Month: November 2008

Greg Mankiw Channels Keynes

I am struck by the degree of consensus among mainstream economists about how to deal with the current recession. Greg Mankiw, Chairman of President Bush’s Council of Economic Advisors from 2003 to 2005, wrote a New York Times op-ed arguing for a Keynesian response to the recession – which is what Summers, Stiglitz, and all the other Democrats are calling for.

It’s also a wonderfully clear exposition of the challenge, considering in order the logical possibilities for increasing aggregate demand. Mankiw doesn’t quite come out and endorse an increase in government spending, although he does say it’s the only component that can plausibly be increased (as opposed to consumption, investment, and net exports). He holds out some hope for expansionary Federal Reserve policy. In any case, it’s a quick read and worth it.

Oh, It’s Nice to Have the World’s Reserve Currency

When times are tough, governments have to borrow money. Luckily for us Americans, we can borrow it for free (for now at least – I know this isn’t going to be true forever): 3-month Treasuries have a yield of 0.01%, and even 3-years are at 1.25%, both below the rate of inflation. (By the way, even if you don’t have Bloomberg, you can get Treasury yields at Yahoo! Finance among other places.)

By contrast, the UK and Italy recently had unexpected trouble selling 3- and 4-year bonds, respectively, having to offer 10 basis points over similar existing debt. Mind you, this isn’t Iceland and Hungary we’re talking about here, but two members of the G7. Basically, investors are getting worried that deep recession (which crimps tax revenues) and large bailout packages, piled on top of existing debt, are creating the risk that at some point governments will either default on their debt or, in the case of the UK (which still controls its currency), inflate it away. The same concern can be seen in credit default swap spreads (remember Friday’s post?). Italy’s have climbed from single digits for most of 2007 and 40 bp in the summer to 141 bp.

Italy

Waiting for the European Central Bank, And Waiting

The European Central Bank is widely expected to cut interest rates, perhaps by 50 basis points (half of a percentage point), this week. They could, of course, follow the lead of the Bank of England or the Swiss National Bank and go for a much larger cut (150 basis points and 100 basis points respectively on their most recent rounds). But they probably won’t and not because the economic outlook in the eurozone looks so different from those other parts of Europe or because the the ECB’s Governing Council knows something we don’t or because their interest rates are already low (actually, at 3.25%, they are definitely on the high side.)

The difference really lies in two factors: extreme views about inflation, and the nature of decision-making within the ECB.  Belief that a resurgence of inflation is always imminent is, of course, Germanic but not limited to Germany.  Within the 15 central banks represented on the ECB’s Governing Council, there will always be at least one or two who see unions as looking for an excuse to push up wages.  We can debate whether or not this view is correct under today’s circumstances, but that is irrelevant – these inflation hawks still appear to strongly hold such beliefs.

Of course, there are inflation hawks among all groups that make monetary policy.  But the consensus-seeking process at the ECB is such that even just a few such people can serve as an effective brake on rapid action.  The existence of such views has plainly not prevented the ECB from taking dramatic action on some fronts (e.g., in terms of liquidity provision the ECB arguably moved farther and faster than the Fed last year), but for core monetary policy issues – i.e., when the price stability “mission” is at stake – a couple of outliers can really slow things down (particularly if one or more are members of the Executive Board.)

if the ECB puts through a fairly standard interest rate cut, then it is Business As Usual in the eurozone.  Combined with the rather anemic (or largely smoke and mirrrors) fiscal stimulus in the EU, on top of Europe’s well-known labor market inflexibility (i.e., it is hard to reduce your wage costs, even if business turns down sharply), then the eurozone is in for a rough ride. 

If the ECB surprises the market with a dramatic interest rate cut, at least we will know they are firmly in catch-up mode.  But even then, I’m afraid it is probably too late to have much effect on the recession in 2009.  Under the best of circumstances, interest rate moves affect the real economy with a lag of at least a year.  And the current disruption in the credit market is far from helping monetary policy be effective.

