Tuesday, March 31, 2009

Shiller: Government is still too optimistic

Bob Shiller says recent reading in both housing and PMI are indicating a much worse scenario than the government's forecast.

New ideas of future banking models

Ned Phelps leads you through the fresh new ideas, still under academic discussions, in how to shape American banking system to prevent future systemic risk.

Monday, March 30, 2009

DeLong: Four Ways Out

Brad DeLong of UC Berkeley writes on Economist Voice on the four ways out of depression:

BERKELEY — When an economy falls into a depression, governments can try four things to return employment to its normal level and production to its "potential" level. Call them fiscal policy, credit policy, monetary policy, and inflation.

Inflation is the most straightforward to explain: the government prints up lots of banknotes, and spends them. The extra cash in the economy raises prices. As prices rise, people don't want to hold cash in their pockets or their bank accounts—its value is melting away every day—so they step up the pace at which they spend, trying to get their wealth out of depreciating cash and into real assets that are worth something. This spending pulls people out of unemployment and into jobs, and pushes capacity utilization up to normal and production up to "potential" levels.

But sane people would rather avoid inflation. It is a very dangerous expedient, one that undermines standards of value, renders economic calculation virtually impossible, and redistributes wealth at random. As  John Maynard Keynes put it, "there is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose…" But governments will resort to inflation before they will allow another Great Depression—we just would very much rather not go there, if there is any alternative way to restore employment and production.

The standard way to fight incipient depressions is through monetary policy. When employment and output threaten to decline,
the central bank buys up government bonds for immediate cash, thus shortening the duration of the safe assets that investors hold. With fewer safe, money-yielding assets in the financial market, the price of safe wealth rises. This makes it more worthwhile for businesses to invest in expanding their capacity, thus trading away cash they could distribute to their shareholders today for a better market position that will allow them to reward their shareholders in the future. This boost in future-oriented spending
today pulls people out of unemployment and pushes up capacity utilization.

The problem with monetary policy is that, in responding to today's crisis, the world's central banks have bought so many safe government bonds for so much cash that the price of safe wealth in the near future is absolutely flat—the nominal interest rate on government securities is zero. Monetary policy cannot make safe wealth in the future any more valuable. And this is too bad, for if we could prevent a depression with monetary policy alone, we would do so, as it is the policy tool for macroeconomic stabilization that we know best and that carries the least risk of disruptive side effects.

The third tool is credit policy. We would like to boost spending immediately by getting businesses to invest not only in projects that trade safe cash now for safe profits in the future, but also in those that are risky or uncertain. But few businesses are currently able to raise money to do so.

Risky projects are at a steep discount today, because the private-sector financial market's risk tolerance has collapsed. No one is willing to buy assets and take on additional uncertainty, because everyone fears that somebody else knows more than they do—namely, that anyone would be a fool to buy. Although the world's central banks and finance ministries have been devising many ingenious and innovative policies to stimulate credit, so far they have not had much success.

This brings us to the fourth tool: fiscal policy. Have the government borrow and spend, thereby pulling people out of unemployment and pushing up capacity utilization to normal levels. There are drawbacks: the subsequent deadweight loss of financing all the extra government debt that has been incurred, and the fear that too rapid a run-up in debt may discourage private investors from building physical assets, which form the tax base for the future governments that will have to amortize the extra debt.

But when you have only two tools left, neither of which is perfect for the job, the rational thing is to try both—credit policy and fiscal policy—at the same time. That is what the Obama administration is attempting to do right now.

Top 20 financials: then and now

(click to enlarge; source: FT)

What's your career "Plan B"?

Listen to the conversation from our own Boston host Tom Ashbrook. (source: NPR)

This G20 Meeting is going to be interesting

If the G20 meeting were to be disrupted just like what happened in Seattle in 1999, what will happen to the world markets? But no matter what, don't wear banker's suits on London streets.

China and IMF

The world wants China to play a bigger role in funding IMF;  China, in return, wants more voting power from IMF, rightly so. 

If IMF, an outdated organization out of the WWII, wants to reassert its prominence in international monetary policy making, then it should reform itself to reflect today's global economic structure and give more voting powers to emerging economies like China, India and Brazil.  This will happen.  The question is just when.

NYT reports this issue on the eve of G20 meeting in London

"Unhappy China"

WSJ took a dynamic view on China's nationalism.

BEIJING -- A hot-selling new book that excoriates the U.S. and calls for China to be more assertive is fueling debate among Chinese about nationalism and their country's role in the world.

"Unhappy China" is a collection of essays by five authors who argue that China has been too deferential to a Western world that is hostile toward it. They argue that China needs to use its growing power and economic resources to carve out its own position of pre-eminence. "From looking at the history of human civilization, we are most qualified to lead this world; Westerners should be second," the book says.

[Unhappy China]

The authors, a group of scholars, single out the U.S. for special scorn, and say their book's message -- aimed largely at younger Chinese -- has been helped by the economic crisis. "This economic problem has shown the Chinese people that America does have problems, that what we've been saying is right," said Wang Xiaodong, in an interview Friday in Beijing with three of his co-authors: Liu Yang, Song Qiang and Huang Jisu. The fifth author is Song Xiaojun.

Since being released March 13, the book has sold out its initial shipments in many Chinese bookstores and landed on the best-seller list at leading online retailer The publisher has printed 270,000 copies, and says sales are far outpacing expectations.

Yet much of the response has been negative, reflecting the complex place that nationalism holds in today's China. Several reviews in the Chinese media have ridiculed "Unhappy China" as an attempt to cash in on nationalistic sentiment. The book is a way to "fish money from the pockets of the angry youth and angry elderly," wrote one critic in the China Youth Daily, a leading state-run newspaper.

An English-language article by Xinhua, the state-run news agency, said the book had failed to hit a chord with average Chinese, and quoted blistering critiques from bloggers and academics calling its nationalism embarrassing and unconstructive.

"Unhappy China" comes as the economic crisis has damaged the West and, in the minds of some Chinese, left China relatively strong.

In January, at the World Economic Forum in Davos, Premier Wen Jiabao blamed the U.S. for creating the economic crisis. Earlier this month, he expressed concern about China's holdings of U.S. government debt given questions over Washington's economic policies. Last week, Zhou Xiaochuan, China's central-bank governor, proposed adopting a global currency to replace the dollar as a world standard. But Chinese officials, like their Western counterparts, also have called for more international cooperation to help pull the global economy out of its slump.

The authors of "Unhappy China" reject such talk, reciting a litany of grievances against the U.S., from a monetary policy that threatens to devalue China's holdings of U.S. Treasurys to Washington's support for Taiwan.

Many of the prescriptions in "Unhappy China" echo positions China's government espouses -- strengthening the country's reliance on domestic technology and innovation, and bolstering its military, for example.

The authors, however, reserve some of their greatest resentment for China's current political and economic leadership.

"I've already lost all hope in China's elite," says Mr. Wang. The authors see last year's angry protests by mainly young Chinese against foreign criticism of China's Tibet policies and its hosting of the Olympics as a "milestone" for relations with the West.

"America will face a less friendly China in the future," says Mr. Wang.

PPIP In A Nutshell

A crystal clear explanation of the PPIP (public-private investment program). The plan opens the door to further manipulations of the system and "moral hazard". The success of the plan hinges on: whether banks' problem is liquidity or insolvency. But the bottom line is taxpayer will end up paying for this mess. And no one will take responsibility?

(note: a small mistake in the video is FDIC not the Fed will lend the money).

Sunday, March 29, 2009

Larry Summers' Fiction

Bob Shiller writes on NYT.

