also been preventing the widespread dissemination of detailed data on, say, credit derivatives prices. Similarly, while bankers have taken the idea of creative destruction as an article of faith, in terms of how markets are supposed to work, they have been operating on the assumption that their own industry would never suffer too violent a wave of creative destruction. And securitisation has produced a particularly curious – or absurd – paradox. A few years ago, it was widely assumed that the process of slicing and dicing credit would create a more “complete”, free-market financial system. But by 2005, credit products had become so complex and bespoke, that most never traded at all. Thus they had to be valued according to models, since they could not even be priced in a market – in a supposed free- market system. These days such paradoxes look so extraordinary that it is hard to believe they went unnoticed for so long. But the really interesting question about all this “complicitous silence”, as Bourdieu says, is not simply why it arose in the past – but what it implies about the future. After all, one reason why this double-think persisted for so long is that bankers and policy makers alike have all been trained in recent years to take economic theories at their face value, shorn from social context, or power structures. But if regulators and politicians are to have any hope of building a more effective financial system in future, it is crucial that they start thinking more about power structures, vested interests and social silence. That might sound like an irritatingly abstract or pious plea. However, it has some very practical implications about how policy is formulated. I will seek to flesh out some of those in next week’s column, in relation to some striking ideas being quietly developed by a few financial officials, such as Adair Turner, Britain’s chief regulator (and, by a happy chance, a former McKinsey consultant too). [email protected] Gillian Tett Eliminate financial double-think August 20 2009 http://www.ft.com/cms/s/0/96810a0e-8d8f- 11de-93df-00144feabdc0.html
335 Opinion
August 17, 2009 OP-ED COLUMNIST The Swiss Menace By PAUL KRUGMAN It was the blooper heard round the world. In an editorial denouncing Democratic health reform plans, Investor’s Business Daily tried to frighten its readers by declaring that in Britain, where the government runs health care, the handicapped physicist Stephen Hawking “wouldn’t have a chance,” because the National Health Service would consider his life “essentially worthless.” Professor Hawking, who was born in Britain, has lived there all his life, and has been well cared for by the National Health Service, was not amused. Besides being vile and stupid, however, the editorial was beside the point. Investor’s Business Daily would like you to believe that Obamacare would turn America into Britain — or, rather, a dystopian fantasy version of Britain. The screamers on talk radio and Fox News would have you believe that the plan is to turn America into the Soviet Union. But the truth is that the plans on the table would, roughly speaking, turn America into Switzerland — which may be occupied by lederhosen-wearing holey-cheese eaters, but wasn’t a socialist hellhole the last time I looked. Let’s talk about health care around the advanced world. Every wealthy country other than the United States guarantees essential care to all its citizens. There are, however, wide variations in the specifics, with three main approaches taken. In Britain, the government itself runs the hospitals and employs the doctors. We’ve all heard scare stories about how that works in practice; these stories are false. Like every system, the National Health Service has problems, but over all it appears to provide quite good care while spending only about 40 percent as much per person as we do. By the way, our own Veterans Health Administration, which is run somewhat like the British health service, also manages to combine quality care with low costs. The second route to universal coverage leaves the actual delivery of health care in private hands, but the government pays most of the bills. That’s how Canada and, in a more complex fashion, France do it. It’s also a system familiar to most Americans, since even those of us not yet on Medicare have parents and relatives who are. Again, you hear a lot of horror stories about such systems, most of them false. French health care is excellent. Canadians with chronic conditions are more satisfied with their system than their U.S. counterparts. And Medicare is highly popular, as evidenced by the tendency of town-hall protesters to demand that the government keep its hands off the program. Finally, the third route to universal coverage relies on private insurance companies, using a combination of regulation and subsidies to ensure that everyone is covered. Switzerland offers the clearest example: everyone is required to buy insurance, insurers can’t
336 discriminate based on medical history or pre-existing conditions, and lower-income citizens get government help in paying for their policies. In this country, the Massachusetts health reform more or less follows the Swiss model; costs are running higher than expected, but the reform has greatly reduced the number of uninsured. And the most common form of health insurance in America, employment- based coverage, actually has some “Swiss” aspects: to avoid making benefits taxable, employers have to follow rules that effectively rule out discrimination based on medical history and subsidize care for lower-wage workers. So where does Obamacare fit into all this? Basically, it’s a plan to Swissify America, using regulation and subsidies to ensure universal coverage. If we were starting from scratch we probably wouldn’t have chosen this route. True “socialized medicine” would undoubtedly cost less, and a straightforward extension of Medicare-type coverage to all Americans would probably be cheaper than a Swiss-style system. That’s why I and others believe that a true public option competing with private insurers is extremely important: otherwise, rising costs could all too easily undermine the whole effort. But a Swiss-style system of universal coverage would be a vast improvement on what we have now. And we already know that such systems work. So we can do this. At this point, all that stands in the way of universal health care in America are the greed of the medical-industrial complex, the lies of the right-wing propaganda machine, and the gullibility of voters who believe those lies. • Correction: In Friday’s column I mistakenly asserted that Senator Johnny Isakson was responsible for a provision in a House bill that would allow Medicare to pay for end-of- life counseling. In fact, he is responsible for a provision in a Senate bill that would allow a different, newly created government program to pay for such counseling. http://www.nytimes.com/2009/08/31/opinion/31krugman.html?em
337 08/17/2009 11:12 AM Reversing the Economic Plunge Will Germany Beat the US to Recovery? By Moira Herbst The race to economic health is pitting export-driven economies with strong social- assistance programs against those that count on consumer spending. Germany and Europe are looking good this quarter, but doubts persist about whether the recovery can be sustained. It has been a rhetorical battle of Anglo-Saxon vs. Continental capitalism. Since the onset of the economic crisis, German leaders have scored political points by railing against the flaws of the US and British economic systems, even as counterparts such as US President Barack Obama and UK Prime Minister Gordon Brown pressed for bigger economic stimulus packages. Just this month, German Economics Minister Peer Steinbrück warned that the "casino capitalism" practiced in overseas financial centers will resume without stronger regulation. DDP: Initiatives such as the "cash-for-clunkers" car scrappage program could see Germany push ahead in the race to economic recovery. On Aug. 13 the Continental gang got a bit more to crow about. Data released that day showed that France and Germany both posted surprising 0.3 percent economic growth in the second quarter, even as US gross domestic product slipped 1 percent and Britain's sagged 3.2 percent over the same period. It was a vote of confidence in the Continental model, suggesting that the more traditional, consensual, and export-driven German economy -- Europe's largest -- could be better positioned for economic recovery. Of course, one quarter's growth rate doesn't provide a complete picture -- and it's too early to tell how each economy will fare once recovery has set in. But the unexpectedly faster European turnaround only deepens the debate over the merits of different economic models. Could export-driven economies with considerable social-assistance programs be in a better position to bounce back than those, such as America's, that rely heavily on services and consumer spending? Support for the Jobless Not surprisingly, economists don't share a consensus on the answers. But many point to several factors that helped Germany return to growth in the second quarter. One is the success of the government's €2,500 ($3,540) cash-for-clunkers subsidy (Abwrackprämie) for trading in old cars for new, more fuel-efficient ones. The program stimulated considerable demand in new car sales. Another is the oft-cited "automatic stabilizers" in the German economy, including more generous support for the jobless and government subsidies for workers whose hours have been cut. Analysts say this "Kurzarbeit" (short term work) program has prevented hundreds of thousands of job losses this year. A recovery in China and the developing world also stands to benefit Germany, whose economy relies heavily on exports. German second-quarter growth was already helped by exports to non-Japan Asia, especially China, says Thomas Mayer, chief European economist for Deutsche Bank in London. That bodes well for the country's economic
338 model, he says: "Germany's export model has been sustained for the last few decades and will probably remain in place for the future." Indeed, amid an overall revival in global trade, "European economies are in a better position to recover," says Martin Lueck, an economist at UBS. "In the US, everything hinges on the consumer. As long as the savings rate keeps rising, house prices falling, and employment weakening, there is very little leeway for the consumer [sector] to recover." However, Lueck sees the most critical split occurring not between countries or economic regions but rather between economic classes. "If you draw a line dividing the winners and losers [of the past 20 years], it is not between US or UK economic systems and Europe's, but rather the owners of capital vs. the owners of work. The losers are the owners of work in all parts of the world, particularly Western countries. The winners have been the owners of capital." A Sustainable Recovery? That's why, in spite of the good news about the second quarter, doubts persist about sustaining the recovery in Germany and the rest of Europe next year. Stimulus measures, including Germany's cash-for-clunkers program, will expire in 2010, when new car sales could fall again. Some analysts say Germany's temporary assistance to workers, which allows them to stay employed, may have merely delayed layoffs and that unemployment will rise again by the end of the year. And European banks still aren't lending at previous levels as they work to rebuild capital. So while Germany will likely hold on to its export-powered economic model, analysts say the global slowdown won't allow it to regain the strength it once had. "An export-led economy is of course reliant on growth elsewhere, and if major export partners suffer, Germany will suffer, too," says Natascha Gewaltig, director of European economics at consultancy Action Economics. "The road of the German economy to pre-crisis levels remains long and winding," wrote UniCredit economists Alexander Koch and Andreas Rees in a research note. Dirk Schumacher, senior European economist for Goldman Sachs, suggests that Germans will have to start consuming more so their economy doesn't rely too heavily on exports. "A global imbalance means it's not just one country's problem," says Schumacher. "Every country needs to take a deep look and see what needs to change." URL: http://www.spiegel.de/international/business/0,1518,643166,00.html RELATED SPIEGEL ONLINE LINKS: • End of Recession in Sight?: German Consumer and Business Confidence Increases (07/27/2009) http://www.spiegel.de/international/business/0,1518,638522,00.html • Economic Recovery In Germany: 'The End of the World Has Been Cancelled' (07/08/2009) http://www.spiegel.de/international/business/0,1518,635055,00.html • Tackling the Global Downturn: Obama Calls for Fast Action to Fight Recession (03/24/2009) http://www.spiegel.de/international/world/0,1518,615153,00.html • SPIEGEL 360: Our Full Coverage of the Global Economic Downturn http://www.spiegel.de/international/business/0,1518,k-7312,00.html
339 07/08/2009 12:47 PM Harbinger of Change?
