Post-Lehman, reduced rehypothecation results in higher funding costs for financial institutions

TO BE NOTED: From All About Alpha:

"This Earth Day - Reduce, Reuse, Rehypothecate Apr 16th, 2009 | Filed under: Today's Post

It turns out that in the financial ecosystem, re-using collateral is good for the environment. This according to a new IMF working paper.

Unfortunately, the demise of Lehman put a crimp in things and discouraged such recycling. Says the working paper:

“…rehypothecation was acknowledged to be positive for the global financial system, prior to Lehman.” (our emphasis)

The report, titled “Deleveraging After Lehman - Evidence from Reduced Hypothecation” concludes that the practice of rehypothecation dropped off just as hedge funds began to think the unthinkable: what if their own prime broker went belly up?

This is a valid concern. As The Independent wrote last fall:

“Funds have found that assets such as equities whose recovery from the prime brokerage division should have been straightforward are in doubt because of “rehypothecation”. The small print of the contracts said that Lehman could use the securities itself, including lending them out to short sellers. This meant the assets were reclassified as unsecured, putting them further down the queue for repayment and raising the prospect of big losses. Hedge funds may have up to $70bn in Lehman prime brokerage accounts, with the value of rehypothecated non-cash assets estimated at $22bn.”

The new IMF working paper (by Manmohan Singh of the IMF and James Aitken of UBS) finds that the collateral held by prime brokers that is eligible for rehypothecation fell not just because Lehman bought the farm, but also because clients of other major prime brokers pulled in the reigns - reducing the assets made available for rehypothecation. As the table from the paper shows, the total rehypothecatable assets held by the largest 4 prime brokers fell from about $3.1 trillion in May 2008 to $1.1 trillion only 6 months later…

As Singh and Aitken argue, rehypothecation has been hit by a bit of a double-whammy. Not only have investors opted for segregated accounts (that would prevent their assets from being rehypothecated), but less securities lending has reduced the supply of rehypothecatable assets:

“…reduced rehypothecation is being accompanied by reduced securities lending. The decline in the amount of collateral thus flowing from the securities lending operations of the major custodians from end-2007 to end-September 2008 is about $737 billion, which could have been pledged and possibly repledged.”

Indeed, the table below from the report shows a precipitous drop in securities lending (due to the unwillingness of major investors to lend out their stocks, but no doubt also in large part due to short bans).

So Lehman seems to have put a chill into the rehypothecation game, and the concurrent reduction in securities lending compounded the problem. The authors of this paper say that if institutional investors and hedge funds don’t loosen up on their requirement for segregated (nonrehypothecatable*) accounts, the financial environment will suffer…

“If collateral could not be rehypothecated, though, the entire financial system would be put at risk as this was the basis of so much activity in the system. Post-Lehman, reduced rehypothecation results in higher funding costs for financial institutions that have until recently been able to use their client money/collateral.”

"Deleveraging after Lehman—Evidence
from Reduced Rehypothecation
Manmohan Singh and James Aitken
WP/09/42