Equity market thru the lens of credit market

Credit market still signals the recent market rally is a sucker's rally (source: WSJ):

If there is really a financial recovery on the way, someone forgot to tell the corporate bond market. U.S. Treasury Secretary Timothy Geithner's plan to rescue the financial system sent the S&P 500 soaring 7% on Monday alone, bringing its gains from its lowest point on March 6 to an impressive 21%. But credit markets have hardly budged.

Corporate debt is still priced for disaster. Investment-grade nonfinancial U.S. corporate bonds rallied in January but have now stalled, with spreads around four percentage points over Treasurys, Markit iBoxx indices show. More worryingly, even as bank stocks have climbed, with the KBW index gaining 54% from its lows, U.S. senior bank bond spreads remain at their widest levels since Lehman Brothers collapsed.

Bonds are pricing in unheard of and devastating levels of default. Deutsche Bank recently calculated dollar investment-grade corporate bonds were pricing in a five-year default rate of 40% assuming average recovery rates. Even if one makes the unlikely assumption that bondholders recover nothing after default, prices suggest a 25% default rate over five years. The worst five-year investment-grade default rate since 1970 is just 2.4%. The average is 0.9%.

On that basis corporate debt is almost absurdly cheap -- and so a lot of investors are pumping money into the market. That this has failed to fuel a rally in the credit markets similar to that in equities should ring warning bells for stock market investors. What is holding back the credit markets is a lack of demand for financial debt -- a sure sign that all is still not well in the banking system.

Demand in the credit markets is mostly for nonfinancial debt, but this is being met by huge supply as borrowers look to bypass the banking system, thereby preventing spreads from tightening. The vast majority of financial debt finding buyers is that guaranteed by governments -- hardly a vote of confidence. Asset-backed securities and leveraged loans remain unloved.

Until investors recover confidence in financial assets, credit spreads are unlikely to tighten significantly. And without a sustained improvement in the credit market -- the seat of the crisis -- it seems irrational to expect a durable move higher in equities.

Roubini on economic outlook

Roubini touches many crucial questions: whether Geithner's plan will work; whether the economy and housing market are near the bottom.

link to the video interview (source: Bloomberg)

Bridgewater's view on Toxic Asset Plan

Source: Reuters

Hedge fund Bridgewater mulls U.S toxic asset plan

NEW YORK (Reuters) - Bridgewater Associates Inc, one of the world's biggest hedge-fund managers, said on Tuesday it might be interested in participating in the U.S. Treasury's public-private investment program, calling it a "big transfer of money from the government to the banks and to the buyers."

Bridgewater manages roughly $80 billion in global investments for a wide array of institutional clients, including foreign governments and central banks.

In a letter to clients, Bridgewater said its interest in buying the distressed assets under the terms being offered would depend on the pricing and on "whether we can get over our fears of partnering with the government."

Last week's political furor surrounding the American International Group Inc bonus payments raised the risks for private capital firms thinking about partnering with the Treasury. Many have expressed reservations regarding retroactive curbs on compensation and profits.

But investors' concerns were muted after Federal Reserve Chairman's Ben Bernanke's statement to a congressional hearing on Tuesday in which he said: "I do think we have to provide assurances to participants" in the Term Asset-Backed Securities Loan Facility and the Public-Private Investment Fund, for example, "that their involvement will not be retroactively penalized in some way."

Ray Dalio, the founder of Bridgewater, is considered one of the world's most successful investors. Bridgewater's Pure Alpha fund returned 8.68 percent last year, according to Absolute Return magazine, while many hedge funds posted double-digit losses for the same period.

In August 2007 when markets were in near free-fall, Bernanke held discussions with financial experts, including Dalio.

In the letter, Bridgewater said: "From a macro perspective, this is a big transfer of money from the government to the banks (who are getting the higher prices for their assets) and to the buyers (who are probably going to get a heck of a deal because of the non-recourse loan and the easy access to leverage).

"If the government was operating in an economic way, it would not do this deal -- it would deal with the banks' finances separately and sell this insurance (i.e. the implied put arising from the non-recourse loan) for what it's worth," Bridgewater said in the letter.

"But, politics being what they are, this route is probably motivating this non-economic behavior. We are eager to see how it is received on the Hill," it said.

Has the economy turned the corner? Part 2

"We've passed the period where every indicator is plummeting, and that's good news," he said. "We may not be exactly at the turning point, but we're getting pretty close to it."

Read this full report on possible bottoming out of the economy. The highlights are mine. Keep watching.

Economy Raises Tentative Hopes a Trough Is Finally in Sight

Just as the U.S. recession is set to become the longest since the Great Depression, some economic signs are encouraging, if tentative.

April will mark the 17th month of the recession that began in December 2007, making it the lengthiest downturn of the post-Depression era. For the most part, forecasters don't see U.S. economic growth turning positive until early autumn, and even then, expect the unemployment rate to hit double digits this year or next.

This week, though, has brought a spate of good economic news. Consumer spending rose marginally in February, the Commerce Department said Friday, as did consumer sentiment in a household survey by Reuters and the University of Michigan. The housing market also appears to have stabilized from its free fall, and an uptick in orders for big-ticket items is helping raise hopes of a future pickup in manufacturing.

During a meeting with President Barack Obama and other bank executives Friday at the White House, Bank of America Corp. Chief Executive Ken Lewis and Northern Trust Corp. CEO Rick Waddell expressed cautious optimism that the economic downturn was either at or near the bottom of the cycle, according to people at the meeting.

"There's growing evidence supporting the optimists' view, and I am surprised at that," said Robert J. Gordon, an economist at Northwestern University and a member of the National Bureau of Economic Research committee that is the official arbiter of when recessions begin and end. "I was sort of in the pessimists' camp until I started looking at things."

He points to one indicator in particular with a remarkable track record: the number of Americans filing new claims for unemployment benefits. In past recessions, it has hit its peak about four weeks before the economy hit a trough and began to grow again. As of right now, the four-week average of new claims hit its peak of 650,000 in the week ended March 14. Based on the model, "if there's no further rise, we're looking at a trough coming in April or May," he said, which is far earlier than most forecasts currently anticipate.

But a turn toward positive growth is not the same as a recovery, particularly now with the current 8.1% unemployment rate at a quarter-century high and marching higher by the month. Nariman Behravesh, chief economist at IHS Global Insight in Lexington, Mass., says unemployment could hit 10.5% by late next year, even if the economy is growing at a 3% rate by that point.

"What comes next, I'm afraid, will be the mother of all jobless recoveries," said Bernard Baumohl, chief global economist at the Economic Outlook Group in Princeton, N.J. "While we may emerge from recession from a statistical standpoint later this year, most Americans will be hard-pressed to tell the difference between a recession and recovery the next 12 months."

In a reflection perhaps of households' angst, the personal saving rate in February was 4.2% of disposable income, compared with the near-zero rates seen during the boom. A survey to be released Saturday by AlixPartners, a business-advisory firm, shows Americans' "new normal" spending levels will return to just 86% of pre-recession levels in the next 10 years.

Income growth is showing signs of weakness after a decent performance in the past year. The Commerce Department said personal after-tax income fell 0.1% in February, its third decline in four months, and a reflection of U.S. companies' aggressive cost-cutting amid a difficult business environment. But aggressive efforts by the government and the Federal Reserve to counteract the financial-market meltdown are seen as kicking in to help offset that.

The Dow Jones Industrial Average has rebounded by some 20% from its lows, though it lost some ground on Friday, and credit markets have calmed as well. The $8,000 tax credit included in the stimulus package for those who purchase a home before Dec. 1 is helping to draw buyers into the market, while mortgage applications to purchase or refinance a home jumped 32% last week, boosted by the Fed's efforts to drive down mortgage rates.

