The results are an overwhelming rejection of the conservative, pro-business Independence Party

TO BE NOTED: From the WSJ:

"Associated Press

REYKJAVIK -- Iceland's leftist government was headed Saturday for a strong victory in the country's general election, according to preliminary results.

Early results showed that a left-wing coalition made up of the Social Democratic Alliance and the Left Green Movement has won 35 out of the 63 seats in parliament.

The two parties are part of a caretaker government that took office in February after public protests about Iceland's economic collapse toppled the previous conservative administration. The left-wing coalition is led by interim Prime Minister Johanna Sigurdardottir.

The results are an overwhelming rejection of the conservative, pro-business Independence Party, which headed a coalition government last fall when the banking system failed. For the first time in the party's 70 years history it is not the largest party in the parliament.

Sigurdardottir was in an upbeat mood at the election party.

"The nation is settling the score with the neoliberalism, with the Independence Party, who have been in power for much too long," she told supporters. "The people are calling for a change of ethics. That is why they have voted for us."

The results represent a strong victory for Iceland's pro-European Social Democratic Alliance. The Left Green Movement, which has traditionally opposed closer ties with the European Union, has performed slightly worse than expected, leaving the Social Democrats a chance to lead a parliament with a pro-European majority.

"It (the results) gives the Social Democrats a strong position and puts pressure on the Left Green Movement," said political analyst Egill Helgason.

The Social Democratic Alliance has won 22 seats in parliament with 33% of the votes counted, while the Left Green Movement has 13 seats with 19.9% of votes, early results show. The Independence Party has 15 seats with 22.5% of votes.

The centrist Progressive Party has nine seats with 12.8% of votes and the Citizens Movement has four seats with 8.2% of the vote. Around 38% of all votes have been counted so far.

The global financial crisis washed up hard on the shores of this volcanic island of 320,000 people. After racking up massive debts during years of laissez-faire economic regulation and rapid expansion, the country's three main banks collapsed within the space of a week in October.

The government sought a $10 billion International Monetary Fund-led bailout and the country's currency, the krona, has plummeted.

Unemployment and inflation have spiraled and the IMF has predicted that the economy will shrink by about 10% in 2009, which would be Iceland's biggest slump since it won full independence from Denmark in 1944.

Iceland's election commission announced the early results Saturday night shortly after polls closed around the country."

Protests against governments and banks have increased in some European countries as the global economy has deteriorated.

Proof of what I've been warning about with social dislocations and disruptions. From Reuters:

"Jan 22 (Reuters) - Protests against governments and banks have increased in some European countries as the global economy has deteriorated.

Here are details of some of the protests around Europe:

* ICELAND:

-- Police used teargas against anti-government protesters when a demonstration outside parliament turned violent on Thursday.

-- The parliament building has become the focus of anger against Prime Minister Geir Haarde's coalition government's handling of the financial crisis. Demonstrators have called for the prime minister and other senior officials to resign and his limousine was pelted with eggs by demonstrators on Wednesday.

* BULGARIA:

-- Hundreds of Bulgarians demanded economic and social reforms in the face of a global slowdown on Wednesday in a second week of anti-government protests.

-- Students, teachers, green activists, doctors and public servants took part in the rally in front of parliament in Sofia, calling on the Socialist-led government to take action or step down. Many shouted "Mafia" and "Resign".

-- Last week hundreds of protesters clashed with police, smashed windows and damaged cars in Sofia when a rally against corruption and slow reforms( NB ) in the face of the economic crisis turned into a riot.

* GREECE:

-- High youth unemployment( NB ) was a main driver for unrest in Greece, initially sparked by the police shooting of a youth in an Athens suburb. General unemployment runs just above the EU average at 7.4 percent but the figure is 21.2 percent for the 15-24 age group and 10.5 percent for those aged 25-34. The protest forced a government reshuffle.

* LATVIA:

-- Last week, a 10,000-strong protest in Latvia descended into a riot, some protesters trying to storm parliament before going on the rampage. Government steps to cut wages( NB ), as part of an austerity plan( NB ) to win international aid, have angered people.

* LITHUANIA:

-- Police fired teargas last week to disperse demonstrators who pelted parliament with stones in protest at government cuts in social spending( NB ) to offset an economic slowdown. Police said 80 people were detained and 20 injured during the violence.

-- Prime Minister Andrius Kubilius, who was only sworn in in December, said the violence would not stop an austerity plan( NB ) launched after a slide in output and revenues."

These governments are not facing protesters who want less government. Dream on. To the extent that governments seem incompetent, indifferent, and corrupt, there are very real chances of major social disruptions and dislocations. Anybody not taking this problem seriously is making a major mistake.

" The trio of Bernanke, Geithner and Summers are likely to produce a veritable moral hazard monsoon.'

Buiter in the FT:

"Can the UK government stop the UK banking system going down the snyrting without risking a sovereign debt crisis?

January 20, 2009

From Reykjavik

Late last night I returned from a four-day visit to Iceland with Professor Anne Sibert, co-author of a report anticipating the collapse of the Icelandic banking system and joint carer for our cats and children.

Iceland’s largest three banks with border-crossing activities collapsed last fall, as did its currency. The three banks are in administration and new state-owned banks with a purely domestic focus have been set up. Strict capital controls make external borrowing all but impossible and discourage foreign investment. The country now has an IMF program. Strangely enough, the program does not impose any fiscal pain until 2010. This year the fiscal automatic stabilisers are allowed to work freely, although no further discretionary expansionary fiscal measures are being proposed. Starting in 2010, under the program, discretionary fiscal tightening of more than eight percent of GDP is envisaged between now and 2013. That number could be higher if the external indebtedness of the state turns out to be higher than the 110 percent of annual GDP estimate of the IMF.

The true state of the gross and net external indebtedness, including contingent off-balance sheet exposure, of the Icelandic state is a mystery even now( HOW CAN THAT BE? ). In addition to sovereign debt and sovereign-guaranteed debt, there are credit lines and possibly other contingent external liabilities whose take-up has to be estimated/guessed to get an accurate view of the state’s external obligations. It is possible that the IMF figures include an offset against the sovereign’s external liabilities in the form of an estimate of the recovery value of some of the external assets of the sovereign (e.g. its share in the assets of the UK subsidiaries of Kaupthing and Landsbanki). Assigning any positive value to these assets is an act of faith( YIKES ). In any case, it would be helpful to have the hard external liabilities and the soft external assets reported separately.

Iceland’s government had to let the country’s three main banks go into administration because it did not have the fiscal capacity to bail out financial institutions with balance sheets amounting to six to seven hundred percent of annual GDP. Any attempt to commit further government resources to the rescue of the banking system would have precipitated a sovereign default.

With each day that passes, estimates of the recovery value of the assets of the three ‘bad banks’ melts away like snow in April. The decision not to guarantee the liabilities or the assets of the banks (other than retail deposits, including retail deposits with foreign branches for amounts up to €20,000) was the only wise thing the Icelandic authorities have done in this whole sorry mess. It isn’t even clear that the Icelandic authorities came up with this sensible idea themselves. More likely the IMF opened their eyes. The creditors of the banks, which include Commerzbank and Bayerische Landesbank will have to explain to their own shareholders and tax payers why they now effectively own large chunks of three defunct Icelandic banks.

…to London

Returning to London from Reykjavik last night was like coming home from home. Allowing for the differences in the scale of the Icelandic economy and the British economy (the UK population is more than 200 times larger than Iceland’s Coventry-sized population), there are disturbing economic parallels. The excesses in Iceland during the past decade were greater than in the UK, but not qualitatively different. In both countries, the regulation of banks was laughably lax( MORE LIKE COLLUSION ). The UK’s much-touted light-touch regulation turned out to be soft-touch regulation. Relaxation of regulatory norms was consciously used by the British government as an instrument for attracting financial business to London, mainly from New York City. Fiscal policy in both countries became strongly pro-cyclical during the boom years preceding the financial crisis. Households were permitted, indeed encouraged, to accumulate excessive debt - around 170 percent of household disposable income in the UK, over 210 percent in Iceland.

Both countries permitted the real exchange rate of their currencies to become materially over-valued, more so in Iceland than in the UK, but still to a worrying extent even in the UK. The same version of the ‘Dutch disease’ - the crowding out of the non-financial internationally exposed sectors (exporting and import-competing) by the excessive growth of the financial sector and the construction industry - occurred in both countries, again to a greater extent in Iceland than in the UK, but to an highly undesirable extent even in the UK. Iceland’s gross and net external indebtedness are much greater than that of the UK, and its current account deficits during the years just prior to the crisis were much larger than those of the UK. But the UK too built up very large stocks of gross foreign assets and liabilities and ran persistent current account deficits.

Both countries pay the price for the hubris of policy makers who believed that they had engineered the end of boom and bust and replaced it with perpetual boom. The risks associated with asset market and credit booms and bubbles were dismissed (”how can you be sure it is a bubble? Do you know better than the market etc.”). In neither country have the responsible parties (the prime minister, the minister of finance, the governor of the central bank and the head of banking regulation and supervision) admitted any personal responsibility for the disaster. Instead we are told tales of a once-in-a-lifetime calamity, coming at us from abroad, that ruined a perfectly sensible and sustainable set of domestic policies, regulations, rules and arrangements. As if!

