Friday, October 31, 2008

Lessons from Japan’s failure

A sensible analysis, and good lessons for the US policy makers to learn.

Morgan Stanley: deflation is unlikely

Dick Berner, Chief US economist at Morgan Stanley, argues deflation is unlikely.

Krugman: The capitulation of the American consumer

Krugman writes on today's NYT, after yesterday's data release that consumption dropped 3.1% in 3Q:

When Consumers Capitulate

The long-feared capitulation of American consumers has arrived. According to Thursday's G.D.P. report, real consumer spending fell at an annual rate of 3.1 percent in the third quarter; real spending on durable goods (stuff like cars and TVs) fell at an annual rate of 14 percent.

To appreciate the significance of these numbers, you need to know that American consumers almost never cut spending. Consumer demand kept rising right through the 2001 recession; the last time it fell even for a single quarter was in 1991, and there hasn't been a decline this steep since 1980, when the economy was suffering from a severe recession combined with double-digit inflation.

Also, these numbers are from the third quarter — the months of July, August, and September. So these data are basically telling us what happened before confidence collapsed after the fall of Lehman Brothers in mid-September, not to mention before the Dow plunged below 10,000. Nor do the data show the full effects of the sharp cutback in the availability of consumer credit, which is still under way.

So this looks like the beginning of a very big change in consumer behavior. And it couldn't have come at a worse time.

It's true that American consumers have long been living beyond their means. In the mid-1980s Americans saved about 10 percent of their income. Lately, however, the savings rate has generally been below 2 percent — sometimes it has even been negative — and consumer debt has risen to 98 percent of G.D.P., twice its level a quarter-century ago.

Some economists told us not to worry because Americans were offsetting their growing debt with the ever-rising values of their homes and stock portfolios. Somehow, though, we're not hearing that argument much lately.

Sooner or later, then, consumers were going to have to pull in their belts. But the timing of the new sobriety is deeply unfortunate. One is tempted to echo St. Augustine's plea: "Grant me chastity and continence, but not yet." For consumers are cutting back just as the U.S. economy has fallen into a liquidity trap — a situation in which the Federal Reserve has lost its grip on the economy.

Some background: one of the high points of the semester, if you're a teacher of introductory macroeconomics, comes when you explain how individual virtue can be public vice, how attempts by consumers to do the right thing by saving more can leave everyone worse off. The point is that if consumers cut their spending, and nothing else takes the place of that spending, the economy will slide into a recession, reducing everyone's income.

In fact, consumers' income may actually fall more than their spending, so that their attempt to save more backfires — a possibility known as the paradox of thrift.

At this point, however, the instructor hastens to explain that virtue isn't really vice: in practice, if consumers were to cut back, the Fed would respond by slashing interest rates, which would help the economy avoid recession and lead to a rise in investment. So virtue is virtue after all, unless for some reason the Fed can't offset the fall in consumer spending.

I'll bet you can guess what's coming next.

For the fact is that we are in a liquidity trap right now: Fed policy has lost most of its traction. It's true that Ben Bernanke hasn't yet reduced interest rates all the way to zero, as the Japanese did in the 1990s. But it's hard to believe that cutting the federal funds rate from 1 percent to nothing would have much positive effect on the economy. In particular, the financial crisis has made Fed policy largely irrelevant for much of the private sector: The Fed has been steadily cutting away, yet mortgage rates and the interest rates many businesses pay are higher than they were early this year.

The capitulation of the American consumer, then, is coming at a particularly bad time. But it's no use whining. What we need is a policy response.

The ongoing efforts to bail out the financial system, even if they work, won't do more than slightly mitigate the problem. Maybe some consumers will be able to keep their credit cards, but as we've seen, Americans were overextended even before banks started cutting them off.

No, what the economy needs now is something to take the place of retrenching consumers. That means a major fiscal stimulus. And this time the stimulus should take the form of actual government spending rather than rebate checks that consumers probably wouldn't spend.

Let's hope, then, that Congress gets to work on a package to rescue the economy as soon as the election is behind us. And let's also hope that the lame-duck Bush administration doesn't get in the way.

Thursday, October 30, 2008

Blowing bubbles in college financing?

Forbes reports:

Blowing Bubbles

This is at a price. College tuition has increased by more than three times the rate of inflation for the last 20 years, despite U.S. wages flat-lining since 2000. The average tuition at a private four-year institution grew 6.6% year-over-year in 2007 to $23,712, according to the College Board. This is pricey in itself, but when you add in all the luxe living expenses, the total bill touches $50,000 a year at the high end.

To the chagrin of financial advisers, students are increasingly turning to higher interest private loans to meet the burgeoning college bill. Private loans made up 24% of total education loans in 2006-07, up from 6% a decade ago. In 2008, students secured $20 billion in private loans--amounting to roughly a fifth of total undergraduate borrowings for the year. Taxpayers pony up, too, chipping in an average $4,000 per student through government loans and grants to private institutions, which usually come up with $3,720 in aid (often in the form of discounted tuitions) as well.

It's a scenario familiar to anyone who watched the housing bubble blow. "We are at a trend line that cannot be sustained," says Matt Snowling, an analyst at Friedman, Billings and Ramsey, who covers the student loan industry. "Tuition must go down, or there will be limited demand at high-priced private schools."

Åslund: It CAN be worse than the Great Depression

From Peterson Institute's Anders Aslund. He argues that yes we may not see stupid policies like 1930s to repeat today, but we are much more leveraged, world economy is much more globalized, and bad news never spread faster.

This is the worst global asset bubble and financial panic since the Great Depression of 1929-1933. Still, almost all argue that it cannot become equally bad, because we have learned those lessons.

Analytically, that statement does not hold. True, our policymakers are not likely to repeat the same mistakes of the Great Depression, but they may commit other mistakes. Bank deposit insurance has come to stay for good, but not all advances represent progress, and many create new vulnerabilities.

One 1930s mistake was to defend exchange rates by all means. Today, most exchange rates float freely. Right now, we are seeing an unprecedented US dollar surge, which is not warranted by fundamentals but reflects a desperate search for a safe haven. The new hazard might be excessive and destabilizing exchange rates fluctuations caused by financial panic. Then, the major financial powers need to intervene to stabilize exchange rates.

Milton Friedman attacked the Fed during the Depression for allowing the nominal monetary supply to contract sharply, and John Maynard Keynes argued for more public expenditures through budget deficits, while the prevailing policy was budget surplus. The monetary expansion and budget deficits may become excessive this time.

Deficit spending and monetary expansion are supposed to boost demand, but people spend less in a financial panic, rendering increased public expenditures rather ineffective. We learned the limitation of Keynesianism in the 1970s. In recent decades, some former communist countries and Latin America have shown how the expansion of public expenditure beyond the permissible can lead to state default.

In the 1930s, states did not go bankrupt, fearful of the consequences of those who had done so in the wake of the first world war.

Now, major states, such as Italy, have more than 100 percent of GDP in public debt even before the crisis, rendering major state bankruptcies a real danger. Fiscal and monetary stimulation are needed and deflation must be avoided, but currently fiscal considerations are disregarded altogether, which is a recipe for disaster. State default can easily lead to hyperinflation, which is far worse than deflation.

The global financial system is so much deeper and more sophisticated than in the 1920s, but that is a problem. The 1920s had its version of subprime loans, but it did not have non-transparent collateralized debt obligations. The many derivatives have created the mother of all bubbles. The deeper the financial system, the harder we may fall.

Although the Great Depression had worldwide reach, it largely emanated from two countries, the US and Germany. Never before has the world seen such a monstrous and truly global bubble. The real estate bubble is probably worst in the Persian Gulf and Moscow, while also extreme in Britain, Spain and Ireland.

Never have big financial institutions been as overleveraged as Fannie Mae and Freddie Mac or the former US investment banks, not to mention the hedge funds. The excessive leverage is now being unwound by financial panic, apart from what is countered with re-capitalization.

The 1930s protectionism must not be repeated, but frozen finances have already left countries such as Iceland and Ukraine temporarily outside of the world financial system. Such exclusion must not be allowed to become permanent.

In the 1920s, both the US dollar and gold were unchallenged sources of value. Today, the US dollar is neither stable nor an uncontested world currency. At 10, the euro is too young to be a debutant, and the biggest question is if it holds together in this rough financial weather, especially if one or several euro countries would default.

Everybody from Milton Friedman to John Kenneth Galbraith have criticized the Federal Reserve and US President Herbert Hoover for their policies during the Depression, but at least they were policymakers and stood for principles. As if to illustrate their impotence, President George W. Bush is assembling the political leaders of the group of 20 large countries for a photo opportunity in Washington on November 15.

Their failure to come up with anything but vanity could unleash untold financial panic. This crisis envelops the whole world, but global financial governance is missing.

Finally, the 1920s had neither television nor the internet. Information, decisions and implementation can now be carried out in seconds, which harm the quality of decisions and nerves. Transparency is usually preferable, but unmitigated speed might be harmful. CNBC and Bloomberg can spread worldwide panic instantly.

We must not repeat the mistakes of the Great Depression, but we need to ascertain that new policies are not even worse.

Anders Åslund is a senior fellow of the Peterson Institute for International Economics in Washington, D.C

Tuesday, October 28, 2008

Roubini: Severe global recession and possible stag-deflation ahead

Bloomberg interview of Dr. Doom, Nouri Roubini at NYU. (audio, about 20 minutes)

Will the US suffer a Japanese deflation?

