Labels: Culture, Politics

Anti-Jewish bigotry and prejudice in British academe anno 2007

The unspeakables are at it again: the University and College Union (a trade union of higher education academic and academic-related staff) is proposing to boycott contact and exchanges with Israeli educators and academic institutions. The reason given is that the Israeli government is acting beastly towards the Palestinians and that Israeli educators and academic institutions are financed by the Israeli state and are therefore agents of the Israeli government, and complicit in this execrable behaviour.

To be fair, the University and College Union is also calling for a boycott of all contact and exchanges with the following

• Educators and academic institutions from the People’s Republic of China, because of the suppression of the Tibetan nation and the Uigur ethnic minority, and because of the Chinese government’s responsibility for the Tiananmen Square massacre.
• Educators and academic institutions from the Islamic Republic of Iran, for its persecution of the Bahai and its oppression of women.
• Educators and academic institutions from the Russian Federation, because of its genocide in Chechnya.
• Educators and academic institutions from the Sudan, because of its government’s complicity in the genocide in the Darfur region, and its earlier attempts to crush the Christian and Animist African population in the South of the Sudan.
• Educators and academic institutions from Myanmar, because of its government’s brutal suppression of ethnic minorities, its continued used of forced labour and its most unkind treatment of a great lady, Aung San Suu Kyi.
• Educators and academic institutions from Turkey, because of its government’s refusal to acknowledge responsibility for the Armenian genocide/massacre/regrettable incident.
• Educators and academic institutions from Zimbabwe, because of its government’s suppression of the Matabele and its ruthless suppression of any form of dissent.
• Educators and academic institutions from Saudi Arabia, because of that countries denial of religious rights to adherents of faiths other than Islam, and because of its oppression of women.
• Educators and academic institutions from Vietnam, because of its government’s systematic oppression of non-Vietnamese ethnic minorities, including the hill tribes.

Of course, the Jew-haters of the University and College Union have not called for any such boycotts, except for the one against educators and academic institutions from Israel. I wonder why? What are the likely drivers of this curiously selective exercise of moral indignation?

I believe that the Palestinians are indeed the step-children of the 20^th century - victims of ignorance, fear and brutality perpetrated against them by Israel, the Lebanon, Syria, Jordan, Egypt and the other Arab, Middle-Eastern and Gulf countries. They have been and continue to be used opportunistically and ruthlessly by all and sundry, during the Cold War and during the so-called war on terror. They are exploited and victimised by the jihadists and their paymasters and by the Christian fundamentalists that have egged on the Bush administration for these past 7 years. But what, in the name of Sarah and Hagar, has this got to do with calling for a boycott of educators and academic institutions from Israel? Or perhaps this proposal of the UCU is just the latest example of the cynical abuse of the plight of the Palestinians by third parties - this time by an association of non-entities trying to vent its anti-Jewish spleen and get some free publicity and lumpen-street-cred in the process?

I will keep talking to, arguing with and exchanging views with any Israeli educator willing to talk, argue and exchange views. We call this academic freedom - a concept apparently unfamiliar to some would-be academic Gauleiters. Remember the old saying: those who can, do; those who cannot, teach? In academe it should be amended as follows: those who can, teach and do research; those who cannot, do academic administration; those who cannot even do that, run academic trade unions; and those who fail even there, try to arrange academic boycotts of Israel.

Labels: Ethics, Politics

Legalising assisted suicide

I would like to thank the US social worker working with senior citizens and people with disabilities for the comment on my earlier post on this subject (link).

I agree that my proposal (1) to recognise the right of any adult of sound mind to take his/her own life and (2) to make it legal for others to assist in the suicide of someone who satisfies (1), carries with it the risk of abuse. While steps can be taken to minimize that risk, it cannot be eliminated altogether. But if “People with disabilities (and or terminal illness) who want to commit suicide are going to fit the criteria for clinical depression”, then they would not, under the guidelines I envisage, qualify for legal assisted suicide. I doubt, actually, whether someone who is reasonably depressed about his appalling medical prospects would easily be confused with someone suffering from clinical depression, but it clearly behoves us to tread very carefully here.

Yes, it would be some committee consisting of psychiatrists, psychologists, social workers, other health professionals and secular or religious experts on ethics, that would have to reach a view of whether the person wishing to end her life was of sound mind - any potentially conflicted party should be kept well away from the process. That’s a tough decision, but one that comes with the territory. Heroic modern medicine allows us to keep people alive well beyond what their bodies evolved for. We are paying the price for a disjuncture between what we can do medically and what we ought to do morally.

