What happened to the global economy and what we can do about it
The emerging markets rout continues: Russia, she of the $500 billion war chest of foreign currency reserves, spent 19% of those reserves trying to fight off a currency devaluation. Today, Russia didn’t quite give up the fight, but conceded some ground, widening the allowed trading range and at the same time increasing interest rates. Just goes to show: fighting those nasty currency speculators rarely works, if ever.
(Thanks to Free Exchange for catching this.)
Barack Obama has been getting a mountain of unsolicated economic advice; here’s one selection. In case he needs more to read, we posted our long-term recommendations on the WSJ Real Time Economics blog today. In short, we see a long-term challenge – and opportunity – to shift resources from the financial sector and into what is colloquially called the “real economy.” This will require, among other things, investment in education, openness to immigration, consolidated financial regulation, and assistance for workers affected by restructuring.
GM is mounting a massive PR campaign to convince Washington that a GM bankruptcy would be catastrophic to the national economy, resulting in the loss of millions of jobs, costing taxpayers over $100 billion, and plunging the economy into a depression (whatever that is). In addition to Nancy Pelosi and Harry Reed, Barack Obama has now called for an auto bailout.
I don’t want the US auto industry to go away. Yes, if GM and every one of its suppliers and dealers stopped operating tomorrow, that would cost hundreds of thousands or millions of jobs. But it’s not clear to me why bankruptcy would have the same effect. Ordinarily, when a company goes bankrupt – especially a big one – it goes right along doing whatever it was doing before, except now it doesn’t have to pay off all its creditors, and its operations are monitored by a court. The bankruptcy process is intended to find a reasonable outcome for all of the stakeholders that reflects the order of priority of their claims, but also (in the case of a company as big as GM) reflects the public interest. Airlines, for example, have been going in and out of bankruptcy for years in order to force their unions to negotiate long-term cost reductions, and even use the threat of bankruptcy as a negotiating tool.
… that the US dollar will remain stronger than …
Baseline Scenario, November 10, 2008
By Peter Boone, Simon Johnson, and James Kwak, copyright of the authors
The Baseline Scenario is our periodic overview of the current state of the global economy and our policy proposals. It includes two sections:
Please note that we do not currently publish our upside and downside risk scenarios in detail.
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ANALYSIS
The roots of the crisis
For at least the last year and a half, as banks took successive writedowns related to deteriorating mortgage-backed securities, the conventional wisdom was that we were facing a crisis of bank solvency triggered by falling housing prices and magnified by leverage. However, falling housing prices and high leverage alone would not necessarily have created the situation we are now in.
Way back in the heady days of September, we criticized the original version of TARP because it seemed designed to ensure the government would overpay for toxic assets. Instead, we recommended splitting the transaction into two parts: (a) buy the assets at market (cheap) prices, and (b) explicitly recapitalize the banks. In mid-October, Treasury committed $250 billion to explicit recapitalization, but to all intents and purposes seems committed to using some of the other $450 billion to buy those same toxic assets – at what price is still unclear. (Why they would still bother doing this is also unclear, for that matter.)
Until now.
Today’s government re-re-bailout of AIG (WSJ article; Yves Smith commentary) can be hard to follow, but one provision is the creation of a new entity with $5 billion from AIG and $30 billion from the government to buy collateralized debt obligations (CDOs). The goal is to buy CDOs that AIG insured (using credit default swaps), because if those CDOs are held by an entity that is friendly to AIG, that entity will no longer demand collateral from AIG. The theory is that in the long run these CDOs will not default and that the new entity will make money on the deal.
The rub is that this entity is planning to pay 50 cents on the dollar for these CDOs. This has two problems. First, 50 cents is almost certainly more than these CDOs are worth on their own (hence the title of this post). If they were really worth 50 cents on the dollar, AIG wouldn’t be having the problems it is having posting collateral; like the original TARP plan, this is an unfounded bet that the market is mispricing these assets. Second, and more bafflingly, the CDS contract is presumably separate from the ownership of the CDO; that is, buying the CDO from the counterparty doesn’t eliminate AIG’s obligation to pay if the CDO defaults, and hence doesn’t serve its stated purpose. If, on the contrary, the CDS contract is contingent on the counterparty holding the CDO, then the CDO is worth a lot more than 50 cents to the counterparty, because it is insured for 100 cents by AIG – and we all know the government isn’t going to let AIG default on those swaps. And no sane counterparty would sell for 50 cents.
Supposedly Treasury had enough time to think about how AIG should be bailed out and this is a better bailout than the original. If it is, I must be missing something.
What exactly is on the table for the G20 heads of government meeting in Washington at the end of this week? One possibility is some sort of synchronized or joint fiscal policy stimulus in most G20 member countries. (Yes, I know that the communique from this weekend’s meeting of finance ministers and central bank governors was somewhat on the vague side.)
Continue reading “China’s Stimulus, the IMF’s Forecast, and France’s G20 Agenda”
Other countries can only drool with envy. China today announced a $586 billion stimulus package – that’s 17% of 2007 GDP. Spread through the end of 2010, it’s still more than 7% of GDP per year. By comparison, the US stimulus package earlier this year was just over 1% of GDP, and after causing a small uptick in spending in Q2 it vanished into the sea of bad news; our recent proposal was for 3% of GDP, and that was at the higher end of the range.