Export Jump Brings Hope for End of Crisis German's Federal Statistics Office released export figures for June on Friday, and they have a lot of people smiling. Exports grew to 68.5 billion euros, a 7 percent rise over May's figure. The data is the latest in a string of positive economic news being released around the world. With figures released Friday showing that Germany enjoyed a 7 percent jump in exports in June, Germans are hoping that the end to its deepest postwar recession might be coming into view. Germany's Federal Statistical Office announced the figures in its preliminary report for the month, noting that it was the biggest rise in exports since September 2006, when the figure was 7.3 percent. Experts had only anticipated a 1.1 percent rise after the figures were seasonally adjusted. The figure in May was a mere 0.2 percent gain. Some see this as just the first bit of good news for Europe's largest -- and predominantly export-driven -- economy. Andreas Rees, for example, an economist at Unicredit in Munich, told the Financial Times that it marked a "tremendous comeback" and that "definitely more is in the pipeline in the months to come." 'A Further Sign of Stabilization' Others are more tempered in their optimism. "This is a further sign of stabilization," Deutsche Bank analyst Stefan Bielmeier told Reuters. "But we are still a long way from a self-supporting recovery." But optimists are hoping that global economic growth will soon return to its pre-crisis levels. They point out that the most important economic early indicators are currently climbing around the world. In the US, the purchasing managers index has climbed in recent weeks back to levels not seen since before the bankruptcy of investment bank Lehman Brothers. In China, companies have been opening their pocketbooks for investments again for the past three months. And Europe appears to have emerged from the worst, too. According to the latest poll data from economic research institute Ifo, export expectations in the German auto industry have almost returned to pre-crisis levels. Still Plenty of Room for Catchup The agency announced that Germany's total exports for June amounted to €68.5 billion ($98.6 billion), which is down 22.3 percent from the same period last year -- meaning that Germany still has a lot of catching up to do. The Federation of German Wholesale and Foreign Trade (BGA) is forecasting an 18 percent slump in export sales for 2009, the first contraction since 1993 and the largest in postwar history. For 2010, BGA president Anton Börner is anticipating a return to growth of 5 or 10 percent. Imports to Germany were also up slightly in June, climbing by 6.8 percent compared to the previous month. In total, goods valued at €56.3 billlion euros were imported -- 17.2 percent less than the same period in 2008. On Thursday, Germany's Economics Ministry announced that industrial orders in the country had risen 4.5 percent in June, marking a continuing trend over May, when orders saw a 4.4 percent rise.
340 Next week, the country will release data on what is expected to be a modest contraction of the economy for the second quarter, following a first quarter which saw negative GDP growth of 3.8 percent. jtw -- with wire reports
URL: • http://www.spiegel.de/international/business/0,1518,641063,00.html RELATED SPIEGEL ONLINE LINKS: • A Campaign of Rainmakers: Despite Promises, Downturn Will Hit Coffers of Social Safety Net (08/06/2009) http://www.spiegel.de/international/germany/0,1518,640829,00.html • End of Recession in Sight?: German Consumer and Business Confidence Increases (07/27/2009) http://www.spiegel.de/international/business/0,1518,638522,00.html • SPIEGEL 360: Our Full Coverage of the Global Economic Downturn http://www.spiegel.de/international/business/0,1518,k-7312,00.html 06/08/2009 11:23 AM 'Some Executives Didn't Hear Bang' Germany's Steinbrück Warns of Return of 'Casino Capitalism' Germany's finance minister, known for his fierce criticism of banking excesses that caused the global financial crisis, is warning that the plague of "casino capitalism" is returning to some banking centers. He also takes a stab at German executives. REUTERS: With the return of profits, banks and executives are again getting large bonuses. "Some didn't hear the bang," warns Germany's Peer Steinbrück. German Finance Minister Peer Steinbrück is going after bankers and executives again -- at least via the media . This time he's warning about the return of the old culture of " casino capitalism." "In some financial centers abroad there is such a tendency," Steinbrück told the southern German Passauer Neue Presse newspaper. "In the United States and Britain, lobbyists are already questioning some regulatory measures." But the finance minister didn't reserve his criticism for New York and London alone. In Germany, too, he said, "some board members and executives still haven't learned that the times have changed when it comes to the issue of bonus payments." Some, he said, "live in another world." "Some executives didn't hear the bang," he continued. "They are responsible for the the fact that approval of our system of doing business is waning," he added, referring to exorbitant payments and bonuses to banking executives. The minister, a member of the center-left Social Democrats, also criticized Chancellor Angela Merkel's conservatives, with whom his party is in coalition, for not heeding his party's demand to limit the ability
341 of companies in Germany to deduct bonus payments as expenditures. "Taxpayers are continuing to completely finance big bonuses," he said. dsl -- with wires
URL: • http://www.spiegel.de/international/business/0,1518,640813,00.html RELATED SPIEGEL ONLINE LINKS: • The Return of Greed: Banks Reopen Global Casino (07/28/2009) http://www.spiegel.de/international/business/0,1518,638732,00.html • The End of Arrogance: America Loses Its Dominant Economic Role (09/30/2008) http://www.spiegel.de/international/world/0,1518,581502,00.html
342 Sunday Book Review
August 9, 2009 School for Scoundrels By PAUL KRUGMAN THE MYTH OF THE RATIONAL MARKET A History of Risk, Reward, and Delusion on Wall Street.By Justin Fox, 382 pp. Harper Business/HarperCollins Publishers. $27.99 THE SAGES Warren Buffett, George Soros, Paul Volcker, and the Maelstrom of Markets By Charles R. Morris, 199 pp. PublicAffairs. $23.95 Last October, Alan Greenspan — who had spent years assuring investors that all was well with the American financial system — declared himself to be in a state of “shocked disbelief.” After all, the best and brightest had assured him our financial system was sound: “In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. . . . The whole intellectual edifice, however, collapsed in the summer of last year.” Justin Fox’s “Myth of the Rational Market” brilliantly tells the story of how that edifice was built — and why so few were willing to acknowledge that it was a house built on sand. Do we really need yet another book about the financial crisis? Yes, we do — because this one is different. Instead of focusing on the errors and abuses of the bankers, Fox, the business and economics columnist for Time magazine, tells the story of the professors who enabled those abuses under the banner of the financial theory known as the efficient- market hypothesis. Fox’s book is not an idle exercise in intellectual history, which makes it a must-read for anyone who wants to understand the mess we’re in. Wall Street bought the ideas of the efficient-market theorists, in many cases literally: professors were lavishly paid to design complex financial strategies. And these strategies played a crucial role in the catastrophe that has now overtaken the world economy. This journey to disaster began with a beautiful idea. Until 1952, finance theory, such as it was, consisted of a set of wise observations and rules of thumb, without any overarching framework. But in that year Harry Markowitz, a graduate student at the University of Chicago, gave finance theory a new, hard-edged clarity by equating the concept of risk — previously a vague term for potential losses — with the mathematical concept of variance. Markowitz’s model told investors what they should do, rather than predicting what they actually do. But by the mid-1960s other theorists had taken the next step, analyzing financial markets on the assumption that investors actually behaved the way Markowitz’s model said they should. The result was an intellectually elegant theory of stock prices — the so-called Capital Asset Pricing Model, or CAPM (pronounced “cap-em”). CAPM is a deeply seductive theory, and it’s hard to overemphasize how thoroughly it took over thinking about finance, not just in business schools but on Wall Street.
