Month: October 2008

Nobel Laureates Debate Financial System Regulation

The Economist is hosting a debate on financial system regulation between no less than two Nobel Laureates, Myron Scholes and Joseph Stiglitz. (Be sure to read the opening statements before the rebuttals, or it may not make sense.) The debate is less over specifics than over the general question of how much regulation there should be. They may be lying low right now, but there will surely be legions of executives and economists arguing that we actually need less regulation in order to foster financial innovation.

The Economist recruited Scholes to defend this view, but unfortunately he puts on a rather tepid defense. I read his arguments three times and I think they boil down to this: Crises stem from too much leverage, and therefore bank capital requirements should be increased. (He also says, however, that “Determining the amount of leverage to be used by financial institutions is a business decision.”) If banks need additional capital in a crisis, it should be provided by the government and priced accurately. In his rebuttal he also proposes a new accounting framework, potentially implemented by a regulator, that provides a more accurate assessment of the risk faced by a financial institution. So, as far as I can tell, it boils down to: (a) higher capital requirements; (b) government capital in times of crisis; and (c) better accounting. For the rest, we can count on existing laws against things like fraud. Unfortunately, the only evidence he provides for the thesis that “more regulation is bad” is that economic growth was lower from the 1930s to the 1970s, which he calls an era of regulation, than since the 1970s, an era of deregulation. (Like everything in history, economic growth levels are overdetermined, meaning that you can find a dozen different explanations of any given historical phenomenon.)

Stiglitz doesn’t do such a great job proving the “more regulation is good” thesis, either; his evidence is that countries with “strong regulatory frameworks” are less likely to have financial crises. But Stiglitz gets at the basic question: is unbridled financial innovation good or bad? Does it really lower the cost of capital enough to compensate for the costs of crises like the current ones? Which innovations are good and which are bad? Can we get the good ones without the bad ones?

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From Your Far-Flung Correspondents, at MIT

I spent most of the last two days teaching some special sessions on the global crisis at MIT and doing final preparations for a couple of courses that will start next week.

Three relevant points strike me from interacting with students, faculty and other members of the MIT community, which – as you might guess – is a very international set of people.

First, everyone now understands this is a truly global crisis. The ramifications are already apparent in places that, even a month ago, you would have thought quite distant from the US financial sector, such as small business in India or Australian real estate (the link is of course credit). There is very little that can, in some sense, shock any more: Chinese growth could stall, credit may tighten further, European medium-term prospects are already being be called into question, and so on.

Second, very few people yet see the complete picture. We all have some pieces clear in our minds, but it’s only when we talk – particularly in a free-wheeling classroom discussion – that we begin to see how it all fits together. It’s only when you engage with someone from Iceland, or a person with money in a UK bank, or a student whose income is in a depreciating currency, that you really begin to realize the scale and interconnectedness of the problem.

Third, I’m struck and encouraged by the calmness that follows a really open discussion. People are worried, but talking about the problems helps them get perspective and start thinking about strategies. How exactly are they going to cope, what should they do differently, and where will they see the impact on this or that business?

All of this makes me think that we can usefully contribute to each other’s understanding by talking (and arguing) through more dimensions of the crisis and its impact. In that spirit, we will open up our classroom over the next two months, to bring your views and questions to MIT and vice versa. We’re still working on the exact details of how best to do this (and we’re very open to suggestions), but as much as possible it will be through this website. Tell me if it helps.

Want to Be on NPR?

One of my life’s ambitions is to be on This American Life. Now you can do the next best thing. NPR’s excellent Planet Money podcast is looking for people to talk about their personal economic situations; the hosts, joined by my co-author Simon Johnson, will talk about how you fit into the global economy and the financial crisis. It’s all explained here.

Why Banks Won’t Lend – My Theory

Some people have said that Americans go to hockey games to see fistfights and go to NASCAR races to see car crashes. This thought occurred to me over the past few days while reading The New York Times online. If there were a New York Times index, it would indicate that the financial crisis is over. I can’t recall the last time a financial crisis-related story was at the top of the home page. (Today’s Fed intervention into money markets may have been on top, but by the time I got there the lead story was Kirk Kerkorian selling stock in Ford.) Instead, we’re back to the presidential election and Iraq. For a while there, it seemed like we might have the car crash to end all car crashes in the financial system, with banks failing left and right. Now, it looks like we’ve just got a boring old recession, where millions of people will lose their jobs. Move along.

But even if the multi-car pileup has been averted, the cars are still just barely limping around the track. The problem seems to be a lack of fuel – credit, in this case. Andrew Ross Sorkin in that same New York Times points out that banks are taking their money and stuffing it into a mattress instead of lending it to companies. (Yves Smith at naked capitalism says that consumers are doing the same thing, which, while personally wise, is not the best thing for the economy.) Now, banks only make money by lending money. So why aren’t they lending?