Against the risk of abuse of the right to die and of the legalisation of assisted suicide, we must put the existing certainty of the widespread abuse of those kept alive against their will. I have witnessed friends and relatives who begged to be allowed to die but were denied that right. People trussed up like Christmas turkeys with tubes, needles, sensors, monitors and other medical contraptions, with every vital organ supported by some engineering miracle, and with no realistic hope of a change for the better in their condition. I have seen too much torture in the houses of the dying to be willing to sit back and whisper supportive nothings about sharing your pain.

If we could really share in the suffering, that is, take for ourselves some of the pain and agony of those living a slow death, and in so doing diminish the pain and agony of those who are suffering, that would be a true alternative to what I propose. Unfortunately, that is not possible. According to my faith, Christ took away the sins of the world, but even He did not, through His suffering, take away the world’s, that is, our pain and suffering. We all have to bear our own pain and cannot volunteer to bear even the smallest part of another’s.

Sympathy, empathy and love are great blessings, but they don’t alleviate pain. It is therefore an abuse of language to speak of sharing someone else’s suffering or pain, because this choice of words implies that suffering or pain are what economists call ‘rival goods’ (or bads), that is, something of which there is less for you when I take more of it. ‘Sharing pain and suffering’ instead really means that the person in pain continues to suffer as he would have without the sharing, and that, in addition, the person sharing the pain now is miserable and depressed as well. Any psychological benefits of the sharing for the original person in pain are likely to be minor, if the original sufferer has empathy for those who wish to share his pain.

I believe that the caring professions, including psychologists, social workers, physicians, other medically qualified people like nurses, have a duty of care towards their clients/patients, but that this duty of care does not amount to keeping them alive at all cost, even against their will. The medical profession should work to reduce human suffering, not to prolong life regardless of the pain and suffering this inflicts on those whose lifespan is being stretched beyond endurance. For a Christian, the second commandment is to love your neighbour, not to torture your neighbour by keeping him alive well beyond his appointed time.

I hope to be in a position, when my time comes, to use my God-given intellect to find a way to avoid living past my sell-by date. I also believe that my sell-by date should be determined either by blind fate or by myself, not by a committee of utilitarian economists or by some other group of servants of the state.

Labels: Ethics, Politics, Religion

Tax all (capital) income the same way

Let’s get the moral indignation stuff out of the way first. It is indeed outrageous that a multi-millionaire private equity wizard is assisted in his attempt to become a multi-billionaire private equity wizard by having to pay just a 10 percent tax rate (in the UK) on that part of his private equity income that can be classified as ‘carried interest’ – a form of lightly taxed capital gains designed to favour the venture capital industry. Nick Ferguson, Chairman of SVG capital was right when he questioned whether it make sense that some of his industry’s richest men paid tax at a lower rate - the 10 percent capital gains tax on carried interest - than their office cleaners, who would pay the 22 percent UK basic rate of income tax. It made no sense and it is indeed outrageous – the unacceptable face of capitalism. The arguments in defense of this ludicrously unfair and distortionary tax arrangement are self-serving twaddle. There is nothing specially meritorious about capital gains as opposed to dividends, interest or any form of capital income. Venture capital or private equity is not more meritorious or wealth-creating than any other form of capital. All these references to seed-corn, founts of growth are hogwash. It is true that private equity investors often buy into an illiquid investment that is held for many years to yields an uncertain return. They get rewarded for making illiquid and risky investments by earning the appropriate risk-adjusted rate of return. There is no need for a helping hand from the rest of the tax payers.

Moral indignation at a blatantly unfair, regressive and distortionary tax anomaly can, however, be a poor guide to policy. The knee-jerk response to the observation that some private equity fund owner/managers pay too little tax is: let’s increase the tax burden on private equity. It makes a lot more sense to stand back a bit and ask how capital income should be taxed. The question should be, what do the three key considerations of (1) equity (fairness), (2) efficiency (incentives) and (3) administrative feasibility (enforcement) suggest about the taxation of capital income in all its manifestations. This will then also teach us how the taxation of ‘carried interest’ can, along with the taxation of all other forms of capital income, be brought into conformity with these principles of fair and efficient taxation.

All capital income is fungible…. A newly -founded company issues $10 million worth of equity, uses that $10 million to buy some recently bottled wine, plus a wine cellar to store it in. For the next ten years no further costs are incurred, nor are any payments made to the shareholders. At the end of the ten years the wine and the cellar are sold, say for $15 million, and the company is liquidated. The money made from the sale of the assets is returned to the shareholders, who have all hung on to their shares.

The money can be returned to the shareholders in a number of ways. At the end of the ten years, the company could make a single $ 5 million dividend payment to its shareholders and buy back the ex-dividend shares from its shareholders at the original issue price, $ 10 million. Alternatively, the company could repurchase the stock from the shareholders, paying them $15 million for it. Of that, $5 million would be capital gains. From a substantive economic point of view, paying dividends to shareholders or returning money to shareholders through capital gains are equivalent. Clearly, if capital gains were taxed more lightly than dividends, the company would return the money as capital gains. If dividends were taxed more lightly than capital gains, shareholders would obviously prefer to be paid dividends.

