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 economics. Show all posts
Showing posts with label economics. Show all posts
Tuesday, March 31, 2009
Tuesday, May 13, 2008
Defunct economist and price stability
The defunct economist whose slaves today’s practitioners of price stability are is Keynes himself!
The infamous, eloquent ending passage (p. 383) of J. M. Keynes’s The General Theory describes: “…the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men … are usually the slaves of some defunct economist.”
Keynes’s A Tract on Monetary Reform – dedicated to the Governors and Court of the Bank of England in 1923 – argues for why the Treasury and the Bank of England “should adopt the stability of sterling prices as their primary objective” (p. 147).
Of course, the book simultaneously advocates the policy of flexible exchange rates: stability of sterling prices “would not prevent them aiming at exchange stability as a secondary objective.” The Fed “failing to keep dollar prices steady, sterling prices should not…plunge with them merely for the sake of maintaining a fixed parity of exchange” (p. 147).
Keynes clearly gives credit to Irving Fisher as “the pioneer of price stability as against exchange stability,” but he doubts Fisher’s policy approach based on automatic index adjustments: “If we wait until a price movement is actually afoot before applying remedial measures, we may be too late.”
Keynes quotes Hawtrey’s Monetary Reconstruction (1922) “It is not the past rise in prices but the future rise that has to be counteracted”, points to “the, often more injurious, short-period oscillations”, warns not “advisable to postpone action until it was called for by an actual movement of prices” and adapts Fisher’s approach by presenting the idea of price stability in terms of an official index number, the price of a standard composite commodity:
“It would promote confidence … (if) the authorities were to adopt this composite commodity of a standard of value in the sense that they would employ all their resources to prevent a movement of its price by more than a certain percentage in either direction away from the normal”.
Keynes favored “a general judgment of the situation based on all the available data” in the regulation of the bank steering rate over a cut-and-dry formula and in detail described what in essence comprises the economic and monetary analysis that the European Central Bank (ECB), or the Fed or the Bank of England for that matter, bases it decisions on.
“The main point is that the objective of the authorities, pursued with such means as are at their command, should be the stability of prices.” (p. 149)
Keynes was too optimistic of the power of economic ideas over vested interests: “Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas”.
Nothing explains better than vested interests the 70 year chain of monetary policy disasters all over the world, up to Black Wednesday or the 13 percent drop of the GDP from 1990 to 1993 in Finland’s banking crisis.
Keynes was right in the long run. The ideas which civil servants and politicians applied to monetary management during the 1990’s were definitely not the newest in the perspective of his A Tract on Monetary Reform. But the ideas were new to many economic scribblers and still are not accepted by agitators.
Unlike Keynes’s “practical men, who believe themselves to be quite exempt from any intellectual influences”, today’s central bankers know Keynes, Irving Fisher and results of academic research. Apart from charlatans, they are nobody’s intellectual slaves, but independent thinkers and professionals of the highest caliber.
(All italics here are as in the original text!)
The infamous, eloquent ending passage (p. 383) of J. M. Keynes’s The General Theory describes: “…the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men … are usually the slaves of some defunct economist.”
Keynes’s A Tract on Monetary Reform – dedicated to the Governors and Court of the Bank of England in 1923 – argues for why the Treasury and the Bank of England “should adopt the stability of sterling prices as their primary objective” (p. 147).
Of course, the book simultaneously advocates the policy of flexible exchange rates: stability of sterling prices “would not prevent them aiming at exchange stability as a secondary objective.” The Fed “failing to keep dollar prices steady, sterling prices should not…plunge with them merely for the sake of maintaining a fixed parity of exchange” (p. 147).
Keynes clearly gives credit to Irving Fisher as “the pioneer of price stability as against exchange stability,” but he doubts Fisher’s policy approach based on automatic index adjustments: “If we wait until a price movement is actually afoot before applying remedial measures, we may be too late.”
Keynes quotes Hawtrey’s Monetary Reconstruction (1922) “It is not the past rise in prices but the future rise that has to be counteracted”, points to “the, often more injurious, short-period oscillations”, warns not “advisable to postpone action until it was called for by an actual movement of prices” and adapts Fisher’s approach by presenting the idea of price stability in terms of an official index number, the price of a standard composite commodity:
“It would promote confidence … (if) the authorities were to adopt this composite commodity of a standard of value in the sense that they would employ all their resources to prevent a movement of its price by more than a certain percentage in either direction away from the normal”.