David Gitlitz writes on the Journal that "We won't suffer a Japanese Deflation".  A good review of history.

As U.S. credit markets continue to be roiled in chaos, some are bandying about the notion that America's problems resemble those of Japan in its deflationary "lost decade" of the 1990s. "Deflation looms. It certainly does loom," said one functionary for a major international bank. "The cycle in which debt destruction and asset price destruction reinforce each other clearly has a very, very, strong negative effect on the economy."

This analysis expresses a common fallacy that asset-price declines give rise to economic weakness, and the effect is therefore deflationary. But "deflation" is not a synonym for economic contraction. Deflation is rather a sustained decline in the overall price level, i.e., the opposite of inflation. Like inflation, deflation is a monetary phenomenon.

There is no evidence that deflationary influences are now at work in the U.S. economy. I was very familiar with the Japanese deflation, having been the first to recognize and name it in a 1995 op-ed on this page. I was exposed to considerable public criticism by the Bank of Japan at the time, but history has shown my diagnosis to be entirely correct.

Aside from some superficial similarities, the current U.S. financial market disturbance bears no resemblance to the economic misery that afflicted Japan for more than a decade, and in important ways continues to linger there. In fact, the comparison should provide some comfort to Americans. U.S. monetary conditions are nearly the exact opposite of the devastating deflation that characterized the Japanese experience.

The U.S. had its real-estate bubble through the first six years or so of the current decade, and on the surface, that might seem comparable to the real-estate bubble that preceded Japan's decade of deflation. Our bubble had its roots in the Fed's exceptionally accommodative monetary policy -- a situation not unlike Japan through the late 1980s, when the Bank of Japan was also too easy for too long. But unlike the Fed, the BoJ turned toward tightness with a vengeance, apparently with the objective -- at least initially -- of pricking the bubble.

Japanese land prices began their long fall in 1991 on the heels of a sharp currency appreciation in 1990, with the yen soaring nearly 20% against both the dollar and gold. That was just the beginning. By 1995, the yen/dollar would see a nearly 50% appreciation, and the BoJ's deflationary bias remained in place for a number of years. The relentless rise in the currency's purchasing power magnified the real burden of yen debt, crushing borrowers and crippling the Japanese banking system.

Contrast that with the U.S. experience, in which the decline in real-estate values would coincide not with a deflationary appreciation of the dollar, but an inflationary depreciation. From the time home prices peaked in mid-2006 through the currency's lows last spring, the trade-weighted value of the dollar fell by some 18%. Over the same period, the price of gold rose by about 75%. While the dollar has rebounded moderately in the last several months, by any objective measure it remains in a weak position. On a trade-weighted basis, it has returned to its levels of about a year ago. But before doing so, it had never been weaker. At around $830 in gold terms, the dollar has recovered a modicum of the purchasing power lost when gold soared above $1,000 last March in the midst of the Bear Stearns calamity. But at current levels the price of gold is double what it was four years ago.

The relative damage to real-estate values between the U.S. and Japan is instructive. Thus far, U.S. home prices have fallen about 12.5% from their peak. But they remain about 40% above their 2000 levels. In Japan, by 2001 the destruction of values brought land prices down to about half their levels of the late 1980s.

The U.S. housing downturn and associated financial-market turbulence is attributable not to tight monetary conditions, but to an unsustainable speculative bubble triggered by loose monetary conditions. The current market turmoil might well put the economy into at least a shallow and short-lived recession. But unlike Japan, the U.S. economy will not have to dig its way out of a debilitating, long-lasting monetary deflation.

On the contrary, the current economic climate is marked by a considerable upswing in inflation, with the headline consumer price index now running at about 5.4%, up from less than 2% a year ago. The decline in crude oil prices will keep down the reported rate for a few months. But once oil stops falling, the underlying inflationary influences will reassert themselves, and no sizeable long-lasting decline in reported inflation is likely in the foreseeable future.

The "lost decade" of stagnation and monetary deflation, and its remaining legacy today, were the product of a persistently too-tight Bank of Japan. The Fed was not tight even before the present crisis, and as the crisis has unfolded has gotten progressively easier. Today, America's real concern is inflation.

Mr. Gitlitz is chief economist at Trend Macrolytics, LLC.

Gordon: A short banking history of the US

John Gordon, author of "An Empire of Wealth: The Epic History of American Economic Power" offers us a good short history of American Banking:

We are now in the midst of a major financial panic. This is not a unique occurrence in American history. Indeed, we've had one roughly every 20 years: in 1819, 1836, 1857, 1873, 1893, 1907, 1929, 1987 and now 2008. Many of these marked the beginning of an extended period of economic depression.

How could the richest and most productive economy the world has ever known have a financial system so prone to periodic and catastrophic break down? One answer is the baleful influence of Thomas Jefferson.

Jefferson, to be sure, was a genius and fully deserves his place on Mt. Rushmore. But he was also a quintessential intellectual who was often insulated from the real world. He hated commerce, he hated speculators, he hated the grubby business of getting and spending (except his own spending, of course, which eventually bankrupted him). Most of all, he hated banks, the symbol for him of concentrated economic power. Because he was the founder of an enduring political movement, his influence has been strongly felt to the present day.

Consider central banking. A central bank's most important jobs are to guard the money supply -- regulating the economy thereby -- and to act as a lender of last resort to regular banks in times of financial distress. Central banks are, by their nature, very large and powerful institutions. They need to be to be effective.

Jefferson's chief political rival, Alexander Hamilton, had grown up almost literally in a counting house, in the West Indian island of St. Croix, managing the place by the time he was in his middle teens. He had a profound and practical understanding of markets and how they work, an understanding that Jefferson, born a landed aristocrat who lived off the labor of slaves, utterly lacked.

Hamilton wanted to establish a central bank modeled on the Bank of England. The government would own 20% of the stock, have two seats on the board, and the right to inspect the books at any time. But, like the Bank of England then, it would otherwise be owned by its stockholders.

To Jefferson, who may not have understood the concept of central banking, Hamilton's idea was what today might be called "a giveaway to the rich." He fought it tooth and nail, but Hamilton won the battle and the Bank of the United States was established in 1792. It was a big success and its stockholders did very well. It also provided the country with a regular money supply with its own banknotes, and a coherent, disciplined banking system.

But as the Federalists lost power and the Jeffersonians became the dominant party, the bank's charter was not renewed in 1811. The near-disaster of the War of 1812 caused President James Madison to realize the virtues of a central bank and a second bank was established in 1816. But President Andrew Jackson, a Jeffersonian to his core, killed it and the country had no central bank for the next 73 years.

We paid a heavy price for the Jeffersonian aversion to central banking. Without a central bank there was no way to inject liquidity into the banking system to stem a panic. As a result, the panics of the 19th century were far worse here than in Europe and precipitated longer and deeper depressions. In 1907, J.P. Morgan, probably the most powerful private banker who ever lived, acted as the central bank to end the panic that year.

Even Jefferson's political heirs realized after 1907 that what was now the largest economy in the world could not do without a central bank. The Federal Reserve was created in 1913. But, again, they fought to make it weaker rather than stronger. Instead of one central bank, they created 12 separate banks located across the country and only weakly coordinated.

No small part of the reason that an ordinary recession that began in the spring of 1929 turned into the calamity of the Great Depression was the inability of the Federal Reserve to do its job. It was completely reorganized in 1934 and the U.S. finally had a central bank with the powers it needed to function. That is a principal reason there was no panic for nearly 60 years after 1929 and the crash of 1987 had no lasting effect on the American economy.

While the Constitution gives the federal government control of the money supply, it is silent on the control of banks, which create money. In the early days they created money both through making loans and by issuing banknotes and today do so by extending credit. Had Hamilton's Bank of the United States been allowed to survive, it might well have evolved the uniform regulatory regime a banking system needs to flourish.

Without it, banking regulation was left to the states. Some states provided firm regulation, others hardly any. Many states, influenced by Jeffersonian notions of the evils of powerful banks, made sure they remained small by forbidding branching. In banking, small means weak. There were about a thousand banks in the country by 1840, but that does not convey the whole story. Half the banks that opened between 1810 and 1820 had failed by 1825, as did half those founded in the 1830s by 1845.

Many "wildcat banks," so called because they were headquartered "out among the wildcats," were simple frauds, issuing as many banknotes as they could before disappearing. By the 1840s there were thousands of issues of banknotes in circulation and publishers did a brisk business in "banknote detectors" to help catch frauds.

The Civil War ended this monetary chaos when Congress passed the National Bank Act, offering federal charters to banks that had enough capital and would submit to strict regulation. Banknotes issued by national banks had to be uniform in design and backed by substantial reserves invested in federal bonds. Meanwhile Congress got the state banks out of the banknote business by putting a 10% tax on their issuance. But National banks could not branch if their state did not allow it and could not branch across state lines.

Unfortunately state banks did not disappear, but proliferated as never before. By 1920, there were almost 30,000 banks in the U.S., more than the rest of the world put together. Overwhelmingly they were small, "unitary" banks with capital under $1 million. As each of these unitary banks was tied to a local economy, if that economy went south, the bank often failed. As depression began to spread through American agriculture in the 1920s, bank failures averaged over 550 a year. With the Great Depression, a tsunami of bank failures threatened the collapse of the system.