If interest income were taxed more lightly than dividends and capital gains (or if interest costs were deductible from the corporate profit tax base), the company could obtain its initial $10 million by, say, only issuing stock worth $ 1 million and borrowing $ 9 million from its shareholders. At the end of the 10-year period, the $15 million gross revenue could be returned to the shareholders either as capital gains, as dividends or as interest income, so as to minimize the total tax burden on its shareholders.

This simple example can be elaborate and made more realistic in a million different ways. The conclusion remains the same. A company can, by changing its financial structure (debt vs. equity) and/or by changing its dividend pay-out or retention policy, seamlessly and at little or no cost transform dividend payments into interest payments and/or capital gains. To avoid undermining and in the limit destroying the capital income tax base, it is therefore obviously necessary that all forms of capital income – interest, capital gains and dividends, be taxed in the same way – at the same rate.

Let me repeat that the frequently-heard argument that capital gains, especially capital gains on risky, illiquid investments held for a long period, are uniquely meritorious and should be taxed at a lower rate than other capital gains (and than dividends or interest income) is self-serving hogwash. If I own a piece of God-given, unimproved land, I can enjoy its (uncertain) capital gains or losses, without ever lifting a finger to do honest work or exercising a single brain cell in productive risk-taking entrepreneurial activity. I am sure that managers of private equity funds like their ‘carried interest’ to be taxed at ten percent rather than the forty percent they would pay if carried interest was considered dividend income, but such preferential or discriminatory tax treatment would be distortionary and inefficient as well as grossly unfair.

Likewise, the notion that our legislatures can determine which investment activities (those undertaken by small owner-managed firms, SMEs in general, investments held for at least X months, investments in specific industries, sectors, regions or whatever) are subject to obvious externalities that drive a wedge between the social and private rates of return, is fatuous. Let me summarise this as follows:

The iron law of capital income taxation: because trivial financial engineering can transform any form of capital income into any other, all capital income – dividends, capital gains, interest or whatever – should be taxed in the same way.

How to turn labour income into capital income (& vice versa) The conclusion that all forms of capital income should be taxed at the same rate, because each one can be easily transformed into any other does not imply that this common capital income tax rate should be the same as the tax rate on labour income – or indeed that capital income should be taxed at all. There are indeed almost-respectable arguments for having a zero capital income tax rate, at least in the long run (lest owners of capital get too excited about this, the same analysis, due to Christophe Chamley http://www.bu.edu/econ/faculty/chamley/index.html , with some later elaborations by Nobel laureate Robert E. Lucas http://home.uchicago.edu/~sogrodow/ ) also show that in the short run, capital should be taxed at the highest administratively feasible rate – confiscation would be best! The question than becomes whether, in real time, we are in the short run or the long run).

The argument for taxing capital income and labour income the same way is not that simple financial engineering can turn capital income into labour income. It is rather that while capital income and labour income remain conceptually distinct, there is an important group of economic actors - small businesses where the shareholders and the labour force coincide - for which the information required to determine which part of the income of the business represents a return to capital and which part a return to labour, is private information of the owners/employees of the firm.

Basically, at the end of each tax year, the owners/employees sit down with their accountants and ask: how much of the value added of the firm last year shall we pay ourselves as wages and how much as dividends? The owners/employees know what’s what, but the tax authorities do not. Only the total value added of these small enterprises is verifiable by outsiders, not their breakdown between wages and profits. The decision on how to report the company’s income is therefore purely tax-driven (including national insurance/social security considerations, corporate pension and health plan contribution issues etc.). Setting up a small limited company in the UK is cheap, fast and easy and can all be done on the internet.

With just about every government in the known universe keen to improve its ranking in the World Bank’s Doing Business Survey (http://www.doingbusiness.org/ ), the day will soon come when every individual worker will have his or her own limited company, with the former wage paid to the company under some contract as fee income or whatever. The company can then pay what used to be the wage bill to its sole shareholder/employee as dividends or wage income, depending only on tax/benefit considerations. Both fairness and the desire to preserve any kind of income tax base at all therefore point towards taxing labour income and all forms of capital income the same way.

Let me summarise this as follows:

The iron law of income taxation: Tax in the same way any income tax bases/forms of income that can be easily transformed into each other or whose distinct nature cannot be observed and verified easily by outsiders (third parties) including the tax authorities.

