Libertarian Democrat Point Of View: An Eccentricity: Currencies

Showing posts with label Currencies. Show all posts

Thursday, May 7, 2009

A policy mistake made by some major central bank may bring inflation risks to the whole world

TO BE NOTED: From Alphaville:

"Quote du jour: fears of competitive devaluation Posted by Sam Jones on May 07 11:35.

A policy mistake made by some major central bank may bring inflation risks to the whole world. As more and more economies are adopting unconventional monetary policies, such as quantitative easing, major currencies’ devaluation risks may rise.

- People’s Bank of China quarterly report, May 6 (via Bloomberg)

The PBC has been getting gradually more vocal in its criticisms of the Fed and the BoE. Things cant be great if you’ve got a mountain of US Treasuries, of course.

We’ll be watching to see what the BoE has to say about QE - if anything - at noon.

This entry was posted by Sam Jones on Thursday, May 7th, 2009 at 11:35 and is filed under Capital markets. Tagged with currencies, People's Bank of China, quantitative easing."

And:

"China Says Global Easing Policies Risk Devaluation (Update2)

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By Sandy Hendry

May 6 (Bloomberg) -- Global central banks risk inflation, currency devaluation and a “big consolidation” in bond markets by pumping cash into their economies, the People’s Bank of China said in its quarterly monetary policy report.

The Federal Reserve and the Bank of England this year started quantitative easing, or printing money to buy government bonds, a policy that the Bank of Japan pioneered to revive its economy at the start of the decade. The European Central Bank’s 22-member board, which meets tomorrow, is split on whether it should buy financial assets to tackle its recession.

“A policy mistake made by some major central bank may bring inflation risks to the whole world,” China’s central bank said in the report today. “As more and more economies are adopting unconventional monetary policies, such as quantitative easing, major currencies’ devaluation risks may rise.”

Chinese Premier Wen Jiabao expressed concern in March that the dollar will weaken, eroding the value of China’s holdings of Treasuries, as the U.S. borrows unprecedented amounts to spend its way out of recession. China’s Treasury holdings climbed 52 percent in 2008 and stood at about $744 billion as of the end of February, according to U.S. government data.

“In the medium and long term, as the financial markets stabilize and economies gradually recover, increasing inflation expectations, rising interest rates and central bank’s liquidity-absorbing operations may cause a ‘big’ consolidation in bond prices,” the central bank’s statement said.

Bernanke

Federal Reserve Chairman Ben S. Bernanke told the congressional Joint Economic Committee yesterday that inflation will “remain low” even as a recovery gets underway because businesses will be slow to build back production and payrolls.

ECB council member Athanasios Orphanides yesterday said the financial crisis needs “drastic” measures. Orphanides and fellow member George Provopoulos from Greece have indicated they may support cutting the target rate to less than 1 percent and buying debt to pump money into the economy.

ECB Executive Board member Lorenzo Bini Smaghi said on April 28 that policy makers should be “wary of the possible side-effects” of unconventional measures.

The euro may rise against the dollar because ECB policy makers will probably decide against introducing so-called quantitative easing when they meet May 7, Bank of Tokyo- Mitsubishi UFJ Ltd. said.

“The failure to move to quantitative easing in the near term should help support the euro, especially against the dollar, given the Federal Reserve’s contrasting aggressive monetary easing approach,” Lee Hardman, a foreign-exchange strategist in London at Bank of Tokyo, wrote in a note yesterday.

To contact the reporter on this story: Sandy Hendry in Hong Kong at shendry@bloomberg.net"

Me:

Don the libertarian Democrat May 7 15:08

I keep quoting this speech, which pretty much details China's position on QE in a financial crisis:

http://www.pbc.gov.cn/english//detail.asp?col=6500&ID=138

"2. The role and contribution of China, as a responsible big country, in Asian financial crisis

In order to mitigate the impact of Asian financial crisis and help crisis-stricken Asian countries walk out of the plight, then China's Premier Zhu Rongji promised, on behalf of the Chinese government, to the world that the RMB would not depreciate, followed by a series of active measures and policies.

(1) China made vigorous efforts to participate in the IMF's rescue operations to help related Asian countries. After the outbreak of financial crisis, under the arrangement framework of the IMF, the Chinese government provided a total of over US$4 billion assistance to Thailand, as well as export credit and emergency free medicine assistance to Indonesia and other East Asian countries, although China had inadequate foreign exchange reserves at that time.

(2) China actively cooperated with relevant parties to participate in and advance regional cooperation. At the sixth ASEAN informal leaders' meeting, then China's President Jiang Zhemin unveiled three proposals of strengthening regional cooperation to refrain the crisis from spreading, reform and improve international financial system, and respect self-selected measures of relevant countries and areas to overcome financial crisis. At the second informal ASEAN+China, Japan and Korea leaders' meeting and the informal ASEAN+China leaders' meeting, then Vice President Hu Jintao emphasized that East Asian countries should vigorously engage in reform and adjustment of financial system, with the most pressing need to intensify the management and supervision over short-term capital flow. He called on the East Asian countries to strengthen exchange on macroeconomic issues such as financial reform, have dialogue between deputy finance ministers and deputy governors of central bank, and form expert team at appropriate time to launch in-depth research on specific measures on managing short term capital flow. The above measures adopted by the Chinese government received positive response and support from most crisis-stricken countries.

(3) China promised that the RMB would not depreciate. Being a highly responsible country, the Chinese government made the decision of no depreciation of the RMB with an aim of safeguarding regional stability and promoting development, which played a pivotal role in maintaining economic and financial stability of the Asian countries and the world at large, as well as Asian countries' economic recovery and regaining of rapid growth in later years.

(4) China implemented policies to boost domestic demand and stimulate economic growth. While sticking to no depreciation of the RMB, the Chinese government took a wide range of measures to boost domestic demand and stimulate economic growth, which safeguarded health and stability of domestic economic growth, mitigated difficult situation in the Asian economies, and fueled recovery of Asian economy.

The adoption of these measures by the Chinese government embodied that as a part of Asia, China had a full awareness of collective interests and responsibility and has made its due contribution to the rapid recovery and regaining of growth momentum of the Asian economy."

Friday, March 20, 2009

I cannot find any currency that I feel it is going to be a sound currency

TO BE NOTED: From Jim Rogers blog:

"There isn`t a Sound Currency

I cannot find any currency that I feel it is going to be a sound currency. Even Singapore, which insists in having a sound currency has the problem, if they have a sound currency and everybody debases theirs they will go out of business.

Jim Rogers is a legendary investor known for his ability to predict major long term trends in several markets. Jim trades and tracks commodities, stocks, futures and interest rates all over the world. Jim has travelled extensively around the world and has written some of the best investment books available for traders. His latest book is a Bull in China, a book about the chinese stock market. "

A sale of Banamex, at prices mooted around $9-12bn, would have a significant impact on the currency.

TO BE NOTED: From Alphaville:

"Citi, Banamex and the peso Posted by Tracy Alloway on Mar 20 08:53.

Citi’s Banamex saga has taken a rather ludicrous turn:

MEXICO CITY, March 19 (Reuters) - Mexico said on Thursday that foreign governments can own stakes in its banks given the crisis in global financial markets, meaning Citigroup will not have to sell its Mexican subsidiary Banamex for now.

The finance ministry had been examining whether a U.S. government rescue plan to take a stake in Citigroup (C.N) would force a sale of Banamex, Mexico’s second-biggest bank and one of the crown jewels in Citi’s global banking empire.

“The law does not cover emergencies derived from the global crisis,” the ministry said in a statement, referring to legislation barring foreign governments from owning Mexican banks.

While the statement did not mention Banamex or Citi by name, it made clear that Mexico does not want to rile battered financial markets by forcing a Banamex sale.

If the legal logic behind this deal sounds rather strange, it’s because it is. There is something else going on here.

These two graphs, from Standard Chartered, should give you a hint of what that might be.

Standard Chartered - Mexico charts

The Mexican peso has weakened substantially since August 2008, meanwhile inflation in the country has stuck at quite a high level, creating something of a headache for the country’s central bank in terms of policy decisions; it can’t lower interest rates to boost its economy without further weakening the peso and increasing inflation.

A sale of Banamex, at prices mooted around $9-12bn, would have a significant impact on the currency.

RBS currency strategist Flavia Cattan-Naslausky explained to us last month:
… in 2001 Citibank paid USD12.5bn for Banamex. Banamex makes about USD900m in annual profits which is about 9x-10x book value. So that’s where this US9bn consensus number is coming from. But there are really several issues. First is who has that kind of cash?! And whoever does, do they want to put it all in Mexico these days?! So it would be more probable that there would need to be some financing scheme involved that lowers the cash portion of the payment. This would have strong implications for FX flows (or lack of) I think that it is a very big deal this whole sale as it will set a precedence for other foreign banks that need to divest in mexico because of nationalization of banks. It can get very complicated. That is why I think there is still a good amount of risk for the currency.

