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 financial crisis. Show all posts
Showing posts with label financial crisis. Show all posts
Tuesday, March 31, 2009
Wednesday, February 11, 2009
Bad “bad bank”
The task of a bad bank should be to sell their good assets to the good banks and to other potential buyers as to the “vulture” funds. When Chairman Bernanke’s approach is followed: “to set up and capitalize so-called bad banks, which would purchase assets from financial institutions in exchange for cash and equity in the bad bank”, we get exactly the incentive problem that caused yesterday’s jitter in the markets: how to value the toxic assets. The pricing of such asset categories too low would make many big banks insolvent while purchasing at an inflated price above market values means the taxpayers handing a subsidy to the banks.
In the banking crisis of Finland in the beginning of the 1990s, the “bad banks” were fallen angels, banks fallen to the control of the government, which sold their good assets to the remaining healthier banks and to foreign financiers. Thereafter the bad banks managed their portfolio of sour loans and real estate holdings as every bank is accustomed to do.
Pretty soon after the first fallen angel emerged, all banks were offered a capital loan on equal terms in proportion to their risk-weighted assets and off-balance commitments. Such funding was junior enough to count as tier I capital: interest could only be paid after the receiving banks had fulfilled their other commitments, but dividends on preference shares and common stock could be distributed after the banks had paid interest on the capital loans.
In practice, the government’s capital loan offer funded “mating”. During the consolidation process the banks were able to raise private co-finance, both equity and long-term debt, in the financial markets. Those banks that did not find a stronger partner ended up as bad banks.
Besides the customary political process, the delay in solving the Finnish banking crisis was caused by the lack of a government agency that received fallen angels. But, the USA has an experienced government agency for that purpose, the FDIC.
US Treasury Secretary Geithner need allocate the remaining TARP funds to the FDIC. What the USA is lacking is a government offer for funding that would facilitate the amicable mating ritual on equal terms for every partner.
It is not the purpose of a government agency to profit from solving the banking crisis. It was astounding to read in today’s press Chairman Bernanke to have announced yesterday that the Fed expects to make big profits from its increased role in the credit markets.
The task of the Fed and other federal agencies is to breathe new life to the speculative confidence of private actors as well as strengthening credit creation. This follows from Keynes’s analysis in Chapter 12 “The state of long-term expectation of his General Theory (p. 158): “the recovery requires the revival of both”. The whole chapter eloquently covers the difficulty of valuing long-term investments in the stock market.
In the banking crisis of Finland in the beginning of the 1990s, the “bad banks” were fallen angels, banks fallen to the control of the government, which sold their good assets to the remaining healthier banks and to foreign financiers. Thereafter the bad banks managed their portfolio of sour loans and real estate holdings as every bank is accustomed to do.
Pretty soon after the first fallen angel emerged, all banks were offered a capital loan on equal terms in proportion to their risk-weighted assets and off-balance commitments. Such funding was junior enough to count as tier I capital: interest could only be paid after the receiving banks had fulfilled their other commitments, but dividends on preference shares and common stock could be distributed after the banks had paid interest on the capital loans.
In practice, the government’s capital loan offer funded “mating”. During the consolidation process the banks were able to raise private co-finance, both equity and long-term debt, in the financial markets. Those banks that did not find a stronger partner ended up as bad banks.
Besides the customary political process, the delay in solving the Finnish banking crisis was caused by the lack of a government agency that received fallen angels. But, the USA has an experienced government agency for that purpose, the FDIC.
US Treasury Secretary Geithner need allocate the remaining TARP funds to the FDIC. What the USA is lacking is a government offer for funding that would facilitate the amicable mating ritual on equal terms for every partner.
It is not the purpose of a government agency to profit from solving the banking crisis. It was astounding to read in today’s press Chairman Bernanke to have announced yesterday that the Fed expects to make big profits from its increased role in the credit markets.
The task of the Fed and other federal agencies is to breathe new life to the speculative confidence of private actors as well as strengthening credit creation. This follows from Keynes’s analysis in Chapter 12 “The state of long-term expectation of his General Theory (p. 158): “the recovery requires the revival of both”. The whole chapter eloquently covers the difficulty of valuing long-term investments in the stock market.