While we will no doubt look back on this crisis as having its epicenter in the U.S., it’s the lack of coherent policy response (monetary, fiscal, regulatory) in Europe over the past year that has really helped turn this into a sustained global crisis.

Synthetics and School Boards

OK, remember Felix Salmon’s explanation of synthetic CDOs from my previous post? Good, because you’re going to need it.

Earlier this month, Planet Money and The New York Times collaborated on a story about how five Wisconsin school districts may have blown $200 million – $165 million of which was borrowed – on an investment that no one involved, including the investment banker selling the deal, seems to have understood. The details aren’t entirely clear from the main Times article, but by looking up a couple of other Planet Money posts, I’m pretty sure it went something like this:

  1. 5 Wisconsin school boards took $35 million of their own money and borrowed another $165 million from Depfa.
  2. They used the $200 million to buy a tranche of a synthetic CDO created by Royal Bank of Canada.
  3. Royal Bank of Canada took that money, and presumably money from other people as well, and created that synthetic CDO by selling insurance (using credit default swaps) on $20 billion worth of corporate bonds. The synthetic CDO was like an ordinary CDO in that it had cash flows coming in – premium payments on the credit default swaps. The up-front money (including the schools’ $200 million) was needed as collateral. It’s not clear how senior the schools’ tranche was, but the Times says that most if not all of the $200 million in collateral will be lost, so it was probably pretty junior.
  4. If there were no defaults, the schools would have netted $1.8 million per year – a 5.1% return.

We’ve all made bad investment decisions. I don’t want to pick on the Wisconsin schools for choosing a bad investment, but for something else: having the wrong investment goal.

Continue reading “Synthetics and School Boards” →

Credit Default Swaps, Herald of Doom (for Beginners)

No, this isn’t another article about how credit default swaps (CDS) have ruined or are going to ruin the economy. It’s about one of the nice side benefits of CDS: the habit they have of pointing out who is going to get into trouble next. And it has pretty Bloomberg charts!

As everyone probably knows by know, a CDS is insurance against default on a bond or bond-like security. If you think about it for a while, you will realize that this means the price of the CDS reflects the market expectation that the issuer will default.

Continue reading “Credit Default Swaps, Herald of Doom (for Beginners)” →

And a Volcker on Top

Or a Volcker in a pear tree, if you prefer.

Quick, name the current head of Council of Economic Advisors. Or the head of the National Economic Council. Stumped?

The head of the CEA is Edward Lazear, a former economics professor at Chicago and Stanford GSB. The head of the NEC is Keith Hennessey (I had to look that one up), a former, um, tester for Symantec (a software company), research assistant at a think tank, staffer for a Senate committee, and staffer for Trent Lott, with a masters in public policy from the Kennedy School. (That’s according to Wikipedia.) They are being replaced by Christina Romer and Larry Summers, respectively, two of the most prominent and respected economists in the world.

And now, for an encore, Obama has named Paul Volcker, now the most respected chairman of the Federal Reserve in recent memory, the hawk who choked off high inflation in the early 1980s, as head of the new Economic Recovery Advisory Board.

Does having an all-star lineup of economists and public servants guarantee a sound economic strategy? No, of course not. After all, you should have only one economic strategy, and we know about kitchens and too many cooks. But Obama is clearly trying to project the impression that he is bringing overwhelming firepower to bear on the problem, in an effort to bolster confidence in the markets. He is also signaling that his administration will follow a centrist, or at most moderate Democratic line. (Volcker first joined Treasury under Nixon, and was appointed Chairman of the Fed by Carter and then re-appoitned by Reagan; Geithner is an independent.)

Remember those charges of socialism in the last weeks of the election? The few socialists out there are sure to be disappointed.

International Implications of the Citigroup Bailout

The Citigroup bailout was a good deal for Citi shareholders (who wouldn’t appreciate a big transfer from the taxpayer during this holiday season?) and a great deal for Citigroup management.  But it also has three global implications that perhaps have not yet been fully thought through.