Even so, IHS Global Insight estimates GDP fell at a 7%-8% annualized rate in the first quarter, topping the fourth quarter of 2008's steep 6.3% drop, as weakness shifts from consumers to businesses. Business investment and exports could both post nearly 30% annualized declines, Mr. Behravesh said, a severe restraint on growth, even if the largest component of GDP -- consumer spending -- is flat or shows modest growth.

Saturday, March 28, 2009

The reserve currency and its obligations

It is true that there is no successor to the US Dollar as international reserve currency. Not now, nor in next 30 years. But being reserve currency also carries its obligations, i.e., US monetary policy must be responsible not only to the US, but to the world. The policy of inflating US dollar to get out the current mess will only produce more dissatisfied neighbors. The consensus assumes China won't choose to diversify away from the US dollar because the attempt to do so will hurt China's foreign reserve portfolio when the value of US dollar plummets. But China also faces its own domestic pressure at home. What will happen when China and her nationalistic-prone citizens feel cheated? Countries, as individuals, may well act irrationally, some times. Ben Bernanke, be warned.

Opinion piece from WSJ:

China and the Dollar

As if the dollar didn't have enough problems, Timothy Geithner took China's bait yesterday and said he was "quite open" to its suggestion this week to displace the greenback with an "international reserve currency." The dollar promptly fell and stocks followed, before the Treasury Secretary re-emerged to say "the dollar remains the world's dominant reserve currency. I think that's likely to continue for a long time."

[Review & Outlook]

Mr. Geithner is learning on the job, and yesterday's lesson is that it isn't smart to fool with currency markets when you are already tempting fate with a gigantic U.S. reflation. Treasury and the Federal Reserve are flooding the world with dollars to break the recession, and the world is rightly getting nervous. The solution floated by Chinese central bank governor Zhou Xiaochuan -- an increased role for the International Monetary Fund -- isn't desirable. But his warning about the dangers of dollar weakness and exchange-rate instability is still worth heeding.

Since the collapse of Bretton Woods in 1971, the global economy has tried to function with floating exchange rates, in which the "market" is said to set currency prices. As the world discovered in the 1970s and the Bush Treasury forgot, however, the market for currencies isn't the same as for apples or copper. Central banks control the supply of currencies through their monopoly on money creation. Often, as at the Alan Greenspan-Ben Bernanke-Donald Kohn Federal Reserve this decade, they get policy wrong, with disastrous consequences. Amid the global economic downturn, some central banks, like Vietnam's, are also turning to currency devaluation for a trade advantage.

Mr. Zhou may want to head off this potential train wreck. On Monday he proposed an international reserve currency "anchored to a stable benchmark and issued according to a clear set of rules." He wants the supply of money to allow for "timely adjustment" to "changing demand," and those adjustments to be "disconnected from economic conditions and sovereign interests of any single country." And he thinks the IMF can create a global currency by expanding the use of its already-existing Special Drawing Rights (SDRs), a synthetic currency linked to the underlying currencies of IMF states.

Yet who would determine the "right price" of the SDR -- the IMF? The multilateral institution's economic prescriptions have sent numerous nations into tailspins, particularly in Asia. There's nothing to say, too, that national monetary authorities wouldn't cheat and adjust their domestic money supplies as they saw fit -- or apply political pressure on the IMF to change the SDR's currency weightings in their favor.

But the main problem with the SDR is that it can't be used for anything in the real world. When the IMF allocates SDRs, recipient countries exchange them for local currencies at local central banks. That money is then used to buy real assets and facilitate trade. That exchange inflates the money supply of the domestic country that's accepting the SDRs in exchange for local currency.

There isn't consensus within China's central bank on the idea of empowering the IMF, though Beijing is eager to have more say at the institution. Hu Xiaolian, a vice governor of the bank, said Monday that "investing in U.S. Treasury bonds is an important component of China's foreign currency reserve investments." She added: "We are naturally relatively concerned with the safety and profitability of U.S. government bonds."

Ms. Hu isn't alone, and we only wish the Treasury, the White House and the Fed were equally as concerned. The dollar's status as a reserve currency gives the U.S. enormous advantages, and it should be protected ferociously by our public officials. It means we don't have to repay our debts in foreign currency and that our borrowing costs are cheaper. To the extent that the rest of the world follows a dollar standard, it also gives us far greater global sway.

It is this influence that Russia, China and others sometimes resent and would like to see displaced. The problem is that there really isn't an obvious successor to the dollar. No other economy is large enough, with deep enough capital markets. The euro might become an alternative down the road, but it remains too new and lacks the necessary underpinning of political cohesion.

Yet Mr. Zhou's demarche is also a warning that reserve currency status carries special obligations. It means the U.S. isn't conducting monetary policy only for itself but for much of the world. And it means that when the U.S. falls for the temptation to debase its currency, it sends shocks through the entire global trading system. The dollar's sharp but needless gyrations during this decade are in our view one of the major causes of the housing and commodity asset bubbles that led to the financial panic and global recession.

If Mr. Geithner meant yesterday that he is "open" to broader monetary and exchange-rate cooperation, that could be a step forward. But instead of abdicating to IMF bureaucrats, this would mean working with the world's most important governments and central banks -- for starters, the Fed, ECB, and the Banks of England, Japan and China. The world could use monetary reform, but the goal should be to reduce currency fluctuations and enhance price stability and world trade. In the meantime, the dollar's special status is an asset worth preserving.

Claw-back in hedge funds

The right way to set compensation is to link the pay to longer-term performance, not a single year. This should apply to both CEO pay and the fees received by hedge fund managers. The alternative compensation scheme, which is based on a five-year average investment performance, for example, is a much better solution than the current one.

Report from WSJ on big pension funds forcing hedge funds to change fee terms:

Calpers, the California public pension fund that is one of the biggest investors in hedge funds, is demanding better terms from funds, including lower prices and "clawbacks" of fees if performance weakens.

The $172 billion pension fund is a bellwether in the money-management business. A Calpers investment can help money managers like hedge funds attract other clients.

The move by the California Public Employees' Retirement System underscores the changing dynamics between hedge funds and their clients. Just two years ago, investors clamored to get into highflying funds, agreeing to pay fees that in some cases reached 3% of assets and 30% of profits. Lately, hedge funds have come under fire for failing to live up to their promise to perform in good and bad markets.

While other investors are pushing for fee cuts, Calpers, which has $5.9 billion in hedge-fund investments, holds significant clout. "Calpers is the 800-pound gorilla, pushing so much money through the system," said Eric Roper, chairman of the hedge-fund practice at New York law firm Gersten Savage LLP.

Calpers's demands were outlined in a March 11 memo sent to the 26 hedge funds and nine funds of hedge funds that do business with Calpers; it was reviewed by The Wall Street Journal.

Some of the hedge funds that manage Calpers money include Tremblant Capital, Atticus Capital and Och-Ziff Capital Management, according to Calpers records and people familiar with the investments. Spokesmen for the funds didn't comment.

Besides pressure on fees, hedge funds are likely to face closer scrutiny from regulators, threats of higher taxes and more constraints on their trading strategies, after a year of broad-based losses.

Calpers said the changes are "extremely important" and required of "managers wishing to become, or remain" in Calpers's stable of managers. The pension fund said every hedge fund won't face the same demands and that it is willing to listen to counterproposals.

One area Calpers is focusing on includes performance fees. Typically they are collected at the end of each year, but Calpers instead wants fees spread out over several years. Calpers also wants clawbacks, which allow clients to recoup fees from previous profitable years after a period of poor performance.

