More on the Solvency Crisis

Here are several interesting pieces that lend support to the view that more liquidity--even if creatively injected through the new term action facility--will not solve the lack of interbank lending. The reasons is because this is not crisis of liquidity, but of solvency.

Fed's Auctioning Money Won't Fix Credit Problems

John M. Berry

This is more of a credit and confidence problem than a liquidity one similar to that which followed the Sept. 11 attacks on the World Trade Center... The issue now is the large losses -- both announced and unannounced -- that many financial institutions have experienced from securities backed by subprime mortgages, many of which have gone into default.

Read the rest

The Art of Crisis Management: Auctions and Swaps

Stephen Cecchetti

(This is a great piece for understanding the new term action facility)

Why are big private banks unwilling to lend to each?
Clearly, they were worried about the quality of the assets on the balance sheets of the potential borrowers. My guess is that banks were having enough trouble figuring out the value of the things they owned, so they figure that other banks must be having the same problems. The result has been paralysis in inter-bank lending markets. Banks have not been able to fund themselves. And, as I will discuss in a moment, non-US banks faced an added problem – they could not get dollars. This was either because they could not get euros or pounds to then sell for dollars, or once they got their domestic currency they were unable to make the exchange.

Read the rest

Is Nouriel Roubini Losing his Religion?

Nouriel Roubini is one of the few economists to early on make the call that our current financial quagmire was a solvency crisis rather than one of just illiquidity. As a result, Nouriel concluded back in August that "liquidity injections and lender of last resort bail out of insolvent borrowers--however necessary and unavoidable during a liquidity panic--will not work; they will only postpone and exacerbate the eventual and unavoidable insolvencies." I found his reasoning then and now to be compelling.

Recently, however, it appears that Nouriel has begun to lose his religion. He wrote a post to his blog a few days titled "Why monetary policy easing is warranted even in the current insolvency crisis." In this piece, Nouriel makes that argument that there should be global easing of monetary policy so as to

"... reduce the length of such a recession and dampen its depth. Monetary policy may be impotent in affecting the likelihood of a economic downturn... but it is not impotent in affecting how deep and long such a recession will be."

Nouriel goes on to say he believes monetary policy can dampen the severity of the recession without (1) postponing the needed real economic adjustments, (2) creating new asset bubbles elsewhere, or (3) generating excessive inflationary pressures. So Nouriel now is articulating the following: let the recession happen, but do not let it get out of hand. In other words, let's avoid the Great Depression scenario of the 1930s where bad policies let a normal recession--that may have been necessary to purge the excesses of the 1920s--turn ugly.

The Great Depression is one scenario. Let me propose another one that I believe fits our current situation better: Japan in the 1990s. Here, there was an asset bubble that popped and similarly led to rot in the banking system--large amount of non-performing loans--that was not quickly removed. The rot, in turn, contributed to a stagnant economy for almost a decade. The non-performing loans and government support programs in Japan sound eerily familiar to the situations in the U.S. today. If the Japan scenario is the right one, then Nouriel's proposal simply postpones and potentially creates more problems down the road.

Paul Krugman, who has not lost his religion on this topic, says the following

"
How will it all end? Markets won’t start functioning normally until investors are reasonably sure that they know where the bodies — I mean, the bad debts — are buried. And that probably won’t happen until house prices have finished falling and financial institutions have come clean about all their losses. All of this will probably take years. Meanwhile, anyone who expects the Fed or anyone else to come up with a plan that makes this financial crisis just go away will be sorely disappointed."

I hope Nouriel's concerns over a Great Depression type scenario are wrong, but the alternative Japan scenario is not much better. Hang in there world.

The Laffer Curve Showdown at the Mark Thoma Corral

Okay, it is not quite a showdown at the OK Corral, but Mark Thoma comes out swinging in a response to Justin Fox and Brad DeLong who suggest there is some truth to the Laffer curve. First, a recap of the statements that caused Mark to respond:

Brad DeLong: "As I read the evidence, Arthur Laffer is probably right at the top end: reducing the top tax rate from 70% to 50% is probably a revenue gainer and surely not much of a loser. From 50% to 28% is, I think, very different: a big revenue loser."

Justin Fox: (from initial posting) "Some tax cuts do raise revenues, of course.... (later posting) Just two off the top of my head: The 1964 Kennedy reduction of the top marginal income tax rate from 91% to 70% (it was enacted after JFK's assassination, but it was his bill), the 1981 Reagan reduction of the top marginal rate from 70% to 50%. I'm not at all an expert on this, but I don't think it's too controversial among economists to assert that those particular changes (but not the rest of the of Kennedy and Reagan tax legislation) were a break-even or better for the Treasury... The common thread is that these were cuts in punitively high marginal rates. They paid off in large part because they removed incentives to shelter income from taxes."

