Saturday, February 28, 2009

Current State of Europe

First watch this interview of World Bank Chief Robert Zoellick on Europe and what can be done. (source: FT). In his own words, "2009 is a dangerous year".

Second, read this piece from BusinessWeek, "How the crisis is hitting Europe", and this nice snapshot of the current state of European economies.

(click to enlarge; source: BW)

Friedman 1979 to "moment of doubt about capitalism"

How to restructure big banks?

Two plans were proposed in the video (source: CNBC)

1. temporarily nationalize banks, separate good assets from bad assets, make quick sale of the bad assets, and get banks' balance sheets clean; then hopefully banks will start lending again.

2. create a new big bank by the government, at the $1 trillion range, and let this big new bank lend to the economy. And it solves the problem of bank's unwillingness to lend in this extremely risk-averse and uncertain period.

My bottom line for solution 1 (Roubini's proposal) is the nationalization has to be temporary and government needs to get out of private business asap.

My bottom line for solution 2 is government can create lending, but it can't be run by bureacrats, an alternative is to hire professional banks from wall street to run the newly created bank. But even so, this newly created bank don't have any existing facilities. And it's hard to imagine how you can quickly put up a new bank, in $1 trillion size.

Summers, Roubini, Mishkin, Zandi: Current State of the Economy

A worth watching 1-hour video that keeps you updated with Obama's housing plan and economic stimuli, and what are the challenges ahead. (source: Charlie Rose)

Friday, February 27, 2009

Euroisation of Eastern Europe?

Europe is in a mess, can Western Europe afford the collapse of their eastern neighbors? Or should some Eastern European countries be allowed to join Euro so to avoid further currency devaluation? In any case, European Union now is facing the gravest challenges since the inception of the union, and it is more likely than ever that the European Union will break up.

Source: Economist magazine, Feb., 2009

The bill that could break up Europe,
if eastern Europe goes down, it may take the European Union with it

TUMBLING exchange rates, gaping current-account deficits, fearsome foreign-currency borrowings and nasty recessions: these sound like the ingredients of a distant third-world-debt crisis from the 1980s and 1990s. Yet in Europe the mess has been cooked up closer to home, in east European countries, many of them now members of the European Union. One consequence is that older EU countries will find themselves footing the bill for clearing it up.

Many west Europeans, faced with severe recession at home, will see this as outrageously unfair. The east Europeans have been on a binge fuelled by foreign investment, the desire for western living standards and the hope that most would soon be able to adopt Europe's single currency, the euro. Critics argue, with some justice, that some east European countries were ill-prepared for EU membership; that they have botched or sidestepped reforms; and that they have wasted their borrowed billions on construction and consumption booms. Surely they should pay the price for their own folly?

Yet if a country such as Hungary or one of the Baltic three went under, west Europeans would be among the first to suffer (see article). Banks from Austria, Italy and Sweden, which have invested and lent heavily in eastern Europe, would see catastrophic losses if the value of their assets shrivelled. The strain of default, combined with atavistic protectionist instincts coming to the fore all over Europe, could easily unravel the EU's proudest achievement, its single market.

Indeed, collapse in the east would quickly raise questions about the future of the EU itself. It would destabilise the euro—for some euro members, such as Ireland and Greece, are not in much better shape than eastern Europe. And it would spell doom for any chance of further enlarging the EU, raising new doubts about the future prospects of the western Balkans, Turkey and several countries from the former Soviet Union.

The political consequences of letting eastern Europe go could be graver still. One of Europe's greatest feats in the past 20 years was peacefully to reunify the continent after the end of the Soviet empire. Russia is itself in serious economic trouble, but its leaders remain keen to exploit any chance to reassert their influence in the region. Moreover, if the people of eastern Europe felt they had been cut adrift by western Europe, they could fall for populists or nationalists of a kind who have come to power far too often in Europe's history.