The pension fund also seeks greater control of its investment funds, saying it would explore opening managed accounts. In that scenario, hedge funds would place Calpers's assets in a separate bucket from other investors' assets, so if a fund faces an exodus of investors and sought to freeze redemptions, Calpers wouldn't be limited from withdrawing its funds.

Calpers also wants money managers to disclose every security held in a fund. "The only issue that keeps hedge funds from providing security transparency is their lack of cooperation," Calpers spokeswoman Pat Macht said in an interview Friday. She said that detailed fund information won't be made public.

Calpers is basically trying to wield its investment clout to shape its relationship with hedge funds. The memo says Calpers "will no longer invest in managers" that adhere to industry standards with no regard for individual situations. At the same time, Calpers bills the directives as good for hedge funds as well as for institutional investors -- a means to "improving the relationship" for the long term.

The sought-after changes would apply to new money added to existing funds and money put into new hedge funds, and will take about a year to implement, Calpers said. None of its hedge funds have formally agreed to the new terms, though discussions have started with most and cooperation appears to be widespread, Ms. Macht says.

Calpers's demands come as other institutional investors are issuing similar requests in an effort to upend industry protocols. In January, the Utah Retirement Systems circulated a four-page letter to 40 hedge fund managers, and to many like-minded investors, that called for similar changes.

"We clearly are on the same page with regards to most issues," said Larry Powell, deputy chief investment officer for the Utah fund, referring to the Calpers memo.

Bank Executives' Game

Under current TARP/TALF/PPIF program, the best 'move' for American bank executives is to return TARP money and not to lend to the broader economy. This will postpone recovery and lead to a lose-lose situation. Why so?

If bank executives were to keep TARP money, the U.S. government will have rights to cap executive pay or force them to accept 'sacrifice' on compensation. But we know "moral persuasion" seldom works (don't dream on that). Bank executives will return TARP money even they know a huge mess is still waiting on their balance sheets to deal with. This is the classic principal-agent problem in economics.

So what are the solutions? There are only two alternatives out of this:

1. Obama government temporarily leaves bank executives alone and postpones the plan to cap executive's pay. This will be very difficult in the current anti-Wall Street environment, but it can be done.

2. Obama government overcomes the taboo of nationalization, i.e., take over those "too-big-to-fail" banks and remove bank executives from deciding on their own compensation or even fire them. Government then will force banks to lend to the broader economy. But be reminded the nationalization has to be temporary ---government can never replace private banks in financial markets.

We are living through a period of, I call, "mother of all moral hazards". Government should make a quick calculation on their rescue strategy. Failing to do so will put American economy into real danger and possibly onto the path of Japan-like malaise.

Watch this video from Fortune:

Mama Bear: where do we stand now?

An update on the trend of the current mama bear market.

I am not a technical charter, not a believer either. But the remarkable similarity between the current bear market and the Great Depression really makes me nervous.

Let's hope for the best.

(click to enlarge; source:

Friday, March 27, 2009

The future of capitalism

The future of capitalism and globalization from a London panel

Link to the video (source: FT)

The US-China Currency Game

China has limited choices. What China really wants is a strong dollar.

Also, watch is video interview of David Malpass, former Chief economist of Bear Stearns.

Thursday, March 26, 2009

Lardy calls China's crisis response gold standard

China's Role in the Origins of and Response to the Global Recession

by Nicholas R. Lardy, Peterson Institute for International Economics

Transcript of testimony at the hearing before the US-China Economic and Security Review Commission
February 17, 2009

I would like to thank the commissioners for inviting me to participate in this hearing today. I would like to focus my remarks on the actions that China is taking in response to the global downturn and to give an assessment of their likely effects.

The key point I would emphasize is that China is the gold standard in terms of its response to the global economic crisis. If you look at the magnitude of what they are doing in several domains, it is very substantial, and among the economies that matter, at least according to the International Monetary Fund (IMF), China's stimulus program relative to the size of its economy is larger than that of any other country including the United States, and I think they may have underestimated what China is doing.

I would highlight three aspects of what they have announced so far, and I will start with monetary easing, since China announced that in September last year. It was one of the first steps that they took, eliminating lending quotas, reducing interest rates, and a number of other steps.

Unlike in the United States where banks for the most part have not been willing to lend, we have seen over the last three months a very substantial increase in Chinese lending to corporates and to households. So the financial sector in China is responding very well so far to the slowdown in global economic growth.

The second component that I would highlight, and I think this is better known, is the infrastructure investment program that China rolled out in November. We can argue about some of the details, but I think this is going to amount to a stimulus in the neighborhood of two to three percentage points of GDP. It seems very well focused on areas where returns should be high, and I do not think China is going to have the problem of Japan a decade ago of building bridges to nowhere.

The third component which I think has been less widely noted or analyzed is that China has very substantially stepped up its social programs and its transfer payment programs. The social programs are extremely important because they do contribute, I believe they will contribute to rebalancing the economy, will reduce the precautionary demand for savings, and lead households to spend a larger share of their disposable income.

I think the most notable example in this regard is the commitment that China has now made to expand health insurance coverage to include an additional 400 million Chinese, which will give them near universal coverage by 2011. This will mean that the share of total health care expenditures in China paid for by the government is going to more than triple over the next three years. The share paid by households on an out-of-pocket basis will decline very dramatically.

On the transfer payment side, China has done quite a bit. They have some transfer of payment programs for 75 million low-income people. Those people are getting much, much more money this year than they have in previous years, and China has also substantially increased pension payments to pensioners. The increases are several times the rate of inflation.

In all three areas, I think China has done extremely well. The conclusion I draw from this quite frankly is that China has the prospect of bottoming earlier than any other major economy in the globe. I do not know whether it will be this quarter that it will be off the bottom or the second quarter, but I'm reasonably confident that either this quarter or the second quarter of this year, China will come up from the 6.8 percent growth recorded in the fourth quarter of last year. I say this because China does not have any toxic financial assets. It did not acquire very much from abroad, and its regulators have not allowed the introduction of complex derivative products of any kind, and the result is the central government has not had to inject capital into any financial institution, bank or otherwise, as a result of the crisis, nor have they had to guarantee the liabilities of any bank or other kind of financial institution.

Secondly, China is very underleveraged, particularly by comparison with the United States. This is a theme that I know Stephen Roach has written about for years very forcefully, and I can just summarize it in one comparison: Household debt to GDP in the United States is roughly 100 percent; household debt to GDP in China is 20 percent.

We are having a huge contraction because demand is not just slowing but actually shrinking, and consumption demand in China is not shrinking; it is still growing fairly rapidly, and households do not need to deleverage as is the case in the United States. We will have a substantial increase in our savings rate over the next few years, which means that our recovery, when it does come, will be relatively slow. Just to give you a few further points, the average loan-to-value ratio for a mortgage in China taken out by a household today is 50 percent. They do not have home equity loans. You cannot go back and refinance and take your equity out if there's been a price increase.

China is now the largest market for cars in the United States. Ninety percent of them are sold for cash. Bank lending or other kinds of lending for financing automobiles is minuscule in China. That contributes to the low household debt.

The corporate leverage has also been falling in recent years, which puts them in a relatively strong position. So, as I say, I do not think consumption demand in China is going to collapse as we've seen in the United States. It's likely to continue to grow fairly rapidly and put a floor on China's economic growth, and the lack of a need to delever means that consumption can play a more important role for reasons that I mentioned earlier.

I would say finally that China has the prospect of converging back to its long-term potential growth rate much sooner than most other countries on the globe, and in part this is because the government does not have very much debt. Debt to GDP is roughly 20 percent, slightly less, of the government, and going forward, I believe the United States and many other countries will have a very substantial medium-term fiscal sustainability issue that is going to restrict government expenditures, require increased taxes, or require higher interest rates.