343 Markowitz would eventually share a Nobel in economic science with William Sharpe, who played a key role in developing CAPM, and Merton Miller, another central figure in the development of modern financial theory. Long before then, however, the innovative idea had hardened into a dogma. One of the great things about Fox’s writing is that he brings to it a real understanding of the sociology of the academic world. Above all, he gets the way in which one’s career, reputation, even sense of self-worth can end up being defined by a particular intellectual approach, so that supporters of the approach start to resemble fervent political activists — or members of a cult. In the case of finance theory, it happened especially fast: by the early 1960s Miller began a class at the University of Chicago’s business school by drawing a line down the middle of the blackboard. On one side he wrote M&M, for “Modigliani-Miller” — that is, the new, mathematicized, CAPM approach to finance. On the other he wrote T — for “Them,” meaning the old, informal approach. In this sense, efficient-market acolytes were like any other academic movement. But unlike, say, deconstructionist literary theorists, finance professors had an enormous impact on the business world — and, not incidentally, some of them made a lot of money in the process. This may seem strange, since CAPM and the broader work it inspired were based on the assumption that investors make mathematically optimal investment decisions with the information at their disposal. As a result, Eugene Fama, of Chicago’s business school, wrote, “actual market prices are, on the basis of all available information, best estimates of intrinsic values.” Fama called a market with this virtue an “efficient market” — and argued that the data showed that real-world financial markets are, in fact, efficient, or very nearly so. But if the markets are already getting it right, who needs finance professors? In fact, however, Wall Street was eager to hire “rocket scientists,” especially after Fischer Black and Myron Scholes, working at M.I.T.’s Sloan School, came up with a formula that seemingly solved the puzzle of how to value options — contracts that give investors the right to buy or sell assets at predetermined prices. The quintessential collaboration between big money and academic superstars was the hedge fund Long-Term Capital Management, whose partners included Scholes and Robert Merton, with whom Scholes shared another finance Nobel. L.T.C.M. eventually imploded, nearly taking the world economy down with it. But efficient-markets theory retained its hold on financial thought. All along, there were critical voices. Robert Shiller, who has become famous for predicting both the Internet crash and the housing bust, first made his mark by casting statistical doubt on the evidence for efficient markets. Lawrence Summers, now a senior official in the Obama administration, began a paper on financial markets thus: “THERE ARE IDIOTS. Look around.” And a whole counterculture emerged in the form of “behavioral finance,” which argued that investors are irrational in predictable ways. But the sheer scope and sweep of the efficient markets hypothesis — not to mention the fact that so many people devoted their careers to it — allowed it to brush off most of these challenges. Of course, there have always been men of affairs wise enough to see past the current dogma. In “The Sages,” Charles R. Morris profiles three of them: George Soros, Warren Buffett and Paul Volcker.
344 Morris, the author of “The Trillion Dollar Meltdown,” doesn’t have much patience with economic theory, and it shows; I almost gave up on the book after Morris managed, in the space of just a few pages, to thoroughly misrepresent the ideas of both John Maynard Keynes and Milton Friedman. But the book comes to life with its personal profiles, especially the surprisingly endearing portrait of Warren Buffett as a young man. Do the lives of the sages carry useful lessons for the rest of us? Soros doesn’t really seem to have a method, except that of being smarter than anyone else. Buffett does have a method — figure out what a company is really worth, and buy it if you can get it cheap — but it’s not a method that would work for anyone without his gifts. And Volcker’s main asset is his implacable integrity, which most mortals would find hard to match. Indeed, I came away from reading these books wondering if their shared underlying premise — that the current crisis will put an end to Panglossian views of financial markets — is right. Fox points out that academic belief in the perfection of financial markets survived the 1987 stock market crash and the bursting of the Internet bubble. Why should the reaction to the latest catastrophe be any different? In fact, what I hear from my finance professor friends is that there’s a lot less soul-searching under way than you might expect. And Wall Street’s appetite for complex strategies that sound clever — and can be sold to credulous investors — survived L.T.C.M.’s debacle; why can’t it survive this crisis, too? My guess is that the myth of the rational market — a myth that is beautiful, comforting and, above all, lucrative — isn’t going away anytime soon. Paul Krugman, an Op-Ed columnist for The Times, is the author of “The Return of Depression Economics and the Crisis of 2008.” http://www.nytimes.com/2009/08/09/books/review/Krugman- t.html?sq=krugman%20justin%20fox&st=cse&scp=1&pagewanted=print
345 Books
August 9, 2009 ‘The Myth of the Rational Market’ By JUSTIN FOX Chapter One: Irving Fisher Loses His Briefcase, and Then His Fortune The first serious try to impose reason and science upon the market comes in the early decades of the twentieth century. It doesn't work out so well. It is 1905. A well-dressed man in his late thirties talks intently into a pay phone at Grand Central Depot in New York. Between his legs is a leather valise. The doors of the phone booth are open, and a thief makes off with the bag. It is, given what we know of its owner, of excellent quality. Finding a willing buyer will not be a problem. The contents of the valise are another matter. Stuffed inside is an almost-completed manuscript that brings together economics, probability theory, and real-world business practice in ways never seen before. It is part economics treatise, part primer on what rational, scientific stock market investing ought to look like. It is a glimpse into Wall Street's distant future. That science and reason might be applied to the stock exchange was still a radical notion in 1905. "Wall Street and its captains ran the stock market, and they and their friends either owned or controlled the speculative pools," recalled one journalist of the time. "The speculative public hardly had a chance. The right stockholders knew when to buy and sell. The others groped." Times, though, were changing. Good information about stocks and bonds was getting easier for the "speculative public" to obtain. Corporations had become too big and too interested in respectability to be controlled by just a few cronies. The dark corners of Wall Street were being illuminated. Maybe the investing world was ready for a more scientific approach. The stolen manuscript was never seen again, but its author, Yale University economics professor Irving Fisher, had a habit of overcoming setbacks that might cause a lesser (or more realistic) individual to despair. As he prepared to set off for college in 1884, his father died of tuberculosis, leaving the undergraduate to support his mother and younger siblings. Just as his academic career began to take off in the late 1890s, Fisher himself came down with TB, which incapacitated him for years. In 1904, finally healthy and working again, he watched as fire consumed the house just north of Yale's campus where he lived with his wife and two children. And then the theft of his manuscript. Afterward, inured by then to disaster, Fisher went right back to work. He resolved always to close the door when he entered a phone booth, and he rewrote his book, this time making copies of each chapter as he went along. Published in 1906 as The Nature of Capital and Income, it cemented his international reputation among economists. It became, as one biographer wrote, "one of the principal building blocks of all present-day economic theory." Its impact on Wall Street was less immediately obvious. Stockbrokers and speculators did not rush out to buy the book. There's no evidence that investors began making probability calculations before they bought stocks, as Fisher recommended. But Fisher was at least as
346 persistent as he was lacking in street smarts. His ideas began to have some impact in his lifetime, and after his death in 1947, they took off. Books directly or indirectly descended from Fisher's work now adorn the desks of hedge fund managers, pension consultants, financial advisers, and do-it-yourself investors. The increasingly dominant quantitative side of the financial world — that strange wonderland of portfolio optimization software, enhanced indexing, asset allocators, credit default swaps, betas, alphas, and "model-derived" valuations — is a territory where Professor Fisher would feel intellectually right at home. He is perhaps not the father, but certainly a father of modern Wall Street. Hardly anyone calls him that, though. Economists honor Fisher for his theoretical breakthroughs, but outside the discipline his chief claim to lasting fame is the horrendous stock market advice he proffered in the late 1920s. Read almost any history of the years leading up to the great crash of October 1929, and the famous Professor Fisher serves as a sort of idiot Greek chorus, popping up every few pages to assert that stock prices had reached a "permanently high plateau." He wasn't just talking the talk. Fisher blew his entire fortune (acquired through marriage, then increased through entrepreneurial success) in the bear market of late 1929 and the early 1930s. Fisher's two historical personas — buffoon of the great crash and architect of financial modernity — are not as alien to each other as they might at first appear. In the early years of the twentieth century Fisher outlined a course of rational, scientific behavior for stock market players. In the late 1920s, blinded in