How to avert disaster

The question for western Europe's leaders is how best to avert such a disaster. Although markets often treat eastern Europe as one economic unit, every country in the region is different. Three broad groups stand out. The first includes countries that are a long way from joining the EU, such as Ukraine. Here European institutions may help financially or with advice, but the main burden should fall on the International Monetary Fund. These countries will have to take the IMF medicine of debt restructuring and fiscal tightening that was meted out so often in previous emerging-market crises.

Things are different for the countries farther west, all EU members for which the union must take prime responsibility. One much-touted remedy is to accelerate their path to the euro, or even let them adopt it immediately. It might make sense for the four countries with exchange rates pegged to the euro: the Baltic trio of Estonia, Latvia and Lithuania, plus Bulgaria. (Slovenia and Slovakia have joined the euro already.) None of these will meet the Maastricht treaty's criteria for euro entry any time soon. But they are tiny (the Baltics have a population of barely 7m), so letting them adopt the euro ought not to set an unwelcome precedent for others nor should it damage confidence in the single currency. Yet the European Central Bank and the European Commission firmly oppose this form of "euroisation", even though two Balkan countries, Montenegro and Kosovo, use the euro already.

Unilateral or accelerated adoption of the euro would make far less sense for a third group of bigger countries with floating exchange rates: the Czech Republic, Hungary, Poland and Romania. None of these is ready for the tough discipline of a single currency that rules out any future devaluation. Their premature entry could fatally weaken the euro. But as their currencies slide, the big vulnerability for the Poles, Hungarians and Romanians, especially, arises from the debt taken on by firms and households in foreign currency, mainly from foreign-owned banks. What once seemed a canny convergence play now looks like a barmy risk, for both the borrowers and the banks, chiefly Italian and Austrian, that lent to them.

Stopping the rot

The first priority for these four must be to stop further currency collapse. The second is to prop up the banks responsible for the foreign-currency loans that are going bad. The pain of this should be shared four ways: between the banks and their debtors, and between governments of both lending and borrowing countries. From outside, these two tasks will necessitate help from several sources: the European Central Bank as well as the IMF, the commission's structural funds, the European Bank for Reconstruction and Development and perhaps the European Investment Bank. Given the scale of the problem, the lack of co-ordination between these outfits has been scandalous. A third aim must be to get eastern European countries to restart the structural reforms they have evaded thus far.

Bailing out the same mythical Polish plumbers who just stole everybody's jobs will be hard for Europe's leaders to sell on the doorsteps of Berlin, Bradford and Bordeaux, especially with the xenophobic right in full cry. German taxpayers are already worried that others are after their hard-earned cash (see article). The bill will indeed be huge, but in truth western Europe cannot afford not to pay it. The meltdown of any EU country in the region, let alone the break-up of the euro or the single market, would be catastrophic for all of Europe; and on this issue there is little prospect of much help from America, China or elsewhere. It is certainly not too late to rescue the east; but politicians need to start making the case for it now.

Japan: why unemployment fell during recession?

One simple fact: more people became discouraged, and gave up searching.

source: WSJ

Japan's Nasty Employment Surprise

Surely the only thing worse than looking for employment and not being able to find it is giving up the search altogether.

Discouraged workers are pulling out of Japan's labor pool. That led the nation's unemployment rate to drop to 4.1% from December's revised 4.3%. Economists -- expecting the unemployment rate to rise to 4.6% -- didn't quite anticipate this.

[Japan employment]

It's not difficult to see why job seekers are so discouraged. In January, there were only 67 positions for every 100 job seekers, according to the government -- the weakest labor demand since September 2003. Compare that with 85 just six months ago.

There's more bad news ahead.

Companies are trying to maintain positions by cutting work hours and furloughing staff. These are measures that'll only last so long. In a separate report Friday, Japan said industrial production plunged 10% in January -- a record drop which doesn't bode well for employment in months ahead.

Recently the hit has been most severe in Japan's export-oriented manufacturing centers. The home of Toyota Motor, Aichi prefecture, saw the number of jobs available plunge by 20%, the sharpest drop in the country.

So Japan is now fighting a war on two fronts. Consumers account for 55% of the nation's gross-domestic product and there's little encouraging them to spend.

