What happened to the global economy and what we can do about it
Author: James Kwak
Right here. I wouldn’t ordinarily just pass along a link you can find elsewhere, but I can’t help remarking that that makes two former chief economists of the IMF to take this position. That was Simon’s old job; his article on the topic is here. Of course, you are free to keep whatever opinion you may have about the IMF and its chief economists.
(Thanks to Mark Thoma for flagging this.)
My former employer has published a survey of business people around the world conducted in early November. It’s not particularly surprising, but I especially liked this chart (free registration required), according to which a plurality (39% to 38%) of North American companies think that their profits this fiscal year will be better than last fiscal year. (The “current” fiscal year ends sometime between November 2008 and October 2009, so in most cases it includes the steep part of the downturn.) The global numbers are 38% up and 43% down.
Maybe being an executive at a large company selects for unnaturally optimistic people. I’ve always suspected that there is a significant, quantifiable optimism bias to the statements of business people, even their private ones. (Their public ones, of course, are colored by the desire to positively influence their stock price, which can lead to some interesting results.) It’s something I’ve thought of studying but never had the time for. If anyone knows of any research, let me know.
So, the global economy is falling apart, but not in the way people expected. Under the de facto arrangement sometimes known as “Bretton Woods II,” emerging market countries pegged (officially or unofficially) their currencies to developed world currencies at artificially low rates, having the effect of promoting exports and discouraging consumption by emerging market countries and promoting consumption and discouraging exports in developed countries. Of course, the classic example of this was China and the U.S. The U.S. trade deficit and Chinese trade surplus created a surplus of dollars in China, which were invested in U.S. Treasuries and agency bonds, keeping interest rates low and indirectly financing the U.S. housing bubble and consumption binge of the last decade (and, therefore, growth in Chinese exports).
The general fear was that U.S. indebtedness would lead China to diversify away from U.S. assets, causing the dollar to fall and U.S. interest rates to rise, hurting the U.S. economy and making it harder to finance the national debt. This may yet happen someday. But instead of demand for Treasuries collapsing, it’s been demand for every other type of asset that has fallen. Treasury yields have collapsed and the dollar has appreciated about 20%. Still, despite this increased purchasing power, the fall in U.S. (and global) consumption is having a severe impact on growth of the Chinese economy. Even though the Chinese government has signaled that it will do everything in its power to keep growth above 8% per year (down from 11-12% in the past few years), the slowdown has severely constrained the ability of the urban manufacturing sector to absorb internal migration from the countryside, and there are signs of a reverse migration that is aggravating the problem of rural poverty in China. Although China may seem to have all the cards – high economic growth, large foreign currency reserves – it could yet turn out to be a major loser of the global economic crisis.
This is of course just a brief introduction. For more I recommend Brad Setser, among others: some of his posts are here, here, and here.
OK, there are probably other lawsuits already. But now a hedge fund is suing Countrywide (Bank of America), claiming that its loan modification program violates contract law and that if Countrywide wants to modify any mortgages it must buy out the existing investors at face value.
This is one aspect of the “securitization problem” that got a lot of air time on this blog a few weeks ago.
With the Federal Reserve’s main policy tool, the Fed funds rate, past the point of diminishing returns (although the target rate is 1%, the actual rate has been well below that for weeks), there are more signs that the Fed is willing to use new tools to stimulate the economy. Fed Chairman Bernanke’s speech today spelled out quite clearly (no more Greenspan-speak here) what the plan is (emphasis added):
Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve’s quiver–the provision of liquidity–remains effective. Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand. Indeed, last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. . . .
Second, the Federal Reserve can provide backstop liquidity not only to financial institutions but also directly to certain financial markets, as we have recently done for the commercial paper market. Such programs are promising because they sidestep banks and primary dealers to provide liquidity directly to borrowers or investors in key credit markets. In this spirit, the Federal Reserve and the Treasury jointly announced last week a facility that will lend against asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. . . .
Expanding the provision of liquidity leads also to further expansion of the balance sheet of the Federal Reserve. To avoid inflation in the long run and to allow short-term interest rates ultimately to return to normal levels, the Fed’s balance sheet will eventually have to be brought back to a more sustainable level. The FOMC will ensure that that is done in a timely way. However, that is an issue for the future; for now, the goal of policy must be to support financial markets and the economy.
There have been a number of articles in the last week on the shift toward quantitative easing, and in particular the fact that the Fed is no longer sterilizing all of its liquidity injections (compensating for them by selling Treasuries to suck up cash). Here’s one from FT Alphaville with some nice graphs.
In their Real Time Economics post a week ago, Simon and Peter argued that this is precisely what we need. However, opinions differ – some fear that the increased long-term risk of inflation outweighs the benefits of monetary stimulus now.
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.
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.
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:
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.
Felix Salmon has a great introductory post on synthetic bonds and CDOs.
I have a post I want to write about synthetics and inappropriate investments in general, but I have to find an hour to write it.
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)”
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.
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.
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.”
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.
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:
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!)
The Baseline Scenario 