part by his own spectacular financial success, he became convinced that America's masses of speculators and investors (not to mention its central bankers) were in fact following his advice. Nothing, therefore, could go wrong. Irving Fisher had succumbed to the myth of the rational market. It is a myth of great power — one that, much of the time, explains reality pretty well. But it is nonetheless a myth, an oversimplification that, when taken too literally, can lead to all sorts of trouble. Fisher was just the first in a line of distinguished scholars who saw reason and scientific order in the market and made fools of themselves on the basis of this conviction. Most of the others came along much later, though. Irving Fisher was ahead of his time. He was not, however, alone in his advanced thoughts about financial markets. In Paris, mathematics student Louis Bachelier studied the price fluctuations on the Paris Bourse (exchange) in a similar spirit. The result was a doctoral thesis that, when unearthed more than half a century after its completion in 1900, would help to relaunch the study of financial markets. Bachelier undertook his investigation at a time when scientists had begun to embrace the idea that while there could be no absolute certainty about anything, uncertainty itself could be a powerful tool. Instead of trying to track down the cause of every last jiggling of a molecule or movement of a planet, one could simply assume that the causes were many and randomness the result. "It is thanks to chance — that is to say, thanks to our ignorance, that we can arrive at conclusions," wrote the great French mathematician and physicist Henri Poincaré in 1908. (Continues...) Excerpted from The Myth of the Rational Market by Justin Fox Copyright © 2009 by Justin Fox. Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher. Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site. http://www.nytimes.com/2009/08/09/books/excerpt-myth-of-the-rational-market.html?ref=review
347 Opinion
August 3, 2009 OP-ED COLUMNIST Rewarding Bad Actors By PAUL KRUGMAN Americans are angry at Wall Street, and rightly so. First the financial industry plunged us into economic crisis, then it was bailed out at taxpayer expense. And now, with the economy still deeply depressed, the industry is paying itself gigantic bonuses. If you aren’t outraged, you haven’t been paying attention. But crashing the economy and fleecing the taxpayer aren’t Wall Street’s only sins. Even before the crisis and the bailouts, many financial-industry high-fliers made fortunes through activities that were worthless if not destructive from a social point of view. And they’re still at it. Consider two recent news stories. One involves the rise of high-speed trading: some institutions, including Goldman Sachs, have been using superfast computers to get the jump on other investors, buying or selling stocks a tiny fraction of a second before anyone else can react. Profits from high- frequency trading are one reason Goldman is earning record profits and likely to pay record bonuses. On a seemingly different front, Sunday’s Times reported on the case of Andrew J. Hall, who leads an arm of Citigroup that speculates on oil and other commodities. His operation has made a lot of money recently, and according to his contract Mr. Hall is owed $100 million. What do these stories have in common? The politically salient answer, for now at least, is that in both cases we’re looking at huge payouts by firms that were major recipients of federal aid. Citi has received around $45 billion from taxpayers; Goldman has repaid the $10 billion it received in direct aid, but it has benefited enormously both from federal guarantees and from bailouts of other financial institutions. What are taxpayers supposed to think when these welfare cases cut nine-figure paychecks? But suppose we grant that both Goldman and Mr. Hall are very good at what they do, and might have earned huge profits even without all that aid. Even so, what they do is bad for America. Just to be clear: financial speculation can serve a useful purpose. It’s good, for example, that futures markets provide an incentive to stockpile heating oil before the weather gets cold and stockpile gasoline ahead of the summer driving season. But speculation based on information not available to the public at large is a very different matter. As the U.C.L.A. economist Jack Hirshleifer showed back in 1971, such speculation often combines “private profitability” with “social uselessness.” It’s hard to imagine a better illustration than high-frequency trading. The stock market is supposed to allocate capital to its most productive uses, for example by helping companies with good ideas raise money. But it’s hard to see how traders who place their
348 orders one-thirtieth of a second faster than anyone else do anything to improve that social function. What about Mr. Hall? The Times report suggests that he makes money mainly by outsmarting other investors, rather than by directing resources to where they’re needed. Again, it’s hard to see the social value of what he does. And there’s a good case that such activities are actually harmful. For example, high- frequency trading probably degrades the stock market’s function, because it’s a kind of tax on investors who lack access to those superfast computers — which means that the money Goldman spends on those computers has a negative effect on national wealth. As the great Stanford economist Kenneth Arrow put it in 1973, speculation based on private information imposes a “double social loss”: it uses up resources and undermines markets. Now, you might be tempted to dismiss destructive speculation as a minor issue — and 30 years ago you would have been right. Since then, however, high finance — securities and commodity trading, as opposed to run-of-the-mill banking — has become a vastly more important part of our economy, increasing its share of G.D.P. by a factor of six. And soaring incomes in the financial industry have played a large role in sharply rising income inequality. What should be done? Last week the House passed a bill setting rules for pay packages at a wide range of financial institutions. That would be a step in the right direction. But it really should be accompanied by much broader regulation of financial practices — and, I would argue, by higher tax rates on supersized incomes. Unfortunately, the House measure is opposed by the Obama administration, which still seems to operate on the principle that what’s good for Wall Street is good for America. Neither the administration, nor our political system in general, is ready to face up to the fact that we’ve become a society in which the big bucks go to bad actors, a society that lavishly rewards those who make us poorer. http://www.nytimes.com/2009/08/03/opinion/03krugman.html
349
China, new financial superpower … Posted on Monday, August 3rd, 2009 By bsetser One of the biggest economic and political stories of this decade has been China’s emergence as the world’s biggest creditor country. At least in a ‘flow” sense. China’s current account surplus is now the world’s largest – and its government easily tops a “reserve and sovereign wealth fund” growth league table. The growth in China’s foreign assets at the peak of the oil boom – back when oil was well above $100 a barrel – topped the growth in the foreign assets of all the oil-exporting governments. Things have tamed down a bit – but China still is adding more to its reserves than anyone else. Yet China is in a lot of ways an unusual creditor, for three reasons: One, China is still a very poor country. It isn’t obvious why it makes sense for China to be financing other countries’ development rather than its own. That I suspect is part of the reason why China’s government seems so concerned about the risk of losses on its foreign assets. Two, almost all outflows from China come from China’s government. Private investors generally have wanted to move money into China at China’s current exchange rate. The large role of the state in managing China’s capital outflows differentiates China from many leading creditor countries, and especially the US and the UK. Of course, the US government organized large loans to help Europe reconstruct in the 1940s and early 1950s, and thus the US government played a key role recycling the United States current account surplus during this period. But later in the 1950s and in the 1960s, the capital outflows that offset the United States current account surplus (and reserve-related inflows) largely came from private US individuals and firms. And back in the nineteenth century, private British investors were the main financiers of places like Argentina, Australia and the United States. We now live in a market-based global financial system where the biggest single actor is a state. Three, unlike many past creditors, China doesn’t lend to the world in its own currency. It rather lends in the currencies of the “borrowing” countries – whether the US dollar, the euro, the British pound or the Australian dollar. That too is a change from historical norms. Many creditor countries have wanted debtors to borrow in the currency of the creditor country. To be sure, that didn’t always work out: it makes outright default more likely (ask those who lent to Latin American countries back in the twentieth century … ). But it did offer creditors a measure of protection against depreciation of the debtor’s currency. This system was basically stable for the past few years – though not with out its tensions. Now though there are growing voices calling for change. China seems to be inching toward the position that those countries borrowing its funds should start to take on some of the risks that China’s government now assumes. The basic idea is simple: China keeps its lending, but gets a better renminbi returns while taking less (currency) risk. That, though, would be a fundamental change in the current international financial system. And it isn’t quite clear how China can change
350 its external profile so long as it wants above all to maintain a peg to the dollar at a level that requires sustained intervention – and a controlled capital account. Some of China’s borrowers, by contrast, are arguing that maybe China shouldn’t be quite so keen to lend the world quite so much … Makes for an interesting world. http://blogs.cfr.org/setser/2009/08/03/china-new-financial-superpower- %e2%80%a6/#more-6127