Tokyo can't do much about exports, but even on the domestic front it's offered few solutions. A planned $120 cash handout has been widely panned, and a potentially massive stimulus package -- totaling up to $300 billion -- could be delayed by politics.

Japan's leaders need to stop worrying about their own jobs and act.

Unprecedented state budget shortfall

Graph courtesy of John Mauldin.

The first graph looks at percentage of states that are to meet revenue projections.

The second graph has a longer history, and it looks at the yearly change of tax receipts.

Yuan appreciation: first Dollar, now Euro

How good is economic growth and stock market correlated in China?

The Chinese A share market has been a better indicator of China's economic fundamentals since the second half of 2005, thanks to the non-tradable share reform and growing composition of institutional investors.

    Chinese A Share

Do Private Equity Firms "Create Value"?

A NBER digest commentary (author: Laurent Belsie) looking at the following research: Do Private Equity Firms "Create Value"?

" Private equity owned companies use much stronger incentives for their top executives and have substantially higher debt levels ... (but there is) little evidence that (they)...outperform public firms in profitability or operational efficiency."

In Managerial Incentives and Value Creation: Evidence from Private Equity (NBER Working Paper No. 14331), co-authors Phillip Leslie and Paul Oyer analyze the differences between companies owned by private equity (PE) investors and similar public companies. They observe that the PE-owned companies use much stronger incentives for their top executives and have substantially higher debt levels. However, they find little evidence that PE-owned firms outperform public firms in profitability or operational efficiency. Leslie and Oyer also show that the compensation and debt differences between PE-owned companies and public companies disappear over a very short period (one to two years) after the PE-owned firm goes public. This raises questions about whether and how PE firms, and the incentives they put in place, create value.

A central tenet of PE investors is that they fix companies by improving their management. A major method for accomplishing this is through managers' compensation: lower salaries than their counterparts in public corporations, but bigger equity stakes in their company. The idea is that by tying compensation more closely to corporate performance, these managers will make the tough but needed changes. That theory doesn't always work out in practice, though.

Leslie and Oyer examine 233 U.S. companies that either underwent a leveraged buyout (LBO) between 1996 and 2004 and then completed an initial public offering (IPO) before the end of 2005 or went private between 1998 and October 2007 (and about which there is compensation data available). They supplement that data with interviews of half a dozen experienced executives at private equity firms. They find that since 1996 the highest paid executive in a privately owned firm earned about 12 percent less salary, but got 3.3 percentage points more company equity and 12.6 percent more of his cash compensation through bonuses and other variable pay, than the CEO of a public corporation. And, they claim that it's not just the CEO who got this treatment: the 20 to 80 top managers typically also got significant equity in the company.

"A very important aspect of the equity programs is that managers are required to contribute capital -- managers purchase the equity with their own personal funds," they write. They say that their study is the first to document the changes in management incentives in private buyouts since 1990, when the PE landscape was far different. The impact of these incentives is less clear, however. "While the incentives given to PE-owned firms' managers keep their companies operating at average levels of profitability and efficiency, we do not find evidence that they create significant excess profits," the authors conclude. In only one category they measured - sales per employee - did private-equity ownership have a significant positive effect. Even that effect dissipated in a few years once the company went back to being a public corporation.

Indeed, the high debt levels and pay structure under private equity management also tended to disappear in one to two years after the firm reverted back to a public company, the study finds. Petco, the pet-supplies chain, illustrates the cycle. When it was a public company between 1995 and 1999, Petco's CEO Bruce Devine owned about 2 percent of the stock. After he took the company private in 2000, his share rose to about 10 percent. When the company went through an IPO in 2002, his share of the company fell immediately to 7 percent. By 2006, when he was chairman but no longer CEO, his share had fallen to 4 percent. The chain's debt-to-asset ratio tripled after it went private but began to fall back toward pre-2002 levels once it was public again.