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Sign of the Apocalypse: The TED Spread Gadget

Back in the glory days of 1999-2000 (I was in Silicon Valley at the time, and for us that was the real boom, not this housing thing everyone else likes to talk about), otherwise reasonable people would spend an inordinate amount of time checking stock tickers on their computers. It was probably one of the things, along with email, that first made the Internet a mass phenomenon. (For you kids out there, no, we didn’t have YouTube.) Well, in a perverse, bizarro-world echo of those times, now you can track the TED Spread using a Google gadget (you can add it to your iGoogle home page, or, I believe, to Google Desktop). So now you can distract yourself at work worrying about the fate of the financial system, without even having to go to Bloomberg.

By the way, it’s at 2.56, down from 4.64 on October 10. So the first battle is going well, although there are many more to fight.

(Thanks to Planet Money for catching that.)

Reader Question Roundup, 10/20/08

Besides the questions we get in comments, we got a bunch in email last week because of our op-ed in the Washington Post. (By the way, I’m behind in responding to comments on the blog, so if you see one you can answer, by all means go for it.)

Here are a few.

1. Is mark-to-market accounting part of the problem? Should it be replaced by discounted cash flow valuation?

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Korea Joins the Bailout

South Korea was one of the major casualties of the 1997-98 “emerging markets” crisis. I put “emerging markets” in quotes because, at the time, Koreans were very proud that their country had the 11th-largest economy in the world. Today it is 13th, by nominal GDP.

Yesterday South Korea announced its version of the bailout plan that is sweeping the world – $30 billion in foreign currency reserves made available to its banks, and a $100 billion guarantee on new foreign debt of its banks. But in Korea, the stakes are higher than in the US and other G7 countries. Korea is another of those countries whose banks’ have a disproportionately high level of foreign currency obligations. Rolling those over suddenly got a lot harder in the last month, for reasons we all know; now as creditors fear that banks may not be able to pay them off, the currency declines, making them even harder to pay off, and so on. The central government has $240 billion in foreign currency reserves, but that may or may not be enough to support its banking sector, which has $235 billion in foreign liabilities.

Korea is important not just because my family is from there, but because it is so big, economically – three times as big as Iceland, Hungary, and Ukraine put together in GDP terms. If the crisis spreads to countries of Korea’s scale, it’s not clear that the IMF has the resources to bail them out (and an IMF bailout would be enormously unpopular in any case).

Banks Can Borrow Money; You, Not So Much

The TED spread is down again today to 3.20 (down from 4.64 at its peak ten days ago). This means that banks are beginning to lend money to each other, which means we are less likely to see serial bank failures and a complete collapse of the financial system. This is good.

However, all is not rosy. Mortgage rates unexpectedly shot up last week – from 5.87 to 6.38 percent for a 30-year fixed-rate mortgage in the US – in a demonstration of the law of unintended consequences. Apparently, what happened was this. During the panic, investors lent money only to the US government, not to banks. However, since the nationalization of Fannie Mae and Freddie Mac, they have been regarded as as safe as the US government, and hence benefited from abnormally low funding costs. As banks become more attractive places to lend money – particularly because of the government guarantee on new senior debt, which means existing debt gets safer (banks can issue new guaranteed debt and use it to pay off the existing debt) – Fannie and Freddie become relatively less attractive. So their borrowing costs go up, and because they play an enormous role in the US mortgage system, mortgage rates go up.

The short-term jump is probably not something to get too worried about, since it basically corrects an anomalous feature of the last few weeks. However, it points out a larger problem. The Fed and Treasury are like firefighters. They decided that the top priority was preventing a collapse of the financial sector, and I agree with that priority. But now that banks are beginning to lend to each other, the next priority is resuscitating the real economy, and for that banks will have to lend to real people and real companies. We aren’t there yet.

Baseline Scenario, 10/20/08

Baseline Scenario, October 20, 2008
By Peter Boone, Simon Johnson, and James Kwak, copyright of the authors
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The Baseline Scenario is our periodic overview of the current state of the global economy and our policy proposals. It includes three sections:

Updates that have caused us to modify the baseline since the last version
Analysis of the current situation and how we got here
Policy proposals

Please note that we do not currently publish our upside and downside risk scenarios in detail.

_______________________________________________________________
UPDATES

This edition of the Baseline Scenario has been extensively updated to reflect recent events, in particular the adoption by the world’s leading economic powers of the first two of our proposals in our original Baseline Scenario.