Mark begins his response by quoting two intermediate macroeconomic texts that essentially say "large budget deficits of the early 1980s = failure of the Laffer curve." He then goes on to say that one cannot look at the 1960s tax cut in isolation since the Fed monetized the public debt, providing an added economic stimulus that masks the true budget deficit reality. What I believe Mark is getting at here in this latter point--and something that is too often glossed over in these Laffer curve debates--is that one should distinguish between the structural budget balance and the cyclical budget balance when passing judgement on the merits of the Laffer curve. Okay, I will give him that point, but it cuts both ways. The Reagan budget deficits--that are supposedly evidence against the Laffer curve according to the cited textbooks--must also be parsed for the structural and cyclical components. After all, the sharpest post-WWII economic downturn occured during Reagan's tax cuts. What part of Reagan's deficits were due to the double-dip recessions in the early 1980s versus his tax policy?

The Congressional Budget Office provides data to answer this and other structural vs. cyclical budget balance questions. The figure below (click here for a larger picture) shows this decomposition as a percent of GDP from 1962 to 2006. (Other adjustments in figure consist of deposit insurance, receipts from auctions of licenses to use the electromagnetic spectrum, timing adjustments, and contributions from allied nations for Operation Desert Storm.)

Consistent with Mark's claim, this figure does show a positive cyclical contribution to the overall budget balance following the 1964 tax cut. The cyclical contribution, however, only turns positive in 1964 so one could argue it came from the tax cut itself. Regarding Reagan, the cyclical component clearly dragged down the budget balance during the early-to-mid 1980s, although the structural budget balance was the most important component overall. This figure also makes clear that both cyclical and structural forces were at work with Clinton--it was a combination of his tax policies and a booming economy that generated the budget surplus.

I am not sure this figure settles any questions, but it does highlight the importance of distinguishing between a structural budget balance and a cyclical budget balance. Personally, I find the nuanced Laffer curve view--if I can call it that--of Justin Fox, Brad DeLong, and Greg Mankiw a reasonable position to hold.

Rogoff on the Dollar's Reserve Status

Kenneth Rogoff tells us why the dollar's decline does not necessarily mean the loss of reserve status:

"The good news for Americans is that there is enormous inertia in the world trading and financial system. It took many decades and two world wars before the British pound lost its super-currency status. Nor is there any obvious successor to the dollar yet. Indeed, the sub-prime crisis has made the European financial system look just as vulnerable as that of the US. Likewise, while the Chinese Yuan might be king in 50 years, China's moribund financial system will prevent it from being crowned anytime soon. A huge share of world trade is denominated in dollars, even if some Opec presidents, such as Venezuela's Hugo Chávez, openly preach mutiny. Central banks still hold more than 50% of their foreign exchange reserves in dollars."

Read the rest of the article.

Why the U.S. Needs A Recession to Correct Global Imbalances

I have argued in previous postings that past monetary policy profligacy in the United States has contributed to the global imbalances (here, here, here, and here). Here is an article by Gilles Saint‑Paul that takes a similar view and follows this line of reasoning to its logical conclusion: the current easing by the Federal Reserve puts off the correction of these imbalances--and allows them to continue to build--until a later time when correcting them will be more painful.

It is refreshing to see a thoughtful article on global imbalances that does not bow at the altar of the 'saving glut' goddess. This article takes seriously the 'liquidity glut' view of global imbalances and shows why the conduct of monetary policy for the world's reserve currency can be distortionary for the global economy.

Update: Saint-Paul mentions Volker's recessions in the early 1980s. See here for comments on this experience

Update II: Bill C at Twenty-Cent Paradigms cautions us not to put too much faith in the ability of monetary policy to correct the global imbalances.

How the US imbalances can be corrected
Gilles Saint‑Paul

There is agreement among many analysts that the Fed should pursue a low interest rates policy in order to prevent the US credit crisis from degenerating into a recession. On what grounds are we told that? The bottom line is that monetary policy is supposed to fine-tune the economy by targeting inflation and the output gap. Thus, monetary policy is supposed to become tighter when there are fears of inflation, and looser when there are fears of a recession and no sign of inflation. Consequently, the fed’s recent moves to lower interest rates seem perfectly orthodox.

