Monthly Archives: April 2009

Google is to privacy and respect for intellectual property rights what the Taliban are to women’s rights and civil liberties: a daunting threat that must be fought relentlessly by all those who value privacy and the right to exercise, within the limits of the law, control over the uses made by others of their intellectual property.  The internet search engine company should be regulated rigorously, defanged and if necessary, broken up or put out of business.  It would not be missed.

In a nutshell, Google promotes copyright theft and voyeurism and lays the foundations for corporate or even official Big Brotherism.

I am not going to use this opportunity to deepen the gloom by exploring at length the possible consequences of a worldwide pandemic of a virulent form of swine flu.  Just a few depressing words will have to suffice.  From an economic perspective, a flu pandemic amounts to at least a temporary reduction in the effective supply of labour.  If flu-related mortality is high, there will be a permanent reduction in labour supply.  The dependency ratio rises (temporarily or permanently, depending on whether mortality increases).  Trade and travel are interrupted.  A flu pandemic therefore represents an adverse supply shock.  Notional consumption demand need not decline materially, but effective consumption demand may well be depressed if many would-be shoppers cannot reach the sellers of goods and services or arrange for delivery.  Investment is bound to suffer.

A flu pandemic therefore also represents an adverse shock to aggregate demand.  It is bad news on both the demand and supply side.  It will however, impact favourably on global warming.  Now you know.  In what follows I will analyse global economic prospects on the assumption that there will not be a global swine flu pandemic.

The real economy downturn in the US is about 1½ years old; the UK recession has been with us for at least three quarters; the rest of Europe, Japan and most emerging markets and developing countries have juvenile recessions, barely a couple of quarters old.

As regards the overdeveloped world, or at least the North Atlantic part of it, the odds are that this contraction of real economic activity will be deeper and last longer than other post-war recessions.

In a recent interview with the Financial Times, the President of the German Bundesbank, Axel Weber, is quoted as saying: “I find it surprising that European institutions view crossborder operations within the EU as foreign operations”. There is, rather to my regret, nothing suprising about it.  As my colleague Charles Goodhart has said: (crossborder) “banks are international in life but national in death” (transcript of interview can be found here).

Regulation and supervision of banks in the EU is a mess; liquidity and solvency support of banks in the Euro Area is a mess.  Lender-of-last resort operations in the Euro Area need fiscal backing for the national central bank participating in it, including a full indemnity by the national treasury involved.  This is not a problem as long as the national identity of the bank is clear.  Whenever this in not the case, disaster can strike.

The Belgian, Dutch and Luxembourg authorities made a joint attempt to rescue the Fortis Group as a crossborder bank.  Crossborder fiscal burden sharing lasted a week.  Then the Dutch took 100 percent of the Dutch bit of Fortis, the Belgian authorities 100 percent of the Belgian bit and the Luxembourg authorities 100 percent of the Luxembourguese remnants.  If the Benelux cannot find its way to ex-post fiscal burden sharing, who can? Market-maker-of-last-resort operations in the Eurozone (including quantitative easing and credit easing operations) are restricted by the lack of clear fiscal burden-sharing rules for losses incurred by the Eurosystem as part of their monetary, liquidity and credit operations.

Alistair Darling is a good chancellor of the exchequer. He has presented a Budget that does  essentially nothing – a good budget, given the dreadful economic circumstances. The global economic environment is the least hospitable since 1945 and a dozen years of specific British policy mistakes have left the British economy more vulnerable than almost any other to the financial crisis.

In an earlier post I questioned the green credentials of ‘cash-for-clunkers’/'dosh-for-bangers’ schemes that provide financial incentives to scrap old, energy-inefficient cars early and purchase greener jalopies instead. The argument is simple. The total environmental impact of a car is the sum of the impact caused by its production and the impact of operating the vehicle over its lifetime. Scrapping my old hooptie earlier and replacing it with a more energy-efficient model will undoubtedly reduce the environmental operating impact of the vehicle. However, the subsidy is also likely to increase the cumulative production of vehicles. The net environmental impact depends on the balance of these two effects. I haven’t done the eco-engineering analysis that would enable me to give a convincing opinion on the net environmental impact of the scheme, but neither, as far as I can tell, has anyone else.

But at least as regards the impact on the demand for automobiles, the effect of the ‘dosh-for-bangers’ scheme is unambiguous. While the financial incentive is in effect, it will stimulate the demand for cars. If the incentive is credibly announced today but does not take effect until some time in the future (January 1, 2011, say), the demand for new cars will fall between the announcement date (today) and the implementation date (January 1, 2011). The reason is obvious: there is a strong incentive to delay the scrapping of your current clunker until you can take advantage of the financial incentive. If the ‘dosh-for-bangers’ scheme is temporary, it will also be followed, after it expires, by a period during which the demand for new cars is lower than it would have been without the scheme.

