Monthly Archives: October 2008

By Benn Steil

Given the unprecedented credit market turmoil and central bank interventions of recent days, the US government’s mammoth $700bn Troubled Asset Relief Program (TARP), approved with great haste and huge expectations just a few days prior, is already looking like a sideshow. If the Federal Reserve is to return to being a lender of last resort, rather than first resort, Treasury Secretary Henry Paulson needs immediately to get TARP front and center of the economic relief effort.

The reason TARP has failed to calm the markets is that it is still almost completely undefined. The universe of troubled assets that the Treasury could potentially buy is far too large for anyone to speculate as to its likely economic effects. It is therefore critical that Secretary Paulson significantly narrow the scope of the intervention in a way that is clearly and transparently connected with the two most urgent tasks: reviving the credit markets and preventing a spiraling freefall in the housing market. Here is how it should be done. Read more

By John Muellbauer

Fed minutes released on October 7 disclosed that as recently as Sept 16, Fed officials thought risks to growth and inflation were roughly equally balanced. And Federal Reserve Chairman Ben Bernanke acknowledged on the same day that though the inflation outlook had improved somewhat, it remained uncertain. The market may have taken these views as representative of central banks round the world, particularly given the ECB decision of October 2 not to reduce rates. Following these releases, the Dow Jones index fell by about 6.5 percent as the market thought the internationally co-ordinated interest rate cut it had been expecting had become less likely. This and the knock-on effects on world markets then helped to force central banks to make the cut the market had expected, but on October 8.

Central banks’ caution about inflation risks is understandable given the experiences of 2008. Forecasting inflation is notoriously difficult. There have been big structural shifts in the world economy such as trade and financial globalisation and in individual economies, such as the decline in trade union power. Monetary policy itself has shifted to a far greater focus on inflation. Energy and food price shocks can be large and very hard to predict. Indeed, the speed of price changes tends to increase with big shocks. Most forecasting models used by central banks therefore put a large weight on recent inflation. This tracks inflation quite well except at turning points because the models miss key underlying influences. Read more

By Graham Turner

The markets have given their emphatic response to the banking bailouts put forward in the UK and US. Both rescue packages are flawed and will fail to stem the slide into not just recession, but possibly a global depression.

These bailouts were aimed at the symptoms, rather than the cause. Money markets are frozen because nobody knows how far property prices will slide, or the scale of losses banks will suffer. Banks are deemed insufficiently capitalised for the same reason.

The policy response of Western governments has, therefore, been back to front. If they solved the underlying problem – chronic property deflation on a scale not seen since the 1930s – liquidity will eventually return.

There is only one conventional policy that will work: deep interest rate cuts followed by a shift to quantitative easing. Read more

By Laurence Kotlikoff and Perry Mehrling

So now Uncle Sam has an additional $700 billion to work with.  Will it be enough?  It depends on what he does with the money.

The original idea was to buy assets outright, $700 billion worth and then we’re done.  But the debate has moved on, and today’s idea seems to be to use the money to recapitalize the banks by making a $700 billion investment in preferred stock.  There is no question that this approach would give you more bang for the buck, but there is an even better way.

In recent discussion, the preferred stock injection has been described as a kind of insurance, and so it is.  FT readers know this: “US may follow UK on bank bail-outs”.  The yield on the stock is like the premium on the insurance, and the total injection is like a cap on the total amount of claims that will be paid.

The problem is that no one knows how much the total claims might be in the absolute worst case scenario.  And a preferred stock injection provides no protection against that worst case scenario.

What the system needs most is not protection against the next 10% of losses – the Warren Buffetts of the world are happy to provide that – but protection against everything that might possibly come after that.  What the system needs is a credit insurer of last resort. Read more

By Dominique Strauss-Kahn

Some weeks ago, I published an appeal for a comprehensive policy solution that spanned the core problems in the financial sector (ie, lack of liquidity in markets, doubts about the value of troubled assets and a clear shortage of capital) and spanned financial markets around the world (ie, not just a few money centres). Although a great many policy actions have since been taken, they have been neither comprehensive nor global. Indeed, the approaches taken have been so varied and inconsistent, especially with regard to deposit guarantees, that they are intensifying problems for other countries. It should come as no surprise then that market confidence has not been restored. Read more

“Things that can’t go on forever, don’t.” – Herbert Stein, former chairman of the US presidential Council of Economic Advisers

What confronts the world can be seen as the latest in a succession of financial crises that have struck periodically over the last 30 years. The current financial turmoil in the US and Europe affects economies that account for at least half of world output, making this upheaval more significant than all the others. Yet it is also depressingly similar, both in its origins and its results, to earlier shocks. Read more

As John Maynard Keynes is alleged to have said: “When the facts change, I change my mind. What do you do, sir?” I have changed my mind, as the panic has grown. Investors and lenders have moved from trusting anybody to trusting nobody. The fear driving today’s breakdown in financial markets is as exaggerated as the greed that drove the opposite behaviour a little while ago. But unjustified panic also causes devastation. It must be halted, not next week, but right now. Read more

by Peter Boone and Simon Johnson

The US government has moved dramatically, in what it argues is a comprehensive manner, to counteract serious problems in the financial system, and to reduce the risk of a serious recession or worse.  Eurozone policymakers are far more reluctant to intervene.  They remain inclined to handle growing bank failures on a case-by-case basis; and, while their central banks have provided liquidity, they have avoided using other fiscal and monetary policy tools.  If the fortunes of the world economy depended only on the US policy response, we would predict just a fairly severe recession.  The absence of any indication that there will soon be a decisive European policy response suggests we could be in for something considerably worse.