Keynes favored “a general judgment of the situation based on all the available data” in the regulation of the bank steering rate over a cut-and-dry formula and in detail described what in essence comprises the economic and monetary analysis that the European Central Bank (ECB), or the Fed or the Bank of England for that matter, bases it decisions on.
“The main point is that the objective of the authorities, pursued with such means as are at their command, should be the stability of prices.” (p. 149)
Keynes was too optimistic of the power of economic ideas over vested interests: “Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas”.
Nothing explains better than vested interests the 70 year chain of monetary policy disasters all over the world, up to Black Wednesday or the 13 percent drop of the GDP from 1990 to 1993 in Finland’s banking crisis.
Keynes was right in the long run. The ideas which civil servants and politicians applied to monetary management during the 1990’s were definitely not the newest in the perspective of his A Tract on Monetary Reform. But the ideas were new to many economic scribblers and still are not accepted by agitators.
Unlike Keynes’s “practical men, who believe themselves to be quite exempt from any intellectual influences”, today’s central bankers know Keynes, Irving Fisher and results of academic research. Apart from charlatans, they are nobody’s intellectual slaves, but independent thinkers and professionals of the highest caliber.
(All italics here are as in the original text!)
Monday, April 21, 2008
Green cheese factories fight excess demand for the moon – let sovereign wealth funds rescue!
Keynes likened a central bank to a green cheese factory under public control. In Chapter 17, ”The essential properties of interest and money”, of the General Theory, he emphasized the combination of three characteristics of money – via their effect on the money rate of interest - to cause contraction of output and employment at the emergence of an excess demand for money.
“Through the working of the liquidity-motive, (money) rate of interest may be somewhat unresponsive to a change in the proportion which the quantity of money bears to other forms of wealth measured in money” and “money has … zero (or negligible) elasticities both of production and substitution” (p. 234).
“Unemployment develops, that is to say, because people want the moon; - men cannot be employed when the object of desire (i.e. money) is something which cannot be produced and the demand for which cannot be choked off. There is no remedy but to persuade the public that green cheese is practically the same thing and to have a green cheese factory (i.e. central bank) under public control” (p. 235).
Where does the excess demand for money stem from? In my understanding, it is the same as the source of de-leveraging.
Fifteen years ago we, in the Government Guarantee Fund established to tidy up the banking mess in Finland, fancied the US system of securitizing the loan books of the banks to transfer credit risks to the ultimate investors as insurance companies, pension schemes, mutual funds and other agents of the end savers.
But, the occurrences in the USA show that the credit risks were not totally transferred outside the financial intermediation sector, but mostly remained therein. The reason is that the risks were only wiped off the balance sheets to the SIVs (Structured Investment Vehicles). They financed the long-term loans by issuing short-term commercial paper to the ultimate investors, that is, by applying even a riskier maturity transformation strategy than the banks themselves which originate mortgages.
As the ultimate investors started to suffer losses on the mortgage-backed securities they had purchased, they grasped to be exposed to the same credit risks via commercial paper of the SIVs. To limit their losses, the investors refused to no longer buy the SIV commercial paper; they would rather hold truly liquid assets that will bear no capital loss as short-maturity treasuries. Hence an excess demand for liquid cash started, but it was endogenously magnified by another feature of the SIVs that they had credit lines from their parent banks. Who else would have re-financed the mortgages in the SIVs?
So the SIVs had to draw short-term finance from their parent banks as soon as their commercial paper market started to dry up. The same commercial and investment banks that previously parceled loans into securities are now writing down those loans, that is, the credit risks were effectively not transferred from the balance sheet of the financial intermediation sector.
Hence the US, UK and also partly Eurozone markets are in the state of an excess demand for “the moon” which cannot be choked off! The Fed, the BoE and the ECB all try “to persuade the public that green cheese is practically the same thing” by swapping government bonds for mortgage securities to kick-start bank lending, that is, by socializing the credit risks of the underlying mortgages.