The reorganization of the Federal Reserve and the creation of the Federal Deposit Insurance Corporation hugely reduced the number of bank failures and mostly ended bank runs. But there remained thousands of banks, along with thousands of savings and loan associations, mutual savings banks, and trust companies. While these were all banks, taking deposits and making loans, they were regulated, often at cross purposes, by different authorities. The Comptroller of the Currency, the Federal Reserve, the FDIC, the FSLIC, the SEC, the banking regulators of the states, and numerous other agencies all had jurisdiction over aspects of the American banking system.

The system was stable in the prosperous postwar years, but when inflation took off in the late 1960s, it began to break down. S&Ls, small and local but with disproportionate political influence, should have been forced to merge or liquidate when they could not compete in the new financial environment. Instead Congress made a series of quick fixes that made disaster inevitable.

In the 1990s interstate banking was finally allowed, creating nationwide banks of unprecedented size. But Congress's attempt to force banks to make home loans to people who had limited creditworthiness, while encouraging Fannie Mae and Freddie Mac to take these dubious loans off their hands so that the banks could make still more of them, created another crisis in the banking system that is now playing out.

While it will be painful, the present crisis will at least provide another opportunity to give this country, finally, a unified banking system of large, diversified, well-capitalized banking institutions that are under the control of a unified and coherent regulatory system free of undue political influence.

Fisher quotes Deng Xiaoping

According to this BW article, titled "Forget Adam Smith, Whatever Works", Federal Reserve Bank of Dallas President Richard W. Fisher, in addressing the high and mighty of global finance in Washington during pivotal meetings of the Group of Seven and the International Monetary Fund, borrowed a Chinese proverb popularized by the late Chinese leader Deng Xiaoping: "No matter if it is a white cat or a black cat, as long as it can catch mice, it is a good cat."

Washington's partial nationalization of banks marks a fundamental shift in thinking about the relationship of the public and private sectors.

Read more about the future of capitalism.

Derivatives and Mass Financial Destruction

Complex financial products can be useful if regulated properly (source: wsj)

Proposals for a makeover of the financial system include reform of the credit derivatives market, which offers over $50 trillion of default insurance coverage. Do investors need that much insurance, or is this mainly a dangerous casino operating under the radar of regulators -- until a major financial institution like AIG needs a bailout? What sort of reform is needed?

The seller of protection in a credit derivatives contract receives premiums from the buyer of protection until maturity, or until default of the named borrower. Contracts are negotiated over the counter, not on an exchange, so it is difficult to know how much insurance exists on each borrower, or to know who has insured whom, and for how much.

That privacy is not unusual in the normal course of business contracts. What is unusual is the size of the potential claims. There is a public interest in knowing that systemically important sellers of protection have not overdone it. If a large bank or insurance company does not have enough capital to cover settlement claims, then its failure, or the threat of it, can cause mayhem, as we have just seen.

The largest credit derivatives positions are held by big-bank credit derivatives dealers. Because they intermediate between buyers and sellers, dealers often have nearly offsetting positions. For example, according to J.P. Morgan's latest quarterly report, it had bought protection coverage on $5.2 trillion of debt principal, and sold protection on $5 trillion. The vast quantity of outstanding derivatives in the global market is therefore not a good gauge of the effective amount of insurance offered.

Of the $532 trillion notional amount of financial instruments covered by over-the-counter derivatives in June of this year -- including credit derivatives, interest-rate swaps and equity derivatives -- the International Swaps and Derivatives Association estimates potential exposures to counterparties of $2.7 trillion. These exposures are further reduced by collateral held against the potential failure of counterparties.

Of roughly $350 billion in credit derivative settlement claims that arose in Lehman's default, about $6 billion in actual settlement payments were scheduled for payment yesterday, after canceling offsetting claims. For illustration, suppose that Goldman Sachs had sold protection to the point that it owed $7 billion in Lehman settlement claims, and had purchased protection on which it was owed $7.5 billion. In this situation, Goldman would collect a net of $0.5 billion, unless a counterparty fails to pay. Suppose that one of Goldman's counterparties, say a hedge fund, had failed to pay Goldman a $100 million settlement claim. If Goldman had received the industry-average 65% collateralization from its counterparty, it would keep the collateral and be out $35 million. Goldman could then pursue additional recoveries as a claimant in the hedge fund's bankruptcy. The Depository Trust & Clearing Corporation, which keeps records of the majority of credit derivatives trades and settlements, reported yesterday that there were no payment failures on scheduled Lehman credit derivative settlements.

So far, the credit derivatives settlement process has worked smoothly through several large defaults, but the safety of the settlement process could be improved significantly. Because dealers lay off such large positions with each other, a large fraction of their exposures is unnecessary. For example, suppose that Bank A is exposed to Bank B for $1 billion, while B is exposed to C for $1 billion, and C is exposed to A for $1 billion, all on the same underlying named borrower. That circle of exposures is eliminated if all three banks clear their positions with the same central clearing counterparty. Because Bank A is long and short by the same amount, it would have no settlement payment to make or to receive from the clearing counterparty. Banks B and C would likewise have no potential loss. In practice, exposures would not be offset so neatly, but a large fraction of them would.

The Fed is pressing dealers to quickly establish clearing in credit derivatives. The dealers have expressed an interest in using their own clearing counterparty, the Chicago Clearing Corporation. Alternatively, they could clear credit derivatives with a new joint venture of the Chicago Mercantile Exchange and Citadel (a large hedge fund). Either way, regulators should ensure that a clearing counterparty is extremely well capitalized and has strong operational controls.

Unfortunately, the urgency to set up clearing for credit derivatives may lead us to miss the opportunity to reduce exposures even further by clearing credit derivatives along with other forms of over-the-counter derivatives, such as interest-rate swaps and equity derivatives, which represent similarly large amounts of risk transfer. Regulators should press dealers to clear more types of derivatives with the same clearing house.

That investors can benefit from a market for insurance against default risk does not seem controversial. The market premiums offered on credit derivatives also provide investors with "price discovery" of the financial health of corporations and sovereign states. (Although trading is private, samples of prices are disseminated by financial news services.)

There is a public interest in limiting the exposure of large, systemically important financial institutions, relative to their capital, whether from derivatives or from other forms of risk taking. We were supposed to have had such limits, but they were not effective, and will presumably be revisited by regulators soon.

Regulators should also have access to more detailed information on the potential exposures of large financial players to each other. But general public disclosure of specific derivatives trades seems unnecessary in most cases, can lower incentives to invest efficiently, and runs counter to our norms for privacy. We do nothing like this in other financial markets, such as those for common stocks, except when positions are large enough to suggest the potential control of public corporations. (Derivatives do not carry control rights.)

Public disclosure can nevertheless be a good disinfectant whenever sufficiently severe conflicts of interest lead to inefficient control of risk (moral hazard) or to unfair exploitation of counterparties. If a lender can largely insure itself against its borrower's default, it has lessened its interest in the financial health of the borrower, and may neglect to monitor the borrower. Default losses to the lender would be passed on to credit derivatives counterparties, who may not be aware of the conflict of interest.

When unconstrained by good regulations, derivatives can be financial weapons of mass destruction. Our new regulations should be smart and surgical.

Mr. Duffie is a professor of finance at Stanford University's Graduate School of Business.

Crisis Hits Ivory Tower

source: wsj

Crisis Shakes the Foundations of the Ivory Tower

The financial and economic tsunami that has ripped through Wall Street and the housing market is beginning to wash across the college green.

Higher education hasn't yet seen anything to compare with foreclosures and bank nationalizations in the private sector. But seized-up credit markets, shrinking endowment funds and a reduction in state subsidies are punishing universities from California to Vermont.

A campus construction boom is slowing, administrations are cutting jobs and faculty may be forced to pay more into their pension funds. The demise of a $9.3 billion investment fund used by 900 colleges has some schools scrambling to pay their bills.

It all brings a gloomy pall to what has been, until recently, a booming industry. Higher education has grown rapidly in the last half-century into a formidable slice of the economy. U.S. colleges and universities spend $334 billion annually, employ 3.4 million people and and enroll 17.5 million students.

The boom was powered by a growing stream of donations, strong returns on endowments, rising enrollments and tuition prices that climbed well above the rate of inflation -- paid, more and more, by families who borrowed heavily to meet the bills.

All of these wealth generators for the Ivory Tower are facing threats in the current economic turmoil. The cratering stock market has already hit endowments. Falling markets typically take a toll on gifts, many of which are made, for tax reasons, in the form of appreciated stocks and bonds. Analysts and schools are predicting even bigger tuition increases than those seen so far. But this time, families may be in no position to meet the higher bills. Falling house prices have sapped their ability to use home-equity loans for tuition payments, and the credit crunch has forced many lenders to stop making student loans.

At a time when many political candidates -- notably Democratic presidential nominee Barack Obama -- are stressing the importance of access to college to the country's economic future, financial exigencies threaten to offset or overcome anything the government can do to promote more college attendance.

"This is the worst environment for colleges I can remember," says Mark Ruloff, a consultant at Watson Wyatt in Arlington, Va., who advises college endowments. With their ability to raise capital curtailed by the crisis, schools may be forced to sell their most liquid endowment assets at a time when the markets are not offering much, he predicts.

Molly Corbett Broad, president of the American Council on Education, which represents 1,600 colleges and universities, says public schools face the greatest challenge in a slumping economy because they get as much as three-quarters of their revenue from state taxpayers.

She says students could face double-digit tuition increases next year, up from the typical 4% to 6% level in recent years. Some university presidents privately confided to her that their institutions, which she declined to name, are even considering midyear tuition hikes. Ms. Broad adds that small private colleges without hefty endowments may have to consider merging with bigger rivals.

