Why does mayhem in world financial markets continue without a clear sign of ending? Why recovery of real economies delays? Economists seem to join lemmings in the political market and to succumb to its guiding forces, populism and opportunism, in their proposals to implement tighter regulation of financial institutions and looser budgetary policies. Shouldn’t they rather stick to the basic body of their science?
When politicians slightly open the strings of their purses, it pays for the actors in private markets to delay their decisions in the hope for milking more generous subsidies and expenditure programs. That is why sound fiscal policy would now call for an end of constructing new such programs. The worldwide downturn will anyhow immensely deteriorate public budgets through automatic forces, by reducing tax revenues and increasing social transfers because of stalling production and enhanced unemployment. Thus lesson no. 1 is that a responsible piece of economic advice would not only limit public budgets to their present stance but would also kill the option to delay in taking private action.
In monetary policy, central banks have largely emptied their ammunition, steering rates of interest set at their historical bottom; quantitative easing remains, i.e., central banks buy unconventional assets from the banking system to directly create loanable reserves.
Only the ECB has room for additional maneuver in its steering rate. – You guessed it! I do not recommend the ECB to cut the rate of its main lending facility on April 2. In the current circumstances it is time for thinking about future; price developments in the euro zone, the harmonized index of consumer prices rising 0.4 per cent in the month of February, are not encouraging for a rate cut. The lags of monetary policy are notoriously long and variable. Sticking to the most basic lesson of monetary policy – inflation is always and everywhere a monetary phenomenon, lesson no. 2 – would kill the option to delay the start of lending by big banks.
The “too-big-to-fail” –doctrine is not economics but sociology of economic policy. Politicians and their economic advisors should abandon it in favor for admitting the fact that in mayhem, as the current one, all financial institutions are zombies if strict mark-to-market financial accounting were applied to them. Therefore no kind of discretionary cleansing of banks from their bad loans would make the system safer.
The banks were lured to risk taking by regulation itself, by the incentives that softened the impact of regulatory red tape on them. And, those incentives were hugely fuelled by the Fed’s lax monetary policy since Alan Greenspan’s acclaim “irrational exuberance” - acclaim because he did not act accordingly.
Banks are currently passing through a real stress test. Therefore it is irresponsible economic management by the ministries of finance and by the central banks if they try to benefit from the difficulties of the banks. Rather, I would see the ministries of finance advancing credit on equal terms to every bank regulated by the Fed and the ECB at the same interest rate as the governments can raise themselves. But after a two year’s grace period, a progressive penalty rate over the next 5-7 years need be applied to such loans to recover the taxpayers’ funds. Banks and individuals will react to changes in relative prices; so, lesson no. 3 is that let the markets decide which bank will fail and which stay.
Lesson no. 4 is to get rid of other kind of bank regulation, except for requiring the top managers and the major owners of the banks to be fit-and-proper professionals, in the first instance, and for preventing them from looting their banks in case a bank will walk plank. Part of such preventive rules would be to install a claw-back clause on the managers’ future compensations so that their remunerations will retrospectively - perhaps over the last five years before a bank failure - be reduced to a decent benchmark.
Showing posts with label banking crisis. Show all posts
Showing posts with label banking crisis. Show all posts
Tuesday, March 31, 2009
Tuesday, January 20, 2009
Preventing the world from central bankers’ ego
Instead of Keynes, would the old Friedman rule be worth studying again? Milton Friedman invented his rigid rule for monetary growth to save the citizens of a free society from the central bankers’ ego unlike Lenin’s instruction to most effectively destroy a society by destroying its money.
Friedman was fearful of “the assignment of wide discretionary powers to a group of technicians, gathered together in an ‘independent’ central bank” and wanted “to establish institutional arrangements that will enable government to exercise responsibility for money, yet at the same time limit the power thereby given to government and prevent this power from being used in ways that will tend to weaken rather than strengthen a free society”; Capitalism and Freedom (1962, p. 39). Friedman introduced the idea of a constant annual rate of growth of money stock, regardless of changing economic conditions, to curtail the discretionary power of the monetary authorities in A Program for Monetary Stability (1959).
“The fact is that the Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than any inherent instability of the private economy”; the Federal Reserve System exercised its power to conduct monetary policy “so ineptly as to convert what otherwise would have been a moderate contraction into a major catastrophe” (C&F, p. 38).
