On July 27, I will be leaving these shores for the health spas of Martha’s Vineyard, where I will remain until August 28, rejoicing in the company of the nattering nabobs of negativism. This blog will lie fallow till early September. The blogging business is addictive. I have done it non-stop since April 2007 and am overdue for a break (as are those who stumble upon my blog). Cold turkey starts now. Enjoy your summer.
The Council of Mortgage lenders has made a constructive proposal for reviving the markets for securitising residential mortgages. The response from the Bank of England and the Treasury has been a deafening silence. I believe the Bank and the Treasury are making a mistake.
Legitimate fear of moral hazard should not degenerate into pointless and unnecessarily costly moralizing: they have sinned, therefore they must be punished, even if the punishment goes beyond what is necessary to induce better behaviour in the future.
There is no doubt that in 2005, 2006 and the first half of 2007, mortgage lending in the UK was out of control. There was reckless lending and reckless borrowing. Ludicrous loan-to-value ratios became the norm (no mortgage really should exceed 80 percent of the value of a residential property – ever). Income and asset verification became perfunctory and often degenerated into self-certification. Just as self-regulation means no regulation, so self-certification means no checking and no verification of the borrower’s capacity to handle increased indebtedness. Banks and other mortgage lenders offered ludicrously low interest rates on mortgage borrowing. Borrowers believed that these low rates were part of the New Jerusalem of painless credit. Even today, real interest rates on mortgages continue to be low, even as nominal mortgage rates have risen. Further increases, to ensure normal spreads over the funding costs of mortgage lenders, can be expected.
But the correction since the middle of 2007 has been brutal. New mortgage approvals are at the lowest level ever in a series that goes back to 1987, that is, well before the last great housing market collapse. Turnover in the housing market is likewise at its lowest level since 1987. I am aware that both mortgage approvals and turnover were dangerously inflated prior to the middle of last year. A lot of churning in the housing market may make estate agents and solicitors happy, but does not contribute to economic well-being per se. Some turnover is a necessary condition for labour mobility, but there can be little doubt that just before the bust, growing numbers of buyers were taking out mortgages they were not planning or expecting to service, because they expected instead to be able to sell the newly acquired property at a higher price soon after completing their purchase.
Even French president Nicolas Sarkozy can be right about some things – malgré soi. He wants the ECB to publish the minutes of the rate-setting meetings of its Governing Council, including an account of each member’s view on the appropriate level of the ECB’s official policy rate – the inelegantly named Main refinancing operations Minimum bid rate. And about time too. But before it makes sense for the ECB to publish the minutes of its rate-setting meetings, the ECB has to start voting on its interest rate decisions.
Remarkably, the fact that the ECB’s Governing Council has never voted on the interest rate it sets does not appear to be widely known. Last night, the ECB correspondent of CNBC contradicted me when I asserted that the Governing Council had never voted on interest rates. She asserted that the ECB president, Jean-Claude Trichet, had often referred to the vote being unanimous. He hasn’t, of course. What he did say on a number of occasions was that the decision had been unanimous.
The ECB has never had a formal vote on interest rates. I know this straight from the mouths of horses who between them have attended every single one of the ECB Governing Council’s rate-setting meetings since the first one in January 1999. Instead of voting on the interest rate, the ECB’s Governing Council ‘reach a consensus’ without ever taking a vote. The mystical process through which this consensus is achieved can only be guessed at.
The UK Treasury are reported to be working on plans to reform the two fiscal rules introduced by Gordon Brown. These are the ‘Golden Rule’, that over the cycle the government’s current account be in balance or in surplus and the ‘Sustainable Investment Rule’ that the ratio of net general government debt to annual GDP be no more than 40 percent.
Before reforming the substance of the rules, the UK government should think about how it would enforce whatever rule or rules it comes up with. Both the ‘Golden Rule’ and the ‘Sustainable Investment Rule’ were respected only as long as they did not bind. When they became binding constraints on the government’s ability to borrow they were bent, fiddled and now ‘reformed’, that is, ignored. The fiscal rules of the EU’s Stability and Growth Pact – the general government financial deficit should not exceed three percent of GDP, and over the cycle the general government financial deficit should be close to balance or in surplus – to which the UK also signed up, have been ignored/violated with equal equanimity. With zero credibility as regards its willingness to respect its own fiscal rules or those of the EU, why would anyone pay any attention to a new set of rules that the Treasury may come up with?
The UK financial regulator, the FSA, recently introduced, without any public discussion and (prima facie) without much deliberation, the requirement that investors disclose short positions in stocks undertaking a rights issue if they amount to an interest above 0.25% of the outstanding quantity of shares. The US federal financial markets regulator, the SEC, even more recently banned the practice of naked short selling of certain stocks.
A naked short sale is the sale of a stock you don’t own and haven’t borrowed. A speculator sells short if he expects the price of the stock to fall by enough to compensate him for the cost of borrowing the stock or the opportunity cost of assuming a short position in some other way. There are, of course, other ways to profit from an expected decline in the price of a stock that exceeds what is priced in by the futures markets. Instead of borrowing the stock and selling it, expecting to buy it back at a low price before the loan of the stock expires and to redeem your borrowed stock at a profit, you could acquire a (put) option to sell the stock at or before some future date, hoping and expecting to be able to purchase the stock in the future cash market at a lower price than the strike price of your option.