Some colleges are already feeling squeezed. As part of steep statewide budget cuts, the University of Massachusetts system this week said it would have to cut its budget by about $25 million, or 5%. The flagship Amherst campus froze hiring in all but the most critical positions. To avoid reductions in financial aid or increases in fees, the University of Massachusetts president, Jack M. Wilson, promised work force cuts and consolidations.

Boston University's president sent faculty a letter late last month announcing that the school is imposing a freeze on new hires and new construction projects. The crisis, Robert A. Brown wrote, has "created unprecedented volatility for our students, their parents and the University."

The debt markets' breakdown comes at an inopportune time for colleges, which have been building gyms and dorms to attract top students. College construction soared to $15 billion in 2006 from $10 billion in 2001, according to College Planning and Management magazine. The figure slipped slightly to $14.5 billion in 2007 amid concerns about a weakening economy.

The state of Colorado has frozen hiring and state construction projects, including about $50 million worth at public universities, such as the renovation of an arts and science center at the University of Colorado at Boulder.

The Tennessee Board of Regents, which oversees the University of Memphis, five other universities and 13 community colleges, has been forced to cut $58 million since July.

Bob Adams, vice chancellor for business and finance, says the system, with 190,000 students, may have to increase tuition "fairly significantly" next year. Including tuition, room and board and other fees, students typically pay $12,500 annually.

The University of Memphis recently announced a voluntary employee buyout program. Mr. Adams says schools are also delaying equipment purchases, such as laboratory equipment, and library acquisitions, including books and subscriptions. He says he suspects that classes will get larger because of rising enrollments and shrinking staffs. "It may get to the point where we don't have the facilities to meet the demand," Mr. Adams says.

The University of California, Berkeley, faces $28 million in cuts or unavoidable cost increases for the academic year that began in July, according to Nathan Brostrom, vice-chancellor of administration. He says that rising health care costs will result in an 11% increase in the cost of providing medical and dental benefits to staff starting in 2009. Starting in July, Berkeley faculty and staff have been told to expect to make contributions to their pension funds for the first time since 1990 because slumping stock markets have eaten away the pension surplus.

Before the meltdown, richer colleges such as Harvard and Yale had responded to pressure from Washington and started to spend more of their endowments to lessen the tuition burden. Endowments have swelled in recent years, with 785 of the wealthiest holding more than $400 billion in assets as of 2007.

Now, Moody's Investors Service, the bond rater, is projecting endowment returns to be negative for the first time since 2002. In a report Thursday, the ratings agency estimates that college endowment losses averaged 5% to 7% in the year ended June 30. Since then, including spending and stock market losses, Moody's figures colleges experienced another 30% decline in cash and investments.

The crisis has even made colleges wary about where they keep their ready cash. Earlier this month, a fund that invests cash for about 900 colleges suddenly froze withdrawals. Schools, which can now withdraw about 40% of their money, may not be able to get all of it back until 2011.

Before Wachovia Corp., the fund's trustee, said it was terminating the fund, it held $9.3 billion in assets. The Commonfund Short-Term Fund, used like a checking account at many schools, invested in some mortgage-backed securities that now can't be sold for their full value.

At the University of Vermont, the finance chief secured a $50 million outside line of credit from a local bank to ensure he meets payroll and other monthly obligations -- a move he made after learning the school cannot withdraw a chunk of the $79 million it held from a short-term cash fund until next year at the earliest.

Monday, October 27, 2008

Charlie Rose with Paul Krugman

Charlie Rose interview with 2008 Nobel Economics winner Paul Krugman.

Krugman: Why the crisis spread to emerging markets?

Paul Krugman writes on today's NY Times:

The really shocking thing, however, is the way the crisis is spreading to emerging markets — countries like Russia, Korea and Brazil.

These countries were at the core of the last global financial crisis, in the late 1990s (which seemed like a big deal at the time, but was a day at the beach compared with what we're going through now). They responded to that experience by building up huge war chests of dollars and euros, which were supposed to protect them in the event of any future emergency. And not long ago everyone was talking about "decoupling," the supposed ability of emerging market economies to keep growing even if the United States fell into recession. "Decoupling is no myth," The Economist assured its readers back in March. "Indeed, it may yet save the world economy."

That was then. Now the emerging markets are in big trouble. In fact, says Stephen Jen, the chief currency economist at Morgan Stanley, the "hard landing" in emerging markets may become the "second epicenter" of the global crisis. (U.S. financial markets were the first.)

What happened? In the 1990s, emerging market governments were vulnerable because they had made a habit of borrowing abroad; when the inflow of dollars dried up, they were pushed to the brink. Since then they have been careful to borrow mainly in domestic markets, while building up lots of dollar reserves. But all their caution was undone by the private sector's obliviousness to risk.

In Russia, for example, banks and corporations rushed to borrow abroad, because dollar interest rates were lower than ruble rates. So while the Russian government was accumulating an impressive hoard of foreign exchange, Russian corporations and banks were running up equally impressive foreign debts. Now their credit lines have been cut off, and they're in desperate straits.

Mankiw: Have we learned enough?

From today's NY Times.

But Have We Learned Enough?

LIKE most economists, those at the International Monetary Fund are lowering their growth forecasts. The financial turmoil gripping Wall Street will probably spill over onto every other street in America. Most likely, current job losses are only the tip of an ugly iceberg.

But when Olivier Blanchard, the I.M.F.'s chief economist, was asked about the possibility of the world sinking into another Great Depression, he reassuringly replied that the chance was "nearly nil." He added, "We've learned a few things in 80 years."

Yes, we have. But have we learned what caused the Depression of the 1930s? Most important, have we learned enough to avoid doing the same thing again?

The Depression began, to a large extent, as a garden-variety downturn. The 1920s were a boom decade, and as it came to a close the Federal Reserve tried to rein in what might have been called the irrational exuberance of the era.

In 1928, the Fed maneuvered to drive up interest rates. So interest-sensitive sectors like construction slowed.

But things took a bad turn after the crash of October 1929. Lower stock prices made households poorer and discouraged consumer spending, which then made up three-quarters of the economy. (Today it's about two-thirds.)

According to the economic historian Christina D. Romer, a professor at the University of California, Berkeley, the great volatility of stock prices at the time also increased consumers' feelings of uncertainty, inducing them to put off purchases until the uncertainty was resolved. Spending on consumer durable goods like autos dropped precipitously in 1930.

Next came a series of bank panics. From 1930 to 1933, more than 9,000 banks were shuttered, imposing losses on depositors and shareholders of about $2.5 billion. As a share of the economy, that would be the equivalent of $340 billion today.

The banking panics put downward pressure on economic activity in two ways. First, they put fear into the hearts of depositors. Many people concluded that cash in their mattresses was wiser than accounts at local banks.

As they withdrew their funds, the banking system's normal lending and money creation went into reverse. The money supply collapsed, resulting in a 24 percent drop in the consumer price index from 1929 to 1933. This deflation pushed up the real burden of households' debts.

Second, the disappearance of so many banks made credit hard to come by. Small businesses often rely on established relationships with local bankers when they need loans, either to tide them over in tough times or for business expansion. With so many of those relationships interrupted at the same time, the economy's ability to channel financial resources toward their best use was seriously impaired.

Together, these forces proved cataclysmic. Unemployment, which had been 3 percent in 1929, rose to 25 percent in 1933. Even during the worst recession since then, in 1982, the United States economy did not experience half that level of unemployment.

Policy makers in the 1930s responded vigorously as the situation deteriorated. But like a doctor facing a patient with a new disease and strange symptoms, they often acted in ways that, with the benefit of hindsight, appeared counterproductive.

Probably the most important source of recovery after 1933 was monetary expansion, eased by President Franklin D. Roosevelt's decision to abandon the gold standard and devalue the dollar. From 1933 to 1937, the money supply rose, stopping the deflation. Production in the economy grew about 10 percent a year, three times its normal rate.

Less successful were various market interventions. According to a study by the economists Harold L. Cole and Lee E. Ohanian, both of the University of California, Los Angeles, and the Federal Reserve Bank of Minneapolis, President Roosevelt made things worse when he encouraged the formation of cartels through the National Industrial Recovery Act of 1933. Similarly, they argue, the National Labor Relations Act of 1935 strengthened organized labor but weakened the recovery by impeding market forces.

LOOKING back at these events, it's hard to avoid seeing parallels to the current situation. Today, as then, uncertainty has consumers spooked. By some measures, stock market volatility in recent days has reached levels not seen since the 1930s. With volatility spiking, the University of Michigan's survey reading of consumer sentiment has been plunging.

Deflation across the economy is not a problem (yet), but deflation in the housing market is the source of many of our present difficulties. With so many homeowners owing more on their mortgages than their houses are worth, default is an unfortunate but often rational choice. Widespread foreclosures, however, only perpetuate the downward spiral of housing prices, further defaults and additional losses at financial institutions.

The Fed and the Treasury Department, intent on avoiding the early policy inaction that let the Depression unfold, have been working hard to keep credit flowing. But the financial situation they face is, arguably, more difficult than that of the 1930s. Then, the problem was largely a crisis of confidence and a shortage of liquidity. Today, the problem may be more a shortage of solvency, which is harder to solve.

What's next? Perhaps the most troubling study of the 1930s economy was written in 1988 by the economists Kathryn Dominguez, Ray Fair and Matthew Shapiro; it was called "Forecasting the Depression: Harvard Versus Yale." (Mr. Fair is an economics professor at Yale; Ms. Dominguez and Mr. Shapiro are at the University of Michigan.)