By Friedman’s hindsight, the error list of the Fed included the unusually tight monetary conditions since mid-1928 culminating in an attempt to curb “speculation”, but leading to the 1929 stock market crash - that is, the Fed pricked the bubble which Greenspan’s Fed declined to carry out; the money stock declined by nearly 3 per cent from August 1929 to October 1930 – “a larger decline than during the whole of all but the most severe prior contractions”; prior to October 1930, there had been no sign of a liquidity crisis, or any loss of confidence in banks, but thereafter the economy was plagued by recurrent liquidity crises, runs on banks and waves of bank failures, but the Fed “stood idly by” because of “will, not of power”; Britain went off the gold standard in September 1931 inducing gold withdrawals from the USA, but two years of severe economic contraction did not prevent the Fed from defending the dollar and ending the gold drain by raising the discount rate – the rate at which it lent to member banks; the US money stock fell by one third from July 1929 to March 1933 with over two-thirds of the decline after Britain’s departure from the gold standard.
No wonder, Friedman wanted to avoid important policy actions being “highly dependent on accidents of personality” by introducing his rule of money growth that would also prevent monetary policy from being subject to the day-to-day whim of the politicians.
Was Alan Greenspan’s ego too big because of Friedman’s infamous research on and critique of the US monetary policy of the 1930s in A Monetary History of the United States 1967-1960 with Anna Swartz (1963)? Did Alan want to show how the Fed’s errors of the 1930s can be avoided? Alan fought preventively against “deflation”, a continuous downward spiral of prices and wages, in 2003-2005 during the most rapid global economic growth ever experienced! Greenspan’s Fed ridiculed active monetary policy by inventing to raise the steering rate of interest at a “measured” pace – the flip side of Friedman’s rule of a constant rate of growth of money supply?
What went wrong? The world is a global village was already taught in the mid-1960s. With a number of emerging market currencies pegged to the US dollar and the pound sterling and the euro shadowing the US policy rate changes, the USA is no longer a small open economy. The Fed ought to have a surveillance of monetary and fiscal conditions in the whole dollar block, not only the US economy, before taking decisions.
Also, the new rule of raising the steering rate at a “measured” pace softened the signal of monetary policy to the market participants in contrast to the previous policy actions and greatly increased long-term uncertainty about inflation and interest rates though making the next policy step more predictable - and lulled all financial journalists as well.
Is Ben Bernanke’s ego also too big? He earned his academic credentials by research on the Great Depression, lectured as a Governor of the Fed on quantitative easing, Deflation: Making Sure "It" Doesn't Happen Here, by using the balance sheet of the Fed. He is regarded as THE expert on financial crises, on exactly those sequences of events the world has experienced during the past two years.
This crisis has shown that Keynes's green cheese, money created by the banks and other financial intermediaries, is no substitute for the US treasuries in case of real excess demand for the “moon”, currency and highly liquid government bonds. So, global imbalances and their financing patterns matter for monetary policy.
Friedman confessed in the 1986 Economic Inquiry that his “rule” did not satisfy the most basic incentive scheme because it was not in the self-interest of the Fed hierarchy to follow the hypothetical policy of such a rule. But in the end, Friedman was after getting rid of the whole Fed: private markets would deliver financial and price stability at equal or less resource cost.
Friedman was fearful of “the assignment of wide discretionary powers to a group of technicians, gathered together in an ‘independent’ central bank” and wanted “to establish institutional arrangements that will enable government to exercise responsibility for money, yet at the same time limit the power thereby given to government and prevent this power from being used in ways that will tend to weaken rather than strengthen a free society”; Capitalism and Freedom (1962, p. 39). Friedman introduced the idea of a constant annual rate of growth of money stock, regardless of changing economic conditions, to curtail the discretionary power of the monetary authorities in A Program for Monetary Stability (1959).
“The fact is that the Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than any inherent instability of the private economy”; the Federal Reserve System exercised its power to conduct monetary policy “so ineptly as to convert what otherwise would have been a moderate contraction into a major catastrophe” (C&F, p. 38).