So being a bit flexible on legal rules on foreign ownership will save the Mexican government the hassle of sterilising currency outflows related to the deal and help preserve its fragile currency. A budding trade dispute with the US might might also have played a role in Mexican leniency, in this case.

But, make no mistake, this flexibility is meant to be very temporary. The Mexican government plans to send a bill to Congress to ‘clarify’ exemptions on foreign ownership restrictions in times of crisis. As Bloomberg reports, under that proposal:
… banks, after three years of operating under the exemption to allow foreign government stakes, would have to sell 25 percent of their Mexican unit’s shares on the local market. That requirement would rise to 50 percent of shares after six years.

So unless something changes in Citi’s ownership structure, Banamex is set to go — albeit eventually — whenever this ‘global crisis’ is over.

Related links:
Citigroup (C): Mexico moves the goalposts - Inca Kola
A Mexican US-fallout wave - FT Alphaville

This entry was posted by Tracy Alloway on Friday, March 20th, 2009 at 8:53 and is filed under M&A, Capital markets. Tagged with banamex, citi, currencies, mexico, Peso."

Me:

Don the libertarian Democrat Mar 20 14:03

Unless I'm mistaken, it sounds as if this would also allow the US to seize Citi, and hence, Banamex, and hold it until it was sold, at least for three years.

Thursday, March 19, 2009

that it has the deepest and most sophisticated bond markets in the world (so there is somewhere to park capital reserves)

From the FT:

"The US dollar, the Norwegian krone and the ‘ugly contest’ Posted by Gwen Robinson on Mar 19 10:43.

All eyes have been on the Fed in the past 24 hours - and all currency gyrations, particularly the dollar’s sharp depreciation - have been attributed to the Fed’s move to spend $300bn on buying long-term Treasuries, among other measures. As some currency analysts observed on Thursday, however, the dollar’s steep decline suggests there may have been some over-reaction to the Fed’s move.

But there are other factors at work behind the dollar’s downward trajectory - not least, growing disenchantment in some parts of the world with US economic policies (or lack thereof), and rumbles about dumping the dollar as the world’s reserve currency and adopting a shared basket of currencies.

In an article about a gathering of top Asian think tanks on Thursday in Tokyo, Reuters reported:
The role of the US dollar as the key global currency will decline after the financial crisis, and its value may also weaken due to America’s current account deficit, officials at some of Asia’s top think tanks said. But Asia, which is heavily invested in US assets, hopes any decline in the dollar will be gradual to avoid further shocks to financial systems, the officials said on Thursday.

The bottom line was summed up by Chalongphob Sussangkarn, a former Thai finance minister and now president of Thailand Development Research Institute, who said:The US deficit is so huge. This is why all countries, particularly East Asia, are concerned because we hold a lot of these assets. What happens if the US dollar falls 40 percent? Many central bankers will be losing huge amounts of money.”

Such fears, now spreading among governments about their relatively large holdings of dollar reserves, have been fuelling moves at the United Nations and there is now growing speculation among analysts and forex markets that the UN is preparing a recommendation to member countries to move away from using the dollar as the world’s reserve currency and instead, adopt a shared basket of currencies. No matter that the UN often appears bureaucratic and ineffectual - it sometimes does make an impact - and almost certainly will if it goes ahead with such a push.

Growing speculation about such an announcement was “as large a reason for the overnight sell-off in the dollar, as was the Fed’s announcement to buy US Treasuries as part of their quantitative easing policy”, noted Richard Grace, CBA’s chief currency strategist in a Thursday note.

While Grace suggests it’s “worth waiting until next week” to see the full intention of the UN’s recommendation to diversify out of dollar, he voices three key reservations about such a move:(1) The UN does not carry as much weight as the G7. If it were a G7 announcement (or even an IMF announcement) then the announcement effect (and the full ramifications) on the USD would be extremely significant (and USD negative). We do not expect such an announcement from the G7 anytime soon.

(2) Most major currency reserve managers already diversify (out of USD) anyway. There is nothing new here. Currency reserve managers will diversify according to liquidity, expected return, and to cover a mix of underlying assets (be it imports or underlying securities). Central bank data from the IMF illustrates that, while there is plenty of room for diversification, a significant amount of reserves are already diversified in non-USD currencies (chart 4).

(3) Most trade contracts and commodity prices are priced in USD. If the UN statement is designed to re-price commodities and trade contracts in an alternative to the USD, and toward a basket of currencies such as Special Drawing Rights (SDR’s), then it is a significant announcement by the UN, and clearly USD negative. But it is worth waiting until next week to see if this is the intention of the UN, and if it has endorsement from the US Treasury. The logistics of such a move are huge and will take some time to implement, but an immediate depreciation of the USD under the above circumstances would certainly occur.

Afterall, notes Grace, the two major foundations which keep the dollar stable as the world’s major reserve currency are first, that the US is the largest economy in the world; and second, that it has the deepest and most sophisticated bond markets in the world (so there is somewhere to park capital reserves). “It takes time for alternative markets to grow and adjust to additional demand”, he noted.

Even so, it’s clear, as the FT reported recently, that countries such as China, which hold massive dollar reserves, are concerned, and that there is some interest in at least radically reducing dollar holdings if not shift out of the dollar as the reserve currency. And as we saw last week, moves by Switzerland to intervene in its currency - and fresh speculation that Japan may go the same route (see Related Links, below) has triggered much discussion within governments about forex holdings and safe-haven currencies.

On top of that is the point made by Morgan Stanley’s Stephen Jen this week, that plans to massively boost the IMF’s funds in order to channel aid to Eastern Europe could ultimately see the euro gaining substantial ground. Still, as Hong Kong-based research and investment house Gavekal remarks in a note on Thursday:

There are numerous reasons to dislike the euro … some valid concerns about sterling and the yen, and, with the Fed clearly indicating its “no holds barred” approach to printing money to spur economic activity, dollar-aversion is no surprise either…

Still, we continue to believe that, warm and fuzzy IMF statements aside, the issues Europe is confronting are very serious and will necessitate a political will and flexibility which we have yet to see on the Old Continent. Thus, of all the three-legged blind mules out there, the euro remains, in our view, the most structurally challenged.

Perhaps, as the FT’s currency correspondent Peter Garnham suggests on Thursday, Norway’s krone may emerge as the big, new safe-haven currency.

The bottom line, as Gavekal concludes, remains that picking a currency has truly become an “ugly contest”. Meanwhile, it says, “away from the spotlight, some currencies either offer tremendous value because they have been oversold concerns about debt exposure (SEK, KRW, IDR…), or because they have sound-enough fundamentals which, in these panicked times, the markets are ignoring (CA$, BRL, MYR…).”

This entry was posted by Gwen Robinson on Thursday, March 19th, 2009 at 10:43 and is filed under Capital markets. Tagged with currencies, Dollar, euro, norway."

Me:

Don the libertarian Democrat Mar 19 14:10

"The US deficit is so huge. This is why all countries, particularly East Asia, are concerned because we hold a lot of these assets. What happens if the US dollar falls 40 percent? Many central bankers will be losing huge amounts of money.”

Isn't the fact that the Flight to Safety necessitated losses when the economy reversed course understood? Surely they knew that it was a hedge against deflation, but that deflation was the one thing that everyone feared and the fight against it would be substantial. I guess what I'm saying is that they don't want to lose money on treasuries, but they want to US economy to strengthen as well, which seem contradictory goals, unless, again, you see the Flight to Safety as a hedge.

Frankly, the fact that there is a focal point for the Flight to Safety might end up being good, as it acted as a kind of LOLR for the world. I'm not sure yet that countries won't want to keep that burden, if you will, on the US, but time will tell.

Sunday, February 15, 2009

This is looking ugly indeed, and that's before you consider that European banks are on average much more leveraged than their US counterparts.

From Yves Smith:

"Sunday, February 15, 2009

Will Eastern Europe Trigger a Financial Meltdown?

We've commented from time to time that a possible financial flashpoint is countries that got themselves in the same fix as Iceland , of having a banking sector engaged in the generally risky practices that were standard form recently, and was outsized relative to the economy (Willem Buiter also points out that that precarious situation is made worse by having your own teeny currency).

While Ireland is in that fix, a more immediate trigger for trouble is Eastern Europe. We've mentioned in particular the precarious position of Austria, which was a big lender to the region. As Ambrose Evans-Pritchard remarks in the Telegraph:

Austria's finance minister Josef Pröll made frantic efforts last week to put together a €150bn rescue for the ex-Soviet bloc. Well he might. His banks have lent €230bn to the region, equal to 70pc of Austria's GDP.

"A failure rate of 10pc would lead to the collapse of the Austrian financial sector," reported Der Standard in Vienna. Unfortunately, that is about to happen.