The three researchers show that the leading economists at the time, at competing forecasting services run by Harvard and Yale, were caught completely by surprise by the severity and length of the Great Depression. What's worse, despite many advances in the tools of economic analysis, modern economists armed with the data from the time would not have forecast much better. In other words, even if another Depression were around the corner, you shouldn't expect much advance warning from the economics profession.

Let me be clear: Like Mr. Blanchard at the I.M.F., I am not predicting another Great Depression. We have indeed learned a lot over the last 80 years. But you should take that economic forecast, like all others, with more than a single grain of salt.

N. Gregory Mankiw is a professor of economics at Harvard. He was an adviser to President Bush and advised Mitt Romney in his campaign for the Republican presidential nomination.

Friday, October 24, 2008

Sachs: "We need Nodic models"

Jeff Sachs crys out, "We need bigger government".  Are we going to see a reversal of intellectual thinking?  (audio source: Bloomberg)

Capital Flow and Crisis

Reinhart's write about capital in and out hot region and crises:

A pattern has often been repeated in the modern era of global finance. Global investors turn with interest toward the latest "foreign" market. Capital flows in volume into the "hot" financial market. The exchange rate tends to appreciate, asset prices to rally, and local commodity prices to boom. These favourable asset price movements improve national fiscal indicators and encourage domestic credit expansion. These, in turn, exacerbate structural weaknesses in the domestic banking sector even as those local institutions are courted by global financial institutions seeking entry into a hot market.

But tides also go out when the fancy of global investors shift and the "new paradigm" looks shop worn. Flows reverse or suddenly stop à la Calvo and asset prices give back their gains, often forcing a painful adjustment on the economy.

In a recent paper, we examined the macroeconomic adjustments surrounding episodes of sizable capital inflows in a large set of countries. Identifying these "capital flow bonanzas" turns out to be a useful organising device for understanding the swings in investor interest in foreign markets as reflected in asset price booms and crashes and for predicting sovereign defaults and other crises.

more here

Thursday, October 23, 2008

Why the Fed buys short term paper directly from mutual funds?

good discussion on the subject and the implication of the Fed's action. (source: Bloomberg video)

Greenspan in Shock

Bloomberg video on Greenspan's testimony today

Mundell, Volcker and Stiglitz

talk at Columbia:

Bob Mundell and Joe Stiglitz, with Paul Volcker sitting in the middle

an interesting mix...I always like Mundell's bluntness...

Wednesday, October 22, 2008

European Economic Forecast

source: FT

(click to enlarge)

Ever expanding Fed balance sheet

Fed balance sheet has "exploded" literally, adding another $300 billion from my last update.

Two comments: 
1) The Fed either kill lending freeze very quickly by this massive injection of liquidity;
2) Fed got the wrong diagnosis and used wrong tools, and it won't save the economy and US dollar are going to have big trouble down the road.

Monday, October 20, 2008

How Hard China will be Hit by Global Economic Slowdown?

This piece of news came as a huge surprise to me.
This morning's 3Q GDP release was pretty bad, but nothing compares to this:

Xinhua news agency says nearly 80 percent of toy factories in Guangdong province have closed, along with almost half the shoe factories. According to one state-run newspaper, 37 percent of Dongguan businesses are losing money.

link to full text

Jim Grant on Market Confidence

Jim Grant, the editor of Grant's Interest Rate Observer (source: WSJ):

[The Confidence Game ]
In disclosing plans to buy a quarter-trillion dollars of bank stock in the name of the American taxpayer, Treasury Secretary Hank Paulson harped on confidence. "Today, there is a lack of confidence in our financial system, a lack of confidence that must be conquered," he said on Tuesday.

What Mr. Paulson did not get around to mentioning was the excess of confidence that preceded the shortfall. Under the spell of soaring house prices (and before that, of stock prices), Americans trusted the things they ought to have doubted. But markets are cyclical, and there is always a new day. In compensating fashion, people will eventually doubt the things they ought to have trusted. Investment opportunity follows disillusionment. It's complacency that precedes bear markets.

If the confidence deficit seems so high, it's because the preceding confidence surplus was full to overflowing. People suspended critical judgment. They accepted at face value the pretensions of central bankers and the competence of investment bankers. Not one professional investor in 50, probably, doubted that wads of subprime mortgages could be refashioned into bonds that were just as creditworthy as U.S. Treasurys.


But it wasn't the vigilance of monetary policy that facilitated the construction of the tree house of leverage that is falling down on our heads today. On the contrary: Artificially low interest rates, imposed by the Federal Reserve itself, were one cause of the trouble. America's privileged place in the monetary world was -- oddly enough -- another. No gold standard checked the emission of new dollar bills during the quarter-century on which the central bankers so pride themselves. And partly because there was no external check on monetary expansion, debt grew much faster than the income with which to service it. Since 1983, debt has expanded by 8.9% a year, GDP by 5.9%. The disparity in growth rates may not look like much, but it generated a powerful result over time. Over the 25 years, total debt -- private and public, financial and non-financial -- has risen by $45.1 trillion, GDP by only $10.9 trillion. You can almost infer the size of the gulf by the lopsided prosperity of the purveyors of debt. In 1983, banks, brokerage houses and other financial businesses contributed 15.8% to domestic corporate profits. It's double that today.


In investment markets, confidence and coherence tend to restore themselves. The hardy souls who lead the way back derive their confidence not from the Treasury Secretary but from the pages of "Security Analysis," by Benjamin Graham and David L. Dodd, the value investor's bible.

Anna Schwartz Is not Happy about What the Fed's Doing

Another I-don't-buy-it story from Anna Schwartz, coauthor with Milton Friedman on "A Monetary History of the United States" (1963).  Being 92 years old and having lived through the period from 1929 to 1933, she may know more monetary history and banking than anyone alive. :

Fed Chairman Ben Bernanke, of all people, should understand this, Ms. Schwartz says. In 2002, Mr. Bernanke, then a Federal Reserve Board governor, said in a speech in honor of Mr. Friedman's 90th birthday, "I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

"This was [his] claim to be worthy of running the Fed," she says. He was "familiar with history. He knew what had been done." But perhaps this is actually Mr. Bernanke's biggest problem. Today's crisis isn't a replay of the problem in the 1930s, but our central bankers have responded by using the tools they should have used then. They are fighting the last war. The result, she argues, has been failure. "I don't see that they've achieved what they should have been trying to achieve. So my verdict on this present Fed leadership is that they have not really done their job."

Full text here (source: WSJ). Some of her major points:

The Fed should aim to help banks get rid of bad assets. In the process, it should allow some banks to fail.  Capital injections only prolong the current credit crisis, because if bad assets remain on banks' balance sheets, banks still won't trust and lend to each other.

Much like 1920s, today's housing and credit bubbles were fueled by the Fed's easy monetary policy.  Greenspan can't absolve himself from failing to prevent the bubble from forming. The old thinking needs to be revised that there was no way you could really terminate the boom because you'd be doing collateral damage to areas of the economy that you don't want to damage.

Sunday, October 19, 2008

Hong Kong to impose minimum wage

In Crisis, It's good to re-read Keynes

A well-written essay on Keynes...can't be more relevant to today's crisis..."We are all Keynesians now", ONCE AGAIN.

Man in the News: John Maynard Keynes

By Ed Crooks

Man in the News: JM Keynes

"We have reached a critical point," John Maynard Keynes wrote in March 1933. "We can ... see clearly the gulf to which our present path is leading." If governments did not take action, "we must expect the progressive breakdown of the existing structure of contract and instruments of indebtedness, accompanied by the utter discredit of orthodox leadership in finance and government, with what ultimate outcome we cannot predict."

As the world reels from a 1929-style stock market plunge and a 1931-style banking crisis, his words are a fair assessment of the dangers we face once again. Keynes, whose life's mission was to save capitalism from itself, is more relevant than at any time since his death in 1946.

His renewed influence can be seen everywhere: in Barack Obama's planned stimulus package, for example. When George W. Bush said his administration's plan to take equity in banks was "not intended to take over the free market, but to preserve it", he could have been quoting Keynes directly.

The key to Keynes was his commitment to preserving the market economy by making it work. He was dismissive of Marxism but believed the market economy could survive only if it earned the support of the public by raising living standards.

The role of the economist, he believed, was to be the guardian of "the possibility of civilisation", and no economist has ever been more suited for that role.

Lionel Robbins, later head of the London School of Economics, described Keynes as "one of the most remarkable men that have ever lived," surpassed in his time only by Winston Churchill. Even Friedrich Hayek, Keynes' staunchest adversary, described him as "the one really great man I ever knew, and for whom I had unbounded admiration".

His optimistic, positive thought reflected his comfortable and happy upbringing and career. An academic's son, he won scholarships to Eton and Cambridge and fell in with the Bloomsbury Group, the circle of writers and artists such as Virginia Woolf and Lytton Strachey who embodied an ideal of cultured living.

He was an imposing figure, six feet, six inches tall and full of jokes, gossip and sharp observations. Alongside economics, he had an array of other interests as mathematician, administrator, academic, investor, journalist, art collector, politician, impresario and diplomat. He was even an exemplary husband, devoted to his wife, Lydia Lopokova, a ballerina. In his language he could be carelessly provocative. But, as he said: "Words ought to be a little wild, for they are the assaults of thoughts on the unthinking."