© 2009 International Monetary Fund WP/09/42
IMF Working Paper
Monetary and Capital Markets Department
Devleveraging after Lehman—Evidence from Reduced Rehypothecation
Prepared by Manmohan Singh and James Aitken1
Authorized for distribution by Udaibir S. Das
March 2009
Abstract
This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those
of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published
to elicit comments and to further debate.
Rehypothecation is the practice that allows collateral posted by, say, a hedge fund to their prime
broker to be used again as collateral by that prime broker for its own funding. In the United
Kingdom, such use of a customer’s assets by a prime broker can be for an unlimited amount of the
customer’s assets. And moreover, there are no customer protection rules (such as in the United
States under the Securities Act of 1933). The paper shows evidence that, following Lehman’s
bankruptcy, the extent of rehypothecation has declined substantially, in part because investment
firms fear losing collateral if their prime broker becomes insolvent.. While less rehypothecation
reduces counterparty risk in the system, it also reduces market liquidity.
JEL Classification Numbers: G21; G28; F33; K22; G18; G15
Keywords: Rehypothecation; Lehman’s bankruptcy; Counterparty risk; Liquidity risk
Author’s E-Mail Address: msingh@imf.org; james.aitken@ubs.com
1 Manmohan Singh is a Senior Economist with the International Monetary Fund and James Aitken is an
Executive Director with UBS. The authors wish to thank Darrell Duffie, Kimberly Summe, Paul Mills,
Herve Ferhani, Mahmood Pradhan, and Peter Stella for their comments. The views expressed are our own
and not of the IMF or UBS. We are responsible for any errors or misinterpretations.
2
Contents Page
I. Introduction ..........................................................................................................................3
II. Rehypothecation in the United States and the United Kingdom..........................................3
III. Rehypothecation After Lehman’s Bankruptcy ....................................................................5
IV. Conclusion ...........................................................................................................................7
References...............................................................................................................................11
Tables
1. Collateral Received that can be Pledged is Decreasing .........................................................6
2. Securities Lending by Major Custodians...............................................................................6
Appendix
1. Securities Exchange Act’s Rule 15c3–3 ................................................................................9
3
I. INTRODUCTION
Rehypothecation means that the collateral posted by a prime brokerage client (e.g., hedge
fund) to their prime broker can be used as collateral also by the prime broker for its own
purposes.2 Every Customer Account Agreement or Prime Brokerage Agreement with a prime
brokerage client will include a blanket consent to this practice unless stated otherwise.
Market sources suggest that rehypothecation of assets has historically been a cheaper way of
financing the prime business than turning to the repo market.3 In Section II we describe the
differences between rehypothecation rules in the United States and in the United Kingdom.
In the United Kingdom and Europe, such use of a customer’s or hedge fund’s assets by a
prime broker can be for an unlimited amount of the customer’s pledged assets. However,
there are no customer protection rules such as those offered under the Securities Act of 1933
in the United States. In Section III, we show evidence that, following Lehman’s bankruptcy,
rehypothecation is becoming much more limited. While this may reduce counterparty risk, it
can in turn aggravate global liquidity risk. In the concluding section, we highlight the need to
discuss reduced rehypothecation as it is likely to continue.
II. REHYPOTHECATION IN THE UNITED STATES AND THE UNITED KINGDOM
A defined set of customer protection rules for rehypothecated assets exists in the United
States, but not in the United Kingdom. This difference meant that when Lehman Brothers
International (Europe) filed for insolvency, there was no statutory protection available to
those customers as the United Kingdom insolvency regime is not specific to entity type. In
the United States, however, the Securities Investor Protection Act (SIPA) of 1970 provides
for certain procedures that will apply in the event of the insolvency of a broker-dealer.
Hence, the customers of Lehman Brothers Inc. (U.S.) could potentially be treated more
advantageously than the U.K. customers of Lehman Brothers International (Europe) in terms
of the timing and identification of the return of rehypothecated assets. The customer
protection rule is designed to work in conjunction with the Federal bankruptcy scheme for
broker-dealers created by SIPA.
2 According to IMF WP 08/258, rehypothecation was acknowledged to be positive for the global
financial system, prior to Lehman.
3 Empirical work to test this hypothesis has been absent or very limited, but may be very relevant if
rehypothecation loses ground in the near future. Repos have a cost that can be higher if there is failed
delivery; rehypothecation is a legal assignment and thus is/was costless (until Lehman’s bankruptcy
especially in United Kingdom).
4
In the United Kingdom, rehypothecation can be for an unlimited amount of the customer’s
assets and there are no customer protection rules such as Rule 15c3–3 in the United States.4
(see Appendix 1). Rule 15c3–3 prevents a broker-dealer from using its customers securities
to finance its proprietary activities. Under Rule 15c3–3, the broker-dealer may
use/rehypothecate an amount up to 140 percent of the customer’s debit balance (i.e.
borrowing from the broker-dealer).5
Created by SIPA, the Securities Investor Protection Corporation (SIPC) is an important part
of the overall system of investor protection in the United States. SIPC’s focus is very
specific: restoring funds to investors with assets in the hands of bankrupt and otherwise
financially troubled brokerage firms (e.g., Lehman). Since 1970, SIPC has accumulated
almost $2 billion from its members’ assessments that can be used by investors to recover
assets during insolvency.
A key reason why hedge funds may have previously opted for funding in Europe is that
leverage is not capped as in the United States via the 140 percent rule under Rule 15c3–3.
Leverage levels at many U.K. hedge funds, banks and financial affiliates have been higher, as
both United Kingdom (and continental Europe) do not have a parallel to SIPA.6 Thus, prime
brokers and banks would rehypothecate their client’s assets along with their own proprietary
assets as collateral for funding from the global financial system. However, since the U.K.’s
bankruptcy law does not make a distinction between banks and broker-dealers and does not
provide the associated protection from broker-dealers (like SIPA in the United States), hedge
fund assets remain frozen in the United Kingdom, whereas thanks to SIPA, this is not the
case in the United States. Disentangling hedge fund assets from the broker-dealer/banks’
proprietary assets that have been rehypothecated together, will remain an onerous task in the
United Kingdom.
Rehypothecation is allowed only on margin securities in the United States. Fully-paid
securities, which are the securities for which a customer has actually made full payment, are
generally held in the cash account and are not permitted to be rehypothecated. Excess margin
securities, which are that portion of a customer’s margin securities having a market value that
4 A customer includes any person from whom or on whose behalf a broker-dealer holds securities or
cash unless specifically excluded. A customer excludes counterparties to repo and stock lending
agreements.
5 Assume a customer has $500 in pledged securities and a debit balance of $200, resulting in net
equity of $300. The broker-dealer can rehypothecate up to $280 of the customer’s assets (140 percent
x $200).
6 Market sources indicate that there is asymmetry within continental Europe on rehypothecation rules;
however, there is no equivalent to U.S. Sec 15c3–3.
5
exceeds 140 percent of the customer’s debit balance to the broker-dealer, are also not
permitted to be rehypothecated. Margin securities, which are customer securities held in a
margin account and for which the customer has not made full payment, are not subject to the
possession and control requirement, so a broker-dealer can use these securities in its own
business—including rehypothecation—subject to certain limitations.
III. REHYPOTHECATION AFTER LEHMAN’S BANKRUPTCY
Based on recent 10Q reports, rehypothecation is declining rapidly. After Lehman’s
bankruptcy, prime brokers have been demanding more cash collateral in place of securities
(unless they are highly liquid securities). Liquidator PriceWaterhouseCoopers (PWC)
confirmed in October 2008 that certain assets provided to Lehman Brothers International
Europe (LBIE) were rehypothecated and no longer held for the client on a segregated basis
and as a result the client may no longer have a proprietary interest in the assets.7 As such,
investors of LBIE fell within the general body of unsecured creditors. Hedge funds often use
their securities for their own repo trades and financing of their own positions, and are
increasingly seeking to ensure that assets that have not been pledged as collateral are kept in
segregated client accounts, so that prime brokers have absolutely no claim over the assets in
them. Segregated accounts, broadly speaking, includes sweeping non-collateral assets into
custody accounts, restricting rehypothecation rights, using multiple prime-brokers, and
applying for client money protection as under U.K. FSA’s Client Money Rules.8
Some investors have now taken precautionary measures against the practice by taking term
loans from large banks and sweeping assets which are not being used as collateral by the
prime brokers. The (former) investment banks are now showing a trend away from
rehypothecation (Table 1). We measure this from their 10Q and 10K filings by subtracting
the collateral that was pledged from the collateral received. The latest data show that since
end-2007 the decline in rehypothecation (i.e., total collateral received that can be pledged)
by the largest four broker-dealers was $1.774 trillion.
7 There was a case in London in the High Court on September 22, 2008 where the High Court refused
to grant the petitioning hedge fund the return of its assets—despite the fact that their agreement
indicated that Lehman could not use its assets for rehypothecation. In the United Kingdom, it is title
transfer (unlike the United States, where the client retains ownership but the broker would have a
security interest).
8 Some of the astute fund managers in the United Kingdom are already doing so. Brevan Howard’s
Annual Investment Manager Review states: “We limit the rights of prime brokers to rehypothecate
our securities. We move our cash balances away from our prime brokers to segregated custody
accounts at third parties.”
6
Table 1. Collateral Received that can be Pledged is Decreasing
Nov 2005 Nov 2006 Nov 2007 May 2008 Aug 2008 Nov 2008
Lehman 528 621 798 518
Morgan Stanley 798 942 948 953 877 294
Goldman Sachs 629 746 891 869 832 579
Merrill Lynch 538 634 855 865 676 327
JPMorgan /9
Source: 10Q and 10K reports; For Merrill Lynch the column dates are December, June and September instead of
November, May, and August.
Furthermore, reduced rehypothecation is being accompanied by reduced securities lending.
The decline (in absolute dollar terms) in the amount of collateral thus flowing from the
securities lending operations of the major custodians from end-2007 to end-September 2008
is about $737 billion, which could have been pledged and possibly repledged (Aitken, 2009).
The decline in collateral if measured from March 2008 (the peak) is about $814 billion (See
Table 2).10
Table 2. Securities Lending by Major Custodians
(billions of dollars)
Dec 31, 2007 March 31, 2008 June 30, 2008 Dec 31, 2008
Bank of NY $619 $637 $567 $341
State Street $558 $591 $550 $325
JPMorgan $385 $411 $362 $169
Total $1,562 $1,639 $1,479 $825
Source: 10Q and 10K reports
9 JPMorgan’s recent 10Q and 10K reports show an increase in ‘collateral received that can be
pledged’ due to the combined reporting of Bear Stearns and the perception of ‘being close to Fed’
bank. It is difficult to disentangle these and other issues that contributed to a growth in this area for
JPMorgan.
10 Rehypothecation, legally is distinct from repos which includes collateral received from dealer repo
counterparties, among other uses; however, their economic impact is the same for global liquidity
purposes.
7
The above are the three major custodians and not the entire financial system; the reduction,
due to the aversion to rehypothecation and reduced securities lending globally, is likely to be
much higher as the number of investors who are banning the lending of securities by their
custodians continues to grow.
Overall, good collateral is increasingly getting scarce in the present credit crisis (Duffie and
Zhu, 2009). Since December 2007, the recent 10Qs of the large four (former) investment
banks show a reduction of almost $1.8 trillion in ‘collateral received that can be pledged’ i.e.,
a sharp decline in rehypothecated collateral. Also, between the major three global custodian
banks there has been a decline of about $750 billion since December 2007 in collateral
flowing in the global financial system. This decline stems from their own counterparty risk,
mandate constraints from their clients, and the deleveraging that is taking place. This reduced
liquidity of over $2.5 trillion in the United States banking system alone, adds to the cost of
funding in the financial system.
Before Lehman, high grade collateral was encouraged to be pledged, repledged and
rehypothecated. If collateral could not be rehypothecated, though, the entire financial system
would be put at risk as this was the basis of so much activity in the system (Segoviano and
Singh, 2008). Post-Lehman, reduced rehypothecation results in higher funding costs for
financial institutions that have until recently been able to use their client money/collateral.
Thus, one may argue that reduced rehypothecation is a positive development especially if
jurisdictions like the United Kingdom do not have swift bankruptcy resolution (or a SIPC
type institution like in the United States). It is likely that, in the near future, hedge funds will
have to pay increased fees for services of the prime broker if their collateral is now allowed
to be rehypothecated.
While the use of collateral mitigates counterparty risk, it can aggravate funding liquidity risk
because counterparties have to provide additional collateral at short notice if conditions
change.11 During the recent turmoil, shortages of high-quality collateral emerged prompting
special operations by central banks.
IV. CONCLUSION
Having access to high quality collateral did not always guarantee that troubled institutions
could maintain access to wholesale funding, as evidenced in the case of Bear Stearns.
However, presently major financial institutions worldwide have either increased or created
11 The more widely collateralization is used, the more significant this risk becomes, especially as
market prices movements in hedged portfolios result in changes in the size of counterparty credit
exposures.
8
sizable liquidity buffers of high-grade collateral, and cash. This is a rational response in the
aftermath of Bear Stearns, Lehman and AIG.
Following the collapse of Lehman, hedge funds have become more cognizant of the way the
client money and asset regime operates in the United Kingdom. For some, the United
Kingdom provides a platform for higher leveraging (and deleveraging) not available in the
United States.12 For others—especially those affected adversely by the Lehman bankruptcy
—if jurisdictions like the United Kingdom do not provide for swift bankruptcy resolution (or
a SIPC type institution like in the United States) they will limit rehypothecation. The trend so
far from Table 1 is an overall aversion to rehypothecation.
Does reduced rehypothecation encourage secured lending (e.g., repo market)? Adrian and
Shin (2009) show a declining trend in primary dealer repo activity (adjusted for M2) that is
contributing towards the credit crunch.13 In the present financial crisis, overnight inter-bank
banks (e.g., fed funds) rates have dropped with liquidity injections, so repo rates and rebate
rates approach zero, which means that failure to return collateral has a small penalty (at least
until the new delivery failure penalties are approved and kick in). Thus, there was an
increasing number of delivery failures in the repo market last fall, and such failures are still
continuing, albeit to a somewhat lesser extent. This further disrupts the supply of collateral,
because collateral can then be hoarded at trivial penalties. The resulting deleveraging is
leading to dislocations in the cash bond market (e.g., negative basis).
From a policy perspective, the recent trend depicted in the two tables above is likely to
continue. In the aftermath of Lehman, banking clients such as hedge funds in the United
Kingdom are demanding “segregated accounts” (Sidley Austin, 2008).14 Looking forward,
this may result either in the prime business changing in favor of tri-party repo-financing
and/or assigned custody, or in a move to a U.S. brokerage. In general, if the financial crisis
deepens, there will be an increasing tendency for those providing collateral to counterparties
to ask for it to be segregated from the counterparty’s assets and to place limits on its further
use.
12 Reduced rehypothecation leads to deleveraging (via the proprietary trading desks of the brokerdealer)
that results in further aversion to rehypothecation.
13 Bridgewater, Daily Observations, February 13, highlighting that many foreign central banks are not
keen on lending U.S. Treasuries in the repo market.
14http://www.sidley.com
9
APPENDIX I. SECURITIES EXCHANGE ACT’S RULE 15C3–3
In essence, Rule 15c3–3 of the Securities Exchange Act of 1934 prevents a broker-dealer
from using its customers’ securities to finance its proprietary activities. The rule has three
principal requirements:
• A broker-dealer must maintain possession or control of certain customer securities
(all fully paid securities and excess margin customer securities i.e., securities in a
customer’s margin account that exceed 140 percent of the margin debit in their
account.)
• As to customer cash, a broker-dealer must deposit the cash or “qualified securities” of
like value in a special account known as the “reserve account”. In other words, the
broker-dealer is required to segregate all customer cash or money obtained from the
use of customer property that has not been used to finance transactions of other
customers.
• As to customer securities that are not required to be in the broker’s control (e.g., those
securities posted as required collateral that can be pledged as collateral to third
parties), the broker-dealer is subject to limits on the amount it can borrow against
such securities.
The customer protection rule is designed to work in conjunction with the Federal bankruptcy
scheme for broker-dealers created by SIPA.
A. Customer
“Customer” includes any person from whom or on whose behalf a broker-dealer holds
securities or cash unless specifically excluded.
Customer excludes:
• Subordinated lenders to the broker-dealer;
• Other brokers or dealers and municipal securities dealers or government securities
broker-dealers; and
• Counterparties to repo and stock lending agreements.
A U.S. bank is generally a customer, even if it is affiliated with the broker-dealer. A nonbroker-
dealer affiliate of the broker-dealer, even a subsidiary, can be a customer.
10
B. Control Requirement
The broker-dealer must obtain and maintain physical possession or control of all customer
fully-paid and excess margin securities. A good control location is a U.S. bank. Outside the
United States, securities can be held at a non-U.S. bank, broker or dealer, depository or
clearing agency designated by the SEC. In addition, the SEC has permitted service firms
affiliated with a foreign investment company that performs various services for the fund to
serve as foreign control locations. Control means that the securities are located in an account
in the name of the broker-dealer at a clearing corporation, depository or bank, free of any
lien.
C. Types of Securities
The customer protection rule divides securities held or purchased by a broker-dealer into four
categories:
• “Fully-paid securities”, which are generally held in the cash account into which a
customer has actually made full payment;
• “Excess margin securities”, which are that portion of a customer’s margin securities
having a market value that exceeds 140 percent of the customer’s debit balance to the
broker-dealer;
• “Margin securities”, which are customer securities held in a margin, or any other
Regulation T account for which a customer has not made full payment. Margin
securities are not subject to the possession and control requirement, so a broker-dealer
can use these securities in its own business, subject to certain limitations; and
• Non-customer securities (proprietary positions, for example).
Fully paid securities and “excess margin securities” cannot be rehypothecated (they have to
be “controlled”). A broker-dealer has the right to rehypothecate customer (margin) securities
when the customer pledges those securities to the broker-dealer to support a margin debit.
Under Rule 15c3–3, the broker-dealer may use an amount up to 140 percent of the
customer’s debit balance.
11
REFERENCES
Adrian, Tobias and Shin, Hyun Song, Money, Liquidity, and Monetary Policy, Federal
Reserve Bank of New York, January, 2009
Aitken, James, 2009, The Plumbing, UBS presentation, January 28, 2009.
Duffie, Darrell and Zhu, Haoxiang, “Does a Central Clearing Counterparty Reduce
Counterparty Risk,” forthcoming.
Segoviano, Miguel and Manmohan Singh, 2008, Counterparty Risk in OTC Derivatives, IMF
Working Paper 08/258.
Sidley Austin LLP, Hedge Funds and the U.K. Prime Brokers in the Post-Lehman
Environmnet (December 2, 2008)"