The authors concede that their sample is limited because, in most cases, private-equity firms don't have to report compensation practices. Thus, the sample represents a minority of the private-equity universe: 144 companies that did publish compensation data as part of a reverse LBO (where the private equity owners sell out in an initial public offering). But the authors find no reason that managerial incentives at firms with an LBO should be different from others owned by private-equity firms. The authors control for the other concern -- that their sample might be skewed because private-equity firms target companies with already high managerial incentives - by looking at the characteristics of 89 other U.S. firms that were attractive to private equity firms but not yet owned by them.

Although papers published in 1989 and 1990 documented differences in the share of CEO equity ownership between publicly traded firms and firms that had undergone a management buyout, this study is the only one to study the phenomenon on post-1990 buyouts.

Thursday, February 26, 2009

When the housing market will stop falling?

The key to end this mess, especially in banking sector, is to stablize the housing market. Without any policy interventions, let's look at how far we are close to a housing bottom.

The first graph (all graphs curtesy of Calculatedrisk) shows you the price-to-rent ratio. Historical average is around 1.1, now we are at 1.2. Looks quite optimistic.

But the drop of price-to-rent ratio may be due to rising rents, as more people switched to rental in this depressing market. So we now look at price-to-income ratio. You actually find the similar story: historical average is at 1.0, now we are at 1.1. Almost there.

So does this mean we are near the housing bottom?

Not necessarily. Just like stock price, housing price tends to overshoot (in this case, undershoot). The overshooting scenario is very much likely giving the monthly supply of existing homes still remains at historical high level --- we still have more than 9 months of supply to clear, that's 4 months more than normal.

Looking at the same problem from a different angel: if we compare the existing home sales with new home sales--- in the past, the two sales figures moved closely along with each other. But since early 2007, this relationship has diverged, with existing home sales trying to hold up and falling at a slower speed, while new home sales suffering almost a free fall.

This partially explains why the inventory of existing home sales has built up and remained high -a lot of home buyers suffered a huge blow to their wealth as their mortgage values are significanly higher than the current market price (underwater mortgage). And imagine the impact on consumptions: home owners basically have to cut their spending to fill the hole of falling housing price.

With huge inventory buildup, it's very likely housing price will overshoot on the downside. But without price correction, the inventory will not clear. It's a dilemma for policy makers. If policy makers try to intervene and stop the price from falling at current level, it will delay the market clearing process, and we are likely to see a very anemic recovery of housing market and consumption.

Economic history shows when recession happens along with housing bubble, the recession tends to last much longer.

Arthur Levitt on the "N-word"

Arthur Levitt's view on bank nationalization

Monday, February 23, 2009

Volcker: Capitalism will survive

Volcker, "This is mother of all financial crises...but capitalism will survive, although financial industry needs revisions".

Watch this video speech by Paul Volcker

A debate on bank nationalization

video link from Bloomberg.

Sunday, February 22, 2009

Stiglitz on bank nationalization

or click the video link here

Saturday, February 21, 2009

America enters the lost decade

S&P 500 dropped to the lowest point since 2003, and the index is back to the level of mid 1997.

(click to enlarge)

Saturday, February 14, 2009

How bad is current unemployment?

David Altig at Atlanta Fed analyzes the current unemployment in historical comparative perspective. Also refer to my previous posts on this: here and here.

How bad is the employment picture, really?

We quite likely have not hit bottom in the labor market yet, and the percent loss in nonfarm payroll employment since the beginning of the current recession is already worse than all of the previous seven recessions save the 1981–82 contraction:


A cross-recession look at employment losses, but based on data from a survey of households (as opposed to payroll data collected from business establishments):


TED spread has come down

We may well have passed the storm eye and Q4 2008 may well be the worst quarter in this cycle. But I don't see the light at the end of the tunnel. The recovery is not in sight and it will be slow and gradual, if any.