Both countries allowed the unbridled growth of banks that became too large to fail( THE REAL PROBLEM ). In the case of Iceland, the banks also became too large to rescue. In the UK, the jury is still out on the ‘too large to rescue’ issue, but I have serious and growing concerns. Incrementally, the British authorities have guaranteed or insured ever-growing shares of the balance sheets of the UK banks. And these balance sheets are massive. RBS, at the end of June 2008 had a balance sheet of just under two trillion pounds. The pro forma figure ws £1,730 bn, the statutory figure £1,948 (don’t ask). For reference, UK GDP is around £1,500 bn. Equity was £67 bn pro forma and £ 104bn statutory, respectively, giving leverage ratios of 25.8 (pro forma) and 18.7 (statutory), respectively.

With a 25 percent leverage ratio, a four percent decline in the value of your assets wipes out your equity. What were they thinking? The fact that Deutsche Bank used to have a leverage ratio of 40 and is now proud to have brought it down to just below 34 is really not a good excuse.

Lloyds-TSB Group (now part of the Lloyds Banking Group) reported a balance sheet as of June 30, 2008 of £ 368 bn and shareholders equity of £11 bn, giving a leverage ratio of just over 33. Of course, for all these banks, the risk-adjusted assets to capital ratios are much lower, but because the risk-weightings depend both on private information of the banks (including internal models) and on the rating agencies, they are, in my view, worth nothing - they are the answer from the banks to the question “how much capital do you want to hold?”. That the answer is “not very much, really”, should not come as a surprise. For the same date, HBOS, the other half of the new Lloyds Banking Group, reported assets of £681 bn and equity of £21 bn, giving a leverage ratio of just over 32; Barclays reported total assets of £1,366 bn and shareholders equity of £33bn giving a leverage ratio of 41, and HSBC (including subsidiaries) reported assets of £2,547 bn and equity of £134 bn for a leverage ratio of 19.

The total balance sheets of these banks about to around 440% of annual UK GDP. The government seems to be well on its way towards guaranteeing most if not all of it( THEY WILL HAVE TO ). No one outside the banks (and perhaps even no-one inside them) has a good sense of the true value of what they hold on and off their books.

There is a strong possibility that the UK banks are still hiding( FRAUD ) toxic or dodgy assets on and off their balance sheets, or are still valuing them at substantially more than their fair value. They are aided and abetted in this by the relaxation of fair value (mark-to-market) principles condoned by the International Accounting Standards Boards, when it permitted the reclassification of certain investments between the three categories of (1) ‘assets held for trading’ (which are valued at market prices and have these valuations reflected through the profit and loss account), (2) assets ‘available for sale’ (which are valued at market prices have these valuations reflected only in the balance sheet, not through the profit and loss account) and (3) ‘assets held for investment’ (which need not be valued at market prices). The new IASB rules are an invitation to management to hide capital losses or to delay their translation into the profit and loss account by strategic reclassification of the assets in question. It is truly scandalous that the IASB approved this ex-post reclassification of investments.( SO MUCH FOR MARK-TO-MARKET )

In the name of preventing a collapse of the UK banking system, we are witnessing the socialisation - at first gradual, but now quite rapid - of all balance sheet risk of the UK banks by the UK government. This is risky and, in my view, unwise( TRY NECESSARY ). The manner in which it is done also seems designed to maximise moral hazard( TRUE ). The good news is that it is unnecessary for restoring and maintaining the flow of new credit in the the British economy.

The state is stretching and testing its current and future fiscal resources both by guaranteeing or insuring ever-growing amounts of new and existing bank funding and bank assets, and through its assumption of private credit risk through such facilities as the £200 bn Special Liquidity Scheme (SLS), which swaps Treasury bills against securities backed by mortgages and other loans originated before 2008. The new £50 bn Asset Purchase Facility, through which the Bank of England will engage in qualitative easing (increasing the proportion of private and possibly illiquid securities in its portfolio) through outright purchases of private securities rather than by accepting them as collateral in repos and at the discount window, also raises sovereign credit risk, even though the Bank of England is required to purchase only “high-quality” assets. ABS backed by US subprime mortgages were considered high quality once.

In view of this progressive socialisation of the balance sheet risk of the UK banks, it is not surprising that there has been some convergence between the CDS rates of the UK sovereign and of the UK banks whose balance sheets are guaranteed or insured to an ever-growing extent by the UK sovereign. I expect this convergence to continue, with the CDS rates of the banks falling and that of the UK sovereign rising. A similar pattern of converging sovereign and banking sector credit risk premia can be observed in other countries. As the banks become more secure, the government becomes less secure( THAT'S THE TRADE OFF ).

The UK may not be the first EU member state to face a sovereign debt crisis. According to the rating agencies, the CDS rates and the 10-year sovereign spread over Bunds, the leading candidates for a sovereign solvency crisis are Greece, Spain, Portugal, Italy and Ireland. Some of these countries are in fiscal trouble not because of their sovereign’s exposure to the banking sector but for other reasons, such as a long-standing inability to reduce a very high public debt to GDP ratio, coupled with the prospect of large cyclical deficits as the economy goes into a deep recession. Greece and Italy fall into that category.

Among the countries where the sovereign is highly exposed to the banking sector, Ireland may well be the next country where the ‘too large to rescue’ theory may be tested, although countries like the Netherlands, Belgium, Luxembourg, the UK and, outside the EU, Switzerland, are also potential candidates for the ‘too big to rescue’ (without external support) club. Ireland’s outstanding sovereign debt is low as a share of GDP (around 25 percent) , but the exposure of the sovereign to its overgrown banking system is massive: the Irish state guaranteed the entire liability side of the banks’ balance sheets, except for the equity.

Irish 10-year sovereign debt spreads over Bunds stood at 198 basis points on January 16. We may get a test of Eurozone or even of EU fiscal solidarity before this crisis is over, as argued by Walter Munchau. I believe that this crisis will certainly deepen EU-wide fiscal cooperation between national governments. It may even provide the spur for the creation of an embryonic proper supranational EU fiscal authority with independent revenue raising and borrowing powers.

But even if the UK is not the next European country to face a sovereign debt challenge, there is a non-negligible risk that before too long, the growing exposure of the British sovereign to the banking system (and especially to the foreign currency funding risk faced by the UK banking system), together with the 9 and 10 percent of GDP general government fiscal deficits expected for the next couple of years, may prompt a loss of confidence by the global financial community in the British banks, currency and sovereign.

We may well witness the UK authorities going cap-in-hand to the IMF, the EU, the ECB and the fiscally super-solvent EU member states (if there are any left), prompted by a triple crisis (banking, sterling and sovereign debt), to request a bail out( ROUND AND ROUND IT GOES ). I hope and trust that the UK authorities are in regular contact with the IMF, the US administration, Brussels, Frankfurt and the leading EU member countries to prepare for a possible internationally coordinated bail-out operation for the British banking system and sovereign.

My belief that the UK government should take over all UK high street banks (on a temporary basis) is based on the simplification this would provide as regards the governance of these institutions under extreme circumstances, when private ownership and governance have clearly failed( TRUE ), and on its positive effect on incentives for future bank behaviour (’moral hazard( I AGREE )). When the public interest and the interests of the existing private shareholders and the incumbent managers and boards of directors diverge( THIS IS WHY A HYBRID WON'T WORK ) as manifestly as they do in this crisis, the sensible thing to do is to buy out the existing shareholders (as cheaply as possible). That way the failed and failing management and boards can be restructured (fired without golden parachutes) and the new owner can insist on and enforce an open, verifiable valuation of toxic and dodgy assets, on and off the balance sheet of the bank.( YES )

The non-state shareholders of the UK high street banks ought no longer to be a factor in the discussion of what to do. As of yesterday, their market capitalisations were (according to today’s Financial Times) as follows: Lloyds Banking Group £10.6 bn, Barclays £7.4 bn, RBS £4.6 bn and HSBC £60.8 bn. And these valuations reflect the implicit subsidies( YES ) granted the banks through their access to such state-owned and state-run facilities as the Special Liquidity Scheme, the government’s guarantee of new bank borrowing, deposit guarantees, and the mitfull of new insurance/guarantee schemes announced yesterday( YES. NOT ENOUGH. ).

The second major rescue package for UK banks in three months includes very large (and in at least one case potentially uncapped) packages of guarantees and insurance offered to the banks by the state on terms that are not clear. This is very much in the US tradition, promoted by the US Treasury, the Fed and the FDIC, of maximising moral hazard for a given amount of immediate crisis fire-fighting. In the incoming Obama administration, both Treasury Secretary Geithner and NEC Chair Summers have had many years of experience, in the US and all over the globe, throwing good money after bad in pointless bail-out packages( YES ). The trio of Bernanke, Geithner and Summers are likely to produce a veritable moral hazard monsoon( WELL PLAYED ).

The second installment of the UK bank rescue package provides unnecessary, undesirable and costly comfort for existing management and boards, for existing private shareholders and for existing creditors and bond holders of the banks. It is unnecessary because the same quantum of crisis-fighting solace can be provided with much smaller effects on the banks’ future incentives for excessive risk taking, by taking the banks into full public ownership and restricting government guarantees to new credit flows( YES ).

