Too Small To Fail

By now you probably know all you need to know about Too Large To Fail (Citigroup), Too Interconnected To Fail (AIG), and Too Many Potential Job Losses To Fail Before A New Administration Takes Office (GM).  Almost all the bailout cases we have seen recently were some combination of the above and they generally shared the characteristic of being large relative to the US and perhaps global financial system.  We have become accustomed to bailout increments in the hundreds of billions of dollars, and to periodically reassessing how many trillions have been committed by the Federal Reserve and others.

Today we received confirmation of something quite different: a bailout package for Latvia.  Latvia is a small country (2.2m people) and it is receiving a loan of just $2.35bn from the IMF.  The loan is obviously tiny compared with other bailouts (Citigroup received at least 10 times as much in November), but it is big in relation to Latvia’s economy – in IMF parlance, the loan is 1,200 percent (or 12x) Latvia’s quota.  Quotas are based on the size of your economy, among other things, and it used to be that 3x quota was a big loan and 5x quota really raised eyebrows.  (Iceland recently broke some records in this regard (official numbers here), and perhaps we are now in a brave new world where borrowing over 10x quota becomes more standard.)

We can scrutinize the full details of the program when it becomes public, but the press release already makes the key point quite clear,

Continue reading “Too Small To Fail” →

All Financial History for Beginners

I was really hoping I could recommend The Ascent of Money by Niall Ferguson as a kind of catch-all Beginners book, in the spirit of my Beginners articles. Its subtitle is “A Financial History of the World,” after all. But I have to say it fell short of my expectations, although it would still make a nice gift. And although it has 360 pages, the spacing is wide and the margins are big, so you could buy it in the morning, read it in the afternoon, and still wrap it up in time for Christmas.

The book proceeds through a series of historical lessons, one for each major asset class – money (meaning primarily bank credit), bonds, stocks, insurance, real estate, and “international finance.” And there is certainly a lot of fascinating history to learn in there. For example, although I spent seven years dealing exclusively with insurance companies, and I knew about the usage of insurance in early Renaissance Italy, I had never read the story of the Scottish Widows’ Fund, the first true insurance fund designed to be self-financing in perpetuity. Nor did I know how Nathan Rothschild made a fortune betting that UK government bonds would rise in the years after Waterloo (because the government’s need for borrowing would decline). And the book does touch on many of the historical parallels you have probably been reading about during the past few months, from the Great Depression to the S&L crisis to Japan’s lost decade and the emerging markets crisis of 1997-98. Ferguson is also an excellent writer, and even your friends and relatives who are less excited by topics such as bond yields and the money supply will probably find most of it enjoyable going.

But the problem is that the book is just too short. Niall Ferguson made his reputation writing some very big books about considerably smaller topics. Reading this smallish book about an enormous topic, I got the feeling that he wasn’t allowing himself enough pages to deal with each topic in the depth he would have liked. This has two consequences. First, even though he is clearly writing for the general reader, there are places where he doesn’t take enough care to define his terms, and where he is bound to lose large parts of his audience. For example, describing the capital structure of what would become the Mississippi Company, which mixed new shareholder’s capital, billets d’etat issued by Louis XIV, and perpetual bonds, he lost me. So if you really want to understand the shift of European governments from confiscatory taxation to borrowing, you’ll need to look elsewhere.

Second, The Ascent of Money necessarily treats in just a few pages topics on which entire books – and quite long ones, sometimes – have been written, and if you’ve read those books, you’ll find the summaries here pale by comparison. For example, Ferguson makes Enron (on which see The Smartest Guys in the Room) into an emblematic bubble company (“the Mississippi Company all over again”), the bubble this time inflated by cheap money, courtesy of the Federal Reserve. I think calling Enron a bubble company is a only part of the story, since much of what it did – dating back to the early 1990s – was accounting fraud that needed no bubble to exist (although the bubble certainly magnified the scale of the take); Pets.com would be more of a pure bubble company. Similarly, Ferguson’s account of Long-Term Capital Management emphasizes the quantitative arbitrage premise of the fund; but the big bet that killed LTCM was not arbitrage by any means, but a one-sided bet against volatility – a bet that was informed by quantitative analysis (volatility was high, so LTCM thought it would go down) but was ultimately a gambler’s bet, as described in When Genius Failed.