This focus on macroeconomic aggregates ignores any other effect that interest rates can have on the economy. It totally ignores that interest rates are a price which affects many allocative decisions and has important distributive consequences. In 2001, the Fed engaged in a policy of drastic reduction of interest rates, for fear that the conjunction between the end of the so-called “Internet bubble” and the attacks of September 11 would drive the US economy into a recession. These considerations were compounded by the increasingly popular view that inflation was no longer a problem. The strong expansion of the late 1990s had been accompanied with little inflationary pressures and there were fears that the deflationary experience of Japan might hit the United States.

The result of these policies is that the US was in a regime of very low real interest rates. From 2002 to 2004, the federal funds rate did not exceed some 1.5 %, while inflation moved from 1.6 % to 2.7 % during that period. Thus short-term real interest rates were clearly negative. As for longer maturities, some real rates fell to 1.5 %. Many would argue that this was the right thing to do; GDP stayed at its potential level, or below it, and the incipient increase in unemployment was reversed.

The problem is that low interest rates not only stimulate the economy, they do plenty of other things. In other words, focusing only on GDP has costs and may generate mounting problems—the low rates policy makes a current recession better, but the next one may be worse.

One reason why the US economy is less inflation-prone than in the past is that a bigger share of any increase in domestic demand is absorbed by imports: the economy is more open than it used to be. Thus, instead of having “overheating” because demand is greater than supply, the gap between the two is filled by trade deficits. Hence, low rates stimulated consumer spending and the trade balance deteriorated by two percentage points of GDP. The US is rapidly accumulating foreign debt and that may lead to a brutal correction with a sharp drop in consumer spending and a large depreciation of the real exchange rate. In fact, that correction may have already begun. Yet the Fed is not supposed to look at the net foreign asset position of the US economy, even though both its deterioration and rising inflation are the symptom of the same problem – excess domestic demand.

The other issue is asset prices. When interest rates are very low, and expected to remain so, asset prices can be very high. In fact, when interest rates fall below the growth rate, assets become impossible to price. Consider, for example, a share that pays a dividend which grows at 5 % a year. With a 2% interest rate, it is profitable to buy that asset regardless of its price, because I only need to hold it for a sufficiently long time for the dividends to eventually exceed the interest payments. So the price of the asset is in principle infinite. In fact, people do not live forever, so they will have to sell the asset back at some point; but one can show that any change in markets' expectations about that future price can be validated by a corresponding change in the current price—so, the current price can be anything.

In particular, low interest rates may start asset bubbles. One mechanism is as follows. As the price starts rising due to lower interest rates, irrational speculators start buying the asset on the grounds that the price increases are going to continue. That fuels the price increase which may eventually develop into a bubble where all speculators, including the rational ones, pay a high price for the asset because they expect the price to be even higher in the future. So one by-product of the fall in interest rates is that real house prices started to go up very quickly.
To summarise, the low interest rate policy led to a wrong intertemporal price of consumption – consumption was too cheap today relative to the future – which led to excess spending and trade deficits. It also led to a mis-pricing of housing, which led to excess residential investment and excess borrowing by households. That is the price that was paid to make the 2001-2002 slowdown milder.

These imbalances have to be corrected. In principle, consumer spending can be brought down without the economy having to go through a recession, provided there is a sharp real depreciation of the US dollar, which would shift the structure of demand away from domestic spending and in favour of exports. On the other hand, the correction in house prices is likely to be contractionary. Some consumers have borrowed against the capital gains they made on their house, to purchase, for example, a second house or consumer durables. They are going to cut their consumption since they are more likely to become insolvent. As the collateral value of their houses falls, consumers will get less credit; hence a further drop in consumption. Furthermore, the securities backed by mortgages, subprime or otherwise, have been used as collateral by financial institutions; that collateral is worth less, thus reducing credit between those institutions. As a consequence, they will have more trouble lending to firms, so that investment will also be hit. The housing bubble has jeopardised the financial sector both because people have borrowed to hold it and because institutions have used the corresponding securities as collateral.

Because of this gloomy scenario, the Fed has been under pressure to cut rates. The problem is that such a policy is likely to perpetuate the current imbalances. Indirectly, it amounts to bailing out the poor loans and poor investment decisions made by many banks and households in the last five years. The bail-out comes at the expense of savers and new entrants in the housing market. The signal sent by the Fed is that it is sound to join any market fad or bubble provided enough people do so, because one will be rescued by low interest rates once things turn sour. Worse, the more people join, the greater the lobby in favour of an eventual bail-out.