I do not believe these conditions will prevail in China. Yes, China will run a budget deficit this year, but it will be relatively small and quite easily financed. So I think the prospects are that China will bottom earlier, converge back to its long-term growth potential faster, and thus make, since it's the third-largest economy on the globe, a very substantial contribution to the global recovery that we're all looking for.

Sachs: stealth plan to rob taxpayer

Jeffrey Saches thinks the Treasury's plan could rob taxpayer.

Source: FT

By Jeffrey Sachs

The Geithner-Summers plan, officially called the public/private investment programme, is a thinly veiled attempt to transfer up to hundreds of billions of dollars of US taxpayer funds to the commercial banks, by buying toxic assets from the banks at far above their market value. It is dressed up as a market transaction but that is a fig-leaf, since the government will put in 90 per cent or more of the funds and the "price discovery" process is not genuine. It is no surprise that stock market capitalisation of the banks has risen about 50 per cent from the lows of two weeks ago. Taxpayers are the losers, even as they stand on the sidelines cheering the rise of the stock market. It is their money fuelling the rally, yet the banks are the beneficiaries.

The plan's essence is to use government off-budget money to overpay for banks' toxic assets, perhaps by a factor of two or more. This is done by creating a one-way bet for private-sector bidders for the toxic assets, then cynically calling it "private sector price discovery". Consider a simple example: a toxic asset with face value of $1m pays off fully with probability of 20 per cent and pays off $200,000 with probability of 80 per cent. A risk-neutral investor would pay $360,000 for this asset.

Along comes the government and says it will finance 90 per cent of the investor's purchase and, moreover, do so as a non-recourse loan. Non-recourse means the government's loan is backed only by the collateral value of the toxic asset itself. If the pay-out is low, the loan is defaulted and the government ends up with the low pay-out rather than full repayment of the loan.

Now the investor is prepared to bid $714,000 (with rounding) for the same asset. The investor uses $71,000 of his/her own money and $643,000 of the government loan. If the asset pays off in full, the investor repays the loan, with a profit of $357,000. This happens 20 per cent of the time, so brings an expected profit of $71,000. The other 80 per cent of the time the investor defaults on the loan, and the government ends up with $200,000. The investor just breaks even by bidding $714,000, as we would expect in a competitive auction.

Of course, the investor has systematically overpaid by $354,000 (the bid price of $714,000 minus the market value of $360,000), reflecting the investor's right to default on the loan in the event of a poor pay-out of the toxic asset. The overpayment equals the expected loss of the government loan. After all, 80 per cent of the time (in this example) the government loses $443,000 (the $643,000 loan minus the $200,000 repayment). The expected loss is 80 per cent of $443,000, equal to $354,000.

The idea of "private sector price discovery" is therefore flim-flam. There would be price discovery if the government's loan had to be repaid whether or not the asset paid off in full. In that case, the investor would bid $360,000. But under the Geithner-Summers plan the loan is precisely designed to be a one-way bet, for the purpose of overpricing the toxic asset in order to bail out the bank's shareholders at hidden cost to the taxpayers.

The banks could be saved without saving their shareholders – a better deal for taxpayers and without the moral hazard of rescuing shareholders from the banks' bad bets. Most simply, the government could provide loans to buy the toxic assets on a recourse basis, therefore without the hidden subsidy. Alternatively, the plan could give the taxpayers an equity stake in the banks in return for cleaning their balance sheets. In cases of insolvency, the government could take over the bank, the much dreaded nationalisation, albeit temporary. At the end of the Bush administration, Congress voted for the $700bn (€517bn, £479bn) troubled asset relief programme (Tarp) on the assurance the taxpayer would get fair value for money (for example, by taking equity stakes in the rescued banks). The new plan does not offer that.

Tim Geithner, Treasury secretary, and Lawrence Summers, director of the White House national economic council, suspect that they cannot go back to Congress to fund their plan and so are raiding the Federal Reserve, the Federal Deposit Insurance Corporation and the remaining Tarp funds, hoping that there will be little public understanding and little or no congressional scrutiny. This is an inappropriate institutional use of the Fed, the FDIC and the Tarp. Mr Geithner and Mr Summers should at the very least explain the true risks of large losses by the government under their plan. Then, a properly informed Congress and public could decide whether to adopt this plan or some better alternative.

Still Hard US Dollar

From Economist Magazine: Zhou's proposal to replace US dollar as international reserve currency is a sound one in theory, but also an unrealistic one giving America's dominance in the world economy and in military power.

(click to enlarge; graph courtesy of WSJ)

Handle with care
Mar 26th 2009

China suggests an end to the dollar era

IN FUTURE, changes to the international financial system are likely to be shaped by Beijing as well as Washington. That is the message of an article by Zhou Xiaochuan, the governor of the People's Bank of China. Mr Zhou calls for a radical reform of the international monetary system in which the dollar would be replaced as the main reserve currency by a global currency. It is a delicate issue, however. When Tim Geithner, America's treasury secretary, discussed the proposal in New York on March 25th, his remarks sent the dollar tumbling before he made clear that, naturally, he thought the greenback should remain the dominant reserve currency.

Mr Zhou's proposal is China's way of making clear that it is worried that the Fed's response to the crisis—printing loads of money—will hurt the dollar and hence the value of China's huge foreign reserves, of which around two-thirds are in dollars.

He suggests that the international financial system, which is based on a single currency (he does not actually cite the dollar), has two main flaws. First, the reserve-currency status of the dollar helped to create global imbalances. Surplus countries have little choice but to place most of their spare funds in the reserve currency since it is used to settle trade and has the most liquid bond market. But this allowed America's borrowing binge and housing bubble to persist for longer than it otherwise would have. Second, the country that issues the reserve currency faces a trade-off between domestic and international stability. Massive money-printing by the Fed to support the economy makes sense from a national perspective, but it may harm the dollar's value.

Mr Zhou suggests that the dollar's reserve status should be transferred to the SDR (Special Drawing Rights), a synthetic currency created by the IMF, whose value is determined as a weighted average of the dollar, euro, yen and pound. The SDR was created in 1969, during the Bretton Woods fixed exchange-rate system, because of concerns that there was insufficient liquidity to support global economic activity. It was originally intended as a reserve currency, but is now mainly used in the accounts for the IMF's transactions with member countries. SDRs are allocated to IMF members on the basis of their contribution to the fund.

Mr Zhou's plan could win support from other emerging economies with large reserves. However, it is unlikely to get off the ground in the near future. It would take years for the SDR to be widely accepted as a means of exchange and a store of value. The total amount of SDRs outstanding is equivalent to only $32 billion, or less than 2% of China's foreign-exchange reserves, compared with $11 trillion of American Treasury bonds.

There are also big political hurdles. America would resist, because losing its reserve-currency status would raise the cost of financing its budget and current-account deficits. Even Beijing might want to rethink the idea. Mr Zhou praised John Maynard Keynes's proposal in the 1940s for an international currency, the "Bancor", based on commodities. But as Mark Williams of Capital Economics says, central to Keynes's idea was that a tax be imposed on countries running large current-account surpluses, to encourage them to boost domestic demand.

Has the economy turned the corner?

Interview of Ed. Leamer, at UCLA Anderson Forecast Center.

Wednesday, March 25, 2009

China's investment: Government took over

In 2009, all investments in China will come from government, at least from the most recent World Bank China Quarterly report.

(click to enlarge; source: The World Bank)

Beijing's Dilemma

China is concerned about the dollar, but what can she do? Reports from WSJ. (by the way, Geithner should really be let go; he is not qualified for the job).

Geithner's Foot-in-Mouth Disease

Timothy Geithner seems to suffer from China syndrome.