China linkfest Posted on Saturday, August 1st, 2009 By bsetser Qing Wang of Morgan Stanley: “Given China’s high national savings rate, from the perspective of the economy as a whole, there are only three forms in which China can deploy its savings: 1) onshore physical assets; 2) offshore physical assets; and 3) offshore financial assets. …. We therefore think that from the perspective of the economy as a whole, the opportunity cost of domestic fixed asset investment, or formation of physical assets onshore, should be the total returns on US government bonds. Put in simple terms, in the debate about over-investment at the current juncture, it actually boils down to an investment decision on building railways in China versus buying US government bonds, given China’s high national savings. David Pilling: “Far from a sign of strength, Beijing’s accumulation of vast foreign reserves is the side-effect of an economic model too reliant on exports. The enormous trade surplus is the product of an undervalued renminbi that has allowed others to consume Chinese goods at the expense of Chinese people themselves. Beijing cannot dream of selling down its Treasury holdings without triggering the very dollar collapse it purports to dread. Nor are its shrill calls for the US to close its twin deficits – which would inevitably involve buying fewer Chinese goods – entirely convincing. Rather than exposing the superiority of China’s state-led model, the global financial crisis has laid bare the compromising embrace in which the US and China find themselves. ” Peter Garnham touches on similar themes for the FT. Philip Bowring on the obstacles (mostly self-created) to internationalizing the renminbi: “China’s expressions of desire to reduce the role of the dollar are anyway contradicted by its actual policy of maintaining a de facto peg to the U.S. currency, meanwhile continuing to accumulate dollars in reserves now totaling $2 trillion. The modest yuan appreciation after 2005 came to a halt more than a year ago as China has sought to sustain exports in the face of the global slump. There is conflict between macro-economic stabilization goals and pressures from industries and employment creation not to put more pressure on exporters. … Nor has there been any significant move towards full convertibility as the financial crisis has, with good reason, made the authorities nervous of liberalization …. any significant use of yuan requires and significant offshore stock of the currency. That is incompatible with China’s expressed desire to reduce its dollar reserve dependence.” Robert Pozen on the limits of the SDR. Michael Pettis on his blog and in the Financial Times: ” If the Chinese economy was the biggest beneficiary of excess US consumption growth, it is likely also to be the biggest
351 victim of a rising US savings rate. … Eventually, and maybe this is already happening, the decline in the US trade deficit must result in a decline in China’s ability to export the difference between its growth in production and consumption. When this happens, China’s economy will grow more slowly than Chinese consumption, just as the opposite is happening in the US. Put another way, rather than act as the lower constraint for GDP growth as it has for the past two decades growth in Chinese consumption will become the upper constraint, as for the next several years Chinese consumption necessarily rises as a share of GDP, just as US consumption must decline as a share of US GDP. And Paul Cavey on China’s credit boom — which clearly jump-started China’s economy in the second quarter. The Economist on China’s low level of consumption. Additional recommendations welcome. Update, based on the suggestions in the comments: Lardy and Goldstein on China’s exchange rate regime. And John Makin’s evaluation of the risks associated with China’s stimulus program. Makin and Pettis don’t seem all that far apart: Both worry about efforts to support production in anticipation of future demand, and worry about the impact of rapid money and credit growth of China’s long-run economic health. Free exchange claims that many things you know about China are wrong, specifically arguing against the notion “China depresses domestic demand to boost its exports” as Paul Cavey forecasts that “China’s current-account surplus will fall to under 6% of GDP this year and 4% in 2010, down from a peak of 11% in 2007. Exports amounted to 35% of GDP in 2007; this year … that ratio will drop to 24.5%.” There are other forecasts that suggest a smaller fall in China’s surplus (it is down in q2 09 v q2 08, but is still running at roughly the same level as in 2008 in nominal dollar terms), but projecting some fall in China’s surplus isn’t unreasonable in a “rebalancing world.” Let’s be clear here though. No one is arguing that China is currently limits domestic demand to support its exports; China is currently stimulating domestic demand. The question is whether or not Chinese policy makers took steps to depress domestic demand back when net exports were contributing 2 percentage points or more to growth, bring China’s surplus up to that 2007 peak. And on that point, I don’t think there is much room for debate. Fiscal policy was tight — look at the data on the central government’s fiscal balance from 2004 to 2007, and the large deposits that the government built up over this time. More importantly, after 2003, the government reigned in bank lending with administrative limits on loan growth and high reserve requirements. As a result — according to the IMF data — China entered into this crisis with one of the lowest loan to deposit ratios in the emerging world. That, in turn, gave China greater capacity to stimulate than most, as it could simple take its foot off the brakes it was applying to the banking system. China is not currently suppressing domestic demand. But back when exports were booming China opted to limit inflationary pressures with a range of policies to limit domestic demand growth rather than allowing currency appreciation (yes, the RMB appreciated v the dollar after 2005, but that appreciation came when the dollar was generally depreciating v many currencies). Look back at China’s policy choices back in 2003/04, when a lending boom threatened to produce a sustained rise in inflation. There is a reason why China’s import growth didn’t keep pace with China’s export growth from
352 the end of 2003 to the end of 2006. See the data in this post; there is a clear dip in import growth in 2004, one that coincides with China’s decision to limit bank lending. I agree though with other argument that Free exchange (drawing on the Economists’ coverage of China) makes, namely that China’s export boom was capital rather than labor intensive, and didn’t generate all that many jobs. That is one reason why labor income slid relative to GDP during China’s boom. http://blogs.cfr.org/setser/2009/08/01/china-linkfest/#more-6132
353 Opinion
July 26, 2009 Op-Ed Contributor The Great Preventer By NOURIEL ROUBINI LAST week Ben Bernanke appeared before Congress, setting off a discussion over whether the president should reappoint him as chairman of the Federal Reserve when his term ends next January. Mr. Bernanke deserves to be reappointed. Both the conventional and unconventional decisions made by this scholar of the Great Depression prevented the Great Recession of 2008-2009 from turning into the Great Depression 2.0. Mr. Bernanke understands that in the Great Depression, the collapse of the money supply and the lack of monetary stimulus during contractions worsened the country’s economic free fall. This lesson has paid off. Mr. Bernanke’s decision to keep interest rates low and encourage lending has, for now, averted the L-shaped near depression that seemed highly likely after the financial collapse last fall. To be sure, an endorsement of Mr. Bernanke’s reappointment comes with many caveats. Mr. Bernanke, a Fed governor in the early part of this decade, supported flawed policies when Alan Greenspan pushed the federal funds rate (the policy rate set by the Fed as its main tool of monetary policy) too low for too long and failed to monitor mortgage lending properly, thus creating the housing and credit and mortgage bubbles. He and the Fed made three major mistakes when the subprime mortgage crisis began. First, he kept arguing that the housing recession would bottom out soon (it has not bottomed out even three years later). Second, he argued that the subprime problem was a contained problem when in reality it was a symptom of the biggest leverage and credit bubble in American history. Third, he argued that the collapse in the housing market would not lead to a recession, even though about one-third of jobs created in the latest economic recovery were directly or indirectly related to housing. Mr. Bernanke’s analysis was mistaken in several other important ways. He argued that monetary policy should not be used to control asset bubbles. He attributed the large United States current account deficits to a savings glut in China and emerging markets, understating the role that excessive fiscal deficits and debt accumulation by American households and the financial system played. Still, when a liquidity and credit crunch emerged in the summer of 2007, Mr. Bernanke engineered a U-turn in Fed policy that prevented the crisis from turning into a near depression. He did this largely with actions and programs that were not in the traditional toolbox of monetary policy. The federal funds rate was effectively pushed down to zero to reduce borrowing costs and prevent the collapse of consumer demand and capital spending by business. New programs encouraged skittish institutions to resume lending. For the first time since the Great Depression, the Fed’s role as lender of last resort was extended to investment banks. Mr. Bernanke also introduced a wide range of other programs, like those to maintain the functioning of the commercial paper market (which makes short-term loans to companies