By Friedman’s hindsight, the error list of the Fed included the unusually tight monetary conditions since mid-1928 culminating in an attempt to curb “speculation”, but leading to the 1929 stock market crash - that is, the Fed pricked the bubble which Greenspan’s Fed declined to carry out; the money stock declined by nearly 3 per cent from August 1929 to October 1930 – “a larger decline than during the whole of all but the most severe prior contractions”; prior to October 1930, there had been no sign of a liquidity crisis, or any loss of confidence in banks, but thereafter the economy was plagued by recurrent liquidity crises, runs on banks and waves of bank failures, but the Fed “stood idly by” because of “will, not of power”; Britain went off the gold standard in September 1931 inducing gold withdrawals from the USA, but two years of severe economic contraction did not prevent the Fed from defending the dollar and ending the gold drain by raising the discount rate – the rate at which it lent to member banks; the US money stock fell by one third from July 1929 to March 1933 with over two-thirds of the decline after Britain’s departure from the gold standard.
No wonder, Friedman wanted to avoid important policy actions being “highly dependent on accidents of personality” by introducing his rule of money growth that would also prevent monetary policy from being subject to the day-to-day whim of the politicians.
Was Alan Greenspan’s ego too big because of Friedman’s infamous research on and critique of the US monetary policy of the 1930s in A Monetary History of the United States 1967-1960 with Anna Swartz (1963)? Did Alan want to show how the Fed’s errors of the 1930s can be avoided? Alan fought preventively against “deflation”, a continuous downward spiral of prices and wages, in 2003-2005 during the most rapid global economic growth ever experienced! Greenspan’s Fed ridiculed active monetary policy by inventing to raise the steering rate of interest at a “measured” pace – the flip side of Friedman’s rule of a constant rate of growth of money supply?
What went wrong? The world is a global village was already taught in the mid-1960s. With a number of emerging market currencies pegged to the US dollar and the pound sterling and the euro shadowing the US policy rate changes, the USA is no longer a small open economy. The Fed ought to have a surveillance of monetary and fiscal conditions in the whole dollar block, not only the US economy, before taking decisions.
Also, the new rule of raising the steering rate at a “measured” pace softened the signal of monetary policy to the market participants in contrast to the previous policy actions and greatly increased long-term uncertainty about inflation and interest rates though making the next policy step more predictable - and lulled all financial journalists as well.
Is Ben Bernanke’s ego also too big? He earned his academic credentials by research on the Great Depression, lectured as a Governor of the Fed on quantitative easing, Deflation: Making Sure "It" Doesn't Happen Here, by using the balance sheet of the Fed. He is regarded as THE expert on financial crises, on exactly those sequences of events the world has experienced during the past two years.
This crisis has shown that Keynes's green cheese, money created by the banks and other financial intermediaries, is no substitute for the US treasuries in case of real excess demand for the “moon”, currency and highly liquid government bonds. So, global imbalances and their financing patterns matter for monetary policy.
Friedman confessed in the 1986 Economic Inquiry that his “rule” did not satisfy the most basic incentive scheme because it was not in the self-interest of the Fed hierarchy to follow the hypothetical policy of such a rule. But in the end, Friedman was after getting rid of the whole Fed: private markets would deliver financial and price stability at equal or less resource cost.
Wednesday, October 1, 2008
Modify Paulson’s plan!
Do not offer to buy bad assets from financial institutions but offer them capital infusion, Mr. Treasury Secretary! Cannot you invent any fiscal incentives for the first-time homebuyers that would re-vitalize housing market?
Events of the current financial crisis unfold very quickly - during those days and weeks spent abroad or in the outback, in particular. That is why I have had no comparative advantage over financial press to comment the process.
Paulson’s rescue plan rejected by the House would have given the bureaucrats broad powers to buy mortgage backed securities from distressed financial institutions at deeply discounted prices. That is, the bureaucrats would determine in casu how big a hidden subsidy each deal would involve for the seller institution.
Why cannot the banks and other financial institutions themselves trade such assets at market prices? They lack strong enough financial muscles.
The idea of recapitalizing financial institutions in the April 21st post stated that only equity injections and other sources of tier I capital will truly convey the banks over the “death valley”.
Since nationalizing Freddie Mac and Fannie Mae less than a month ago, the US Treasury has been subject to wide criticism for rewarding short-term players, short sellers, by nullifying the existing long-term value investors’ equity stakes. On this chosen road no private sector investor will participate in the recapitalization of any US financial institution.