1-year Ted spread:

3-year Ted spread:

(click to enlarge; source: Bloomberg)

Analyzing Gold Demand

Pretty good analysis of gold demand (source: wsj). Something I don't know is jewelry demand accounts for almost 3/4 of total demand. Also, from investor's perspective, I think gold often serves the following functions:

1. inflation hedge
2. currency hedge (consider central banks use it as hedge for $)
3. safe haven (during panic time)
4. precious metal (during commodity boom)

In all, gold should be a good and rewarding investment in coming years.

Besides its luster, gold is prized for its malleability -- and not just by metalworkers.

Gold's shifting identity as safe haven, currency, raw material and adornment draws in all manner of buyers. That complicates judging the gold price's next move. Goldbugs, for example, must wonder why, at about $900 an ounce, it remains 10% below its March peak, despite the subsequent intensification of the global economic crisis.

[Getting a Grip on Gold's Price] 

Their disappointment results, in part, from the reluctance of Indian brides to buy gold once it reaches $750 an ounce or more. According to the Bombay Bullion Association, India's gold imports plunged 81% in December. This collapse in jewelry demand has extended world-wide -- witness Tiffany & Co's woes. That matters given trinkets have accounted for almost three quarters of gold demand this decade.

Further falls in jewelry demand this year are certainly possible. But investors are the marginal buyers of gold. Jewelry consumption fell from over 3,000 metric tons in 2001 to just over 2,000 metric tons in 2008, according to HSBC analysts. Yet rising demand from investors, particularly in exchange traded funds, offset half that decline. Along with reduced mining output, that underpinned the price rally.

How investment demand holds up will determine how brightly gold shines over the next couple of years. In particular, retail demand -- individuals buying gold ETFs, bars, wafers and coins -- is the swing factor. Institutional speculators in the gold futures market have retreated since last summer, as hedge funds have imploded.

[Getting a Grip on Gold's Price]

Individuals, however, have a renewed taste for bling. UBS analysts report an acceleration of inflows into gold ETFs in recent weeks, as well as strong demand for physical gold -- unusual given the rally in the US dollar since mid-December.

Can it be maintained? The key, reckons UBS metals strategist John Reade, is whether gold switches from being a "small minority" investment to merely a "minority" investment. The eight gold ETFs he tracks are worth, collectively, around $36 billion -- roughly 1% of the savings in U.S. money market funds.

A relatively small shift in the percentage of their portfolios that investors tuck away in gold would keep the price elevated. While inherently uncertain, there are valid reasons to expect such an outcome. Dislocation in equities and other traditional investments should encourage diversification -- perhaps even in India, given the collapse in the Sensex and the scandal at Satyam Computer Services Ltd.

Investors may also finally question the merits of piling into US Treasurys as a safe haven: Why lower Washington's borrowing costs even as it spews out ever more paper? Quantitative easing necessarily raises the specter of deflation, which is bad for gold prices. Equally, however, it speaks to general currency mayhem and increased risk of a longer-term inflationary overshoot -- both good for gold.

Long recession and anemic recovery

This WSJ analysis looks at the trend of corporate earnings growth, and it shows (in graph) we are having a downside overshot on earnings and it will take longer than normal to recover. This is not good for stock market.

There are hints lately that the economy's collapse isn't quite as precipitous as it once was, which suggests the worst may be over for corporate profits, too. That doesn't mean they are anywhere close to normal.

Since World War II, earnings have grown at about 6% a year, slightly trailing economic growth. But earnings have fallen well off trend during the current recession.

[S&P 500 earnings quarterly]

a similar but much gorgeous chart:

(click to enlarge; chart via Bob Bronson Capital Management)

"As-reported" earnings per share -- which, unlike "operating" EPS, conform to accounting standards -- of companies in the S&P 500 are on pace to total just $28.75 for the past four quarters, according to Standard & Poor's. That is roughly 61% below where they would be had they maintained a 6% growth rate in recent years, estimates Vitaliy Katsenelson, head of research at Investment Management Associates in Denver.

Earnings overshot the trend by about 31% before the downturn, Mr. Katsenelson estimates, and if recent history is any guide the payback will be vicious. Earnings got 18% above trend during the tech-stock boom, for example, but then fell 50% below trend and took 2½ years to crawl back. Given current forecasts for as-reported earnings, profit growth could still be nearly 40% below trend by the end of 2010.