It appears unavoidable that, whenever prices of financial assets are falling sharply, short sellers will be pointed at as the bogeymen. Likewise, whenever prices of real commodities are rising sharply, both hoarders/middlemen stockpiling the commodities and long speculators in financial derivatives based on the underlying commodities’ spot prices will be put in the stocks. Clearly, in speculative markets as in all markets, collusive behaviour, attempts to corner the market or to exercise market power in some other way, and other forms of market abuse (spreading rumours you know to be false and trading on these rumours, e.g. ‘trash and trade’) should be illegal. But what’s wrong with a naked short position per se? Is there something obviously distortionary or market-abusive about me entering into a contract today to deliver a stock at a known price one week from now without me owning the stock today or borrowing it today and holding the stock for another week? As long as I and my counterparty are confident that there will be a spot market a week from now in which I can buy the stock I promise today to deliver a week from now, such a transaction ought to be allowed.
What is even more mystifying is that there is no full symmetry in the degree to which short and long speculators are vilified. The FSA’s new restrictions on short selling are not matched by comparable restrictions on taking long positions in the stock. The SEC’s selective ban on naked short selling is also not matched by a symmetric ban on naked long buying – this would be buying stock you don’t owe and have not lent. Why is this?
Ricardo Caballero’s argument in his Financial Times column of July 14, Moral hazard misconception about moral hazard, is essentially that doing the right thing to minimize moral hazard would be too costly in terms of the likely negative impact of such actions on the real economy. The way he presents his case is a textbook example of how a combination of lack of commitment/opportunistic behaviour, myopia and strategic interaction between the private sector and the government can create a very bad equilibrium. I will refute his argument, focusing mainly on the case against bailing out Fannie Mae and Freddie Mac, unless this involves the euthanisia of the existing shareholders of the two GSEs and a material haircut for their creditors.
In what follows I show, first, that even if we wish to keep Fannie and Freddie in their current form, the immediate crisis need not get worse if their shareholders and creditors are treated harshly, thus maintaining incentives for future responsible lending, borrowing and investing. Second, I show that a more efficient and equitable solution is available that ends the institutional obfuscation inherent in Fannie’s and Freddie’s current form: public sector sheep dressed in private sector wolf’s clothing.
This past year has been the first time since the Bank of England was made operationally independent in May 1997, that monetary policy has been politically difficult. From a technical point of view, designing the right monetary policy has also been slightly more complicated than usual, but nothing that a bunch of moderately intelligent graduate students in economics wouldn’t be able to handle. The same applies to the ECB, which started functioning as the central bank of the euro area on January 1, 1999. The Fed has not gone through any institutional transformation since the Humphrey-Hawkins act of 1978, but it too has not been in the current painful policy position since the early 1980s.
So far, these three leading central banks have failed the test. They have looked inflation in the face, blinked and hoped for a better tomorrow.
The bail-out of Fannie Mae and Freddie Mac by the combined forces of the US Treasury and the Federal Reserve Board is the ugliest exercise of its kind I have ever observed outside early transition economies and mature banana republics.
There are two open-ended (possibly permanent) measures by the US Treasury and one supposedly temporary measure by the Fed. The Treasury’s proposals require Congressional approval to become effective, something that should be forthcoming some time next week. The Fed measure does not require Congressional approval.
Are Fannie Mae and Freddie Mac adequately capitalised, as asserted recently by US Treasury Secretary Hank Paulson, Federal Reserve Board Chairman Ben Bernanke and their regulator Office of Federal Housing Enterprise Oversight Director James B. Lockhart III? The answer is: obviously not, if these two government-sponsored enterprises of the US federal government had to make a living on normal private commercial terms. Obviously not if they were subject to the market discipline preached by Paulson and Bernanke, but not practiced when it comes to large financial institutions perceived as systemically important (too large or too interconnected to fail) or too politically sensitive to fail.
How far will the real price of oil and other carbon-based resources rise? Experts (I am not one of them) differ widely in their medium-term and long-term predictions, but my reading of the evidence suggests that there is a fair chance that the sky is the limit. In the short run (the next 2 or 3 years) a global cyclical slowdown may provide some temporary relief from rising commodity prices in general and rising oil prices in particular. This temporary cyclical energy price comfort will be deeper and longer-lived if the key emerging markets that have let inflation get out of control (effectively all of them except for Brazil) tighten monetary and fiscal policies to bring inflation down to politically tolerable levels. The resulting cyclical slowdown in emerging market growth will be bad news for economic activity in the industrial world, but will put downward pressure on commodity prices. We will be unemployed but able to afford petrol.
Once global growth returns to its underlying trend, however, say three or four years from now, I expect the relentless upward march of commodity prices, including oil, gas and agricultural commodities, to continue. The reason is simple. Global demand growth is heavily biased towards energy-intensive production and consumption in emerging markets. Even if common sense breaks out in India, China (perhaps even in the Middle East and other oil and gas producers) and domestic oil and energy use is priced at its global opportunity cost, the energy-intensity of global production and demand will be rising for quite a while. At a horizon of a decade or more, high energy costs may reduce the energy intensity of production, investment and consumption, but total energy demand is still likely to rise even if global real GDP growth averages only 3 or 4 percent per annum.