US Treasury must do it itself by offering convertible notes which would count as tier I capital for the institutions. All banks subject to federal regulation should be eligible for accepting such an offer of capital infusion in proportion to their size, measured by their risk-weighted assets and off-balance –sheet commitments as stipulated by the BIS standards. The total of the capital offering of the size of 200 billion dollars, about 1.5 percent of the GDP, is roughly needed.
And, the terms should such that the offering would be attractive enough even for the most solvent and most liquid banks: a seven-year note, the first two years at the current interest rate on the 2-year US treasuries (about 2 percent), the third year interest rate at Libor, and thereafter each year at rising penalty rates above the Libor.
Such terms would buy time for settling the crisis. The offer of capital would provide the strongest institutions enough power not only to acquire assets at market prices from the weaker ones and to raise additional tier I and tier II capital in financial markets, but also would offer them an incentive to pay back the notes to the US Treasury before the convertibility carver threatens their independence.
Instead, the taxpayers’ money should be directed towards attracting buyers to the housing market. Buyers flee the market if they expect home prices to further fall. The most obvious target group, mentioned most often, is the first-time buyers, whether they intend to buy new or existing homes. There must be ways of temporarily granting a more generous mortgage relief or deducting one-off expenses from taxable income.
The above scheme would represent a market solution to the current crisis of financial markets in contrast to Paulson’s plan of giving power to the bureaucrats, i.e. to the central planners.
(Incidentally, I happened to participate in settling the Finnish banking crisis as deputy member of the board of the Government Guarantee Fund)
Events of the current financial crisis unfold very quickly - during those days and weeks spent abroad or in the outback, in particular. That is why I have had no comparative advantage over financial press to comment the process.
Paulson’s rescue plan rejected by the House would have given the bureaucrats broad powers to buy mortgage backed securities from distressed financial institutions at deeply discounted prices. That is, the bureaucrats would determine in casu how big a hidden subsidy each deal would involve for the seller institution.
Why cannot the banks and other financial institutions themselves trade such assets at market prices? They lack strong enough financial muscles.
The idea of recapitalizing financial institutions in the April 21st post stated that only equity injections and other sources of tier I capital will truly convey the banks over the “death valley”.
Since nationalizing Freddie Mac and Fannie Mae less than a month ago, the US Treasury has been subject to wide criticism for rewarding short-term players, short sellers, by nullifying the existing long-term value investors’ equity stakes. On this chosen road no private sector investor will participate in the recapitalization of any US financial institution.
US Treasury must do it itself by offering convertible notes which would count as tier I capital for the institutions. All banks subject to federal regulation should be eligible for accepting such an offer of capital infusion in proportion to their size, measured by their risk-weighted assets and off-balance –sheet commitments as stipulated by the BIS standards. The total of the capital offering of the size of 200 billion dollars, about 1.5 percent of the GDP, is roughly needed.
And, the terms should such that the offering would be attractive enough even for the most solvent and most liquid banks: a seven-year note, the first two years at the current interest rate on the 2-year US treasuries (about 2 percent), the third year interest rate at Libor, and thereafter each year at rising penalty rates above the Libor.
Such terms would buy time for settling the crisis. The offer of capital would provide the strongest institutions enough power not only to acquire assets at market prices from the weaker ones and to raise additional tier I and tier II capital in financial markets, but also would offer them an incentive to pay back the notes to the US Treasury before the convertibility carver threatens their independence.
Instead, the taxpayers’ money should be directed towards attracting buyers to the housing market. Buyers flee the market if they expect home prices to further fall. The most obvious target group, mentioned most often, is the first-time buyers, whether they intend to buy new or existing homes. There must be ways of temporarily granting a more generous mortgage relief or deducting one-off expenses from taxable income.
The above scheme would represent a market solution to the current crisis of financial markets in contrast to Paulson’s plan of giving power to the bureaucrats, i.e. to the central planners.
(Incidentally, I happened to participate in settling the Finnish banking crisis as deputy member of the board of the Government Guarantee Fund)
Friday, April 4, 2008
Comeback of corporation tax! Goodbye banking crisis!
The economics profession long ago doomed source-based taxes on real capital to a race to the bottom because of increased mobility of resources, capital in particular. Corporation tax is the major source-based tax on capital, having visible tax competition as regards the statutory rate.
Viewed from Finland, the reality shows quite an opposite development. Tax revenue from corporation tax has tripled over the past two decades!
