Year: 2010

G-20 Rules; Time for Germany-Bashing

This guest post is by Arvind Subramanian, senior fellow at the Peterson Institute for International Economics.

Yesterday’s announcement by China to introduce greater exchange rate flexibility is unambiguously good news. Greater currency flexibility will help China with its domestic overheating problem. But China deserves a lot of credit for its act of responsible international citizenship, for making its contribution to global re-balancing. Two implications follow.

First, the G-20 deserves a lot of credit for the change in China’s policy. True, Secretary Geithner played his cards skillfully, balancing private chiding with public encouragement. It is also true that recent sabre-rattling by the US Congress to impose trade measures against Chinese exports may have played a role in persuading China. But it is the fact of the G-20 that allowed Secretary Geithner to convert the China currency issue from a bilateral US-China matter (on which little progress had been made for many years) to one in which a broader set of countries had a stake. The public pronouncements by Brazil and India earlier this year re-inforced this “multilateralization” of China’s currency undervaluation. This multilateralization had two positive effects. It forced China to take more seriously the international consequences of its currency policy. And it also made the politics of changing policy easier because China is seen not as caving to bilateral pressure but as responding to the wider international community. Regardless of what happens at the G-20 Summit in Toronto over this week-end, the G-20 can already count the change in China’s currency policy as its victory. Continue reading “G-20 Rules; Time for Germany-Bashing” →

It’s Not a Bailout — It’s a Funeral

The following guest post was contributed by Jennifer S. Taub, a Lecturer and Coordinator of the Business Law Program within the Isenberg School of Management at the University of Massachusetts, Amherst (SSRN page here). Previously, she was an Associate General Counsel for Fidelity Investments in Boston and Assistant Vice President for the Fidelity Fixed Income Funds.

In poetry and politics, metaphor matters. Expect some fighting figures of speech on Thursday, when the conference committee takes up the topic of the Orderly Liquidation Fund or “OLF.” Under the proposed financial reform legislation, the OLF is the facility that would hold the money needed by the FDIC to shut down a systemically important, insolvent financial institution before its failure can contaminate other firms and the broader economy. In other words, one purpose of the resolution authority and OLF is to avoid repeating the disorder and disruption of either the Lehman bankruptcy or the AIG bailout.

To be clear, many question whether regulators will have the courage to invoke this provision and pull the plug on a dying bank. Accordingly, the “prevention” measures under discussion in the legislation are critical — these included the swaps desk spinoff, hard leverage caps on financial firms, regulatory oversight over shadow banks and inclusion of off-balance sheet transactions in capital standards, among others.

One of the hottest debates concerning funding the OLF is over who should pay into the fund and when should they pay. On the question of “who,” the choices have been framed as either industry or taxpayers. And the “when” options are described as in advance of or after a failure. Many, including the House majority in its bill and FDIC Chairman Sheila Bair, support an up-front assessment on industry. Those who oppose an industry pre-fund have tried to damn the OLF as a “bailout fund” and at times the financial reform legislation as a “bailout bill.”

Continue reading “It’s Not a Bailout — It’s a Funeral” →

Why “Living Wills” Fail

By Simon Johnson

A central idea in the financial reforms currently undergoing final negotiation in the United States – and also in similar initiatives in Europe – is that large banks must draw up “living wills” that should explain, in considerable detail, how they will be wound down in the event of future failure.

The concept is appealing in theory. No one knows their business better than the banks, the reasoning goes, so they should have responsibility for explaining how they can close down their various operations – or perhaps sell more valuable parts while limiting losses for unprofitable activities. This is often presented as “smart regulation”, with government regulators requiring private sector experts to do the difficult technical work.

Tuesday’s hearing of the House Energy and Commerce Committee shed considerable light on why living wills are highly unlikely to work in practice. The hearing was actually about the oil industry – and its government-mandated plans to deal with oil spills. The committee posted the spill response plans for the Gulf of Mexico of five companies – BP, Chevron, ConocoPhillips, Exxon Mobil, and Shell – which demonstrated striking, peculiar and disconcerting similarities. Continue reading “Why “Living Wills” Fail” →

After “Financial Reform”

By Simon Johnson

Informed opinion is sharply divided about how the next 12 months will play out for the global economy. Those focused on emerging markets are emphasizing accelerating growth, with some forecasts projecting a 5% increase in world output. Others, concerned about problems in Europe and the United States, remain more pessimistic, with growth projections closer to 4% – and some are even inclined to see a possible “double dip” recession.

