Showing posts with label financial crisis. Show all posts
Showing posts with label financial crisis. Show all posts
Thursday, November 3, 2011
Thursday, May 26, 2011
How Long Did the Housing Bubble Go On For?
Brad DeLong posts this on his blog:
I see basically three separate periods here. 69-81 looks like 2 business cycle driven very volatile periods with a little growth. After the 82 trough the expansion seems sustained a little longer and the fall off doesn't seem so steep. The red portion, which somewhat arbitrarily begins in 1992 is the beginning of an virtually uninterrupted climb in residential housing (even during the 2001 recession) that eventually became what everybody agrees was the housing bubble of the mid-2000s in which residential investment stays above the trend of the previous years until the collapse in 2006/7.
That chart reminds me of this chart:
Bubble run ups usually have a long period of above trend growth before you hit the "mania phase". In the case of housing, that's still above trend investment and is part of the overbuilding that still needs to be "corrected".
I think the case that the bubble had been a long time coming can be made. For instance, if we take 2003-2006 as the mania phase then it makes sense that this is the period where subprime mortgages arise. There are two stories people tell about subprime. The first is "chasing yield" story. That is, banks were lending to risky borrowers they said were safe but still paid high interest rates. The other story is that subprime was the last place to go because all the good borrowers had already taken out mortgages and refinanced etc. To the extent that the second story is true, how long did it take to make it all the way through the credit worthy borrowers? Did mortgage lenders become instantaneously aggressive in 2003 or was there a slow push of the supply curve of mortgages out further and further?
This brings me to the next argument in favor of my new pet theory. I'm a big subscriber to the "giant pool of money" theory of the housing bubble. However, I tend to date the capital inflow bonanza from the Asian Crisis of 1997. In the late 90s there was a sudden shift from capital flow "excess" into government deficits to "private deficits" (Private Savings - Investment < 0). Meanwhile, the current account balance continued it's historic decline. The dot com bubble, of course, is what everyone thought about and thinks about but a stock market bubble is not mutually exclusive with a housing bubble's infancy.
So whats the point? Well, I want to go back to Professor DeLong's idea that housing was only over built by $300billion and that we are "missing" $1.7trillion in residential investment that will eventually come roaring back. The increase in prices above the my trendline if measured from 1992 adds another $1.4trillion dollars to the overbuilding total. So if we think of the housing bubble as a generational phenomenon and not just a couple of years we had over $1.7 trillion in excess housing being built. The "correction" so far according to the 67-92 tread line is also much shallower, only about $425 billion. Suggesting we still have a long way to go before we come out even on residential housing.
Over the four-year period 2003-2006, annual construction spending rose to a level $150 billion above and then fell back to its long-run trend. Thus by the start of 2007 United States was overbuilt: about $300 billion had been spent building buildings in excess of the long-run trend.
When this construction was undertaken these buildings were expected to more than pay their way. But the profitability of these buildings depended on two shaky foundations: a permanent fall in long-term risky real interest rates, and permanent optimism about real estate as an asset class. Both these foundations collapsed.
By 2007, therefore, it would have been reasonable to expect that construction spending in United States would be depressed for some time to come. Since construction spending had run a cumulative amount of $300 billion ahead of trend, it would have to run $300 billion behind trend over a number of years in order to get back into balance. So everybody in 2007 was expecting a slowdown to be led by construction. But we were expecting a minor one: a fall in construction spending below trend of $150 billion a year for two years or $100 billion a year for three years or $75 billion a year for four years.
And starting in 2007 construction spending did indeed fall below trend. But we were expecting a minor one: a fall in construction spending below trend of $150 billion a year for two years or $100 billion a year for three years or $75 billion a year for four years. Instead, it fell $300 billion a year below trend. And it has so far stayed down for four years. And there is no prospect of rapid return to anything like normal levels.
Therefore when this construction cycle will have run its course, the United States will have first have spent an excess $300 billion, and then fallen short of trend by a cumulative $2 trillion of construction spending not undertaken. The net effect will be an at least $1.7 trillion construction shortfall in the United States: $1.7 trillion of houses, apartment buildings, offices, and stores not built.
He's basically describing this graph:
I don't know if I necessarily disagree with Professor DeLong, but I am curious about his trendline decision. He justifies it here:
Now let me briefly turn to construction. We expected a construction slump after the mid-2000s boom. Take construction spending in the United States as it stood back in 2001--when nobody thought we were overbuilding or overbuilt--and project it forward at the 3% growth rate of the American economy. We should probably project the construction trend at a slightly higher rate than that, because as people grow richer they do want to spend a greater share of their larger incomes on housing in a way that they don't for, say, food.
I'm not totally convinced by this. Post financial crisis "nobody thought" isn't very solid ground. So I looked at the longer annual real residential investment series:
I see basically three separate periods here. 69-81 looks like 2 business cycle driven very volatile periods with a little growth. After the 82 trough the expansion seems sustained a little longer and the fall off doesn't seem so steep. The red portion, which somewhat arbitrarily begins in 1992 is the beginning of an virtually uninterrupted climb in residential housing (even during the 2001 recession) that eventually became what everybody agrees was the housing bubble of the mid-2000s in which residential investment stays above the trend of the previous years until the collapse in 2006/7.
That chart reminds me of this chart:
Bubble run ups usually have a long period of above trend growth before you hit the "mania phase". In the case of housing, that's still above trend investment and is part of the overbuilding that still needs to be "corrected".
I think the case that the bubble had been a long time coming can be made. For instance, if we take 2003-2006 as the mania phase then it makes sense that this is the period where subprime mortgages arise. There are two stories people tell about subprime. The first is "chasing yield" story. That is, banks were lending to risky borrowers they said were safe but still paid high interest rates. The other story is that subprime was the last place to go because all the good borrowers had already taken out mortgages and refinanced etc. To the extent that the second story is true, how long did it take to make it all the way through the credit worthy borrowers? Did mortgage lenders become instantaneously aggressive in 2003 or was there a slow push of the supply curve of mortgages out further and further?
This brings me to the next argument in favor of my new pet theory. I'm a big subscriber to the "giant pool of money" theory of the housing bubble. However, I tend to date the capital inflow bonanza from the Asian Crisis of 1997. In the late 90s there was a sudden shift from capital flow "excess" into government deficits to "private deficits" (Private Savings - Investment < 0). Meanwhile, the current account balance continued it's historic decline. The dot com bubble, of course, is what everyone thought about and thinks about but a stock market bubble is not mutually exclusive with a housing bubble's infancy.
So whats the point? Well, I want to go back to Professor DeLong's idea that housing was only over built by $300billion and that we are "missing" $1.7trillion in residential investment that will eventually come roaring back. The increase in prices above the my trendline if measured from 1992 adds another $1.4trillion dollars to the overbuilding total. So if we think of the housing bubble as a generational phenomenon and not just a couple of years we had over $1.7 trillion in excess housing being built. The "correction" so far according to the 67-92 tread line is also much shallower, only about $425 billion. Suggesting we still have a long way to go before we come out even on residential housing.
Saturday, December 4, 2010
Naked Capitalism: Marshall Auerback: Bankers Gone Wild in Ireland AND Germany
Marshall Auerback: Bankers Gone Wild in Ireland AND Germany
By Marshall Auerback, a hedge fund manager and portfolio strategist who writes for New Deal 2.0.
Despite a blame-a-thon on Ireleand, Germans banks are really at the core of the eurozone catastrophe.
Much ink has been spilled in the press over the Irish problem and the laxity of the country’s southern Mediterranean counterparts in contrast to the highly “disciplined” Germans. But perhaps we have to revisit that caricature. Not only has the Irish crisis blown apart the myth of the virtues of fiscal austerity during rapidly declining economic activity, but it has also illustrated that Germany’s bankers were every bit as culpable as their Irish counterparts in helping to stoke the credit bubble.
One of the traditional rationales for the creation of the euro was that a single currency and strict Maastricht criteria would keep the profligate Mediterraneans and their Celtic equivalents in line. Instead, critics, particularly in Germany, increasingly see the European Monetary Union as a means for freeloading nations to offload their liabilities onto fitter neighbors.