the firm was “too big to fail” and its bankruptcy caused a “quantum” jump in the magnitude of the financial crisis.

TO BE NOTED: From Bloomberg:

"Yellen Signals Fed’s Decision to Let Lehman Fail Was a Mistake

Share | Email | Print | A A A

By Michael McKee and Vivien Lou Chen

April 17 (Bloomberg) -- Federal Reserve Bank of San Francisco President Janet Yellen signaled that it was a mistake to allow Lehman Brothers Holdings Inc. to collapse, saying the firm was “too big to fail” and its bankruptcy caused a “quantum” jump in the magnitude of the financial crisis.

The impact of Lehman’s failure “was devastating,” Yellen said yesterday after a speech in New York. “That’s when this crisis took a quantum leap up in terms of seriousness.”

Lehman was forced into bankruptcy on Sept. 15 after a weekend of negotiations at the Federal Reserve Bank of New York failed to produce a buyer and Fed and Treasury officials decided not to provide the firm with a loan.

Credit markets froze in the days after Lehman’s failure. Commercial paper markets almost ceased functioning as lenders shunned risk and the spread between the London Interbank Offered Rate, a measure of banks’ willingness to lend, and the average rate on overnight swaps rose 360 basis points in two weeks.

Yellen said she disagrees with Fed officials who argued in September that a government bailout of Lehman would encourage excessive risk-taking among investors. She commented in response to an audience question after a speech sponsored by the Levy Economics Institute of Bard College

“Lehman was a systemically important institution,” Yellen said, noting she was “sitting in California” at the time of Fed deliberations and “wasn’t involved in anything having to do with it.”

Yellen, echoing Fed Chairman Ben S. Bernanke and other federal regulators, said government officials need the authority to close down non-bank financial institutions.

‘Orderly Wind-Down’

Congress should “pass legislation that would provide for the orderly wind-down of a non-bank institution,” she said. “I’m sure it would have been used in the case of Lehman,” Yellen said, while declining to label the decision not to rescue Lehman an error.

Without a suitable “tool box,” Fed officials have been forced to improvise throughout the credit crisis.

“Bear Stearns, Lehman, AIG -- these have all been horrendous, miserable situations,” Yellen said. “We’re pushing the envelope of our powers, but we’re choosing to do that because the consequence of failing to do that seem unthinkable.”

Before joining the San Francisco Fed, Yellen served as a member of the Fed’s Board of Governors from 1994 to 1997. She left that post to become Chairman of the White House Council of Economic Advisers under former President Bill Clinton.

Policy Tools

Yellen also said she no longer opposes using the central bank’s policy tools to avert harmful asset-price bubbles similar to the one in U.S. housing this decade.

“Now that we face the tangible and tragic consequences of the bursting of the house price bubble, I think it is time to take another look,” she said in her speech. “What has become patently obvious is that not dealing with certain kinds of bubbles before they get big can have grave consequences.”

Yellen’s remarks make her at least the second Fed official after Gary Stern, of Minneapolis, to rethink the central bank’s hands-off approach toward bubbles, an article of faith during former Chairman Alan Greenspan’s 18-year tenure. The Fed’s low interest-rate targets between 2002 and 2004 were partly to blame for the easy credit and housing-price escalation that led to the current financial crisis, the San Francisco bank president said.

“I would not advocate making it a regular practice to use monetary policy to lean against asset price bubbles,” Yellen said in a speech at the conference. “However, recent experience has made me more open to action. I can now imagine circumstances that would justify leaning against a bubble with tighter monetary policy.”

Long-Held Ideas

While Yellen’s remarks are unlikely to result in immediate monetary-policy changes, they demonstrate how officials are questioning long-held ideas about the Fed’s role in markets. Yellen has led the San Francisco Fed since 2004.

A report yesterday showed that San Francisco Bay Area home prices fell a record 46 percent in March from a year earlier, the 16th month of declines.

Data released this week on employment and other areas of the economy suggest that the U.S. slump is easing. The reports buttress Bernanke’s assessment this week that the “sharp decline” in the economy appears to be moderating.

The economy, in areas such as home sales and consumer confidence, is showing “tentative signs” that the decline is slowing, Bernanke said in an April 14 speech in Atlanta. He added that “a leveling out of economic activity is the first step toward recovery.”

The central bank said in its Beige Book business survey on April 15 that the contraction slowed across several of the biggest regional economies last month, with some industries “stabilizing at a low level.”

“While we’ve seen some tentative signs of improvement in the economic data very recently, it’s still impossible to know how deep the contraction will ultimately be,” said Yellen, 62, who votes on rates this year."

After we come out of this crisis, we must remember how it happened, and make sure they are never broken again

TO BE NOTED: From the FT:

View from the Top

Felix Rohatyn of FGR Associates on the final days at Lehman

"Speech: ‘Rebuilding the Economy by Rebuilding America’

By Felix Rohatyn

Published: April 1 2009 17:30 | Last updated: April 1 2009 17:30

The following is a speech given by Felix Rohatyn, president of FGR Associates and former US ambassador to France, to the Economic Club of Chicago on March 24, 2009.

It is good to be back at the Economic Club of Chicago and to see so many friends. It is always a privilege to speak here and I am grateful to be your guest.

We meet today at a time of grave concern about the global economy and our position in it. As Roosevelt did almost eighty years ago, we are searching for a strategy for reviving America and allowing us to lead. I believe that a central component of that strategy must be significant new investment in our public infrastructure.

I have argued for greater attention to infrastructure for many years. President Obama’s stimulus program now includes infrastructure, and his budget for next year proposes a federal infrastructure bank to fund projects of regional and national significance – an idea that holds great promise for smarter, more effective federal spending.

I hope that these early initiatives, as important as they are in themselves, will lead to the massive level of infrastructure investment that we need in order to secure our future quality of life, increase economic productivity and create millions of jobs.

As of now, we must end the sterile debate over “big” or “small” government that has stopped us from making the investments we need to prosper. For almost three decades, we have been seized by a caricature of government as fundamentally inept and wrong-headed. But as we have seen in recent events, this makes for a better speech than a rule for governing. Governor Mario Cuomo once said to me: “We should have all the government that we need but only the government that we need.” He was right.

I am a capitalist but I do worry that capitalists may, through short-sightedness, greed, and/or vanity, bring our system into jeopardy. We need to move past the simplistic notion that we all will prosper if government would only “get out of the way.”

My experience in both government and business has taught me that sometimes, particularly in times such as these, government clears the way. Throughout American history, government investment has served as a platform for economic growth and a more affluent and inclusive society. From the Louisiana Purchase and the Erie Canal, through the creation of the Land Grant colleges, to the Interstate Highways and the G. I. Bill, government investment was pivotal.

These important episodes offer us important lessons. One is that none of them was born of consensus. In retrospect, we regard the Louisiana Purchase and the Erie Canal as “no-brainers.” But in their day, many people thought those projects were wasteful budget-busters –they could not see how valuable these investments would be. And I worry that today our budget rules don’t distinguish adequately between investment and consumption, leaving us with too little of the former, and too much of the latter.

Moreover, the opposition to these investments was often self-interested and privileged. The elite private universities saw no need for the Land Grant Colleges. Private utilities were appalled by the idea of TVA. And there were simply political elites who feared that the sweeping change investments bring would undermine their own power.

A third lesson of these episodes is that few of them ever work out perfectly. The railroad barons rode the Transcontinental Railroad to great and undeserved wealth. Speculators found room to maneuver within the Homestead Act. There were often great abuses of good programs. But the fact that these programs weren’t perfect doesn’t mean they weren’t worthwhile. The prospect of problems should focus us, but not immobilise us.