A modest proposal

So here is my proposal:

(1) Take into complete state ownership all UK high street banks. This has to be mandatory, even for the banks that still like to think of themselves as solvent.( YES )

(2) Fire the existing top management and boards, without golden or even leaden parachutes, except those hired/appointed since September 2007.( YES )

(3) Don’t issue any more guarantees( HERE I DISAGREE ) on or insurance for existing assets - regardless of whether they are toxic, dodgy or merely doubtful. Issue guarantees/insurance only on new lending, new securities issues etc. A simple rule: guarantee the new flows, not the old stocks. This will reduce the exposure of the government to credit risk without affecting the incentives for new lending.

(4) Transfer all toxic assets and dodgy assets from the balance sheets of the now state-owned banks (or from wherever they may have been parked by these banks) to a new ‘bad bank’. If possible, pay nothing( GOOD ) for these toxic and dodgy assets. Since the state owns both the high-street banks (I won’t call them ‘good’ banks) and the bad bank, the valuation does not matter. If the gratis transfer of the toxic or dodgy assets to the bad bank would violate laws, regulations or market norms, let an independent party organise open, competitive auctions for these assets - auctions in which the bad bank, funded by the government, would be one of the bidders. Whatever price is realised in these auctions is paid by the new bad bank to the old banks.( OK )

Capitalize the bad bank with the minimum amount of capital required to meet regulatory norms. Fund the rest of the assets through a loan from the state to the bad bank or through a bond issued by the bad bank and bought by the state.

As regards the bad bank, that’s effectively it. With toxic and dodgy securities on the asset side of its balance sheet and with the state owning all the equity and as the only creditor, the assets can either be sold off, if a market develops again, or held to maturity, earning whatever cash flows they may yield.

(5) As a special case of (4), take the high street banks into full public ownership and treat these existing banks in their entirety as bad banks. Close the existing banks for all new business. Transfer the deposits of the high street banks (now the bad banks) to new (state-owned) ‘good’ banks (or perhaps rather, not yet bad banks). Replace the deposits on the books of the bad banks with loans from the state to the bad banks or with bond issues by the bad banks purchased by the state. Let the new banks (New Lloyds, New RBS, New Barclays and New HSBC) acquire, in a competitive bidding process also open to other market participants, any of the assets of the old banks. Run the new banks as competing publicly owned, profit maximising banks until they can be privatised again, when a sensible regulatory regime for banks is in place and the market for bank shares recovers. Don’t guarantee or insure any items on the balance sheet of the old banks. Use guarantees/insurance exclusively for new lending and new investments by the new banks. Gradually run down the old banks as their assets mature, as under (4).( A GOOD PLAN )

The miracle of limited liability applies also when the state is the owner. As long as the state-owned bad banks (which could be merged into a single super bad bank) don’t obtain sovereign guarantees for their obligations( I SEE THIS AS KEEPING THE CALLING RUN GOING ), the financial exposure of the sovereign is limited to its equity stake and the existing guarantees and insurance it has provided in the past.

It is key that there be no further injections of funds by the state into the bad banks until there are no longer any private creditors. If a bad bank becomes balance-sheet insolvent or liquidity insolvent and it still has private creditors (as it would, in general, under the model of item (5)), the bad bank should be put into administration and its debt to parties other than the British state should be converted into equity. That equity would be then be purchased by the UK state. With the bad bank now not just 100 percent state-owned but also without private creditors of any kind, the assets can be managed as the state sees fit - one hopes in such as way as to maximise the present discounted value of their held-to-maturity cash flows.( OK )

The balance sheets of the British banks are too large and the quality of the assets they hold too uncertain/dodgy, for the British government to be able to continue its current policy of extending its guarantees to ever-growing shares of the banks’ liabilities and assets, without this impairing the solvency of the sovereign. Britain risks becoming a victim of the new inconsistent quartet: (1) a small open economy with (2) a large internationally exposed banking sector, (3) a currency that is not a serious global reserve currency and (4) limited fiscal capacity. It risks a triple crisis and a threefold run: on its banks, on its currency and on its sovereign debt.( BUT ISN'T IT IN A CALLING AND PROACTIVITY RUN ALREADY? )

Limiting the exposure of the sovereign to what is fiscally sustainable may imply giving up on saving (all of) the banks. If my proposal for institutionally and legally separating existing stocks of assets and liabilities from new flows of credit and lending is acted upon, the flow of new lending and the supply of new credit need not require the survival of all (or indeed any) banks hitherto deemed systemically important.

I look forward to the time when I will be blogging on the best way of privatising the banks again, under new regulatory and governance regimes."( ME TOO )

I still believe that gurantees are needed to end the Calling Run, and the Bad Bank idea is a little iffy to me. But this plan is worth a try.

"It is becoming easier and easier to find signs of trade tensions and potential for friction."

Now Pettis:

"The Ox approaches( WHOSE WILL GET GORED?) January 2nd, 2009 by Michael | Filed under Exports and imports, Trade protection.

It is becoming easier and easier to find signs of trade tensions and potential for friction( UNWINDING THE SAVER/SPENDER SYMBIOSIS WILL INEVITABLY CREATE BOTH ). On Tuesday’s post I already mentioned the fact that South Korea had shifted from deficits to surpluses, and that Vietnam had devalued the dong as a reaction to falling exports. Yesterday’s Financial Times has the kind of article I expect to see a lot more of in the coming months:

Western countries should close their markets to sales of Chinese trains because China’s domestic market is closing to outside suppliers, says the head of one of the world’s largest rolling stock builders. In a Financial Times interview, Philippe Mellier, chief executive of Paris-based Alstom Transport, also claimed that Chinese companies were offering trains for export using technology derived from western suppliers. Such technology is usually supplied on condition it not be used outside China. The comments by Mr Mellier, whose company is the world’s number two trainmaker, underline the growing tension in the world’s train-building industry over China’s role.

A recent Washington Post article listed a number of trade-related measures:

Only a few weeks after world leaders vowed at a Washington summit to reject trade protectionism and adhere to free-market principles( THEY HAVEN'T BEEN FROM THE BEGINNING ) as they combat the global financial crisis, a host of nations are already breaking that promise.

Moving to shield battered domestic manufacturers from foreign imports, Indonesia is slapping restrictions on at least 500 products this month, demanding special licenses and new fees on imports. Russia is hiking tariffs on imported cars, poultry and pork. France is launching a state fund to protect French companies from foreign takeovers. Officials in Argentina and Brazil are seeking to raise tariffs on products from imported wine and textiles to leather goods and peaches, according to the World Trade organization.

At the same time The Wall Street Journal had a related article with a conflicting message:

The U.S. current account deficit narrowed more than expected in the third quarter as a broad gain in exports outstripped the rise in imports. The current account deficit decreased to $174.1 billion during the July through September period, from a downwardly revised $180.9 billion in the second quarter, the Commerce Department said Wednesday. The second-quarter deficit was originally reported as $183.1 billion.

Obviously enough if the US current account deficit decline – about 90% of which is the trade in goods and services – other countries current account surpluses must also decline( THAT'S IT ). Continuing on that subject Brad Setser has a post( I JUST POSTED ON IT ) today in his blog on the subject:

China’s export sector hasn’t experienced a sharp cyclical downturn in a long time. In 2001 global trade did contract. But that contraction didn’t hit China all that hard. It came at a time when the electronics industry was migrating to China, allowing China to increase its share of a shrinking global market. Year-over-year export growth slowed from 25% at the peak of the .com boom in 2000 to 5% — but it didn’t turn negative. In dollar terms, the y/y increase in a rolling 12m sum of China’s exports went from $50b to $15-20b. But y/y exports never fell in dollar terms.

But China now is a much much bigger share of global trade. China’s 2008 exports — in dollar terms — will be more than five times large than its 2000 exports. That means that China is now far more exposed to the global economic cycle than it was. And this cycle looks brutal.

Korea is reporting its biggest drop in industrial production in twenty-one years. That is the kind of data point that gets my attention. I was a bit surprised to hear that the current fall is sharper than the fall that accompanied Korea’s own crisis in 97/98.

The whole Korean story has been an interesting one which I have been watching peripherally with great interest. The collapse in Korean export was a real warning signal for China because one of the few export areas for China that held up until recently had been sales of machinery and capital goods, but those have always been important areas for Korean exports and the very weak demand for Korean machinery boded ill for China.

There is not much else to report since today most things in China were closed, including the stock market. The last time I mentioned the stock market was on December 9, when the SSE Composite had traded up sharply the day before to close at 2091. Since then it has declined pretty steadily, with only five up days, to close yesterday at 1821, down 12.9% albeit on very thin volume. We are racing towards Chinese New Year and I suspect everyone is eager to put the Year of the Rat behind them. It is the first year in the cycle and is supposed to be a time of hard work and renewal. It ends in three weeks and will be followed by the Year of the Ox, which symbolizes prosperity through fortitude. We’ll see — fortitude will probably be necessary."

Since I found the use of Terrorism Laws to skewer Iceland so offensive, even as Gordon Brown was telling everyone not to beggar your neighbor, I'm going to say that the skewering of Iceland was an example to other countries that not beggaring your neighbor is a farce. After all, what do you call the current situation in Iceland?