“Green cheese”, unaged cheese, is near money created by the financial intermediaries.
But, aren’t these measures rather an attempt to prevent from scoring an own goal without changing the long-term strategy of monetary policy? The central banks all behave today as if the nominal quantity of liquidity were fixed as under the gold standard in Keynes’s mind and follow his advice (p. 234): “The only relief … can come from … an increase in the quantity of money, or … a rise in the value of money”, the latter meaning a decline of money rates of interest on commercial lending.
The interbank rates of the eurozone are ¾ of a percentage point higher than the steering rate of the ECB; the interbank three-month dollar rate is more than half a percentage point higher than the Fed’s steering rate and almost a full percentage point in the case of the pound sterling.
The spread of the corporate bond rates over the steering rate is almost four percentage points for the dollar, almost three percentage points for the pound while only one and a quarter percentage points for the euro. The eurozone suffers from the global banks’ access to the Euribor market via their subsidiaries therein which Sweden avoids.
Excessive rate of expansion of financial intermediaries was the true cause of the ultimate investors’ losses on mortgage securities. The US banks advanced credit to 20 percent over the value of the asset purchased, benefiting from the interbank rates of interest of one to two percent, but in the end fished too many customers who could not afford servicing their loans.
Why to venture the taxpayers’ money? Such an approach only induces the banks to walk on stilts until the next round of socializing credit risks.
Money is currently flowing to oil-producing countries at the rate which is more than enough to recapitalize all ailing US, UK and Eurosystem banks by the next Labor Day? In the end, only equity injections and other sources of tier I capital will truly convey the banks over the “death valley”.
Such a market-driven event, secretly and quickly implemented, would enable The Fed, the BoE and the ECB to score against inflation and, in a way, would represent their “hand of God” goal.
“Through the working of the liquidity-motive, (money) rate of interest may be somewhat unresponsive to a change in the proportion which the quantity of money bears to other forms of wealth measured in money” and “money has … zero (or negligible) elasticities both of production and substitution” (p. 234).
“Unemployment develops, that is to say, because people want the moon; - men cannot be employed when the object of desire (i.e. money) is something which cannot be produced and the demand for which cannot be choked off. There is no remedy but to persuade the public that green cheese is practically the same thing and to have a green cheese factory (i.e. central bank) under public control” (p. 235).
Where does the excess demand for money stem from? In my understanding, it is the same as the source of de-leveraging.
Fifteen years ago we, in the Government Guarantee Fund established to tidy up the banking mess in Finland, fancied the US system of securitizing the loan books of the banks to transfer credit risks to the ultimate investors as insurance companies, pension schemes, mutual funds and other agents of the end savers.
But, the occurrences in the USA show that the credit risks were not totally transferred outside the financial intermediation sector, but mostly remained therein. The reason is that the risks were only wiped off the balance sheets to the SIVs (Structured Investment Vehicles). They financed the long-term loans by issuing short-term commercial paper to the ultimate investors, that is, by applying even a riskier maturity transformation strategy than the banks themselves which originate mortgages.
As the ultimate investors started to suffer losses on the mortgage-backed securities they had purchased, they grasped to be exposed to the same credit risks via commercial paper of the SIVs. To limit their losses, the investors refused to no longer buy the SIV commercial paper; they would rather hold truly liquid assets that will bear no capital loss as short-maturity treasuries. Hence an excess demand for liquid cash started, but it was endogenously magnified by another feature of the SIVs that they had credit lines from their parent banks. Who else would have re-financed the mortgages in the SIVs?
So the SIVs had to draw short-term finance from their parent banks as soon as their commercial paper market started to dry up. The same commercial and investment banks that previously parceled loans into securities are now writing down those loans, that is, the credit risks were effectively not transferred from the balance sheet of the financial intermediation sector.
Hence the US, UK and also partly Eurozone markets are in the state of an excess demand for “the moon” which cannot be choked off! The Fed, the BoE and the ECB all try “to persuade the public that green cheese is practically the same thing” by swapping government bonds for mortgage securities to kick-start bank lending, that is, by socializing the credit risks of the underlying mortgages.
“Green cheese”, unaged cheese, is near money created by the financial intermediaries.