1. The Citi deal shifts pressure from US financial institutions, at least for a while.  But to the markets it raises the question: who or what is next?  And the indications again point to the eurozone.  Credit default swap spreads indicate increasing differentiation between Germany on the one hand and, say, Greece (or Ireland or Italy or Spain) on the other hand.  I don’t want to single out Greece, but the recent IMF Article IV Report has some very interesting debt path simulations (the report’s Figure 3) – if you update these in the light of current global circumstances, you can see why Greece may well need a bailout before too long (remember: their government debt is in euros and cannot be inflated away, unlike in the US or UK, for example.)  The market view is that some European governments could not really afford the generous bank bailouts they provided in October.

2. For all the increased discussion among politicians and academics about reforming the global system, to preempt the next crisis, why would the most powerful people on Wall Street want this?  The Citi deal shows that the clout of the US financial industry has, if anything, actually increased over the past eighteen months.  “Wall Street owns the upside and the taxpayer owns the downside” is an old saying which seems more appropriate now – and on a bigger scale – than ever.  There is no harm in proposing changes to deficient national regulatory systems and international, rather creaky, Bretton Woods structures.  But strong forces just found out that these structures are completely compatible with rather juicy bailouts (and there may be more to come), so don’t expect rapid or meaningful real reform. 

3. If we are now at the next stage of bailouts and of figuring out who can afford to do the bailing, then existing resources – in and around the IMF – for helping emerging markets are really not enough.  The G7’s strategy proposal to emerging markets is clearly: “finance, don’t adjust (much),” i.e., keep on growing one way or another.  This might or might not be a good idea, but it will only work if backed by enough official loan support when needed – this is what many countries will need to sustain a current account deficit or offset capital outflows and keep growth on track.  IMF available resources, even with the recent loan from Japan, are only around $200bn.  You really cannot save many banks/countries with that amount of money these days – the IMF lent over $40bn this month alone.

$7.8 Trillion and Counting

The New York Times has an arresting chart on the government’s new financial commitments made during the financial crisis. According to the Times, the government has committed $3.1 trillion as an insurer, $3.0 trillion as an investor, and $1.7 trillion as a lender. Wow, you may think, that’s a lot of money. US GDP is about $14 trillion per year; the budget deficit in recent years has been running in the half-trillion range. But wait, there’s more: the Times omits roughly $5 trillion in guarantees made by Fannie Mae and Freddie Mac that are now officially on the government balance sheet (although they were always implicitly there).

All that said, though, there’s a big difference between these “commitments” and ordinary government spending. Ordinary government spending simply evaporates into the economy: for example, Medicare expenses go to pay for people’s health care, and the government will never get them back. Making financial commitments is what banks and other financial institutions do, and they do it because they expect to get their money back. What we are seeing is the growth of a massive financial institution within the government. This one’s primary goal is the public interest – in this case, the health of the economy – rather than getting its money back. But still, it should get most of the money back.

Continue reading “$7.8 Trillion and Counting” →

Signs of Monetary Expansion

There was a new theme buried in today’s announcements about purchasing $600 billion in mortgage-backed assets $200 billion in assets backed by other debt including student loans, credit cards, car loans, and small business loans. The New York Times story included these two paragraphs (emphasis added):

The action by the Federal Reserve on buying mortgage-backed securities brings the full force of monetary policy to bear on the credit markets. Having already reduced the benchmark federal funds rate to just 1 percent, the central bank is now effectively using what economists call “quantitative easing” to reduce the costs of money.

Instead of trying to reduce overnight lending rates in the hope of influencing longer-term interest rates for things like mortgages, the Fed is directly subsidizing lower mortgage rates. It is doing so by printing unprecedented amounts of money, which would eventually create inflationary pressures if it were to continue unabated.

The Bloomberg article has a similar passage, indicating that this is a message the Fed is consciously putting out, while taking care to deny that they are trying to increase inflation (emphasis added)

The Fed won’t be removing cash from other parts of the financial system to make up for the purchases, government officials told reporters on a conference call. They rejected any comparison with Japan’s so-called quantitative easing effort to combat deflation, saying that the Fed’s objective is to buttress credit markets rather than ramp up money.