"It was a largely unregulated system. And it was largely offshore, at least legally. "

Brad Setser:

"The collapse of financial globalization …

Posted on Monday, December 29th, 2008

By bsetser

The last six months — if not the last year — logged what felt like a decade’s worth of financial news. So perhaps it isn’t surprising that swings that normally would attract an enormous amount of attention have gone almost unnoticed. Like the near-total collapse of private capital flows.

Both private capital inflows to the US and private capital outflows from the US have fallen sharply. They have gone from a peak of around 15% of US GDP to around zero in a remarkably short period of time …( FEAR AND AVERSION TO RISK )

The fall in private flows over the last four quarters has been much sharper than the fall in the US current account deficit. The current account deficit continues to hover around $700 billion (5% of US GDP). Financial globalization — the growth in private cross-border flows, and associated rise in private inflows and private outflows — doesn’t seem to have been as central to the ability of the United States to sustain large current account deficits as some thought back in 2004 and 2005.( INTERESTING )

The preceding graph is based on the BEA’s balance of payments data, scaled to US GDP (the quarterly data was transformed into an annual series by calculating a rolling 4q sum and the sign on private outflows was reversed). I did adjust the latest BEA data in one way. From q2 2007 on I subtracted “private” purchases of Treasuries from the “private’ total. The last survey of foreign portfolio holdings — which revised the data from mid-2006 to mid-2007 — basically re-attributed all private purchases of Treasuries from private investors in the UK to the world’s central banks. My adjustment thus anticipates the revisions that are likely to follow from the next survey.*

But even if “private” Treasury purchases since mid-2007 are counted there still would have been a stunning fall in private capital flows. Direct investment flows have continued. Other financial flows though have largely gone in reverse, with investors selling what they previously bought.( FLIGHT TO SAFETY ) In the third quarter foreign investors sold about $90b of US securities (excluding Treasuries) and Americans sold about $85 billion of foreign securities. And the reversal in bank flows on both sides (as past loans have been called) has been absolutely brutal. ( FROM THE CALLING RUN? )

This sharp fall has bearing on the bigger debate over the role global capital, global savings and foreign central banks played in helping to to create the conditions that allowed US households to sustain a large deficit for so long — and whether American and other policy makers should have paid more attention to the risks that came with the surge in foreign demand for US financial assets earlier this decade.

Back in 2004 and 2005 — when it was beginning to be apparent that the growth in central bank reserves had led to unprecedented demand for US assets from reserve managers — many argued that central banks weren’t as important to the financing of the US deficit as it seemed. While net central banks demand seemed large in relation to net private demand for US assets, central banks only accounted for a small share of gross inflows — and in some sense total foreign purchases of US assets matter more than anything else. Ergo, central bank demand wasn’t central to the ability to the United States’ ability to sustain large current deficits, whether from large fiscal deficits (03-04) or a rise in household borrowing (05-06).

Fair enough. But even then it seemed like the increase in private inflows was tied to an increase in private outflows, so there was a reason why the growth in private flows wasn’t generating much net financing. Note how closely gross inflows and gross outflows move together in the graph — setting aside the inflows attracted by high US interest rates in the 1980s and the period in the late 1990s when foreign investors really were clamoring to buy US equities. Most of the rise in total flows reflected a rise short-term flows and short-term cross-border bank flows often seem to offset each other. Or to put it a bit differently, the US deficit has not been financed by short-term borrowing from the world’s private banks. ( OK )

Think of the process this way. Suppose a US bank lends a billion dollars to a bank in London that lends that money to a hedge fund domiciled the Caribbean that buys a billion dollars of US securities. That chain results in an outflow and inflow, but the outflow just financed the inflow — it doesn’t help to finance the current account deficit. By contrast, China’s purchases of Treasuries and Agencies reflect in large part China’s current account surplus — not Chinese banks borrowing from US banks. They certainly help to finance the US current account deficit.

I think we now more or less know that the strong increase in gross capital inflows and outflows after 2004 (gross inflows and outflows basically doubled from late 2004 to mid 2007) was tied to the expansion of the shadow banking system.( OK )

It was a largely unregulated system. And it was largely offshore, at least legally( THIS IS WHAT I SAY WOULD HAVE HAPPENED WITH MORE US REGULATION ). SIVs and the like were set up in London. They borrowed short-term from US banks and money market funds to buyer longer-term assets, generating a lot of cross border flows but little net financing. European banks that had a large dollar book seem to have been doing much the same thing.** The growth of the shadow banking system consequently resulted in a big increase in gross private capital outflows and gross private capital inflows.

Those private flows have now disappeared, or even reversed. They actually started to disappear back in August 2007. That didn’t keep the US from continuing to run a large (5% of GDP) current account deficit. The fall in private flows has been far sharper than the fall in the current account deficit.

Why didn’t the total collapse in private flows lead financing for the US current account deficit to dry up? That, after all, is what happened in places like Iceland — and Ukraine.

My explanation is pretty straightforward.

Central banks were the main source of financing for the US deficit all along.*** Setting Japan aside, the big current account surplus countries were all building up their official reserves and sovereign funds — and they were the key vector providing financing to the deficit countries.

And when (net) private demand for US assets fell, official flows picked up. As I noted earlier, private purchases of Treasuries after June 2007 are almost certainly really official flows. If those purchases are added to recorded official flows,**** total official flows over the last four quarters of data (q4 07 to q2 08) now almost match the current account deficit.

That is true even though I have calculated net official flows — and in the third quarter of 2008 for the first time in a long time the US central bank was a net lender to the world. Yep. The Fed provided $226 billion of credit through various swap lines in q3, and foreign central banks only bought $118 billion of US assets. This shows up cleanly if official inflows are plotted against official outflows (the graph is done on a rolling four quarter basis).

Central banks lent the proceeds of their swap lines with the Fed to private banks abroad, and private banks in turn repaid their maturing dollar debts — so the swap lines financed the unwinding of existing US loans to the rest of the world. Call it facilitating the unwinding of some of the legacy of the excesses of the past few year. Or call it a new wave of financial globalization, one led by the central banks …

At this point, I don’t really think that there can be much doubt that the enormous increase in central bank reserves over the last five years was central to the process that allowed the US to run large current account deficits during a period when private demand — that is private inflows net of private outflows — for US financial assets wasn’t there. At least not on the scale needed to finance the United States big deficits.

In my judgment, the US housing bubble — and the associated rise in private consumption as households borrowed against the rising value of their home — wouldn’t have been able to grow for as long as it did without this inflow from the rest of the world. But that is a story for a different post.( I NEED TO SEE THAT )

*Watch what happens when the data from the June 2008 survey is released. I would expect a large upward revision in official inflows from q3 07 to q2 08. The BEA data currently indicate $478 billion in official purchases over these four quarters and another $256 billion of private purchases of Treasuries.
** We know this in large part because of how much they have borrowed (indirectly, through their “home” central bank) from the Fed after financing from the interbank market and US money market funds dried up after Lehman’s collapse.
*** In theory, central banks could have bought a lot of euros and private European investors could have bought a lot of US assets, allowing the US to run a large deficit financed by European private investors even in the absence of a European current account surplus. This perhaps happened to an extent — but it seems to have been less important than central bank purchases of dollar assets.
**** This still likely under counts total official flows. Before they stopped buying Agencies this fall, central banks (especially China’s central bank) also bought Agency bonds from private intermediaries, so the survey tended to revise private Agency purchases down and official purchases up. And even the revised data doesn’t seem to pick up a large fraction of Gulf purchases — whether purchases of “risk” assets by sovereign funds or “safe” assets by SAMA (the Saudi Monetary Agency) and Gulf central banks."

I would expect the Central Banks of Saver Countries to be the buyers of our Treasuries and Agencies, and Japan to do so in order to keep exports high. This fits in with two of my predictions:

1) It is the Saver Countries ( China, Germany, Japan ) that want to really keep this current arrangement going.

2) Investors would simply have done more offshore investing had the US had tougher regulations.

I would add that two main problems:

1) The Flight To Safety ( Into Treasuries )

2) The Calling Run ( The need to raise capital )

Are bound up with this system. How? Very simple. As I've said before, foreign investors were also counting on strong and decisive government intervention in a financial crisis. They were directly tied into the same ideas and presuppositions as US investors. Our leaders didn't perceive that we were the LOLR for the whole world, and the Implicit And Explicit Guarantees extended to the whole world, by these Central Banks buying our debt.

"“For the first time in my life I have sympathy with the Bolsheviks; with the French revolutionaries who put up the guillotine.”

A Burkean view of what happens if a society doesn't have a thriving Middle Class on the FT:

"Iceland gives Christmas frosty reception

By Sarah O’Connor in Reykjavik

Published: December 23 2008 20:14 | Last updated: December 23 2008 20:14

On the ground floor of one of Reykjavik’s gleaming office buildings, a well-dressed crowd shuffles and waits. Tinny Christmas songs blare from a small hi-fi by the door.

As numbers are called out one by one, people file into the next room where rudimentary shelves are filled with free tins, fish, clothes, books and wrapping paper.