As for the current crisis, Ferguson had the fortune or misfortune of finalizing the book in May, and so missed out on the events of the last few months. At the time he was writing, it still seemed like the crisis would only hasten the day when China would overtake the U.S. as the world’s largest economy (“at the time of writing Asia seems scarcely affected by the credit crunch in the U.S.”). Which, of course, only shows how unpredictable the events of the last four months have been, that China is now facing its most serious labor unrest of the last ten years. Hey, I didn’t see it coming, either. As a historian, the narrative he wants to tell is one of a shift in the balance of economic power from the U.S. to China. Of course, it still may happen – we just won’t know for a couple of decades, at least.

Thanks, But We Can Take Care of Ourselves

Every once in a while, someone leaves a snarky comment on this blog along the lines of “Well, have you ever started your own company?” I usually leave them alone, although occasionally I can’t resist responding. In general, I just think that my experience co-founding one company in one industry does not really qualify me to say anything that knowledge and logic wouldn’t qualify me to say anyway. In particular, having been through the experience, I can say that the amount of luck you need dwarfs any other attributes you bring to the table, so starting a company is not a particularly useful filter.

But now Michael Malone has managed to aggravate me with an op-ed in the Wall Street Journal called “Washington Is Killing Silicon Valley.” And Silicon Valley being one of the parts of our economy I know particularly well, I feel compelled to respond.

Continue reading “Thanks, But We Can Take Care of Ourselves” →

German Finance Minister Confirms What We Have Been Saying

The Wall Street Journal’s Real Time Economics/Secondary Sources today juxtaposes:

1. Peer Steinbruck, the German Minister of Finance, saying that Germany will not engage in “extensive debt financed-spending or tax-reduction programs.”

2. My posting, from yesterday, which makes the point that a big fiscal stimulus in the US strengthens the incentive for our major trading partners to free ride, i.e., not to engage in their own extensive debt financed-spending or tax-reduction programs.

Looks like we are still on at least this part of our baseline.

What About Bank Capital?

The Obama team’s plans are big and bold on key dimensions.  The fiscal stimulus will be one of the largest ever in peacetime.  We don’t yet know how much support there will be for a housing refinance initiative, but there is no question that the proposal will be huge.

But in this mix the lack of serious discussion (yet) of the need for new capital in the banking system is striking.  It could be, of course, that reports on the lack of capital have been greatly exaggerated.  And it could also be that a detailed assessment of the capital injections so far might indicate they have had less effect than previously expected – although you have to think about the counterfactual, what would the situation be now without these capital injections?

Most likely, the strategic thinking is along three possible lines here.

1) No more capital is needed because the fiscal stimulus will be large enough to turnaround the economy, bringing back growth and gradually steepening the yield curve (so banks can go back to making money the good old-fashioned way; borrow short, lend longer).  This is a plausible approach, but  risky.  There is a great deal that can go wrong or at least delay the positive effects of a big fiscal push, particularly in the current global economic environment – see my piece on Forbes.com today.

2) If more capital is needed at any point, it can be provided on the same sort of terms that Citigroup received in November.  This seems dubious because I would expect a political backlash if there is an attempt to repeat or scale up this deal.  The terms were simply too unfavorable to the taxpayer.  And we should probably now move beyond relying on weekend rescues of major financial institutions; too much can go wrong under that kind of pressure.