The European Bank for Reconstruction and Development (EBRD) says bad debts will top 10pc and may reach 20pc. The Vienna press said Bank Austria and its Italian owner Unicredit face a "monetary Stalingrad" in the East.

Mr Pröll tried to drum up support for his rescue package from EU finance ministers in Brussels last week. The idea was scotched by Germany's Peer Steinbrück. Not our problem, he said.....

Yves here. Recall we said a few days ago (based on admittedly a small number of conversations, but the Austrian and German businessmen were knowledgeable) that the Austrian banks were widely known to be bankrupt, that Austrians knew they needed to be rescued and would need help. The Austrians were highly confident that Germany would fund a bailout, and the Germans were mystified that the Austrians were so certain. The Germans' doubts appear to have been well founded. Back to the piece:

Stephen Jen, currency chief at Morgan Stanley, said Eastern Europe has borrowed $1.7 trillion abroad, much on short-term maturities. It must repay – or roll over – $400bn this year, equal to a third of the region's GDP. Good luck. The credit window has slammed shut....

"This is the largest run on a currency in history," said Mr Jen.

In Poland, 60pc of mortgages are in Swiss francs. The zloty has just halved against the franc. Hungary, the Balkans, the Baltics, and Ukraine are all suffering variants of this story. As an act of collective folly – by lenders and borrowers – it matches America's sub-prime debacle. There is a crucial difference, however. European banks are on the hook for both. US banks are not.

Almost all East bloc debts are owed to West Europe, especially Austrian, Swedish, Greek, Italian, and Belgian banks. En plus, Europeans account for an astonishing 74pc of the entire $4.9 trillion portfolio of loans to emerging markets....

Whether it takes months, or just weeks, the world is going to discover that Europe's financial system is sunk, and that there is no EU Federal Reserve yet ready to act as a lender of last resort or to flood the markets with emergency stimulus....

Erik Berglof, EBRD's chief economist, told me the region may need €400bn in help to cover loans and prop up the credit system....

The sums needed are beyond the limits of the IMF, w...We are nearing the point where the IMF may have to print money for the world, using arcane powers to issue Special Drawing Rights.

Its $16bn rescue of Ukraine has unravelled. The country – facing a 12pc contraction in GDP after the collapse of steel prices – is hurtling towards default, leaving Unicredit, Raffeisen and ING in the lurch. Pakistan wants another $7.6bn. Latvia's central bank governor has declared his economy "clinically dead" after it shrank 10.5pc in the fourth quarter...

"This is much worse than the East Asia crisis in the 1990s," said Lars Christensen, at Danske Bank.

This is looking ugly indeed, and that's before you consider that European banks are on average much more leveraged than their US counterparts.

Thursday, October 30, 2008

" The irony is that Japanese regulators were once hugely protective of retail investors"

Yves Smith on Naked Capitalism about PRDC's in Japan:

"This Times Online story is frustratingly vague about the exact nature of these complicated and risky foreign exchange products sold to Japanese retail investors. While the size of the problem ($90 billion) may seem not all that bad in comparison, say, to subprime exposures, recall that these trades are likely to be unwound in a compressed period of time when currency markets are already volatile, thus increasing the potential for havoc.

The irony is that Japanese regulators were once hugely protective of retail investors and placed tough restrictions on what products could be sold to them. That attitude clearly went out the window.

From the Times Online:"

Please read the story. Here are my posts, with Yves thrown in:

Don said...: See John Gapper on FT here:

http://blogs.ft.com/gapperblog/2008/10/mrs-watanabe-and-the-sudden-rise-of-the-yen/

"The accounts showed that it was common for Japanese retail investors to be offered leverage of 20 times or more for their cash. In other words, they could deposit the equivalent of $1,000 and take trading positions of $20,000. A lot of them had used the opportunity to buy higher-yielding foreign assets.

The trade worked fine for Japanese investors as long as currencies remained stable and they could in effect switch yen into higher-yielding assets denominated in other currencies. But the sharp rise in the yen - and comparative fall in the value of these foreign assets - is probably landing Mrs Watanabe and her friends with big losses.

Here, to expand the point, is a prescient piece from FT Alphaville a year ago."

Don the libertarian Democrat; October 30, 2008 1:05 AM

And:

Don said...: "The important thing to know about Mrs Watanabe is that, temporarily at least, she has all but stopped flapping her wings"

Who is Mrs. Watanabe?

"Mrs Watanabe is crude shorthand for Japan’s $15,000bn pool of savings, the deepest in the world and worth more than the annual economic output of the US. These vast resources are somewhat apocryphally marshalled by Japanese women, who have traditionally held a firm grip on family finances."

Let's see:

1) Rising yen
2) Lower interest rates
3) Next bubble

David Pilling in the FT:

http://www.ft.com/cms/s/0/0df30044-a5f4-11dd-9d26-000077b07658.html

"The yen carry trade has not been the only cheap source of liquidity in recent years. But Ashraf Laidi, chief currency strategist at CMC Markets, reckons it has been the biggest. He quotes figures suggesting that Japanese households alone, discounting savings mediated through life assurers and other institutions, have mobilised $500bn in outbound funds. That leaves aside speculators, who have borrowed unknowable amounts of yen to invest abroad, often on highly leveraged terms.

Just as state bank bail-outs risk moral hazard, more recklessness and the need for future bail-outs, so the unwinding of the carry trade carries with it the danger of the next great bubble. In Japan, the central bank appears to have reacted to a rising yen and sinking stock market by contemplating the uncontemplatable: a rate cut. Even the rumour of such has provoked a mini equity rally and a weakening of the currency.

This is poison for the BoJ. It hated having to keep rates low, fearing that cheap money can cause bubbles in real estate, in capital investment and in the carry trade. Its sightings of inflationary danger everywhere provoked mirth among outside experts. But few are laughing now."

And so:
"If Japan really is about to reverse course towards zero interest rates, it will once again become the source of almost free money for anyone with an appetite to invest. Worse even than that, says Mr Laidi, is the potential for an even more dangerous dollar carry trade. The Federal Reserve has been desperately cutting rates, and lopped another half point off again on Wednesday. The nearer US interest rates approach zero, the greater the incentive to move dollars into higher-yielding assets elsewhere.

These gyrations do nothing to solve the underlying problem, which is that Asia has an excess of savers and the US and Europe an excess of spenders. Unless that is solved, the world seems condemned to repeat the swings of recent years, as capital is arbitraged between countries where money is cheap to those where it is expensive."

Problems:

1) Dollar carry trade

2) Asia saves, the West spends

3) Here we go again

Is this real?

Don the libertarian Democrat; October 30, 2008 1:27 AM

And:

Don said...

Following an earlier comment about Japan, if you have domestically:
1)Low interest rates
2)Stagnant stock market
3)Stable exchange rate
4)Low inflation
Doesn't it make sense that you would try and invest overseas? And after the tech bubble, doesn't it make sense that you would look for bonds that would provide you higher yields?
Naturally, if any of these variable change significantly, you could be in trouble. So when the story says:
"The products combine exposure to foreign exchange, interest rate differentials and domestic inflation"
it's not saying anything profound.
And when we read this:
"The PRDC's complexity disguised from the buyers the fact that they were taking on the same big foreign exchange risks as the regular carry trade but with additional exposure to global interest rate volatility."
it's a little hard to credit, since I just described the investment's worth and problems in a few short lines?

Don the libertarian Democrat

October 30, 2008 10:04 AM

And Yves:

Yves Smith said...: Don,

The shortcoming in the list above is 'stable currency". In a world of floating currencies (or mainly floating, and Japan was not one of the ones maintaining a dollar peg) the FX risk is huge, although for extended period (perhaps up to a couple of years with not too much movement) it can look low.

And if you read the stories on Japanese retail currency traders, they were as frenetic last year as day traders in the tech bubble here.

The yen was in fact cheap, so the risk was that despite the pickup in yield, you would lose far more due to a fall in the higher-yielding currency. When I was a kid, no one would EVER think of making deposits in higher-yielding currencies, everyone understood that the high yield was a big big signal that a price fall was in the cards.; October 30, 2008 6:35 PM

And me again ( the dummy ):

Don said...: Yves, Thanks. Great point. I was just about to mention these PRDC's on a post about securitization. I think that you make my case, and that we're both on the same page.

I agree that the assumptions seem crazy, my only point was that you would have thought the risks you just rightly pointed out should be easily explainable, even if the products inner workings are complex. From your comments, I was trying to understand how even you were having a hard time with them, and I now see that it's the risk as much as the complexity. I hope I've understood you now, and that my point is clearer.

Don the libertarian Democrat

PS Your blog is great. I'm learning so much from it, but I won't blame my mistakes on you. Take care; October 30, 2008 7:14 PM

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Don's Hermeneutics: Like Rabbi Yishmael's Rules, Only Not

"Searle's Sagacity":

"If a person can't explain something simply, then they don't know what they're talking about. The only exception being Kant."