Stock prices can still rise during that recovery. And profit growth tends to be turbocharged coming out of a recession, helping earnings catch up to their long-term average.

But long-term growth could be slowed for years to come by a hobbled banking sector and debt-shedding U.S. consumers. In short, stocks mightn't be quite as cheap as they look.

Thursday, February 12, 2009

Employment: V-recovery or jobless recovery?

I've discussed this issue in my previous post. Now here is another update:

(click to enlarge)

Oil will break below $30

With shattering demand and oil supply reaching 82-week high, it's become almost unstoppable that oil will break below $30 per barrel.

(click to enlarge; source: wsj, weekly price of March 09 future)

Watch this video analysis from Bloomberg

Wednesday, February 11, 2009

IMF's latest world economic forecast

(click to enlarge, source: IMF)

The problems of capping top executive's pay

Incentive matters.  Here is a look at potential problems of capping executive's pay proposed by the new President.  (source:WSJ)

The Obama administration had to do something. But capping executive pay at $500,000 at banks needing "exceptional assistance" could make as many problems as it solves.

First, it could distort labor markets. Employees and executives will be tempted to flee troubled banks to subsidiaries of foreign banks or stronger U.S. institutions. That could make the weak even weaker.

Second, the plan caps pay for top employees. It doesn't yet address the arguably more important issue of generous pay structures lower down in organizations. The cap could encourage those in, say, better paid jobs running big departments at an investment bank to shun top positions where pay would be limited.

True, the limits aren't rigid. Large amounts of restricted stock could still be issued, although this would have value only if executives could dig their banks out of a deep hole and pay back taxpayers.

Third, the rules aren't retroactive. So AIG, theoretically, can bumble along, while a company getting into such trouble now would be subject to tougher rules.

On the positive side, the plan does encourage banks to pay back government aid as quickly as possible, even if it means tapping public markets at expensive rates. But even that could create a distortion. Those who took special assistance early, such as Bank of America and Citigroup with their loss-sharing agreements, would be under less pressure to refund that help early.

Not for the first time, the most incompetent, who hit trouble first, could end up relatively better off. Contrast creditors who had exposure to Bear Stearns -- who were made whole -- with those exposed to bankrupt Lehman Brothers.

The still lagging ECB

ECB is dragging the feet of European economy, WSJ reports:

The European Central Bank is still dragging its feet, even as the euro zone sinks deeper into recession. Instead of continuing the sharp cuts to its refinancing rate – down 2.25 percentage points to 2% in three months – it stood pat Thursday. It needs to do more, and fast.

President Jean-Claude Trichet did soften his tone. While reiterating his view that zero interest rates aren't desirable, he notably added "at this stage." And one view is that ECB is heading toward a zero-rate policy on the sly.

The overnight interbank lending rate, known as Eonia, has actually fallen sharply to 1.2% from 2.1% in the past three weeks. But why say one thing and do another? Other central banks see no need for that. The Federal Reserve has got rates down to zero. The Bank of England lopped another half-point off its base lending rate to 1% Thursday. It hasn't ruled out further cuts.

The ECB faces similar economic challenges to other regions. There were unexpectedly steep declines in Spanish industrial production and German factory orders in December. BNP Paribas forecasts euro-zone GDP will fall 2.8% this year, with Germany, the biggest euro-zone economy, shrinking by 3.3%. Meanwhile, the ECB has not yet unblocked the banking system.

The ECB's worry about creating a liquidity trap looks like a red herring. Central Bank of Cyprus Governor Athanasios Orphanides has pointedly broken ranks with other ECB governors. Mr. Orphanides has warned of the danger of inaction should a central bank worry needlessly that it might run out of monetary policy ammunition if it reduces rates to zero. After all, the earlier such ammunition is used, the longer it has to work and the more likely it will have an effect.