Corporation tax typically raised revenue from 1% to 1.5 % of the GDP in the 1980’s but 3.7 % in 2006 while the statutory rate on corporations was simultaneously slashed from 60 per cent to 26 percent.
Hence the growth of tax revenue resulted from the broadening of the tax base. The companies are no longer forced to invest in machinery and structures to gain abundant tax depreciation charges for the purpose of hiding their taxable profits as in the 1980’s.
Instead of thinking the short-term tax savings brought about by business investments, the corporations think nowadays about their true long-term profitability. Hence the tax system of the 1980’s induced businesses to wasteful, inefficient real investments while the current tax system promotes efficient allocation of investment and capital.
How come did the politicians of Finland have such a foresight as regards the growth of tax revenue when they chose for a lower rate of corporate tax applied to a broader base of taxable income? They didn’t. The reason was the banking crisis in the beginning of the 1990’s.
Lax monetary policy from the mid 1980’s in the western world meant that international financiers flushed Finland with foreign money because the poor Bank of Finland did not understand how to control the growth of money and credit stocks in financial markets. The bank was accustomed to only give prescripts.
The Finnish bankers had previously rationed loans, granted them to their favored customers. At the end of the 1980’s bankers regarded themselves as businessmen. Their remuneration depended on the growth of loans granted.
And, everyone in Finland tried to hedge against galloping inflation by investing in real estate in particular. The other bugbear to hedge against was the taxman, but it offered ideal fiscal incentives for investments – accelerated tax depreciations combined with a high statutory tax rate.
The result was reckless bank lending and a classical banking crisis. One means to end it was to restore profitability of the enterprise sector and solvency of the bank customers. That is why the politicians parted from their old dirigible fiscal tools.
Connecting with the current calamity in financial markets, we have seen international investors financing the growth of consumption and investment in the USA and learnt from asymmetric incentives in its mortgage origination and repackaging businesses.
The only material difference from the crisis of Finland is that the US foreign debt is denominated in its own currency. Therefore the consequences on real economy from the debt crisis will not be so severe and long lasting in the USA as was the case with banking crises of both Sweden and Finland.
Viewed from Finland, the reality shows quite an opposite development. Tax revenue from corporation tax has tripled over the past two decades!
Corporation tax typically raised revenue from 1% to 1.5 % of the GDP in the 1980’s but 3.7 % in 2006 while the statutory rate on corporations was simultaneously slashed from 60 per cent to 26 percent.
Hence the growth of tax revenue resulted from the broadening of the tax base. The companies are no longer forced to invest in machinery and structures to gain abundant tax depreciation charges for the purpose of hiding their taxable profits as in the 1980’s.
Instead of thinking the short-term tax savings brought about by business investments, the corporations think nowadays about their true long-term profitability. Hence the tax system of the 1980’s induced businesses to wasteful, inefficient real investments while the current tax system promotes efficient allocation of investment and capital.
How come did the politicians of Finland have such a foresight as regards the growth of tax revenue when they chose for a lower rate of corporate tax applied to a broader base of taxable income? They didn’t. The reason was the banking crisis in the beginning of the 1990’s.
Lax monetary policy from the mid 1980’s in the western world meant that international financiers flushed Finland with foreign money because the poor Bank of Finland did not understand how to control the growth of money and credit stocks in financial markets. The bank was accustomed to only give prescripts.
The Finnish bankers had previously rationed loans, granted them to their favored customers. At the end of the 1980’s bankers regarded themselves as businessmen. Their remuneration depended on the growth of loans granted.
And, everyone in Finland tried to hedge against galloping inflation by investing in real estate in particular. The other bugbear to hedge against was the taxman, but it offered ideal fiscal incentives for investments – accelerated tax depreciations combined with a high statutory tax rate.
The result was reckless bank lending and a classical banking crisis. One means to end it was to restore profitability of the enterprise sector and solvency of the bank customers. That is why the politicians parted from their old dirigible fiscal tools.
Connecting with the current calamity in financial markets, we have seen international investors financing the growth of consumption and investment in the USA and learnt from asymmetric incentives in its mortgage origination and repackaging businesses.
The only material difference from the crisis of Finland is that the US foreign debt is denominated in its own currency. Therefore the consequences on real economy from the debt crisis will not be so severe and long lasting in the USA as was the case with banking crises of both Sweden and Finland.
Subscribe to:
Posts (Atom)
