idea that fraud and reckless lending flourished because US financial markets were unable to honestly and efficiently intermediate

TO BE FILED: From Vox:

"Global imbalances and the crisis: A solution in search of a problem

Michael Dooley Peter Garber 21 March 2009

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This column argues that current account imbalances, easy US monetary policy, and financial innovation are not the causes to blame for the global crisis. It says that attacking Bretton Woods II as a major cause of the crisis is an attack on the world trading system and a sure way to metastasise the crisis in the global financial system into a crisis of the global economic system.

The current crisis is likely to be one of the most costly in our history, and the desire to reform the system so that it will not happen again is overwhelming. Our fear is that almost all this effort will be misdirected and unnecessarily costly. Three important misconceptions could lead to a disastrous reform agenda:

1. That the crisis was caused by current account imbalances, particularly by net flows of savings from emerging markets to the US.
2. That the crisis was caused by easy monetary policy in the US.
3. That the crisis was caused by financial innovation.

In our view, a far more plausible argument is that the crisis was caused by ineffective supervision and regulation of financial markets in the US and other industrial countries driven by ill-conceived policy choices. The important implication of the crisis itself is that for the next few years, at least, the misbehaviour that flourished in this environment will not be a problem, unless replicated under government pressure to restore the flow of credit to the uncreditworthy. If anything, excessive risk aversion and deleveraging will limit effective private financial intermediation. So the first precept for reform is that there is no hurry.

When markets recover, the key lesson is that the industrial countries need to focus on moral hazard, public and private, as the source of the problem and apply the prudential regulations they already have to financial entities that are too large to fail. It is not sensible to try to limit international trade and capital flows, to ask central banks to abandon inflation targeting, to stifle financial innovation, or to regulate entities such as hedge funds¹ that do not generate systemic risks.

International capital flows

One “lesson” that seems to be emerging is that international capital flows associated with current account imbalances were a cause of the crisis and therefore must be eliminated or at least greatly reduced.² The idea that fraud and reckless lending flourished because US financial markets were unable to honestly and efficiently intermediate a net flow of foreign savings equal to about 5% of GDP, while having no problem with intermediating much larger flows of domestic savings, is astonishing to us. If so, would not the much larger gross capital flows into and out of the US also cause an outbreak of bad behaviour even without a net imbalance? If this were true, we would have to stop all capital flows, not just net imbalances. In the US context, we are unable to think of any plausible model for such behaviour.

If capital inflows did not directly cause the crisis perhaps they did so indirectly by depressing real interest rates in the US and other industrial countries. We have emphasised that capital inflows to the US from emerging markets associated with managed exchange rates caused persistently low long-term real interest rates in both the US and generally throughout the industrial world (Dooley, Folkerts-Landau and Garber 2004, 2009). Low real interest rates in turn drove asset prices up, particularly for long-duration assets such as equity and real estate.³ At the same time, low real interest rates temporarily reduced credit risks and a stable economic environment generated a marked decline in volatility of asset prices.

We have not argued that a “savings glut” in emerging markets is the fundamental driving force behind these capital flows. We have argued that the decisions of governments of emerging markets to place an unusually large share of domestic savings in US assets depressed real interest rates in the US and elsewhere in financial markets closely integrated with the US. These official capital flows are not offset, but reinforced, by private capital flows because managed exchange rate pegs are credible for China and other Asian emerging markets.

Low risk-free real interest rates that were expected to persist for a long time, in the absence of a downturn, generated equilibrium asset prices that appeared high by historical standards. These equilibrium prices looked like bubbles to those who expected real interest rates and asset prices to return to historical norms in the near future.

Along with our critics, we recognised that if we were wrong about the durability of the Bretton Woods II system and the associated durability of low real interest rates, the decline in asset prices would be spectacular and very negative for financial stability and economic activity. The hard landing predicted for Bretton Woods II was not to be caused by low real interest rates per se but by the sudden end to low interest rates as unsustainable capital inflows to the US were reversed. This is not the crisis that actually hit the global system.

But the idea that an excessive compression of spreads and increased leverage were directly caused by low real interest rates seems to us entirely without foundation.⁴ The alternative hypothesis is that an effective deregulation of US markets driven by government-dictated social policy, especially in mortgage origination and packaging, allowed the ever-present incentive to exploit moral hazard to flourish.⁵ This could just as well have happened with stable or rising real interest rates, as it did, for example, during the lead up to the US S&L crisis in the 1980s, another government manufactured disaster. Falling real interest rates in themselves should make a financial system more stable and an economy more productive.

Imagine a global system with permanent 4% equilibrium real interest rates. Now imagine a system with permanent 2% real interest rates. Why is one obviously more prone to fraud and speculation than the other? The vague assumption seems to be that capital inflows were large and interest rates were low, and this encouraged “bad” behaviour.

The current conventional interpretation is that low interest rates and rising asset prices generated an environment in which reckless and even dishonest financial transactions flourished. One version of this story is that rising real estate prices led naïve investors to believe that prices would always rise so that households with little income or assets could always pay for a house with capital gains on that house. Moreover, households could borrow against these expected capital gains to maintain current consumption at artificially high levels. This pure bubble idea does not provide much guidance for reforming the international monetary system. Clearly we should enforce prudential regulations that discourage people from acting on such expectations. But do we really want to reform away anything that causes real interest rates to fall and asset prices to rise?

Easy money and financial innovation

There is no sensible economic model that suggests that monetary policy can depress or elevate real long-term interest rates. The Fed could in theory target nominal asset prices (for example equity prices), but it would then lose control over the CPI. Would Alan Greenspan’s critics have preferred a monetary contraction necessary to depress the CPI enough to allow the real value of equities to rise? The Fed could, and may still, inflate away the real value of financial assets but this requires inflation as conventionally measured. This may yet come, but it was not a part of the story in recent years, and it is still not expected by market participants.

Third in the roundup of usual suspects in the blame game is financial innovation. There is no doubt that innovation has dramatically altered the incentives of financial institutions and other market participants in recent years. Securitisation of mortgages, for example, clearly reduces the incentives for those that originate credits to carefully screen applications. But securitisation also reduced the cost of mortgage credit and increased the value of housing as collateral. Private equity facilitated the dismantling of inefficient corporate structures. Venture capital has directed capital to high-risk but high-reward activities. Before we give up these benefits we need to ask if it is possible to retain the advantages of these innovations without the costs associated with the current crisis.

The problem was not financial innovation but the failure of regulators to recognise that innovation generated new ways to exploit moral hazard. Even more, it was the wilful ignorance of policymakers in often overriding the instincts of regulators and financial institutions in order to implement a desired flow of funds to uncreditworthy borrowers.

Fraud is not a financial innovation. The unhappy fact is that any change in the financial environment can generate new ways to undertake dishonest and imprudent positions. The regulators in turn have to adapt their procedures for monitoring and discouraging such activities. If it is really the case that regulators cannot understand the risks associated with modern financial markets and instruments, then there is a strong case for trying to return to a simple and relatively inefficient system. But we do not believe the story that no one can understand these innovations. To the contrary, it seems clear to us that the bankers that used these innovations to exploit moral hazard knew very well what they were doing and why. The first-best response to this is to attract a few of the many quants who are now unemployed to help enforce the prudential regulations already on the books.

Conclusions

In this crisis, three macro-financial institutional arrangements remain to hold the financial system together. These are the dollar as the key reserve currency with US Treasury securities as the ultimate safe haven, the integrity of the euro, and the global monetary system as defined by the Bretton Woods II view. Attacking the latter as a major cause of the crisis and seeking its end is, at the end of the day, an attack on the basis of the international trading system. It is a sure way to metastasise the crisis in the global financial system further into a crisis of the global economic system.