3) If more capital is needed, there is a plan but it is secret for now.  This might have some appeal, in the sense that any plan would be controversial and could distort incentives.  But Congress would surely appreciate knowing at least the potential scale and strategic direction for bank recapitalization in advance – after all, Mr. Paulson’s surprise request to them in September did not go down well initially and did not work out well later.  Any sensible plan would presumably involve the commitment of some hundreds of billions of dollars.  This would be an investment on which the government can earn a good return, but more details in advance on potential deal structures could help us understand exactly the value proposition for the taxpayer.

Some proposals – after we saw what happened at Citigroup – for recapitalizing the banking system are here.  Our approach may not be the answer, and I understand why many on Wall Street would prefer to do things differently.  But I do think we need more debate around a plan for recapitalization contingencies, and this should be done sooner rather than later.

The Perils of Exports

The steep decline in U.S. consumer spending is clearly taking its toll on the U.S. economy. But still, the U.S. has one advantage over many of its trading partners. Theoretically at least, our government has the tools it needs to boost domestic demand and thereby increase production. This is not true of the many countries who depend on exports for a large share of their economic growth.

I was taking a tour of the world’s news today and came across the following (courtesy of the FT):

  • Japanese exports fell 27% year-over-year in November, the largest fall ever; remember, exports were a major reason Japan finally emerged from its decade-long slump a few years ago.
  • Thai exports fell 19% year-over-year in November, the first decline since 2002 – and exports make up 70% of GDP. The numbers may have been artificially reduced by political conflict in late November, but political conflict is hardly a good thing in itself.
  • China is looking less and less like the big winner of the global recession and more and more like a significant loser. 10 million migrant workers have lost their jobs by the end of November. In response, “the State Council, China’s highest governing body, issued a decree to local governments over the weekend ordering them to create jobs for migrant workers who had returned to their home towns.” Prime Minister Wen Jiabao went as far as saying that a government priority is to “make sure all graduates have somewhere constructive to direct their energy” – somewhere other than social protest, that is.

One of the challenges of an export-driven economy is that when your consumers (Americans and Europeans) stop buying, you have few direct tools to get them buying again. There has been speculation that China could take the opportunity to stimulate domestic consumption and shift its economy away from reliance on exports, but that clearly can’t happen fast enough. Another trick exporters can use is to devalue their currencies, but that will crimp domestic purchasing power and potentially lead to a round of competitive devaluations, with wealthy countries printing money in an effort to stave off deflation and thereby devaluing their own currencies. In the meantime, everyone will be watching the Obama stimulus plan carefully.

One World Recession, Ready or Not

The usual grounds for optimism these days is the fact that the Obama Administration is clearly going to propose a big fiscal package with two components: a large conventional stimulus (spending plus tax cuts); and a big housing refinance scheme, in which the Treasury will potentially become the largest-ever intermediary for mortgages.

These ideas are appealing under the circumstances, but this Fiscal First approach also has definite limitations, for both domestic and foreign reasons.  Continue reading “One World Recession, Ready or Not” →

Japan for Beginners

For a full list of Beginners articles, see the Financial Crisis for Beginners page.

The most common point of comparison for our current economic crisis is, far and away, the Great Depression. The Depression is most often bracketed with some version of the phrase, “but we’re unlikely to see a depression, just a recession,” whatever that’s supposed to mean. And, fortunately for us, with the addition of Christina Romer, we now have two scholars of the Great Depression on our nation’s economic policymaking team.

But in many ways, a more relevant comparison may be the Japanese “lost decade” of the 1990s, when the collapse of a bubble in real estate and stock prices led to over a decade of deflation and slow growth. This is the Nikkei 225 index from 1980 to the present.

Nikkei

Continue reading “Japan for Beginners” →

We Have a Winner?

After seeing dozens of mortgage proposals emerge over the past several months, there are news stories that Larry Summers and the Obama economic team are converging on an unlikely candidate: the proposal by Glenn Hubbard and Christopher Mayer first launched on the op-ed page of the Wall Street Journal on October 2. Hubbard and Mayer published a summary of the plan in the WSJ last week; a longer version of the op-ed is available from their web site; and you can also download the full paper, with all the models.