Not surprisingly, this has engendered much discussion that perhaps it would serve Germany’s interests to leave the euro, rather than booting one of the Mediterranean “scroungers” out. But as Simon Johnson has pointed out, this comforting narrative of German prudence matched up against Irish profligacy doesn’t really stack up:
German banks in particular lost their composure with regard to lending to Ireland — although British, American, French and Belgian banks were not so far behind. Hypo Real Estate — now taken over by the German government — has what is likely to be the highest exposure to Irish debt.
But look at loans outstanding relative to the size of their domestic economies (using the BIS data on what they call an “ultimate risk basis”).
German banks are owed $139 billion, which is 4.2 percent of German G.D.P. [my emphasis]
Where were the German regulators? As my colleague Bill Black has noted:
They seem to have believed that ‘What happens in Vegas (Dublin) stays in Vegas (Dublin).’ Instead, their German banks came back from their riotous holidays in the PIIGS with BTDs (bank transmitted diseases). The German banks’ regulators continue to let them hide the embarrassing losses they picked up on holiday, but that cover up will collapse if any of the PIIGS default. The PIIGS will default if the EU does not bail them out, so there will be a bail out even though the German taxpayers hate to fund bailouts.
German banks’ relatively high exposure to Ireland does pose the question as to whether there is some wild, Weimar-style hyperinflationista lurking deep in the heart of every German, only able to express itself fully when away from the prying eyes of fellow citizens.
All of the rescue plans that have been introduced in Ireland or Greece thus far rest on the assumption that, with more time, the eurozone’s problem children could get their fiscal houses in order — and Europe could somehow grow its way out of trouble. But the fiscal austerity being offered as the “medicine” is turning out to be worse than the disease. It has exacerbated the downturn and unleashed a horrible debt deflation dynamic in all of the areas where it was reluctantly implemented.
But here’s the thing: these fiscal straitjackets obscure the history of how we came to today’s horrible impasse and, more specifically, the German banks’ role in helping to fuel the credit binge. Also lost is the reason why this has metastasized into a far greater crisis: as part of the eurozone, Ireland does not have the fiscal freedom to come up with a sufficiently robust government response. The UK had a comparable real estate bubble in the late 1980s, which culminated with the Soros attack on the pound in 1992 and the ejection of sterling from Exchange Rate Mechanism (the precursor to the EMU). This was a blessing in disguise. Withdrawal from the ERM saved the UK because it allowed the country sufficient latitude to reflate. Yes, the country had a major recession (in many ways a consequence of the surrender of fiscal freedom as a result of joining the ERM in the first place), but there was never a systemic risk that posed a threat to the country’s overall solvency as is the case in Ireland today. And this is exacerbating the problem in Ireland because it persists in chasing its tail repeatedly with futile fiscal austerity measures.
The truth of the matter is this: the eurozone seems rotten to the core, literally. Germany represents that core. The Germans might occupy the penthouse suite, but it is the suite of a roach motel. And we know what happens to those who enter such “establishments.”
Yes, longer term the problems currently afflicting the eurozone could be sorted via the creation of a supranational fiscal authority — a “United States of Europe”. But with each crisis (Ireland today; Portugal and Spain tomorrow; Italy and then France next?), the political forces are coalescing in a radically different direction. The Germans are becoming increasingly resentful as they perceive their country as the bailout mechanism of last resort (even though the Irish experience suggests that their bankers are also guilty of many of the same excesses as the “Celtic Tiger”). The PIIGS themselves are seeing that the benefits of euro membership have been vastly overstated and in fact now act as a cancerous influence through the Germanic embrace of austerity. (Paradoxically, it has been the “profligate” behavior of those so-called lazy Mediterraneans that has enabled Germany to retain its export-driven model, as well as allowing it to run lower budget deficits than most other countries.)
The eurozone could ultimately end up like Yugoslavia writ large. Prior to the break up of that country, the relatively rich republics, Slovenia and Croatia, resented policies that transferred wealth to the poorer republics like Serbia, Macedonia, Montenegro, or the autonomous region of Kosovo. Once Tito’s organizing genius disappeared, the links stitching the country together became frayed and eventually snapped as old grievances manifested themselves in newer forms. The same could happen to the Europe Union if it underwent a supranational fiscal union — the beginnings of which are already in evidence. I think the Germans are beginning to recognize that, which is why there is discussion about leaving the euro.
But let’s first be clear: German Chancellor Angela Merkel has persistently argued that it is essential that private investors, notably the bond holders, begin to suffer losses so that they will have the proper incentives to provide effective “private market discipline” going forward. She has further argued that it is fair that they suffer losses, given the premium yields they received and their lack of due diligence. That’s an honorable policy. But it’s like the old Irish joke of the driver who gets lost, asks for directions, and is told, “Well, I wouldn’t be starting from here.” By the same token, Ireland clearly illustrates that German banks, as well as their Mediterranean counterparts, would be big losers under the Merkel proposal. Ironically, German financial institutions could find themselves subject to the same kinds of bailouts that Chancellor Merkel and many of her counterparts in Berlin are urging on the Irish and Greeks.
As always, leave it to the Irish to come up with the most poetic response to the crisis. True, W.B. Yeats did not live to see this disaster, but his passionate “September 1913” does evoke the tragedy of today’s Ireland and the futility of the current policy responses for their people (and beyond):
Was it for this the wild geese spread
The grey wing upon every tide;
For this that all that blood was shed,
For this Edward Fitzgerald died,
And Robert Emmet and Wolfe Tone,
All that delirium of the brave?
Romantic Ireland’s dead and gone,
It’s with O’Leary in the grave.
Graves that might soon include not only the O’Learys, but also the Garcias, Texeiras, Moreaus, and Schmidts if a more rational course of action throughout the euro zone is not adopted soon.
Monday, August 30, 2010
Naked Capitalism: Japan’s Experience Suggests Quantitative Easing Helps Financial Institutions, Not Real Economy
Japan’s Experience Suggests Quantitative Easing Helps Financial Institutions, Not Real Economy
A few days ago, we noted:
When an economy is very slack, cheaper money is not going to induce much in the way of real economy activity.
Unless you are a financial firm, the level of interest rates is a secondary or tertiary consideration in your decision to borrow. You will be interested in borrowing only if you first, perceive a business need (usually an opportunity). The next question is whether it can be addressed profitably, and the cost of funds is almost always not a significant % of total project costs (although availability of funding can be a big constraint)…..
So cheaper money will operate primarily via their impact on asset values. That of course helps financial firms, and perhaps the Fed hopes the wealth effect will induce more spending. But that’s been the movie of the last 20+ years, and Japan pre its crisis, of having the officialdom rely on asset price inflation to induce more consumer spending, and we know how both ended.
Tyler Cowen points to a Bank of Japan paper by Hiroshi Ugai, which looks at Japan’s experience with quantitative easing from 2001 to 2006. Key findings:
….these macroeconomic analyses verify that because of the QEP, the premiums on market funds raised by financial institutions carrying substantial non-performing loans (NPLs) shrank to the extent that they no longer reflected credit rating differentials. This observation implies that the QEP was effective in maintaining financial system stability and an accommodative monetary environment by removing financial institutions’ funding uncertainties, and by averting further deterioration of economic and price developments resulting from corporations’ uncertainty about future funding.
Granted the positive above effects of preventing further deterioration of the economy reviewed above, many of the macroeconomic analyses conclude that the QEP’s effects in raising aggregate demand and prices were limited. In particular, when verified empirically taking into account the fact that the monetary policy regime changed under the zero bound constraint of interest rates, the effects from increasing the monetary base were not detected or smaller, if anything, than during periods when there was no zero bound constraint.
Yves here This is an important conclusion, and is consistent with the warnings the Japanese gave to the US during the financial crisis, which were uncharacteristically blunt. Conventional wisdom here is that Japan’s fiscal and monetary stimulus during the bust was too slow in coming and not sufficiently large. The Japanese instead believe, strongly, that their policy mistake was not cleaning up the banks. As we’ve noted, that’s also consistent with an IMF study of 124 banking crises:
Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.
Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery.5 Of course, the caveat to these findings is that a counterfactual to the crisis resolution cannot be observed and therefore it is difficult to speculate how a crisis would unfold in absence of such policies. Better institutions are, however, uniformly positively associated with faster recovery.