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.
Friday, November 7, 2008
Taxpayers’ greed will retard growth. Music started!
The UK and US Treasuries succumbed to taxpayer populism and set too demanding conditions on the preference shares acquired in the partially or wholly socialized banks so that the banks would concentrate on purchasing the stakes held by the governments and that the taxpayers’ funds would be reimbursed without losses.
A 10 percent dividend yield on such shares is well above any long-term real rate of return on equities. Therefore the banks will maintain the present high margins on their lending to businesses and households to safeguard that the governments receive their dividends and that no additional socialization (nationalization) will occur. But, high margins on lending rates of interest will also prevent the economies from a quick recovery. That is, the taxpayers’ ultimate investment losses will only convert into a slower rise of their living standards.
Of course, there is the other route. The contracts are in nominal terms. Therefore by setting on a higher rate of inflation over the next five years or so, the governments can erode the real value of their claims in the banks but to secure a nominal capital gain on the taxpayers’ investments. That is why music started again – the recent aggressive cuts of the steering rates all over the world.
However this route causes additional losses in the financial system by melting the bubble in the government bond prices which further retards world growth, because the losses can only be covered from operating cash flows of the basic lending business; see trough of the US debt crisis.
Farewell inflation targets! Goodbye independence of central banks!
PS. Alternatively, the governments could have advanced amicable cannibalism within the banking sector by granting access to the government loans on equal terms for every regulated bank, but with less government money at risk.
A 10 percent dividend yield on such shares is well above any long-term real rate of return on equities. Therefore the banks will maintain the present high margins on their lending to businesses and households to safeguard that the governments receive their dividends and that no additional socialization (nationalization) will occur. But, high margins on lending rates of interest will also prevent the economies from a quick recovery. That is, the taxpayers’ ultimate investment losses will only convert into a slower rise of their living standards.
Of course, there is the other route. The contracts are in nominal terms. Therefore by setting on a higher rate of inflation over the next five years or so, the governments can erode the real value of their claims in the banks but to secure a nominal capital gain on the taxpayers’ investments. That is why music started again – the recent aggressive cuts of the steering rates all over the world.
However this route causes additional losses in the financial system by melting the bubble in the government bond prices which further retards world growth, because the losses can only be covered from operating cash flows of the basic lending business; see trough of the US debt crisis.
Farewell inflation targets! Goodbye independence of central banks!
PS. Alternatively, the governments could have advanced amicable cannibalism within the banking sector by granting access to the government loans on equal terms for every regulated bank, but with less government money at risk.
Monday, October 20, 2008
The Lesson of the Financial Crisis
Would tighter control have prevented East Germany from collapse? An analogous lesson to avoid future financial crises is currently offered all over the world by both professionals in financial stability and all-round intellectuals, in particular.
Of course, there were skeptics who did not believe in the Fed funds rate cut of 18 March 2008 as a healer of the credit crunch: why an additional dose of the same drug, low nominal and real rates of interest which was behind the excessive growth of credit and money. There are possibly fewer skeptics who see the on-going crisis as a consequence of the regulatory system of banks.
Any effective measure of regulation creates its own counterforce that tries to nullify the initial impact of regulation because inventive individuals are always clever in finding out ways to circumvent the constraints set on them. Solvency regulation of banks is based on the risk-weighted assets in the balance sheet of a bank that must be matched by the minimum of the so-called tier I capital, i.e., equity in practice.
Because equity is an expensive source of funding the simplest way to avoid issuing new equity is to reduce the size of the risk-weighted balance sheet in respect of a growing loan book. Therefore the US financial institutions transferred the risky loans off balance sheet by the originate-to-distribute practice. Though in Federal Reserve Chairman Ben Bernanke’s words the model "broke down at a number of key points, including at the stages of underwriting, credit rating, and investor due diligence," he believed in fixing the model April 10, 2008. My Green cheese factories post explained why the credit risks were not transferred off balance sheets in the end and why recapitalization of the financial institutions quickly would help the central banks to fight the inflation problem.