I mention these events because I hope that President Obama’s recent stimulus will be the beginning of a rebalancing of investment and consumption in our economy, and a long-term reappraisal of what our government does and why.

In fact, infrastructure is only one of a number of pressing, national investment needs.

Too many children go to school in dilapidated facilities. Too many suffer from illnesses because we underinvest in public health. We must make the transition to a domestically-based, carbon-free economy. We need to complete a broadband, Internet network. These are the investments that will define our future, as surely as the Land Grant Colleges or the Panama Canal did in their day.

The stimulus package passed by the Congress was not perfect. But I am dismayed when I hear it derided as wasteful public spending, or that infrastructure spending is unwarranted because some of it would take a year to get underway.

There is clearly a need for stimulus – we need to create employment. But we need to balance the short- and long-terms more artfully. We may need another stimulus in very short order.

This is another lesson reinforced by the current crisis – the recognition that we need to invest federal dollars consistently and rationally.

Again it’s not just infrastructure. We may soon invest in salvaging the auto industry; I think we should. But that investment will be wasted if we do not implement an energy tax program that will make the investments in new automobile technology worthwhile.

Our global competitors are investing in their own futures. If China’s investments in education match its massive investments in infrastructure, China will become even more competitive. The Chinese already have plans to construct 300,000 km of rural roads and nearly 100 new airports. In fact, a recent article in the New York Times noted that China is using the need for domestic fiscal stimulus as a platform for making new, public investments that will make them a better competitor.

For many years, I have looked for a different approach to the way we finance infrastructure. Our current programs are good at spending money, but not at getting something in return. They subsidise construction but spend too little on maintenance. They skirt the issue of what users are obliged to pay. And they do not make different types of investments compete for scarce taxpayer dollars.

Americans are willing to pay for infrastructure if they get value for their money. Recent polling results show that 94 percent of Americans are concerned about our infrastructure and four out of five are willing to pay more for it.

For example, Mayor Bloomberg’s proposal to charge mid-town drivers a congestion fee was killed with demagoguery. But the issue will soon be how to impose such charges, not whether to do so. You can’t build your way out of urban gridlock or airspace congestion. We will have to use pricing to ration and smooth out demands, just as we do now for electricity.

A further reality our programs overlook is that private money is now in the infrastructure funding business to stay. Our challenge is to figure out the best way to use it.

Private money should be guided towards more productive purposes – such as the construction of new facilities, as opposed to the refinancing of old ones.

When we add it all up, these new realities require a new system for appraising, selecting, and funding our public works.

Two years ago, a bipartisan Commission chaired by Senator Warren Rudman and myself unanimously recommended creating a National Infrastructure Bank. All the infrastructure funding programs would be folded into the Bank, and any major federal investment in an individual project would have to be approved by the Bank’s evaluators.

The Bank would be able to negotiate with the individual state or local sponsors of a project. Alternatively, it could help groups of states come together for projects with national implications, such as the upgrading of the national rail freight nexus in Chicago or high-speed inter-city rail that saves energy and frees up airspace while addressing security concerns, or many others.

It would also create an avenue for private investors to put risk capital into new projects and protect their involvement through the Bank’s own participation. In short, it would treat Infrastructure like an investment, and not just a jobs program.

The Bank would be capitalised by giving it the amounts that now go into the existing programs, about $60-70bn per annum. But the Bank would be free to support projects in any number of ways, as would a private sector bank in a competitive environment.

The American Society of Civil Engineers estimates it will take $2,200bn dollars to bring our infrastructure to an acceptable level within five years. This is a staggering sum, and it speaks to the negligence of which we have been guilty. The $120bn allocated in the stimulus is only a small part of a solution. However, the Bank could make significant strides towards filling these needs by issuing its own long term bonds and, with conservative leverage, could raise several hundred billion dollars initially, and become self-financing over time. Thus, the Bank could become a strong partner with domestic and foreign sources of capital to finance our infrastructure investments. The goal of $500bn of new investment over the next five years would be readily achievable if we refocused federal programs and added outside sources.

This would require a sweeping reorganisation of the way we invest in our country, and at this time may seem like a far-fetched proposal. But the problems we face are so important and our tools so outdated that only a full reorganisation will do.

I know that consideration of infrastructure financing must be weighed in the context and climate of the economic issues we face, here at home and all over the world: energy security; the prospect of global climate change; the need to reform our health care system; security against terror and the proliferation of weapons of mass destruction, to name but a few.

It is a disconcerting list, and fixing these problems will not be easy. But we are now talking about these problems realistically. I do not know if President Obama will succeed in his arduous agenda. But at least we now have an agenda, and that is the first step.

Within this framework, one of the most important issues is the necessity for the western democracies to forge even stronger ties aimed at global growth and stability. The difficulties in the organisation of the recent G20 Summit have not been encouraging on that score.

The last years of the 20th Century were years of astounding wealth creation. The markets demanded cheap money and the Fed gave it to them. Reckless speculation and excessive leverage were aided and abetted by regulators blind to what was happening. With the repeal of the Glass-Steagall Act in 1999, our leading financial firms were given the license to become too big to fail and they, in turn, became too big to be managed. New financial creations, hedge funds and private equity, invented by bankers and traders all over the world, were searching for higher and higher returns. The markets then turned into casinos and the Bernie Madoffs and Allen Stanfords became heroes to those they would destroy. Close behind came the global financial crisis. And then the music stopped.

It is futile to search for one responsible party; everyone who matters was guilty. The question now before us is how we might meet the challenge of this remarkable moment and rebuild our country.

We have so far not found a secure formula to reverse these developments. The United States has taken the lead in urging strong stimulus by the developed countries, which is beginning to create a split between the positions of the US and the UK on the one hand, and the rest of the world on the other.

I believe the Europeans are wrong about stimulus, but they have ample reason to distrust American views. During the last two years an increasing level of controversy has surrounded our capital markets and, in particular, executive compensation, which gives rise to a general critique of American capitalism in today’s world.

During my four years as United States Ambassador to France, I spent considerable time and effort singing the praises of American market capitalism. It was met generally by European skepticism of its dangers and of its harshness. America’s capitalism over the decades has had enormous successes, but we must now show that our system is fair and that we are prepared to manage it pragmatically if we are to continue being the leaders of the world.

When the Prime Minister of China, our biggest creditor, publicly raises questions as to the security of Chinese assets in the US, it is time to give some serious thought to this issue. The recent controversies involving some of our biggest investment firms, banks and insurance companies require that the United States react with high standards – that we stand for the creation of wealth within a framework of fairness.

I know from my own experience that crises can lead to the kinds of reforms that build confidence and stability. My own involvement with a major financial crisis was the crisis of New York City in 1975. That crisis had been brought about by excessive lending by our banks and reckless spending by the City.

We succeeded in rescuing the City in the face of opposition created by President Ford’s Administration. It was not until President Giscard d’Estaing of France and Chancellor Helmut Schmidt of Germany warned President Ford of the danger of a bankruptcy of New York, that we were able to negotiate a modest federal loan to the City. But this averted the catastrophe of a bankruptcy that would have seriously wounded both the City as well as the State of New York. It was an early symptom of global financial integration.

We succeeded in rescuing the City and used our momentum to put New York’s fiscal house in order, thanks in large part to my friend and leader, Governor Hugh Carey. But the crisis New York City faced was less dangerous than today’s global crisis. In 1975, the banks were the rescuers – today they are the rescued. Many have been as short-sighted as New York itself was more than 30 years ago.

We’re now learning the cost of inadequate regulation and oversight . We will inherit partial ownership of a number of financial institutions and, if we do not stabilise the economy, we may have to nationalise several big banks temporarily – a circumstance fraught with danger. This was recently predicted by former Fed Chairman Alan Greenspan, a fervent supporter of deregulation. It may be that our government will turn out to be the only credible and large enough entity to provide financial shelter to some of our large financial institutions.

Market capitalism is a sophisticated system that requires adherence to sophisticated rules; we are now witnessing what happens when these rules are ignored. The financial system must be regulated with an eye to system risk. Institutions must maintain adequate capital and submit to greater transparency and strict boundaries on the kinds of businesses they enter. We cannot count on the conservativism or common sense of the system or its managers for its long-term stability. America must be a trustworthy partner in economic policy, and must keep its own house in order. These are the rules. After we come out of this crisis, we must remember how it happened, and make sure they are never broken again. This may be easier said than done, but the world depends on our doing it."

I am confident that increasing the supply of money will eventually lead to an increase in nominal demand.

TO BE NOTED: From The FT:

"Credibility is key to policy success

By Martin Wolf

Published: April 2 2009 19:29 | Last updated: April 2 2009 19:29

The UK has followed the US and Japan into “unconventional monetary policy”. Meanwhile, Mervyn King, governor of the Bank of England warns the UK government of the dangers of further discretionary fiscal stimulus. Yet what are the implications of the policies followed by central banks? Are these not the big threat to monetary stability?

According to forecasts from the International Monetary Fund, the UK’s general government deficit will be 9.5 per cent of gross domestic product this year and 11 per cent in 2010, the largest in the Group of 20. As I argued earlier this week (“Why G20 leaders will fail to deal with the big challenge”), the rise in the deficit, from 2.7 per cent of GDP in 2007, is the counterpart of the swing in the private balance, forecast at 8.9 per cent of GDP between 2007 and 2009.

As my colleague, Samuel Brittan, asked last week, why should such a temporary increase in the fiscal deficit be terrifying? UK net public debt – forecast at 61 per cent of GDP this year – remains well below the average of advanced country members of the G20. At the end of the Napoleonic and second world wars, UK public debt was close to 2.7 times GDP. Yet even this triggered none of the hyperinflationary consequences now widely feared. As the IMF also notes, even a 100 percentage point increase in the debt ratio should require an offsetting shift in the primary fiscal balance (with interest payments removed from spending) of no more than 1 per cent of GDP, provided fiscal credibility is maintained.