Continue reading “We Have a Winner?” →

When Consumers Get Depressed

The Return of Depression Economics, by Paul Krugman, is certain to be one of the most gifted books this holiday season; that’s what happens when you combine a Nobel Prize with a massive economic crisis and book with the word “depression” in the title. Here’s another reason to buy it for someone, as I found out: it’s so short you can read it in a couple of hours before wrapping it up.

The title of the book refers broadly to the recurrence of a need to deal with Depression-style economic threats, a theme that originally (in the 1999 edition) referred to the emerging markets crisis of 1997-98 and and the stagnation in Japan caused by the collapse of their housing bubble at the beginning of the 1990s. More particularly, however, it refers to the problems brought on by a collapse in economic demand – “insufficient private spending to make use of the available productive capacity,” as Krugman puts it. And it seems clear that that’s where we are today. The Case-Shiller index of housing prices reached its peak in real terms sometime in 2006, but the economy continued to grow until the end of 2007, even as housing prices fell significantly. Although the negative wealth effect of falling housing must have had some effect, people still wanted to spend. When the severe phase of the crisis began in September 2008, it was widely described as a credit crunch, meaning that reductions in the supply of credit were making it difficult for borrowers to get the money they needed, either for investment or consumption. Today, however, as Simon has said before, falling demand for credit may be just as big a problem. People just don’t want to borrow money any more, and if that’s the case, then increasing the supply of credit (by funneling cash into banks) will have only a limited effect, as we’ve seen. This is what Krugman finds most worrying about the current situation: the “loss of policy traction,” in which even dramatic moves by the Fed have only a limited impact ont he real economy.

He doesn’t quite come out and say it in so many words, but a lot of Krugman’s story has to do with what might be called psychology. He describes how economic crises may be the product of poor governmental policies and weak economic fundamentals – or they may be entirely the product of panics that have the very real effect of destroying wealth and setting countries back for years. Seen from this perspective, the scale of the current crisis may not have any proportional relationship to the fundamental flaws of our economy (or the global economy). It may simply reflect the fact that the scale, liquidity, and leverage of the global financial system have made it possible for panics to have much greater damage than they did in the past. (I know we’re still not dealing with anything on the scale of the Great Depression, but while the financial system was simpler then, it also had a simpler flaw – the lack of deposit insurance – and a simpler mistake – the failure to expand monetary policy in response to the downturn.)

The fact that you are reading this blog probably means that you would not learn a lot about the current crisis from Krugman’s book (especially if you’ve already read his article in The New York Review of Books), but you might learn something about the crisis of the 1990s, and the dynamics of currency crises. In 1997-98, multiple unrelated emerging market countries suffered panics and currency crises, and the response of “Washington” (the U.S. and the IMF) was to demand fiscal austerity – higher interest rates, lower government spending, higher taxes – in exchange for bailout loans. Now, of course, when large parts of wealthy country economies need to be bailed out, few people are calling for austerity; in the U.S., liberals and (most) conservatives differ only on whether the deficit should be increased through government spending or through tax cuts. Ten years ago, perhaps the austerity argument was defensible: in order for countries to gain credibility (and be able to pay back their loans), they needed to improve their government balance sheets. And at the time, the U.S. could be confident that reduced purchasing power in Thailand, South Korea, and Russia would have little effect on our economy. Today, however, the entire world is facing a steep downturn, and an economic stimulus will be most effective if it is roughly coordinated across countries, including emerging markets. So far the IMF appears to be using a gentler hand than last time, although so far most countries are attempting to steer clear unless absolutely necessary. The fact is that preventing an economic collapse in emerging markets will be an important of our recovery this time, both because of the importance of foreign trade and because of the amount of cross-border investment (think about the massive inflows into international stock funds in the past ten years).