Some 2,500 people have applied for Christmas relief packages from Iceland’s three main charities in recent weeks, a 30 per cent rise on last year, as growing numbers of the middle class lose their jobs in the wake of Iceland’s banking collapse.

Jon Omar Gunnarsson, a pastor at Hallgrimskirkja, Reykjavik’s main church, says applications to the Church Aid group have doubled.

“It’s mostly middle class people who have all these obligations, mortgages that are going up, many are losing their jobs ... they just can’t carry the burden alone,” he says.

Iceland is still reverberating after its economy crumpled in October in the face of global financial turmoil.

Inflation and interest rates are both at 18 per cent as the country struggles to shore up its currency, which plunged after its three banks collapsed. It has borrowed $10bn from the International Monetary Fund and others which it needs to repay, meaning taxes are rising even as recession deepens."

So, they have:

1) Interest rates at 18%

2) A Falling currency

3) Borrowed $10 Billion from the IMF

4) Higher taxes

5) A recession

"The charities believe more people need help but are too ashamed to ask.

“We should just forget about Christmas, just cancel it,” says Sigridur, 57, waiting for her number to be called.

“My husband lost his job, I don’t have one either – I am recovering from cancer. We cannot even pay for the house.”

Sigridur and her husband are considering moving to Norway where there are jobs in construction. “We would just post the house key back to the bank.”

Asa, 44, will give her children Christmas presents provided by charity this year. “You have to take off your pride,” she says. “It’s very difficult to do it.

“There will be a lot of people who leave this country, just go away. Think of the future here for the children. When they are 95 they will still be paying for this( YIKES ).”

Although growing, the number of people needing food aid is still small. Many of those who have lost their jobs will continue to get paid until February. The government, which owns the three main banks, has promised mortgage holidays for people who cannot meet repayments. But even those who have not been badly hit are changing their lifestyles. This Christmas, people are giving each other books, home-made trinkets and practical presents such as warm socks.

Last year’s must-haves, flat screen televisions and games consoles, are on the list of things people here call “so 2007”.

For many, Christmas brings a welcome distraction from the crisis. But others find it impossible to get into the seasonal spirit.

Sitting in an old fisherman’s cafe by the port, Orn Svavarsson shakes with rage. He sold his health food business three years ago when he was 54 and, like many of his countrymen, put the money into the stock market. It has been wiped out.

“The Icelandic people are too lazy,” he says. “Why don’t we go to the airport and block it until we get answers?

“For the first time in my life I have sympathy with the Bolsheviks; with the French revolutionaries who put up the guillotine.”

Note well the last sentence. If Icelanders should come to lose confidence in the social system as well as the economic system, then things could actually get ugly.

"But don't kid yourself that the sentiment might not spread. "

Yves Smith on Beggaring Thy Neighbor:

"Has Beggar Thy Neighbor Started? ( MY THESIS IS THAT IT IS HAS BEEN GOING ON ALL ALONG, ALTHOUGH NOT FULL BLAST, BUT MODERATED. I CONSIDER ENGLAND'S ACTIONS TOWARD ICELAND BEGGARING THY NEIGHBOR, OR, BETTER YET, BUGGERING. ALSO, CHINA , JAPAN ( WITH CURRENCY AND STIMULUS ISSUES ), AND GERMANY( WITH STIMULUS ISSUES ), HAVE PLAYED A MODERATE FORM. HOWEVER, ONE COULD ARGUE THAT THEY'RE SIMPLY BUYING TIME TO GET IN A BETTER POSITION TO DEAL WITH TOUGH ISSUES.)

One of the ugly features of the Great Depression that in many (but not all) cases worsened the severity of the contraction was that countries adopted "me first" policies with little regard to their broader ramifications. The poster child of this pattern is Smoot Hawley. Although there is some dispute among economists as to whether it was as deleterious as sometimes claimed, the US increased tariffs to protect domestic employment. This proved to be short-sighted, since the US was the biggest exporter, and had a great deal to lose when other countries retaliated.

Similarly, England left the gold reserve comparatively early, in 1931. Currency devaluation proved a great help in escaping the worst of the Depression. However, competitive devaluations also limited the benefits for any one player.

We are now seeing what looks to be "devil take the hindmost" behavior. China has quietly gone back to a hard peg against the dollar (as opposed to letting the RMB do what it would otherwise do, appreciate). This is very detrimental, since it means that China is going to try to continue to rely on exports to see its way through this downturn, rather than use more aggressive fiscal stimulus( TRUE, BUT THEY HAVE A PROBLEM WITH THE STIMULUS BEING A SAVER COUNTRY ). It also means that China is trying to prop up the system of global imbalances (Chinese savings glut, US overconsumption and borrowing from China et. al.) that helped create this mess( THEY LIKE THE SYSTEM. I'VE ALREADY BLOGGED ABOUT THAT ). We need to collectively find our way out of this smoky airplane, but everyone seems to want to go back to their seats and strap themselves in.

In a very good Financial Times piece, Wolfgang Munchau in passing mentions "unsynchronised monetary policies" and suggests that the Fed's aggressive move to quantitative easing (oh, we don't dare call it that, the Fed insists its flavor is different) will force the ECB to follow suit to a fair degree. Munchau does not consider this to be a plus( I HAVE POSTED ABOUT THIS POST ):

I am sceptical about the benefits of the Fed’s new policy of quantitative easing. We do not have a liquidity crisis, but a solvency crisis, which expresses itself in large spreads and dysfunctional money markets. I cannot see how adding more and more liquidity to the system solves this problem.

Instead of propping up each bank, and swamping the market with cash, we need to restructure and shrink the banking system, as a first step to a sustainable solution to this crisis. Quantitative easing without deep structural financial reform could cause lot of trouble in the long run.

I think, however, there is a case for temporary interest rate cuts in Europe, but only on condition that this policy would be forcefully reversed once credit markets start to recover, and once the economy emerges from the slump.

But we should not delude ourselves into thinking that monetary policy can save the world. It can play a useful role, especially since we do not have the stomach for an optimal fiscal policy response. But it will not prevent the worst slump of our generation.

Ambrose Evans-Pritchard chronicles a rise in good old garden variety protectionism, so far limited to secondary and emerging economies. But don't kid yourself that the sentiment might not spread( VERY TRUE ).

It is important to keep in mind that cartoon extremes often cloud the debate. How smart is it to advocate open trade when some countries stack the deck by having artificially cheap currencies? That is tantamount to an export subsidy( BY KEEPING THE PRICE OF THEIR GOODS LOW ), but we haven't done much except jawbone China very late in the game (and the yen has been awfully cheap until recently too, and Japan has remained an export powerhouse, but we never gave them a hard time due to the sorry state of their domestic economy). Similarly, we consider it completely reasonable to restrict exports of advanced military technology, and acquisition of strategic assets.

Again, I am not saying trade is a bad thing, merely that we have often been faced with counterparties with mercantilist objectives, and our responses appear not to have served us well in the long term( TRUE ).

From Evans-Pritchard:

We are advancing to the political stage of this global train wreck. Regimes are being tested. Those relying on perma-boom to mask a lack of democratic or ancestral legitimacy may try to gain time by the usual methods: trade barriers, saber-rattling, and barbed wire...

Russia has begun to shut down trade...It has imposed import tariffs of 30pc on cars, 15pc on farm kit, and 95pc on poultry (above quota levels). "It is possible during the financial crisis to support domestic producers by raising customs duties," said Premier Vladimir Putin.

Russia is not alone. India and Vietnam have imposed steel tariffs. Indonesia is resorting to special "licences" to choke off imports...

There have been street protests in Moscow, St Petersburg, Kaliningrad, Vladivostok and Barnaul. Police crushed "Dissent Marchers" holding copies of Russia's constitution above their heads in Moscow's Triumfalnaya Square.

"Russia has not seen anything like these nationwide protests before," said Boris Kagarlitsky from Moscow's Globalization Institute....

The omens are not good in China either...

Exports fell 2.2pc in November. Toy, textile, footwear, and furniture plants are being closed across Guangdong, now the riot hub of South China. Some 40m Chinese workers are expected to lose their jobs. Party officials have warned of "mass-scale social turmoil".

The Politburo is giving mixed signals. We don't yet know how much of the country's plan to boost domestic demand through a $586bn stimulus package is real, and how much is a wish-list sent to party bosses in the hinterland without funding.
Shortly after President Hu Jintao said China is "losing competitive edge in the world market", we saw a move towards export subsidies for the steel industry and a dip in the yuan peg...

Such raw mercantilism can only draw a sharp retort from Washington and Brussels in this climate.

"During a global slowdown, you can't have countries trying to take advantage of others by manipulating their currencies," said Frank Vargo from the US National Association of Manufacturers. ( IT ISN'T GOOD, NO )

It is a view shared entirely by President-elect Barack Obama. "China must change its currency practices. Because it pegs its currency at an artificially low rate, China is running massive current account surpluses. This is not good for American firms and workers, not good for the world," he said in October. The new intake of radical Democrats on Capitol Hill will hold him to it.

There has been much talk lately of America's Smoot-Hawley Tariff Act.... The relevant message of Smoot-Hawley is that America was then the big exporter, playing the China role. By resorting to tariffs, it set off retaliation, and was the biggest victim of its own folly( TRUE ).