But (to put it charitably) the Fed sees the world through a bank-centric lens, so surely what is good for its charges must be good for the rest of us, right? So if the economy continues to weaken, the odds that the Fed will resort to it as a remedy will rise, despite the evidence that it at best treats symptoms rather than the underlying pathology.
A few days ago, we noted:
When an economy is very slack, cheaper money is not going to induce much in the way of real economy activity.
Unless you are a financial firm, the level of interest rates is a secondary or tertiary consideration in your decision to borrow. You will be interested in borrowing only if you first, perceive a business need (usually an opportunity). The next question is whether it can be addressed profitably, and the cost of funds is almost always not a significant % of total project costs (although availability of funding can be a big constraint)…..
So cheaper money will operate primarily via their impact on asset values. That of course helps financial firms, and perhaps the Fed hopes the wealth effect will induce more spending. But that’s been the movie of the last 20+ years, and Japan pre its crisis, of having the officialdom rely on asset price inflation to induce more consumer spending, and we know how both ended.
Tyler Cowen points to a Bank of Japan paper by Hiroshi Ugai, which looks at Japan’s experience with quantitative easing from 2001 to 2006. Key findings:
….these macroeconomic analyses verify that because of the QEP, the premiums on market funds raised by financial institutions carrying substantial non-performing loans (NPLs) shrank to the extent that they no longer reflected credit rating differentials. This observation implies that the QEP was effective in maintaining financial system stability and an accommodative monetary environment by removing financial institutions’ funding uncertainties, and by averting further deterioration of economic and price developments resulting from corporations’ uncertainty about future funding.
Granted the positive above effects of preventing further deterioration of the economy reviewed above, many of the macroeconomic analyses conclude that the QEP’s effects in raising aggregate demand and prices were limited. In particular, when verified empirically taking into account the fact that the monetary policy regime changed under the zero bound constraint of interest rates, the effects from increasing the monetary base were not detected or smaller, if anything, than during periods when there was no zero bound constraint.
Yves here This is an important conclusion, and is consistent with the warnings the Japanese gave to the US during the financial crisis, which were uncharacteristically blunt. Conventional wisdom here is that Japan’s fiscal and monetary stimulus during the bust was too slow in coming and not sufficiently large. The Japanese instead believe, strongly, that their policy mistake was not cleaning up the banks. As we’ve noted, that’s also consistent with an IMF study of 124 banking crises:
Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.
Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery.5 Of course, the caveat to these findings is that a counterfactual to the crisis resolution cannot be observed and therefore it is difficult to speculate how a crisis would unfold in absence of such policies. Better institutions are, however, uniformly positively associated with faster recovery.
But (to put it charitably) the Fed sees the world through a bank-centric lens, so surely what is good for its charges must be good for the rest of us, right? So if the economy continues to weaken, the odds that the Fed will resort to it as a remedy will rise, despite the evidence that it at best treats symptoms rather than the underlying pathology.
ProPublica: Banks’ Self-Dealing Super-Charged Financial Crisis
Banks’ Self-Dealing Super-Charged Financial Crisis
Short/no reading version of the story:
Planet Money
Over the last two years of the housing bubble, Wall Street bankers perpetrated one of the greatest episodes of self-dealing in financial history.
Faced with increasing difficulty in selling the mortgage-backed securities that had been among their most lucrative products, the banks hit on a solution that preserved their quarterly earnings and huge bonuses:
They created fake demand.
A ProPublica analysis shows for the first time the extent to which banks -- primarily Merrill Lynch, but also Citigroup, UBS and others -- bought their own products and cranked up an assembly line that otherwise should have flagged.
The products they were buying and selling were at the heart of the 2008 meltdown -- collections of mortgage bonds known as collateralized debt obligations, or CDOs.
As the housing boom began to slow in mid-2006, investors became skittish about the riskier parts of those investments. So the banks created -- and ultimately provided most of the money for -- new CDOs. Those new CDOs bought the hard-to-sell pieces of the original CDOs. The result was a daisy chain [1] that solved one problem but created another: Each new CDO had its own risky pieces. Banks created yet other CDOs to buy those.
Short/no reading version of the story:
Planet Money
Over the last two years of the housing bubble, Wall Street bankers perpetrated one of the greatest episodes of self-dealing in financial history.
Faced with increasing difficulty in selling the mortgage-backed securities that had been among their most lucrative products, the banks hit on a solution that preserved their quarterly earnings and huge bonuses:
They created fake demand.
A ProPublica analysis shows for the first time the extent to which banks -- primarily Merrill Lynch, but also Citigroup, UBS and others -- bought their own products and cranked up an assembly line that otherwise should have flagged.
The products they were buying and selling were at the heart of the 2008 meltdown -- collections of mortgage bonds known as collateralized debt obligations, or CDOs.
As the housing boom began to slow in mid-2006, investors became skittish about the riskier parts of those investments. So the banks created -- and ultimately provided most of the money for -- new CDOs. Those new CDOs bought the hard-to-sell pieces of the original CDOs. The result was a daisy chain [1] that solved one problem but created another: Each new CDO had its own risky pieces. Banks created yet other CDOs to buy those.
Monday, July 12, 2010
Dean Baker: The IMF Black Helicopter Gang Wants Your Social Security
Dean Baker
Co-director, Center for Economic and Policy Research :
The IMF Black Helicopter Gang Wants Your Social Security
A few years back there was a fear in some parts about black UN helicopters that were supposedly taking part in the planning of an invasion of the United States. While there was no foundation for this fear, there is basis for concern about another international organization, the International Monetary Fund (IMF).
This week the IMF told the United States that it needs to start getting its deficit down and put cutting Social Security at the top of its “to do” list. This one is more than a bit outrageous for two reasons.
First, the IMF can take a substantial share of the blame for economic crisis that gave us big deficits in the first place. The IMF is supposed to oversee the operations of the international financial system. According to standard economic theory, capital is supposed to flow from rich countries like the United States to poor countries to finance their development. In other words, the United States should be having a trade surplus, which would correspond to the money that we are lending to poor countries to finance their development.
However, the IMF messed up its management of financial crises so badly in the last decade that poor countries decided that they had to accumulate huge amounts of reserves in order to avoid ever being forced
to deal with the IMF. This meant that capital was flowing in huge amounts in the wrong direction. One result of this reverse flow was that the United States ran a huge trade deficit instead of a trade surplus. Another result was the $8 trillion housing bubble, the collapse of that crashed the U.S. economy.
The other reason that the IMF advice is infuriating is the incredible hypocrisy involved. The average Social Security benefit is just under $1,200 a month. No one can collect benefits until they reach the age of
62. By contrast, many IMF economists first qualify for benefits in their early 50s. They can begin drawing pensions at age 51 or 52 of more than $100,000 a year.
This means that we have IMF economists, who failed disastrously at their jobs, who can draw six-figure pensions at age 52, telling ordinary workers that they have to take a cut in their $14,000 a year Social
Security benefits that they can’t start getting until age 62. Now that is black helicopter!
Co-director, Center for Economic and Policy Research :
The IMF Black Helicopter Gang Wants Your Social Security
A few years back there was a fear in some parts about black UN helicopters that were supposedly taking part in the planning of an invasion of the United States. While there was no foundation for this fear, there is basis for concern about another international organization, the International Monetary Fund (IMF).
This week the IMF told the United States that it needs to start getting its deficit down and put cutting Social Security at the top of its “to do” list. This one is more than a bit outrageous for two reasons.
First, the IMF can take a substantial share of the blame for economic crisis that gave us big deficits in the first place. The IMF is supposed to oversee the operations of the international financial system. According to standard economic theory, capital is supposed to flow from rich countries like the United States to poor countries to finance their development. In other words, the United States should be having a trade surplus, which would correspond to the money that we are lending to poor countries to finance their development.
However, the IMF messed up its management of financial crises so badly in the last decade that poor countries decided that they had to accumulate huge amounts of reserves in order to avoid ever being forced
to deal with the IMF. This meant that capital was flowing in huge amounts in the wrong direction. One result of this reverse flow was that the United States ran a huge trade deficit instead of a trade surplus. Another result was the $8 trillion housing bubble, the collapse of that crashed the U.S. economy.