Also, the ECB has hardly been shy of unorthodox policy responses. It was the first to broaden massively the collateral it would accept for its repurchasing activities and has increased the size of its balance sheet by a third. Mr. Trichet says other measures, such as buying sovereign debt or commercial paper to bypass the blocked banking system, are on the table. But he's doing nobody any favors in insisting pre-emptive cuts in interest rates remain a policy response the bank won't consider as the economic storm gathers.

How many Chinese oversea students have returned home?

I worked out an interesting graph, and would like to share with all of you.

(source: author's own calculation and China's National Bureau of Statistics)

There was a huge surge in terms of number of students who chose to go abroad right around the millennium. I suspect this was due to China's higher education reform and many more high school students were able to go to colleges, and thus it became more difficult for them to find ideal jobs in China after graduation.

Concerning students return ratio, the average ratio for the recent decade was around 25%, and it has been trending higher gradually. However, the recent return ratio is much lower than late 80s and early 90s, which was around 60%.

I am a little puzzled by the two huge drops of the return ratios: one was around early 90s, and the other was around late 90s. The first drop might be the ripple effect of the 1989 incident, but I am not sure.

Central Banks: the creatures of financial crises

Milton Friedman years ago suggested to get rid of central banks...Alan Greenspan, the Maestro, and his legacy will be and is already being reevaluated.

Justin Larhart of WSJ looks at Central's role in financial crises. Also, be sure to read John Taylor's recent criticism on the Fed's policy missteps that exacerbated this crisis.

Since the beginning of the financial crisis in 2007, the Federal Reserve has come to the rescue so many times that even seasoned central-bank watchers have trouble keeping track.

It has injected more than $1 trillion into the financial system. It has backstopped corporate short-term lending. It has cut its overnight target rate from 5.25% in August 2007 to between zero and 0.25% -- the lowest level in the Fed's 95 years. Since it can't lower rates any more, it has begun effectively to print money in an attempt to bolster the economy.

But its actions don't seem so extraordinary from the perspective of three centuries of central-banking history. Central banks have been built on financial crises, with each major tremor expanding their role. And today's economic convulsions foreshadow more changes to come at the Fed.

If it wasn't for crises, central banks might not exist. In Britain, after years of civil war and the ouster of King James by William III in 1688, the country's public finances were in tatters, with tax collection falling short of what the government needed to pay its bills and lenders unsure about the stability of the government. The Bank of England, one of the first central banks and for centuries the most important one, was founded in 1694 to purchase government debt and curtail the funding crisis.

The establishment of the Bank of England came at the beginning of a great societal shift, when new ideas were challenging old doctrines, and rising world trade was giving new power to merchant classes. But the expansion in commerce and banking also made financial crises more prevalent. Speculative bubbles led to spectacular market crashes.

"The Bank of England received heavy criticism in many of the crises of the 19th century when it didn't act fast enough," says Rutgers University economic historian Michael Bordo. "It learned to be lender of last resort."

As laid out by the 19th-century economic writer Walter Bagehot, the bank's role as lender of last resort was to lend freely against any sound collateral during financial crises, but to lend at higher-than-market rates to prevent borrowers from becoming over-reliant on the bank. It was a lesson that other central banks, such as the Bank of France, also came to learn.

But for much of the 19th century and into the 20th, the U.S. had no central bank. Many Americans feared that nothing good could come from one bank wielding so much power. In 1816, a central bank to help fund government finances that had been badly depleted by the War of 1812 was established. In his 1832 veto of the extension of the bank's charter, President Andrew Jackson wrote that "Great evils...flow from such a concentration of power in the hands of a few men irresponsible to the people."

While financial crises in England diminished through the 19th century, they were a regular feature of American life.

"Crises are much more frequent when we don't have a central bank," says New York University Stern School economic historian Richard Sylla. With nobody willing to step into the fray when borrowers ran into trouble, small credit-market problems could easily spin into major ones.