References

Bernanke, Ben (2007) “Global Imbalances: Recent Developments and Prospects" speech delivered at Bundesbank Berlin September 11.
BIS 78^th Annual Report (2008).
Dooley, Michael P., David Folkerts-Landau and Peter M. Garber (2004) “The Revived Bretton Woods System,” International Journal of Finance and Economics, 9:307-313.
Dooley, Michael P., David Folkerts-Landau and Peter M. Garber (2009) “Bretton Woods II Still Defines the International Monetary System,” NBER Working Paper 14731 (February).
Dunaway, Steven, Global Imbalances and Financial Crisis, Council for Foreign Relations Press, March, 2009.
Economic Report of the President (2008)
Economist (2009) When a Flow Becomes a Flood,” January 22.
Paulson, Henry (2008) “Remarks by Secretary Henry M. Paulson, Jr., on the Financial Rescue Package and Economic Update,” U.S. Treasury press release, November 12.
Sester, Brad (2008) “Bretton Woods 2 and the Current Crisis: Any Link?", Council on Foreign Relations

Notes

1. Of course, a bank thinly disguised as a hedge fund should be regulated as a bank just as a hedge fund thinly disguised as a bank should be.
2. See Paulson (2008), Dunaway (2009).
3. This is arithmetic, not economics. A permanent fifty percent decline in the level of real interest rates, for example from 4% to 2%, is the same thing as a doubling of an infinite maturity financial asset’s price, provided that the payout from that asset is unchanged. For practical purposes, thirty years is good enough to about double prices.
4. This view has taken hold in central banks see Bernanke (2007), Hunt (2008), BIS (2008). In the financial press, see Sester (2008) and Economist (2009). It should be noted for the record that these claims are always raw assertions, without theoretical, empirical, or even logical basis.
5. The financial system problems in many other countries are independent of regulatory problems in the US. The banking collapses in Iceland, the UK, and Ireland were home grown. The loans of the European banking system to Eastern Europe and to emerging markets in general were independent of US financial system behavior.

policymakers have thrown the most aggressive fiscal and monetary stimuli and financial rescues ever seen at this crisis

TO BE NOTED: From the FT:

"This crisis is a moment, but is it a defining one?

By Martin Wolf

Published: May 19 2009 19:48 | Last updated: May 19 2009 19:48

Is the current crisis a watershed, with market-led globalisation, financial capitalism and western domination on the one side and protectionism, regulation and Asian predominance on the other? Or will historians judge it, instead, as an event caused by fools, signifying little? My own guess is that it will end up in between. It is neither a Great Depression, because the policy response has been so determined, nor capitalism’s 1989.

Let us examine what we know and do not know of its impact on the economy, finance, capitalism, the state, globalisation and geopolitics.

On the economy, we already know five important things. First, when the US catches pneumonia, everybody falls seriously ill. Second, this is the most severe economic crisis since the 1930s. Third, the crisis is global, with a particularly severe impact on countries that specialised in exports of manufactured goods or that relied on net imports of capital.

Fourth, policymakers have thrown the most aggressive fiscal and monetary stimuli and financial rescues ever seen at this crisis. Finally, this effort has brought some success: confidence is returning and the inventory cycle should bring relief. As Jean-Claude Trichet, president of the European Central Bank, remarked, the global economy is “around the inflection point”, by which he meant that the economy is now declining at a declining rate. ( NB DON )

We can also guess that the US will lead the recovery. The US is again the advanced world’s most Keynesian country. We can guess, too, that China, with its massive stimulus package, will be the most successful economy in the world.

Unfortunately, there are at least three big things we cannot know. How far will exceptional levels of indebtedness and falling net worth generate a sustained increase in the desired household savings of erstwhile high-spending consumers? How long can current fiscal deficits continue before markets demand higher compensation for risk? Can central banks engineer a non-inflationary exit from unconventional policies?

On finance, confidence is returning, with spreads between safe and risky assets declining to less abnormal levels and a (modest) recovery in markets. The US administration has given its banking system a certificate of reasonable health. But the balance sheets of the financial sector have exploded in recent decades and the solvency of debtors is impaired.

We can guess that finance will make a recovery in the years ahead. We can guess, too, that its glory days are behind it for decades, at least in the west. What we do not know is how far the “deleveraging” and consequent balance-sheet deflation in the economy will go. We also do not know how successfully the financial sector will see off attempts to impose a more effective regulatory regime. Politicians should have learnt from the need to rescue financial systems stuffed with institutions deemed too big and interconnected to fail. I fear that concentrated interests will overwhelm the general one.

What about the future of capitalism, on which the Financial Times has run its fascinating series? It will survive. The commitment of both China and India to a market economy has not altered, despite this crisis, although both will be more nervous about unfettered finance. People on the free- market side would insist the failure should be laid more at the door of regulators than of markets. There is great truth in this: banks are, after all, the most regulated of financial institutions. But this argument will fail politically. The willingness to trust the free play of market forces in finance has been damaged.

We can guess, therefore, that the age of a hegemonic model of the market economy is past. Countries will, as they have always done, adapt the market economy to their own traditions. But they will do so more confidently. As Mao Zedong might have said, “Let a thousand capitalist flowers bloom”. A world with many capitalisms will be tricky, but fun.

Less clear are the implications for globalisation. We know that the massive injection of government funds has partially “deglobalised” finance, at great cost to emerging countries. We know, too, that government intervention in industry has a strong nationalist tinge. We know, as well, that few political leaders are prepared to go out on a limb for free trade.

Most emerging countries will conclude that accumulating massive foreign currency reserves and limiting current account deficits is a sound strategy. This is likely to generate another round of destabilising global “imbalances”. This seems an inevitable result of a defective international monetary order. We do not know how well globalisation will survive all such stresses. I am hopeful, but not that confident.

The state, meanwhile, is back, but it is also looking ever more bankrupt. Ratios of public sector debt to gross domestic product seem likely to double in many advanced countries: the fiscal impact of a big financial crisis can, we have been reminded, be as costly as a large war. This, then, is a disaster that governments of slow-growing advanced economies cannot afford to see repeated in a generation. The legacy of the crisis will also limit fiscal largesse. The effort to consolidate public finances will dominate politics for years, perhaps decades. The state is back, therefore, but it will be the state as intrusive busybody, not big spender.

Last but not least, what does the crisis mean for the global political order? Here we know three important things. The first is that the belief that the west, however widely disliked by the rest, at least knew how to manage a sophisticated financial system has perished. The crisis has damaged the prestige of the US, in particular, pretty badly, although the tone of the new president has certainly helped. The second is that emerging countries and, above all, China are now central players, as was shown in the decision to have two seminal meetings of the Group of 20 leading nations at head of government level. They are now vital elements in global policymaking. The third is that efforts are being made to refurbish global governance, notably in the increased resources being given to the International Monetary Fund and discussion of changing country weights within it.

We can still only guess at how radical the changes in the global political order will turn out to be. The US is likely to emerge as the indispensable leader, shorn of the delusions of the “unipolar moment”. The relationship between the US and China will become more central, with India waiting in the wings. The relative economic weight and power of the Asian giants seems sure to rise. Europe, meanwhile, is not having a good crisis. Its economy and financial system have proved far more vulnerable than many expected. Yet how far a set of refurbished and rebalanced institutions for international co-operation will reflect the new realities is, as yet, unknown.

What then is the bottom line? My guess is that this crisis accelerated some trends and has proved others – particularly those in credit and debt – unsustainable. It has damaged the reputation of economics. It will leave a bitter legacy for the world. But it may still mark no historic watershed. To paraphrase what people said on the death of kings: “Capitalism is dead; long live capitalism.”

Write to martin.wolf@ft.com
More columns at www.ft.com/martinwolf"

the aggressive steps taken by the government have so far muted the impact of “deleveraging”

TO BE NOTED: From the NY Times:

"Economic Scene
As Job Losses Slow, a Recovery Could Move In

By DAVID LEONHARDT

Ben Bernanke sounded more optimistic on Tuesday than he has in a long time, and President Obama has talked about glimmers of hope. The stock market has risen 34 percent from its 2009 nadir.

On Friday morning, we will get the clearest sign yet of whether these glimmers are real. That’s when the Labor Department will release its monthly jobs report, the single most important economic indicator out there. As bad as the job market is, it no longer seems to be getting worse at an accelerating pace. In both February and March, the economy lost fewer than 670,000 jobs; in January, it had lost 741,000.

In past recessions, a slowdown in the rate of job loss has been a telling sign. A few months after that, the economy typically began growing again. The vicious cycle turned virtuous.

After a stretch of unrelenting bad news, dating to last year, the economic signals have been more mixed lately. In just the last week, data on home sales, manufacturing and the service sector have all been better than expected. This welcome news has caused many of us who are pessimistic about the economy’s near-term fortunes to reassess.

“At the moment,” says Joshua Shapiro, chief United States economist with MFR, a New York research firm, “those forecasting nearer-term recovery have the recent data on their side.”

There is still a strong case to be made that the economy won’t feel truly healthy anytime soon, not this year or perhaps even next.