The other reason that the IMF advice is infuriating is the incredible hypocrisy involved. The average Social Security benefit is just under $1,200 a month. No one can collect benefits until they reach the age of
62. By contrast, many IMF economists first qualify for benefits in their early 50s. They can begin drawing pensions at age 51 or 52 of more than $100,000 a year.
This means that we have IMF economists, who failed disastrously at their jobs, who can draw six-figure pensions at age 52, telling ordinary workers that they have to take a cut in their $14,000 a year Social
Security benefits that they can’t start getting until age 62. Now that is black helicopter!
Thursday, March 25, 2010
Economist's View: Stop Panicking.
"Stop Panicking: Capitalism Repeatedly Recovers from Financial Crises"
Bill Easterly emails to ask what I think of this:
Stop panicking: Capitalism repeatedly recovers from financial crises, by William Easterly: I am just beginning to dive into the awesome book by Carmen Reinhart and Ken Rogoff, This Time is Different: Eight Centuries of Financial Folly. Along with great analysis, they have some wonderful pictures, evidence, and data. What I say here is my own take on it.
First, financial crises are remarkably common. Their Figure 5.1 shows the number of countries that have defaulted on their external debt (one possible dimension of a financial crisis) over the last two centuries. The numbers come in episodic waves of defaults and involve a remarkably high number of countries in each wave:
Second, the global capitalist system does well in the long run anyway. Average per capita income in the world (a shaky estimate, but probably right order of magnitude) increased by a multiple of 12 over 1800-2008, despite repeated epidemics of financial crises.
The US is arguably the country with democratic capitalism the longest, and it also shows a steady upward trend from 1870 to the present, despite repeated banking crises (using those identified by Reinhart and Rogoff), with usually little effect of each crisis on output relative to trend (except for the Great Depression).
Reinhart and Rogoff calculate directly the growth pattern before and after crises in advanced capitalist economies, and growth does indeed recover quickly to the trend growth rate of around 2 percent per capita per annum. 2 percent per capita is roughly the same growth rate that increased US per capita income so much from 1870 to the present.
y-axis reads "Real GDP Growth (Percent)"
I don’t mean to minimize the short run pain that the current financial crisis has caused. It’s horrible. But there is no reason to panic about the long run growth potential looking forward.
The obvious rejoinder is Keynes’ “in the long run, we are all dead.” But we can’t ignore that Capitalism already survived repeated financial crises and has made us all vastly better off despite them. So here’s a counter-quote: “In the long run, we are all better off because our dead ancestors stuck with capitalism.”
My take is a bit different. The graph of per capita income from 1870 - 2008 seems to say we shouldn't worry that aggressive intervention to stimulate the economy will cause long-run problems. It may help substantially in the short-run, but the graph above indicates it's unlikely to have long-run consequences. So, I agree, let's not panic. Let's not panic and start reducing stimulus measures too soon, or be too timid with stimulative policies, out of fear it might harm long-run growth. As the Great Depression shows us -- a time when there were legitimate fears about capitalism ending -- the more attention we pay to the short-run problems that undermine support for capitalism, the better chance there is that it will survive in the long-run.
I should acknowledge the Reinhart and Rogoff finding that debt levels higher than 90% of GDP are associated with lower economic growth:
...[D]ebt burdens are racing to thresholds of (roughly) 90 per cent of gross domestic product and above. That level has historically been associated with notably lower growth.
While the exact mechanism is not certain, we presume that at some point, interest rate premia react to unchecked deficits, forcing governments to tighten fiscal policy. Higher taxes have an especially deleterious effect on growth. ...
Given these risks of higher government debt, how quickly should governments exit from fiscal stimulus? This is not an easy task, especially given weak employment, which is again quite characteristic of the post-second world war financial crises... Given the likelihood of continued weak consumption growth in the US..., rapid withdrawal of stimulus could easily tilt the economy back into recession. Yet, the sooner politicians reconcile themselves to accepting adjustment, the lower the risks of truly paralysing debt problems down the road. ...
But as Rogoff notes elsewhere,
Monetary policy has done what it can to limit damage. Fiscal policy I would also give high marks to. We moved in the right direction in as timely a manner as possible.
I am not as willing to give fiscal policy high marks. We could have, and should have, done more to help the economy, and it certainly could have been more timely. As for fears more aggressive intervention will lower long-run growth, so long as we have the discipline to exit from these policies gracefully -- to pay the bill for the stimulus package in the good times -- long-run growth should not be affected by aggressive intervention in the short-run.
I believe that when the time comes to pay for the stimulus package, we'll do the right thing, just as we've always done in the past (yes, I know I'm being Pollyannish). And, in any case, the long-run debt problem has little to do with the stabilization measures used to counter the effects of the recession. The growth in health care costs is the problem in the long-run, nothing else matters much in comparison. If we fix the health cost escalation problem, a much more aggressive intervention to help the economy could have easily been absorbed into the budget without creating problems. And if we don't fix the health cost problem, the size of the stimulus package is of little consequence by comparison.
Finally, on the general "stop panicking" message, when people are hurting -- and they are -- we ought to panic. Legislators have given little indication that the understand the urgency of the employment problem we face. We need more panic, not less, about the employment situation.
Bill Easterly emails to ask what I think of this:
Stop panicking: Capitalism repeatedly recovers from financial crises, by William Easterly: I am just beginning to dive into the awesome book by Carmen Reinhart and Ken Rogoff, This Time is Different: Eight Centuries of Financial Folly. Along with great analysis, they have some wonderful pictures, evidence, and data. What I say here is my own take on it.
First, financial crises are remarkably common. Their Figure 5.1 shows the number of countries that have defaulted on their external debt (one possible dimension of a financial crisis) over the last two centuries. The numbers come in episodic waves of defaults and involve a remarkably high number of countries in each wave:
Second, the global capitalist system does well in the long run anyway. Average per capita income in the world (a shaky estimate, but probably right order of magnitude) increased by a multiple of 12 over 1800-2008, despite repeated epidemics of financial crises.
The US is arguably the country with democratic capitalism the longest, and it also shows a steady upward trend from 1870 to the present, despite repeated banking crises (using those identified by Reinhart and Rogoff), with usually little effect of each crisis on output relative to trend (except for the Great Depression).
Reinhart and Rogoff calculate directly the growth pattern before and after crises in advanced capitalist economies, and growth does indeed recover quickly to the trend growth rate of around 2 percent per capita per annum. 2 percent per capita is roughly the same growth rate that increased US per capita income so much from 1870 to the present.
y-axis reads "Real GDP Growth (Percent)"
I don’t mean to minimize the short run pain that the current financial crisis has caused. It’s horrible. But there is no reason to panic about the long run growth potential looking forward.
The obvious rejoinder is Keynes’ “in the long run, we are all dead.” But we can’t ignore that Capitalism already survived repeated financial crises and has made us all vastly better off despite them. So here’s a counter-quote: “In the long run, we are all better off because our dead ancestors stuck with capitalism.”
My take is a bit different. The graph of per capita income from 1870 - 2008 seems to say we shouldn't worry that aggressive intervention to stimulate the economy will cause long-run problems. It may help substantially in the short-run, but the graph above indicates it's unlikely to have long-run consequences. So, I agree, let's not panic. Let's not panic and start reducing stimulus measures too soon, or be too timid with stimulative policies, out of fear it might harm long-run growth. As the Great Depression shows us -- a time when there were legitimate fears about capitalism ending -- the more attention we pay to the short-run problems that undermine support for capitalism, the better chance there is that it will survive in the long-run.
I should acknowledge the Reinhart and Rogoff finding that debt levels higher than 90% of GDP are associated with lower economic growth:
...[D]ebt burdens are racing to thresholds of (roughly) 90 per cent of gross domestic product and above. That level has historically been associated with notably lower growth.
While the exact mechanism is not certain, we presume that at some point, interest rate premia react to unchecked deficits, forcing governments to tighten fiscal policy. Higher taxes have an especially deleterious effect on growth. ...
Given these risks of higher government debt, how quickly should governments exit from fiscal stimulus? This is not an easy task, especially given weak employment, which is again quite characteristic of the post-second world war financial crises... Given the likelihood of continued weak consumption growth in the US..., rapid withdrawal of stimulus could easily tilt the economy back into recession. Yet, the sooner politicians reconcile themselves to accepting adjustment, the lower the risks of truly paralysing debt problems down the road. ...