354 so they can cover operating expenses like payrolls). The Fed was involved directly in the rescue of financial institutions like Bear Stearns and American International Group. It lent money to foreign central banks to ease a global shortage of dollars. The Fed even committed to purchasing up to $1.7 trillion of Treasury bonds, mortgage-backed securities and agency debt to reduce market rates. These are all radical actions that had almost never been undertaken before. Some of these moves have raised important questions: Did the Fed help bail out institutions that should have been allowed to fail? Did it cause moral hazard as reckless lenders and investors were effectively bailed out? How and when will the Fed mop up the excess liquidity that its actions have created? Will these actions eventually cause inflation and a sharp fall of the value of the dollar? Has the Fed lost its independence as it has accommodated the fiscal needs of the government by bailing out banks and printing money to cover large fiscal deficits? Still, the basic point remains: The Fed’s creative and aggressive actions have significantly reduced the risks of a near depression. For this reason alone Mr. Bernanke deserves to be reappointed so that he can manage the Fed’s exit from its most radical economic intervention since its creation in 1913. Nouriel Roubini is a professor of economics at the New York University Stern School of Business and the chairman of an economic consulting firm. http://www.nytimes.com/2009/07/26/opinion/26roubini.html
355 Thomas Palley Economics for Democratic and Open Societies Letter to the Queen: Why No One Predicted the Crisis Her Majesty The Queen Buckingham Palace London SW1A 1AA 29 July 2009 MADAM, In response to your question why no one predicted the crisis you have recently received a letter from Professors Tim Besley and Peter Hennessy, sent on behalf of the British Academy. They claim economists’ failure to foresee the crisis was the result of a “failure of the collective imagination.” That claim is tendentious and will mislead you. The failure was due to the sociology of the economics profession. This failure was a long time in the making and was the product of the profession becoming increasingly arrogant, narrow, and closed minded. One was compelled to adhere to the dominant ideological construction of economics or face exclusion. That was the mindset of the IMF and the World Bank with their “Washington Consensus”, and it was the mindset of central bankers (including your own Bank of England) with their thinking about the sufficiency of inflation targeting and hostility to regulation. The crisis was predictable and was predicted. See, for example: (1) “The Weak Recovery and the Coming Deep Recession,” Mother Jones, March 2006. (2) “Debt and Lending: A Cri de Coeur,” Levy Institute, April 2006. (3) “The Fallacy of the Revised Bretton Woods Hypothesis: Why Today’s Financial System is Unsustainable,” Levy Institute, June 2006. Professors Besley and Hennessy’s letter is another example of the economics profession’s complete inability to come to grips with its sociological failure which produced massive intellectual failure with huge costs for society. This is a very serious social problem and we will all continue to pay the costs as long as it is unaddressed. Respectfully yours, Tom Palley
This entry was posted on Thursday, July 30th, 2009 at 7:43 am http://www.thomaspalley.com/?p=148
356 The Observer This is how we let the credit crunch happen, Ma'am ... Heather Stewart, economics editor The Observer, Sunday 26 July 2009
Luis Garicano at LSE shows Queen Elizabeth II a chart explaining how the credit crunch was caused. Photograph: Kirsty Wigglesworth/PA Archive/Press Association Ima A group of eminent economists has written to the Queen explaining why no one foresaw the timing, extent and severity of the recession. The three-page missive, which blames "a failure of the collective imagination of many bright people", was sent after the Queen asked, during a visit to the London School of Economics, why no one had predicted the credit crunch. Signed by LSE professor Tim Besley, a member of the Bank of England monetary policy committee, and the eminent historian of government Peter Hennessy, the letter, a copy of which has been obtained by the Observer, tells of the "psychology of denial" that gripped the financial and political world in the run-up to the crisis. The content was discussed at a seminar at the British Academy in June that was attended by economic heavyweights including Treasury permanent secretary Nick MacPherson, Goldman Sachs chief economist Jim O'Neill and Observer economics columnist William Keegan. The letter explains that as low interest rates made borrowing cheap, the "feelgood factor" masked how out-of-kilter the world economy had become beneath the surface, with some countries, such as the United States, running up enormous debts by borrowing from others, including China and the oil-rich Middle Eastern states, that were sitting on vast piles of cash. Despite these yawning imbalances, they say, "financial wizards" managed to convince themselves and the world's politicians that they had found clever ways to spread risk throughout financial markets - whereas "it is difficult to recall a greater example of wishful thinking combined with hubris". "Everyone seemed to be doing their own job properly on its own merit. And according to standard measures of success, they were often doing it well," they say. "The failure was to
357 see how collectively this added up to a series of interconnected imbalances over which no single authority had jurisdiction." That meant when the reckoning came it was extreme, starting in summer 2007 and culminating in the near-collapse of the entire world financial system after the bankruptcy of Lehman Brothers last autumn. "In summary, Your Majesty," they conclude, "the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole." Besley stressed that the experts had not been in "finger-wagging mode" and had agreed that the causes of the credit crunch were extremely complex. "There was a very complicated, interconnected set of issues, rather than one particular person or one particular institution." Other experts at the seminar last month included Paul Tucker, deputy governor of the Bank of England, Vernon Bogdanor, the constitutional expert from Oxford University, and HSBC's chief economist, Stephen King. A spokesman for Buckingham Palace said the Queen has displayed a particular interest in the causes of the recession, summoning Bank of England governor Mervyn King to a private audience earlier this year to explain what he was doing to tackle it. Official figures published on Friday revealed that Britain's economy has now been contracting for 15 months, and the recession is deeper than any since the 1930s, outside of wartime. Robin Jackson, chief executive and secretary of the British Academy, said: "The global recession is a huge development, and it is reasonable to ask to what extent it could have been foreseen. What's more, we can't say 'never again' if we don't fully understand what occurred. The academy forum was an opportunity to get an exceptional range of experts, participants and commentators in one room, sifting fact from fiction and shedding light on what had gone on. We hope Her Majesty - and indeed others - will find our letter informative." The academy plans to hold a second seminar later in the year to ask how best to prevent another such crisis occurring. Besley denied that economics as a profession had been discredited by the scale of the crisis, but admitted that unconventional ideas - about how herd psychology and bouts of irrationality can grip financial markets, for example - had sometimes received "less play" during the boom years. He said the academy hopes to provide a forum for airing economic differences: "What we need is a forum where people can come together on a very open basis, to provide challenges and have a debate." Professor Luis Garicano, to whom the Queen directed her question when she visited the LSE in November last year, said: "She seemed very interested, and she asked me: 'How come nobody could foresee it?' I think the main answer is that people were doing what they were paid to do, and behaved according to their incentives, but in many cases they were being paid to do the wrong things from society's perspective." http://www.guardian.co.uk/uk/2009/jul/26/monarchy-credit-crunch
358 PRIVATE AND CONFIDENTIAL STRICTLY EMBARGOED UNTIL SUNDAY 26 JULY 2009 AT 00:01 HRS Her Majesty The Queen Buckingham Palace London SW1A 1AA
10 Carlton House Terrace London SW1Y 5AH Telephone: +44 (0)20 7969 5200 Fax: +44 (0)20 7969 5300 22 July 2009
MADAM, When Your Majesty visited the London School of Economics last November, you quite rightly asked: why had nobody noticed that the credit crunch was on its way? The British Academy convened a forum on 17 June 2009 to debate your question, with contributions from a range of experts from business, the City, its regulators, academia, and government. This letter summarises the views of the participants and the factors that they cited in our discussion, and we hope that it offers an answer to your question. Many people did foresee the crisis. However, the exact form that it would take and the timing of its onset and ferocity were foreseen by nobody. What matters in such circumstances is not just to predict the nature of the problem but also its timing. And there is also finding the will to act and being sure that authorities have as part of their powers the right instruments to bring to bear on the problem. There were many warnings about imbalances in financial markets and in the global economy. For example, the Bank of International Settlements expressed repeated concerns that risks did not seem to be properly reflected in financial markets. Our own Bank of England issued many warnings about this in their bi-annual Financial Stability Reports. Risk management was considered an important part of financial markets. One of our major banks, now mainly in public ownership, reputedly had 4000 risk managers. But the difficulty was seeing the risk to the system as a whole rather than to any specific financial instrument or loan. Risk calculations were most often confined to slices of financial activity, using some of the best mathematical minds in our country and abroad. But they frequently lost sight of the bigger picture.
