By Ronald McKinnon
The global credit crunch which began in 2007 but became acute in 2008, originated from the collapse in the bubble in US house prices and, to a lesser extent, in European ones.
Unsurprisingly, the declining home values made people feel poorer, so consumption spending fell. This fall in aggregate demand in the US and Europe reduced demand for imports and caused a parallel slump in the rest of the world, including in emerging markets. Read more
Is the UK once again the economic sick man? Or is it, as Alistair Darling, chancellor of the exchequer, argued in his Budget speech on Wednesday, just one of a number of hard-hit high-income countries? The answers to these questions are: yes and yes. The explanation for this ambiguity is that the fiscal deterioration is extraordinary, but the economic collapse is not. Read more
Spring has arrived and policymakers see “green shoots”. Barack Obama’s economic adviser, Lawrence Summers, says the “sense of freefall” in the US economy should end in a few months. The president himself spies “glimmers of hope”. Ben Bernanke, chairman of the Federal Reserve, said last week “recently we have seen tentative signs that the sharp decline in economic activity may be slowing, for example, in data on home sales, homebuilding and consumer spending, including sales of new motor vehicles”. Read more
By Michael Pomerleano
My education (Harvard Business School and economics department) and professional experience prime me to advocate finance’s role in the growth of economies. Politically, I am moderate and not a flaming liberal. However, the conduct of professionals in the financial crisis leads me to reassess these beliefs. I am not alone. Read more
By Rebel A. Cole
The financial crisis has thrown the US economy into a deep and lingering recession. Most analysts agree that delinquent mortgages are at the heart of the crisis, and that opaque mortgage-related securities have spread their toxicity to other sectors of the credit markets. Read more
By Michael Pomerleano
The Obama administration program to address the fragility of the banking system is based on a two major initiatives. First, it has proposed the Geithner- Summers Plan to buy subprime securitized assets from the banks. The toxic assets plan deals with less that 40 percent of the balance sheet of the banks that is in marketable securities. It does not deal with the 60 percent of the balance sheets of US banks that are loans and are not marked to market. Further, it will take six months to get the program in motion. The plan elicited deserved criticism from reputable analysts, including Paul Krugman in his NYT column. As Krugman points out in his column this plan is the third variant of an old plan to lift the value of toxic assets. The plan meets Einstein’s definition of madness: continuing to do the same thing, hoping for a different outcome. Jeff Sachs (FT, March 23), Joseph Stiglitz (NYT, April 1) and Peyton Young (FT, April 1) added their concerns that the plan nationalizes losses and privatizes profits.
The second part of the administration program is the now famous stress test of the nation’s largest banks. The other dimensions of the Geithner plan are the loan-purchase program run by the FDIC, the Treasury securities-purchase component of the PPIP is supplemented by the expanded Fed TALF program, and the various programs aimed at lowering rates in the conforming mortgage market.
This article argues that The Obama administration is in denial regarding the problems in the financial system. The losses in the banking system are not an “unknown unknown”. As shown below, the stress test calculations can be conducted by any informed analyst, and the losses are known with a reasonable degree with approximation. The stress test is simply a “smoke screen” designed to postpone the inevitable moment when the administration has to deal with the well known and severe problems in the banking system. Read more
By Michael Pomerleano
In an article this month, “Promising signs of progress in the ‘Bad Bank’ Plan” I wrote that the approach sketched out by Tim Geithner, US Treasury secretary, deserved consideration and support from the policymaking and financial communities for the following reasons: Read more
By Michael Pomerleano, Harald Scheule, and Andrew Sheng
The US Treasury just announced a Financial Stability Plan (revamped Tarp) to help purge banks of their bad bets by partnering with the private sector to buy troubled assets. The basic idea is to lend government money (US Federal Reserve) or guarantee borrowings (Federal Deposit Insurance Corporation) at a suitable spread over Libor to anyone- e.g., hedge funds and pension funds – who wants to buy toxic assets from the banks. Read more
By Laurence Kotlikoff and Perry Mehrling
As we advocated two months back (Bagehot plus RFC: The Right Financial Fix), Uncle Sam is finally starting to sell systematic risk insurance on high-grade securities in exchange for preferred stock. This is a critical function for the US government; Uncle Sam is the only player capable of hedging systemic risk because he’s the only player capable of taking actions that keep the overall economic system on the right course. Read more
By Michael Spence
The crisis we are now in globally had its origins in an asset bubble fuelled by the interaction of excessive leverage and a widespread underestimation of the endogenously rising systemic risk – roughly the degree to which individual risks were becoming highly correlated via balance sheet linkages. The potential seriousness went unnoticed or not fully understood (by market participants, regulators and commentators) for several years. Read more
By Ricardo Caballero and Arvind Krishnamurthy
Financial institutions specialise in handling risk but are not nearly as efficient in dealing with uncertainty. To paraphrase a recent Secretary of Defense, risk refers to situations where the unknowns are known, while uncertainty refers to situations where the unknowns are unknown. This distinction is not only linguistically interesting but also has significant implications for economic behaviour and policy prescriptions. There is extensive experimental evidence that economic agents faced with (Knightian) uncertainty become overly concerned with extreme, even if highly unlikely, negative events. Unfortunately, the very fact that investors behave in this manner, makes the dreaded scenarios all the more likely. This mechanism has played an important role in the financial crisis. Read more