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Capitalism = Government Intervention

OK, that may be an overstatement. When I was in graduate school, I was a “reader” (meaning I graded exams) for a course on recent US history taught by Richard Abrams. What I took away from that course was that virtually all government intervention in or regulation of the economy was done at the request of some part of the business community – most often entrenched incumbents lobbying the government for protection from new entrants.

Colleen Dunlavy of the University of Wisconsin has a blog post about the history of government intervention in the economy. Most critics of government intervention take one or both of two positions: (a) it doesn’t work or (b) it’s un-American (read: socialist). Dunlavy pretty much destroys argument (b) and, along the way, gets in some blows to argument (a). It’s useful reading as we head into a season of expanded government intervention and regulation in the financial sector.

Regulating the Financial Sector: A Modest Proposal

Building a new regulatory structure for the financial sector to replace the current, completely discredit regulatory structure will be a major task for the next administration and congress. However, at present there is a wide range of opinion over what needs to be done – believe it or not, there are those out there who think that what we need is less regulation rather than more. We’ll be pointing out serious proposals that we find out there. Note that linking does not necessarily constitute endorsement.

James Crotty and Gerald Epstein of the University of Massachusetts have put forth their nine-point plan for financial system regulation (abstract online, or download the PDF – it’s only 13 pages). Most economists (though perhaps not most people) would classify them somewhere on the heavy-handed end of the spectrum. The nine points, in summary, are:

Restrict or eliminate off-balance sheet vehicles
Require due diligence by creators of complex structured financial products (so if you create a CDO, you have to understand all the stuff in it)
Prohibit the sale of financial securities that are too complex to be sold on exchanges
Transform financial firm incentive structures that induce excessive risk-taking (so people who get big bonuses in good years have to pay them back in bad years)
Extend regulatory over-sight to the “shadow banking system” (hedge funds, private equity, special investment vehicles)
Implement a financial pre-cautionary principle (like with drugs, innovations have to be approved first)
Restrict the growth of financial assets through counter-cyclical capital requirements (um … read the proposal yourself)
Implement lender-of-last-resort actions with a sting (punish the people responsible when you bail out their companies)
Create a bailout fund financed by Wall Street (use a securities transaction tax to create a bailout fund to use next time)

I’m skeptical about 4 and 8 – human ingenuity is perhaps nowhere so unparalleled as in the creation of executive compensation schemes designed to avoid any possible constraint. 3 and 6 will be extremely controversial and can be seen as infringements on freedom of contract, at least where “sophisticated” investors are concerned. 9 is also controversial, although a variant of it was actually in the $700 billion bailout bill. But it doesn’t hurt to start thinking about it now.

Recession in China?

OK, that may be a bit of a stretch. But there’s little doubt that the global recession will take its toll on China’s double-digit growth rates.

One (emailed) response to our recent Washington Post op-ed criticized us for overlooking the role of China (although we did discuss China in the following Forbes article). In particular, the reader said, “it is my opinion that China holds all of the cards and I believe they will likely play some of them early in the next U.S. administration” – this because of China’s role in financing the U.S. deficits by investing in Treasuries. This may be true in the long run, although of course China cannot try to damage the U.S. economy without also crippling its own export-dependent economy. More immediately, though, China is facing an old-fashioned slowdown of its own.

All Things Considered did a story this past week on the impact of the global slowdown on Chinese exporters. One figure jumped out at me: 80% of the toy factories in Guangdong province have closed.

Also, the Baltic Dry Index, a measure of bulk cargo shipping costs and hence of global demand for heavy stuff (largely commodities) has fallen off a cliff this year (see the second chart in that post) – one reason why the Shanghai Composite Index is down more than 60% this year.

China is a place I won’t claim to understand. But as we all know, the Chinese government relies on an unsteady equilibrium in which it uses economic growth to legitimize the political system and convince the growing middle classes not to question the political order. Tocqueville’s observation (which I alluded to in my previous post) about the tendency of political strife to arise not out of prolonged abject misery, but when increasing expectations are dashed, could turn out to be particularly appropriate for China.

Update: Thanks to Randy for his comment (below). I fixed the error regarding the Baltic Dry Index.

Update: The Economist has a post with almost the same title as this post – but no question mark.

Emerging Market Developments

One of our readers raised some good questions about emerging markets on another post, and I’ve been planning to give you a brief update about events outside the G7, especially since we’ve been warning about potential problems.

First, according to Satyajit Das on Planet Money, Iceland’s stock market has lost 80% of its value, its currency has lost 95% of its value, and people are beginning to wonder if the country will have enough foreign currency to import enough food. In Iceland, as many people have reported, the main issue is a rapid de-leveraging as a banking sector that grew rapidly using foreign borrowing collapses as credit dries up.