When bad policies were making economic problems worse, he felt a moral obligation to change them. He worked with distinction at the Treasury during the first world war and at the war's end argued presciently against the imposition of excessively harsh conditions on Germany. When his advice was ignored, he left and published his views in his first great polemic, The Economic Consequences of the Peace .

Returning to Cambridge, Keynes kept up a flow of books and articles, including The Economic Consequences of Mr Churchill, savaging Britain's return to the gold standard in 1925. It was not until the Great Depression, however, that his ideas reached their full flowering, published as The General Theory of Employment, Interest and Money in 1936.

The heart of the book is the idea that economic downturns are not necessarily self-correcting. Classical economics held that business cycles were unavoidable and that peaks and troughs would pass. Keynes contended that in certain circumstances economies could get stuck. If individuals and businesses try to save more, they will cut the incomes of other individuals and businesses, which will in turn cut their spending. The result can be a downward spiral that will not turn up again without outside intervention.

That is where government comes in: to pump money back into the economy by some means, such as spending on public works, to persuade individuals and businesses to save less and spend more themselves.

Keynes wrote to George Bernard Shaw that he expected the General Theory to "largely revolutionise ... the way the world thinks about economic problems", and so it proved. Economists such as Paul Samuelson and James Tobin systematised Keynes' ideas, using them as the foundations of what became orthodox thought and economic policy for more than two decades after the second world war.

The cover of Time magazine in December 1965 quoted Milton Friedman saying: "We are all Keynesians now." Friedman later said he had been misrepresented by selective quotation, but the point held good. Charles L. Schultze, then US budget director, felt able to tell Time: "We can't prevent every little wiggle in the economic cycle, but we now can prevent a major slide."

By the time Richard Nixon borrowed Friedman's line in 1971, however, the tide was already beginning to turn. Like a share tip from a lift boy, Nixon's endorsement was a sign that Keynes' intellectual stock was about to fall. Keynesian economics seemed as inadequate in the 1970s stagflation as classical economics had been for the 1930s depression, and Friedman's monetarism eclipsed it among policy-makers in the US and Britain.

After crude applications of monetarism also foundered in the 1980s, modern macroeconomic orthodoxy blended ideas from both, reflecting a belief in the ability of monetary and fiscal policy to affect employment and growth, but also concern for inflation and budget deficits.

As the financial crisis has deepened, that orthodoxy has been shaken. The problems Keynes faced in the 1930s, such as the ineffectiveness of monetary policy and banking failures triggered by falling asset prices, again seem the most pressing. Keynes' solutions, including greater public spending funded by borrowing, are becoming popular. The criticisms that this will fuel inflation and raise budget deficits are still heard but are increasingly seen as irrelevant.

Robert Skidelsky writes at the end of his definitive three-volume biography that Keynes' ideas "will live so long as the world has need of them". It certainly seems to need them now. Keynes was scathing about the view that the Great Depression was a return to normality, a necessary correction after the unsustainable excesses of the 1920s. On the contrary, he argued, the economic expansion should be seen as the normal state of affairs and the downturn was an "extraordinary imbecility".

With the right policies, he said, the good times could be brought back. He was right then; we must hope he will be right again.

Panic, Fear and Financial Crisis

Edward Chancellor of GMO looks back in history of the similarities in financial crises.

"The passion of fear," declared The Times on the day of Overend's collapse, "is even more powerful than that of hope. There are men who can resist the seductions of promised profits and high premiums, but when depositors think a stoppage is imminent each rushes to secure his deposit in time, caring little for the consequences. Not long ago men trusted everybody; it would seem now that they trust nobody. A great machinery is thrown out of gear."

full text is here:

The financial panic we have been living through has much in common with the great banking panics of the past: rumours of foundering financial giants, concerns about counterparties, the shepherding of cash and flight to the highest quality and most liquid credit instruments, the dumping of riskier assets regardless of price, international contagion and, above all, a heightened sense of the fragility of a weakened financial system. Yet this panic will pass, just like its predecessors.

Bank panics always have the same origin. "Every genuine business panic springs from the same root, which is rank speculation," wrote one Victorian commentator. Thomas Tooke, the ­early 19th century merchant and author, ascribed the British crisis of 1793 to "a great and undue extension of the system of credit and paper circulation". A year earlier, Thomas Jefferson, observing the first financial collapse in the independent United States, noted that "our paper bubble has burst".

Bank panics invariably reveal the poor quality of lending that accompanied the preceding boom. Walter Bagehot, the greatest of 19th-century writers on finance, was aghast at the stupidity of the directors of the discount house Overend Gurney, whose failure in 1866 was the cause of the last run on a British bank before the ignominious demise of Northern Rock. "They ruined a firm almost inconceivably good by business so inexplicably bad that it could hardly be much worse if they had of set purpose tried to make it bad," wrote Bagehot.

The behavioural characteristics of the panic are the obverse of those of the boom. Excessive confidence is replaced by extreme fearfulness and a nervous distrust takes the place of blind trust. During the panic, the buying frenzy of the boom gives way to panicky disposals.

Loss aversion becomes extreme during the panic. "The passion of fear," declared The Times on the day of Overend's collapse, "is even more powerful than that of hope. There are men who can resist the seductions of promised profits and high premiums, but when depositors think a stoppage is imminent each rushes to secure his deposit in time, caring little for the consequences. Not long ago men trusted everybody; it would seem now that they trust nobody. A great machinery is thrown out of gear."

The machinery is thrown out of gear by the failure of what economists would call a systemically important financial institution, such as the Ayr Bank in June 1772, Pole Thornton & Co in December 1825, Overend Gurney in May 1866 (which The Times called "the greatest instrument of credit in the Kingdom"), Jay Cooke & Co in September 1873 and the downfall of the Bank of the United States in December 1930. Likewise, the bankruptcy filing of Lehman Brothers on September 15 triggered our current panic.

The main consequence of the panic is a wild scramble for liquidity. Money becomes scarce. This was even more pronounced when currencies were convertible into gold: in every panic, there was too little of the precious metal to go round. Interest rates rose and the securities prices collapsed. "The best mortgages cannot be converted into money without a sacrifice of 20 per cent, and undoubted business paper is selling in Wall Street at a discount of 3 per cent a month," wrote the New Yorker Philip Hone during the panic of November 1837. Call money rates reached 100 per cent in October 1907.

Every panic is marked by a sense that the financial system is close to complete collapse. Never were such feelings more marked than during the panic that started in London in December 1825. "If the difficulties which existed in the money market had continued only eight-and-forty hours longer ..." William Huskisson, the president of the Board of Trade, told the House of Commons, he sincerely believed "that the effect would have been to put a stop to all dealing between man and man, except by way of barter." Or, as a director of the Bank of England put it during the midst of the crisis: "We must ask not who is gone, but who stands?"

Yet even in 1825 the authorities belatedly succeeded in quelling the panic in that incident by borrowing money from France and distributing a stash of old banknotes found in the vaults of the Old Lady. In the 20th century, the end of the panic tended to coincide with decisive government intervention: Roosevelt's bank holiday of March 1933, the launching of the Bank of England's "lifeboat" in December 1974 and the nationalisation of Japan's Long-Term Credit Bank in October 1998, which was accompanied by a $500bn capital injection into the stricken banking system.

There is good cause for concern. Our modern credit system is more complex, more interconnected and more leveraged than in earlier times. On the other hand, the measures taken by the authorities to allay the crisis are far more extensive than on earlier occasions. Witness the wild scramble by governments around the world to guarantee bank debts, provide loans against dubious securities and inject capital into stricken financial firms.

It is important not to exaggerate the dangers. Dr Johnson dismissed the "general distrust and timidity" on display in 1772 as "little more than a panick terrour from which when they recover, many will wonder why they were frighted". The current panic will pass as others have done beforehand. This does not mean the aftermath will be pleasant for the wider economy. Emergency measures may allay the panic but they cannot correct the credit excesses that are the root cause of the crisis.

The writer is a member of GMO's Asset Allocation team

The Great Iceland Meltdown

Tom Friedman wrote on NY Times:

Who knew? Who knew that Iceland was just a hedge fund with glaciers? Who knew?

If you're looking for a single example of how the globalization of finance helped get us into this mess and how it will help get us out, you need look no further than British newspapers last week and their front-page articles about the number of British citizens, municipalities and universities — including Cambridge — that are in a tizzy today because they had savings parked in Icelandic banks, through online banking services like


When I went to the Icesave Web site to see what it was all about, the headline read: "Simple, transparent and consistently high-rate online savings accounts from Icesave." But then, underneath in blue letters, I found the following note appended: "We are not currently processing any deposits or any withdrawal requests through our Icesave Internet accounts. We apologize for any inconvenience this may cause our customers."

Any "inconvenience?" When you can't withdraw savings from an online bank in Iceland, that is more than an inconvenience! That's a reason for total panic.


In a flat world, money can easily seek out the highest returns, and when word got around about Iceland, deposits poured in from Britain — some $1.8 billion. Unfortunately, though, when global credit markets closed up, and the krona fell, "the Icelandic banks were unable to finance their debts, many of which were denominated in foreign currencies," The Times reported. When depositors rushed to get their money out, the Icelandic banking system had too little reserves to cover withdrawals, so all three banks melted down and were nationalized.