The overhang from the 20-year bubble in stocks and then real estate won’t simply go away. As Mr. Shapiro says, “Wage and salary growth has evaporated, credit is very tight, home prices continue to decline, financial asset values have been decimated and household balance sheets are extremely stressed.”

But the difference between a bad economy and a depression is real. We’ve taken a few steps away from depression lately. If Friday’s jobs report shows more progress, it will suggest that Mr. Bernanke’s optimism is legitimate.

•

Wall Street has a notoriously bad forecasting record. It almost always predicts that the economy will grow by something like 3 percent a year, which happens to be correct most of the time. But when a forecast would most be useful — when the economy is turning — Wall Street doesn’t offer much guidance. Amazingly enough, Wall Street’s consensus forecast has failed to predict a single recession in the last 30 years.

A small firm in New York called the Economic Cycle Research Institute has a much better record. It was founded by Geoffrey Moore, an economist who helped invent the idea of leading indicators. He used historical patterns to predict the economy’s direction, and unlike most Wall Street forecasters, he wasn’t afraid to stand apart from the crowd. In 2006, while most forecasters were still talking about 3 percent growth, Mr. Moore’s protégés were issuing warnings (though they were still too optimistic).

Today, they think the economy is on the verge of turning. “We’re in the worst recession since World War II,” says Lakshman Achuthan, the managing director of the Economic Cycle Research Institute. “However, the days of this recession are limited.”

The main reason, he says, is the economy’s normal self-correcting mechanism. That mechanism, I realize, is somewhat counterintuitive. You often hear — and we in the news media often write — about the vicious cycle of job cuts, spending cuts and yet more job cuts. Eventually, though, the cycle always ends, and momentum reverses.

How? Prices fall by enough to tempt households to spend. Businesses cut their costs, become profitable again, and begin to expand. Spending begets more spending. This is what’s happening now, Mr. Achuthan argues. The stimulus plan is also making a difference, he says, and so are the government’s efforts to reduce the cost of borrowing.

Obama administration officials have been a bit more circumspect. They have said, as you would expect them to, that more disappointments are likely. But Lawrence Summers, the top economic adviser, has also been talking lately about the economy’s tendency to self-correct.

To replace worn-out vehicles and accommodate a growing population, Americans need to buy roughly 14 million vehicles a year, Mr. Summers says. Recently, they have been selling at an annual pace of only nine million. At some point, more people will have to start buying.

The Economic Cycle Research Institute’s data show that, in every previous downturn in the last 75 years, the economy has started to grow no more than four months after its pace of deterioration has unquestionably slowed. So that’s what the institute is forecasting: the Great Recession will most likely be over by Labor Day.

Friday’s jobs report, covering April, will support this case if, at the very least, it shows job losses of no more than 650,000 a month. The average forecast among economists is roughly 610,000. The Labor Department’s revisions to its February and March numbers will also be worth watching.

Still, even most optimists, including Mr. Achuthan, are not predicting a fabulous recovery. The forces weighing on the economy are too strong.

Stock prices, despite their dizzying fall, are only slightly below their historical average, relative to long-term earnings, which suggests that a true bull market is unlikely. Home prices still have some way to fall. Eventually, the government will need to bring down the budget deficit, and doing so will hold back economic growth.

Morgan Stanley’s economists put out a thoughtful report this week, pointing out that the aggressive steps taken by the government have so far muted the impact of “deleveraging” — the paying down of debt by households and Wall Street. But this debt repayment is still happening, and it will be a drag on growth for a long time. The debt and the severity of this recession also raise the risk that the recent signs will turn out to be a false dawn, much as the economy slipped back into a deep downturn in the mid-1930s.

And whenever the economy begins growing again, it won’t feel good for a while. Slowing job losses aren’t the same as job gains. The unemployment rate may continue to rise into 2010 — and not come down to a healthy level until even later.

As a point of reference, the recession of the early 1990s ended in March 1991, but Americans were still so dissatisfied that they removed George H. W. Bush from office a year and a half later.

So the situation is not as dark as it was a few months ago. Maybe Friday’s jobs report will bring more reason for hope. But the Great Recession, or at least its impact, still has a way to go.

E-mail: leonhardt@nytimes.com"

Their creditors would naturally believe they were lending to governments

TO BE NOTED: From the FT:

"Fixing bankrupt systems is just the beginning

By Martin Wolf

Published: April 28 2009 21:59 | Last updated: April 28 2009 21:59

Can we afford to fix our financial systems? The answer is yes. We cannot afford not to fix them. The big question is rather how best to do so. But fixing the financial system, while essential, is not enough.

The International Monetary Fund’s latest Global Financial Stability Report provides a cogent and sobering analysis of the state of the financial system. The staff have raised their estimates of the writedowns to close to $4,400bn (€3,368bn, £3,015bn). This is partly because the report includes estimates of writedowns on European and Japanese assets, at $1,193bn and $149bn, respectively, and on emerging markets assets held by banks in mature economies, at $340bn. It is also because writedowns on assets originating in the US have jumped to $2,712bn, from $1,405bn last October and a mere $945bn last April.

To put this in context, the writedowns estimated by the IMF are equal to 37 years of official development assistance at its 2008 level. Estimated writedowns on US and European assets, largely held by institutions located in these regions, also come to 13 per cent of the aggregate gross domestic product.

The IMF estimates the additional equity requirements of the banks as well. It starts from total reported writedowns up to the end of 2008, which come to $510bn in the US, $154bn in the eurozone and $110bn in the UK. The capital raised to the end of 2008 is, again, $391bn in the US, $243bn in the eurozone and $110bn in the UK. But the IMF estimates additional writedowns in 2009 and 2010 at $550bn in the US, $750bn in the eurozone and $200bn in the UK. Against this, it estimates net retained earnings at $300bn in the US, $600bn in the eurozone and $175bn in the UK.

The IMF points out that the ratio of total common equity to total assets – a measure investors burned by more sophisticated risk-adjusted ratios increasingly trust – was 3.7 per cent in the US at the end of 2008, but 2.5 per cent in the eurozone and 2.1 per cent in the UK. The IMF concludes that the extra equity needed to reduce leverage to 17 to 1 (or common equity to 6 per cent of total assets) would be $500bn in the US, $725bn in the eurozone and $250bn in the UK. For a 25 to 1 leverage, the required infusion would be $275bn in the US, $375bn in the eurozone and $125bn in the UK.

In current dire circumstances, the chances of raising such sums from markets are zero. Part of the reason is that they could still prove to be too little. After all, the IMF’s estimates of the potential writedowns on US assets alone have grown nearly three-fold in just one year. It would not be surprising if they rose again.

Yet these are not the only sums required. Governments have so far provided up to $8,900bn in financing for banks, via lending facilities, asset purchase schemes and guarantees. But this is less than a third of their financing needs. On the assumption that deposits grow in line with nominal GDP, the IMF estimates that the “refinancing gap” of the banks – the rollover of short-term wholesale funding, plus maturing long-term debt – will rise from $20,700bn in late 2008 to $25,600bn in late 2011, or a little over 60 per cent of their total assets (see chart below). This looks like a recipe for huge shrinkage in balance sheets. Moreover, even these sums ignore the disappearance of securitised lending via the so-called “shadow banking system”, which was particularly important in the US.

The IMF also provides new estimates of the ultimate fiscal costs of rescue efforts (see chart below). At the high end are the US and the UK, at 13 per cent and 9 per cent of GDP, respectively. Elsewhere, costs are far lower. These, happily, are affordable sums. Indeed, compared with the recession’s impact on public debt, they look quite manageable. True, costs are likely to end up higher. But the overwhelming likelihood remains that the fiscal costs of deep recessions are substantially greater than those of rescuing finance. Refusing to rescue financial systems because it looks too expensive is a classic case of being “penny wise, pound foolish”.

A better reason for refusing to bail out banks is its dire effect on incentives. The alternative must then be bankruptcy. Jeremy Bulow of Stanford University and Paul Klemperer of Oxford University have advanced a scheme that would do this neatly. Valuable banking functions of each institution would be split off into a new “bridge” bank, leaving liabilities (apart from deposits) in the old bank. Creditors left behind would be given equity in the new bank. Governments could “top up” some creditors beyond this level, without making all creditors whole, as now.

Respectable opinion assumes that it would be best to provide full bail-outs of creditors in systemically important institutions. The rationale for this is that it is the only way to eliminate further panic. The objection is not the fiscal cost. It is that a limited number of large, complex and “too-big-to-fail” institutions would then emerge. Their creditors would naturally believe they were lending to governments. This would be a recipe for yet bigger catastrophes in future years.