This is an interesting debate, but it misses the bigger picture. In response to the crisis of 2007-2009, governments in most industrialized countries put in place some of the most generous bailouts ever seen for large financial institutions. Of course, it is not politically correct to call them bailouts – the preferred language of policymakers is “liquidity support” or “systemic protection.” But it amounts to essentially the same thing: when the chips were down, the most powerful governments in the world (on paper, at least) deferred again and again to the needs and wishes of people who had lent money to big banks.

[to read the rest of this article, on Project Syndicate, click here]

They’re Just Irrational?

By James Kwak

Don’t get me wrong: I like behavioral economics as much as the next guy. It’s quite clear that people are irrational in ways that the neoclassical model assumes away, and you can’t see human nature quite the same way after hearing Dan Ariely talk about his experiments on cheating. But I don’t think cognitive fallacies are the answer to everything, and I don’t think you can explain away the myriad crises of our time as the result of them, as Richard Thaler does in his recent New York Times article.

Like many people, Thaler wants to write about the parallels between the financial crisis and the BP oil leak. For Thaler, the root cause of both crises is that “people in general are not good at estimating the true chances of rare events, especially when human error may be involved” — catastrophic market seizures in the first case, catastrophic oil rig explosions in the latter case.

I have no doubt that it is true that people have problems estimating the chances of certain rare events.* But to stop there is to whitewash the sins of the companies and the executives who created these crises.

Continue reading “They’re Just Irrational?” →

Don’t Forget The Kanjorski Amendment

By Simon Johnson

Substantive discussion in the House-Senate financial reform reconciliation conference is focusing on the Lincoln amendment, with some back-and-forth on the Volcker Rule (as manifest in the Merkley-Levin amendment). The FT reports today that Paul Volcker is no longer opposed to the Lincoln approach – now it has become clear that this is really just about (substantially) raising the capital that banks need to back derivatives trading. And the influential Tom Hoenig, of the Kansas City Fed, appears to be strongly in the Lincoln camp.

While our most experienced regulators weigh in, the lobbyists start to struggle. The mobilization of broader support against gutting the legislation also helps – the earlier Senate debate has raised sensitivity levels and there is a new concentration to the public scrutiny. The reconciliation process itself is much more open than would ordinarily be the case – a result of outside pressure.

But amidst all this excitement and potential moving parts, don’t forget about the Kanjorski amendment (not currently on the list of most prominent topics). Continue reading “Don’t Forget The Kanjorski Amendment” →

Why Section 716 is the Indispensable Reform

By Jane D’Arista

This guest post is contributed by Jane D’Arista, a research associate at the Political Economy Research Institute at the University of Massachusetts, Amherst, and co-coordinator of its Economists’ Committee for Stable, Accountable, Fair, and Efficient Financial Reform (SAFER). She has taught in graduate economics programs at several universities and served on committee staffs of the U.S. House of Representatives.

Dominated by the world’s largest banks, the over-the-counter (OTC) derivatives market has been expanding since the break-down of the Bretton Woods Agreement in the early 1970s privatized the international monetary system by shifting the payments process from central banks to commercial banks. The proliferation of foreign exchange forwards and swaps that followed set in motion an ever-expanding menu of exotic instruments that reached a nominal value of over $600 trillion by the middle of the current decade. Central banks and financial regulators ignored the implications of the growth of this market and ignored warnings from the Bank for International Settlements (BIS) and the International Monetary Fund (IMF) from 2002 forward that OTC derivatives were at the center of what had become a global casino in which the largest international institutions were the biggest speculators.

The large, international institutions that created the OTC market for foreign exchange forwards and swaps were commercial banks. Following established banking practice, they conducted their derivatives business like portfolio lenders rather than broker/dealers, buying and selling forwards and swaps outside of established markets. But OTC derivatives contracts can’t be classified as assets or liabilities until they are settled and can’t be held on banks’ balance sheets the way loans and deposits are held. Instead, they were booked off balance sheet as contingent liabilities. The market structure that emerged in what came to be the largest market in the global economy was one in which non-tradable contracts were bought by and sold to customers without real time information on volume or pricing or the aggregate positions of the dealers themselves. Moreover, the fact that the contracts were illiquid required constant hedging by dealers that expanded their positions and inflated the size of the market relative to all other national and international financial markets. Meanwhile, the commercial bank dealers’ derivatives business was operating with all the implicit guarantees and subsidies that governments put in place to protect this core financial sector. In 2008, those guarantees became explicit and were exercised.