In the view that is increasingly prevalent in the US, we are not facing a Keynesian demand recession, nor the supply side shocks of the 1970s. It is a crisis of confidence very similar to the Asian crisis of 1997-98.  The lesson from these events is when trust in highly leveraged financial markets weakens, there can be long and enduring repercussions across all sectors of the economy. The Federal Reserve’s implicit policy model since September 2007 appears to be tied in part to those events.

In contrast, the frame of reference for European authorities appears to be drawn from the lessons of the 1970s.  They are concerned about inflation and second round effects from past commodity price rises, so they keep interest rates higher.  They have not announced national programmes to bail out financial institutions and borrowers, in part, because of perceived costs relating to future moral hazard. Read more

by Raghuram Rajan

Financial markets are in panic. Central banks are willing to lend against all manner of collateral. Yet inter-bank credit markets are freezing up. Why? Have central banks contributed to the problem? And what do we do now?

The root of the problem, of course, lies in one class of assets, mortgage backed securities, rising in complexity as a result of defaults on the underlying housing mortgages, and falling in liquidity and value. Banks found they could no longer pledge these assets as collateral against borrowing. A bank now had two problems.

One was an immediate liquidity problem. It had to find a way to finance the mortgage backed securities that were previously financed with debt. The second was a capital problem. Because the market value of its assets had fallen, it was very thinly capitalized on a market value basis. But this problem could be handled later.

This, in a sense, was the Bear Sterns situation – illiquidity rather than insolvency. Central banks reacted by expanding the range of entities they would lend to and the range of assets they would accept as collateral. This immediately alleviated the liquidity problem, as banks borrowed pledging illiquid assets at the central bank. Read more

By Christopher Carroll

Economists of all stripes remain puzzled about how Treasury Secretary Henry Paulson’s Troubled Asset Relief Plan is supposed to fix the American financial system.

What is not in dispute is that the crisis has been triggered by a collapse in confidence about how much of their debt subprime borrowers will repay.  (This affects financial stability and the real economy because bankrupt banks cannot lend, even to sound borrowers.)

An example might help clarify the root of our confusion.  Suppose that as of Tuesday, August 24, 79 AD , the Bank of Rome had lent a total of $110 million to citizens of the Roman Empire, funded by deposits of $100 million.  Result: Bank of Rome has a net value of $10 million.  On Wednesday, the eruption of Mount Vesuvius engulfs properties mortgaged by the Bank of Rome to the tune of $20 million.  Result: The Bank of Rome is bankrupt; its depositors can expect to get back at most 90 percent of their money, and the bank cannot lend any new money even to the profitable and creditworthy Marcus L. Crassus Corporation.

The reason the Bank of Rome is bankrupt is that there has been a collapse of confidence that the (now extinct) citizens of Pompeii will repay their mortgage loans.

It is not clear, fundamentally, how this situation differs from the one confronting American banks now. Read more

By Thomas Palley

The Federal Reserve and U.S. Treasury continue to fail in their attempts to stabilize the U.S. financial system. That is due to failure to grasp the nature of the problem, which concerns the parallel banking system. Rescue policy remains stuck in the past, focused on the traditional banking system while ignoring the parallel unregulated system that was permitted to develop over the past twenty-five years.

This parallel banking system financed vast amounts of real estate lending and consumer borrowing. The system (which included the likes of Thornburg Mortgage, Bear Stearns and Lehman Brothers) made loans but had no deposit base. Instead, it relied on roll-over funding obtained through money markets. Additionally, it operated with little capital and extremely high leverage ratios, which was critical to its tremendous profitability. Finally, loans were usually securitized and traded among financial firms. Read more

by Martin Wolf  Read more

By Lucian Bebchuk

Most immediate reactions to the defeat of the emergency legislation in the House of Representatives seem to assume that, facing a choice between approval and government inaction that could bring about a financial meltdown, the House irresponsibly and irrationally opted for the latter. But the defeat of this particular bill hardly leaves us with inaction as the only alternative.

The bill was defeated at least partly because of its inability to gather sufficient public support due to its evident flaws. Congress can and should adopt quickly a bill that would address these flaws and consequently enjoy strong public support.

There is widespread recognition of the depth of the crisis and the need for governmental intervention. Why was the bill nonetheless defeated? Because there is an equally widespread recognition that spending $700 billion on purchasing (and insuring) toxic paper would be a highly flawed form of intervention.

During the week preceding the vote, it has become evident that the government’s contemplated plans for valuing troubled assets would lead to a quagmire. Opposition to the bill grew due to expectations that purchasing toxic paper could well result in massive complexities, large giveaways, and substantial public losses. Read more