An additional means to reduce the size of the risk-weighted assets is to buy insurance for the loan book which contributed to the exceptionally low world interest rates. AIG, an established and profitable insurance company but a novice in evaluating credit risks, was the biggest underwriter of such deals, i.e., the final counterparty that was supposed to bear the risks of mortgage defaults.
Perhaps the final feature of the US system which so abruptly ended the music playing is that their mortgages are non-recourse loans. Such a legal contract gives the borrower the incentive for walking away from the mortgage whenever she expects the value of her house to remain below the value of the mortgage. After the repossession of the collateral, the mortgage will no longer be the borrower’s problem, but the bank gets an additional problem from the realization of the house.
Imagine yourself as investing the extra cash of your bank in short-maturity mortgage backed securities to awaken next morning to the fact that your over-night investment returns a capital loss. You would immediately lose confidence in the issuer of the securities and in all those middlemen who originally helped in its issue. That is why short-term money market rates of interest, libors and euribors, shot up well above the steering rates of the central banks.
Tight solvency regulation of banks combined with low steering rates of central banks is at the root of the current crisis.
One policy comment focuses on tighter regulation, another on better regulation and a third comment on border-crossing regulation in preventing the world from future crises. East Germany was controlled by border-crossing military forces. They did not prevent it from collapse, though choked down uprisings.
Of course, there were skeptics who did not believe in the Fed funds rate cut of 18 March 2008 as a healer of the credit crunch: why an additional dose of the same drug, low nominal and real rates of interest which was behind the excessive growth of credit and money. There are possibly fewer skeptics who see the on-going crisis as a consequence of the regulatory system of banks.
Any effective measure of regulation creates its own counterforce that tries to nullify the initial impact of regulation because inventive individuals are always clever in finding out ways to circumvent the constraints set on them. Solvency regulation of banks is based on the risk-weighted assets in the balance sheet of a bank that must be matched by the minimum of the so-called tier I capital, i.e., equity in practice.
Because equity is an expensive source of funding the simplest way to avoid issuing new equity is to reduce the size of the risk-weighted balance sheet in respect of a growing loan book. Therefore the US financial institutions transferred the risky loans off balance sheet by the originate-to-distribute practice. Though in Federal Reserve Chairman Ben Bernanke’s words the model "broke down at a number of key points, including at the stages of underwriting, credit rating, and investor due diligence," he believed in fixing the model April 10, 2008. My Green cheese factories post explained why the credit risks were not transferred off balance sheets in the end and why recapitalization of the financial institutions quickly would help the central banks to fight the inflation problem.
An additional means to reduce the size of the risk-weighted assets is to buy insurance for the loan book which contributed to the exceptionally low world interest rates. AIG, an established and profitable insurance company but a novice in evaluating credit risks, was the biggest underwriter of such deals, i.e., the final counterparty that was supposed to bear the risks of mortgage defaults.
Perhaps the final feature of the US system which so abruptly ended the music playing is that their mortgages are non-recourse loans. Such a legal contract gives the borrower the incentive for walking away from the mortgage whenever she expects the value of her house to remain below the value of the mortgage. After the repossession of the collateral, the mortgage will no longer be the borrower’s problem, but the bank gets an additional problem from the realization of the house.
Imagine yourself as investing the extra cash of your bank in short-maturity mortgage backed securities to awaken next morning to the fact that your over-night investment returns a capital loss. You would immediately lose confidence in the issuer of the securities and in all those middlemen who originally helped in its issue. That is why short-term money market rates of interest, libors and euribors, shot up well above the steering rates of the central banks.
Tight solvency regulation of banks combined with low steering rates of central banks is at the root of the current crisis.
One policy comment focuses on tighter regulation, another on better regulation and a third comment on border-crossing regulation in preventing the world from future crises. East Germany was controlled by border-crossing military forces. They did not prevent it from collapse, though choked down uprisings.
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