Of course, the stakes for China are very high. GDP growth ranged between 11 and 12% in 2006 and 2007, but the IMF recently cut its estimate for 2009 to 8.5% (down from the 9.3% estimate just a month ago), and according to the New York Times article the annualized rate for this quarter could be as low as 5.8%. While these are growth rates that the developed world hasn’t seen for decades, the huge population migration from countryside to city requires high growth simply to keep unemployment in check. So the Chinese government brought out the heavy economic artillery.
The current crisis has proven, if it needed any proof, that even China is susceptible to the fortunes of the global economy. If it can lead to greater participation by China in the global financial system, including institutions like the IMF, that would be one positive outcome.
FLYP, which I can only describe as an online multimedia magazine, has a “cover story” entitled “Now What?” on the challenges the country faces and various perspectives on what the Obama administration should do about them. Simon is interviewed (in video) for “pages” 7 (domestic economy) and 10 (global financial system), but there are also sections on foreign policy, energy, the environment, health care, and so on.
(I should add that FLYP is very slick and well-produced – you might enjoy browsing around the other stories and issues, although the user interface is not particularly intuitive.)
With the footsteps of a new Treasury Secretary audible around the corner, Henry Paulson’s days running the country are essentially at an end. The best he can do now is delay whatever changes the Obama administration will make.
Looking back over the last two months, Paulson’s record (and that of the rest of the Bush administration) in combating the greatest financial crisis of our lifetimes is poor, though not catastrophic. The one thing that can be said in his favor is that the financial system did not completely collapse and Ben Bernanke’s supposed warning in the dark hours of September 18 that “we may not have an economy on Monday” did not come to pass. We have said on this site that stabilizing the financial system was job one, and the patient is stable.
A few weeks ago, three economists at the Federal Reserve Bank of Minneapolis set off a debate among Internet-addicted economists by claiming that, in essence, lending to the real economy was just fine and anyone who said there was a credit crisis was wrong. (See my initial reaction, as well as links to the original paper and several perspectives.) Now we have been treated by four economists at the Federal Reserve Bank of Boston, who argue that there was, in fact, a credit crisis. In particular, they say:
and similar points. Take a look; some of the charts are fascinating.
240,000 jobs lost in October; September revised from 159,000 to 284,000; August from 73,000 to 127,000. That’s 419,000 jobs less than we thought we had a month ago. It’s 651,000 less than there were three months ago. And because we need 140,000 new jobs each month just to keep place with population growth, that’s over 1 million fewer jobs than the economy would need to maintain unemployment where it was three months ago. Unfortunately, everyone expects this quarter and next quarter to be worse than last quarter. On top of that, unemployment is a lagging indicator: because of the transaction costs in firing and hiring workers, companies exhaust their other cost-cutting opportunities before laying people off, and they don’t hire again until they are certain that the economy is growing again.
More than 22% of the unemployed have been out of work more than six months, which is usually when unemployment benefits expire. For this and other reasons, only 32% of the unemployed were receiving state benefits in October. These are more reasons to expand unemployment benefits in multiple directions, at the very least for a limited time period. Alan Krueger has described the other ways our unemployment insurance system is broken.
Unfortunately, there is fear that President Bush (remember him?) will veto the stimulus package, including extended unemployment benefits, that the Democrats want to pass in November, thereby accomplishing nothing except delaying it by two months. Sigh.
Silicon Valley is often touted as an example of what is best about American capitalism – entrepreneurial, risk-taking, innovative, hard-working, and sometimes fabulously successful. Of course, it is also periodically criticized as a land of con men and get-rich-quick schemes.
Sequoia Capital, perhaps the most venerated VC firm in the Valley, held a “secret meeting” in October to discuss the impact of the credit crisis and economic downturn on the technology industry and startup companies. The slides have been leaked, beginning with a tombstone with the words “R. I. P. Good Times.” (By the way, those of you not from the business world – particularly those with academic backgrounds – may find the presentation amusing for the way it combines large amounts of incommensurate data with an extreme scarcity of verbs, thereby avoiding the need for a coherent argument. My favorite is slide 42. But believe me, this is far better than most business presentations.)
One of the first employees of my company has a much more original and intelligent perspective on what the recession means for Silicon Valley.
Since the Lehman credit default swaps settled without the sky falling, there has been a small wavelet of support for the once-obscure financial instruments that are widely blamed for amplifying the effects of the financial crisis, including a Forbes.com op-ed entitled “Credit Default Swaps Are Good for You.” I happen to agree that CDS can play a useful role in enabling bond investors to hedge against the risk of default, and thereby make it easier for some institutions to get credit. But it’s a bit premature to proclaim that all is well and good in swapland.
Most obviously, there is the troubling matter of AIG, which has recently received additional scrutiny from the likes of the New York Times and the Wall Street Journal (subscription required). AIG has already burned through most of its initial $85 billion loan from the government, has drawn down half of a separate $38 billion loan for its securities lending business, and recently got permission to sell up to $20 billion of commercial paper to the Fed. (And remember, when negotiations over the AIG bailout began around September 12, the company was saying it only needed $20 billion.)
Continue reading “AIG, Credit Default Swaps, and “Risk Management””
You can now download the video of our November 4th (Tuesday) class. The class covered a range of topics, as advertised (although I always like a class to jump around as students and guests make good points.) The highlights from my perspective were:
Continue reading “Downloadable MIT Class on the Global Crisis”
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