Yet imposing large losses on creditors is indeed risky. It would probably have to be done simultaneously everywhere. Only after it was obvious that surviving banks were sound would anybody be willing to lend to them without guarantees.

Even worse than this choice between grim alternatives is the fact that the path to recovery is likely to be slow, whichever is chosen. As the latest World Economic Outlook notes in an important chapter, recessions that follow financial crises are unusually severe. So, too, are globally synchronised recessions. But now we are living through a globally synchronised recession that coincides with a huge financial crisis that emanates from the core countries of the world economy, particularly the US. This is a recipe for a long recession and a weak recovery. Whatever is done about the financial system, “deleveraging” is the order of the day (see chart). The UK’s position in this looks dire. But that of the US looks quite bad, too, even compared with that of Japan in the 1990s.

For better or worse, the authorities have decided to bail out their financial systems with taxpayer money. Almost all the affected countries should be able to afford to do this, at least on the IMF’s numbers. So now, having made the fundamental decision to prevent bankruptcy, they must return their financial systems to health as swiftly as they possibly can.

Even so, that will prove to be a necessary, not a sufficient, condition for a return to robust economic health. The overhang of debt makes deleveraging inevitable. But it has hardly begun. Those who hope for a swift return to what they thought normal two years ago are deluded.

martin.wolf@ft.com

More columns at www.ft.com/martinwolf

Read and post comments at Martin Wolf’s blog"

The world economy cannot go back to where it was before the crisis, because that was demonstrably unsustainable

TO BE NOTED: From the FT:

"Why the ‘green shoots’ of recovery could yet wither

Published: April 21 2009 20:24 | Last updated: April 21 2009 20:24

Spring has arrived and policymakers see “green shoots”. Barack Obama’s economic adviser, Lawrence Summers, says the “sense of freefall” in the US economy should end in a few months. The president himself spies “glimmers of hope”. Ben Bernanke, chairman of the Federal Reserve, said last week “recently we have seen tentative signs that the sharp decline in economic activity may be slowing, for example, in data on home sales, homebuilding and consumer spending, including sales of new motor vehicles”.

Is the worst behind us? In a word, No. The rate of economic decline is decelerating. But it is too soon even to be sure of a turnround, let alone of a return to rapid growth. Yet more remote is elimination of excess capacity. Most remote of all is an end to deleveraging. Complacency is perilous. These are still early days.

As the Organisation for Economic Co-operation and Development noted in its recent Interim Economic Outlook, “the world economy is in the midst of its deepest and most synchronised recession in our lifetimes, caused by a global financial crisis and deepened by a collapse in world trade”. In the OECD area as a whole, output is forecast to contract by 4.3 per cent this year and 0.1 per cent in 2010, with unemployment rising to 9.9 per cent of the labour force next year. By the end of 2010, the “output gap” – a measure of excess capacity – is forecast to be 8 per cent, twice as large as in the recession of the early 1980s.

In the US, the rate of decline of manufactured output compares with that of the Great Depression. Japan’s output of manufactures has already fallen by almost as much as in the US during the 1930s (see chart). The disintegration of the financial system is, arguably, worse than it was then.

If the world experiences a “Great Recession”, rather than a Great Depression, the scale of policy support will be the explanation. Three of the world’s most important central banks – the Federal Reserve, the Bank of Japan and the Bank of England – have official rates close to zero and have adopted unconventional policies. The real OECD-wide fiscal deficit is forecast at 8.7 per cent of gross domestic product next year, with a structural deficit of 5.2 per cent. In the US, the corresponding figures are 11.9 and 8.2 per cent. Governments of wealthy countries have also put their healthy credit ratings at the disposal of their misbehaving financial systems in the most far-reaching socialisation of market risk in world history.

It would be impossible for such activism to have had no effect. We can indeed see partial normalisation of financial markets, with a marked reduction in spreads between riskier and less risky assets (see charts). The FTSE All-World index has jumped by 24 per cent and the S&P 500 by 23 per cent since March 9 2009. Purchasing managers’ indices are picking up (see chart). More broadly, the chances of a manufacturing turnround are high: big falls in demand generate inventory build-ups and collapses in output. The latter are sure to reverse. China’s growth is also rebounding.

We can say with some confidence that the financial system is stabilising and the rate of decline in demand is slowing. But this global recession is different from any other since the second world war. Its salient characteristic is uncertainty.

Consider obvious perils: given huge excess capacity, a risk of deflation remains, with potentially dire results for overindebted borrowers; given the rising unemployment and huge losses in wealth, indebted households in low-saving countries may raise their savings rates to exceptional levels; given the collapse in demand and profits, cutbacks in investment may be exceptionally prolonged and severe; given massive and persistent fiscal deficits and soaring debt, risk aversion may lead to higher interest rates on government borrowing; and given the flight from riskier borrowers, a number of emerging economies may find themselves in a vicious downward spiral of weakening capital inflow, falling output and reductions in the quality of assets.

In short, as Stephen King and Stuart Green of HSBC note in a recent report, the exceptional dynamics of this crisis suggest a healthy scepticism about the timing and speed of recovery. What is most disturbing, moreover, is the scale of the policy action required to halt this downward spiral. This raises the big question: how and when might the world return to normality, with sustainable fiscal positions, strongly positive short-term official interest rates and solvent financial systems? That Japan has failed to achieve this over 20 years is surely frightening.

What I find most disturbing of all is the reluctance to admit the nature of the challenge. In its policy advice, even the OECD seems to believe this is largely a financial crisis and one that may be overcome in quite short order. Even the latter looks ever more implausible: in its latest Global Financial Stability Report, the International Monetary Fund now estimates overall losses in the financial sector at $4,100bn (€3,200bn, £2,800bn). The next estimate will presumably be higher.

Above all, the financial crisis is itself a symptom of a balance-sheet disorder. That, in turn, is partly the consequence of structural current account imbalances. Thus, neither short-term macroeconomic stimulus nor restructuring of balance sheets of financial institutions will generate sustained and healthy global growth.

Consider the salient example of the US, on whose final demand so much has for so long depended. Total private sector debt rose from 112 per cent of GDP in 1976 to 295 per cent at the end of 2008. Financial sector debt alone jumped from 16 per cent to 121 per cent of GDP over this period. How much of a reduction in these measures of leverage occurred in the crisis year of 2008? None. On the contrary, leverage rose still further.

The danger is that a turnround, however shallow, will convince the world things are soon going to be the way they were before. They will not be. It will merely show that collapse does not last for ever once substantial stimulus is applied. The brutal truth is that the financial system is still far from healthy, the deleveraging of the private sectors of highly indebted countries has not begun, the needed rebalancing of global demand has barely even started and, for all these reasons, a return to sustained, private-sector-led growth probably remains a long way in the future.

The world economy cannot go back to where it was before the crisis, because that was demonstrably unsustainable. It is at the early stages of a long and painful deleveraging and restructuring. Fortunately, policymakers have eliminated the worst possible outcomes. But there is much more yet to be done before fragile shoots become healthy plants.

martin.wolf@ft.com

More columns at www.ft.com/wolf

Read and post comments at Martin Wolf’s blog

Copyright The Financial Times Limited 2009"

large liabilities are important to the extent that bank deleveraging implies a long drawn out curtailment of credit to emerging markets

TO BE NOTED: From Econbrowser:

"Stress

As the G-20 leaders meet in London, one graph should remind the representatives of these disparate countries of their shared interest in restoring the health of the financial systems of the developed countries.

Figure from Box 2 IMF.

What this graph shows is financial stress in the advanced economies leads to financial stress in the emerging markets.

The indices depicted were developed for individual countries and will be detailed in a chapter in the forthcoming* IMF World Economic Outlook (by Ravi Balakrishnan, Stephan Danninger, Selim Elekdag and Irina Tytell), to be released later in April. The advanced country financial stress indices (FSI) are a composite of banking sector, interbank spreads, term spreads (described in the October 2008 WEO, Chapter 4). Specifically:

• Banking sector: rolling 12-month covariance of the year-over-year percent change of a country’s banking sector equity index and its overall stock market index, divided by the rolling 12-month variance of the year-over-year percent change of the overall stock market index.
• TED spread: three-month LIBOR or commercial paper rate minus the government short term rate.
• Inverted term spread: government short term rate minus government long-term rate.