It turns out that more than 120 British municipal governments, as well as universities, hospitals and charities had deposits stranded in blocked Icelandic bank accounts. Cambridge alone had about $20 million, while 15 British police forces — from towns like Kent, Surrey, Sussex and Lancashire — had roughly $170 million frozen in Iceland, The Telegraph reported. Even the bobbies were banking in Iceland!

Globalization giveth — it was this democratization of finance that helped to power the global growth that lifted so many in India, China and Brazil out of poverty in recent decades. Globalization now taketh away — it was this democratization of finance that enabled the U.S. to infect the rest of the world with its toxic mortgages. And now, we have to hope, that globalization will saveth.

Saturday, October 18, 2008

Global Imbalances and the Future of China's SWFs

This current global financial crisis gives urgent need for policy makers in both the US and China to rethink. For the US, more savings/less consumption is needed; for China, more domestic demand needs to nurtured and sustained development should not mean putting all your bets on international trade. If this indeed is the macro trend for the coming ten years, China's current account surplus will be shrinking gradually.

China's foreign exchange reserves has been piling up fast and furious, now close to $2 trillion. To relieve the huge pressure for China's policy makers to seek higher return, and/or to diversify their portfolio holdings, Chinese government should eventually relax the foreign exchange controls, allowing free currency conversion and floating of its exchange rate.

The roots of huge foreign exchange reserves buildup goes back to China's rigid exchange rate regime. By ditching the fixed/managed exchange rate system and realizing free currency conversion, trade surplus will be held by Chinese enterprises and individuals. Instead of putting all money into government's hands and let government agencies, like CIC, do the investment for us (potentially losing our money), individuals and firms should make their own decisions by investing through more sophisticated private institutions. Chinese central bank should only maintain a small amount of foreign exchange reserves, say below $500 billion, to fend off potential currency attacks in future time of crisis. The need for CIC to invest globally will gradually die out and private institutional managers, such as mutual funds or asset management firms, domestic or foreign, will become the dominant force in China. CIC most likely will evolve into one of the many big players in the field, the equivalent of PIMCO, for example.

I hope we are heading toward this direction, and it's healthier than relying government to manage our money.

Friday, October 17, 2008

Land reform in China

I have long been an advocate for land reform in China.  Now the government is doing some very interesting experiments starting from my hometown: Chengdu (source: FT).

China lets farmers trade land use rights

China has approved reform to enable 730m peasant farmers to trade their land use rights more freely and provide greater legal protection for existing landholders.

The Communist party will "construct a healthy market for the transfer of land contract rights . . . based on the principles of legality, free will and adequate compensation for the peasants," wrote Chen Xiwen, director of the office of the central leading group on rural work, in a party magazine published on Thursday.

The first land use rights exchange was set up on Monday in the western city of Chengdu to allow farmers to sell or rent out the rights to use their land.

Qin Shikui, head of the state-owned Chengdu United Assets and Equity Exchange, which opened the exchange, said: "The peasants are very excited about this platform being set up. We have had lots of phone calls and people coming to our offices to find out more about the rules and hoping to transfer their land."

Land has been owned by the state or by rural "collectives" since the the communist revolution in 1949 and cannot be bought or sold by individuals. Under current laws, peasant farmers have mostly been given 30-year land use contracts that allow them to farm plots allocated by local party officials but make it very difficult to sell those contracts or use their land as collateral for loans.

The decision to loosen the constraints on transfers of land use rights and allow exchange markets for trading land titles was made last weekend behind closed doors at a plenary session of the party's central committee.

Before the meeting, senior officials, including Hu Jintao, the president, had hinted strongly that there would be a breakthrough on rural land reform but a communiqué issued on Sunday at the end of the meeting made only passing mention to perfecting the "land management system".

Some observers said the omission signalled serious disagreement among China's top rulers over how far the reform should go towards de facto privatisation of rural land.

Many policymakers have argued that allowing rural citizens to sell their land freely would result in a return to the pre-revolution days of feudal landlords and create a flood of landless poor into the cities.

Mr Chen's article emphasised the delicate balance the party is trying to strike between its ideological roots and raising productivity in the countryside by encouraging concentration of land in larger, more efficient farms.

"We cannot change the collective ownership status of the land," Mr Chen said. "We cannot change the land-use designation [from arable to commercial, residential or industrial] and we cannot damage the peasants' land use contract rights."


Wednesday, October 15, 2008

Hot Money into China Drops Sharply

WSJ reports capital inflow into China slowed sharply:

BEIJING -- Capital flows into China have slowed sharply and even reversed in recent months, according to official data that reflect how the financial crisis has disheartened investors and disrupted banks in this fast-growing nation.

The inflow shift is part of the dramatic turnaround in China's economic situation in the past few months. Earlier this year, China's currency was surging against the dollar, helping to draw tens of billions of investor dollars into the country. Policy makers fretted about whether the speculative inflows were large enough to destabilize the financial system.

Now, the Chinese currency, the yuan, has barely budged against the dollar for two months, leading many investors to unwind bets on its continued appreciation. The property market and export sector, key drivers of recent growth, seem to be deteriorating rapidly. Investors have noticed.

On Tuesday, China's central bank published figures showing its foreign-exchanges reserves -- the world's largest -- rising to $1.906 trillion at the end of September from $1.809 trillion at the end of June. But the pace of increases has slowed and the new funds seem to trail what trade and corporate investment are bringing into the country.

"I think it's pretty certain that we are seeing an outflow of capital at this stage," said Glenn Maguire, Asia economist for Société Générale in Hong Kong. However, he said, "what we are seeing is an unwinding of the hot money flows that occurred earlier in the year, rather than outright capital flight."

[china's foreign exchange reserves]

The new figures suggest China saw very limited, if any, inflows of speculative capital -- sometimes called "hot money" -- in July and August. And analysts estimate that anywhere from $10 billion to $25 billion left the country in September, just as the financial crisis intensified.

China's banks remain flush with cash even amid the strains affecting other nations' financial systems. Few signs exist of a credit crunch. China's large trade surpluses -- which hit a monthly record of $29.37 billion in September -- continue to push large quantities of dollars into the financial system.

Officials say they are sanguine. "The impact of this crisis on China is limited and controllable. We are confident we can maintain the stability of China's financial markets." Chinese Premier Wen Jiabao said Tuesday in a telephone conversation with U.K. Prime Minister Gordon Brown, according to a statement by China's foreign ministry.

Part of the slowdown in reserve accumulation is likely due to the recent rally of the dollar. Since China's reserves are reported in dollars, the value of its nondollar holdings has been shrinking. But currency moves don't explain all of the changes, and there were unusual strains in China's markets in September.

"This outflow likely reflected foreign financial institutions attempting to repatriate capital and hoard dollar liquidity in the midst of the credit crisis," said Logan Wright of Stone & McCarthy Research Associates in Beijing.

Even if it has slowed, the continued increase in China's foreign-exchange reserves is welcome news for the U.S. at the moment. It indicates Chinese demand remains for the Treasury debt that is being used to finance efforts to rescue the financial system. While there has been grumbling within China about the low returns on that investment, many observers don't expect the reserves to be switched away from the U.S. on a large scale.

"China is losing a bit of money investing in U.S. Treasurys, given the dollar is depreciating in a long-term trend," Erh-fei Liu, Merrill Lynch's China chairman, said in Beijing. The alternative is worse, he said: "If China stops buying Treasurys, the U.S. will stop importing from China, and that'll hurt China demand and that'll be a loss-loss situation for both countries."

Tuesday, October 14, 2008

Bernanke on government actions

Ben thinks this time government actions are timely, not too late as in previous crisis, but he acknowledged serious challenges ahead.

video link to his speech

Monday, October 13, 2008

Krugman wins Nobel prize in economics

American Paul Krugman won the Nobel economics prize on Monday for his analysis of trade patterns and location of economic activity.

Mr. Krugman, born in 1953, and a professor at Princeton University in New Jersey and a columnist for The New York Times, formulated a new theory to answer questions about free trade, the Royal Swedish Academy of Sciences said.

"What are the effects of free trade and globalization? What are the driving forces behind worldwide urbanization? Paul Krugman has formulated a new theory to answer these questions," the academy said in its citation. "He has thereby integrated the previously disparate research fields of international trade and economic geography," it said.

Mr. Krugman was the lone winner of the 10 million kronor ($1.4 million) award, the latest in a string of American researchers to be honored. In 2007, Americans Leonid Hurwicz, Eric S. Maskin and Roger B. Myerson won the prize for laying the foundations of mechanism design theory.

Sunday, October 12, 2008

Krugman: Last chance to avoid "Great Depression"

Paul Krugman wrote on NY Times:  Moment of Truth.
and his Bloomberg interview on the urgency of action this weekend to avoid disaster.

Quote: "The only thing people want to buy is treasury bills and a bottle of water..."

Soros' assessment on the current crisis

George Soros on Bill Moyers:

(click on the image to play)

Economists' solution to end the global financial crisis

A booklet of various proposals from a group of prominent economists to end the financial crisis.

download link

Friday, October 10, 2008

MIT panel discussions on current financial crisis

Savings glut, dollar recycle and financial crisis

Martin Wolf wrote on FT that today's financial crisis has much similarities and close connections to the past crises.  His summary of the cause of the current crisis:

A simple way of thinking about what has happened to the global economy in the 2000s is that high-income countries with elastic credit systems and households willing to take on rising debt levels offset the massive surplus savings in the rest of the world. The lax monetary policies facilitated this excess spending, while the housing bubble was the vehicle through which it worked.

Now here is the full text...