But as Rogoff notes elsewhere,
Monetary policy has done what it can to limit damage. Fiscal policy I would also give high marks to. We moved in the right direction in as timely a manner as possible.
I am not as willing to give fiscal policy high marks. We could have, and should have, done more to help the economy, and it certainly could have been more timely. As for fears more aggressive intervention will lower long-run growth, so long as we have the discipline to exit from these policies gracefully -- to pay the bill for the stimulus package in the good times -- long-run growth should not be affected by aggressive intervention in the short-run.
I believe that when the time comes to pay for the stimulus package, we'll do the right thing, just as we've always done in the past (yes, I know I'm being Pollyannish). And, in any case, the long-run debt problem has little to do with the stabilization measures used to counter the effects of the recession. The growth in health care costs is the problem in the long-run, nothing else matters much in comparison. If we fix the health cost escalation problem, a much more aggressive intervention to help the economy could have easily been absorbed into the budget without creating problems. And if we don't fix the health cost problem, the size of the stimulus package is of little consequence by comparison.
Finally, on the general "stop panicking" message, when people are hurting -- and they are -- we ought to panic. Legislators have given little indication that the understand the urgency of the employment problem we face. We need more panic, not less, about the employment situation.
Wednesday, March 17, 2010
Economist's View: Questions and Answers about the Financial Crisis
Questions and Answers about the Financial Crisis>
Gary Gorton
Link to full pdf (the full article is required reading for History of Intl Business and Finance)
Here is the beginning and end of a (much longer) Q&A with Gary Gorton discussing the financial crisis. He explains how the crisis was generated by a bank run much like past bank runs, but in a different type of asset and in a different segment of the banking system.
Rather than a run by individual depositors on demand deposits held in traditional banks (or, further in the past, private bank notes), this run involved firms and institutional investors and it was on repo held in the shadow banking system:
Questions and Answers about the Financial Crisis, Prepared for the U.S. Financial Crisis Inquiry Commission, by Gary Gorton[open link]: 1. Introduction ... Yes, we have been through this before, tragically many times. U.S. financial history is replete with banking crises and the predictable political responses. Most people are unaware of this history, which we are repeating. A basic point of this note is that there is a fundamental, structural, feature of banking, which if not guarded against leads to such crises. Banks create money, which allows the holder to withdraw cash on demand. The problem is not that we have banking; we need banks and banking. And we need this type of bank product. But, as the world grows and changes, this money feature of banking reappears in different forms. The current crisis, far from being unique, is another manifestation of this problem. The problem then is structural.
In this note, I pose and try to answer what I think are the most relevant questions about the crisis. I focus on the systemic crisis, not other attendant issues. I do not have all the answers by any means. But, I know enough to see that the level of public discourse is politically motivated and based on a lack of understanding, as it has been in the past, as the opening quotations indicate. The goal of this note is to help raise the level of discourse.
2. Questions and Answers
Q. What happened?
A. This question, though the most basic and fundamental of all, seems very difficult for most people to answer. They can point to the effects of the crisis, namely the failures of some large firms and the rescues of others. People can point to the amounts of money invested by the government in keeping some firms running. But they can’t explain what actually happened, what caused these firms to get into trouble. Where and how were losses actually realized? What actually happened? The remainder of this short note will address these questions. I start with an overview.
There was a banking panic, starting August 9, 2007. In a banking panic, depositors rush en masse to their banks and demand their money back. The banking system cannot possibly honor these demands because they have lent the money out or they are holding long-term bonds. To honor the demands of depositors, banks must sell assets. But only the Federal Reserve is large enough to be a significant buyer of assets.
Banking means creating short-term trading or transaction securities backed by longer term assets. Checking accounts (demand deposits) are the leading example of such securities. The fundamental business of banking creates a vulnerability to panic because the banks’ trading securities are short term and need not be renewed; depositors can withdraw their money. But, panic can be prevented with intelligent policies. What happened in August 2007 involved a different form of bank liability, one unfamiliar to regulators. Regulators and academics were not aware of the size or vulnerability of the new bank liabilities.
In fact, the bank liabilities that we will focus on are actually very old, but have not been quantitatively important historically. The liabilities of interest are sale and repurchase agreements, called the “repo” market. Before the crisis trillions of dollars were traded in the repo market. The market was a very liquid market like another very liquid market, the one where goods are exchanged for checks (demand deposits). Repo and checks are both forms of money. (This is not a controversial statement.) There have always been difficulties creating private money (like demand deposits) and this time around was no different.
The panic in 2007 was not observed by anyone other than those trading or otherwise involved in the capital markets because the repo market does not involve regular people, but firms and institutional investors. So, the panic in 2007 was not like the previous panics in American history (like the Panic of 1907, shown below, or that of 1837, 1857, 1873 and so on) in that it was not a mass run on banks by individual depositors, but instead was a run by firms and institutional investors on financial firms. The fact that the run was not observed by regulators, politicians, the media, or ordinary Americans has made the events particularly hard to understand. It has opened the door to spurious, superficial, and politically expedient “explanations” and demagoguery. ...
3. Summary
The important points are:
• As traditional banking became unprofitable in the 1980s, due to competition from, most importantly, money market mutual funds and junk bonds, securitization developed. Regulation Q that limited the interest rate on bank deposits was lifted, as well. Bank funding became much more expensive. Banks could no longer afford to hold passive cash flows on their balance sheets. Securitization is an efficient, cheaper, way to fund the traditional banking system. Securitization became sizable.
• The amount of money under management by institutional investors has grown enormously. These investors and non‐financial firms have a need for a short-term, safe, interest-earning, transaction account like demand deposits: repo. Repo also grew enormously, and came to use securitization as an important source of collateral.
• Repo is money. It was counted in M3 by the Federal Reserve System, until M3 was discontinued in 2006. But, like other privately-created bank money, it is vulnerable to a shock, which may cause depositors to rationally withdraw en masse, an event which the banking system – in this case the shadow banking system—cannot withstand alone. Forced by the withdrawals to sell assets, bond prices plummeted and firms failed or were bailed out with government money.
• In a bank panic, banks are forced to sell assets, which causes prices to go down, reflecting the large amounts being dumped on the market. Fire sales cause losses. The fundamentals of subprime were not bad enough by themselves to have created trillions in losses globally. The mechanism of the panic triggers the fire sales. As a matter of policy, such firm failures should not be caused by fire sales.
• The crisis was not a one-time, unique, event. The problem is structural. The explanation for the crisis lies in the structure of private transaction securities that are created by banks. This structure, while very important for the economy, is subject to periodic panics if there are shocks that cause concerns about counterparty default. There have been banking panics throughout U.S. history, with private bank notes, with demand deposits, and now with repo. The economy needs banks and banking. But bank liabilities have a vulnerability.
Update: See also What Really Went Wrong?, BY Steve Landsburg.
Gary Gorton
Link to full pdf (the full article is required reading for History of Intl Business and Finance)
Here is the beginning and end of a (much longer) Q&A with Gary Gorton discussing the financial crisis. He explains how the crisis was generated by a bank run much like past bank runs, but in a different type of asset and in a different segment of the banking system.
Rather than a run by individual depositors on demand deposits held in traditional banks (or, further in the past, private bank notes), this run involved firms and institutional investors and it was on repo held in the shadow banking system:
Questions and Answers about the Financial Crisis, Prepared for the U.S. Financial Crisis Inquiry Commission, by Gary Gorton[open link]: 1. Introduction ... Yes, we have been through this before, tragically many times. U.S. financial history is replete with banking crises and the predictable political responses. Most people are unaware of this history, which we are repeating. A basic point of this note is that there is a fundamental, structural, feature of banking, which if not guarded against leads to such crises. Banks create money, which allows the holder to withdraw cash on demand. The problem is not that we have banking; we need banks and banking. And we need this type of bank product. But, as the world grows and changes, this money feature of banking reappears in different forms. The current crisis, far from being unique, is another manifestation of this problem. The problem then is structural.
In this note, I pose and try to answer what I think are the most relevant questions about the crisis. I focus on the systemic crisis, not other attendant issues. I do not have all the answers by any means. But, I know enough to see that the level of public discourse is politically motivated and based on a lack of understanding, as it has been in the past, as the opening quotations indicate. The goal of this note is to help raise the level of discourse.