But, aren’t these measures rather an attempt to prevent from scoring an own goal without changing the long-term strategy of monetary policy? The central banks all behave today as if the nominal quantity of liquidity were fixed as under the gold standard in Keynes’s mind and follow his advice (p. 234): “The only relief … can come from … an increase in the quantity of money, or … a rise in the value of money”, the latter meaning a decline of money rates of interest on commercial lending.
The interbank rates of the eurozone are ¾ of a percentage point higher than the steering rate of the ECB; the interbank three-month dollar rate is more than half a percentage point higher than the Fed’s steering rate and almost a full percentage point in the case of the pound sterling.
The spread of the corporate bond rates over the steering rate is almost four percentage points for the dollar, almost three percentage points for the pound while only one and a quarter percentage points for the euro. The eurozone suffers from the global banks’ access to the Euribor market via their subsidiaries therein which Sweden avoids.
Excessive rate of expansion of financial intermediaries was the true cause of the ultimate investors’ losses on mortgage securities. The US banks advanced credit to 20 percent over the value of the asset purchased, benefiting from the interbank rates of interest of one to two percent, but in the end fished too many customers who could not afford servicing their loans.
Why to venture the taxpayers’ money? Such an approach only induces the banks to walk on stilts until the next round of socializing credit risks.
Money is currently flowing to oil-producing countries at the rate which is more than enough to recapitalize all ailing US, UK and Eurosystem banks by the next Labor Day? In the end, only equity injections and other sources of tier I capital will truly convey the banks over the “death valley”.
Such a market-driven event, secretly and quickly implemented, would enable The Fed, the BoE and the ECB to score against inflation and, in a way, would represent their “hand of God” goal.
Monday, April 14, 2008
The Maradona theory of interest rate steering - will the ECB need the “hand of God” goal?
EURO 2008 will be in focus in all great Asian betting countries until next July. The question is about football (soccer), not about trading currencies. But, football inspired Mervyn King, Governor of the Bank of England, to develop his Maradona theory of interest rate steering by a successful central bank; see his speech “Monetary Policy: Practice Ahead of Theory”, 17 May 2005
http://www.bankofengland.co.uk/publications/speeches/speaker.htm#king
The Maradona theory deals with the power of expectations about the future conduct of monetary policy affecting the choices of households and firms today.
In the 1986 World Cup in Mexico City, Diego Maradona scored against England after a 60 meter run in a straight line while beating five English players. This spectacular straight-on performance was possible because the defenders reacted to what they expected Maradona to do, to move either left or right.
Monetary policy can work similarly, Governor King described. Market interest rates react to what the central banks are expected to do. When the households and firms expect the official interest rates to move either up or down, those expectations are sometimes sufficient to stabilize private spending while the steering rates in fact move very little.
Hence the action is in the forward rates, in the expected future short rates of interest. They effectuate the outcome. The experience of the Bank of England in 2002 perfectly supports the Maradona theory. Even thereafter the official bank rate has shown considerable stability in contrast to previous decades.
Neither is the behavior of the Eurosystem interest rates against the Maradona theory. The steering rate of the ECB has moved within two percentage points since September 2001 and stayed at 2.00 percent from June 2003 to December 2005.
The Governing Council of the ECB has kept its steering rate on hold since June 2007. Will it score as Maradona to deliver price stability without raising the steering rate?
Prior to last Thursday’s meeting of the Governing Council, financial markets expected two rate cuts of 25 basis points from the ECB by the end of this year, but no longer so after the meeting.
Other powerful forces help the ECB. Strong euro re-diverts world spending from goods and services produced in the euro area toward production outside. Housing markets have cooled in parts of the euro area.
Funding from equity issues is more expensive because of the drop of equity prices: to a raise a given euro amount for investment finance, the companies must hand on a bigger slice of the future dividends to the subscribers of new issue than before the drop of equity prices. High-yield corporate bond issues must similarly promise a higher yield after the re-pricing of their risks. In principle, these make investment finance more expensive.
But, bank borrowing by the non-financial companies is growing briskly, by almost 15 percent annually in February, which may be due to the companies substituting market funding for bank borrowing. It is a sign that investment spending will not be cooling soon. Projects take a long time to complete.