The turning point came in 1907. The availability of credit was tight throughout the world that year, and that October, a speculative attempt to corner the stock of United Copper Co. failed. That sparked a run on the deposits of Knickerbocker Trust Co., which had helped fund the scheme, eventually leading to the firm's collapse. John Pierpont Morgan, the giant of American finance, took on the role of lender of last resort.

Struggling with a bad cold, sleep-deprived and sustaining himself with little more than cigars, Morgan put up millions of his firm's money to avert the crisis and cajoled other bankers into doing the same. In a famous incident, Morgan gathered a throng of bankers and trust executives in his library on the evening of Nov. 3, locking the doors and not opening them until 4:45 the next morning, after the men had agreed to take part in a $25 million loan.

The Panic of 1907 helped push aside longstanding worries over the economic power concentrated in an American central bank, and in 1913 the Federal Reserve Act was passed.

The Fed flunked its first big test when it didn't adequately respond to a series of banking panics that began shortly after the 1929 stock-market crash, helping to precipitate the Great Depression. As an academic, current Fed Chairman Ben Bernanke's area of expertise was the Great Depression. One reason that the Fed has slashed interest rates so deeply in response to the current crisis is that it doesn't want to repeat the mistakes it made in the 1930s.

The big mistake, economists Milton Friedman and Anna Schwartz have argued, wouldn't have happened if it hadn't been for the untimely death in 1928 of Federal Reserve Bank of New York President Benjamin Strong. A disciple of J.P. Morgan's, Mr. Strong would have led the Fed to ease monetary policy more quickly, they argue.

The Great Depression experience led central bankers to expand their role once more. It was no longer enough to be a backstop against financial panic; they now moved toward using monetary policy to fight back economic downturns on the one hand and prevent inflation on the other -- a role that became more important at the Fed after the inflationary crisis of the 1970s.

Politicians often prefer rapid economic growth and inflation, since rising prices make it easier to pay down debt. They therefore pressure the Fed to keep interest rates low. But the Fed is reluctant to do that because those conditions can overheat the economy, which eventually leads to a deep downturn. Over the years, the Fed pushed for political independence to give it the latitude to tame the economy's cycles of boom and bust as it saw fit. It was a shift that took place over years, interrupted during World War II and not bearing its final fruit until Paul Volcker became Fed chairman in 1979. Over many politicians' objections but with the support of President Ronald Reagan, Mr. Volcker raised rates to stem runaway inflation and recession.

In 1997, after a Labor Party landslide, Britain's new Chancellor of the Exchequer Gordon Brown (now its prime minister) granted the Bank of England independence. The Bank of Japan was for years under the sway of Japan's powerful Ministry of Finance. It gained its independence in 1998. The European Central Bank, which was founded in 1998, was designed to be politically independent.

Some worry that that the current crisis will make for a less-independent Fed. "You see the chairman of the Fed standing side by side with the secretary of the Treasury, cozying up to Congress -- is that a sign of an independent central bank?" asks Carnegie Mellon University economist Allan Meltzer.

But University of California at Berkeley economic historian Brad DeLong says that the history of central banks and crises has been a steady expansion in their power.

That can be worrisome, notes NYU's Mr. Sylla. "The central bank is much more powerful, and of course we have to worry about this in a government of checks and balances," he says.

The big step the banks will take in the wake of the current financial crisis may be to target the excessive risk taking that can lead to bubbles, Mr. DeLong thinks. Indeed, Fed officials appear to be edging in that direction.

So far, Fed officials have argued that raising interest rates to counter risky behavior would hurt not only the speculators, but also the economy at large. Rather than raise rates, they prefer to use regulation to clamp down on excesses, putting in place rules that keep risk at bay. Some economists counter that risk takers will figure out how to skirt regulations, so using interest rates is the best approach.

Either approach -- raising rates or regulating -- would be a shift from the Fed's old stance to let bubbles burst of their own accord and clean up afterward. Many critics think that credo led investors to take on too much risk -- the Fed would always be there to catch them when they fell, and so they became incautious. If it ends up curbing risky behavior through regulations, the Fed will be trying to prevent the types of crises that always seem to expand its role.