2. Questions and Answers
Q. What happened?
A. This question, though the most basic and fundamental of all, seems very difficult for most people to answer. They can point to the effects of the crisis, namely the failures of some large firms and the rescues of others. People can point to the amounts of money invested by the government in keeping some firms running. But they can’t explain what actually happened, what caused these firms to get into trouble. Where and how were losses actually realized? What actually happened? The remainder of this short note will address these questions. I start with an overview.
There was a banking panic, starting August 9, 2007. In a banking panic, depositors rush en masse to their banks and demand their money back. The banking system cannot possibly honor these demands because they have lent the money out or they are holding long-term bonds. To honor the demands of depositors, banks must sell assets. But only the Federal Reserve is large enough to be a significant buyer of assets.
Banking means creating short-term trading or transaction securities backed by longer term assets. Checking accounts (demand deposits) are the leading example of such securities. The fundamental business of banking creates a vulnerability to panic because the banks’ trading securities are short term and need not be renewed; depositors can withdraw their money. But, panic can be prevented with intelligent policies. What happened in August 2007 involved a different form of bank liability, one unfamiliar to regulators. Regulators and academics were not aware of the size or vulnerability of the new bank liabilities.
In fact, the bank liabilities that we will focus on are actually very old, but have not been quantitatively important historically. The liabilities of interest are sale and repurchase agreements, called the “repo” market. Before the crisis trillions of dollars were traded in the repo market. The market was a very liquid market like another very liquid market, the one where goods are exchanged for checks (demand deposits). Repo and checks are both forms of money. (This is not a controversial statement.) There have always been difficulties creating private money (like demand deposits) and this time around was no different.
The panic in 2007 was not observed by anyone other than those trading or otherwise involved in the capital markets because the repo market does not involve regular people, but firms and institutional investors. So, the panic in 2007 was not like the previous panics in American history (like the Panic of 1907, shown below, or that of 1837, 1857, 1873 and so on) in that it was not a mass run on banks by individual depositors, but instead was a run by firms and institutional investors on financial firms. The fact that the run was not observed by regulators, politicians, the media, or ordinary Americans has made the events particularly hard to understand. It has opened the door to spurious, superficial, and politically expedient “explanations” and demagoguery. ...
3. Summary
The important points are:
• As traditional banking became unprofitable in the 1980s, due to competition from, most importantly, money market mutual funds and junk bonds, securitization developed. Regulation Q that limited the interest rate on bank deposits was lifted, as well. Bank funding became much more expensive. Banks could no longer afford to hold passive cash flows on their balance sheets. Securitization is an efficient, cheaper, way to fund the traditional banking system. Securitization became sizable.
• The amount of money under management by institutional investors has grown enormously. These investors and non‐financial firms have a need for a short-term, safe, interest-earning, transaction account like demand deposits: repo. Repo also grew enormously, and came to use securitization as an important source of collateral.
• Repo is money. It was counted in M3 by the Federal Reserve System, until M3 was discontinued in 2006. But, like other privately-created bank money, it is vulnerable to a shock, which may cause depositors to rationally withdraw en masse, an event which the banking system – in this case the shadow banking system—cannot withstand alone. Forced by the withdrawals to sell assets, bond prices plummeted and firms failed or were bailed out with government money.
• In a bank panic, banks are forced to sell assets, which causes prices to go down, reflecting the large amounts being dumped on the market. Fire sales cause losses. The fundamentals of subprime were not bad enough by themselves to have created trillions in losses globally. The mechanism of the panic triggers the fire sales. As a matter of policy, such firm failures should not be caused by fire sales.
• The crisis was not a one-time, unique, event. The problem is structural. The explanation for the crisis lies in the structure of private transaction securities that are created by banks. This structure, while very important for the economy, is subject to periodic panics if there are shocks that cause concerns about counterparty default. There have been banking panics throughout U.S. history, with private bank notes, with demand deposits, and now with repo. The economy needs banks and banking. But bank liabilities have a vulnerability.
Update: See also What Really Went Wrong?, BY Steve Landsburg.
Friday, January 8, 2010
Matt Taibbi: The Great American Bubble Machine
Like I said in class, don't read this so much as just about Goldman sachs but about how the financial industry in general has been behaving.
The Great American Bubble Machine
From tech stocks to high gas prices, Goldman Sachs has engineered every major market manipulation since the Great Depression - and they're about to do it again
MATT TAIBBI
Posted Jul 13, 2009 1:49 PM
The first thing you need to know about Goldman Sachs is that it's everywhere. The world's most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money. In fact, the history of the recent financial crisis, which doubles as a history of the rapid decline and fall of the suddenly swindled dry American empire, reads like a Who's Who of Goldman Sachs graduates.
By now, most of us know the major players. As George Bush's last Treasury secretary, former Goldman CEO Henry Paulson was the architect of the bailout, a suspiciously self-serving plan to funnel trillions of Your Dollars to a handful of his old friends on Wall Street. Robert Rubin, Bill Clinton's former Treasury secretary, spent 26 years at Goldman before becoming chairman of Citigroup — which in turn got a $300 billion taxpayer bailout from Paulson. There's John Thain, the asshole chief of Merrill Lynch who bought an $87,000 area rug for his office as his company was imploding; a former Goldman banker, Thain enjoyed a multibilliondollar handout from Paulson, who used billions in taxpayer funds to help Bank of America rescue Thain's sorry company. And Robert Steel, the former Goldmanite head of Wachovia, scored himself and his fellow executives $225 million in goldenparachute payments as his bank was selfdestructing. There's Joshua Bolten, Bush's chief of staff during the bailout, and Mark Patterson, the current Treasury chief of staff, who was a Goldman lobbyist just a year ago, and Ed Liddy, the former Goldman director whom Paulson put in charge of bailedout insurance giant AIG, which forked over $13 billion to Goldman after Liddy came on board. The heads of the Canadian and Italian national banks are Goldman alums, as is the head of the World Bank, the head of the New York Stock Exchange, the last two heads of the Federal Reserve Bank of New York — which, incidentally, is now in charge of overseeing Goldman — not to mention …
But then, any attempt to construct a narrative around all the former Goldmanites in influential positions quickly becomes an absurd and pointless exercise, like trying to make a list of everything. What you need to know is the big picture: If America is circling the drain, Goldman Sachs has found a way to be that drain — an extremely unfortunate loophole in the system of Western democratic capitalism, which never foresaw that in a society governed passively by free markets and free elections, organized greed always defeats disorganized democracy.
The bank's unprecedented reach and power have enabled it to turn all of America into a giant pumpanddump scam, manipulating whole economic sectors for years at a time, moving the dice game as this or that market collapses, and all the time gorging itself on the unseen costs that are breaking families everywhere — high gas prices, rising consumercredit rates, halfeaten pension funds, mass layoffs, future taxes to pay off bailouts. All that money that you're losing, it's going somewhere, and in both a literal and a figurative sense, Goldman Sachs is where it's going: The bank is a huge, highly sophisticated engine for converting the useful, deployed wealth of society into the least useful, most wasteful and insoluble substance on Earth — pure profit for rich individuals.
They achieve this using the same playbook over and over again. The formula is relatively simple: Goldman positions itself in the middle of a speculative bubble, selling investments they know are crap. Then they hoover up vast sums from the middle and lower floors of society with the aid of a crippled and corrupt state that allows it to rewrite the rules in exchange for the relative pennies the bank throws at political patronage. Finally, when it all goes bust, leaving millions of ordinary citizens broke and starving, they begin the entire process over again, riding in to rescue us all by lending us back our own money at interest, selling themselves as men above greed, just a bunch of really smart guys keeping the wheels greased. They've been pulling this same stunt over and over since the 1920s — and now they're preparing to do it again, creating what may be the biggest and most audacious bubble yet.
If you want to understand how we got into this financial crisis, you have to first understand where all the money went — and in order to understand that, you need to understand what Goldman has already gotten away with. It is a history exactly five bubbles long — including last year's strange and seemingly inexplicable spike in the price of oil. There were a lot of losers in each of those bubbles, and in the bailout that followed. But Goldman wasn't one of them.
The Whole article is here.