So the tax structure could be simplified greatly: first, all forms of capital income should be taxed in the same way; simply add them all together and apply a single tax rate or tax schedule to them. Thus dividends, interest and capital gains should all be taxed at the same rate. There should also no differentiation by industry or sector, by size or corporate organisational form of the enterprise or venture that produces the capital income, by whether it is distributed or retained. Clearly, capital income should only be taxed once, in the sense that only the beneficial owners of the capital should pay capital income taxes. It may be administratively convenient to collect some of the capital income taxes at the level of the corporation rather than at the level of the natural persons who are the ultimate beneficial owners of the corporation, but there should be full offset of any taxes collected at the corporate level against the taxes due from the ultimate owners.

For reasons of space I will not here go into the complications created by multiple (national) fiscal jurisdictions, and the distinction between residence based and source-based capital income taxation, questions of domicile and residence etc. These issues are great fun as well as serious mind-benders, and I hope to deal with them at some later date.

When will we find a financial institution small enough and systemically insignificant enough to fail?

Why bail out IKB? A smallish German specialised lender to small and medium-sized businesses, IKB, has been bailed out. Apparently it considered lending to small businesses not sufficiently rewarding, because directly or indirectly it ended up with a serious exposure to the US subprime residential mortgage market. The rescue was a Pan-German affair. It involved the good offices of the regulator (Bafin); a € 3.5bn rescue fund for IKB Deutsche Industriebank, put together by a cross-section of German banks ranging from the largest (private) bank, Deutsche Bank to the publicly owned saving banks – Sparkassen; and a further €8.1 liquidity line from IKB to Rhineland Funding, guaranteed by IKW’s main shareholder, KfW, a state-owned German development bank, that holds a 38% stake in IKW.

Why was IKB bailed out? Bankruptcy and related forms of corporate restructuring are an integral and essential part of the capitalist system; it gives the market system its ultimate Darwinian edge. Without bankruptcy there is no hard budget constraint. Without hard budget constraints a market economy cannot function. This is true for a ball bearings company in Wuppertal. Why is it not true for IKB?

The argument that banks are different because a bank failure may involve material systemic externalities that can cause a system-wide crisis and significant economic dislocation is often alluded to but not often challenged. In fact, the ‘too systemically important to fail’ argument has been extended from (deposit-taking) banks to cover a whole range of financial institutions whose failure would have no direct or intrinsic systemic significance whatsoever, but that acquire indirect or derived significance through their relationships with other financial institutions that are generally considered to be inherently systemically important. Hedge funds, (large) private equity funds and investment banks are examples of institutions that are sometimes argued to have derived or indirect systemic significance because other institutions that are intrinsically or directly systemically important are exposed to them.

Why bail out LTCM? The rescue of Long-Term Capital Management organised in September 1998 by the New York Fed, was justified on the grounds that bankruptcy of LTCM and a quick liquidation of its portfolio would have created serious problems for some of its creditors (which included leading commercial banks and investment banks) and could have meant fire-sale prices for some of the assets to be sold as part of LTCM’s liquidation. Before addressing these points, it is useful to underline the systemic insignificance of LTCM. LTCM was a hedge fund, a betting shop, taking highly leveraged bets on interest rate convergence plays for the prospective Eurozone members. When the Russian crisis intervened in August 1998, the spreads that the LTCM geniuses (including Noble Laureates Merton and Scholes) had bet would narrow, in anticipation of the January 1, 1999 start of EMU, instead widened. Then key financial markets and institutions, including creditors and counterparties of LTCM, ceased to act like the passive price-taking drudges of text-book fully rational optimising finance (the kind of finance theory created and taught by Scholes and Merton) and began to act strategically and/or according to the teachings of behavioural finance.

LTCM was at serious risk of going under and should have been allowed to go under. Its creditors, including commercial banks, might have taken a hit, although it is not at all clear that an orderly bankruptcy process would necessarily have involved the excessively hasty liquidations of LTCM assets that those favouring a rescue invoked. Since no commercial bank was exposed to LTCM an extent that would have undermined its financial viability even if its entire LTCM exposure were to have been written off, there was no reason for the Fed to be involved in the rescue.

Rescues often involve conflicts of interest, even when there is no public money involved. In the case of LTCM, it would, for instance, clearly have been improper for a Chairman/CEO of a financial institution involved in the rescue, to put his institution’s money at risk in the bail out if he had a personal exposure to LTCM. Yet such conflict was present and was implicitly condoned by the Fed, through its involvement in the rescue.

The reasoning that resulted in some of the original LTCM shareholders, including the two boffins, being allowed to keep a small amount of their equity, would be hilarious if it were not so outrageous. Only the unbounded (from above) IQs of the original team were capable of unwinding the infinitely complex and delicate structures that LTCM had on its books. Sure. Half a dozen third-year PhD students in Finance from any top-twenty Economics Department or Business School could have done the job at least as well and for a lot less money. Why give the job to people that had just demonstrated their lack of understanding of both the substance of macro risk and of micro-market structure – the two areas that conventional finance theory has indeed nothing to say about?