359 Many were also concerned about imbalances in the global economy. We had enjoyed a period of unprecedented global expansion which had seen many people in poor countries, particularly China and India, improving their living standards. But this prosperity had led to what is now known as the ‘global savings glut’. This led to very low returns on safer long-term investments which, in turn, led many investors to seek higher returns at the expense of greater risk. Countries like the UK and the USA benefited from the rise of China which lowered the cost of many goods that we buy, and through ready access to capital in the financial system it was easy for UK households and businesses to borrow. This in turn fuelled the increase in house prices both here and in the USA. There were many who warned of the dangers of this. But against those who warned, most were convinced that banks knew what they were doing. They believed that the financial wizards had found new and clever ways of managing risks. Indeed, some claimed to have so dispersed them through an array of novel financial instruments that they had virtually removed them. It is difficult to recall a greater example of wishful thinking combined with hubris. There was a firm belief, too, that financial markets had changed. And politicians of all types were charmed by the market. These views were abetted by financial and economic models that were good at predicting the short-term and small risks, but few were equipped to say what would happen when things went wrong as they have. People trusted the banks whose boards and senior executives were packed with globally recruited talent and their non-executive directors included those with proven track records in public life. Nobody wanted to believe that their judgement could be faulty or that they were unable competently to scrutinise the risks in the organisations that they managed. A generation of bankers and financiers deceived themselves and those who thought that they were the pace-making engineers of advanced economies. All this exposed the difficulties of slowing the progression of such developments in the presence of a general ‘feel-good’ factor. Households benefited from low unemployment, cheap consumer goods and ready credit. Businesses benefited from lower borrowing costs. Bankers were earning bumper bonuses and expanding their business around the world. The government benefited from high tax revenues enabling them to increase public spending on schools and hospitals. This was bound to create a psychology of denial. It was a cycle fuelled, in significant measure, not by virtue but by delusion. Among the authorities charged with managing these risks, there were difficulties too. Some say that their job should have been ‘to take away the punch bowl when the party was in full swing’. But that assumes that they had the instruments needed to do this. General pressure was for more lax regulation – a light touch. The City of London (and the Financial Services Authority) was praised as a paragon of global financial regulation for this reason. There was a broad consensus that it was better to deal with the aftermath of bubbles in stock markets and housing markets than to try to head them off in advance. Credence was given to this view by the experience, especially in the USA, after the turn of the millennium when a recession was more or less avoided after the ‘dot com’ bubble burst. This fuelled the view that we could bail out the economy after the event. Inflation remained low and created no warning sign of an economy that was overheating. The Bank of England Monetary Policy Committee had helped to deliver an unprecedented period of low and stable inflation in line with its mandate. But this meant that interest rates
360 were low by historical standards. And some said that policy was therefore not sufficiently geared towards heading off the risks. Some countries did raise interest rates to ‘lean against the wind’. But on the whole, the prevailing view was that monetary policy was best used to prevent inflation and not to control wider imbalances in the economy. So where was the problem? Everyone seemed to be doing their own job properly on its own merit. And according to standard measures of success, they were often doing it well. The failure was to see how collectively this added up to a series of interconnected imbalances over which no single authority had jurisdiction. This, combined with the psychology of herding and the mantra of financial and policy gurus, lead to a dangerous recipe. Individual risks may rightly have been viewed as small, but the risk to the system as a whole was vast. So in summary, Your Majesty, the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole. Given the forecasting failure at the heart of your enquiry, the British Academy is giving some thought to how your Crown servants in the Treasury, the Cabinet Office and the Department for Business, Innovation & Skills, as well as the Bank of England and the Financial Services Authority might develop a new, shared horizon-scanning capability so that you never need to ask your question again. The Academy will be hosting another seminar to examine the ‘never again’ question more widely. We will report the findings to Your Majesty. The events of the past year have delivered a salutary shock. Whether it will turn out to have been a beneficial one will depend on the candour with which we dissect the lessons and apply them in future. We have the honour to remain, Madam, Your Majesty’s most humble and obedient servants
Professor Tim Besley, FBA Professor Peter Hennessy, FBA
British Academy Forum, 17 June 2009 The Global Financial Crisis – Why Didn’t Anybody Notice? List of Participants Professor Tim Besley, FBA, London School of Economics; Bank of England Monetary Policy Committee Professor Christopher Bliss, FBA, University of Oxford Professor Vernon Bogdanor, FBA, University of Oxford Sir Samuel Brittan, Financial Times Sir Alan Budd Dr Jenny Corbett, University of Oxford Professor Andrew Gamble, FBA, University of Cambridge Sir John Gieve, Harvard Kennedy School Professor Charles Goodhart, FBA, London School of Economics Dr David Halpern, Institute for Government
361 Professor José Harris, FBA, University of Oxford Mr Rupert Harrison, Economic Adviser to the Shadow Chancellor Professor Peter Hennessy, FBA, Queen Mary, University of London Professor Geoffrey Hosking, FBA, University College London Dr Thomas Huertas, Financial Services Authority Mr William Keegan, The Observer Mr Stephen King, HSBC Professor Michael Lipton, FBA, University of Sussex Rt Hon John McFall, MP, Commons Treasury Committee Sir Nicholas Macpherson, HM Treasury Mr Bill Martin, University of Cambridge Mr David Miles, Bank of England Monetary Policy Committee Sir Gus O’Donnell, Secretary of the Cabinet Mr Jim O’Neill, Goldman Sachs Sir James Sassoon Rt Hon Clare Short, MP Mr Paul Tucker, Bank of England Dr Sushil Wadhwani, Wadhwani Asset Management LLP Professor Ken Wallis, FBA, University of Warwick Sir Douglas Wass Mr James Watson, Department for Business, Innovation and Skills Mr Martin Weale, National Institute of Economic and Social Research Professor Shujie Yao, University of Nottingham http://media.ft.com/cms/3e3b6ca8-7a08-11de-b86f-00144feabdc0.pdf
362 Chris's Blog Archives Thursday, April 9, 2009 What the G2 must discuss now the G20 is over
by Martin Wolf Published: April 7 2009 19:57 | Financial Times Did the meeting of the Group of 20 in London last week put the world economy on the path of sustainable recovery? The answer is no. Such meetings cannot resolve fundamental disagreements over what has gone wrong and how to put it right. As a result, the world is on a path towards an unsustainable recovery, as I argued last week. An unsustainable recovery might be better than none, but it is not good enough. This summit had two achievements: one broad and one specific. First, “to jaw-jaw is better than war-war”, as Winston Churchill remarked. Given the intensity of the anger and fear loose upon the world, discussion itself must be good. Second, the G20 decided to treble resources available to the International Monetary Fund, to $750bn, and to support a $250bn allocation of special drawing rights (SDRs) – the IMF’s reserve asset. If implemented, these decisions should help the worst-hit emerging economies through the crisis. They also mark a return to a big debate: the workings of the international monetary system. This is the point at which the eyes of countless readers will glaze over. It is easier for most to believe that the explanation for the crisis is solely the deregulation and misregulation of the financial systems of the US, UK and a few other countries. Yet, given the scale of the world’s macroeconomic imbalances, it is far from obvious that higher regulatory standards alone would have saved the world. This is not just a matter of historical interest. It is also relevant to the sustainability of the recovery. Fiscal deficits are now generally far bigger in countries with structural
363 current account deficits than in those with current account surpluses. This is because the latter can import a substantial part of the stimulus introduced by the former. The Organisation for Economic Co-operation and Development forecasts a jump in US public debt of almost 40 per cent of gross domestic product over three years (see chart). It is quite likely, therefore, that the next crisis will be triggered by what markets see as excessive fiscal debt in countries with large structural current account deficits, notably the US. If so, that could prove a critical moment for the international economic system. Intriguingly, the country raising these big questions is China. This is, no doubt, for self- serving reasons: China is worried about the value of its foreign currency reserves, most of which are denominated in US dollars; it wants to relieve itself of blame for the crisis; it wishes to preserve as much of its development model as possible; and it is, I suspect, seeking to countervail US pressure on the exchange rate of the renminbi. Wen Jiabao, the Chinese prime minister, has noted his country’s concern over the value of its vast reserves. At close to $2,000bn, these are almost half of 2008 GDP. Imagine what Americans would say if their government had invested about $7,000bn (the equivalent relative to US GDP) in the liabilities of not altogether friendly governments. The Chinese government is beginning to realise its mistake – too late, alas. Meanwhile, Governor Zhou Xiaochuan of the People’s Bank of China has produced a remarkable series of speeches and papers on the global financial system, global imbalances and reform of the international monetary system. These are both a statement of the Chinese point of view and a contribution to global debate. One may not agree with all he is saying. Yet the fact that he is speaking out is itself significant. Governor Zhou argues that the high savings rate of China and other east Asian countries is a reflection of tradition, culture, family structure, demography and the stage of economic development. Furthermore, he adds, they “cannot be adjusted simply by changing the nominal exchange rate”. In addition, he insists, “the high savings ratio and large foreign reserves in the east Asian countries are a result of defensive reactions against predatory speculation”, particularly during the Asian financial crisis of 1997-98. None of this can be changed swiftly, insists the governor: “Although the US cannot sustain the growth pattern of high consumption and low savings, it is not the right time to raise its saving ratio at this very moment.” In other words, give us US frugality, but not yet. Meanwhile, adds the governor, the Chinese government has produced one of the largest stimulus programmes in the world. Moreover, the vast accumulations of foreign currency reserves, up by $5,400bn between January 1999 and their peak in July 2008 (see chart), reflect the emerging economies’ demand for safety. But since the US dollar is the world’s main reserve asset, the world depends on US monetary emissions. Moreover, the US tends to run current account deficits, for this reason. The result has been a re-emergence of a weakness discussed in the twilight years of the Bretton Woods system of fixed exchange rates, which broke down in the early 1970s: over-issuance of the key currency. The long- term answer, he adds, is a “super-sovereign reserve currency”. It is easy to object to many of these arguments. Much of the extraordinary increase in China’s aggregate savings is the result of rising corporate profits (see chart). It would surely be possible to tax and then spend a part of these huge corporate savings. The government could also borrow more: at the 3.6 per cent of GDP forecast by the IMF this
364 year, its deficit remains decidedly modest. It is also hard to believe that a country such as China should be saving half of its GDP or running current account surpluses of close to 10 per cent of GDP. Similarly, while the international monetary system is indeed defective, this is hardly the sole reason for the world’s vast accumulations of foreign currency reserves. Another is over-reliance on export-led growth. Nevertheless, Governor Zhou is correct that part of the long-term solution of the crisis is a system of reserve creation which allows emerging economies to run current account deficits safely. Issuance of SDRs is a way of achieving this goal, without changing the fundamental character of the global system. China is seeking to engage the US. That is itself enormously important. However self- seeking its motivation, that is a necessary condition for serious discussion of global reforms. Yet China must also understand an essential point: the world cannot safely absorb the current account surpluses it is likely to generate under its current development path. A country as large as China cannot hope to rely on such large current account surpluses as a source of demand. Spending at home must still rise sharply and sustainably, relative to growth of potential output. It is as simple – and difficult – as that. [email protected] Martin Wolf What the G2 must discuss now the G20 is over April 7 2009 http://toodumbtolivearchive.blogspot.com/2009/04/what-g2-must-discuss-now-g20-is- over.html Lee Myung-bak and Kevin Rudd The G20 can lead the way to balanced growth September 3 2009 http://www.ft.com/cms/s/0/fb1bf220-9821-11de-8d3d-00144feabdc0.html
365 vox Research-based policy analysis and commentary from leading economists The timing of fiscal interventions: Don’t do tomorrow what you can do today
Karel Mertens Morten O. Ravn 26 August 2009
The composition and timing of the fiscal stimulus is a major concern for policymakers. This column presents research showing that anticipated tax cuts result in reduced economy activity before they take effect. During the current downturn, that constitutes a strong argument against stimulus policies that phase in tax cuts over time.