The emerging market FSI is constructed as a weighted average of the exchange market pressure index, sovereign spreads, the banking sector beta, stock returns, and time-varying stock return volatility.

The authors note that the pass through of financial stress from advanced countries to emerging markets is almost one-for-one. That being said:

there is significant cross-country variation. An empirical analysis of stress comovement shows that stronger financial (i.e., banking, portfolio, and FDI) linkages are associated with a higher stress pass-through from advanced to emerging economies. During the most recent crisis, bank lending linkages have been the main driver of stress transmission.

This characterization is obtained via a two-step procedure, as in Forbes and Chinn (2004). In the first step, the coefficient relating emerging market stress to advanced is obtained. These coefficients are then treated as data, in a regression on determinants such as FDI and banking linkages.

Another way of seeing the importance of, for instance, bank linkages is by inspecting the emerging market liabilities to advanced country banks:

Figure from Box 2 IMF.

In my view, large liabilities are important to the extent that bank deleveraging implies a long drawn out curtailment of credit to emerging markets. The IMF analysis observes:

Evidence from past episodes of systemic banking stress in advanced economies (Latin American debt crisis of the early 1980s and the Japanese banking crisis of the 1990s) implies that the decline in capital flows may be sizeable and drawn out. Given their large exposure, emerging European economies might be heavily affected, although EU membership offers some protection.

The complete analysis will come out in the next WEO.

* Full Disclosure: I was a consultant on this forthcoming chapter.

Posted by Menzie Chinn at March 31, 2009 09:24 PM"

I think that the Fed is very capable of taking back the added liquidity

TO BE NOTED: From News N Economics:

"Some random thoughts on inflation (deflation)

Wednesday, April 1, 2009

I was in Mexico for one week and the only news-related materials I had were two March issues of the Economist; and fortunately, this is poolside reading for me. Anyway, the March 19th edition had a nice article about quantitative easing and the associated inflation angst and featured this chart to the left. The article inspired me to think a little more about why the Fed is taking such extreme balance sheet risk: inflation.

Recently, the Federal Open Market Committee shocked markets by announcing its intent to buy Treasuries in excess of the nominal 0.25% federal funds target, and to increase the MBS and agency coupon purchases by $850 billion. In spite of a 0.2% annual inflation rate in February, recent Fed policies like these have sparked fears of inflation, even hyperinflation. From the Economist:

On March 18th America’s inflation rate was reported at 0.2%, year on year, in February. The same day the Fed said “inflation could persist for a time” at uncomfortably low levels. Yet some economists and investors insist high inflation, even hyperinflation, is lurking in the wings. They have two sources of concern. The first is motive: the world is deleveraging, ie, trying to reduce the ratio of its debts to income. Policymakers might secretly prefer to do that through higher inflation, which lifts nominal incomes, than through the painful processes of cutting spending and retiring debt, or default. The second is captured by the Fed’s announcement that it plans to purchase $300 billion in Treasury bonds and an additional $850 billion of mortgage-related debt, bringing such purchases to $1.75 trillion in total, all paid for by printing money. The Fed is doing what it is doing - quantitative easing - in an attempt to restore functionality to credit markets and to accommodate a low and falling money multiplier in order to secure price stability. Banks are hoarding funds (excess reserve balances one year ago were $1.8 billion and $771.2 billion now), which has been exacerbated by the Fed's paying interest on reserves, but nevertheless, reserves are surging. The result has been a collapse in the money multiplier, which disrupts the process by which the Fed's monetary policy measures (adding base to the system) are turned into money.

The chart above shows that the money multiplier has stabilized, but rests at very low levels. This is the bear faced by the Fed, and the primary reason for its extreme measures of late.

But contemporaneously, inflation expectations have taken a likewise turn for the worse. As falling inflation expectations become embedded into current behaviors (buying decisions or interest rate setting), the macroeconomy suffers. When oil was peaking in July of last year, the Fed watched inflation expectations closely for signs of pressure. And now, the Fed is watching those same expectations on the way down.

The chart illustrates market inflation expectations for each year over the next 10 years, as measured by the nominal 10-yr Treasury minus its inflation protected counterpart (TIPS). Admittedly, inflation expectations have improved significantly from their 0.04% low in November 2008 to 1.34% at the end of March. However, the market still expects just 1.34% annual inflation over the next 10 years, which is far below the Fed's new quasi inflation target of 1.7%-2.0%, and obviously a big concern.

This is why the Fed and central banks around the world are building up their balance sheets: inflation (deflation) risk. In the U.S. and according to the Taylor Rule, a nominal interest rate target based on current inflation, inflation expectations, and the output gap, the Fed should cut the federal funds target, the Fed's short-term interest rate to induce monetary stimulus, to -8%. Since that is impossible (a zero lower bound), the Fed is doing everything it can to support price stability.

I think that the Fed is very capable of taking back the added liquidity; and furthermore, I presume that the paying interest on reserve balances is part of the Fed's exit strategy. However, we will know in a year or two if the Fed gets it right. But know this: a $2 trillion balance sheet is just the beginning.

Rebecca Wilder"

"Leverage" -- borrowing -- helped create this mess. Now it's expected to get us out.

TO BE NOTED: From Real Clear Markets:

"Uncle Sam's Massive Hedge Fund By Robert Samuelson

Call it Uncle Sam's hedge fund. The rescue of the American financial system proposed by Treasury Secretary Timothy Geithner is, in all but name, a gigantic hedge fund. The government would lend vast sums to private investors to enable them to buy loss-ridden assets at discounts from banks with the prospect of making sizable profits. If that's not a hedge fund, what would be? The hope is that the $14 trillion U.S. banking system would expand lending if it could get rid of many of the lousy securities and loans already on its books.

Almost everyone thinks that a healthier banking system is necessary for a sustained economic recovery. Can the Geithner plan work? Maybe, though obstacles abound. One is political. Private investors may balk at participating because they fear populist wrath. If the plan succeeds, many wealthy people will become even wealthier. Congress could subject them (or their firms) to humiliating hearings or punitive taxes. Why bother? Another problem: Investors and banks may be unable to agree on prices at which assets would be bought.

But succeed or fail, Geithner's plan illuminates a fascinating irony. "Leverage" -- borrowing -- helped create this mess. Now it's expected to get us out. How can this be? It's not as crazy as it sounds. Start with the basics on how leverage affects investment returns.

Suppose you bought a stock or bond for $100 in cash. If the price rises to $110, you make 10 percent. Not bad. Now, assume that you borrowed $90 of the purchase price at a 5 percent interest rate. Over a year, the stock or bond still increases to $110, but now you've made more than 50 percent. You pay $4.50 in interest and pocket a $5.50 gain on your $10 investment. Note, however, that if the price fell to $95, you'd be virtually wiped out ($4.50 in interest paid plus $5 lost on the security).

Economist John Geanakoplos of Yale University argues that the economy regularly experiences "leverage cycles." When credit is easy, down payment terms are loose. Investors or homeowners can borrow much of the purchase price of houses and securities. Prices of assets (stocks, bonds, real estate) rise, often to artificial levels because investment returns are so attractive. But when credit tightens -- government policy shifts or lenders get nervous -- the process reverses. Prices crash. Leveraged investors sell to repay loans. New borrowers face stiff down payment terms.

To Geanakoplos, we're suffering the harshest leverage cycle since World War II. Three years ago, he says, homebuyers could put down 5 percent or less. Now they've got to advance 20 percent or more. Hedge funds, private equity funds and investment banks could often borrow 90 percent of security purchases; now borrowing can be 10 percent or less. "Deleveraging" has caused prices to plunge to lows that may be as unrealistic as previous highs.

Grasping this, you can understand the idea behind Geithner's hedge fund. It is to inject more leverage into the economy -- not to previous giddy levels but enough to reverse the panic-driven price collapse. Details remain unsettled, but the plan would allow 6-1 leverage ratios in some cases. Here's an example. Private investors put up $5; the Treasury matches that with another $5. This equity investment could then be expanded by $60 of government-guaranteed loans. The entire $70 could be used to buy assets from banks.

Sounds simple. In practice, it won't be. Given all the deleveraging -- a record 15 percent of hedge funds closed last year -- the market prices of many securities have been driven well below prices that seem justified by long-term cash flows. Geanakoplos mentions one mortgage bond whose market value has dropped by roughly 40 percent even though all promised payments have been made and, based on the performance of the underlying mortgage borrowers, seem likely to continue.