This relates to a common argument for preventing bankruptcy – that a corporate entity may be more than the sum of its separately realisable parts, that is, that it has ‘going concern’ value that gets destroyed when the existing legal/organisational entity gets disbanded. I recognise that there may be such forms of ‘organisational social capital’, but I don’t think they played any role in LTCM. Its assets were supposed to be the geniuses that founded it. When the geniuses turned out to be dunderheads instead, the value of the enterprise fell to zero.

Regulatory capture by the financial sector? Why did the Fed (through the New York Fed) offer its good offices by arranging the rescue, even if no public money was put at risk? I believe there are two reasons – manifestations of the two classical regulatory failures: regulatory capture and excessive prudence motivated by a desire not to have any shipwreck on one’s watch.

We have known since the classic work by Stigler that regulators tend to be captured by the industry they are mandated to regulate. The financial sector and its regulators are no exception. The Fed, like every central bank, and especially like every central bank that also has a supervisory and regulatory function, has to be close to the key financial markets and the key players in it, if they are to do their job properly. The central bank operates on a daily basis in the same domestic and financial markets as the financial institutions it regulates and supervises. It also encounters on a daily basis representatives of institutions which, although not themselves supervised or regulated by the central bank, are the counterparties of the central bank directly or of the institutions that are supervised and regulated by the central bank. It is therefore all but unavoidable that the central bank becomes too close to the financial institutions and markets to remain objective and impartial. Even when this does not lead to technical or legal improprieties, it does mean that too much weight is given to the often self-serving arguments of the markets and private financial institutions. This rather incestuous closeness of most central banks, including the Fed, and the private financial institutions may well contribute to the excessive readiness of central banks to bail out failing private financial institutions. It could even extend to the readiness with which former Fed Chairman Greenspan in particular flooded the markets with liquidity to mitigate any actual or threatening collapse of the stock market. The ‘Greenspan put’ could be the expression of ‘psychological regulatory capture’ of the Fed in its monetary policy capacity (not in its regulatory capacity) by the American stock market investing public at large.

The second argument – excessive aversion to a major financial institution failure on one’s watch – is based on the asymmetry of the regulator’s payoff function. If, thanks to central bank intervention, an institution is bailed out that really ought not to have been bailed out, there is some loss of reputation and perhaps some financial penalty if, unlike what happened with LTCM, the central bank puts in some of its own or the government’s money. If a major commercial bank which is regulated by the central bank were to fail and be liquidated, the head of the Chairman of the Federal Reserve Board would roll.

That was then – this is now: no private financial institution is systemically significant The lessons of LTCM were learnt later, with the failures of the Amaranth hedgefund in 2006, the two Bear Stearns hedge funds that found themselves on the wrong side of the subprime mortgage blow-out in 2007.

Hopefully, no hedgefund, however large and well-connected, will be bailed out ever gain with the assistance of the state or through conflicted private sector arrangements. The same ought to hold for private equity funds, investment funds of any kind, pension funds, insurance companies and investment banks.

Are commercial banks uniquely fragile and/or of unique systemic significance? Commercial banks used to have mainly deposits on the liability side of their balance sheets and loans and government debt on the asset side. Deposits, especially sight deposits, were an important member of the set of media of exchange/means of payments. Loans tended to be held to maturity and were an important part of the credit channel of monetary policy. Since sight deposits could be withdrawn on demand and were subject to a ‘sequential service constraint’ – first come, first served – and since loans were illiquid, banks were always potentially vulnerable to runs. With commercial banks both systemically important because of their role in the payment mechanism and vulnerable because of their strange combination of assets and liabilities, a case for considering a bank failure more important that the failure of any other company with comparable net worth could probably be made up till the 1960 or thereabouts.

But that was then and this is now. Today no individual commercial bank is of systemic significance and even collectively, the commercial banking sector is no longer something without which households and non-financial enterprises could not function effectively. Sight deposits are much less important as a medium of exchange/means of payment than they used to be, thanks to electronic funds transfer at the wholesale and retail levels and the use of credit cards, debt cards, travellers cheques, cash-on-a-chip and myriad other means of payment at the retail level. The large-scale clearing, payments and settlement mechanisms, both for inter-bank transactions and for securities not dependent on the survival of any private financial entity.