In January, the Treasury Secretary offended Beijing with accusations of currency manipulation. Wednesday, he prompted a brief dollar selloff by failing to dismiss radical proposals from the governor of China's central bank promoting the creation of a new global reserve currency. Mr. Geithner later clarified his remarks, emphasizing his continued fandom of the greenback.

Fittingly, therefore, rhetoric was met with rhetoric. Reserve currencies are begotten, not made. The dollar's pre-eminence, like sterling's before it, stems from a range of factors including deep capital markets and military power. A replacement cooked up by finance ministers would be the monetary equivalent of Esperanto – an artificial curio.

Beijing's proposal, therefore, looks more like a shot across Washington's bow demonstrating concern about U.S. profligacy.

China's options look limited, however. U.S. Treasurys constitute arguably the only market deep enough for China to invest its surpluses without creating huge distortion or unleashing rampant protectionism. Dumping Treasurys to punish Washington would trash the value of Beijing's own reserves -- and cause upheaval in the U.S., still the buyer of last resort for the goods churned out in the factories that employ China's workers.

Faced with such symbiosis, it's understandable that Beijing keep jawboning Washington to show some fiscal restraint, even if the response is less than concrete.

Frontline: Ten trillion and counting

Link to the full program at PBS

Tuesday, March 24, 2009

Will banks sell their toxic assets?

From WSJ:

Treasury Secretary Timothy Geithner's latest plan to rescue U.S. banks has been widely welcomed by the markets as a potential savior of the global financial system. They may be right -- but not for the reasons they suppose.

To be successful, banks and potential investors need to agree on a price for toxic assets. That's a tall order. Banks that haven't marked their exposures to market won't want to sell assets at prices that would force them to take big losses. And banks that have marked their exposures to market aren't likely to want to sell either - particularly if they believe the assets are performing well and likely to show future gains.

Take HSBC, which holds $33.1 billion of bonds backed by assets like U.S. residential mortgages, commercial mortgages and student loans. At the end of 2008, the market value of those assets was just $20.3 billion, yet the bank took just $279 million of impairments last year through the income statement. Under a severe stress scenario, HSBC expects impairments of $2.5 billion over the life of the assets.

An investor who paid the market price for those assets would, on HSBC's forecasts, make an unleveraged 50% return if held to maturity. Add in the generous leverage terms on offer from the Fed, and the returns would be over 100%.

Of course, banks won't want to sell at prices that give investors returns like that. Granted, the financing provided by the Geithner plan could boost prices by removing some of the illiquidity discount on the toxic assets. But that may not be enough to offset the fear among investors that losses on the assets will keep rising if the economy stays in the doldrums.

Does that mean the plan is doomed to failure? Not necessarily. Its most useful service may yet be to establish more bid prices for toxic exposures, paving the way for more realistic marking of assets, even if they aren't ultimately sold. True, some banks will protest to regulators that the bids are unrealistically low. But the authorities may not listen if the bids reflect values they've arrived at as a result of the stress tests currently being conducted on bank balance sheets.

True, sharply lower asset values could imply insolvency for some banks. The Treasury would then have to decide whether to seize such a bank or keep it alive with government equity injections.

Seizure is fraught with headaches, but at least there would be a ready body of private sector bidders for bank assets.

Krugman: The plan won't work

Paul Krugman thinks the plan is the same as the original Paulson plan. No fundamental change and it won't work:

Pay attention to his words at the end that the Fed will inflate the $ to get out of this crisis. This is another reason to buy gold, and commodities in general.

A nation on debt

Credit is good, but too much of it will have the opposite effect. This graph looks at the total credit as a percent of GDP from 1929 to 2008.

(click to enlarge; source: Morgan Stanley)

Monday, March 23, 2009

Why college towns are recession-resistant?

I always like living in a college town, not only it exposes me to the intellectual environment, but also I get to play sports with a lot of energetic students. Now WSJ reports the college towns are also recession proof. Good news.

Why College Towns Are Looking Smart

Looking for a job? Try a college town.

Morgantown, W.Va., home to West Virginia University, has one of the lowest unemployment rates in the U.S. -- just 3.9% -- and the university itself has about 260 job openings, from nurses to professors to programmers.

"We're hurting for people, especially to fill our computer and technical positions," says Margaret Phillips, vice president for human relations at WVU.


Of the six metropolitan areas with unemployment below 4% as of January, three of them are considered college towns. One is Morgantown. The other two are Logan, Utah, home of Utah State University, and Ames, Iowa, home of Iowa State University. Both have just 3.8% unemployment, based on Labor Department figures that are not seasonally adjusted.

The pattern holds true for many other big college towns, such as Gainesville, Fla., Ann Arbor, Mich., Manhattan, Kan., and Boulder, Colo. In stark contrast, the unadjusted national unemployment rate is 8.5%.

While college towns have long been considered recession-resistant, their ability to avoid the depths of the financial crisis shaking the rest of the nation is noteworthy. The ones faring the best right now are not only major education centers; they also are regional health-care hubs that draw people into the city and benefit from a stable, educated, highly skilled work force.

The big question hanging over these communities is whether their formula for success can outlast the nation's nastiest recession in at least a quarter-century. Amid investment losses and state budget woes, many college cities are starting to see their unemployment rates rise, even though they're still lower than the national average. The longer the recession drags on, the more likely college towns are to catch up with their harder-hit peers.

They already have felt the impact of the recession. WVU saw its endowment fall by nearly a quarter in the second half of 2008, and its hospitals are reducing 401(k) matching contributions and delaying $20 million in capital spending, though its state funding has remained intact.

State Funding Cuts

Utah State University has seen nearly 10% of its state funding cut in the past six months, and in response has laid off about 20 employees and imposed a mandatory weeklong furlough for its employees during spring break to save costs. Iowa State, facing a 9% reduction in state appropriations, just received approval to begin an early-retirement program.

[Looking Smart]

But for now, at least, job seekers who act quickly -- and are willing to relocate -- could well fare better in places like Morgantown, which is about 70 miles south of Pittsburgh near the Pennsylvania border. College towns like Morgantown have a distinct advantage over many other cities: They enjoy a constant stream of graduates, some who stay put and others who return years later -- and each year brings a new crop of students and potential residents to the area.

"I could go almost anywhere and get a job right now," says Shane Cruse, a senior in the WVU school of nursing who graduates in May, citing the shortage of nurses nationwide. But come June 1, he'll be starting as a registered nurse at WVU's Ruby Memorial Hospital.

"I love it here," Mr. Cruse says. "It's a large-enough city that there's plenty to do. But you still leave your house and feel like it's your hometown."

WVU has a current enrollment of nearly 29,000, about the same size as the city of Morgantown, though the metro population is now about 115,000 and draws thousands more daily from the surrounding region for health care, shopping and WVU athletic events.

Today, the university and its hospital system together employ nearly 12,500 people -- the largest employer in the whole state. Job growth in the Morgantown metropolitan area averaged 3.2% a year from 2002-07, according to the university's Bureau of Business and Economic Research, compared to growth of just 1.1% nationally and 0.7% in West Virginia. The university system in total has an estimated annual economic impact of about $3.9 billion statewide.

Highly Skilled Work Force

Economists credit a highly skilled work force for the resilience of college towns. Edward Glaeser, an economics professor at Harvard University, has demonstrated that as the share of the adult population with college degrees in a city increases by 10%, wages correspondingly rise by about 7.8%.

"Apart from weather, human capital has been the best long-run predictor of urban success in the last century," Mr. Glaeser says.

Nikki Bowman, a 1992 graduate of WVU, is the kind of person economists have in mind when they speak of "human capital." She spent years in the magazine industry in places like Chicago and Washington, D.C., before returning last year to start her own magazine, WV Living, which was launched in November.