"Corollary to Searle's Sagacity":

"questions should be simple and comprehensible, and meant to elicit a simple explanation."

"Samuel Johnson's Dictum":

One thing about passing fifty years of age is that I now feel old enough to invoke what I call Samuel Johnson's Dictum. It is thus: If I invoke a view based on an author that I read in the past, and that view is not actually held by that author, I'm more than willing to claim the view as originating with me. The beauty of this Dictum is that it is self-referential. It is based upon my reading of Johnson and on Boswell, but I can't remember the actual references that led me to believe that Johnson believed something like this. In any case, I do.

"Burke's Principle":

Another of my motley list of nostrums is what I call Burke's Principle. Burke's Principle holds that there is a distinction between:
1) Political Theory: A theory of the perfect society, the good life, etc. Your general political philosophy.
2) Politics: The rather messy art of governing which involves dealing with what is possible on earth and compromising as the need arises.

"Burke's Rule":

"All government, indeed every human benefit and enjoyment, every virtue, and every prudent act, is founded on compromise and barter. "

"Burke's Paradox":

"Mere parsimony is not economy. Expense, and great expense, may be an essential part in true economy."

"Burke's Prescience":

"You can never plan the future by the past.

Letter to a Member of the National Assembly (1791)"

"Burke's Wisdom":

"A very great part of the mischiefs that vex the world arises from words.

Letter to Richard Burke"

"Bagehot's Principles":

1) If the Fed exists, it will be the Lender Of Last resort, and that has to be taken in to account in real world Political Economy. It should lend freely in a crisis to solvent banks.

2) The rules for LOLR( from here on down this includes any government guarantee ) intervention should be clear, public, and followed, otherwise Moral Hazard is ineffective. All guarantees must be explicit.

3) The terms must be onerous.

4) The LOLR should get something valuable in return.

Here are a few others:

5) The taxpayer's interests should come first.

6) Moral Hazard needs to be constantly applied by quickly liquidating problem banks in normal times.

7) Any entity receiving a guarantee will have to be supervised or regulated effectively, and violations should be quickly and severely punished.

8) There is no doubt that any entity receiving a LOLR guarantee will need to be more conservative in its practices in order to limit the liability of the taxpayer.

9) There should be a class of financial concerns that can act more freely, but they should not receive LOLR guarantees. They will be strictly supervised or regulated though, and are subject to laws against fraud, etc."

Sources which back up my view of Bagehot:

http://www.pittsburghlive.com/x/pittsburghtrib/opinion/columnists/guests/s_593875.html

"Who can forget the end of "Planet of the Apes" when Charlton Heston, kneeling before the half-buried remains of the Statue of Liberty, slams his fists into the sand and cries, "You maniacs! You blew it up! Ah, damn you ... damn you all to hell!"

Now imagine the same scene, but with a half-buried Morgan Stanley building standing in for Miss Liberty and a time-traveling Walter Bagehot playing the lead and you've got the perfect Hollywood dramatization of the real-life tragedy that, with luck, is having its denouement on Wall Street.

Bagehot? The great Victorian man of letters, best remembered today as the second and most celebrated editor of the British magazine The Economist, wasn't exactly a hunk. But he certainly could have delivered those futile last lines with real conviction, for he was among the first to recognize the vast destructive potential of that newfangled weapon of Victorian finance: the modern central bank.

Bagehot first alerted readers to this potential and offered his suggestions for containing it in an article that appeared in The Economist after the great panic and credit crisis of 1866. That panic witnessed the spectacular collapse of Overend, Gurney & Co., which had long been Great Britain's premier investment house.

Bagehot understood that, during such panics, the Bank of England alone commanded the confidence needed to serve other financial firms as a "lender of last resort." But as Bagehot put it later in his book "Lombard Street: A Description of the Money Market" (1873), the bank's "faltering way" -- its arbitrary and inconsistent use of its unique lending powers -- tended only to make things worse.

"The public," Bagehot wrote, "is never sure what policy will be adopted at the most important moment: it is not sure what amount of advance will be made. ... And until we have on this point a clear understanding with the Bank of England, both our ability to avoid crises and our terror at crises will always be greater than they would otherwise be."

The ultimate source of trouble, Bagehot believed, was the very existence of the Bank of England and the special privileges it enjoyed. But because nothing save a revolution seemed likely to do away with the "Old Lady of Threadneedle Street," as it was called, Bagehot's preferred, practical solution was for the bank expressly to commit itself to lending freely during crises, though on good collateral only, and at "penalty" rates.

The restrictive provisions were supposed to limit aid to otherwise solvent firms panic had rendered illiquid.

Bagehot's recommendation has since become a sort of master precept of central banking -- albeit one that's mainly honored in the breach by central bankers.

To be fair to today's central bankers, there's never been much agreement on how to apply Bagehot's rule in practice. Just what do "good collateral" and "penalty rates" mean in times like these?

While no one might precisely be able to define good collateral -- and one can debate whether the rate at which banks offer to lend unsecured funds to other banks, known as the London Interbank Offered Rate, or LIBOR rate, plus 8 percent constitutes a "penalty" rate -- who even pretends that recent central bank lending has been based on good collateral?

But rescuing insolvent firms is the least of it. The real damage comes from the Treasury's utter lack of any consistent last-resort lending rule. The recently enacted financial institutions bailout bill does little to clarify this.

That's just the sort of thing that troubled Bagehot almost a century and a half ago, when central banks were still in their swaddling clothes. Yet central bankers and governments still don't get it, despite the lip service they pay to this great thinker from our past."

http://www.theweeklystandard.com/Content/Public/Articles/000/000/015/921taekw.asp?pg=1

"The Unwisdom of Crowds
Financial panics still require what Walter Bagehot prescribed--that practical men violate their own principles.
by Christopher Caldwell
12/22/2008, Volume 014, Issue 14

Neither Barack Obama nor John McCain had much of value to say about the financial crisis as it raged through the headlines this fall. Rather than shred their campaign strategies, they played it safe, as most politicians would have. But in the name of justice we ought to recall that there was one candidate who did foresee our predicament with considerable accuracy when it still lay far in the future. Ron Paul, in almost every speech he made during the Republican primaries, spoke of bubbles, reckless credit growth, and the "unsustainability" of present policy. So why isn't there more demand for the common-sense solutions he put forward? Because common sense is not much use in a financial panic.

This was the great discovery of Walter Bagehot, the prolific 19th-century essayist and journalist, who was editor of the Economist from 1860 to 1877. (His name rhymes with gadget.) Ninety-nine percent of the time, common sense is a synonym for practicality. But in a serious banking crisis, doing the commonsensical thing--hunkering down and counting your pennies--has proved to be not practical at all. Bagehot's Lombard Street is an insider's look at the Bank of England, and at the principles on which political and financial leaders act when advanced economies come under pressure. Those principles are depressing in the extreme for anyone with an uncomplicated idea of how a democracy works. But they are effective. That is why, in the so-called Anglo-Saxon world, Bagehot's book still provides the bedrock of policy thinking during financial emergencies, including our present one.

Lombard Street was published in 1873, seven years after the sudden collapse of Overend, Gurney & Co., a bank that lost £11 million, spread panic among investors, sparked a run, and became "the model instance of all evil in business." The crisis made such a deep impression on British finance and government that the country did not have another bank run for 141 years--not until Northern Rock collapsed in the summer of 2007. (English investors must have longer memories than American ones. Most of our own noxious subprime mortgages were contracted, and the securities built on them concocted, after Enron became our own model instance of evil in 2001.) It was the Bank of England that took charge of averting panic, during the Overend, Gurney crisis and thereafter. It did so by injecting credit into the economy, by bailing people out. Bagehot approved of this. Many ordinary retailers could not pay their suppliers until they got the money for the things they sold. Without credit, they would be ruined, and the ruin would spread to those to whom they owed money. This was not a question of moral failing, it was just the way a modern economy worked.

But the modern economic system interacts with the modern political system--democracy--in a rather uncomfortable way. Indeed, at more than one juncture in Lombard Street, Bagehot framed the problem of booms and busts as part of the "increasingly democratic structure of English commerce." People in a democracy are most comfortable when their institutions do the same things that they would do as individuals. In a crisis, banks--like everyone else--reflexively hoard their money. But a central bank must do the opposite. It must lend freely.

This was the most basic affront to common sense that the Bank of England presented, but it was not the worst. The worst was that the bank could carry out its necessary duties as a lender of last resort only by breaking the law. The basis of the bank's operating procedure--and of its soundness--was the Bank Act of 1844. We would call it a regime of sound money. It included stringent caps on the ratio of notes issued to reserves held. These caps were hewed to when the economy was running smoothly. Yet at the time Bagehot was writing, a quarter century later, the law had already been suspended three times. Not just that. "No similar occasion has ever yet occurred," Bagehot wrote, "in which it has not been suspended." So the law on which the solvency of the British nation rested was ironclad, except when someone felt a need to break it.