Continue reading “Why Section 716 is the Indispensable Reform” →

Decision Time: Has the President Abandoned Paul Volcker’s Ideas On Financial Reform?

By Simon Johnson

The official reconciliation process between Senate and House reform bills will get underway next week, but the behind-the-scenes maneuvering (and intense lobbying) is already well underway. The main remaining question is whether the final legislation will ultimately make the financial system at all safer than it was in the run up to the crisis of September 2008.

How do big banks repeatedly get themselves into so much trouble? Dangerous banking in today’s world involves banks trading securities and, in that context, taking positions – i.e., betting their own capital. For example, almost all the profits made by big banks in 2009 came from securities trading. When market conditions are favorable and traders get lucky, the people running these banks (and hopefully their shareholders) get tremendous upside. But when this same risk-taking behavior results in big losses, the major negative impact is felt in terms of a major recession, raising government debt, and sharply lower employment.

“Wall Street gets the upside, and society gets the downside” is an old saying that is now more relevant than ever. This asymmetry in incentives explains how smart people with concentrated financial power can cause so much damage – according to, for example, the Bank of England’s analysis. Continue reading “Decision Time: Has the President Abandoned Paul Volcker’s Ideas On Financial Reform?” →

Can the Buy Side Take on the Sell Side?

By James Kwak

The Economist did not like 13 Bankers: “A broader perspective would have led to more nuanced conclusions. The origins of America’s financial ‘oligarchy’, for instance, might have more to do with campaign-finance rules and political appointees than banks’ size. The faith that Messrs Johnson and Kwak put in merely capping the size of banks is misplaced.”*

But a reader pointed us to the Economist columnist who goes by the name of Buttonwood (the site of the founding of the New York Stock Exchange), who seems a bit more favorable. In a recent column criticizing the rent-seeking of the financial sector, Buttonwood seems to tell broadly the same story:

“Something has clearly changed within the past 40 years. Banking and asset management used to be perceived as fairly dull jobs, which did not attract a significant wage premium. But after 1980, financial wages started to climb much more quickly than those of engineers, another profession that ought to have benefited from technological complexity.

“Around the same time, banks became more profitable.”

He even nods toward breaking up the banks:

“At the moment, governments are wading in with all kinds of levies and regulations, which will probably have unintended consequences. Rather than tackle the big problem (for example, by breaking up the banks), they waste their time on populist measures like banning short-selling.”

Continue reading “Can the Buy Side Take on the Sell Side?” →

The Perils of Studying Economics

By James Kwak

Patrick McGeehan at the New York Times recently wrote about a New York Fed study finding that studying economics makes you a Republican. The headline conclusion is that the more economics classes you take, the more likely you are to be a Republican. Majoring in economics or business is also more likely to make you a Republican. (See Table 2 in the original paper.) The study is based on thousands of observations of undergraduates at four large universities over three decades, so it is focused on undergraduate-level economics.

Studying economics also affects your position on several public policy issues. Of seven issues, economics courses were significantly associated with the five following positions (Table 6):

Tariffs are bad.
Trade deficits are not so bad.
The government should not cap oil prices in response to a supply shock.
Raising the minimum wage increase unemployment for low-wage workers.
Income distribution should not be more equal.

These are all pro-free market, anti-government intervention positions.

Continue reading “The Perils of Studying Economics” →

Investment Banks and the World Cup

By James Kwak

A reader alerted me to the World Cup forecasting competition, which includes links to the predictions made by several major investment banks’ models, and some data you can use if you want to give it a shot. The predictions:

JPMorgan Chase: England
UBS: Brazil (UBS also has South Africa as the team most likely to make the second round, which seems surprising.)
Goldman: Brazil
Danske Bank: Brazil

I typically root for France, because I started following soccer while living in France back in the early 1990s, but I don’t think I can this time because (a) they don’t deserve to be in the World Cup Finals, having beaten Ireland on an obvious hand ball and (b) I can’t stand their coach, who has managed to transform an incredibly talented group of players into a mediocre team.