If banks sold this and similar credits at today's market prices, they would have to record huge losses. ("Banks Face Big Writedowns in Toxic Asset Plan," headlined the Financial Times.) Their capital would be depleted, and they'd have to raise more or request more from the government. Presumably, the government-supplied leverage would enable investors to pay higher prices. After all, that's the purpose. Still, whether sellers and buyers ultimately agree on prices is unclear.

If they can't, Geithner's hedge fund will remain puny. Cautious banks will continue to constrict credit. But success also poses problems. Money managers talk about making huge annual returns of 20 percent or more from a scheme in which government puts up most of the funds and takes most of the risk. A political backlash might squash the project before it starts. Geithner treads a narrow line between financial paralysis and populist resentment.

Page Printed from: http://www.realclearmarkets.com/articles/2009/03/uncle_sams_massive_hedge_fund.html at March 30, 2009 - 08:34:31 AM CDT "

But the same question will be asked even after nationalization: What will happen to the pile of bad stuff?

TO BE NOTED: From Barron's Online: Via Credit Writedowns:

"Recession? No, It's a D-process, and It Will Be Long

Ray Dalio, Chief Investment Officer, Bridgewater Associates

By SANDRA WARD
AN INTERVIEW WITH RAY DALIO: This pro sees a long and painful depression.

NOBODY WAS BETTER PREPARED FOR THE GLOBAL market crash than clients of Ray Dalio's Bridgewater Associates and subscribers to its Daily Observations. Dalio, the chief investment officer and all-around guiding light of the global money-management company he founded more than 30 years ago, began sounding alarms in Barron's in the spring of 2007 about the dangers of excessive financial leverage. He counts among his clients world governments and central banks, as well as pension funds and endowments.

Matthew Furman for Barron's

"The regulators have to decide how banks will operate. That means they are going to have to nationalize some in some form." -- Ray Dalio

No wonder. The Westport, Conn.-based firm, whose analyses of world markets focus on credit and currencies, has produced long-term annual returns, net of fees, averaging 15%. In the turmoil of 2008, Bridgewater's Pure Alpha 1 fund gained 8.7% net of fees and Pure Alpha 2 delivered 9.4%.

Here's what's on his mind now.

Barron's: I can't think of anyone who was earlier in describing the deleveraging and deflationary process that has been happening around the world.

Dalio: Let's call it a "D-process," which is different than a recession, and the only reason that people really don't understand this process is because it happens rarely. Everybody should, at this point, try to understand the depression process by reading about the Great Depression or the Latin American debt crisis or the Japanese experience so that it becomes part of their frame of reference. Most people didn't live through any of those experiences, and what they have gotten used to is the recession dynamic, and so they are quick to presume the recession dynamic. It is very clear to me that we are in a D-process.

Why are you hesitant to emphasize either the words depression or deflation? Why call it a D-process?

Both of those words have connotations associated with them that can confuse the fact that it is a process that people should try to understand.

You can describe a recession as an economic retraction which occurs when the Federal Reserve tightens monetary policy normally to fight inflation. The cycle continues until the economy weakens enough to bring down the inflation rate, at which time the Federal Reserve eases monetary policy and produces an expansion. We can make it more complicated, but that is a basic simple description of what recessions are and what we have experienced through the post-World War II period. What you also need is a comparable understanding of what a D-process is and why it is different.

You have made the point that only by understanding the process can you combat the problem. Are you confident that we are doing what's essential to combat deflation and a depression?

The D-process is a disease of sorts that is going to run its course.

When I first started seeing the D-process and describing it, it was before it actually started to play out this way. But now you can ask yourself, OK, when was the last time bank stocks went down so much? When was the last time the balance sheet of the Federal Reserve, or any central bank, exploded like it has? When was the last time interest rates went to zero, essentially, making monetary policy as we know it ineffective? When was the last time we had deflation?

The answers to those questions all point to times other than the U.S. post-World War II experience. This was the dynamic that occurred in Japan in the '90s, that occurred in Latin America in the '80s, and that occurred in the Great Depression in the '30s.

Basically what happens is that after a period of time, economies go through a long-term debt cycle -- a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren't adequate to service the debt. The incomes aren't adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring. General Motors is a metaphor for the United States.

As goes GM, so goes the nation?

The process of bankruptcy or restructuring is necessary to its viability. One way or another, General Motors has to be restructured so that it is a self-sustaining, economically viable entity that people want to lend to again.

This has happened in Latin America regularly. Emerging countries default, and then restructure. It is an essential process to get them economically healthy.

We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes -- the cash flows that are being produced to service them -- or we are going to have to raise incomes by printing a lot of money.

It isn't complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue.

Isn't the process of restructuring under way in households and at corporations?

They are cutting costs to service the debt. But they haven't yet done much restructuring. Last year, 2008, was the year of price declines; 2009 and 2010 will be the years of bankruptcies and restructurings. Loans will be written down and assets will be sold. It will be a very difficult time. It is going to surprise a lot of people because many people figure it is bad but still expect, as in all past post-World War II periods, we will come out of it OK. A lot of difficult questions will be asked of policy makers. The government decision-making mechanism is going to be tested, because different people will have different points of view about what should be done.

What are you suggesting?

An example is the Federal Reserve, which has always been an autonomous institution with the freedom to act as it sees fit. Rep. Barney Frank [a Massachusetts Democrat and chairman of the House Financial Services Committee] is talking about examining the authority of the Federal Reserve, and that raises the specter of the government and Congress trying to run the Federal Reserve. Everybody will be second-guessing everybody else.

So where do things stand in the process of restructuring?

What the Federal Reserve has done and what the Treasury has done, by and large, is to take an existing debt and say they will own it or lend against it. But they haven't said they are going to write down the debt and cut debt payments each month. There has been little in the way of debt relief yet. Very, very few actual mortgages have been restructured. Very little corporate debt has been restructured.

The Federal Reserve, in particular, has done a number of successful things. The Federal Reserve went out and bought or lent against a lot of the debt. That has had the effect of reducing the risk of that debt defaulting, so that is good in a sense. And because the risk of default has gone down, it has forced the interest rate on the debt to go down, and that is good, too.

However, the reason it hasn't actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth. There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece -- banks and investment banks and whatever is left of the financial sector -- that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.

Is a restructuring of the banks a starting point?

If you think that restructuring the banks is going to get lending going again and you don't restructure the other pieces -- the mortgage piece, the corporate piece, the real-estate piece -- you are wrong, because they need financially sound entities to lend to, and that won't happen until there are restructurings.

On the issue of the banks, ultimately we need banks because to produce credit we have to have banks. A lot of the banks aren't going to have money, and yet we can't just let them go to nothing; we have got to do something.

But the future of banking is going to be very, very different. The regulators have to decide how banks will operate. That means they will have to nationalize some in some form, but they are going to also have to decide who they protect: the bondholders or the depositors?

Nationalization is the most likely outcome?

There will be substantial nationalization of banks. It is going on now and it will continue. But the same question will be asked even after nationalization: What will happen to the pile of bad stuff?

Let's say we are going to end up with the good-bank/bad-bank concept. The government is going to put a lot of money in -- say $100 billion -- and going to get all the garbage at a leverage of, let's say, 10 to 1. They will have a trillion dollars, but a trillion dollars' worth of garbage. They still aren't marking it down. Does this give you comfort?

Then we have the remaining banks, many of which will be broke. The government will have to recapitalize them. The government will try to seek private money to go in with them, but I don't think they are going to come up with a lot of private money, not nearly the amount needed.

To the extent we are going to have nationalized banks, we will still have the question of how those banks behave. Does Congress say what they should do? Does Congress demand they lend to bad borrowers? There is a reason they aren't lending. So whose money is it, and who is protecting that money?

The biggest issue is that if you look at the borrowers, you don't want to lend to them. The basic problem is that the borrowers had too much debt when their incomes were higher and their asset values were higher. Now net worths have gone down.

Let me give you an example. Roughly speaking, most of commercial real estate and a good deal of private equity was bought on leverage of 3-to-1. Most of it is down by more than one-third, so therefore they have negative net worth. Most of them couldn't service their debt when the cash flows were up, and now the cash flows are a lot lower. If you shouldn't have lent to them before, how can you possibly lend to them now?

I guess I'm thinking of the examples of people and businesses with solid credit records who can't get banks to lend to them.