The Great American Bubble Machine
From tech stocks to high gas prices, Goldman Sachs has engineered every major market manipulation since the Great Depression - and they're about to do it again
MATT TAIBBI
Posted Jul 13, 2009 1:49 PM
The first thing you need to know about Goldman Sachs is that it's everywhere. The world's most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money. In fact, the history of the recent financial crisis, which doubles as a history of the rapid decline and fall of the suddenly swindled dry American empire, reads like a Who's Who of Goldman Sachs graduates.
By now, most of us know the major players. As George Bush's last Treasury secretary, former Goldman CEO Henry Paulson was the architect of the bailout, a suspiciously self-serving plan to funnel trillions of Your Dollars to a handful of his old friends on Wall Street. Robert Rubin, Bill Clinton's former Treasury secretary, spent 26 years at Goldman before becoming chairman of Citigroup — which in turn got a $300 billion taxpayer bailout from Paulson. There's John Thain, the asshole chief of Merrill Lynch who bought an $87,000 area rug for his office as his company was imploding; a former Goldman banker, Thain enjoyed a multibilliondollar handout from Paulson, who used billions in taxpayer funds to help Bank of America rescue Thain's sorry company. And Robert Steel, the former Goldmanite head of Wachovia, scored himself and his fellow executives $225 million in goldenparachute payments as his bank was selfdestructing. There's Joshua Bolten, Bush's chief of staff during the bailout, and Mark Patterson, the current Treasury chief of staff, who was a Goldman lobbyist just a year ago, and Ed Liddy, the former Goldman director whom Paulson put in charge of bailedout insurance giant AIG, which forked over $13 billion to Goldman after Liddy came on board. The heads of the Canadian and Italian national banks are Goldman alums, as is the head of the World Bank, the head of the New York Stock Exchange, the last two heads of the Federal Reserve Bank of New York — which, incidentally, is now in charge of overseeing Goldman — not to mention …
But then, any attempt to construct a narrative around all the former Goldmanites in influential positions quickly becomes an absurd and pointless exercise, like trying to make a list of everything. What you need to know is the big picture: If America is circling the drain, Goldman Sachs has found a way to be that drain — an extremely unfortunate loophole in the system of Western democratic capitalism, which never foresaw that in a society governed passively by free markets and free elections, organized greed always defeats disorganized democracy.
The bank's unprecedented reach and power have enabled it to turn all of America into a giant pumpanddump scam, manipulating whole economic sectors for years at a time, moving the dice game as this or that market collapses, and all the time gorging itself on the unseen costs that are breaking families everywhere — high gas prices, rising consumercredit rates, halfeaten pension funds, mass layoffs, future taxes to pay off bailouts. All that money that you're losing, it's going somewhere, and in both a literal and a figurative sense, Goldman Sachs is where it's going: The bank is a huge, highly sophisticated engine for converting the useful, deployed wealth of society into the least useful, most wasteful and insoluble substance on Earth — pure profit for rich individuals.
They achieve this using the same playbook over and over again. The formula is relatively simple: Goldman positions itself in the middle of a speculative bubble, selling investments they know are crap. Then they hoover up vast sums from the middle and lower floors of society with the aid of a crippled and corrupt state that allows it to rewrite the rules in exchange for the relative pennies the bank throws at political patronage. Finally, when it all goes bust, leaving millions of ordinary citizens broke and starving, they begin the entire process over again, riding in to rescue us all by lending us back our own money at interest, selling themselves as men above greed, just a bunch of really smart guys keeping the wheels greased. They've been pulling this same stunt over and over since the 1920s — and now they're preparing to do it again, creating what may be the biggest and most audacious bubble yet.
If you want to understand how we got into this financial crisis, you have to first understand where all the money went — and in order to understand that, you need to understand what Goldman has already gotten away with. It is a history exactly five bubbles long — including last year's strange and seemingly inexplicable spike in the price of oil. There were a lot of losers in each of those bubbles, and in the bailout that followed. But Goldman wasn't one of them.
The Whole article is here.
Sunday, August 30, 2009
Simple explanations for global financial instability and the cure: Keep it simple
Simple explanations for global financial instability and the cure: Keep it simple
Jacopo Carmassi Daniel Gros Stefano Micossi © voxEU.org
Jacopo Carmassi Daniel Gros Stefano Micossi © voxEU.org
13 August 2009
Why is there so much disagreement about the causes of the crisis? This column says that lax monetary policy and excessive leverage are to blame. It argues that many alleged causes are simply symptoms of these policy errors. If that is correct, then the recommended corrective is remarkably simple – there is no need for intrusive regulatory measures constraining non-bank intermediaries and innovative financial instruments.
A remarkable feature of the burgeoning literature on the global financial crisis is vast disagreement about its main causes. Symptoms are often treated as autonomous developments requiring separate correction. There is thus a high risk that the legitimate pursuit of a more stable financial system will lead to a potpourri of excessive and damaging regulatory restrictions. In hope of reducing that risk, we offer a simplified reading of the factors leading to the financial crisis and accordingly simple policy recommendations (Carmassi, Gros, and Micossi 2010).
Why is there so much disagreement about the causes of the crisis? This column says that lax monetary policy and excessive leverage are to blame. It argues that many alleged causes are simply symptoms of these policy errors. If that is correct, then the recommended corrective is remarkably simple – there is no need for intrusive regulatory measures constraining non-bank intermediaries and innovative financial instruments.
A remarkable feature of the burgeoning literature on the global financial crisis is vast disagreement about its main causes. Symptoms are often treated as autonomous developments requiring separate correction. There is thus a high risk that the legitimate pursuit of a more stable financial system will lead to a potpourri of excessive and damaging regulatory restrictions. In hope of reducing that risk, we offer a simplified reading of the factors leading to the financial crisis and accordingly simple policy recommendations (Carmassi, Gros, and Micossi 2010).
The ingredients of speculative bubbles
Recent events feature three main ingredients that are persistently observed in bubbles. First, there was abundant liquidity in world capital markets, fed by large payment imbalances, notably a large and persistent current account deficit in the US financed by ample flows of capital from emerging and oil-exporting countries. These “global” imbalances fostered an unsustainable explosion of financial assets and liabilities.
The second main ingredient was a credit boom leading to unsustainable leverage (the ratio of debt to equity), and the third was financial innovation, including the explosion of securitisation and derivatives and the “originate to distribute” model, which led to a significant deterioration in lending standards. The key point is that the innovations were instrumental in allowing an increase in leverage, as they moved risks still borne by the originators off of their balance sheets, reduced capital requirements with risk mitigation techniques such as credit derivatives, and embedded leverage in the “equity” tranches of structured products.
Leverage in Europe
Higher aggregate leverage generally indicates less capacity to absorb losses. It is not possible to establish a universal benchmark for excessive leverage, as different financial systems can support quite different ratios of credit to GDP. However, rapid increases in this ratio have been identified as reliable predictors of financial crises.
This warning signal was certainly audible in Europe before 2007-08. First, the increase in economy-wide leverage (measured by the debt-to-GDP ratio) was higher in the euro area than in the US. The increase between 1999 and 2007 amounted to 100% of GDP for the euro area, while in the US it was “only” 80% of GDP. Households’ leverage increased strongly in the US (40% of GDP) and much less so in the euro area. Financial sector leverage, however, increased more in the euro area (about 70% of GDP compared to 40% in the US).
As may be seen from the upper quadrant of Figure 1, large EU cross-border banks had an average leverage ratio close to 35; there were peaks of 70 and even 80 for some British, German, and Swiss banks.
As may be seen from the upper quadrant of Figure 1, large EU cross-border banks had an average leverage ratio close to 35; there were peaks of 70 and even 80 for some British, German, and Swiss banks.
Figure 1. Leverage and exposure to market risk of the largest EU and US banks, 1998-2008
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Leverage: total liabilities/net tangible equity. Exposure to market risk: total securities/net tangible equity. Data on 2008 are estimates. Source: R&S - Mediobanca 2009.
Monetary anchors for ever-rising asset prices
Monetary anchors for ever-rising asset prices
Monetary policy in the US was accommodating throughout the 1990s and became aggressively expansionary in the 2000s; nominal interest rates fell below levels recommend by the Taylor rule (and below the inflation rate in 2003-04).