Britain and the Dominions retreated into Imperial Preference. Other countries joined. This became the "growth bloc" of the 1930s, free from the deflation constraints of the Gold Standard. High tariffs stopped the stimulus leaking out.

It was a successful strategy - given the awful alternatives - and was the key reason why Britain's economy contracted by just 5pc during the Depression, against 15pc for France, and 30pc for the US...

This crisis has already brought us a monetary revolution as interest rates approach zero across the G10. It may overturn the "New World Order" as well, unless we move with great care in grim months ahead. This is where events turn dangerous( COULD BE ).

The last great era of globalisation peaked just before 1914. You know the rest of the story." ( YES WE DO )

"It’s about one of the nice side benefits of CDS: the habit they have of pointing out who is going to get into trouble next. "

I want to keep this post and comments for my own reference, so I'm going to enter it here. It's about the use of CDSs to signal trouble. It should not come as any surprise that an insurance policy, meant to cover default or foreclosure, would be sensitive to the likelihood of its having to be paid out. If it were tradeable and saleable, the price should be based on how likely it is that the insurance policy will have to be paid out. It should be more expensive to purchase as it becomes more likely to be paid out. The buying and selling of these insurance policies is predicated on being able to assess the likelihood of its kicking into effect. That's its reason for being, as it were.

Here's James Kwak on Baseline Scenario:

"No, this isn’t another article about how credit default swaps (CDS) have ruined or are going to ruin the economy. It’s about one of the nice side benefits of CDS: the habit they have of pointing out who is going to get into trouble next. And it has pretty Bloomberg charts!

As everyone probably knows by know, a CDS is insurance against default on a bond or bond-like security. If you think about it for a while, you will realize that this means the price of the CDS reflects the market expectation that the issuer will default."

That's right.

"The price of a credit default swap is referred to as its “spread,” and is denominated in basis points (bp), or one-hundredths of a percentage point. For example, right now a Citigroup CDS has a spread of 255.5 bp, or 2.555%. That means that, to insure $100 of Citigroup debt, you have to pay $2.555 per year."

Price=Spread on CDSs.

"CDS exist for various durations and on many different kinds of debt. If someone doesn’t specify the duration or the type of debt, he is usually referring to a 5-year CDS on senior debt. That means that the contract will be open for 5 years, during which one party (the insured) pays premiums and the other (the insurer) promises to pay off if Citigroup defaults. If there is no default within 5 years, the insurer gets to keep the premiums."

Just like home insurance.

"Look at it from the standpoint of the insurer. If Citi doesn’t default, I get $2.555 x 5 = $12.775. If Citi defaults immediately, I have to pay $100. That implies that I think there is about a 12.8% chance that Citi will default (ignoring the time value of money). Actually, my expectation of a default is actually somewhat higher, for a couple of reasons. First, if Citi defaults 4-1/2 years from now, I have to pay $100, but I’ve collected the $12.775 in the meantime (assume premiums are paid at the beginning of each year for simplicity), so my loss is only $87.225. Second, in any case I don’t have to pay the full $100; I only have to pay $100 minus the value of the security, which is unlikely to be zero even in the case of a bankruptcy. For example, Lehman bonds were only worth 9 cents on the dollar (so insurers had to pay out 91 cents), but Washington Mutual bonds were worth 57 cents. So my net loss will be lower, which means that my expectation of a default is higher. (The expectation is the money I expect to gain if there is no default, divided by the net amount I expect to lose if there is a default.)"

The basic points have already been made. However one does it, you're trying to assess the likelihood of default.

"Luckily, Bloomberg can calculate all of this for you, and right now they say the chance of a Citigroup default in the next 5 years is 16.2%. (That’s using a recovery rate of 40 cents on the dollar, but you can type in whatever rate you want.) You can see the valuation on the right side of the screen below.

OK, that’s interesting, but why call credit default swaps heralds of doom? Because CDS have shown the ability to identify what financial institutions (or countries) are going to get into trouble next. When the market starts getting nervous about a company and thinks it is more likely to default, insurance on that company’s debt starts getting more expensive. And this tends to happen before you start reading about that company in the newspaper."

So, you can use CDSs to assess the financial health of a company, or its likelihood to default. This post implies that this modus of assessing a company's finacial health is quite vaulauble because it predates a lot of other information for public viewing.

"Here are a few examples, in which I compare CDS prices to my home-grown “mainstream media” indicator, which is when the first article appeared in the New York Times saying a company was in danger of failure (as opposed to just taking writedowns along with every other bank). This is not scientific, because really you would want to compare the company’s CDS curve to an index of other companies in the industry to separate out sector-wide trends, but you get the point.

This is the chart of Bear Stearns’s CDS. Note that the price started climbing steeply in late February.The first Times article about Bear Stearns’s troubles was published on March 11, referring to the plunge in the stock price the previous day.

This is AIG. It looks like an instantaneous spike in mid-September, but the price had been climbing steadily, from double digits in May to 300 bp in mid-August to 430 bp on September 4. The first Times article appeared on September 12, again describing events on September 11. By September 10, however, CDS spreads were already up to 517 bp.

And this is Iceland. In the middle of 2007, Iceland’s CDS were priced below 10 bp. They spent most of July and August this year in the high 200s, passed 300 in mid-September, and reached 395 bp on Friday, September 26. Iceland only reached the attention of the mainstream media on Monday, September 29 (Times article the next day, in which Iceland barely got a mention).

So whose CDS spreads are climbing now? That will have to wait for another, or several other, posts."

So, using CDSs as an assessment tool about the financial health of a company can be quite useful, especially if you are considering buying its stock or even its bonds.

Here are my questions, with some answers:

"James,

You make a good point about CDSs being useful. But couldn’t the same information of trouble ahead be reflected in the:
1) Price of the stock
2) Price of the Bond, or even Mortgage
3) Credit Ratings
4) Analysts Ratings
5) Company filings
Is there any reason to believe that buyers and sellers of CDSs have access to any more info than other traders in these other investments? Or that CDSs are more finely tuned to express movements in company prospects? All the CDS does is reflect the same, common, info differently, or am I wrong?"

“E.g., Goldman Sachs bought AIG CDSs in early August when AIG failed to meet collateral calls made by GS against AIG.’

I’m assuming that GS had some AIG bonds or product, against which they’re buying protection in case of default. Or, are you saying that GS went out and purchased some existing AIG CDSs, betting one way or another on a default. I’m still trying to see counterparties or anyone can see that a diligent investor can’t.

“CDS prices of financial companies often reveal problems that are evident to trading their counterparties but that are not yet apparent to equity and debt investors of financial companies.”

This sounds like counterparties are purchasing CDSs in case AIG defaults.When this happens, everyone knows there’s a problem, but not before. That makes sense, assuming that wired investors or others in the loop of this company’s investors don’t find out as well.

On the other hand, it certainly can’t help the fortunes of the company they’re buying insurance against. It looks less like hedging than pushing. I’m assuming that’s what you mean by shorting.

Also, you have to remember, there’s a buyer, and a seller. I can see one having the info, but surely the other end of the deal must see something else."

From James Kwak:

"The Goldman-AIG case is unusual but interesting. Goldman had some CDS contracts with AIG on other (non-AIG) bonds. As those contracts moved against AIG, Goldman demanded additional collateral (to protect itself against AIG defaulting and being unable to honor the contracts). AIG refused to give Goldman all the collateral they wanted. So Goldman went out and bought CDS protection on AIG.

Put another way: They knew AIG was in trouble because of their existing trading relationship with AIG, and that’s why they bought CDS protection on AIG. That is something that the general public would not have been able to know. How often this type of scenario occurs I do not know."

Here's me again:

“I’m assuming that GS had some AIG bonds or product, against which they’re buying protection in case of default.”

Your answer:

“Goldman had some CDS contracts with AIG on other (non-AIG) bonds. As those contracts moved against AIG, Goldman demanded additional collateral (to protect itself against AIG defaulting and being unable to honor the contracts). AIG refused to give Goldman all the collateral they wanted. So Goldman went out and bought CDS protection on AIG.

Put another way: They knew AIG was in trouble because of their existing trading relationship with AIG, and that’s why they bought CDS protection on AIG. That is something that the general public would not have been able to know. How often this type of scenario occurs I do not know.”

That’s what I wanted to know. However, would the price or anything about the CDSs become known. Who’s trading the ones on the market? Or is it that, GS can keep the CDS private, and the info will only get out if they try and sell them?

What you say makes sense, in that there is a chance, as I said, that if the info about these GS buys gets out, it can further harm AIG. However, if there is a CDS for any company, it does seem that the only reason to purchase a CDS is if you feel that there is a chance of default, and someone else who is willing to take your position on. CDSs don’t seem like Canaries to me, they’ve already passed on. CDSs seem like a reaction to Canaries, and validation of their deaths."

And that's it. A few other commenters were very helpful as well.

"When morality and justice are increasingly at odds with the law, it is time to challenge and change the law and the government that created it."

Willem Buiter will not be bullied into unethical and immoral behavior, thank you very much. Please read the whole post, I'm picking up the argument here:

"Why can the government and the state not be trusted with certain kinds of information?