Those examples exist, but they aren't, by and large, the big picture. There are too many nonviable entities. Big pieces of the economy have to become somehow more viable. This isn't primarily about a lack of liquidity. There are certainly elements of that, but this is basically a structural issue. The '30s were very similar to this.

By the way, in the bear market from 1929 to the bottom, stocks declined 89%, with six rallies of returns of more than 20% -- and most of them produced renewed optimism. But what happened was that the economy continued to weaken with the debt problem. The Hoover administration had the equivalent of today's TARP [Troubled Asset Relief Program] in the Reconstruction Finance Corp. The stimulus program and tax cuts created more spending, and the budget deficit increased.

At the same time, countries around the world encountered a similar kind of thing. England went through then exactly what it is going through now. Just as now, countries couldn't get dollars because of the slowdown in exports, and there was a dollar shortage, as there is now. Efforts were directed at rekindling lending. But they did not rekindle lending. Eventually there were a lot of bankruptcies, which extinguished debt.

In the U.S., a Democratic administration replaced a Republican one and there was a major devaluation and reflation that marked the bottom of the Depression in March 1933.

Where is the U.S. and the rest of the world going to keep getting money to pay for these stimulus packages?

The Federal Reserve is going to have to print money. The deficits will be greater than the savings. So you will see the Federal Reserve buy long-term Treasury bonds, as it did in the Great Depression. We are in a position where that will eventually create a problem for currencies and drive assets to gold.

Are you a fan of gold?

Yes.

Have you always been?

No. Gold is horrible sometimes and great other times. But like any other asset class, everybody always should have a piece of it in their portfolio.

What about bonds? The conventional wisdom has it that bonds are the most overbought and most dangerous asset class right now.

Everything is timing. You print a lot of money, and then you have currency devaluation. The currency devaluation happens before bonds fall. Not much in the way of inflation is produced, because what you are doing actually is negating deflation. So, the first wave of currency depreciation will be very much like England in 1992, with its currency realignment, or the United States during the Great Depression, when they printed money and devalued the dollar a lot. Gold went up a whole lot and the bond market had a hiccup, and then long-term rates continued to decline because people still needed safety and liquidity. While the dollar is bad, it doesn't mean necessarily that the bond market is bad.

I can easily imagine at some point I'm going to hate bonds and want to be short bonds, but, for now, a portfolio that is a mixture of Treasury bonds and gold is going to be a very good portfolio, because I imagine gold could go up a whole lot and Treasury bonds won't go down a whole lot, at first.

Ideally, creditor countries that don't have dollar-debt problems are the place you want to be, like Japan. The Japanese economy will do horribly, too, but they don't have the problems that we have -- and they have surpluses. They can pull in their assets from abroad, which will support their currency, because they will want to become defensive. Other currencies will decline in relationship to the yen and in relationship to gold.

And China?

Now we have the delicate China question. That is a complicated, touchy question.

The reasons for China to hold dollar-denominated assets no longer exist, for the most part. However, the desire to have a weaker currency is everybody's desire in terms of stimulus. China recognizes that the exchange-rate peg is not as important as it was before, because the idea was to make its goods competitive in the world. Ultimately, they are going to have to go to a domestic-based economy. But they own too much in the way of dollar-denominated assets to get out, and it isn't clear exactly where they would go if they did get out. But they don't have to buy more. They are not going to continue to want to double down.

From the U.S. point of view, we want a devaluation. A devaluation gets your pricing in line. When there is a deflationary environment, you want your currency to go down. When you have a lot of foreign debt denominated in your currency, you want to create relief by having your currency go down. All major currency devaluations have triggered stock-market rallies throughout the world; one of the best ways to trigger a stock-market rally is to devalue your currency.

But there is a basic structural problem with China. Its per capita income is less than 10% of ours. We have to get our prices in line, and we are not going to do it by cutting our incomes to a level of Chinese incomes.

And they are not going to do it by having their per capita incomes coming in line with our per capita incomes. But they have to come closer together. The Chinese currency and assets are too cheap in dollar terms, so a devaluation of the dollar in relation to China's currency is likely, and will be an important step to our reflation and will make investments in China attractive.

You mentioned, too, that inflation is not as big a worry for you as it is for some. Could you elaborate?

A wave of currency devaluations and strong gold will serve to negate deflationary pressures, bringing inflation to a low, positive number rather than producing unacceptably high inflation -- and that will last for as far as I can see out, roughly about two years.

Given this outlook, what is your view on stocks?

Buying equities and taking on those risks in late 2009, or more likely 2010, will be a great move because equities will be much cheaper than now. It is going to be a buying opportunity of the century.

Thanks, Ray."

The question then is whether it is feasible to run a (nearly) capital-less financial system until panic subsides.

From the FT:

"A capital-less financial system

January 26, 2009

by FT

By Ricardo Caballero

World financial markets are being ravaged by uncertainty and fear. The prices of all forms of explicit and implicit financial insurance have skyrocketed and hence, by a basic identity, the prices of risky assets have plummeted or the corresponding markets have disappeared.

Nowhere is this scenario more problematic than in institutions with strict capital requirements, such as banks, insurance companies, and monolines. For them, fire sale asset prices quickly wipe out their capital and, simultaneously, destroy their option to raise new capital since equity values implode.

The conventional advice is for these institutions to deleverage and to raise capital. While this is sound advice when dealing with a single institution in trouble, I believe this is exactly the opposite of what we need at this juncture of a massive systemic crisis.

Forcing institutions to raise capital, be it private or public, at panic-driven fire sale prices threatens enormous dilutions to already shell-shocked shareholders, further exacerbating uncertainty and fuelling the downward spiral. This is self-defeating.

The question then is whether it is feasible to run a (nearly) capital-less financial system until panic subsides. If it is, then a solution to the financial crisis is in sight since it would free up trillions of dollars of hard to raise funds, covering more than even the most extreme estimate of losses.

I believe it is feasible to run such a system for a while, because, essentially, distressed financial institutions need (regulatory) capital for two basic purposes: To act as a buffer for negative shocks, and to reduce their risk-shifting incentives by exposing them to their losses.

However these two functions can be replaced, respectively, by the provision of a comprehensive public insurance, and by strict (and intrusive) government supervision while this insurance is in place.

A few days ago the UK announced a policy package that almost got it right, by pledging to insure banks’ balance sheets and other private liabilities.

Unfortunately, it backfired and caused a worldwide run on financials because it did not dissipate, and even exacerbated, the fear of forced capital raising (or nationalisation).

The events following Lehman’s demise should have taught us that this fear needs to be put to rest until we can return to normality. Financial institutions are too intertwined to predict with any precision the impact of diluting any significant stakeholder, and the markets are too fearful to feed them more uncertainty. Strong guarantees with strict supervision, and the commitment of no further capital injections at fire sale prices (directly or through convertible bonds) should go a long way in building a foundation for a sustained recovery.

With some dismay, I read that an enormous amount of time is being spent discussing what should be the price of the insurance and the first-loss threshold. It seems to me that given the extreme severity of the crisis and the asymmetries involved in failing in one or the other direction in each of these issues, the answers are rather obvious: The price of the insurance should be very low – say risk-neutral pricing plus 20 or 50 basis points of markup; and the first-loss threshold should be sufficiently low that no new capital will need to be raised in the short run if a loss arises.

The second intervention of Citi offers a micro-model of such an intervention, but it needs to be scaled up within each bank and massively across all banks and other key financial institutions. It also needs to be made much more attractive to all systemic financial institutions, even those that are not in deep distress.

What about the taxpayers? The best that can happen to all of us is that the financial crisis ends as soon as possible. This is the first priority, the rest can wait. If the transfer to the financial institutions ends up being too large for society’s taste, then it is always possible for the government to undo some of it through ex-post taxation of excessive earnings. Conversely, if the transfer is too low (the price of the insurance and the first-loss threshold too high), it may well be that we do not get another chance, at great cost not only to financial institutions but also to taxpayers.

Ricardo Caballero is head of the department of economics, the Ford international professor of economics and co-director of the World Economic Laboratory at Massachusetts Institute of Technology

Here's me:

“We have more capital so we don’t have to sell good assets in bad markets,”

From the FT, I actually understand what Liddy of AIG is saying:

http://www.ft.com/cms/s/0/86c1cf26-aefc-11dd-a4bf-000077b07658.html?nclick_check=1

“Mr Liddy said that with the new plan, the authorities wanted to avoid a repeat of the credit markets paralysis that followed the collapse of investment bank Lehman Brothers, which went bankrupt just before the first rescue of AIG.