Stranger still, never did the Bank of England acknowledge its duty as the lender of last resort. Some of its governors even denied that any such duty existed. Bagehot thought the bank should come clean about what it really was:

There should be a clear understanding between the Bank and the public that, since the Bank hold our ultimate banking reserve, they will recognise and act on the obligations which this implies--that they will replenish [the reserve] in time of foreign demand as fully, and lend it in times of internal panic as freely and readily, as plain principles of banking require.

But there was a reason for the central bankers' dissembling. If the bank ever acknowledged a duty to rescue banks by generous extensions of credit, it would create a form of moral hazard. Thomson Hankey, a Bank of England director whom Bagehot much admired (and to whom the financial writer James Grant devotes an admiring essay in his new book Mr. Market Miscalculates), called Bagehot's lender-of-last-resort views "the most mischievous doctrine ever broached in the monetary or banking world in this country."

In practice, Bagehot was right and Hankey was wrong. The bank was beyond question the lender of last resort. In principle, Hankey was right and Bagehot was wrong. Unless there was a real, credible threat that a bank would be allowed to fail, the guarantee of rescue would simply get priced into any financial bubble that developed, making things worse when the bubble popped. The situation required what we would now call "strategic ambiguity"--both Hankey's doctrine and Bagehot's practice, which contradicts it.

The situation today requires the same mix. Central banking is thus often a high-stakes game of chicken. And sometimes, when banks enter the game insufficiently scared, it will be played out to the end. It certainly was in September when the U.S. Treasury terrified the financial world by not coming to the rescue of Lehman Brothers. This was a catastrophe in terms of Bagehot's practice, but it will produce benefits in terms of Hankey's principle. It will discourage people from paying more than is reasonable for assets on the belief that they come equipped with an insurance policy (the promise of a central bank rescue) that has been underwritten by taxpayers. The Republicans who nearly derailed the Treasury's Troubled Assets Relief Program in September played a similar role.

A final problem is that there are limits to how accountable a central bank can be. Everyone is always hollering for clear rules and transparency. But a dirty secret of regulation is that it frequently influences conduct most effectively when it is capricious and opaque. Any regulatory system will reveal its vulnerabilities over long use. If it addresses economic problems in a predictable way, savvy investors will find a way to "game" that predictability. You can draw an analogy with antidepressant drugs. There is no permanent right match of medication for a depressive. Antidepressants work only until the mind (or is it the brain?) finds a way around them, at which point a new, unfamiliar drug must be substituted. In the same way, no matter how good the content of a regulatory regime, it must change periodically if big market players are to be kept from profiting off it.

As Bagehot outlined his system, he was conscious that the practical realities of banking required him to heap paradox upon paradox. There is a hint of both Andrew Jackson and Thomas Aquinas in the way he referred to central banking as an "unnatural" thing in its very conception. "The business of banking ought to be simple," he wrote. "If it is hard it is wrong." If it is hard, the banker is either delegating poorly or has entangled his institution in complex transactions where it has no business. According to Bagehot, "Adventure is the life of commerce, but caution, I had almost said timidity, is the life of banking."

Centralizing a society's cash reserves is complicated, reckless, and artificial:

A republic with many competitors of a size or sizes suitable to the business, is the constitution of every trade if left to itself, and of banking as much as any other. A monarchy in any trade is a sign of some anomalous advantage, and of some intervention from without. . . . The natural system of banking is that of many banks keeping their own cash reserve, with the penalty of failure before them if they neglect it.

In his ideas of company size, Bagehot harkened back to the 18th century rather than ahead to our own. To modern eyes, Bagehot is, as a factual matter, simply wrong. The natural tendency under free-market conditions is towards consolidation, and even monopoly. If you want small firms, you must protect them through government--whether this means Teddy Roosevelt-ian trust-busting, French-style subsidies to tobacconists, the EU's hounding of Microsoft, or the NIMBY anti-Wal-Mart campaigns aimed at preserving Mom-and-Pop stores. Bagehot sometimes contradicted himself on this point, noting also that "a large bank always tends to become larger, and a small one tends to become smaller," but his application of the word unnatural to a large central bank was frequent and must be taken as his settled view. It is curious that Bagehot, a contemporary of Marx, came to the opposite (and false) conclusion about how firms evolve.

Where Bagehot would agree with Marx is in his belief that there is something predictably destabilizing about modern economies. You don't need banks to have a precarious economy, or one liable to speculation--Bagehot noted that there were no banks, as we would understand them, in 1720, at the time of the South Sea Bubble and the Mississippi Scheme. But modern banking is precarious by design. "In exact proportion to the power of this system is its delicacy," he wrote. "I should hardly say too much if I said its danger." The power, delicacy, and danger all have the same source. In fact they are just different names for the same thing: leverage.

At the very opening of the book, Bagehot illustrates with exquisite simplicity how, at least in a boom economy, traders on margin can "harass and press upon, if they do not eradicate, the old capitalist." The old capitalist in question is the poor sap who believes all this stuff about neither-a-borrower-nor-a-lender-be and is foolish enough to be using his own cash:

If a merchant have £50,000 all his own, to gain 10 per cent on it he must make £5,000 a year, and must charge for his goods accordingly; but if another has only £10,000, and borrows £40,000 by discounts (no extreme instance in our modern trade), he has the same capital of £50,000 to use, and can sell much cheaper. If the rate at which he borrows be 5 per cent, he will have to pay £2,000 a year; and if, like the old trader, he make £5,000 a year, he will still, after paying his interest, obtain £3,000 a year, or 30 per cent, on his own £10,000. As most merchants are content with much less than 30 per cent, he will be able, if he wishes, to forego some of that profit, lower the price of the commodity, and drive the old-fashioned trader--the man who trades on his own capital--out of the market.

Later, Bagehot showed that this need for leverage is no different for those selling money than it is for those selling dry goods. The banker can no more choose not to lend than the merchant can choose not to borrow:

The bill-broker has, in one shape or other, to pay interest on every sixpence left with him, and that constant habit of giving interest has this grave consequence: the bill-broker cannot afford to keep much money unemployed. He has become a banker owing large sums which he may be called on to repay, but he cannot hold as much as an ordinary banker, or nearly as much, of such sums in cash, because the loss of interest would ruin him.

In finance, once you can have leverage, you must have leverage. Once you have some leverage, getting more of it than your competitors is a matter of survival. And when governments and central banks debate whether to loosen or tighten up money, they face a constant clamor from the financial world to permit more leverage still. That is why, even in democracies, the instruments of monetary policy tend to be kept far from the influence of voters, and even hidden from view. Otherwise, credit tends to spiral. Bubbles result.

Nothing could be more foolish than to assume that this process of spiraling speculation is unleashed by "greed," unless by greed you mean human nature. Credit spirals are a darker aspect of the world Adam Smith described in The Wealth of Nations and Bernard de Mandeville did in the Fable of the Bees. Just as society can be improved by the uncoordinated action of the selfishly motivated, an economy can collapse for reasons having nothing to do with anybody's cupidity.

We should be moral in the way we think about money, but a credit system tends to make a mess of moral accounting. Bagehot described London's financial district as "a sort of standing broker between quiet saving districts of the country and the active employing districts." Decent, puritanical Suffolk farmers want to put their money in a safe place; Lancashire entrepreneurs want money to put to work. Thanks to London bankers, both can follow their wishes and make a profit in the process. We have an idea that the Suffolk dairyman is the "moral" party here (he's saving) and the Lancashire speculator the "immoral" one (he's gambling). But, once a banking system intervenes, they are both gambling and they are both saving. In good times you are welcome to mouth the folkloric cliché that holds farmers to be better people than financiers. When depression looms, you had better realize that the rain falls on the just and the unjust.

Many Americans who have wound up underwater on their houses and maxed out on their credit cards are greedy, climbing, brand-intoxicated, materialistic shopaholics who thought the world owed them a living. But just as many of them are not. They are trapped, as surely as financial institutions are, in a system based on wild borrowing. Participation in this system is not exactly required, but it is not exactly optional, either. One's quality of life is determined not just by one's purchasing power but also by one's relative economic standing. Chagrin at seeing one's neighbors get richer faster may be a sign of bad character, but do not for a minute assume there is nothing to feel chagrin about! When it comes to the very goods people deem most essential--the proper mate; the schooling of one's children; the size, location, elegance, and comfort of one's house--relative standing is more important than absolute wealth.