What does this mean? It looks like the Fed will be buying securities either by wiring cold, hard cash to sellers, or by increasing their account balances at the Fed itself, without simultaneously selling Treasuries (or asking the Treasury Department to issue new Treasuries) to sop up an equivalent amount of cash. This ordinarily would run the risk of increasing inflation, but with short-term prices falling, arguably a bit of inflation is just what we need, as Simon and Peter argued yesterday.

(If you found the last paragraph confusing, see my Federal Reserve for Beginners post.)

More economics bloggers trying to be funny: Free Exchange reported on today’s $800 billion worth of announcements and concluded with this sentence: “So, you know, hopefully that will work out.”

Bank Recapitalization Options and Recommendation (After Citigroup Bailout)

By Peter Boone, Simon Johnson, and James Kwak (pdf version is here)

Summary

1.       Debt and equity prices for U.S. banks at the close on Friday, November 21, indicated that the market is testing the resolve of the government to support the banking system. Allowing major banks to fail is not an option, as was made explicit in the G7 statement in mid-October. Significant recapitalization will be necessary to stem the pace of global deleveraging (the contraction of loans and sale of assets by banks around the world). However, the administration’s strategy is not clear.

2.       While full bank recapitalization is not a panacea, it is an important part of the policy mix that will get us through mid-2009, at which point a broader set of expansionary fiscal and – most important – monetary policies can begin to take effect.

3.       The response this weekend by the U.S. authorities in providing financial support to Citigroup is a partial, overly generous, and nontransparent recapitalization, including a large guarantee for distressed assets – which is very close to the asset purchases that Treasury only last week said it would not do.  This U-turn confuses the market (again), leaves the fate of other major banks unclear, and implies much larger contingent liabilities and little upside for the taxpayer.  This approach will be difficult to repeat multiple times because of likely political backlash.

4.       The most important goal now is to put in place a stable, transparent set of rules for bank recapitalization, with sufficient political support and limits on the scope for further policy changes.  Mr. Paulson’s seemingly haphazard approach has become a part of the system problem.

5.       While all recapitalization options have problems, the “least bad” is requiring firms to raise more capital and, for those that cannot, injecting capital through substantial purchases of common stock by the government. These can be managed through a special purpose agency or control board, which is designed to keep credit from becoming politicized and to sell the equity stakes when market conditions are sufficiently supportive.

6.       Another TARP-type round, on slightly tougher terms than October, may serve as an emergency stop-gap measure, but it will not solve the underlying problems and any positive effects could be short-lived.

Continue reading “Bank Recapitalization Options and Recommendation (After Citigroup Bailout)” →

How to Create Inflation

Simon and Peter argued in Real Time Economics earlier today that we need some inflation (see the post just before this one) – not only because deflation is bad, but also because it helps protect asset values, including the assets for which the government is now on the hook.

James Hamilton at Econbrowser has a plan for how to create some inflation (he suggests a target of 3%). And if that doesn’t work, he has an even more clever plan.

The Inflation Is Coming, The Inflation Is Coming (?)

Citigroup management gets a great deal; you and I not so much.  Consensus on right sizing the fiscal stimulus increases by about $100bn per week.  The rest of the world drags its feet on anything approaching an appropriate set of monetary and fiscal policies (yes, I’m talking about the eurozone again.)  Where does this all point?

It points to inflation.  Inflation has many drawbacks and brings its own serious risks, but inflation is better than the alternative which, as President-Elect Obama said on Saturday, is now a deflationary spiral (falling wages and prices).  The policymakers are going all in and the question now, we argue in a piece on WSJ.com this morning, is whether inflation still lies within their reach.

