Today’s guest blogger is Elena Panaritis, an expert in property rights, creating markets in illiquid real estate assets, and public sector management. She is also the author of Prosperity Unbound; Building Property Markets with Trust, which is definitely not one of those odious get-rich-quick-in-real-estate-without-capital-brains-or-effort books. Instead it is a get real book for social entrepreneurs about how to turn real estate possessions into socially productive, and indeed also privately profitable, capital.
This Crisis Demands Non-Traditional Solutions to Get to a Path of Quick Recovery
By Elena Panaritis
Two years after it began, there is now a coalescing of opinion about the causes of the U.S. financial crisis and what should be done to resolve it, yet there is a serious element missing both in the causation analysis as well as in the prescriptive solution. This crisis, which has infected the global economy so severely, is very much a non-traditional one that calls for a non-traditional solution. The impact in the United States so far has been worse than anything since the Great Depression: unemployment reached 9.5 percent in June, up from 7.8 percent in January, home prices were down 27% at the end of the first quarter from their 2006 peak, and 1.5 million homes were in foreclosure. After jumping by 30 percent in February, home foreclosure rates tapered off but are again on the rise. According to the New York Times, the loss in property value could total $500 billion.
The Fed is in trouble. Obama administration proposals for enhancing the Fed’s supervisory and regulatory role and for assigning it new macro-prudential responsibilities and powers – effectively turning it into the nation’s systemic risk regulator - are meeting with strong and vocal opposition. The criticism is not just coming from the other agencies in the US financial sector regulatory and supervisory spaghetti bowl – agencies that would stand to lose power and influence or could be put out of business completely. The desire for stronger Congressional oversight of the Fed is no longer confined to a few libertarian fruitcakes, conspiracy theorists and old lefties. It is a mainstream view that the Fed has failed to foresee and prevent the crisis, that it has managed it ineffectively since it started, and that it has allowed itself to be used as a quasi-fiscal instrument of the US Treasury, by-passing Congressional control. Are any or all of these criticisms justified? Let’s ponder a few of them.
California’s public finances are in many ways a microcosm of those of the US as a whole. Admittedly, the state government’s deficit is tiny compared to that of the federal government. The state of California has a budget deficit this year of $26.3bn (about 1.5% of state GDP, which was just over $1.8 trillion in 2007), on revenues of just $113bn. Its total outstanding stock of state debt is also small, with just $59bn in general debt, $8bn in bonds linked to securitised revenues and about $2bn in commercial paper. In contrast, the US federal government is about to run a budget deficit in the 13 to 14 percent of GDP range (that is, the federal deficit is about the size of the state of California’s GDP!).
California, like every US state, will be hit by federal deficit and by the manner in which this is eventually brought under control again, be it through tax increases, public spending cuts, inflation or sovereign default. The state deficit, and the manner of its eventual resolution, represents pain for Californians on top of the shared misery they will endure as a result of California’s contribution to the resolution of the unsustainability in the federal public finances.
Private insurance only works if there is risk. If the risk is eliminated, profitable insurance is impossible. This holds for health insurance as it holds for credit default swaps. When risk vanishes, insurance turns into redistribution. That’s a task for the state, whether through the tax payer or by mandated pooling in quasi-private insurance schemes of individuals with known heterogeneous health profiles.
The rise of genomics - the branch of genetics that studies organisms in terms of their full DNA sequences or genomes – will in the not too distant future kill off most private health insurance. That’s probably a good thing, for two reasons. First, because of asymmetric information, when there is risk and uncertainty about a person’s future health, health insurance markets are badly affected by adverse selection and moral hazard. Second, because the private health insurance industry is a monument to inefficiency everywhere and, especially in the US, a rent-seeking Leviathan whose ruthless lobbying efforts corrupt all it touches.