"It was my dream to come back, and I knew I could make it work," says Ms. Bowman, 37. "Part of why I wanted to be here was to pull from the journalism school and I have a lot of great interns as a result," which helps keep her payroll costs down.

WVU graduate Lindsay Williams, 29, started work as a real-estate broker with Howard Hanna's Morgantown office shortly after leaving WVU while waiting for her then-boyfriend -- now her husband -- to finish his degree. She now serves as president of the Morgantown Board of Realtors.

Another factor helping college towns: "communiversity," the current term for partnerships between universities and their home cities, such as joint economic development projects. The trend also reflects a shift in education to increasingly emphasize out-of-classroom learning, such as internships and volunteer work, that by definition engages the community, according to Sal Rinella, president of the Society for College and University Planning in Los Angeles.

"We could actually call these town-gown partnerships a kind of new movement in American higher education," he says. "In the last 20 years or so, the boundaries between the cities and the universities have really begun to crumble."

Planning experts point to the successful relationships between the University of Pennsylvania and downtown Philadelphia, and Johns Hopkins University's multimillion-dollar partnership with the East Baltimore Development Corp. But the college-town effect has its greatest impact in places like Morgantown.

The close relationship between Morgantown and WVU was partly borne out of desperation. In 1991, a young, reform-minded group including Ron Justice, who is now the mayor, was elected to the city council at a pivotal moment; the decades-long decline of railroad and heavy industry in Morgantown meant the city urgently needed to find a new engine of growth.

The council hired a city manager to oversee municipal finances, and began working more closely with the WVU administration in a joint effort to turn the town around. They started out small, with road-paving projects and public safety. In 2001, the university relocated a major new administration building in the city's blighted Wharf District instead of its downtown campus.

The new building became a catalyst for redevelopment of the whole waterfront. A new hotel, restaurants and a $28 million event center have since been built, and the old railroad tracks are now miles of jogging and biking trails.

The university has continued to upgrade its downtown campus and added new facilities like a $34 million student recreation center with two pools, a climbing wall and a café to its campus a few miles north of town. Construction is now under way on an 88-acre research park near the hospital and a $50 million commercial development featuring a Hilton Garden Inn.

At the same time, WVU president David Hardesty's aggressive expansion of the university's student body -- which has grown 50% since 1995 -- and program offerings in the 1990s, including a world-renowned forensics and biometrics program, helped raise the caliber of the city's work force.

Jason Donahue graduated from WVU in 1993 and followed a career in commercial real-estate development to a job with ECDC Realty in Charleston, S.C., whose primary business is site selection and development for Wal-Mart Stores Inc. He moved back to Morgantown in 2007 to handle development in the Pennsylvania region. "My wife would tell you I picked our house so we could be within walking distance to the football games," he said with a chuckle. They are now season-ticket holders.

His wife, a registered nurse, quickly found work at one of the city's senior centers. Their 7-year-old daughter was in a community play last weekend sponsored by WVU -- a production of "Alice in Wonderland." "She was Gardener No. 7 with two speaking lines, and she did great," Mr. Donahue says.

Digest Treasury's Toxic Asset Plan

The plan consists of two key components:

Legacy Loans Program: a program to combine an FDIC guarantee of debt financing with
equity capital from the private sector and the Treasury to support the purchase of troubled loans from insured depository institutions.

Legacy Securities Program: a program to combine financing from the Federal Reserve and Treasury through the Term Asset-Backed Securities Loan Facility (“TALF”) with equity capital from the private sector and the Treasury to address the problem of troubled securities.

Example How It Works

For Legacy Loans Program

If a bank has a pool of residential mortgages with $100 face value that they are seeking to divest, the bank would approach the FDIC. The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio. The pool would then be auctioned by the FDIC, with several private buyers submitting bids. The highest bid from the private sector – in this example, $84 – would define the total price paid by the private investors and the Treasury for the mortgages. Of this $84 purchase price, the Treasury and the private investors would split the $12 equity portion. The new PPIF would issue debt for the remaining $72 of the price and the debt would be guaranteed by the FDIC. This guarantee would be secured by the purchased assets. The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis – using asset managers approved and subject to oversight by the FDIC. Through transactions like this, the Legacy Loans Program is designed to use private sector pricing to cleanse banks’ balance sheets of troubled assets and create a more healthy banking system.

For Legacy Securities Program

Treasury will launch the application process for managers interested in the Legacy Securities Program. An interested FM would submit an application and be pre-qualified to raise private capital to participate in joint investment programs with Treasury. Treasury would agree to provide a one-for-one equity match for every dollar of private capital that the FM raises and provide fund-level leverage for the proposed PPIF. The FM would commence the sales process for the PPIF and raise $100 of private capital for the PPIF. Treasury would provide $100 of equity capital to be invested on side-by-side basis with private capital and would provide up to a $100 loan to the PPIF if the fund met certain guidelines. Treasury would also consider requests from the FM for an additional loan of up to $100 subject to further restrictions. As a result, the FM would have $300 (or, in some cases, up to $400) in total capital and would commence a purchase program for targeted securities. The FM would have full discretion in investment decisions, although the PPIFs will predominately follow a long-term buy and hold strategy. Depending on the amount of loans provided directly from Treasury, the PPIF would also be eligible to take advantage of the expanded TALF program for legacy securities when that program is operational.

Here is a graph from NYT, making the two examples easier to understand:

(click to enlarge)

Reactions to the plan:

Market crash and income inequality

In 1970s, 3% of Harvard graduates went to financial industry.
By 1993, it's 16%;  by 2006, it's 40%.

Gone the days when young MBAs make their quick million before their 30s.

The Wealth Gap After the Crash, Interview of Lawrence Katz and Claudia Goldin at Harvard University (audio, about 45 mins)

Sunday, March 22, 2009

Gold or Gold Miners?

WSJ analyzes the relative attractiveness of investing in gold vs. gold miners.

Now that the Federal Reserve has pulled the tarpaulin off its shiny new printing press, gold has jumped again.

Not all investors stash coins or buy shares in bullion-backed exchange-traded funds. Others, such as hedge-fund manager John Paulson, just take a stake in a miner, AngloGold Ashanti Ltd. in his case. Which is better?


An employee walks through the headquarters of AngloGold Ashanti Ltd., in Newtown, Johannesburg, South Africa.

In the past five years, it made more sense to buy the type of gold that hurts if it falls on your head: Spot metal more than doubled in price while global gold-mining stocks rose just over one-third. That is odd. Consider, for example, a company producing gold at a cost of $400 an ounce. The price doubles from $500 to $1,000. Even if costs rise 50%, unit profit should quadruple, and the share price should soar.

In part, gold-mining stocks suffered as investors broadened their appetite for all commodities. ETFs have also cannibalized investors' cash, although the impact may be overstated. The collective value of the largest gold ETFs is about $47 billion, according to the World Gold Council. That is equivalent to 30% of the market capitalization of the NYSE Arca Gold Miners Index. Actual inflows over time to ETFs, however, would have been at lower prices than today.

Mining stocks also face structural problems. Intrinsically, they carry exploration and political risk. Legacy hedging programs damp realized prices for their output.

[Miner Problem]

Meanwhile, gold's popularity stems mainly from fears of inflation and financial meltdown. The former should, eventually, erode miners' margins. Malfunctioning credit markets hamper project financing. That tarnishes one advantage miners have over gold: They can expand through exploration, while the metal itself pays no dividends and doesn't breed.