Deposits are increasingly just one liquid asset among many held for precautionary and portfolio investment reasons by households, non-financial enterprises and financial enterprises. Bank loans have been securitised and sold off, and government bonds have been joined on the asset side of banks’ balance sheets by equity, alternative investments. The asset side of commercial banks is looking increasingly like that of investment banks. On the liability side, deposits remain a unique feature of commercial banks, and the sequential service constraint means that they continue to be vulnerable to runs. Runs imply bankruptcy risk only if assets are illiquid however, and commercial banks assets are much more liquid than they used to be, because of securitisation than they used to be. In addition, bank failure or even failure of a large chunk of the entire commercial banking has lost most of its power to disrupt real economic activity because of the ‘demonetisation’ of bank deposits.

So, no Virginia, there are no private systemically important financial institutions any longer. Central banks are systemically important, as the only providers, when the chips are down, of unquestioned liquidity at no cost and without notice. The ‘plumbing’ of the payment, clearing and settlement systems has to be safeguarded against both liquidity crunches and operational risk. The central bank must ensure, through its discount window(s) (which must be open to all those capable of meeting the discount window collateral requirements), that those who need to borrow and possess collateral that would be good in normal times, can indeed borrow in abnormal times when disorderly markets and illiquidity threaten transactions between private parties.

Hedge funds, private equity funds, investment banks and commercial banks can, provided the central bank plays by the rules of the previous paragraph, be treated like the ball-bearings company in Wuppertal: there is no need for public sector involvement in the prevention of bankruptcy or for the condoning by the regulators of conflicted behaviour in privately orchestrated bail outs.

And, yes, IKB should have been left to sink or swim on its own. To see the main shareholder, itself a publicly-owned German development bank, put at risk public money to try and salvage its investment is not a pretty sight. Let’s hope the EU Commission will come down on this weirdly perverse form of state aid (from the tax payers, organised by one agent of the state, via a second agent of the state to a private party in whom this second agent of the state has a large ownership stake) like the proverbial ton of bricks.

Labels: Economics, Financial Markets, Monetary Policy

If there’s a credit crunch, leave the Fed Funds rate alone, raise the discount rate and use the discount window

There is a flood of articles, comments and editorials pointing to the risk of the current renormalisation of credit risk spreads becoming a true credit crunch/squeeze/crisis - choose your own adjective. Almost invariably the author then concludes that, should a credit crunch materialise, the relevant monetary authorities (mainly the Fed at this juncture) will and should lower interest rates. Why?

A credit crunch is a liquidity crisis that can, if things get badly out of hand, lead to disorderly markets – indeed to markets seizing up and ceasing to trade altogether – and to unnecessary and socially costly defaults. I assume everyone is agreed on that. Why would the right response to that be a cut in the short (default-) risk-free nominal interest rate? We don’t have a credit crunch because the short risk-free nominal interest rate is too high. We have a credit crunch because private agents have lost confidence in their counterparties ability to meet their obligations on the agreed terms. What is required, from the policy point of view is an injection of confidence, that is, of liquidity, not a reduction in the short nominal risk-free interest rate.

In a credit crunch, liquidity is everything. Liquidity is a property or characteristic of assets of claims. It is not a binary, all or nothing characteristic – you either have it or you don’t – but measured along a continuous scale. The (degree of) liquidity of an asset is measured by the speed and cost with which it can be realised, that is, turned into cash or cash equivalent instruments. Cost measures both transaction costs (bid-ask spreads and other fixed and variable costs associated with a secure transfer of title and exchange for cash) and the effect on the market price of a successful realisation of the asset. A perfectly liquid asset can be sold instantaneously, at no cost and without any effect on the prevailing market price.

For standardized financial instruments, like a fixed-rate mortgage, a ten-year fixed-coupon bond or an unsecured bank loan of a given maturity, the only determinant of liquidity that matters is the confidence of the potential buyers in the ability of the issuer of the instrument to meet the terms of the contract. If you can, with a reasonable degree of confidence, put a number both on the probability that the issuer of the bond will default and on the amount you will be able to recover should a default occur, the odds are that the market will be able to price the bond and that you will be able to sell it at that price. It’s when there is pervasive Knightian uncertainty, when the market doesn’t have a clue about the creditworthiness of the obligor, that fear and panic take over and trading stops.

The private sector is a lousy source of liquidity Since liquidity is ultimately a function of confidence, the market (whoever she is) and private institutions will never be able to create instruments with the same degree of liquidity as the serious sovereigns of this world. That is because, unlike private agents, the state has the monopoly of the legitimate use of force. It can tax those in its jurisdiction, and it can prescribe and proscribe behaviour. Specifically, it can force those in its jurisdiction to accept in payment and final settlement of debt and other financial obligations, anything it designates as legal tender. The central bank, as the liquid window of the state, tends to be the agent of the state that has some of its liabilities (currency) designated to be legal tender, but it could be any other agency designated by the state.