A key feature of a speculative bubble is the attendant anomalous convergence of expectations that occurs when a growing share of investors believes that prices can only go up and that the risk of reversal somehow disappears. The phenomenon of convergent expectations in the stock market was documented by Robert Shiller’s surveys of investor sentiment. Shiller believes that convergence of expectations is a natural, endogenous phenomenon engendered by such things as a long-established benevolent economic environment and economic innovations announcing a new era of prosperity. In his view, monetary policy is driven by the same psychological forces that feed the bubble and cannot be considered exogenous (Shiller 2000).
However, a straightforward alternative is that monetary policy itself provided the anchor for the convergence of expectations, based on the consistent record that any decline in asset prices would be countered by the Federal Reserve with vigorous monetary expansion. Indeed, Alan Greenspan had just arrived at the Federal Reserve at the time of the 1987 stock market crash; he promptly reacted by aggressively lowering policy interest rates. He did it again in 1998 at the time of the LTCM crisis that followed the East Asian and Russian crisis, and even more aggressively after the end of the dot.com bubble in 2000. In all these episodes, there were no adverse effects of falling asset prices on economic activity and subsequently stock prices recovered.
The pattern is clear – the Fed repeatedly and systematically intervened to counter “negative bubbles”, while it remained passive when confronted with accelerating credit and asset prices. This policy approach, long established and clearly announced for over a decade, must have played an important role in bringing about convergent expectations of ever-rising asset prices, which eventually destabilised financial markets and the economy. Such an asymmetric monetary policy creates a gigantic moral hazard problem, whereby all agents expect to be rescued from their mistakes. This is where excessive leverage and excessive maturity transformation become relevant.
Banks and leveraged credit booms
A feature of banks that has traditionally justified special regulation is that deposits can be withdrawn on demand at par value. Banks normally do not keep sufficient liquidity to pay back all depositors at the same time, which exposes them to the risk of a run when depositors start to doubt their solidity. Bank runs are contagious and may generate systemic instability.
Non-bank intermediaries do not pose an equal threat to financial stability, since their liabilities are not redeemable on demand at par. They are not exposed to the risk of customer runs since their liabilities are market-priced like their assets. When financial intermediaries that raise money from capital markets by issuing securities make wrong investment decisions, their investors will lose their money without further repercussions for the financial system at large.
US investment banks raised a growing share – eventually, up to a quarter of their total liabilities – of their funds in the wholesale money market but without banks’ public safeguards and prudential constraints. When confidence collapsed, their liquidity evaporated and pushed them over the brink, without much regard for the quality of their assets.
Non-bank intermediaries do not pose an equal threat to financial stability, since their liabilities are not redeemable on demand at par. They are not exposed to the risk of customer runs since their liabilities are market-priced like their assets. When financial intermediaries that raise money from capital markets by issuing securities make wrong investment decisions, their investors will lose their money without further repercussions for the financial system at large.
US investment banks raised a growing share – eventually, up to a quarter of their total liabilities – of their funds in the wholesale money market but without banks’ public safeguards and prudential constraints. When confidence collapsed, their liquidity evaporated and pushed them over the brink, without much regard for the quality of their assets.
An apparent puzzle is the behaviour of European universal banks, which combine commercial and investment banking activities within the same organisation, that managed to become not only overleveraged, but also overexposed to toxic assets as much as the riskiest Wall Street investment banks, despite prima facie more stringent regulation (Figure 1). This was partly due to lax oversight by national regulators who wanted their national champions to take larger market shares and participate in the great gains of finance. However, the key factor in explaining EU banks’ leverage was risk-mitigation techniques made possible, and indeed encouraged, by the Basel capital rules.
The fundamental problem with these rules is that they create room for reducing capital requirements by choosing counterparties or tailoring operations to legal features so as to economise capital; moreover, once Basel requirements were met, management felt exonerated from any further scrutiny of actual risks. Capital requirements came to be wholly misinterpreted; during the long upswing in stock prices, keeping a buffer of capital over the minimum was seen as a waste of resources, so that the floor became a ceiling.
anagement demands for tools to reduce capital requirements were met by Wall Street – eager to find outlet for the new breed of structured securities – by multiplying the offer of credit default swaps on those securities and securing Triple-A rating for their senior tranches. Besides, Basel capital rules directly encouraged the explosion of the interbank market, later a major source of instability, since they assigned a low ranking to assets such as interbank deposits and bonds held vis-à-vis other banks.
anagement demands for tools to reduce capital requirements were met by Wall Street – eager to find outlet for the new breed of structured securities – by multiplying the offer of credit default swaps on those securities and securing Triple-A rating for their senior tranches. Besides, Basel capital rules directly encouraged the explosion of the interbank market, later a major source of instability, since they assigned a low ranking to assets such as interbank deposits and bonds held vis-à-vis other banks.
The problem was compounded by a definition of capital that made as many items with little resemblance to equity – such as subordinated debt and other hybrid capital instruments – eligible instruments. As a result, while the target ratio between regulatory capital and risk-weighted assets for European banks was 8%, the ratio between cash and equity and the same assets did not exceed 2%.
Therefore, the key to avoiding repeating this crisis is setting adequate capital requirements that cannot be circumvented for all intermediaries able to raise funds redeemable on demand at par. The simple way of doing it is to set capital requirements with reference to total assets, with no further distinction – 8% should be 8% in cash and equity, with no gimmicks allowed. All risks effectively borne by a bank, regardless of their legal attribution or geographical location, should be included in the asset definition, and accounting principles should be modified accordingly.
Legally separating commercial and investment banking activities or prohibiting banks from undertaking particular activities would not be necessary, which is advantageous considering the enormous hurdles involved in implementing such separation for large cross-border banking groups. At most, one could instead envisage higher capital charges on proprietary trading and lending to highly leveraged financial organisations, so as to reduce their profitability, as currently explored by the Financial Stability Board.
Legally separating commercial and investment banking activities or prohibiting banks from undertaking particular activities would not be necessary, which is advantageous considering the enormous hurdles involved in implementing such separation for large cross-border banking groups. At most, one could instead envisage higher capital charges on proprietary trading and lending to highly leveraged financial organisations, so as to reduce their profitability, as currently explored by the Financial Stability Board.
Conclusion
We have argued that the massive financial instability of 2007-8 was primarily the result of lax monetary policy, mainly in the US. The regulatory system compounded this error by tolerating excessive leverage and maturity transformation by banks in the US and Europe. Innovation did contribute to credit expansion and instability, but in all likelihood, without lax money and excessive leverage, reckless bets on asset price increases would have been much reduced.
The logical conclusion is that a repeat of this instability could be avoided in the future by correcting those two policy faults. By and large, there is no need for intrusive regulatory measures constraining non-bank intermediaries and innovative financial instruments. Our main message in designing the new rules for the global financial system is “keep it simple”.
The logical conclusion is that a repeat of this instability could be avoided in the future by correcting those two policy faults. By and large, there is no need for intrusive regulatory measures constraining non-bank intermediaries and innovative financial instruments. Our main message in designing the new rules for the global financial system is “keep it simple”.
References
Carmassi, Jacopo, Daniel Gros and Stefano Micossi (2010). “The Global Financial Crisis: Causes and Cures”, forthcoming in the Journal of Common Market Studies, Vol. 48, No.1, January 2010, Special Issue on Europe and the Global Financial Turmoil.
Carmassi, Jacopo, Daniel Gros and Stefano Micossi (2010). “The Global Financial Crisis: Causes and Cures”, forthcoming in the Journal of Common Market Studies, Vol. 48, No.1, January 2010, Special Issue on Europe and the Global Financial Turmoil.
Shiller, Robert J. (2000). “Measuring Bubble Expectations and Investor Confidence” Journal of Behavioral Finance, 1542-7579, Volume 1, Issue 1, 2000, Pages 49 – 60.
Friday, July 24, 2009
Podcast: Bloomberg on the Economy: Wolf says 70% of Emerging Markets' Excess Capital Went to U.S.
Bloomberg on the Economy is available for free on ITunes. It is the July 22nd show.
http://www.bloomberg.com/tvradio/podcast/ontheeconomy.html
http://www.bloomberg.com/tvradio/podcast/ontheeconomy.html
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