As for who will win, I would go with Nate Silver (who recently signed with the Times for three years) if he made a prediction, but I don’t think he has.

Enjoy.

Richard Fisher (Federal Reserve Bank Of Dallas): Larry Summers, The G20, And Financial Dementia

By Simon Johnson, co-author of 13 Bankers: The Wall Street Takeover and The Next Financial Meltdown

Richard Fisher, president of the Dallas Fed, has long been a proponent of serious financial sector reform. As a former commercial banker, he sees quite clearly that the legislation now headed into “reconciliation” between House and Senate versions amounts to very little. He also knows that pounding away repeatedly on this theme is the best way to influence his colleagues within the Fed and across the policy community more broadly.

He is now taking his game to a new, higher level. Couched in the diplomatic language of senior officials, his speech on June 3 to the SW Graduate School of Banking was both a carefully calibrated assault on the administration’s general “softly, softly” approach to the big banks and a direct refutation of arguments put forward by Larry Summers in particular.

As the title of Mr. Fisher’s speech implies, if the legislation is not real financial reform (and it is not, according to him), then our current policy trajectory amounts to facilitating further rounds of financial dementia. Continue reading “Richard Fisher (Federal Reserve Bank Of Dallas): Larry Summers, The G20, And Financial Dementia” →

French Connection: The Eurozone Crisis Worsens Sharply

By Peter Boone and Simon Johnson

The big news is France. With sentiment worsening across Europe, France has lost its relative safe haven status – credit default swap spreads on French government debt were up sharply today.

The trigger – oddly enough – was Hungary’s announcement that its budget is worse than expected (blaming the previous government; this is starting to become the European pattern) and in the current fragile environment discussed yesterday, this relatively small piece of news spooked investors. But these developments only reinforced a trend that was already in place. Continue reading “French Connection: The Eurozone Crisis Worsens Sharply” →

The Maginot Line Illusion

By Peter Boone and Simon Johnson

Many commentators suggest Spain is now the euro zone’s Maginot line. The argument is clear: Spain, with GDP over $1.3 trillion (8^th largest in the world; 5^th largest in Europe) and its large outstanding bank and public debt, is simply too big to fail without causing irreparable harm to the euro zone financial system. If we dig in here, the reasoning goes, eurozone market upheavals can be stopped.

Just as Germany did in 1940, in past weeks global market forces circumvented this new Maginot line without serious resistance. The events that shook equity markets were not just in Spain; they were everywhere in the world. The cost of protecting against default on India’s largest private bank rose 79BP, or 44%, and the cost of protecting against major Korean banks’ default similarly rose 45%. Oil prices collapsed and emerging markets found their access to credit markets dried up. The interest rate for lending between banks in US dollars (LIBOR) shot up, and investors piled funds into their currently perceived “safe-havens” driving down the yields of German, French, and US bonds.

This pattern reflects the core problem facing world markets today. Investors have already begun to extrapolate from eurozone problems to understand that the world remains a highly dangerous place. The latent dangers include our overreliance on rapid Asian growth that might falter, the pressure for sharp fiscal tightening in nations with high deficits (other than in the world’s “safe havens”), and highly leveraged banks that continue to own toxic real estate, weak sovereign debt, and other assets. If world financial markets once again decide their risk appetite is again low, there are many unsustainable leveraged institutions and governments that are in for a tough ride. Continue reading “The Maginot Line Illusion” →

Eugene Fama: “Too Big To Fail” Perverts Activities and Incentives

By Simon Johnson, co-author of 13 Bankers

In our continuing financial debate, one of the central myths – put about by big banks and also not seriously disputed by the administration – is that reining in “too big to fail” banks is in some sense an “anti-market” approach.

Speaking on CNBC at the end last week, Gene Fama – probably one of the most pro-market economists left standing – pointed out that this view is nonsense. (The clip is here, and also on Greg Mankiw’s blog; TBTF is the focus from about the 5:50 minute mark.)

Having banks that are Too Big To Fail, according to Fama, is “perverting activities and incentives” in financial markets – giving big financial firms,

“a license to increase risk; where the taxpayers will bear the downside and firms will bear the upside.” Continue reading “Eugene Fama: “Too Big To Fail” Perverts Activities and Incentives” →