Similar to the Fed, the sector also likes to print paper. Stock issuance by gold miners jumped in 2006 and 2007 alongside the gold price, raising three times the amount of the prior two years, according to data provider Dealogic. This year, the sector has tapped investors for $5 billion already, almost as much as all of 2008.

Victor Flores, analyst at HSBC, suspects that has fueled industry cost inflation. He estimates the industry's fully loaded 2008 cost, including such items as exploration expense, was $849 an ounce, barely below the average gold price of $871.

HSBC pegs this year's cost at $749, suggesting good profit growth and stock performance in the near term, especially as the sector was hit in last year's market crisis.

As with any stock, however, investors still favoring gold miners over the metal should pick carefully. Low-cost producers in resource-rich areas are best. And, ideally, they should have other levers to pull to increase value.

AngloGold is based in South Africa and enjoys among the lowest unit costs in the industry. Unwinding its large gold-hedging book should give it better leverage to rising prices for its output. As a sector heavyweight, it is well-positioned for any consolidation opportunities. Looks like Mr. Paulson might be onto something.

Does the Fed have an exit strategy?

Whether 70-style high inflation is inevitable:

Ferguson on "Chimerica"

US-China relationship in the time of crisis:

Friday, March 20, 2009

Becker and Murphy warn backlash against capitalism

This is from FT. Gary Becker and Kevin Murphy ask you to have faith in capitalism. I hope you still do.

Do not let the 'cure' destroy capitalism

Capitalism has been wounded by the global recession, which unfortunately will get worse before it gets better. As governments continue to determine how many restrictions to place on markets, especially financial markets, the destruction of wealth from the recession should be placed in the context of the enormous creation of wealth and improved well-being during the past three decades. Financial and other reforms must not risk destroying the source of these gains in prosperity.

Consider the following extraordinary statistics about the performance of the world economy since 1980. World real gross domestic product grew by about 145 per cent from 1980 to 2007, or by an average of roughly 3.4 per cent a year. The so-called capitalist greed that motivated business people and ambitious workers helped hundreds of millions to climb out of grinding poverty. The role of capitalism in creating wealth is seen in the sharp rise in Chinese and Indian incomes after they introduced market-based reforms (China in the late 1970s and India in 1991). Global health, as measured by life expectancy at different ages, has also risen rapidly, especially in lower-income countries.

Of course, the performance of capitalism must include this recession and other recessions along with the glory decades. Even if the recession is entirely blamed on capitalism, and it deserves a good share of the blame, the recession-induced losses pale in comparison with the great accomplishments of prior decades. Suppose, for example, that the recession turns into a depression, where world GDP falls in 2008-10 by 10 per cent, a pessimistic assumption. Then the net growth in world GDP from 1980 to 2010 would amount to 120 per cent, or about 2.7 per cent a year over this 30-year period. This allowed real per capita incomes to rise by almost 40 per cent even though world population grew by roughly 1.6 per cent a year over the same period.

Therefore, in devising reforms that aim to reduce the likelihood of future severe contractions, the accomplishments of capitalism should be appreciated. Governments should not so hamper markets that they are prevented from bringing rapid growth to the poor economies of Africa, Asia and elsewhere that have had limited participation in the global economy. New economic policies that try to speed up recovery should follow the first principle of medicine: do no harm. This runs counter to a common but mistaken view, even among many free-market proponents, that it is better to do something to try to help the economy than to do nothing. Most interventions, including random policies, by their very nature would hurt rather than help, in large part by adding to the uncertainty and risk that are already so prominent during this contraction.

Government reactions have demonstrated the danger that interventions designed to help can exacerbate the problem. Even though we had well-qualified policymakers, we have gone from error to error since August 2007.

The policies of the Bush and Obama administrations violate the "do no harm" principle. Interventions by the US Treasury in financial markets have added to the uncertainty and slowed market responses that would help stabilise and recapitalise the system. The government has overridden contracts and rewarded many of those whose poor decisions helped create the mess. It proposes to override even more contracts. As a result of the Treasury's actions, we face further distorted decision-making as government ownership of big financial institutions threatens to substitute political agendas for business judgments in running these companies. While such dramatic measures may be expedient, they are likely to have serious adverse consequences.

These problems are symptomatic of three basic flaws in the current approach to the crisis. They are an overly broad diagnosis of the problem, a misconception that market failures are readily overcome by government solutions and a failure to focus on the long-run costs of current actions.

The rush to "solve" the problems of the crisis has opened the door to government actions on many fronts. Many of these have little or nothing to do with the crisis or its causes. For example, the Obama administration has proposed sweeping changes to labour market policies to foster unionisation and a more centralised setting of wages, even though the relative freedom of US labour markets in no way contributed to the crisis and would help to keep it short. Similarly, the backlash against capitalism and "greed" has been used to justify more antitrust scrutiny, greater regulation of a range of markets, and an expansion of price controls for healthcare and pharmaceuticals. The crisis has led to a bail-out of the US car industry and a government role in how it will be run. Even one of the most discredited ideas, protectionism, has gained support under the guise of stimulating the economy. Such policies would be a mistake. They make no more sense today than they did a few years ago and could take a long time to reverse.

The failure of financial innovations such as securities backed by subprime mortgages, problems caused by risk models that ignored the potential for steep falls in house prices and the overload of systemic risk represent clear market failures, although innovations in finance also contributed to the global boom over the past three decades.

The people who made mistakes lost, and many lost big. Institutions that made bad loans and investments had large declines in their wealth, while investors that funded these institutions without proper scrutiny have seen their wealth cut in half or much more. Households that overextended themselves have also been badly hurt.

Given the losses, actors in these markets have a strong incentive to correct their mistakes the next time. In this respect, many government actions have been counterproductive, shielding actors from the consequences of their actions and preventing private sector adjustments. The uncertainty from muddled Treasury policy on bank capital and ownership structure, the willingness of the government to change mortgage and debt contracts unilaterally and the uncertain nature of future regulation and subsidies help prevent greater private recapitalisation. Rather than solving problems, such policies tend to prolong them.

The US stimulus bill falls into the same category. This package is partly based on the belief that government spending is required to stimulate the economy because private spending would be insufficient. The focus on government solutions is particularly disappointing given its poor record in dealing with crises in the US and many other countries, such as the aftermath of hurricane Katrina and failure effectively to prosecute the war in Iraq.

The claim that the crisis was due to insufficient regulation is also unconvincing. For example, commercial banks have been more regulated than most other financial institutions, yet they performed no better, and in many ways worse. Regulators got caught up in the same bubble mentality as investors and failed to use the regulatory authority available to them.

Output, employment and earnings have all been hit by the crisis and will get worse before they get better. Nevertheless, even big downturns represent pauses in long-run progress if we keep the engines of long-term growth in place. This growth depends on investment in human and physical capital and the production of new knowledge. That requires a stable economic environment. Uncertainty about the scope of regulation is likely to have the unintended consequence of making those investments more risky.

The Great Depression induced a massive worldwide retreat from capitalism, and an embrace of socialism and communism that continued into the 1960s. It also fostered a belief that the future lay in government management of the economy, not in freer markets. The result was generally slow growth during those decades in most of the undeveloped world, including China, the Soviet bloc nations, India and Africa.

Partly owing to the collapse of the housing and stock markets, hostility to business people and capitalism has grown sharply again. Yet a world that is mainly capitalistic is the "only game in town" that can deliver further large increases in wealth and health to poor as well as rich nations. We hope our leaders do not deviate far from a market-oriented global economic system. To do so would risk damaging a system that has served us well for 30 years.

The writers are professors of economics and the University of Chicago and senior fellows at the Hoover Institution. Gary Becker was awarded the 1992 Nobel prize in economics and Kevin Murphy was awarded the Clark Medal in 1997. To join the debate go to