Those who kept their money in savings banks in the 1990s lost out to those who did things we are supposed to disapprove of, like "spending money they didn't have," borrowing profligately to invest in stocks and even bonds, which appreciated at an average of 15 percent a year over the decade. Among rich people, how one entered the present decade had more to do with how one had done in the stock market than with how one had done in the labor market. Is that just? Of course it's not! It's easy to see now. But while the boom was going on there was all sorts of rationalizing about why it was okay that the social hierarchy should be reordered through stock and housing speculation. One line of argument was that people who did not have a ton of money in stocks, as well as those who rented rather than bought the houses they lived in, were foolish. This line of argument peaked at the turn of the decade, when Americans elected a president who had argued that the public was foolish for not launching its retirement savings onto the open seas of the stock market.

Bagehot saw that a speculative mania eventually sweeps up everyone in its path. "Every great crisis reveals the excessive speculations of many houses which no one before suspected," he wrote, "and which commonly indeed had not begun or had not carried very far those speculations, till they were tempted by the daily rise of price and the surrounding fever." Avaricious people get hurt, but it is in the nature of crashes that they are not the ones who get hurt most. A tragic figure present in almost every historic account of speculation and collapse in history is the person who believed, year after year, that the boom was an illusion, and held himself aloof until, at the very last minute, whether out of self-doubt or deference to the opinions of his fellow man, he entered the fray and was (having bought at the top, rather than the bottom, of the market) wiped out. What a wicked irony! His punishment is as much for his long and wise forbearance as for his momentary weakness.

So the "cultural contradictions of capitalism" run deeper than we thought. The classic idea, as laid out in their different ways by the economist Joseph Schumpeter and the sociologist Daniel Bell, is that capitalism rewards diligence; diligence produces wealth; wealth begets idleness; and idleness undermines capitalism. But when, as now, push comes to shove, we can ask whether there is really anything particularly capitalist about the virtues of diligence and self-restraint. The real capitalist virtues appear to be optimism and luck. From a central-banking perspective, the cultural contradictions are not results of capitalism but elements of it.

The problem with central banking is that it reacts to a system that has been mismanaged by rewarding the managers. That is why objections to central banking, although they can come from the right (Ron Paul, Jim Bunning) or the left (Barney Frank, William Greider), tend to be populist. Bagehot was no populist. He was comfortable with the idea that what some people think should be more important than what other people think:

Almost all directors who bring special information labor under a suspicion of interest; they can only have acquired that information in present business, and such business may very possibly be affected for good or evil by the policy of the Bank. But you must not on this account seal up the Bank hermetically against living information.

Although he would surely fault Treasury Secretary Hank Paulson for many things, the criticism most often heard at present--that Paulson is too close to former colleagues on Wall Street, where he worked for years as CEO of Goldman Sachs--would strike Bagehot as misplaced.

Because it is on Wall Street, alas, that "the state of credit" is to be determined:

The state of credit at any particular time is a matter of fact only to be ascertained like other matters of fact; it can only be known by trial and inquiry. And in the same way, nothing but experience can tell us what amount of "reserve" will create a diffused confidence.

To be blunt, credit is successfully reestablished when financial elites say, "When." Credit is close to a synonym for the mood of the ruling class. To say an economy is based on credit is to say it is based on animal mysteries. Glamour, prestige, élan, sprezzatura, cutting a figure . . . that is what the economy is made of. It is a rather terrifying thought. Viewed as Bagehot viewed it, from the perspective of a central bank in a crisis, an advanced economy looks an awful lot like a primitive economy."

http://blogs.iht.com/tribtalk/business/globalization/?p=680

"Loyal readers, please take a moment to check out Gretchen Morgenson’s column this week. She’s taken a close look at the buyout of Bear Stearns organized by the Federal Reserve, and she has come to an intriguing conclusion: that the Fed not only wanted to prevent financial havoc - it also wanted to deter speculators who were betting on big banks to fail.

Adherents of the Walter Bagehot school of central banking - and I have been among them at times - have cried foul at the sight of big bailouts and the granting of emergency credit at low interest rates. The Bagehot argument is that emergencies that arise from the risks that banks have chosen to take should not be treated with overwhelming sympathy. Emergency credit should be offered, yes, but at rates that will make banks think twice about using the safety net again. That’s not the case this time around (neither in the United States nor in Britain, and probably not in Europe either by the time the folks in Brussels are finished), so the central banks may be telling financial institutions that they can take silly risks without fear of disaster.

But if Morgenson is right, there is a long-term purpose here, too: to reduce the winnings of those who bet on failure, and thus to reduce the incentives to bring that failure to pass. And let’s face it, the speculators aren’t operating in a vacuum; their bets can start to snowball with market sentiment, as they did against Lehman Brothers last week. Still, the Bagehot argument (often called moral hazard) is also a powerful one - which one do you agree with?"

http://blogs.wsj.com/economics/2007/08/20/from-bagehot-to-bernanke/

"In his 1873 book “Lombard Street,” the closest thing to a user’s guide to central banking, Walter Bagehot criticized the Bank of England’s handling of earlier panics by responding “hesitatingly, reluctantly, and with misgiving.”

Federal Reserve Chairman Ben Bernanke, who has read his Bagehot and kept a copy in his Princeton office when he was a professor, responded to recent developments first by pumping money into the markets through the New York Fed’s open-market operations and then last week by easing the terms on loans to banks from the Fed’s discount window.

Bagehot (pictured at right) still makes for good reading at times like this.

“What is wanted and what is necessary to stop a panic is to diffuse the impression, that though money may be dear, still money is to be had. If people could be really convinced that they could have money if they wait a day or two, and that utter ruin is not coming, most likely they would cease to run in such a mad way for money. Either shut the Bank at once, and say it will not lend more than it commonly lends, or lend freely, boldly, and so that the public may feel you mean to go on lending. To lend a great deal, and yet not give the public confidence that you will lend sufficiently and effectually, is the worst of all policies; but it is the policy now pursued.”

Robert Feldman, Morgan Stanley’s chief economist for Japan, writes in a note today that it’s key to distinguish between internal discredit — private domestic lenders retreating — and external discredit, which Bagehot defined as a foreign drain on a bank’s money. (Bagehot’s solution to the problem of external discredit is to still lend freely but “at very high rates.”) That doesn’t apply in today’s floating rate system, Feldman says, and exchange rates don’t provide a good substitute, with the dollar’s drop against the yen suggesting we have external discredit while the strengthening against the euro saying we don’t.

Feldman writes: “My view is that the modern counterpart of ‘external discredit’ is moral hazard. The credit of the U.S. IS a problem, since no one knows how big the subprime and related housing market problems really are. Given how poorly banks know their clients, the ‘high rates’ part should come into play. There is no way to re-establish confidence unless those who have made loans to questionable borrowers pay a price for rash lending. Only then will markets regain confidence that risk is under control.

“The next stage of the credit problem — and whether it affects the real economy seriously — depend on eliminating the moral hazard,” Feldman says. “The faster the moral hazard in eliminated, the less impact on the real economy.”

Fed officials are acutely aware of the moral hazard, having resisted action for weeks to not be seen as bailing out risky investments. But they also don’t want a crisis to feed on itself. The Fed stressed its statement, in lowering the discount rate for banks, that it would accept “a broad range of collateral…including home mortgages and related assets.” The central bank sought to reassure a market that had been roiled by risky investments in subprime mortgages.

That’s how the Bank of England halted a panic in 1825, as Bagehot recounts: “A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to ‘this man and that man,’ whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them. The way in which the panic of 1825 was stopped by advancing money has been described in so broad and graphic a way that the passage has become classical. ‘We lent it,’ said Mr. Harman, on behalf of the Bank of England, ‘by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power.’ After a day or two of this treatment, the entire panic subsided, and the ‘City’ was quite calm.”

http://www.realclearmarkets.com/articles/2008/03/bagehot_central_banking_and_th.html

"Bagehot advocated in 1873 that a Lender of Last Resort in a crisis should lend at a penalty rate to solvent but illiquid banks that have adequate collateral. The doctrine has been criticised as having no place in our modern interbank market, but this is wrong. Bagehot’s prescription aims to eliminate the coordination problem of investors at the base of the crisis. It is still a useful guide for action when the interbank market stalls.1 It makes clear that discount-window lending to entities in need may be necessary in a crisis.

Bagehot's doctrine, however, is easy to state and hard to apply. It requires the central bank to distinguish between institutions that are insolvent and those that are merely illiquid. It also requires them to assess the collateral offered. Central banks, because of information limitations, are bound to make mistakes, losing face and money in the process. This doesn’t mean they should not try.
Poor collateral versus massive liquidity

The collateral should be valued under “normal circumstances”, that is, in a situation where the coordination failure of investors does not occur. This involves a judgment call in which the central bank values the illiquid assets. A central bank that only takes high quality collateral will be safe, but will have to inject much more liquidity and/or set lower interest rates to stabilise the market. This may fuel future speculative behavior. Some of this may have happened in the Greenspan era, in the aftermath of the crisis in Russia and LTCM, and after the crash of the technological bubble. The ECB and the Federal Reserve have accepted now partially illiquid collateral that the market would not. This seems appropriate and releases pressure to lower interest rates to solve the problem, something that should be done only if there are signs of deterioration in the real economy. The problem is that central banks are extending the lender of last resort facility outside the realm of traditional banks to entities, like Bear Stearns, that they do not supervise and, therefore, over which they do not have first hand information. How does the Fed know whether Bear Stearns or other similar institutions are solvent? It seems that the Fed is not following Bagehot’s doctrine here.