Private institutions, commercial banks, investment banks, hedge funds or what not only create fair weather liquidity: the instruments they issue or guarantee are liquid when you don’t need it, illiquid when you need them to be liquid. The private liquidity accordion looks mighty impressive when fully extended; it is puny when completely compressed.

The central bank (the Fed, as the central bank faced most directly with the mess of the sub-prime mortgage debacle – a mess to a large extent of the Fed’s making) therefore must respond to a credit crunch by guaranteeing the liquidity of a wide range of instruments held by private parties, instruments that without the Fed’s intervention would become illiquid. The Fed should do so by following Bagehot’s 150-year old advice. With one slight clarifying amendment, that advice is as follows: in times of financial stress and distress, lend freely, at a penalty rate, against collateral that would be good in normal times but may by heavily impaired in the extraordinary times prompting the Fed’s intervention.

A proposal The Fed should not lower the Federal Funds target rate by engaging in more aggressive open market purchases. That lowers the cost of funds even to those who are not financially distressed. In addition, even a 100 bps cut in the Fed Funds rate may not help much if irrational fear and despondency cause an escalation of the subjective assessment of counterparty default risk and a collapse of subjective recovery estimates. No, rather than inject liquidity broadly into the market through open market purchases, the Fed should lend directly to the distressed institutions, using its discount window(s) (there are three discount rates; the benchmark primary credit rate currently stands at 6.25%, 1.00% above the Federal Funds target rate; the secondary and seasonal credit rates exceed the primary rate). The Fed should charge a rate well in excess of the (unchanged) Federal Funds rate. The current 100bps spread seems puny and too low to be a proper penalty rate. After all, credit crunches and liquidity squeezes are a well-established feature of how financial markets operate. Private institutions that get into trouble because of inadequate liquidity should pay a price for this.

All borrowing at the discount window is collateralised, and it is key that this continue to be the case. The Fed should indeed insist on ample collateral; private liquidity constrained beggars cannot be choosers and the Fed should require that any loans be over-collateralised at ‘orderly market shadow prices’. The collateral may not be worth much when ‘marked to market’ under credit crunch conditions, but the Fed will have a pretty good idea of what it would be worth when orderly markets are restored.

This policy has a number of advantages.

First, by lending only at a penalty rate and by insisting on adequate collateral, the risk of moral hazard is minimized and private players are reminded where it matters of the importance of managing liquidity properly.

Second, by not cutting the Federal Funds rate, the Fed would avoid the over-liquification of the economy that it engineered and failed to reverse following the stock market crash of 1987, the Asian crisis of 1987 and the Russian crisis of 1988 and the stock market collapse of late 2001. The Fed has, with the help of the Bank of Japan and to a lesser extent of the ECB, created the chronically lax credit conditions that have resulted in the asset booms and financial market excesses of the past couple of decades. Under my proposal, there would be no ‘Bernanke put’ to follow the ‘Greenspan put’. It’s always good not to solve the immediate crisis by laying the foundations for the next one. The Fed has done this too often in the past. It’s time to get serious.

Labels: Economics, Financial Markets, Monetary Policy

Whatever Happened to the New American Era?

Last superpower standing In 1991 the Soviet Union collapsed. The USA was left as the world’s only superpower, dominant not only in the military and diplomatic domains, but also economically, politically and culturally. A New American Era (NAE) was supposed to begin. The first decade following the collapse of the USSR appeared to confirm that a new American hegemony had indeed started. Around the middle of the 1990s, the era of low productivity growth in the US, which had started with the oil crisis of 1973, transformed into an era of high productivity growth, driven by what became known as the New Economy (the application of information and communication technology (ICT) to a growing number of manufacturing and services products and processes). Nobel Laureate Robert Solow’s quip that “You can see the computer age everywhere but in the productivity statistics”, at last ceased to be true, at any rate in the US. The stock market found itself launched on a massive ‘hausse’.

The collapse of the Soviet Union was more than the defeat and disappearance of a rival power – events like that litter the history books and are of no great interest except for those living through them. The collapse of the Soviet Union represented the death of a political and economic system, and of the quasi-religious ideology associated with it. Communism and central planning in the former Soviet Union and in Central, Eastern and South-Eastern Europe, were defeated by, and made way, for market economics and pluralistic, democratic political systems. It was viewed by many in America as the triumph of the American Way over the forces of darkness.

Globalisation The triumph of capitalism over communism and of liberal pluralistic democracy over totalitarian one-party rule appeared a natural complement to the wider processes of globalisation that were transforming the global economic, political, social and cultural domains. During the 1990s, globalisation looked to many commentators, not only American, as though it was made for (and in the views of some even made by) the United States. By globalisation I mean the steady decline in importance of national boundaries and geographical distance as constraints on mobility. A new phase of this process began following the end of World War II and picked up speed and widened its scope relentlessly. People, goods and services, factors of production and their owners, financial capital, enterprises, technology, brand names, knowledge, ideas, culture, values and religious beliefs all move more easily across national frontiers than at any time since the beginning of World War I.