Anyhow, the ECB faces a dilemma in its primary objective, price stability. It may need Maradona’s first goal in the above match. It was the “hand of God” goal that Mr. King described as “an exercise of the old ‘mystery and mystique’ approach to central banking,” acting unexpectedly, time-inconsistently and against the conceived rules.
Such a behavior by the ECB may well be the action which is best consistent with its overall strategy of meeting the inflation target.
http://www.bankofengland.co.uk/publications/speeches/speaker.htm#king
The Maradona theory deals with the power of expectations about the future conduct of monetary policy affecting the choices of households and firms today.
In the 1986 World Cup in Mexico City, Diego Maradona scored against England after a 60 meter run in a straight line while beating five English players. This spectacular straight-on performance was possible because the defenders reacted to what they expected Maradona to do, to move either left or right.
Monetary policy can work similarly, Governor King described. Market interest rates react to what the central banks are expected to do. When the households and firms expect the official interest rates to move either up or down, those expectations are sometimes sufficient to stabilize private spending while the steering rates in fact move very little.
Hence the action is in the forward rates, in the expected future short rates of interest. They effectuate the outcome. The experience of the Bank of England in 2002 perfectly supports the Maradona theory. Even thereafter the official bank rate has shown considerable stability in contrast to previous decades.
Neither is the behavior of the Eurosystem interest rates against the Maradona theory. The steering rate of the ECB has moved within two percentage points since September 2001 and stayed at 2.00 percent from June 2003 to December 2005.
The Governing Council of the ECB has kept its steering rate on hold since June 2007. Will it score as Maradona to deliver price stability without raising the steering rate?
Prior to last Thursday’s meeting of the Governing Council, financial markets expected two rate cuts of 25 basis points from the ECB by the end of this year, but no longer so after the meeting.
Other powerful forces help the ECB. Strong euro re-diverts world spending from goods and services produced in the euro area toward production outside. Housing markets have cooled in parts of the euro area.
Funding from equity issues is more expensive because of the drop of equity prices: to a raise a given euro amount for investment finance, the companies must hand on a bigger slice of the future dividends to the subscribers of new issue than before the drop of equity prices. High-yield corporate bond issues must similarly promise a higher yield after the re-pricing of their risks. In principle, these make investment finance more expensive.
But, bank borrowing by the non-financial companies is growing briskly, by almost 15 percent annually in February, which may be due to the companies substituting market funding for bank borrowing. It is a sign that investment spending will not be cooling soon. Projects take a long time to complete.
Anyhow, the ECB faces a dilemma in its primary objective, price stability. It may need Maradona’s first goal in the above match. It was the “hand of God” goal that Mr. King described as “an exercise of the old ‘mystery and mystique’ approach to central banking,” acting unexpectedly, time-inconsistently and against the conceived rules.
Such a behavior by the ECB may well be the action which is best consistent with its overall strategy of meeting the inflation target.
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.
Monday, March 31, 2008
Trough of the US debt crisis?
Financial commentators show some optimism that asset bubbles would be by-gone. The latest, the bursting of the house prices, may only just be spreading to Europe – Spain and the UK in the forefront, not to forget Estonia in the fringe.
The decline of the high yielding corporate bond prices since their July 2007 high – what was 120 then is 100 today –seems not to entitle to a bubble burst, presumably because their total market is small in respect of the residential mortgages.
But, problems in the latter are spreading into commercial. Prices are also down in commercial properties in which my source of intelligence is David E. Witt, Witt Ventures LLC in Atlanta, Georgia. He has 38 years’ experience in real estate development and investment and saw the 1974 - 1975 melt down of commercial property prices.
“The commercial debt market has come almost to a standstill with the exception of 60 percent to 65 percent loan-to-value mortgages. “ As a wider consequence of the collapse of Bear Stearns, he adds: “no lenders are writing CMBS (commercial mortgage backed securities) debt anymore. That particular market is totally dead.”
Problems in commercial mortgage markets will endogenously feedback the downturn in the residential markets, intensifying the process of debt deflation as shortly described in my previous blog.