Like most authors, I tend to cringe when I read something I wrote more than a few years ago. But while engaging in some authorial auto-archeology recently when preparing the index for a new paper (after all, if I don’t cite myself, who will?), I was pleasantly surprised with a few bits from a paper I wrote in 1999 and published in 2000 in the Bank of England’s Quarterly Bulletin, titled “The new economy and the old monetary economics”.
The paper takes aim at the assertion, rampant in 1999, that the behaviour in recent years of the world economy, led by the United States, could only be understood by abandoning the old conventional wisdom and adopting a ‘New Paradigm’. Prominent among the structural transformations associated with the New Paradigm were the the following: increasing openness; financial innovation; lower global inflation; stronger competitive pressures; buoyant stock markets defying conventional valuation methods; a lower natural rate of unemployment; and a higher trend rate of growth of productivity.
I argue, first, that the New Paradigm has been over-hyped. “…Unfortunately, the ‘New Paradigm’ label has been much abused by professional hype merchants and peddlers of economic snake oil.”
Second, I argue that, to the extent that we can see a New Paradigm in action, its implications for monetary policy have often been misunderstood.
I was particularly pleased that I had written following about financial innovation:
Last week the Eurosystem performed a €442bn injection of one-year liquidity into the Euro Area banking system. They did this at the official policy rate – the Main refinancing operations (fixed rate) – of 1.00 percent, against the usual collateral accepted for Longer Term Financing Operations, effectively anything euro-denominated, not based on derivatives and rated at least BBB-. It was a fixed-rate tender, that is, the ECB was willing to meet any demand at the 1 percent interest rate, as long as eligible collateral was offered; 1121 banks participated in the operation.
You will not be surprised to hear that this was the largest one-day ECB/Eurosystem operation ever. Even more remarkable than its scale are the terms on which the one-year funds were made available. There can be no doubt that this operation represents both a subsidy and a gift from the Eurosystem to the banks that participated in the operation. I hope to clarify the distinction between a subsidy and a gift in what follows.
The too big to fail problem has been central to the degeneration and corruption of the financial system in the north Atlantic region over the past two decades. The ‘too large to fail’ category is sometimes extended to become the ‘too big to fail’, ‘too interconnected to fail’, ‘too complex to fail’ and ‘too international’ to fail problem, but the real issue is size. The real issue is size. Even if a financial business is highly interconnected, that is, if its total exposure to the rest of the world and the exposure of the rest of the world to the financial entity are complex and far-reaching, it can still be allowed to fail if the total amounts involved are small. A complex but small business is no threat to systemic stability; neither is a highly international but small business. Size is the core of the problem; the other dimensions (interconnectedness, complexity and international linkages) only matter (and indeed worsen the instability problem) if the institution in question is big. So how do we prevent banks and other financial businesses from becoming too large to fail?
Whenever the cumulative effect of the daily observation, looking out of my window or into the mirror, of human inequity and wretchedness brings me to the point that I am convinced the human race is an evolutionary dead end, something incredible happens to restore my faith that a hunger for freedom and an unquenchable thirst for justice and fairness are part of our genetic code. Crowds often become mobs and mobs are mostly ugly and destructive. The sight of large numbers of unarmed people, most of them young, facing heavily armed police, regular army, militia or other armed thugs is awe-inspiring.
For the past week, I have put the Green Shootometer in the garden and have taken regular readings. The upshot is: the glass is definitely half empty – or half full. Let me explain.
To think I believed I had seen it all as regards creative uses and abuses of credit default swaps (CDS). But then came Amherst Holdings.
A credit default swap written on a security (a bond, say) is a contract that pays the owner a given amount when there is a default on that security. In the simplest case, the owner of the CDS receives from the issuer or writer of the CDS the face value of the bond that is in default. The writer of the CDS sells insurance against an event of default. The insurance premium is the price of the CDS. The buyer of the CDS buys insurance against default. If the default does not occur, the writer of the CDS wins, because he has received the insurance premia, but has not had to pay out on the insurance policy.