This process of globalisation affects virtually every nation or region in the world. The phenomenon is driven, first, by technological advances reducing the cost of transportation, mobility and communication, and second, by deliberate political decisions to reduce or even to eliminate man-made barriers to international mobility.

The first of these two driving forces is irreversible, barring a catastrophe on the scale of the fall of the Roman empire that causes major technical regress. Setbacks to the processes reducing the cost of transportation, mobility and communication can occur. An example is the global increase in the cost of air travel and in other costs of engaging in international trade resulting from the 9/11 terrorist attacks on the US. The recent proposals for inspecting (and scanning) every container entering the US by sea is an example of negative productivity growth caused by the response to a terrorist threat.

The political forces driving the lowering of man-made obstacles to international trade and mobility cannot be taken for granted. They have been reversed in the past. They can be reversed again. Between 1870 and 1914, international trade in goods and services was as free as it is today. International lending and borrowing were also highly developed and subject to few official restrictions. The range of financial instruments traded internationally was of course much more restricted than it is today. However, mobility of people, including international migration, was less restricted during the Gold Standard days than it is today.

Pathological globalisation In 2000, the election of George Bush and Dick Cheney as President and Vice-President of the USA represented the high-point of American economic, political and cultural triumphalism. Its expression in foreign policy and international relations was a form of high-handed unilateralism not seen before in the annals of the country.

Then the worm turned. The horrors of 9/11 suddenly brought home to America the fact that globalisation meant that everything has become more mobile: the good, the bad and the ugly. For a country that had not been attacked at home by agents of foreign powers since 1812, the trauma and fear created by the events of 9/11 was quite without precedent, both for the leaders and for the people. Globalisation became increasingly seen, also in the USA, as a source of problems and threats rather than as an opportunity.

The events of 9/11 brought home to America the negative side of globalisation, what I have called elsewhere pathological globalisation. Some dimensions of pathological globalisation were, of course, already familiar to the American public and leadership.

• The international spread of contagious diseases affecting humans has accompanied the increased mobility of humans and animals. Historically, smallpox and measles have destroyed societies. Today, TB, HIV-AIDS, Ebola virus, Nile virus and flu virus can spread with alarming speed. So can BSE and foot and mouth disease.
• The threat of international contagion in financial markets, manias and panics, irrational euphoria and despondency is but a phone call, news flash or e-mail message away.
• Many conventional criminal activities (the drugs trade, money laundering, human trafficking, tax evasion) hare now organised on a global scale.
• Global warming, or global climate change in general, results from CO2E emissions anywhere affecting the climate everywhere.
• Threats to national or regional cultures, religions and identities whether posed by materialist consumerism or an aggressively proselitising Saudi-financed Wahhabi form of Islam, made more acute because of the global reach of the modern media, including the internet.

The events of 9/11 added international terrorism to this little shop of horrors - a global threat perpetrated by loose global networks of terrorists and those who support them.

All these pathological forms of globalisation can only be tackled effectively through global action, that is, through world-wide co-ordinated actions by governments, international organisations and civil society. Safety and security through withdrawal, exclusion or isolation is not an option. Neither is shouting “he who is not with me is against me” and charging ahead, guns blazing (literally or metaphorically) to confront enemies you don’t understand.

It was a double tragedy that the leadership of Bush and Cheney, fed by a mixture of ignorance about the world beyond the US, overconfidence alternating with irrational fear, arrogance and plain stupidity, came to guide and lead the most powerful nation in world at the very moment that creative, intelligent multilateralism was more necessary than ever.

Preview:

In future posts on this subject, I plan to discuss (not necessarily in this order), some of the reasons behind the swift decline of American power and influence. At the moment I plan posts on the following topics:

• Limits to what can achieved with military firepower.
• High-handed unilateralism and ignorance of the world beyond the 49 contiguous states.
• Economic weaknesses
• Lower productivity growth
• Rent-seeking vs. wealth-creating entrepreneurship: cronyism, corruption and myopia
• Oil and energy-dependence
• External indebtedness
• Tax distortions
• Weak economic institutions
• Monetary policy
• Financial sector regulation and supervision
• Distorted fiscal federalism
• Weak political institutions
• A nation run by and for lawyers
• Checks and balances or paralysis?
• Inequality of wealth and income and the erosion of representative democracy and the rule of law.

• The unholy alliance of Christian fundamentalism and market fundamentalism

• Loss of moral authority: Guantanamo Bay and extraordinary renditions

• The rise of Chindia and the rest of the Bricks and of the N11

Labels: Economics, Ethics, Politics, Religion