The death of Eddie George (Edward George, or Baron George of St. Tudy in the County of Cornwall, former Governor of the Bank of England) on April 19 came as a shock. I knew he had been ill with cancer for a long time, but one is never prepared for the finality of death. This post is not an attempt to assess his place in history, but just a recording of some tales I will remember him for.

(1) The autodafé of the unsecured creditors is coming to a US bank near you

A binding budget constraint sure concentrates the mind, even for the US Treasury. There is just one way to make the US government’s policy towards the banks work.  That is for the Congress to vote another $1.5 trillion worth of additional TARP money for the banks – $1 trillion to buy the remaining toxic assets off their balance sheets, and $0.5 trillion worth of additional capital.   The likelihood of the US Congress voting even a nickel in additional financial support for the banks is zero.

There is no real money left in the original $700 bn TARP facility – somewhere between $ 100 bn and 150 bn – to do more than stabilise a couple of pawn shops.  The Treasury has been playing for time by raiding the resources of the FDIC (which, apart from the meagre insurance premiums it collects, has no resources other than what the Treasury grants it) and of the Fed.  The Fed has taken an open position in private credit risk to the tune of many hundreds of billions of dollars.  Before this crisis is over, its exposure to private sector default risk could be counted in trillions of dollars.

Useless finance

A derivative is a contingent claim whose payoff depends on the performance of some other financial instrument or security.  For instance, an American equity call option gives the purchaser of the call the right (but not the obligation) to buy a share of equity from the issuer or writer of the call option at or before some future date at a price determined today.  A credit default swap (CDS) is a credit derivative contract between two (counter)parties in which the holder makes periodic payments to the issuer in return for a payoff if the underlying financial instrument specified in the contract defaults.

A derivative contract is formally identical to a lottery, a (simple or compound) bet or gamble.  Like any financial claim, any derivative is  an ‘inside asset’ – it is in zero net supply.  Because pay-offs associated with a derivative contract are functions of observable properties of other financial claims (prices, interest rates, default states), the derivative contract either re-packages existing underlying uncertainty or creates additional ‘artificial’ uncertainty.  It would create additional extraneous uncertainty if it added some noise of its own to the fundamental, exogenous uncertainty that is presumably reflected in the features of the underlying security that determine the pay-offs of the derivative contract.

If the creation and trading of derivatives were costless, derivatives result in zero-sum redistributions of wealth between the issuers and the owners of the derivative contracts.  Costless derivatives would be redundant if markets were complete.  When markets are incomplete, as they are in our unfortunate universe, introducing derivatives can either lead to an increase or to a reduction in efficiency and social welfare. Lower efficiency and social welfare are possible even if creating and trading derivatives were costless.  Derivatives may improve the allocation of risk, but there is no guarantee that they will.  It is my contention that the unbridled explosion of certain categories of derivatives has done considerable harm, and that it is necessary to regulate all derivatives trading.

On April 6, 2009, the Fed, the ECB, the Bank of England, the Bank of Japan and the Swiss National Bank simultaneously made announcements about currency swap arrangements.  I consider these statements to be misleading and quite possibly redundant.

The Great Contraction will last a while longer

This financial crisis will end.  The Great Contraction of the Noughties also will come to an end. But neither the financial crisis nor the contraction of the global real economy are over yet.  As regards the financial sector, we are not too far – probably less than a year – from the beginning of the end.  The impact of the collapse of real economic activity and of the associated dramatic increase in defaults and insolvencies by non-financial enterprises and households on the loan book of what is left of the banking sector will begin to show up in the banks’ financial reports at the end of the summer and in the autumn.  By the end of the year – early 2010 at the latest – we will know which banks will survive and which ones are headed for the scrap heap.  With the resolution of the current pervasive uncertainty about the true state of the banks’ balance sheets and about their off-balance-sheet exposures, normal financial intermediation will be able to resume later in 2010.

Governments everywhere are doing the best they can to delay or prevent the lifting of the veil of uncertainty and disinformation that most banks have cast over their battered balance sheets. The  banking establishment and the financial establishment representing the beneficial owners of the institutions exposed to the banks as unsecured creditors – pension funds, insurance companies, other banks, foreign investors including sovereign wealth funds – have captured the key governments, their central banks, their regulators, supervisors and accounting standard setters to a degree never seen before.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website