All this suggests that the US has to go through a recession in order to get the required correction in house prices and consumer spending. Instead of pre-emptively cutting rates, the Fed should signal that it will not do so unless there are signs of severe trouble (and there are no such signs yet since the latest news on the unemployment front are good) and decide how much of a fall in GDP growth it is willing to go through before intervening. As an analogy, one may remember the Volcker deflation. It triggered a sharp recession which was after all short-lived and bought the US the end of high inflation.

High Oil Prices Will Save the World Economy?

Daniel Gros makes an interesting argument in the Financial Times today. Current high oil prices, he says, may just save the world economy from the intensifying credit squeeze. How so?

"The core of the issue is simple: oil producers tend to save about half of their windfall gains from higher oil prices. If the oil price stays around $90 a barrel, oil producers will increase their current account surpluses by $200bn-$300bn a year. The question will then be: who is willing and able to run corresponding deficits?"

In other words, the oil producing nations generate far more income than they spend and thus have excess savings. The excess savings will be lent out to (or used to buy assets from) countries willing to live beyond their means (i.e. run current account deficit). Since the world economy is being weighed down once again by tightening credit conditions that have emerged from the subprime mess, this injection of excess savings will provide the needed infusion of funding to keep the world economy going. Daniel Gros goes on to say,

"This prognosis implies, provided oil prices stay high, an ex ante savings surplus (in which surplus countries offer more savings than needed by deficit countries). That should lead to lower global real interest rates and/or higher asset prices – depending on the way petrodollars are recycled."

So excess savings from the oil exporters will keep real interest rates low and push asset prices back up. While I find this to be an interesting argument, I also find it confusing. Are we not in this current credit quagmire, in part, because of similar past excess savings from these same countries (and Asia) finding its way into the U.S. economy? (I say "in part" because I believe past U.S. monetary policy also played an important role) And why will there be more ex ante savings surplus this time around? If it is that oil prices are higher now, then why has there not been any impact already? I hope Daniel Gros is right and we soon see a lowering of spreads and easing of credit markets.

If, in fact, there will be more loanable funds coming to credit markets how will the underlying real economic distortions be worked out? Brad Sester provides one possibility in his posting "Should China buy Countrywide?": sell off U.S. assets, particularly troubled financial institutions invested in U.S. housing. He quotes Stephen Jen who says,

“We all know that SWFs [sovereign wealth funds] will have a very difficult time in the future, because of their vilified reputation. Buying cheap, strategic assets and appearing to be rescuing the US will carry immense long-term reputational benefits. More SWFs should jump in now, in my view. Countrywide would not be a bad choice. How much does it cost? Three weeks’ of reserve growth for China? Also, this may be the best time to buy US banks and financial institutions, as there would be the least political impediment to such inflows."

One implication, then, is that the excess savings will save the day as foreigners indirectly (or directly in some cases) buy up the excess U.S. housing inventory. This brings a whole new meaning to home ownership in America.

Is History Repeating Itself?

As we watch the dollar continue to free fall, one thing that really strikes me is how similar these recent developments are to those taking place before the break up of the Bretton Woods System in the early 1970s. Back then, the periphery countries were importing a loose, inflationary monetary policy from the dominant anchor economy, the U.S. The periphery countries also had piled up large amount of dollar reserves that eventually lost value when the system cracked in 1971-1973. Today, the dominant anchor country once again is the U.S. and is exporting a loose, inflationary policy to the periphery countries (i.e. Asia and the Gulf States) who have acquired vast dollar reserves. These countries too are now taking a huge capital loss as the dollar falls. Will this system, called by some the Bretton Wood II System, also crack like the original? Are we living through a time where economic history is repeating itself?

Part of what got me thinking about these historical patterns was the lead article and a subsequent longer piece in the Economist on the dollar's fall. These articles do a nice job explaining the structural reasons--the pressures from the huge U.S. current account deficits are finally being felt--the and cyclical reasons--the increasingly probability of U.S. recession and further rate cuts--for the falling dollar. The Economist also provides an interesting discussion of whether this decline means the U.S. dollar will lose its reserve currency status (answer: not necessarily) and what it means for the global economy. I then followed up by reading Brad Sester's discussion on these same Economist articles. He especially makes a good case that contrary to conventional wisdom, central banks can have a meaningful influence in foreign exchange markets--just look at the influence of the BRICs and the Gulf States.

What a fascinating time to be alive... as long as I keep my job!