Finally, if banks and investors are bailed out now, why should they be careful next time? This is the moral hazard problem: help to the market that is optimal once the crisis starts has perverse effects in the incentives of market players at the investment stage. The issue is that only when the moral hazard problem is moderate does it pay to eliminate completely the coordination failure of investors with central bank help. When the moral hazard problem is severe, a certain degree of coordination failure of investors - that is, allowing some crises - is optimal to maintain discipline when investing and, amending Bagehot, some barely solvent institutions should not be helped."

http://www.house.gov/jec/imf/blueprnt.htm

"This goal is not new. In fact, it underlay Walter Bagehot's (1873) classic policy prescriptions for domestic central banking: to lend freely at a penalty rate on good collateral. Bagehot argued an elastic and immediate supply of liquidity was essential to an effectively structured lender of last resort, and that appropriate loss sharing rules in the form of collateral requirements and penalty interest rates would discourage abuse of the safety net."

http://online.wsj.com/public/article_print/SB120908336730343529.html

"By slashing interest rates too much in 2007-2008, the Fed has accentuated the foreign drain and thus made the alleviation of the domestic drain more difficult. Yet, despite this mistake, Bagehot would approve of other actions the Fed has taken to deal with the domestic drain by unblocking specific impacted domestic markets. These include (1) swapping Treasury bonds for less safe private bonds, (2) opening its discount window to shaky borrowers, and (3) maybe even rescuing Bear Sterns. He would also approve of the relaxation of capital constraints on Fannie Mae, Freddy Mac and so on, for mortgage lending. Yet these measures will be insufficient if the foreign drain continues.

To repeat Bagehot's Rule: "very large (domestic) loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain." The Fed, and the U.S. government more generally, have so far got it only half right."

http://findarticles.com/p/articles/mi_m2751/is_56/ai_55015114/pg_6

"More than a century ago, a British economic journalist, Walter Bagehot, set out the classical principles for a central bank acting as lender of last resort: lend freely in a crisis at a penalty rate against collateral. Adapted to international lending, Bagehot's rule is the proper rule for a restructured, more effective IMF."

http://maverecon.blogspot.com/2007/08/central-banks-in-time-of-crisis.html

"In a number of recent blog contributions, we have sketched the role of a modern central bank as ‘market maker of last resort’ (MMLR). This MMLR is the analogue, in a world where intermediation is increasingly through financial markets, to Bagehot’s lender of last resort (LOLR) in a world where most intermediation took place through banks (see e.g. Willem H. Buiter and Anne C. Sibert “The Central Bank as the Market Maker of last Resort: From lender of last resort to market maker of last resort"; Willem H. Buiter “Central banks as market makers of last resort, again”; Willem H. Buiter and Anne C. Sibert “A missed opportunity for the Fed”).

The market maker of last resort function can be fulfilled in two ways. First, the central bank can make outright purchases and sales of a wider range of securities than they currently do. Second, central banks can accept a wider range of securities as collateral in repos, and in collateralised loans and advances at the discount window than they currently do. Following Bagehot’s rule, the MMLR should buy these securities outright or accept them as collateral only on terms that would imply a stiff financial penalty to the owner. The central bank of course already applies a liquidity ‘haircut’ even to liquid instruments offered as collateral in repos or at the discount window. Because the MMLR would have to establish a buying price ‘in the dark’, that is, unaided by recent relevant market prices, and would inevitably take on much more credit risk than central banks have become accustomed to, the ‘haircuts’ should be severe – a financial version of ‘short back and sides’.

http://www.independent.org/pdf/tir/tir_07_3_wood.pdf

"Further crises in 1857 and 1866 prompted the debate between Bagehot and
Thomson Hankey, a director and former governor of the Bank of England. Notwithstanding
the Bank’s undoubted responsibility, as trustee of the nation’s reserve, to
support the financial markets, Bagehot wrote:
If we ask how the Bank of England has discharged this great responsibility,
we shall be struck by three things: first, . . . the Bank has never by any
corporate act or authorised utterance acknowledged the duty, and some of
its directors deny it; second, (what is even more remarkable), no resolution
of Parliament, no report of any Committee of Parliament (as far as I know),
no remembered speech of a responsible statesman, has assigned or enforced
that duty on the Bank; third (what is more remarkable still), the distinct
teaching of our highest authorities has often been that no public duty of
any kind is imposed on the Banking Department of the Bank; that, for
banking purposes, it is only a joint stock bank like any other bank; that its
managers should look only to the interest of the proprietors and their
dividend; that they are to manage as the London and Westminster Bank or
the Union Bank manages. (1873, 153–54)
Although the Bank usually in the end supplied the market, its “faltering way”
caused needless uncertainty and more severe panics than if it communicated clearly
that it could be counted on (Bagehot 1873, 64). According to Bagehot, the rules—
to lend freely at penalty rates on sound collateral—under which assistance would be
provided should be stated also.
The public is never sure what policy will be adopted at the most important
moment: it is not sure what amount of advance will be made. The best
palliative to a panic is a confidence in the adequate amount of the Bank
reserve, and in the efficient use of that reserve. And until we have on this
point a clear understanding with the Bank of England, both our liability to
crises and our terror at crises will always be greater than they would
otherwise be. (1873, 196–97)"

One which doesn't quite:

http://www.portfolio.com/views/blogs/market-movers/2008/05/13/bernanke-on-bagehot?rss=true

"Bernanke on Bagehot

I doubt a week has gone by since last summer during which I haven't seen some pundit or other trot out Walter Bagehot's dictum that in the event of a credit crunch, the central bank should lend freely at a penalty rate. More often than not, this is contrasted with the actions of the Federal Reserve, which seems to be lending freely at very low interest rates.

Ben Bernanke, in a speech today, addressed this criticism directly:

What are the terms at which the central bank should lend freely? Bagehot argues that "these loans should only be made at a very high rate of interest". Some modern commentators have rationalized Bagehot's dictum to lend at a high or "penalty" rate as a way to mitigate moral hazard--that is, to help maintain incentives for private-sector banks to provide for adequate liquidity in advance of any crisis. I will return to the issue of moral hazard later. But it is worth pointing out briefly that, in fact, the risk of moral hazard did not appear to be Bagehot's principal motivation for recommending a high rate; rather, he saw it as a tool to dissuade unnecessary borrowing and thus to help protect the Bank of England's own finite store of liquid assets. Today, potential limitations on the central bank's lending capacity are not nearly so pressing an issue as in Bagehot's time, when the central bank's ability to provide liquidity was far more tenuous.

I'm no expert on Walter Bagehot, and in fact I admit I've never read Lombard Street. But I'll trust in Bernanke as an economic historian on this one, unless and until someone else makes a persuasive case that Bagehot's penalty rate really was designed to punish the feckless rather than just to preserve the Bank of England's limited liquidity."

"So, we have, what I will call "Grant's Graham For Investing":

1) Decent Size

2) Current Assets Exceed Liabilities By Two Times

3) 10 Continuous Years Of Profit

4) 20 Continuous Years Of Dividends

5) 10 Years Of Earnings Growth Exceeding 33%

6) Price To Earnings Ratio Less Than 15

7 ) Price To Book Ratio Less Than 1.5"

"Cake As Gift Theory":

Now, I feel similarly about government incentives. When Fannie and Freddie tempted investors, this led to the housing bubble. I think that I'm going to call this the Cake As Gift Theory. I hand you a cake assuming that you have the good sense to eat it over time, and you gorge yourself and eat it at one sitting and get sick. Clearly I'm responsible for this by handing you the cake. Give you a gift or incentive, clearly I must assume that it will cause you to be irrational.

"Spigot Theory":

One other pet theory I have about finance, besides Bagehot's Principle, is the Spigot Theory. I might rename it. It applies to the low rate of interest or the sloshing pool of money explanations for the current crisis. Turn the tap too far, then you can't stop the tub from overflowing, even if you're a human agent standing right next to the tub. I call this a mechanistic explanation as opposed to an explanation based on human agency.

"The Pragmatic Milton Friedman Principle":

The Pragmatic Milton Friedman Principle. Friedman introduced a concept called the Negative Income Tax. He proposed it saying that it was a pragmatic compromise between the Welfare State and a basic libertarian position.

