Arvind Subramanian has a new article on the financial crisis in emerging markets. He focuses on some of the differences between the 1997-98 crisis and the present day. For one, increased global trade makes emerging markets more susceptible to economic conditions in wealthy nations – and, as we all know, those conditions are considerably worse now than ten years ago.
Category: External perspectives
Credit Crunch: Did We Make It All Up?
There is a paper by three economists at the Federal Reserve Bank of Minneapolis that is getting a lot of attention on the Internet today. (How often can you write that sentence?) V.V. Chari, Lawrence Christiano, and Patrick J. Kehoe set out to debunk four myths about the financial crisis:
- Bank lending to nonfinancial corporations and individuals has declined sharply.
- Interbank lending is essentially nonexistent.
- Commercial paper issuance by nonfinancial corporations has declined sharply and
rates have risen to unprecedented levels. - Banks play a large role in channeling funds from savers to borrowers.
In short, they are saying that despite all the hand-wringing about banks not lending to consumers and businesses, it just ain’t true, and even if it were, most lending isn’t done by banks anyway. The implication, to simplify somewhat, is that we are in a media storm of hype that may itself have negative effects.
While I would love to believe this, I don’t think they make the case conclusively. A few quibbles (for this to be understandable, you may have to look at the original paper):
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.
The Last Six Weeks, Summarized
One of our goals is to help increase understanding of the financial crisis, so that people can understand the policy choices facing our countries today. Doug Diamond and Anil Kashyap have done two guest posts on the crisis for the Freakonomics blog: one on September 18, just after the announcement of the Paulson plan, and one just yesterday. These aren’t quite explanations for beginners – they presume some understanding of debt, equity, credit default swaps, and so on – but they summarize and explain some of the key developments relatively clearly, and also lay out their opinion of the current U.S. recapitalization plan.
Henry Paulson, Meet Warren Buffett
Bank recapitalization is in the air, which tends to prompt at least two responses: (a) what’s bank recapitalization? or (b) this is socialism!
Bank recapitalization is when an external entity buys new equity shares (stock, as opposed to bonds) in a bank in exchange for cash. The effect is to boost the bank’s assets without increasing its liabilities; since one worry about the banking sector is that it does not have enough capital (that is, it may not have enough assets to balance its liabilities), this is a good thing. (If the bit about capital, assets, and liabilities is confusing, see Financial Crisis for Beginners.) Of course, there’s no such thing as a free lunch, and in this case the bank’s existing shareholders get diluted, because they don’t own as much of the bank as before. But, in general, it’s better to own part of a bank that exists than a larger part of a bank that no longer exists.
Bank recapitalization could be as simple as this: the government (meaning the taxpayer) gets the same kind of deal that Warren Buffett got when he invested in Goldman two weeks ago. In that deal, Buffett paid $5 billion for preferred stock at $123 per share. The preferred stock pays a 10% dividend, meaning that Buffett gets $500 million per year from Goldman’s cash flow. He also got warrants that give him the right to buy up to $5 billion worth of common stock at $115 per share. At the time the deal was announced, Goldman common stock was trading at $125. Even though Goldman closed at $101 yesterday (and has fallen so far today), Buffett is still getting a 10% yield from the $500 million dividend, and if Goldman goes up he stands to make a lot of money from the warrants.
More Economists for Coordinated Recapitalization and Debt Guarantees
The Center for Economic and Policy Research has rushed out, and I mean that in the best sense of the term, a survey of economists’ recommendations for the world’s economic policymakers and, specifically, for the meeting of G7 finance ministers this week. The economists who contributed to the 40-page report (once there, click on the title to download the PDF), while presenting a range of views, generally agree on the need to recapitalize the banking sector and, with some dissent, to guarantee short-term bank liabilities in order to calm fears in the financial markets. They also agree on the urgent need for coordinated action across countries. These are positions we have been advocating on this site, and we are glad to see many other people on the same page.
Who Will Be the Blackwater of the Bailout?
Where there are $700 billion of funds to manage, there will be fund managers. And whether because of the ideological (small-government) preferences of the administration, or because mortgage-backed securities really are hard to analyze and value, or because of the speed required, it is highly likely that those fund managers will be working as contractors, not as employees of the Treasury Department.
Simon and I wrote our first op-ed last week on the challenges of aligning fund managers’ incentives with those of investors (in this case, taxpayers), but with all of the events of the last week this topic has not received a lot of attention. Christopher Dodd did add language addressing the problem of conflicts of interest, but it’s not clear how conflicts will be avoided in practice. Fortunately, Philip Mattera at Dirt Diggers Digest has been focused on just this issue for the past week. His prediction? The big winner could be the bond specialists at Pimco – who boast a special advisor named Alan Greenspan.
The Feldstein Proposal
There’s a resurgence of interest in the proposal originally made by Marty Feldstein. The link to his recent Financial Times piece is here. He wants the Treasury to borrow and on-lend to homeowners, in a way that would improve their cash flow and make it easier for them to avoid defaulting on mortgages. Of course, anyone who participates would reduce their mortgage (a claim on their house) but create a debt to the government (to be collected, if necessary, by the IRS.)
I must say that I find this broadly appealing, in the moment we now find ourselves. I know it doesn’t address mortgages already in default, and there are many questions about how it could be implemented. And I agree that Congress, at this juncture, would need a lot of convincing.
Still, it’s one way to use the Treasury balance sheet to directly reduce likely mortgage defaults. And, if it’s part of a comprehensive approach (including recapitalizing banks), I think this general approach could make sense.
I hope others will post reactions, or links to any variants with plausible details.
The Baseline Scenario 