In any case, it’s a quick read, and for those who are nervous about Krugman’s politics they make only a very brief entry near the end.

Managing Financial Innovation

Financial innovation tends to be a bit of a bad word these days. But while I and many other people are in favor of an overhaul of our regulatory system, that still leaves open the question of how the system should be managed.

A reader pointed me to a 2005 paper by Zvi Bodie and Robert Merton on the “Design of Financial Systems.” They argue that neoclassical finance theory – frictionless markets, rational agents, efficient outcomes – needs to be combined with two additional perspectives: an institutional approach that focus on the structural aspects of the financial system that introduce friction and may lead to non-efficient outcomes; and a behavioral approach that focuses on the ways in which and the conditions under which economic actors are not rational (see my post on bubbles, for example). The paper walks through examples of how to think about some real problems we face, such as the fact that households are increasingly being forced to make important decisions about retirement savings, but generally lack the knowledge and skills to make those decisions. One of their arguments is that while institutional design may not matter in a pure neoclassical world, it does matter in the world of irrational actors: deposit insurance to stop bank runs is an obvious example.

Some of the content may be tough going, but in general the paper offers one perspective on how to think about the relationships between markets, institutions, and individual behavior that make up our financial system.

When Will the G7 Intervene?

The dollar is depreciating in eye-catching and headline-grabbing fashion.  The Japanese authorities are signalling that they are prepared to intervene.  The G7 (remember them?) has the established role of coordinated intervention in major currency markets when things get out of hand.  So where are they now and when will they come in?

The answer is: you may have to wait a long time.  This round of dollar weakening is the direct result of easing monetary policy in the US.  The Fed doesn’t usually talk about the dollar (leaving this to the Treasury, which has a tradition of obfuscation on the issue), but dollar depreciation is fully consistent with (1) wanting to prevent deflation, and (2) hoping to stimulate growth through exports.  The spinmasters would probably also say that actions to restore confidence in the global financial system are reducing demand for dollars as a safe haven, and this is reflected in currency markets.

You may or may not agree with this logic, but from a US perspective there can be little interest in immediate intervention.  The Japanese are obviously unhappy when their exchange rate appreciates beyond 95 yen to the dollar, but their G7 partners are pretty unsympathetic at that level – Japan has been running a massive current account surplus (hence its reserves of over $1trn) and has long been in line for some appreciation.  At 85 yen to the dollar, things would start to get more animated, and almost everyone would support intervention at 80.

The dollar-euro thinking is even more interesting.  The US (and my former colleagues at the IMF) are obviously pressing for a big fiscal stimulus in Europe.  But key European governments are just as obviously demonstrating the desire to free ride, i.e., you put through a hefty fiscal package of $850bn and I’ll get back to growth through selling you more BMWs.  While the US will of course observe every diplomatic nicety in this situation, privately the outgoing and incoming administrations must be enjoying the fact that dollar depreciation puts the European Central Bank – and particularly the Germans’ export driven economy – very much on the spot.

Personally, I think the euro-dollar rate would have to move much further, probably close to 1.6 dollars per euro, for the intervention conversation to get serious.  Of course, if markets become “disorderly” so that prices jump around in an unusual way, there are always grounds for intervening.  But, on the other hand, in this situation you can rationalize almost any short-term exchange rate movement as the market adjusting to new fundamentals.  And you can look very pointedly at the European Central Bank when you say this.

Expansionary Monetary Policy is Infectious

The Federal Reserve’s announcement yesterday makes it clear that we should see its leadership as radical incrementalists.  They will move in distinct incremental steps, some small and some larger, but they will do whatever it takes to prevent deflation.  And that means they will do what it takes to make sure that inflation remains (or goes back to being?) positive.  If they need to err on the side of slightly higher inflation, then so be it.  This is pretty radical (and a good idea, in my opinion.)

What effect does this have on the rest of the world?  Continue reading “Expansionary Monetary Policy is Infectious” →