The condition for this is evident: in his Budget, the chancellor of the exchequer should lay out fiscal measures to go into effect, automatically, once the economy recovers. In short, what is needed is a far more credible fiscal regime.

Yet it is very peculiar to be agitated about the inflationary impact of fiscal deficits, yet relaxed about monetary expansion by central banks. Is the latter not the true danger? Or are these not just two sides of one coin, the ultimate inflationary risk being the central bank financing of deficits?

Yet, even before reaching that point, reliance on aggressive expansion of the balance sheet of the central bank has dangers, including for the fiscal position, as my colleague Willem Buiter has noted in his Maverecon column. Unconventional monetary policies work by expanding the money supply (“quantitative easing”), by easing credit constraints (“credit easing”) and by altering relative yields on assets, particularly through direct purchases of longer-term assets. The Bank of Japan focused on the first; the Federal Reserve has concentrated on the second; and the Bank of England has now initiated the last, with direct purchases of gilts.

Carried out with sufficient single-mindedness, such programmes will “work”. At the limit, a modern central bank can drown an economy in infinite quantities of fiat (or man-made) money. The question is the obverse: it is whether the longer-term inflationary impact of monetary expansion can be reversed in time. To this, again, two answers exist: one concerns feasibility; and the other concerns credibility.

On the former, the broad answer is that a central bank’s unconventional monetary operations are reversible: if it buys bonds, it can resell them; if it buys short-dated paper, it can allow it to expire; if it directly finances government deficits, it can sell the public debt to the public; and even if it sends cheques directly to every citizen, which would be closest to a purely fiscal operation, the government can always sterilise the monetary effects by issuing new bonds. So, if and when economies and, as important, financial systems, recover, aggressive action by the authorities would unwind the inflationary impact of even these unconventional policies.

So, as over fiscal policy, the fundamental question – as Spencer Dale, the Bank’s new chief economist, notes in an important recent speech – is the credibility of the commitment to stability.* If, for example, the central bank takes very large credit risk and the public doubts the willingness of the fiscal authorities to reimburse resulting losses, it will expect these losses to be monetised.

Similarly, the public may well doubt whether the huge expansion in central bank balance sheets – as is evident in the US – would be reversed in time. Inflationary expectations may then gain a firm hold, driving inflation-risk premia up and the exchange rates down. This would greatly increase the costs of restoring credibility on the inflationary upside, thereby further undermining the central banks’ ability to do so when the time comes.

The conclusion is straightforward: the ability to navigate through the crisis, using either fiscal or monetary measures effectively and at modest overall cost, depends in both of these cases on the credibility of the authorities’ commitment to long-term monetary stability. Neither huge fiscal deficits nor massive monetary expansions are themselves an unmanageable threat, provided the regime itself remains credible. This is crucial even for a country as indispensable to the global economy as the US. For the UK, it is close to a matter of economic life and death.

* Tough times, unconventional measures, www.bankofengland.co.uk"