“The collapse of Lehman caused the credit markets to freeze up. Had AIG gone, it would have been even more significant,” Mr Liddy said.

Mr Liddy pledged to press on with a wide-ranging programme of asset sales aimed at raising funds to repay the $100bn in capital injected by the government.

He said the extension of the duration of the main government loan from two to five years and the cutting of the loan’s value from $85bn to $60bn would ensure AIG did not have to dispose of businesses at fire-sale prices.

“We have more capital so we don’t have to sell good assets in bad markets,” he said. AIG has not announced a single major disposal so far, partly because potential buyers have not been able to get funding.”

How is this any different than what you are proposing? If we loan them the money or guarantee it, it comes to the same thing, doesn’t it?

What if the assets turn out to be worthless in the case of AIG? You would tax them afterward, assuming that they survive? What if they merge? How long would it take to get the money back? Are you going to change our system of government so that they can’t lobby away onerous conditions, as they already in fact have?

The financial stocks went down because of nationalization, but I doubt that Walmart fears nationalization. The uncertainty and guarantees are the key, but your plan doesn’t offer either. Plus, it asks the citizenry to accept getting rid of capital standards when many people are calling for them. Doesn’t that add to uncertainty? And leaving proven buffoons in charge? That adds to certainty.

The only certainty that I see is that the banking lobby is damned powerful. So powerful that, after causing a systemic crisis, we’re bending over backward to save them.

I hate to keep pushing a guy named Bagehot, but how are these terms you are proposing onerous? They sound like a gift from God for the banks and their shareholders. The uncertainty is about them, not simply the government.

Posted by: Don the libertarian Democrat | January 26th, 2009 at 10:52 pm | Report this comment Your comment is awaiting moderation."

After I'd written the damned thing, I read this:

"The FT Economists' Forum is a discussion among some of the world's top economists. As a general rule we accept comments from invited members only, but submissions from others will also be considered.

If you are a non-member submitting a comment, please include your relevant academic or financial background."

Yet another damned club that won't let me in!

"The bigger point, however, is not that the package needs to be larger, although it does."

Martin Wolf on the FT:

"Why Obama’s plan is still inadequate and incomplete

By Martin Wolf

Published: January 13 2009 18:28 | Last updated: January 13 2009 18:28

Last week, President-elect Barack Obama duly unveiled his American recovery and reinvestment plan. Its title was aptly chosen, for Mr Obama spoke, astonishingly, as if the policies of the rest of the world had no bearing on the fate of the US. He spoke, too, as if a large fiscal stimulus would be enough to restore prosperity. If that is what he believes, Mr Obama is in for a shock. The difficulties he confronts are much deeper and more global than that.

EDITOR’S CHOICE

Economists’ forum - Oct-01

Every week, 50 of the world’s most influential economists discuss Martin Wolf’s articles on FT.com

I have little doubt that his advisers are telling the president-elect just this. The points they are – or should be – pressing on him are these.

First, the Japanese policymakers who told everyone the US was in danger of falling into a prolonged period of economic weakness were right. To understand why this is true, you need to read a brilliant book by Richard Koo of the Nomura Research Institute*. In this, he explains how the combination of falling asset prices with high indebtedness forces the private sector to stop borrowing and pay down debt. The government then inevitably emerges as borrower and spender of last resort. Because the Japanese government knew this at least, the country suffered a prolonged recession rather than a slump.

It has long been argued that the US could not suffer like Japan. This is wrong. It is true the US has three advantages over Japan: the destruction of wealth in the collapse of the Japanese bubble was three times gross domestic product, while US losses will surely be far smaller; US non-financial companies do not appear grossly overindebted; and, despite efforts by opponents of marking assets to market, recognition of losses has come far sooner.

In other respects, however, the US is still more vulnerable than Japan, after its recent debt binge (see chart). The rest of the world’s economy was big and dynamic enough to sustain Japan’s exports, but the whole world is now in recession; moreover, the US is both a deficit and a debtor country( A SPENDER COUNTRY ). Mrs Watanabe trusts her government. How far does she trust Uncle Sam? How far, indeed, does Hu Jintao?( MORE THAN YOU THINK )

Any complacency about US recovery prospects is perilous. Moreover, the fact that the US has a structural current account deficit has bearing on the second point Mr Obama’s advisers must make. Fiscal stimulus is a necessary palliative for a debt-encumbered economy afflicted by falling asset prices. But the likely longevity and scale of the needed fiscal deficits are quite scary.

In last week’s column (“Choices made in 2009 will shape the globe’s destiny”, January 6) I argued that the debt-encumbered US private sector would now be forced to save (see chart). The excess of income over expenditure in the private sector might be, say, 6 per cent of GDP for a lengthy period. If the structural current account deficit remained 4 per cent of GDP, the overall fiscal deficit would need to be 10 per cent of GDP. Moreover, this would be the structural – or full employment – deficit.

The Congressional Budget Office forecasts that US output will be 7 per cent below potential over the next two years, on unchanged policies. If so, the actual deficit should now be much larger than the structural one. It is easy to see, therefore, why the critics argue that the Obama plan for an additional fiscal stimulus of 5 per cent of GDP over two years is too small, even though the CBO forecasts a baseline deficit of 8.3 per cent of GDP this year. It is also easy to understand why many object strongly to tax cuts, since the more likely cuts are to be saved the larger the package must be – and, in addition, taxes will clearly have to rise in the longer term.( TRUE )

The bigger point, however, is not that the package needs to be larger, although it does. It is that escaping from huge and prolonged deficits will be very hard. As long as the private sector seeks to reduce its debt and the current account is in structural deficit, the US must run big fiscal deficits if it is to sustain full employment.

That leads to the third point Mr Obama’s advisers must make. This is that running huge fiscal deficits for years is indeed possible. But the US could get away with this only if default were out of the question.( ONLY FROM THE POINT OF VIEW OF THE US. THE SAVER COUNTRIES MIGHT CONSIDER IT. )

At the end of the Napoleonic wars, the UK had a ratio of public debt to GDP of 270 per cent. This was brought down over a century: growth, the gold standard and the commitment to balanced budgets did the trick (see chart). The question is how much debt the US (or UK) can accumulate now. My guess is that the US could hope to run large deficits for years if these were used to finance the creation of high-quality assets. But the policy could not safely endure throughout a two-term presidency.

Yet, contrary to widespread belief in the US, a swift return to small fiscal deficits, high employment and rapid growth will not occur spontaneously. It is necessary to make structural changes in the US and world economies first. This is the last point Mr Obama’s advisers must make.

What then are these changes?

First, there must be a credible programme( GIVE ONE AS AN EXAMPLE PLEASE ) for what Americans call “deleveraging”. The US cannot afford years of painful debt reduction in the private sector – a process that has still barely begun. The alternative is forced writedowns of bad assets in the financial sector and either more fiscal recapitalisation or debt-for-equity swaps. It also means the mass bankruptcy of insolvent households and forced writedowns of mortgages.( I DON'T UNDERSTAND THIS. IT HAS TO BE PAINFUL BUT IT CAN'T BE PAINFUL. )

All this would also lead to big one-off increases in public debt( I THOUGHT WE HAVE TO LOWER DEBT ? ). But those increases would probably be much smaller than those generated by a decade of huge fiscal deficits. The aim is to have a slimmer and better-capitalised financial system and a healthier non-financial private-sector balance sheet, sooner rather than later. The troubled asset relief programme should be used for these purposes. It will need to be bigger( IT NEEDS TO BE SLIMMER BUT BIGGER ).

Second and most important, the structural current account deficit has to diminish. The US private sector is no longer in a position to run huge financial deficits as an offset to the demand-draining external deficits. The public sector can do so only for a few years. In the long run, the world economy must be sustainably and healthily rebalanced( WHY ? ). This is a huge challenge for international economic diplomacy. It is also an essential element of sound domestic policy( GOOD LUCK ).

Mr Obama must be fully persuaded of these last points. If the fiscal deficits are to fall sharply in the medium term, as they need to, the new president needs effective programmes for private sector deleveraging and global reform and adjustment. The fate of the US cannot be determined in isolation. What this should mean will be the subject of next week’s column.

*The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession (Wiley, 2008)

martin.wolf@ft.com"

I find this post puzzling. I'm not sure what he's recommending.