But, there still remains the biggest bubble of all, the huge market of the U.S. treasuries, to be punctured. The prices of Treasury notes and bonds have elevated to that infamous level of irrational exuberance. Last Friday’s yields varied from 1.6 percent on the maturity of 2 years to 2.5 percent on the 5 year’s maturity which are well below any estimate of the trend growth rate of the US economy plus the Fed’s implicit medium term inflation target.
After last week’s blunt cut of the steering rate, the Fed’s most important task is to get the inflation expectations quickly anchored so that they will not threaten its goal of price stability in the medium term, by preventing inflation expectations from feeding into the second-round effects in price and wage setting.
The yields on the U.S. Treasuries are bound to rise and their market prices to decline irrespective of whether the steering rate will descend or ascend and whether the Fed succeeds or fails in delivering price stability.
It means massive losses to the investors in the most volatile medium term maturities, in particular. The trough of the debt crisis is yet to be seen.
The financial system is able to cover its losses only from the cash flows of its basic business. Hence over a longer period of time considerably higher risk premiums and higher interest rates on all private sector loans will be needed than experienced during the run up to the liquidity bubble.
Therefore the U.S. economy will recover slowly from its current mayhem – and Europe will pay its share of the costs of the almost global mispricing of risks.
The decline of the high yielding corporate bond prices since their July 2007 high – what was 120 then is 100 today –seems not to entitle to a bubble burst, presumably because their total market is small in respect of the residential mortgages.
But, problems in the latter are spreading into commercial. Prices are also down in commercial properties in which my source of intelligence is David E. Witt, Witt Ventures LLC in Atlanta, Georgia. He has 38 years’ experience in real estate development and investment and saw the 1974 - 1975 melt down of commercial property prices.
“The commercial debt market has come almost to a standstill with the exception of 60 percent to 65 percent loan-to-value mortgages. “ As a wider consequence of the collapse of Bear Stearns, he adds: “no lenders are writing CMBS (commercial mortgage backed securities) debt anymore. That particular market is totally dead.”
Problems in commercial mortgage markets will endogenously feedback the downturn in the residential markets, intensifying the process of debt deflation as shortly described in my previous blog.
But, there still remains the biggest bubble of all, the huge market of the U.S. treasuries, to be punctured. The prices of Treasury notes and bonds have elevated to that infamous level of irrational exuberance. Last Friday’s yields varied from 1.6 percent on the maturity of 2 years to 2.5 percent on the 5 year’s maturity which are well below any estimate of the trend growth rate of the US economy plus the Fed’s implicit medium term inflation target.
After last week’s blunt cut of the steering rate, the Fed’s most important task is to get the inflation expectations quickly anchored so that they will not threaten its goal of price stability in the medium term, by preventing inflation expectations from feeding into the second-round effects in price and wage setting.
The yields on the U.S. Treasuries are bound to rise and their market prices to decline irrespective of whether the steering rate will descend or ascend and whether the Fed succeeds or fails in delivering price stability.
It means massive losses to the investors in the most volatile medium term maturities, in particular. The trough of the debt crisis is yet to be seen.
The financial system is able to cover its losses only from the cash flows of its basic business. Hence over a longer period of time considerably higher risk premiums and higher interest rates on all private sector loans will be needed than experienced during the run up to the liquidity bubble.
Therefore the U.S. economy will recover slowly from its current mayhem – and Europe will pay its share of the costs of the almost global mispricing of risks.
Tuesday, March 25, 2008
The Fed’s bubble policy
The record of the Greenspan era’s Fed in conducting monetary policy repeated a simple behavioral formula: a crisis to which the Fed reacted by swiftly and aggressively cutting its steering rate of interest that quickly increased liquidity in the financial system; in between the crises Wall Street was given a loose rein to trot.
Ben Bernanke’s Fed is a similar addict. Why?
Over two decades the whole world experienced an exceptionally loose monetary policy that kept both nominal and real rates of interest historically low in the developed countries. Central banks allowed the stocks of money and credit to grow too fast for too long that induced the agents to chase returns everywhere and in any possible asset, dismissive from the risks involved. That pumped the prices of equities, bonds and houses up. The whole world lived in an enormous liquidity bubble in which the pricing of risks was distorted.