"Page 1 of 12
Speech by
SPENCER DALE
EXECUTIVE DIRECTOR AND CHIEF ECONOMIST
BANK OF ENGLAND
Tough times, unconventional measures
Remarks at the Association of British Insurers Economics and Research Conference, London
Friday 27th March 2009
I would like to thank Rohan Churm, Alan Mankikar and Tim Taylor for their considerable help in
preparing these remarks. The views expressed are my own and do not necessarily reflect those of
other members of the Monetary Policy Committee.
Page 2 of 12
The UK economy is in a deep recession. Output in the United Kingdom fell at its fastest rate in
nearly thirty years in the final quarter of last year, and a similar fall in output in the first quarter of
this year appears likely. We are in the throes of a synchronised global downturn, which has spread
far and wide.
But the darkest hour is just before the dawn. Although immediate prospects appear bleak, the
substantial economic stimulus that is underway means that there are grounds for thinking that
economic conditions may start to improve later this year. An important part of that stimulus stems
from the extraordinary measures taken by the Monetary Policy Committee over the past six
months, including our decision to start using unconventional policy measures.
Today, I will describe my view of the economic outlook and outline the factors that I believe will
spur a gradual turnaround in our economy. And I will explain why, earlier this month, the
Committee voted to use unconventional policy measures: how they will work and how we will
monitor their effectiveness.
I am delighted to have the opportunity to discuss these issues at the Association of British Insurers.
The insurance industry is a key part of the UK economy and of the financial sector in particular.
Indeed, it accounts for a third of all the jobs in the UK financial sector. Your industry, like
virtually every other sector of the UK economy, is being affected by the recession. And given
your members’ significant holdings of gilts and corporate bonds, it will have a key role to play in
the transmission of the unconventional policy measures recently begun by the Committee.
1. THE ECONOMIC OUTLOOK
The causes of the current recession can be traced back to at least the summer of 2007. The fallout
from the sub-prime mortgage crisis and the resulting pressure on banks’ balance sheets led to a
Page 3 of 12
sharp tightening in the price and availability of credit. And the first stages of what became a
renewed and prolonged surge in oil and other commodity prices began to erode households’
spending power and eat into companies’ profit margins.
As a result, the UK economy gradually slowed through the end of 2007 and into the first half of
2008. But the economic outlook took a dramatic turn for the worse in the autumn of last year.
That deterioration followed the failure of Lehman Brothers, which triggered the most severe
banking crisis for almost a century. Confidence in the very essence of banking – as well as in
individual financial institutions – was shaken to its core and measures of financial market risk and
uncertainty ballooned. The resulting contraction in the supply of credit has had a significant
impact on the ability of households and companies to borrow and spend.
But the nature of the downturn over the past six months cannot be explained solely in terms of the
direct effects of the collapse of Lehman Brothers on the supply of credit. The impact of changes in
credit conditions on investment and consumption decisions tends to be gradual, as existing loans
mature and new contracts are negotiated. This contrasts with the dramatic pace at which economic
activity and sentiment turned during the final quarter of last year. Output, orders and investment
all fell precipitously in a matter of months. Moreover, the downturn in economic activity was
seemingly indiscriminate. Output in virtually every corner of the world fell sharply, irrespective
of a country’s exposure to sub-prime loans, the state of its banking system, or its level of
indebtedness. The effects of the shock were also felt far beyond its epicentre in the financial
sector. Manufacturing output has been particularly hard hit, with UK manufacturing output
estimated to have fallen by 4.9% in the fourth quarter of last year; the largest quarterly fall for over
thirty years. Many other countries have suffered even larger falls: Japanese manufacturing output
is estimated to have contracted by over 12% in Q4 and German manufacturing output by over 7%.
World trade is estimated to have fallen by over 6% in January alone.
Page 4 of 12
The pace, breadth and spread of the global downturn suggest that tighter credit conditions were not
the only force at work. It seems clear that a pronounced and widespread collapse in confidence
also played a major role. With the failure of Lehman Brothers it became all too apparent that the
problems in the financial sector were more acute than had previously been thought. This was
compounded by the realisation that even the largest financial institutions were not ‘too big to fail’.
More fundamentally, the demise of Lehman Brothers may have led to a questioning of
policymakers’ ability to deal effectively with such unprecedented financial turmoil. The view that
the impact of the financial crisis would be largely restricted to the exclusive confines of the Square
Mile and Wall Street was dispelled once and for all. Households and businesses cut back on their
spending as it became increasingly apparent that the effects of the financial crisis on the real
economy were likely to be deeper and more widespread than previously envisaged.
The impact of the tightening in the supply of bank credit and of the widespread collapse of
confidence was compounded by developments in the supply of trade credit. In previous
recessions, many large businesses in the UK were able to support smaller companies by reducing
payment times to companies further up the supply chain and by extending credit to those further
down. But pressures on corporate cash flows and the reduced availability of bank credit may have
limited the scope for larger companies to behave in this way in this downturn. The Monetary
Policy Committee, via its network of regional Agents, is monitoring closely developments in the
demand for and availability of trade credit.
The reduction in the availability of trade credit has been accompanied by a tightening in the supply
of credit insurance. This is at a time when the demand for such insurance is at its highest.
Similarly, heightened uncertainty about the global environment has increased the demand for
letters of credit from UK exporters.
Page 5 of 12
These developments are understandable and predictable: the economic environment has
deteriorated markedly and as insurers you need to protect yourselves against future losses. There
is a limit to how much insurance premiums can be raised before they exceed the profit margin
associated with a particular transaction. Higher prices can have the same effect as the complete
withdrawal of supply.
I know that members of the ABI are working hard with Government and with business to agree
how best to meet these challenges. It is vital for the long-term success of both your industry and
our economy as a whole that a workable solution is found.
Where next for the UK economy?
The Monetary Policy Committee set out its latest economic outlook in the February Inflation
Report. That Report went to great pains to stress the considerable uncertainty surrounding the
prospects for the economy. Nobody can predict with any certainty how the UK economy, or
indeed the world economy, is likely to fare over the next year or so. So beware of anyone that
suggests otherwise.
With that warning in mind, let me outline my central economic outlook, which is broadly similar
to that described in the February Report. Near-term prospects are bleak. Output is likely to
contract further in the first half of this year, as a weakening labour market and concerns about job
prospects weigh on consumption, companies run down their stocks and scale back investment
spending, and the synchronised slowing in world demand restrains export growth. But as we go
through 2009, I believe it is most likely that the pace at which output is contracting will ease and
that we will see some signs of recovery by around the turn of this year.
This view is based on the substantial stimulus that is already starting to flow through the pipelines
of our economy. There has been a marked easing in global monetary and fiscal policies; authorities
Page 6 of 12
around the world have also enacted substantial initiatives to revitalise the global banking system;
the sharp falls in commodity prices will boost households’ purchasing power; and the marked
depreciation in sterling should support demand, both at home and abroad, for domestically
produced output. The scale of this stimulus is significantly greater than that seen at comparable
stages of the recessions in the 1970s, 80s or 90s.
But to repeat, there is huge uncertainty about the precise form and timing of the recovery and so
this central path should be treated with a healthy degree of scepticism. In particular, I think the
risks around this central path are weighted to the downside, reflecting the possibility that the
actions taken by the authorities around the world to improve the availability of credit and to restore
business and consumer confidence are slow to take effect. So there may still be more to do.
Learning from past recessions
When considering the likely scale and duration of this recession, it is natural to examine the
experience from past recessions. And simple comparisons with recent recessions are not
encouraging. For example, taking account of developments in Q1, output appears likely to have
fallen by more in the first few quarters of this recession than in any of the preceding ones. But
when making these comparisons, it is important to recognise that the parallels are far from perfect.
The causes of this downturn are very different from those of most recent recessions and, as I have
just described, the policy response on this occasion has been much quicker and more decisive.
There is also a third factor that needs to be borne in mind when drawing lessons from history.
This is the first recession in the UK for nearly 20 years. The structure of our economy has
changed significantly since the early 1990s, and even more so since the early 1980s and 1970s.
The UK economy has undergone extensive reforms and deregulation, and businesses have been
transformed by the implementation of new technology and the effects of globalisation. It is hard
Page 7 of 12
to quantify precisely the various ways in which the structure of the economy has changed. The
appropriate data are not always available and it may be a long time until the effects are discernible
in aggregate economic statistics. Importantly, the significance of some of these structural reforms
may not be fully apparent until the economy is subjected to a substantial shock.
For example, one consequence of globalisation is that supply chains around the world are far more
integrated. This is likely to have played an important role in the speed and synchronisation of the
world downturn, as the effects of falling demand in a few countries were translated into lower
orders and production in many in a matter of weeks. That increased integration is also likely to
affect the speed and nature of the recovery.
Similarly, the technology used to control and manage inventories has changed substantially over
the past twenty or thirty years. This may have enabled companies to run down their stocks earlier
in this recession than in previous downturns. And indeed there is evidence that firms have already
cut back aggressively on their stock levels. A corollary of this sharp correction is that the stock
cycle may be shorter lived than in previous recessions.
The behaviour of the labour market may also have changed. I have been struck by the number of
business people who tell me about the array of measures they have already taken since their orders
starting falling sharply last autumn. Wages have been frozen or even cut, hours have been
reduced, working practices have been adjusted. To the extent that wages and hours are now more
flexible, the adjustment in employment may be less. But if it is easier for companies to vary their
labour force than in the past, much of this adjustment may come through more quickly than in
previous downturns.
It is hard to know at this stage how significant these structural changes will be in determining the
depth of the recession and the speed of the recovery. But the possibility that there has been a
Page 8 of 12
material structural change in our economy highlights a further danger of viewing the current
recession through the prism of previous ones. The latest economic data on world trade, output and
unemployment are unmistakeably grim, but we must continually challenge ourselves about how to
interpret these and the economic data to come. They could be telling us something about the
causes and size of the downturn, the impact of the policy measures taken so far, or how changes in
economic structure are affecting the response of output and employment.
Let me now say a little about the role the Monetary Policy Committee is playing in addressing the
challenges posed by the global economic downturn.
2. UNCONVENTIONAL POLICY MEASURES
The MPC responded to the marked deterioration in the economic outlook with an aggressive
easing in monetary policy. We reduced Bank Rate from 5% to an historic low of just 0.5% in a
matter of months. Moreover, at our policy meeting earlier this month, the Committee agreed to
finance £75 billion of asset purchases by the issuance of central bank reserves, in order to boost
the supply of money and improve the functioning of corporate credit markets.
The purchase (and sale) of assets by central banks is nothing new; central banks have always
implemented monetary policy by changing the size and composition of their balance sheets. Nor,
importantly, has the objective of monetary policy changed, which is to hit the Government’s 2%
target for CPI inflation. What is different, however, is the range of assets being purchased by the
Bank and the scale of those purchases. Given those changes, I want to explain the rationale for
large scale asset purchases in the current economic climate. In doing so, I will address two key
questions. First, how will asset purchases help us meet the inflation target? And second, how will
we monitor the progress of the policy and assess its effectiveness?
Page 9 of 12
How will asset purchases help us to meet the inflation target?
The objective of the asset purchase programme is to boost nominal spending in order to hit the
inflation target. The tightening in the availability of credit and the collapse in confidence has led
to a sharp slowing in the growth of nominal demand. The four-quarter growth rate of nominal
GDP sank to a record low in the final quarter of last year. The weakness in nominal spending has
been accompanied by a sharp slowdown in the growth of bank lending to firms and households
and in the growth of money holdings of the non-financial sector. At our policy meeting earlier this
month, the Committee judged that without the additional stimulus provided by the asset purchase
programme, the growth of nominal spending would be insufficient to meet the inflation objective.
The MPC instructed the Bank to use the additional reserves to purchase two types of assets: gilts
and high-quality corporate debt. This twin-track approach allows for asset purchases to stimulate
nominal spending in a variety of different ways. Such a pragmatic strategy seems entirely sensible
given that this in the first time these unconventional tools have been used in the UK.
I find it helpful to summarise the different mechanisms through which asset purchases may boost
nominal spending into three broad channels.
First, the purchases of gilts will act to increase their prices and reduce their yields. This change in
the relative attractiveness of holding gilts is likely to cause investors to reallocate their portfolios
into other assets, such as corporate bonds, which in turn will tend to reduce the yields on those
assets. In so doing, the borrowing costs faced by firms and households should fall. As of today,
the Bank has purchased £13bn of gilts from investors.
Page 10 of 12
Second, purchasing assets with central bank reserves will significantly increase the amount of
liquidity in the system. This expansion in the supply of money may in itself encourage greater
levels of lending and borrowing. Bank deposits are likely to increase, providing banks with a
ready source of funding to finance additional lending. Similarly, as the additional liquidity
permeates through the economy, companies may feel less constrained by the need to hoard
liquidity and more able to undertake investment projects.
Third, purchases of high-quality corporate debt should help to improve the functioning of
corporate credit markets. Strains on financial institutions’ balance sheets, combined with
heightened levels of uncertainty and risk aversion, have impaired the liquidity of key corporate
credit markets. Firms’ access to some of these markets has been restricted and the cost of credit
inflated. By purchasing assets in a targeted way, the Bank can aid liquidity in these markets and
so improve the availability of corporate credit. The Bank has been purchasing commercial paper
for over a month now. It made its first purchases of corporate bonds this week. And we are
reviewing the case for intervention in other corporate credit markets.
Importantly, the objective of the Bank’s operations within corporate credit markets is not to
purchase a specific quantity of assets; rather it is to improve the functioning of those markets. The
scale of purchases required to improve market liquidity may in fact be relatively small: the very
knowledge that the Bank stands ready to purchase assets may be as beneficial as the actual asset
purchases themselves. Moreover, the required scale of purchases is likely to diminish over time as
liquidity improves and private investors return to the market. It is important not to judge the
potential significance of this channel by the scale of asset purchases.
How can we monitor the effectiveness of the purchases?
Page 11 of 12
It is much too soon to come to a firm judgement about whether this programme of asset purchases
is having its desired effect. In particular, the impact on the growth of broad money and credit will
not begin to be discernible for several months yet. There are, however, some encouraging signs.
Since the MPC’s announcement, yields on gilts have fallen by 40-60bp at the horizons at which
the Bank is making purchases. This has been accompanied by falls in yields on non-financial
corporate bonds of up to around 30bp. And since the Bank started to operate in the commercial
paper market, spreads have tightened and issuance has increased. These developments have been
mirrored in the positive feedback the Bank has received from issuers of commercial paper.
Over the coming weeks and months, the MPC will be monitoring a wide range of indicators as we
form an initial assessment of the likely effectiveness of the asset purchase programme in
stimulating nominal spending. A critical issue will be the extent to which movements in asset
prices and market spreads are translated into lower borrowing rates faced by businesses and
households. Equally important will be the extent to which the additional liquidity and lower
borrowing rates act to spur the growth of broad money and credit.
I am confident that increasing the supply of money will eventually lead to an increase in nominal
demand. But there is considerable uncertainty about the relative importance of the different
channels through which it may work. As such, I welcome the eclectic, twin-track approach
adopted by the Committee. There is also considerable uncertainty about the overall size and
timing of the impact of the monetary expansion on nominal spending and on the prospects for
inflation. That is why in the minutes of its March meeting, the MPC indicated that, just as with its
decisions on Bank Rate, we would review the appropriate scale of the asset purchase programme
each and every month.
3. CONCLUSION
Page 12 of 12
The extraordinary developments in the global economy since the autumn have been matched by
the magnitude of the policy response. Monetary policy continues to play its part, with Bank Rate
set at a historically low level and the launch of a large-scale asset purchase programme.
Throughout these dramatic developments, the objective guiding the Committee’s decisions has
remained the same: the need to keep inflation on track to meet the Government’s 2% inflation
target. It was that objective that underpinned the decisions to reduce Bank Rate to unprecedented
levels. And it was that objective that drove the MPC to adopt unconventional policy measures.
The inflation target will also dictate the rate at which the stance of monetary policy is returned to
normal as economic prospects recover. The outlook for inflation relative to the inflation target
provides the natural guide to exiting from this period of exceptional monetary stimulus.
Importantly, this exit strategy is clear, transparent and open to public scrutiny. Openness and
transparency have been the cornerstones of UK monetary policy since the Monetary Policy
Committee was established in 1997. That has never been more important than now.
The inflation target is symmetric. That requires the MPC to set policy in a symmetric way. The
Committee adjusted monetary policy boldly and decisively on the way down in order to meet the
inflation target. And, let me assure you that, when the time comes, we will be prepared to respond
with equal vigour on the way back up."