Citigroup Bailout: Weak, Arbitrary, Incomprehensible

According to the Wall Street Journal, the deal is done. Here are the terms. In short: (a) the government gives Citi $20 billion in cash in exchange for $27 billion of preferred on the same terms as the first $25 billion, except that the interest rate is now 8% instead of 5%, and there is a cap on dividends of $0.01 per share per quarter; and (b) the government (Treasury, FDIC, Fed) agrees to absorb 90% of losses above $29 billion on a $306 billion slice of Citi’s assets, made up of residential and commercial mortgage-backed securities. (If triggered, some of that guarantee will be provided as a loan from the Fed.) There is also a warrant to buy up to $2.7 billion worth of common stock (I presume) at a staggeringly silly price of $10.61 per share (Citi closed at $3.77 on Friday).

The government (should have) had two goals for this bailout. First, since everyone assumes Citi is too big to fail, the bailout had to be big enough that it would settle the matter once and for all. Second, it had to define a standard set of terms that other banks could rely on and, more importantly, the market could rely on being there for other banks. This plan fails on both counts.

The arithmetic on this deal doesn’t seem to work for me (feel free to help me out). Citi has over $2 trillion in assets and several hundred billions of dollars in off-balance sheet liabilities. $20 billion is a drop in the bucket. Friedman Billings Ramsey last week estimated that Citi needed $160 billion in new capital. (I’m not sure I agree with the exact number, but that’s the ballpark.) Yes, there is a guarantee on $306 billion in assets (which will not get triggered until that $20 billion is wiped out), but that leaves another $2 trillion in other assets, many of which are not looking particularly healthy. If I’m an investor, I’m thinking that Citi is going to have to come back again for more money.

In addition, the plan is arbitrary and cannot possibly set an expectation for future deals. In particular, by saying that the government will back some of Citi’s assets but not others, it doesn’t even establish a principle that can be followed in future bailouts. In effect, the message to the market was and has been: “We will protect some (unnamed) large banks from failing, but we won’t tell you how and we’ll decide at the last minute.)” As long as that’s the message, investors will continue to worry about all U.S. banks.

The third goal should have been getting a good deal for the U.S. taxpayer, but instead Citi got the same generous terms as the original recapitalization. 8% is still less than the 10% Buffett got from Goldman; a cap on dividends is a nice touch but shouldn’t affect the value of equity any. By refusing to ask for convertible shares, the government achieved its goal of not diluting shareholders and limiting its influence over the bank. And an exercise price of $10.61 for the warrants? It is justified as the average closing price for the preceding 20 days, but basically that amounts to substituting what people really would like to believe the stock is worth for what it really is worth ($3.77).

How does this kind of thing happen? A weekend is really just not that much time to work out a deal. Maybe next time Treasury and the Fed should have a plan before going into the weekend?

Update: Bloggers start trying to be funny, world to end soon:

  • Calculated Risk (on the aborted plan to divide Citi into a “good bank” and a “bad bank”): “Hey, I thought Citi WAS the bad bank!”
  • Tyler Cowen (on the same plan, which morphed into the government’s guarantee of the “bad bank” part of Citi): “Didn’t Paulson tell us just a few days ago that TARP wasn’t needed after all? Doesn’t this mean that Paulson should speak less frequently?”

Update 2: I made a mistake in the original post: although the government is getting $27 billion “worth” of non-convertible preferred stock, it is only paying $20 billion in cash. $7 billion is being granted as the fee for the government guarantee. Thanks to Nemo for catching this. (Note to self: No posts after midnight!)

Federal Reserve for Beginners

We had a comment last week asking for an explanation of, roughly, what it is that the Federal Reserve does, so I thought that would be a good topic for a Beginners post. (For a complete list, go here.) This would have been a relatively easy question to answer a year ago, but since then it’s gotten considerably more complicated. Like all Beginners articles, I’m going to make a number of simplifications, for example generally treating the Federal Reserve as one big bank (it’s really twelve different banks). I’m also going to ignore many of the Fed’s functions; for example, the Federal Reserve is itself a bank regulator, but I’m not going to discuss that.

Continue reading “Federal Reserve for Beginners” →