Second, Hungary and Ukraine are looking for aid packages – Hungary received 5 billion euros from the European Central Bank, Ukraine was looking for $14 billion from the IMF. Dominique Strauss-Kahn, the managing director of the IMF, said, “Many countries seem to be experiencing problems because of the repatriation of private capital by foreign investors or the reduction of credit lines from foreign banks.” In other words, in a global credit crisis, people don’t want to lend to emerging markets. (The FT also published more analysis of Eastern Europe by Stefan Wagstyl.)

Finally, Newsweek has a story about the crisis in Pakistan. While domestic political instability certainly predates the financial crisis, now the economy is also under pressure. One problem: “Whereas the previous government was able to finance its current account deficit through privatization proceeds, bonds issues, and foreign direct investment, these channels have dried up with Pakistan’s security woes and the global credit crisis.” As of today, Pakistan is potentially looking to the IMF for an aid package. I assume most American readers know why instability in Pakistan is a bad thing.

One common thread is that, when lenders stop lending, emerging markets are among the first to lose access to money. Iceland is perhaps the most extreme case, where entire economy had the characteristics of an overleveraged Wall Street bank. But other countries with significant foreign-currency debts are suffering from crises of confidence by external lenders who want to get their money out before everyone else does.

Besides potentially causing steep domestic recessions and severely reducing the purchasing power of local populations, emerging market problems spill back into wealthy countries in at least two ways. First, as banks (or countries) default on their debt, lenders in those wealthy countries have one more asset they have to write down on their balance sheets. Second, the fewer strong economics out there, the fewer people available to buy our exports. Finally, the other thing we should be concerned about is political instability. Economic crises – especially after periods of increasing prosperity (see Alexis de Tocqueville) – have a way of triggering political crises in which unsavory authoritarian governments, or at least anti-Western, anti-capitalist governments, come to power. Let’s hope it doesn’t come to that this time.

Slouching Toward Recession

In any other week, the blizzard of bad real-economy news this week would have been a major story. Not this week, though, when the bailouts announced on Monday and Tuesday left the economic world in a state of cautious optimism and the stock market actually closed up for the week (admittedly, after a terrible previous week). Let’s just summarize:

Construction: Housing starts in September were 31% down from a year before, lower than expected, and building permits were down 38%.
Retail spending fell 1.2% month-over-month in September, after declines in the previous months.
Industrial production fell 2.8% month-over-month, far more than expected.

And remember, the acute phase of the credit crisis only began in the middle of September when, in the space of four days, Lehman failed, AIG was bailed out, and Paulson and Bernanke announced that we were all in serious trouble. The mood of general panic that set in then and only began to dissipate this past week is only partially reflected in these figures. In case anyone isn’t sure why these numbers matter: when consumers buy less, and companies produce less, that’s when companies lay people off.

I don’t think I’m frightening anyone here, since just about everyone thinks that we’re already in a recession. I just want to reiterate the point that even if the credit crisis begins to lift, the preceding slowdown in the real economy has become a major problem that will need major action to solve. Hence the importance of the discussion of fiscal stimulus that is kicking into gear among both economists and politicians.

The G8 called but they didn’t leave (much of) a message

On Wednesday, a colleague drew my attention to the fact that the G8 had issued a statement on the global economy from Grand Rapids, Michigan. I quickly glanced at their points and thought they didn’t add much beyond what had been said at various G-numbered, EU-type, and other subgroups over the weekend: we’re doing a lot, things will get better, trust us, etc.

Still, I was impressed that the G8 had got together quickly and, of course, the fact that Russia had joined hands with the G7 (this is how you get to 8) might be significant given the strains currently apparent in Russia and apparently looming elsewhere. So the following morning I opened the Wall Street Journal to learn more about the form of their meeting and background on the context, including any supplementary communication of messages (i.e., any such statement usually comes with spin.)

To my surprise, I found no mention in the Journal that day (sorry if I missed it; let’s say it wasn’t an article the front page, and if it was in the short highlight points, it was in very small print.) I had an opportunity on Friday to ask someone who tracks the White House closely, and he confirmed the statement came after a phone call or series of calls involving President Bush (who was visiting Michigan) and generally was not much of a news event.

Now, I wouldn’t want to make too much out of this particular incident. And I do think that, overall, policymakers at the G7 level and their close colleagues elsewhere have had a better week. But I do begin to wonder if people are relying on G7-G8 stewardship of the global economy as they have in the past.

And rule #4 in the crisis manager’s handbook is quite clear: when you have nothing to say, say nothing.