The United States’ decisions not to support Lehman — and the United States’ decision a few days later that it had no choice but to bailout AIG.

TO BE NOTED: From Follow The Money:

"Summitry, the global financial architecture and change

Posted on Thursday, April 2nd, 2009

By bsetser

About three months ago, the editors of Finance and Development (an IMF publication) asked me to reflect on the lessons the effort to reform the international financial architecture in the 1990s holds for today’s effort to reform the global financial system. Then, as now, there was a real desire to create a system that was less prone to major crises — though the financial crises of the late 1990s were concentrated in the emerging economies, not the US and Europe.

One of my conclusions was that summits rarely are the venue for the key decisions that end up defining the character of the world’s financial system. Many of the decisions that ended up mattering the most were fundamentally national decisions. Other key decisions were made in the heat of an acute crisis — not in a conference room hashing out communique language.

Three examples:

The US decision to provide Mexico with a large loan to avoid default in 1995, for example, had a bigger impact on the global regime for responding to acute financial crises in emerging economies than any subsequent communique. The US decision ended up spurring the IMF (with US support) to offer a large loan first to Mexico and then to other emerging economies. Lots of time was spent talking about the need to return to a world of smaller rescue loans, but it never really happened. A new norm had been established. The conditions that the IMF — with the support of the US and the rest of the G-7 — attached to their initial loans to cash-strapped Asian economies in 1997 had an equally profound, though different, impact: even if the IMF was willing to lend more than in the past, no emerging economy wanted to be subject to the IMF’s conditions if there was a realistic alternative.

The global exchange rate system of the past decade was defined by China’s decision to stick to its dollar peg. That fundamentally was a national decision — though one that had profound consequences for the system. If China hadn’t followed the dollar down from 2002 to 2005, China’s current account surplus wouldn’t have grown as large as it did, China’s reserves wouldn’t be as large as they are and China’s economy wouldn’t be as dependent on exports as it is.

The system of global financial regulation was defined by a deep reluctance by key nations to regulate financial institutions too tightly — an unwillingness, incidentally, that was shared by both the US and Europe. Markets were trusted more than regulators, and no one wanted to lose financial business to a rival financial center. Alas, the financial system ended up extending ever-more credit against ever-higher real estate values without a corresponding increase in the capital needed to absorb downside risks.

When economic and financial historians look back at the current crisis, I would bet that they will also focus on key national decisions. My list would include:

The United States’ decisions not to support Lehman — and the United States’ decision a few days later that it had no choice but to bailout AIG. The aftershocks of Lehman’s failure demonstrated that many institutions really were too big to fail and needed to be regulated accordingly; the bailout of AIG illustrated that a broad set of institutions could be source of systemic risk. That made a change in US regulation inevitable. And since individual countries bailout (and regulate) the major global financial institutions, a change in US regulation is in some sense a change in global regulation.

The US decision to provide an unlimited supply of dollars to Europe’s central banks so they could act as lenders of last resort — and then to extend (somewhat more limited) swap facilities to the currencies of four emerging market economies effectively transformed the Fed into a global lender of last resort. At least for those institutions needing dollars based in countries whose currencies was considered acceptable collateral.

China’s decision to remain pegged to the dollar. So long as China’s dollar peg remains in place, the current crisis is likely to produce more profound changes in national financial regulation than in the international monetary system.*

China’s decision to shift its reserves from Agencies — and likely other somewhat risky assets — to Treasuries may prove to be equally consequential. The total size of China’s US portfolio probably hasn’t increased all that much over the last six months. But the shift toward Treasuries has made the scale of China’s US portfolio a lot more visible, both inside China and in the US. The risk of large losses in the Agency markets certainly seems to have alerted China’s leaders to the risks of holdings a large portfolio of reserves — though it isn’t yet clear whether the shift in China’ rhetoric augers a real shift in policy.

The US decision to adopt a large fiscal stimulus clearly ranks up there — as does Germany’s reluctance to encourage Europe to follow suit.

Nor have all the key decisions been made by national governments acting alone. The countries of the world collectively decided that they were willing to lend a number of Eastern European countries ten times their IMF quota, or over 10% of the crisis’ countries GDP. That made it clear that the IMF’s stated lending norms weren’t the IMF’s real lending norms, something that IMF formally acknowledged a few weeks ago when it raised its “access” limits.

This though isn’t though an argument against summits. Summits are often a useful spur to national decision-making. Few countries want to appear to be pushed to take a major decision by international pressure. At the same time, a desire to ward off international pressure can be a spur to domestic decision-making. The deadline created by an approaching summit can concentrate the mind.

China announced a large fiscal stimulus last fall primarily because its own economy was slowing. But the fact that China knew it would face pressure to support domestic demand globally at a series of global summits also likely pushed China’s domestic decision-making process along. The Obama Administration’s proposed regulatory reforms respond to a real domestic need. But they also provide President Obama with a positive agenda to push globally.

Moreover, the London summit also looks poised to do more than just highlight existing areas of agreement (formulations like “we agree to what is necessary … can mask disagreement over what is necessary”) and bless existing national decisions. Above all, the leaders look set to expand the IMF’s resources significantly. That is a real change. A few years back the Bush Administration’s policy was to starve the IMF of resources. Now the US is looking to the IMF to avoid a deep crisis in Europe’s backyard. Simon Johnson has this right:

“The IMF currently has about $250bn to lend; this is not enough to really make a difference in a world of trillion dollar problems. The Europeans proposed to raise this to $500bn, which seems still low - particularly as it’s mostly European countries that have a pressing need to borrow; you guessed it, the Germans don’t want to put up more. The Obama Administration is pushing for closer to $1trn in total IMF funding and, after a lot of hard work, seem likely to get close to this target. In essence, this is a clever way to force the Europeans to help themselves. “

The IMF is also trying to change the way it lends. It has a new facility that allows countries to borrow large sums (theoretically unlimited sums) for long periods of time (three to five years) with any conditions when the loan is made. Not every country qualifies of course. Most Eastern European countries, for example, wouldn’t make the cut. But the new facility does seem to be a real effort to make the IMF’s pooled of shared reserves a viable alternative to high levels of national reserves. And Mexico is interested, in a big way.

Martin Wolf is right to argue that this summit has to be evaluated against the demands created by a very sharp global downturn. The OECD is now forecasting a global contraction of close to 3%. I certainly had hoped that the world’s large surplus countries would do more to support a recovery in global demand — and in Germany’s case, to facilitate a needed adjustment among the countries of the European Union.

But as a veteran of almost ten years of debate over the scale and scope of IMF lending, I am amazed by the set of changes that seem poised to happen. Here is one benchmark: the reworking of the IMF’s lending facilities goes well beyond anything that Nouriel Roubini and I proposed back in 2004.** Maybe that is more evidence that Dr. Roubini and I were too timid in our recommendations then than that the world’s leaders are acting boldly now. But it is evidence that the realm of the possible has changed.

Read my article for Finance and Development. And let me know what you think of the argument.

*Of course, a world where China is pegging to appreciating dollar will differ from a world where China pegs to a depreciating dollar. But it also isn’t a world where China’s currency floats against the other major currencies.
** Most of the Roubini/ Setser recommendations are in chapter 9"

An AIG bankruptcy would have triggered shock waves around the world. We were all staring into the abyss at that point.

TO BE NOTED: From Spiegel:

NOTE DATE : DON

"09/29/2008

SPIEGEL INTERVIEW WITH GERMAN FINANCE MINISTER STEINBRÜCK

"'We Were All Staring into the Abyss'

SPIEGEL spoke with German Finance Minister Peer Steinbrück about the roots of the US credit disaster, whether Germany is in grave danger and what the future has in store for world banking.

SPIEGEL: Mr. Steinbrück, Wall Street is imploding. The government of the United States wants to establish a $700 billion (€480 billion) bailout program for its banks and their bad loans. How serious is the situation for the rest of the world?

Steinbrück: We are experiencing the most severe financial crisis in decades, although one should be careful about historic comparisons with 1929. One thing is clear: After this crisis, the world will no longer be the same. The financial architecture will change globally.

AP

German Finance Minister Peer Steinbrück says that it's time for more regulation.

SPIEGEL: Could you be more specific, please.

Steinbrück: There will be shifts in terms of the importance and status of New York and London as the two main financial centers. State-owned banks and funds, as well as commercial banks from Europe, China, Russia and the Arab world will close the gaps, creating new centers of power in the financial world.

SPIEGEL: In other words, we are experiencing the beginning of a tectonic shift…

Steinbrück:... but not one that is abrupt and jarring. It will be an evolutionary process that will take several years.

SPIEGEL: The current thunder is certainly deafening. We have just seen all US investment banks disappear in one fell swoop.

Steinbrück: Three of them were either taken over or went bankrupt. The two others, because they abandoned their business model to save themselves. No one would have thought this possible until recently. Meanwhile, 25 financial service providers have disappeared from the market in the United States. All of this is illustrative of an earthquake. In addition, many institutions are still fundamentally lacking liquidity.

SPIEGEL: And is the United States completely to blame?

Steinbrück: The source and focus of the problems are clearly in the United States. There are many causes. After 9/11, a great deal of cheap money was tossed into the market. Apparently some of that money went to people with poor creditworthiness. This led to the growth of the real estate bubble. The banks embarked on a race over profit margins. Then speculation spun completely out of control…

DER SPIEGEL

German growth could be dropping.

SPIEGEL: …which also benefited German banks for a while.

Steinbrück: But they didn't invent these transactions. The stokers on the financial markets were responsible for that.

SPIEGEL: And how is the US patient doing now?

Steinbrück: It's in the ICU with pneumonia. This means that here in Europe, we can at least expect to get a bad cold. The US patient lacked legislation, a regulatory framework that could have helped avoid this development. That's the key issue for me. The financial products became more and more complex, but the rules and safeguards didn't change. I don't know anyone in New York or London who would have asked for a stronger regulatory framework 18 months ago. They were always saying: The market regulates everything. What a historic mistake!