The current macroeconomic downturn has sparked repeated calls for fiscal stimuli to combat the ensuing decline in activity and labour market conditions (e.g. Blanchard and Cottarelli 2008; Corsetti 2008; Krugman 2008). Common to the proponents of a fiscal intervention has been the appeal for the immediate use of fiscal levers. The prime reasons for this are the fact that the current downturn has been unusually deep (and probably associated with tightening financial constraints) and the view that fiscal policy changes have their fullest effect on the economy only with a considerable delay. Procrastination therefore runs the risk of stimulating the economy when it – we hope – is already recovering. Anticipation of tax changes But, there are other aspects of procrastination that also may matter. Not only may a delay in the application of fiscal measures end up stimulating a recovering economy, but anticipation effects may actually depress the economy until the fiscal changes are implemented. Anticipation effects arise when policy makers announce – or legislate – future fiscal interventions. This phenomenon is quite common as far as tax changes are concerned. Tax laws often contain pre-announced changes in future tax rates because of phase-ins and due to the not so infrequent use of sunsets associated with temporary tax changes. To the layperson, it would seem obvious that the announcement of a low future price of a good may delay its purchase. A supermarket wishing to sell beer today at good profit margins would probably be ill advised to announce a reduction in the price of beer next week. Such principles of forward-looking behaviour and intertemporal choice are deeply rooted in much of macroeconomic theory and apply also to the impact of tax changes (see Hall, 1971, for an early example of the impact of pre-announced tax changes). Yet, empirical investigations have failed to purport the idea that anticipated tax changes affect current choices. Indeed, a number of studies of consumption behaviour have indicated that consumption appears to react little to announcements of future changes in taxes and that consumption does adjust to the implementation of tax changes that were known in advance. Some economists have concluded on this basis that a substantial fraction of households are
366 liquidity-constrained (or fail to be able to make simple forward-looking decisions). In a provocative and influential piece, Mankiw (2000) argues that perhaps up to half of US households may be described as rule-of-thumb consumers that simply consume their current income due to the presence of binding liquidity constraints. For that reason, the fact that tax changes may often be pre-announced matters little – the tax changes simply affect the economy when they are implemented. Procrastination: Does it matter? Nonetheless, while there is little evidence that consumption choices are affected by announcements of future changes in taxes, other key macroeconomic aggregates do react to such policy announcements. Figure 1 shows the dynamics of aggregate output, consumption, investment, and hours worked following announcements of changes in tax liabilities six quarters in the future, which we estimate for the US post-1945 (Mertens and Ravn 2009). The vertical scale show percentage deviations from trend and the size of the change in taxes is normalised to one percent tax liability cut relative to GDP. The announcement dates correspond to the dates at which tax laws were signed by the president relative to the implementation dates stated in the tax legislations. Figure 1. The response of output, consumption, investment, and labour to announced tax changes
The figure makes it clear that pre-announced tax changes cause important adjustments in
367 aggregate activity, hours worked, and investment. Announcing a cut in taxes six quarters out leads to a steep drop in aggregate investment, a decline in aggregate output, and a gradual slide in hours worked. Once the tax cut is implemented, each indicator recovers and peak responses are reached about 2-2.5 years thereafter. Thus, while aggregate consumption appears relatively insensitive to announcements of future tax changes, this is certainly not shared by other main macroeconomic indicators. This evidence challenges the view that lack of consumption responses to anticipated tax changes is evidence for rule-of-thumb behaviour or the absence of forward-looking economic agents. To take one example, the Reagan tax cut of 1981 (the Economic Recovery Tax Act of 1981) introduced new depreciation guidelines and major cuts in personal marginal income tax rates and corporate tax rates. Signed by President Reagan in August 1981, it included changes in taxes that were phased-in from August 1981 until the first quarter of 1984. In fact, the largest change in tax liabilities was the cut of more than $57 billion in 1983, dwarfing the $9 billion tax liability cut of 1981. Therefore, the Economic Recovery Tax Act of 1981 was associated with major anticipation effects. According to our estimates, these expectations of future tax cuts actually contributed to the recessionary impact of the Volcker disinflation that took its course during the early 1980s. Once the economy was back on track in the mid-1980s, the tax cuts were being implemented and therefore further stimulated the uptake in aggregate activity. Relying on news effects So, if this evidence is correct, why do policy makers use phased-in policies, temporary tax changes, and other means of tax changes that introduce anticipation effects? After all, Reagan probably did not intend to deepen the early 1980s recession. Potential reasons likely include concerns about government debt or a desire that economic policy appear predictable rather than haphazard so that households and firms can adjust to changes in taxes (even if some theories of optimal taxes call for the opposite), and one can even write down theories that call for gradual changes in taxes. Another potential reason is the idea that current good news about future economic fundamentals stimulates current activity. Such news effects, if true, would imply that the promise of future tax cuts lead to an uptake in activity even before they are implemented. If this was true, then you can almost “eat your cake and have it too” as the pre- implementation boom that should follow the announcement of future lower taxes would lower government debt through higher tax revenues and therefore help paving the way for a cut in taxes without having to cut spending (at least partially). Conclusions The evidence presented here suggests that there may be good reasons for phasing-in tax changes – relying on news effects, however, does not seem to be one of them. Thus, in the present environment, a good advice to governments is that the use of phased-in tax policies, temporary tax cuts, and other tax policies associated with anticipation effects should be used with great care. Whether the same also holds true for changes in government spending is another question that is still not clear. References Blanchard, Olivier and Carlo Cottarelli (2008), "IMF Spells Out Need for Global Fiscal Stimulus", interview in IMF Survey magazine, 29 December. Corsetti, Giancarlo (2008), “The rediscovery of fiscal policy?” VoxEU.org, 11 February.
368 Hall, Robert E. (1971), “The Dynamic Effects of Fiscal Policy in an Economy with Foresight”, Review of Economic Studies 38, 229-44. Krugman, Paul R. (2008), “Optimal Fiscal Policy in a Liquidity Trap”, Princeton University mimeo. Mankiw, N. Gregory (2000), “The Savers-Spenders Theory of Fiscal Policy”, American Economic Review 90(2), 120-25. Mertens, Karel and Morten O. Ravn (2009), “Empirical Evidence on the Aggregate Effects of Anticipated and Unanticipated U.S. Tax Policy Shocks”, CEPR Discussion Paper no. 7370. http://www.voxeu.org/index.php?q=node/3902
13:45 GMT +00:00 See that tax change coming
Posted by: Economist.com | WASHINGTON
IN AN interesting Vox piece from a few days ago Karel Mertens and Morten O. Ravn argued that policymakers should be wary of phased-in tax changes, or any change in taxation which is made known to taxpayers well before taking effect. Just as consumers anticipate a future sale or hike in prices by increasing or decreasing consumption in the present, taxpayers seem to anticipate large tax changes ahead of time: The latter paragraph is particularly interesting to me. It would seem to suggest that pre- announcing future tax increases could be expansionary, as consumers would rush to invest before the change took effect. If the administration intends to address revenue shortfalls after recession by raising taxes, it could be the case that there would be some gain to passing those increases now but having them take effect at some later date. That might incentivise current investment while also quieting the criticisms of those arguing against stimulative measures on deficit grounds. Or perhaps, the president could simply begin emphasising the fact that the Bush tax cuts are due to expire next year. (Though it's funny to imagine how this all might work. If we assume that Ricardian Equivalence holds, deficit spending in recession should be doubly stimulative, since it implies future tax increases. But Ricardian Equivalence probably doesn't hold.) In fact, the political barriers to raising taxes in recession are sure to be prohibitive. Legislators have a very difficult time separating the future from the present; a number of Senators have noted that health insurance reform should not be undertaken in recession despite the fact that reform as currently envisioned would have little to no budgetary impact until 2011. No one wants to be tarred as having raised taxes in recession. But perhaps legislators can learn to be more cautious about when and how they pass stimulative tax cuts. http://www.economist.com/blogs/freeexchange/2009/08/see_that_tax_change_coming.cfm
369