Asia's revenge

"Things that can't go on forever, don't." – Herbert Stein, former chairman of the US presidential Council of Economic Advisers

What confronts the world can be seen as the latest in a succession of financial crises that have struck periodically over the last 30 years. The current financial turmoil in the US and Europe affects economies that account for at least half of world output, making this upheaval more significant than all the others. Yet it is also depressingly similar, both in its origins and its results, to earlier shocks.

To trace the parallels – and help in understanding how the present pressing problems can be addressed – one needs to look back to the late 1970s. Petrodollars, the foreign exchange earned by oil exporting countries amid sharp jumps in the crude price, were recycled via western banks to less wealthy emerging economies, principally in Latin America.

This resulted in the first of the big crises of modern times, when Mexico's 1982 announcement of its inability to service its debt brought the money-centre banks of New York and London to their knees.

Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University identify the similarities in a paper published earlier this year.* They focus on previous crises in high-income countries. But they also note characteristics that are shared with financial crises that have occurred in emerging economies.

This time, most emerging economies have been running huge current account surpluses. So a "large chunk of money has effectively been recycled to a developing economy that exists within the United States' own borders", they point out. "Over a trillion dollars was channelled into the subprime mortgage market, which is comprised of the poorest and least creditworthy borrowers within the US. The final claimaint is different, but in many ways the mechanism is the same."

The links between the financial fragility in the US and previous emerging market crises mean that the current banking and economic traumas should not be seen as just the product of risky monetary policy, lax regulation and irresponsible finance, important though these were. They have roots in the way the global economy has worked in the era of financial deregulation. Any country that receives a huge and sustained inflow of foreign lending runs the risk of a subsequent financial crisis, because external and domestic financial fragility will grow. Precisely such a crisis is now happening to the US and a number of other high-income countries including the UK.

These latest crises are also related to those that preceded them – particularly the Asian crisis of 1997-98. Only after this shock did emerging economies become massive capital exporters. This pattern was reinforced by China's choice of an export-oriented development path, partly influenced by fear of what had happened to its neighbours during the Asian crisis. It was further entrenched by the recent jumps in the oil price and the consequent explosion in the current account surpluses of oil exporting countries.

The big global macroeconomic story of this decade was, then, the offsetting emergence of the US and a number of other high-income countries as spenders and borrowers of last resort. Debt-fuelled US households went on an unparalleled spending binge – by dipping into their housing "piggy banks".

In explaining what had happened, Ben Bernanke, when still a governor of the Federal Reserve rather than chairman, referred to the emergence of a "savings glut". The description was accurate. After the turn of the millennium, one of the striking features became the low level of long-term nominal and real interest rates at a time of rapid global economic growth. Cheap money encouraged an orgy of financial innovation, borrowing and spending.

That was also one of the initial causes of the surge in house prices across a large part of the high-income world, particularly in the US, the UK and Spain.

What lay behind the savings glut? The first development was the shift of emerging economies into a large surplus of savings over investment. Within the emerging economies, the big shifts were in Asia and in the oil exporting countries (see chart). By 2007, according to the International Monetary Fund, the aggregate savings surpluses of these two groups of countries had reached around 2 per cent of world output.

Government spending

Despite being a huge oil importer, China emerged as the world's biggest surplus country: its current account surplus was $372bn (£215bn, €272bn) in 2007, which was not only more than 11 per cent of its gross domestic product, but almost as big as the combined surpluses of Japan ($213bn) and Germany ($185bn), the two largest high-income capital exporters.

Last year, the aggregate surpluses of the world's surplus countries reached $1,680bn, according to the IMF. The top 10 (China, Japan, Germany, Saudi Arabia, Russia, Switzerland, Norway, Kuwait, the Netherlands and the United Arab Emirates) generated more than 70 per cent of this total. The surpluses of the top 10 countries represented at least 8 per cent of their aggregate GDP and about one-quarter of their aggregate gross savings.

Meanwhile, the huge US deficit absorbed 44 per cent of this total. The US, UK, Spain and Australia – four countries with housing bubbles – absorbed 63 per cent of the world's current account surpluses.

That represented a vast shift of capital – but unlike in the 1970s and early 1980s, it went to some of the world's richest countries. Moreover, the emergence of the surpluses was the result of deliberate policies – shown in the accumulation of official foreign currency reserves and the expansion of the sovereign wealth funds over this period.

Quite reasonably, the energy exporters were transforming one asset – oil – into another – claims on foreigners. Others were recycling current account surpluses and private capital inflows into official capital outflows, keeping exchange rates down and competitiveness up. Some described this new system, of which China was the most important proponent, as "Bretton Woods II", after the pegged adjustable exchange rates set-up that collapsed in the early 1970s. Others called it "export-led growth" or depicted it as a system of self-insurance.

Yet the justification is less important than the consequences. Between January 2000 and April 2007, the stock of global foreign currency reserves rose by $5,200bn. Thus three-quarters of all the foreign currency reserves accumulated since the beginning of time have been piled up in this decade. Inevitably, a high proportion – probably close to two-thirds – of these sums were placed in dollars, thereby supporting the US currency and financing US external deficits.

The savings glut had another dimension, related to a second financial shock – the bursting of the dotcom bubble in 2000. One consequence was the move of the corporate sectors of most high-income countries into financial surplus. In other words, their retained earnings came to exceed their investments. Instead of borrowing from banks and other suppliers of capital, non-financial corporations became providers of finance.

In this world of massive savings surpluses in a range of important countries and weak demand for capital from non-financial corporations, central banks ran easy monetary policies. They did so because they feared the possibility of a shift into deflation. The Fed, in particular, found itself having to offset the contractionary effects of the vast flow of private and, above all, public capital into the US.

A simple way of thinking about what has happened to the global economy in the 2000s is that high-income countries with elastic credit systems and households willing to take on rising debt levels offset the massive surplus savings in the rest of the world. The lax monetary policies facilitated this excess spending, while the housing bubble was the vehicle through which it worked.

The charts show what happened, as a result, to "financial balances" – the difference between expenditure and income – inside the US economy. If one looks at three sectors – foreign, government and private – it is evident that the first has had a huge surplus this decade – offset, as it has to be, by deficits in the other two.

In the early 2000s, the US fiscal deficit was the main offset. In the middle years of the decade, the private sector ran a large deficit while the government's shrank. Now that the recession-hit private sector is moving back into balance at enormous speed, the government deficit is exploding once again.

Looking at what happened inside the private sector, a striking contrast can be seen between the corporate and household realms. Households moved into a huge financial deficit, which peaked at just under 4 per cent of GDP in the second quarter of 2005. Then, as the housing bubble burst, housebuilding collapsed and households started saving more. With remarkable speed, the household financial deficit disappeared. Today's explosion in the fiscal deficit is the offset.

Inevitably, huge household financial deficits also mean huge accumulations of household debt. This was strikingly true in the US and UK. In the process, the financial sector accumulated an ever greater stock of claims not just on other sectors but on itself. This frightening complexity, which lies at the root of many of the current difficulties, was facilitated by the environment of easy borrowing and search for high returns in an environment of low real rates of interest.

A protest against the US banking rescue

These linked dangers between external and internal imbalances, domestic debt accumulations and financial fragility were foretold by a number of analysts. Foremost among them was Wynne Godley of Cambridge university in his prescient work for the Levy Economics Institute of Bard College, which has laid particular stress on the work of the late Hyman Minsky.**

So what might – and should – happen now? The big danger, evidently, is of a financial collapse. The principal offset, in the short run, to the inevitable cuts in spending in the private sector of the crisis-afflicted economies will also be vastly bigger fiscal deficits.

Fortunately, the US and the other afflicted high-income countries have one advantage over the emerging economies: they borrow in their own currencies and have creditworthy governments. Unlike emerging economies, they can therefore slash interest rates and increase fiscal deficits.

Yet the huge fiscal boosts and associated government recapitalisation of shattered financial systems are only a temporary solution. There can be no return to business as usual. It is, above all, neither desirable nor sustainable for global macroeconomic balance to be achieved by recycling huge savings surpluses into the excess consumption of the world's richest consumers. The former point is self-evident, while the latter has been demonstrated by the recent financial collapse.

So among the most important tasks ahead is to create a system of global finance that allows a more balanced world economy, with excess savings being turned into either high-return investment or consumption by the world's poor, including in capital- exporting countries such as China. A part of the answer will be the development of local-currency finance in emerging economies, which would make it easier for them to run current account deficits than proved to be the case in the past three decades.

It is essential in any case for countries in a position to do so to expand domestic demand vigorously. Only in this way can the recessionary impulse coming from the corrections in the debt-laden countries be offset.

Yet there is a still bigger challenge ahead. The crisis demonstrates that the world has been unable to combine liberalised capital markets with a reasonable degree of financial stability. A particular problem has been the tendency for large net capital flows and associated current account and domestic financial balances to generate huge crises. This is the biggest of them all.

Lessons must be learnt. But those should not just be about the regulation of the financial sector. Nor should they be only about monetary policy. They must be about how liberalised finance can be made to support the global economy rather than destabilise it.

This is no little local difficulty. It raises the deepest questions about the way forward for our integrated world economy. The learning must start now.

*Is the 2007 US subprime financial crisis so different? An international historical comparison. Working paper 13761,

**The US economy: Is there a way out of the woods? November 2008,

The writer is the FT's chief economics commentator and author of Fixing Global Finance, published in the US this month by Johns Hopkins University Press and forthcoming in the UK through Yale University Press.