SPIEGEL: Your US counterpart, Treasury Secretary Henry Paulson, began by essentially nationalizing the two US mortgage giants, Fannie Mae and Freddie Mac. But then he allowed investment bank Lehman Brothers to plunge in bankruptcy before saving the insurance giant AIG with an $85 billion (€58 billion) bailout. This doesn't exactly look like a clear course of action.

Steinbrück: In the case of Lehman, the US government wanted to send a signal to the market that they are not prepared to offer a bailout under any circumstances. In the case of AIG, we had direct talks at the G7 level and implored them to stabilize the situation. An AIG bankruptcy would have triggered shock waves around the world. We were all staring into the abyss at that point.

SPIEGEL: What role does the US election campaign play in resolving the crisis?

Steinbrück: I hope that my US counterpart will be capable of taking action for as long as possible. We cannot have a six-month vacuum until the next president takes office and his administration is ready to get to work.

SPIEGEL: Paulson headed the investment bank Goldman Sachs for a long time. Does this make him part of the problem?

Steinbrück: He is undoubtedly doing a good job. And at least Goldman Sachs still had the option of making its own decision to transform itself into a bank holding company.

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SPIEGEL: That same Paulson snubbed you a year and a half ago. You arrived late for a meeting with him in Washington and he gave you all of 11 minutes of his time -- standing up.

Steinbrück: You don't seriously believe that such trivia plays any role whatsoever in my assessment of a counterpart and of the situation!

SPIEGEL: We are alluding to arrogance and a way of thinking that Paulson may have shared with many major players on Wall Street.

Steinbrück: The way of thinking on Wall Street was quite clear: "Money makes the world go round!" The logic went like this: The government should stay out of our business! And when we Germans began -- and perhaps it was even too late by then -- to ask for controls, for more transparency and equity guidelines, they laughed at us at first.

SPIEGEL: When did those initiatives begin?

Steinbrück: Back in the days of Gerhard Schröder's chancellorship. It was reinforced when Germany assumed the G-7 presidency in early 2007. The first real debate on the subject happened in February 2007, during a meeting of the G-7 finance ministers at Villa Hügel in Essen. Then British Chancellor of the Exchequer Gordon Brown was not very amused by our call for more transparency for hedge funds. The talks have been significantly more constructive since last fall.

SPIEGEL: What, specifically, will you call for?

Steinbrück: A few agreements were already reached with the British and Americans within the G-7 in April. They include imposing new rules on the conduct of the rating agencies, tightening equity regulations and gaining a better handle on cross-border bank supervision. But as far I am concerned, it isn't enough for the industry to develop its own code of conduct. I also want to see the banks no longer allowed to sell all of their risks as they see fit. I think it as a dangerous systemic design flaw that not only loans, but also credit risk is 100-percent marketable. This can lead to uncontrollable wildfires, as we are now seeing.

SPIEGEL: How much government does capitalism need? How much can it tolerate?

Steinbrück: Overall, we have to conclude that certain elements of Marxist theory are not all that incorrect.

SPIEGEL: And you, of all people, are saying this?

Steinbrück: Every exaggeration creates, in a dialectic sense, its counterpart -- an antithesis. In the end, unbridled capitalism with all of its greed, as we have seen happening here, consumes itself…

SPIEGEL: …because it creates an unbridled state?

Steinbrück: That would the wrong development. And I don't believe in it, either. Fortunately, we in Germany have done quite well for ourselves with a happy medium, the social market economy.

SPIEGEL: The German government is unwilling to participate in America's $700 billion bailout package. Is this your final word?

Steinbrück: I see neither the need for nor the possibility of taking on the responsibility for American banks. Besides, our situation is more robust.

SPIEGEL: But the United States will certainly bail out US banks first -- a distortion of competition that could put European institutions under more pressure than ever.

Steinbrück: That's an issue, of course. But I can't give you a shoot-from-the-hip solution. First we have to see what exactly the Americans intend to do.

SPIEGEL: And if things became serious in Europe, you would also have to butt heads with Brussels over intervention options.

Steinbrück: You couldn't be more right! And I have already pointed this out. The Americans are clearly faster when it comes to crisis management, because they aren't hampered by these aid procedures.

SPIEGEL: Nevertheless, you do have worst-case scenarios on the back burner.

Steinbrück: It doesn't make any sense to speculate publicly over something like this. A crisis can easily become a self-fulfilling prophecy that way.

SPIEGEL: You recently met with the top executives from the German banking and insurance industries. What was the mood like?

Steinbrück: Very serious and open. But discretion is needed to achieve any progress on this front.

SPIEGEL: The German state-owned banks, at any rate, are a prime example of a case in which government influence does not automatically guarantee more security. On the contrary. The amount of gambling that took place at institutions like SachsenLB was unbelievable. And taxpayers are the ones who end up footing the bill.

Steinbrück: The responsibility lies with the respective shareholders. Some of them, however, are showing signs of wanting to pass this responsibility on to the government. That's when I stop playing Mr. Nice Guy. They should kindly solve their own problems.

SPIEGEL: Some, it would seem, have failed to apply the rules that already exist in the German system.

Steinbrück: I cannot confirm that. The auditors can only examine what is in the financial statements and what is presented to them. IKB and SachsenLB simply outsourced tremendous risks. I also caution against taking a stop-the-thief approach. In one case, for example, a former department head from the finance ministry who was on the supervisory board of one of these banks has been severely criticized. In an effort to pass some blame on to me, it has been conveniently forgotten that half of the who's who in the German economy was on this same board.

SPIEGEL: Perhaps you should have simply allowed something like IKB to go bankrupt, instead of bailing it out with billions from the state-owned bank KfW and then essentially giving it away to an American financial investor.

Steinbrück: And what would have happened then? We had less then five weeks to conduct a thorough audit. We had 36 hours to decide what would be more costly -- stabilization or insolvency. That was the situation on July 28 and 29 of last year. What happens to the €25 billion ($36 billion) worth of deposits at the IKB? Are they supposed to vanish into thin air? What would have been the consequences for the overall German financial economy? The damage would have disproportionately higher. It's easy to be critical now.

SPIEGEL: And what about the fact that KfW just happened to transfer €319 million ($463 million) to Lehman Brothers, the US investment bank that declared bankruptcy that very same day? This sort of thing doesn't exactly create confidence in state-owned banks.

Steinbrück: That was an awful mistake, of course. A grotesque error. But it was a mistake made by bank executives, not the administrative board, which includes politicians among its members.

SPIEGEL: It proves that normal risk management procedures failed completely -- directly under the nose of the finance minister.

Steinbrück: No, it proves that an inexcusably wrong decision was made. Do you think I wasn't livid about this? The entire crisis we are talking about here is incomprehensible for the normal citizen. But such an idiotic transfer -- even my 89-year-old mother is outraged about it. All 80 million German citizens understand this…

SPIEGEL: …and suddenly you had the tabloid Bild calling the KfW "Germany's stupidest bank."

Steinbrück: Okay, okay. But it's also worth noting that KfW passed all tests and checks regarding its risk management procedures that were performed by the federal audit court and auditors last year. Of course, I know that the bottom line is that what happened was completely ridiculous. But even that has to be carefully examined. We cannot simply start shooting at random, just to flush out a few executives and keep the public happy.

SPIEGEL: At any rate, the failures and breakdowns among many state-owned German banks show that the government isn't exactly an effective banker.

Steinbrück: I never claimed that it was. The government is neither better nor worse as a banker. Financial transactions are not its core field of operations. The fact that many bankers working for state-owned banks clearly miscalculated is partly the result of their having lost sight of the relationships between risks and profitability. But let me say this once again: Lehman was no state-owned bank, nor was Bear Stearns, Northern Rock or IKB.

SPIEGEL: How dramatic will the effects of the financial crisis be on the German economy?

Steinbrück: So far, the only obvious outcome is that numbers are getting worse. At this point, no one can provide a credible estimate of how bad they will become. Of course, this crisis will also affect growth. However, some developments are currently moving in the opposite direction. The employment market is still strong. And we are still pleased with our tax revenues.

SPIEGEL: You were optimistic only two weeks ago. You said that there was no reason to expect cataclysmic scenarios, and that growth for the year would remain at 1.7 percent.

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Steinbrück: I object to your criticism. I have always been on the cautious side, and at the beginning of the year I stated that 2009 will be worse than 2008. I have no reason to revise my predictions for 2008. But 2009 will be significantly worse than the previous estimate of 1.2 percent growth.

SPIEGEL: Should German depositors be concerned about their savings?

Steinbrück: No. No one should be worried about savings accounts. We will see a tectonic shift in the global financial system. Entire types of banks and their business models will disappear, but that doesn't mean that anyone in Germany should be worried about their savings.

SPIEGEL: Is capitalism currently undergoing a general crisis?

Steinbrück: I don't think so. But the behavior of some elites is worth criticizing. We have to be careful not to allow enlightened capitalism to become tainted with questions of legitimacy, acceptance or credibility. This isn't merely an issue of excessive salary developments in some areas. I'm talking about tax evasion and corruption. I'm talking about scandals and affairs of the sort we have recently experienced, although one shouldn't generalize these occurrences. But they are the sort of thing the general public understands all too well. And when they are allowed to continue for too long, the public gets the impression that "those people at the top" no longer have to play by the rules. There have been times in Germany when these elites were closer to the general population. Some things have gotten out of control in this respect.

SPIEGEL: One cannot regulate morality.

Steinbrück: No, but that too is dialectics. The elites must understand that it is a matter of self-protection, of developing a sense of the right balance or allowing judgment to prevail.

SPIEGEL: Mr. Steinbrück, thank you very much for taking the time to speak with us.

Interview conducted by Wolfgang Reuter and Thomas Tuma

Translated from the German by Christopher Sultan"