(1) They lose it

If I were the recipient of every laptop filled with confidential information left on trains, in taxis or on park benches by those entrusted with maintaining data confidentiality, I would have the largest second-hand laptop franchise in the world.

There really is no such thing as confidential information. This is one reason why I oppose even universities collecting information on student attendance. If tomorrow the police were to turn up in Houghton Street demanding the information the LSE has in its files, who will deny them access? The Serjeant at Arms of the House of Commons, if we cannot get the Speaker of the House of Commons himself?

In my own immediate family, there have been examples of confidential medical information being leaked to parties that had no business accessing this information. The first time was in the US, and the leaky institution was a university Health Center; the second time was in the UK, and the institution concerned was an NHS hospital.

(2) They abuse it

Governments abuse information always and everywhere. My prediction that any information entrusted to the state can and will be abused is based on a rich historical record, spanning all countries and all of history. Who does not remember Richard Nixon going after his political enemies using the US tax authorities and their unique (confidential) data base?

Government access to more and more information greatly facilitates the gradual slippage towards a ‘guilty unless proven innocent’ legal system in the UK. The European Court of Human Rights (for the Euro-ignorant - this is not an EU institution, but instead an institution associated with the Council of Europe) recently ruled that the law permitting the police in England and Wales to keep, for an indefinite period, the finger prints and DNA samples of persons not convicted of a crime (and a-fortiori permitting these data to be kept on a criminal register!) breached article eight of the Human Rights Convention, covering the right to respect for private and family life.

The repeated attempts by the current UK government to introduce a mandatory ID card - preferably one that stores a host of personal details other than name, rank and serial number - should be resisted. “Ausweis, bitte”, does not sound good, even in English.

The fact that throughout history and in the UK today information is lost and/or abused by the government means that the government should be prevented from obtaining information it would be useful for the government to have if it were competent and benevolent, and could be trusted.

Because the state can never be trusted fully or unconditionally, and because it can become incompetent and/or malevolent - often unexpectedly and at short notice - I have in the past been moved to micro acts of civil disobedience. This involved no more than not providing all the requested/required information in the periodic censuses I have had to fill in, both in the USA and in the UK. The last time I returned a deliberately incomplete census was in the UK in 2001. I wrote about this in one of my first blogs on June 30, 2007, before the blog moved to FT.com. It is titled ‘Our Right for the Government Not to Know’.

The road to serfdom

Perversion of the intent of the law

In the UK, the powers granted to the government to fight terrorism have been perverted and abused. These powers were used to keep an 82-year-old Labour Party Conference heckler, Walter Wolfgang, from re-entering the conference after his ejection. They were also used to arrest two women who stood at the Cenotaph and read out the names of civilians killed in the Iraq war.

The UK government froze the UK assets of the Icelandic bank Landsbanki under the 2001 Anti-Terrorism, Crime and Security Act passed after the September 11, 2001 terrorist attacks in the USA. This was an outrageous and deeply worrying perversion of the intent of the Act. The UK government may have had a financial dispute with the Icelandic government about who should cough up for deposit protection in case of bank failure, but not even the most paranoid denizen of Whitehall would be able to find a link between Icesave and Landsbanki and terrorism.

Given this record, would one be surprised if those ticking the boxes for the PBS reporting exercise were told to complete an additional entry for students from that well-known terrorist-breeding nation Iceland? Will we see requests for additional information on students of middle-eastern or Indian sub-continental appearance? On Islamic students? On students wearing the hijab? On bearded students? Or perhaps just on bearded students wearing the hijab?

Police officers from a counter-terrorist unit arrested the conservative MP and spokesman on immigration matters Damian Green, and searched his home and his office in the House of Commons. The ‘terrorist conspiracy’ they were investigating concerned Home Office leaks, none of which involved national security issues. The offence that provided the fig-leaf for his arrest is a common law license to harass the opposition, to prevent government embarrassment and to undermine the public’s right to know: “conspiring to commit misconduct in a public office” and “aiding and abetting, counselling or procuring misconduct in a public office” .

The Regulation of Investigatory Powers Act was designed to grant the power to intercept/spy on e-mails and telephone conversations just to the police and the security services. It was, however, extended to local authorities, who now use it to snoop on suspected abuse of welfare benefits, violations of school catchment areas, dog fouling and littering. This fits seamlessly with the sad observation that the UK has more surveillance cameras and other CCTV-type equipment (private and public) per person and per square mile than any country in the world. Big brother is definitely watching you.

The undermining of habeas corpus

My relief at the failure of the government to extend to 42 days the period for which persons suspected of terrorist acts (I assume this now includes all Icelanders) can be held in detention without being charged, is severely qualified by the realisation that 28 days detention without charge is the new status quo. Even 28 days represents an unacceptable encroachment on habeas corpus - the right of the accused to face his or her accuser and to have his day in court. Forty eight hours should be all this is required for putting out fires. Don’t forget, that the Labour government in 2005 tried to extend the period of detention without charge for terrorist suspects to 90 days. Too many members of the current government have learnt all they know about constitutional rights and fundamental human rights at the Guantanamo Bay School of Law.

The right to remain silent

The right not to incriminate yourself, or the right to silence/to remain silent no longer exists in any meaningful sense in the UK.

The “right to silence” is an essential legal protection given to people undergoing police interrogation or trial. The right is recognised in many of the world’s legal systems. In the UK, it was first codified in the Judges’ Rules in 1912. In 1996, the European Court of Human Rights stated: “the right to remain silent under police questioning and the privilege against self-incrimination are generally recognised international standards which lie at the heart of the notion of a fair procedure under Article 6 [of the European Convention on Human Rights].”

The Terrorism Act 2000 undermined this right, and indeed appears to have abolished it altogether. Schedule 7 states that “a person who is questioned under paragraph 2 or 3 must give the examining officer any information in his possession which the officer requests.” The purpose of this obligation to provide information is supposed to be “determining whether he appears to be a person falling within section 40(1)(b).”, that is, whether he “has been concerned in the commission, preparation or instigation of acts of terrorism.” But Article 2.4. of this Schedule says that “an examining officer may exercise his powers under this paragraph whether or not he has grounds for suspecting that a person falls within section 40(1)(b).” Duh?!

You have to provide all the information the interrogating police officer requests in order for him to determine whether you are an actual or potential terrorist. But the interrogating officer can demand that information regardless of whether he has any grounds for suspecting you of being an actual or suspected terrorist! Instead he could suspect me of murder, rape, robbery, double parking or ‘conspiring to commit misconduct in a public office’. This is mad. Joseph Goebbels would have been proud of this fantastic pseudo-logical piece of legal gobbledygook. The law is not an ass but a poisonous viper in this case. This Catch-22 construction castrates the right to silence.

The ‘examining officer’ also has the power to “search anything which [the person] has with him, or which belongs to him”, and to hold him for up to 9 hours for the purpose of “examination”. Damian Green was held by the police for 9 hours. Just a coincidence.

The duty of civil disobedience when the law is unjust

What is to be done? First-best would be to get rid of the Points-Based visa system. Second-best would be to get an exemption from the law for the universities. Third-best would be for the universities, severally or jointly, to decide that they will not comply with the legal requirement to provide these data to the Home Office or any other government agency.

Regrettably, institutions like universities are likely to feel compelled to comply. They are vulnerable to financial and other sanctions from the state. This is true today as it was in the 1930s in Germany and under communist rule in Central and Eastern Europe. Institutions are therefore almost always cowards. There are many lapdog state churches for each bekennende Kirche. An isolated bekennende Kirche is also likely to be crushed by the power of government and the state. Only a collective ‘no’ from the world of higher education can stare down the government on this issue. The Fourth-best would be for individual faculty members to refuse to comply with the law.

If the fourth-best option is the only one available, it is the one I shall choose. As regards the practical side of this, effective sabotage of the law is not achieved, as I understand it, by simply refusing to take attendance. This would leave all non-EEA students open to harassment by the authorities. The way to subvert the law without putting students at risk is to record all students as present, even when they are absent or absent with reason. It may be enough to record students that are absent as ‘absent with reason’ - I intend to find out more about this. But under no circumstances will I, in my capacity as a faculty member, collect and pass on information regarding student attendance that can be used by the government to harass - even to deport - students or others living in this country.

It is unfortunate that one may be forced to lie, indeed to lie ‘in writing’, if one is to do one’s job - one’s duty - as an educator and teacher. But this is preferable to turning informer for the government. As that great conservative, Barry Goldwater said: Extremism in the defense of liberty is no vice. . .. Moderation in the pursuit of justice is no virtue.

When morality and justice are increasingly at odds with the law, it is time to challenge and change the law and the government that created it."

How well said. Here's my comment:

1. “The Fourth-best would be for individual faculty members to refuse to comply with the law.

   If the fourth-best option is the only one available, it is the one I shall choose. As regards the practical side of this, effective sabotage of the law is not achieved, as I understand it, by simply refusing to take attendance. This would leave all non-EEA students open to harassment by the authorities. The way to subvert the law without putting students at risk is to record all students as present, even when they are absent or absent with reason. It may be enough to record students that are absent as ‘absent with reason’ - I intend to find out more about this. But under no circumstances will I, in my capacity as a faculty member, collect and pass on information regarding student attendance that can be used by the government to harass - even to deport - students or others living in this country.”