"Hardy's Harangue": To Me:

"There is no scorn more profound, or on the whole more justifiable, than that of the men who make for the men who explain. Exposition, criticism, appreciation, is work for second-rate minds. "

"Titchmarsh's Two Truths":

1)"Perhaps we could regard numbers as a sort of medium of exchange, like money. Most people are really interested in the goods and services which the world offers, and to them money is only a symbol for these. But it is not a meaningless symbol. A system of barter, in which we do without money and merely exchange goods, would be very inconvenient, and practically impossible in a complicated society. So a system in which we reduce all mathematics to statements such as "I have more fingers than you have noses" would be too cumbrous to contemplate seriously. Numbers are symbols, and very useful and interesting ones. To mathematicians who work with them every day they acquire a reality at least equal to that of anything else. "

2) "The question what numbers are has been much debated by philosophers, and they do not seem to have reached any agreement about it. There is nothing particularly surprising or distressing about this. It has been said that mathematicians are happy only when they agree, and philosophers only when they disagree. Philosophic doubts about the nature of number have never prevented mathematicians from getting on with their calculations, or from agreeing when they have got the right answer. So perhaps the situation is satisfactory to all parties. "

"Thoreau's Truth":About Government:
"I heartily accept the motto, "That government is best which governs least"; and I should like to see it acted up to more rapidly and systematically. Carried out, it finally amounts to this, which also I believe--"That government is best which governs not at all"; and when men are prepared for it, that will be the kind of government which they will have. Government is at best but an expedient; but most governments are usually, and all governments are sometimes, inexpedient."

"Will's Warning": Concerning The Use Of "Socialism":
Hyperbole is not harmless; careless language bewitches the speaker's intelligence. And falsely shouting "socialism!" in a crowded theater such as Washington causes an epidemic of yawning.

"Kling's Principle":About Regulated Banks And Unregulated Financial Entities
"The banks seem to find a way to take risks, and the unregulated folks seem to find a way to get guarantees."

"Janeway's Dictum": On Political Economy
"Political economy is not a science, it's a clinical art, like medicine."

"Cowen's Creed": On Policies

"YOU CAN’T TURN BAD TO GOOD The good New Deal policies, like constructing a basic social safety net, made sense on their own terms and would have been desirable in the boom years of the 1920s as well. The bad policies made things worse. Today, that means we should restrict extraordinary measures to the financial sector as much as possible and resist the temptation to “do something” for its own sake."

"Hendry's Heartfelt":

"I antagonise people,' says Hugh Hendry. 'It's part of my skill set."

"Diebel's Dare:

"You can’t be forced out further on the yield curve than a perpetual.”

"Peston's Promise": Good Until ...

"And, as I've been pointing out for some time, we are being asked to provide life support to a swathe of the real economy, from steel makers to car manufacturers.

The Government will succumb and will lend taxpayers' money to non-financial companies.

In a way, there's no choice, because we'll be hobbled for years as an economy if our few remaining manufacturers and exporters are wiped out."

"Trader's Narrative's Due Diligence":

"The process of investigation undertaken by an party to gather material information on actual or potential risks involved in a financial transaction or relationship."

The Quotes Above

W. Bagehot, R.W. Emerson, M. Proust, W.H. Auden, W. Bagehot, P.Levine

Read J.L. Austin "A Plea For Excuses" here:

http://www.ditext.com/austin/plea.html

Read " Reflections on the Revolution in France by Edmund Burke 1790" here:

http://www.constitution.org/eb/rev_fran.htm

P. Levine reading "They Feed They Lion"

http://www.ibiblio.org/ipa/poems/levine/they_feed_they_lion.php

Read H.D. Thoreau " On Civil Disobedience " here:

http://sunsite.berkeley.edu/Literature/Thoreau/CivilDisobedience.html

Read W. Bagehot " Lombard Street" here:

http://bagehot.classicauthors.net/LOMBARDSTREET/LOMBARDSTREET9.html

Read Irving Fisher's "The Debt-Deflation Theory Of Great Depressions" here:

http://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf

Read H.D. Thoreau "Walking" here:

http://www.ecotopia.org/ehof/thoreau/walking.html

About Rabbi Ishmael's Rules, see here:

http://en.wikipedia.org/wiki/Baraita_of_Rabbi_Ishmael

Read E.C. Titchmarsh on "Counting" here:

http://www-groups.dcs.st-and.ac.uk/~history/Extras/Titchmarsh_Counting.html

Read Granville Barker's "Voysey Ineritance" here:

http://books.google.com/books?hl=en&id=jFNFAAAAIAAJ&dq=the+voysey+inheritance&printsec=frontcover&source=web&ots=7TZP8W9Hlh&sig=yEoasq-eebAqE6H0iOnVaJhqFRs&sa=X&oi=book_result&resnum=4&ct=result#PPA6-IA3,M1

Read Henry James "The Sacred Fount" here:

http://www2.newpaltz.edu/~hathaway/sacredfount.html

Read "The Calculus Of Consent" here"

http://www.econlib.org/library/Buchanan/buchCv3Cover.html

Read "Did Reagan Rule In Vain? A Closer Look at True Expenditure Levels in the United States and Europe by Jacob Funk Kirkegaard " here:

http://petersoninstitute.org/publications/interstitial.cfm?ResearchID=1096

Read "The Postulates Of Political Economy" by Bagehot here:

http://books.google.com/books?id=ZrA-AAAAIAAJ&dq=bagehot+political+economy&printsec=frontcover&source=bl&ots=dN6OiMA8wi&sig=gV8nfKIxA1hYR9oAIxvQFdNZD0w&hl=en&ei=15uXSZf7CoKqsAPHz-mLAQ&sa=X&oi=book_result&resnum=2&ct=result#PPP1,M1

Read W.Buiter "Helicopter Money" here:

http://www.nber.org/~wbuiter/helijpe.pdf

Read Remarks by Governor Ben S. Bernanke
Before the National Economists Club, Washington, D.C.
November 21, 2002 Deflation: Making Sure "It" Doesn't Happen Here"

http://www.federalreserve.gov/boardDocs/speeches/2002/20021121/default.htm#f8

Jackson's Rules Of The Road

I'm going to be a happy idiot
And struggle for the legal tender
Where the ads take aim and lay their claim
To the heart and the soul of the spender
And believe in whatever may lie
In those things that money can buy
Thought true love could have been a contender
Are you there?
Say a prayer for the pretender
Who started out so young and strong
Only to surrender

Gotta do what you can just to keep your love alive
Trying not to confuse it with what you do to survive

And in the end they traded their tired wings
For the resignation that living brings
And exchanged loves bright and fragile glow
For the glitter and the rouge
And in the moment they were swept before the deluge

Don't confront me with my failures
I had not forgotten them

But its a long way that I have come
Across the sand to find you here among these people in the sun
Where your children will be born
You'll watch them as they run
Oh its so far the other way my life has gone

I caught a ride into the city every chance I got
I wasn't sure there was a name for the life I sought
Now I'm a long way gone down the life I got
I don't know how I believed some of the things I thought

Rock me on the water
Sister will you soothe my fevered brow
Rock me on the water, maybe Ill remember
Maybe Ill remember how
Rock me on the water
The wind is with me now
So rock me on the water
Ill get down to the sea somehow

But you said "morocco" and you made me smile
And it hasn't been that easy for a long, long while
And looking back into your eyes I saw them really shine
Giving me a taste of something fine
Something fine

V. Frankl

"In camp too, a man might draw the attention of a comrade working next to him to a nice view of the setting sun shining through the tall trees of the Bavarian woods (as in the famous water color by Dürer), the same woods in which we had built an enormous, hidden munitions plant. One evening, when we were already resting on the floor of our hut, dead tired, soup bowls in hand, a fellow prisoner rushed in and asked us to run out to the assembly grounds and see the wonderful sunset. Standing outside we saw sinister clouds glowing in the west and the whole sky alive with clouds of ever-changing shapes and colors, from steel blue to blood red. The desolate grey mud huts provided a sharp contrast, while the puddles on the muddy ground reflected the glowing sky. Then, after minutes of moving silence, one prisoner said to another, 'How beautiful the world could be!'

Libertarian Democrat Point Of View: An Eccentricity

Thursday, May 7, 2009

A policy mistake made by some major central bank may bring inflation risks to the whole world

Friday, March 20, 2009

I cannot find any currency that I feel it is going to be a sound currency

A sale of Banamex, at prices mooted around $9-12bn, would have a significant impact on the currency.

Thursday, March 19, 2009

that it has the deepest and most sophisticated bond markets in the world (so there is somewhere to park capital reserves)

Sunday, February 15, 2009

This is looking ugly indeed, and that's before you consider that European banks are on average much more leveraged than their US counterparts.

Will Eastern Europe Trigger a Financial Meltdown?

Thursday, October 30, 2008

" The irony is that Japanese regulators were once hugely protective of retail investors"

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From "The Snowfall" by D. Justice

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V. Frankl

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