The disequilibrium created two forces that are in effect during the process of adjustment that started about a year ago.
The prices of goods and services are closing “normal” their gap to asset prices that sped up the rate of inflation.
An increased appreciation of investment risks brought about a decline of private sector asset values and, in particular, the market prices of the assets that represent claims to the original assets. It causes debt deflation that will freeze up the whole financial system.
Such a destructive spiral was experienced in Finland during the years of 1991-1993. The agents’ attempts to pay off their debts were eroded by declining asset values, creating negative equity. That decreased spending and production, causing massive credit losses in the banking sector, after the collapse of the fixed exchange rate regime in particular. The bail out of the banks, their depositors and international financiers cost 8 per cent of the year 1990 GDP to the taxpayers. In addition, the banks themselves digested credit losses equivalent to over 6 per cent of the 1990 GDP.
The Fed regards the force of debt deflation as a much greater peril than the threat of quickening inflation. That is why it chose to lean on the proven drug, in a way, giving support to the top level players of the financial system.
Does an alternative medication exist? Perhaps not, after the crisis erupts.
But, before the event there are many preventive cures from an explicit inflation target in the medium term to classical surveillance of money and credit stocks. Will the Fed be the first to also weigh asset prices in its inflation target?
Some observers always recommend tighter regulation of the financial system. John Maynard Keynes - in the final chapter of his 1939 edition of The General Theory of Employment, Interest and Money – conceived “a somewhat comprehensive socialisation of investment” and the State being able to determine “the basic rate of reward to those who own” investment resources. And, he believed in “a right analysis of the problem to cure the disease whilst preserving efficiency and freedom.”!!!
Regulation and non-neutral taxation of the final savers (owners) are the engines of financial innovation because they induce regulatory arbitrage and tax arbitrage. By combining those with lax monetary policy, the process to the present calamity in the financial system is to be understood.
Ben Bernanke’s Fed is a similar addict. Why?
Over two decades the whole world experienced an exceptionally loose monetary policy that kept both nominal and real rates of interest historically low in the developed countries. Central banks allowed the stocks of money and credit to grow too fast for too long that induced the agents to chase returns everywhere and in any possible asset, dismissive from the risks involved. That pumped the prices of equities, bonds and houses up. The whole world lived in an enormous liquidity bubble in which the pricing of risks was distorted.
The disequilibrium created two forces that are in effect during the process of adjustment that started about a year ago.
The prices of goods and services are closing “normal” their gap to asset prices that sped up the rate of inflation.
An increased appreciation of investment risks brought about a decline of private sector asset values and, in particular, the market prices of the assets that represent claims to the original assets. It causes debt deflation that will freeze up the whole financial system.
Such a destructive spiral was experienced in Finland during the years of 1991-1993. The agents’ attempts to pay off their debts were eroded by declining asset values, creating negative equity. That decreased spending and production, causing massive credit losses in the banking sector, after the collapse of the fixed exchange rate regime in particular. The bail out of the banks, their depositors and international financiers cost 8 per cent of the year 1990 GDP to the taxpayers. In addition, the banks themselves digested credit losses equivalent to over 6 per cent of the 1990 GDP.
The Fed regards the force of debt deflation as a much greater peril than the threat of quickening inflation. That is why it chose to lean on the proven drug, in a way, giving support to the top level players of the financial system.
Does an alternative medication exist? Perhaps not, after the crisis erupts.
But, before the event there are many preventive cures from an explicit inflation target in the medium term to classical surveillance of money and credit stocks. Will the Fed be the first to also weigh asset prices in its inflation target?
Some observers always recommend tighter regulation of the financial system. John Maynard Keynes - in the final chapter of his 1939 edition of The General Theory of Employment, Interest and Money – conceived “a somewhat comprehensive socialisation of investment” and the State being able to determine “the basic rate of reward to those who own” investment resources. And, he believed in “a right analysis of the problem to cure the disease whilst preserving efficiency and freedom.”!!!
Regulation and non-neutral taxation of the final savers (owners) are the engines of financial innovation because they induce regulatory arbitrage and tax arbitrage. By combining those with lax monetary policy, the process to the present calamity in the financial system is to be understood.
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