   Don’t worry Buiter, if they put you in whatever you call jails over there, or, God forbid, prison, I’ll organize a crusade to free you, and write the first check for your defense. I’ll even fly to London and speak in Trafalgar Square on your behalf, and I’m agoraphobic.

   I don’t know what’s gotten into you, but you are writing one outstanding column after another. I totally agree with you, even as to immigration laws.

   They ought to give you one of those knighthood things, or at least another plane. Jesting aside, I’m dazzled and awed by your recent passion and wisdom for human rights and effective economic policy as expressed in these postings. I find myself in almost total agreement. And that, my friend, should scare the hell out of you.

   Hopefully, others, more respectable types, will post comments backing you up in this matter. If you have to rely on me, I hope you enjoy cramped quarters.

   Cheers. Don

   Posted by: Don the libertarian Democrat | December 7th, 2008 at 1:33 am | Report this comment

“Switzerland is absolutely not immune to global developments, especially not as regards the financial crisis and the economy.”

Switzerland Watch on Bloomberg:

"Dec. 1 (Bloomberg) -- An isolated European country with an economy geared toward finance and winter sports is no longer a monetary bastion as credit evaporates around the globe. Banks teeter, the once-impregnable currency depreciates and a proudly independent people question whether a centuries-old go-it-alone strategy can survive.

Even Switzerland is wondering if it’s immune to the forces ravaging Iceland.

The drama playing out in the Nordic nation, whose economy the International Monetary Fund says may shrink about 10 percent next year, offers a cautionary tale for the no less fiercely independent Swiss. While they are in far better shape, their status as custodians of the world’s wealth is under threat by a global economic upheaval they can’t control and miscues by the banks that made them great.

“The Swiss model of isolationism is not an advantage” in the current environment, says Michael Baer, 46, the great- grandson of Julius Baer, founder of Switzerland’s largest independent wealth manager. “Switzerland is absolutely not immune to global developments, especially not as regards the financial crisis and the economy.”

Heads up for terrorism laws. No more going-it-alone, perhaps. I wonder if this will lead to a much more integrated financial system worldwide. Some countries have tried building up their financial independence recently, but has it worked?

"Baer -- scion of a legendary family in one of the world’s oldest financial centers -- has moved his own business to one of the youngest: In 2006, he set up Baer Capital Partners in Dubai to tap Middle Eastern wealth.

For the 7.6 million Swiss, signs of stress are evident amid a cataclysm in world markets that has besieged them with reasons to doubt a splendid isolation dating back to medieval times."

What other changes would this lead to?

"are endangered more by the response of the UK and US governments to the threat posed by Al-Qaeda and other terrorist groups, than by the terrorists "

Willem Buiter with an excellent post on human and civil rights:

"I have long held the view that our freedom, our civil liberties and human rights, and indeed our open society, pluralist political system and way of life are endangered more by the response of the UK and US governments to the threat posed by Al-Qaeda and other terrorist groups, than by the terrorists themselves.

A further reminder of just how assiduously the British government has been chipping away at our freedom is provided by the arrest of the opposition spokesman on immigration, Mr. Damian Green, by counter-terrorism officers, his questioning by these counter-terrorism officers for nine hours and the search of his home and office. The ‘terrorist conspiracy’ being investigated concerned Home Office leaks."

Read the rest. It's true here in the US as well. Here's my comment:

“When challenged on this prima facie inappropriate use of the counter-terrorism command, the London Metropolitan Police confirmed that Mr Green was arrested by members of its counter-terrorism command. It said the investigation was not terrorism-related but did fall within the counter-terror unit’s remit. Mr Green was not charged with any offence but was released on bail until February.”

It’s odd how, when you give authorities power in one supposedly delimited realm, they use the power in whatever realm they happen to find themselves. This is so certain an occurrence that it can be defined in Newtonian Mechanics.

Also, didn’t the PM use terrorism rules against Iceland? What does “terrorism” mean in Britain? Let me know, because I speak a language called English.

“According to the BBC’s website, among the recent leaks that got Home Office knickers twisted so viciously were the following:”

Now, I want it clearly understood that I have no, I say no, personal knowledge about this, but I truly doubt that people this reckless with laws and language even have the common decency to wear knickers. Just my impression. No more.

You’ve written a very important post. Thank you for continuing to use this blog for serious and important policy recommendations and warnings.

Posted by: Don the libertarian Democrat | November 28th, 2008 at 6:27 pm | Report this comment

Here's his reply:

Re Don: the British government did indeed, to its eternal shame, invoke the 2001 Anti-Terrorism, Crime and Security Act to freeze the UK assets of a couple of Icelandic banks. This misuse of an instrument created to fight terrorism in an ordinary commercial/financial dispute between neighbouring countries is not just wrong, it is deeply evil. Did I hear anyone say “the end justifies the means”? Posted by: Willem Buiter | November 28th, 2008 at 6:50 pm

"We need new safe-fail policies to prevent inevitable institutional failures from snowballing into economic crises.

Here's a pretty good argument for putting Derivatives on an exchange or Clearinghouse from Benn Steil in the FT:

"The global financial crisis is rightly prompting calls for a rethink of how we regulate financial institutions and markets. Most such calls are focused on what might be called “fail-safe” regulations, designed to reduce the risk that institutions will make reckless lending and investment decisions. Even libertarian-leaning policymakers and thinkers, such as Alan Greenspan, are now concerned with the capacity of our globally connected financial system to spread failures of risk management from one institution to another."

I hadn't heard them called Fail Safe Regulations until now, but the point is well taken. We want regulation to keep these kinds of financial crises from occurring. A global approach makes sense to me. No, it's not global government.

"In this crisis, institutions that bought up buckets of complex mortgage-linked securities found themselves facing huge losses as house prices fell. Their counterparts and clients, fearing the worst, provoked the worst by ceasing to do business with them. Others who wrote insurance against their failures-to-pay (credit default swaps) then lost huge sums as well, fuelling the fires of system-wide panic and default. But better regulation of lending standards and risk management, the argument goes, will prevent such systemic problems in the future.

History does not provide much comfort here. In financial markets, there are always new risks to take and new ways for risk management models and procedures to break down. Fail-safe approaches can also go too far: witness Japan in the early 1990s, when heavy-handed government intervention effectively shut down financial innovation. Furthermore, government policy promoting imprudent risk-taking – witness long-standing US congressional support for failed mortgage giants Fannie Mae and Freddie Mac – can overwhelm regulations intended to control it."

I think that the cause of the problem was the search for investments that needed less capital requirements, not the investments themselves.

His two main points I agree with:

1) It's hard to stop financial innovation, since its intent is to evade current regulations

2) Over-regulation is a serious problem

"The key is to supplement prudent fail-safe interventions with safe-fail ones: interventions that recognise that institutional failures will continue to occur and that focus on limiting the systemic damage after they do."

Here's "prudent" again, meaning nothing specific, but it will work.

"A case in point is the mammoth global derivatives markets. Despite wild swings in prices, derivatives exchanges have not contributed one iota to market instability. This is because exchange-traded contracts are centrally cleared and trader defaults – which are rare because of continuously adjusted margin requirements – are absorbed by well-capitalised clearing houses. Compare the 2006 collapse of hedge fund Amaranth, whose derivatives exposures were on-exchange, with the 2008 collapses of Lehman Brothers and AIG, both of which had large exposures in non-cleared, over-the-counter CDSs. Amaranth’s derivative defaults had trivial systemic ripples, while those of Lehman and AIG created major shockwaves. AIG invisibly built up huge under-collateralised sell positions on the back of a faulty credit rating. Yet if those contracts had been transacted on a trading platform with central clearing, margin calls would have short-circuited the strategy well before the company’s September collapse. US and European regulators (whose institutions comprise the vast bulk of OTC trading) should require central clearing once volume barriers in a contract are breached. This will not prevent an institution from losing large sums in derivatives trading, but will stop its default from spreading big losses to others that may be far removed from the original transactions."

This is the argument for an Exchange or Clearinghouse. It's pretty convincing to me.

"There are safe-fail macroeconomic counterparts as well. In August 2007, former Salvadoran finance minister Manuel Hinds and I spoke out at a Reykjavik conference in favour of Iceland unilaterally “euroising”. At the time, the country had more than enough foreign exchange reserves to redeem all the krona in the country for euros at the then-current exchange rate. This would not have stopped the three large Icelandic banks from overextending, but it would have prevented national financial catastrophe. Countries that have adopted one of the two main internationally accepted currencies – the dollar (Panama, El Salvador and Ecuador) or the euro (think in particular of Italy, Portugal and Greece) – have effectively eliminated the risk of currency crisis (that is, not being able to pay short-term foreign debts for lack of access to “hard currency”)."

That's interesting. It seems that the choice is between the Dollar and Euro. But eliminating a currency crisis is important.

"If we are wise and fortunate, in the future we will have corporate governance, capital standards and monetary policy regimes that better constrain the dangerous build-up of excessive leverage among consumers, banks and governments. But that is not enough. We need new safe-fail policies to prevent inevitable institutional failures from snowballing into economic crises."

Notice the focus on excess leverage. That's the main point, I believe.