There go the Emerging Markets

We talked in class today about Sweden's need to raise overnight lending rates to ridiculous levels in its attempt to defend the kroner in the fall of 1992. I read tonight that Romania has a current account deficit of 14 percent of GDP and has pushed overnight rates to 900 percent to defend its peg against the euro.

As was the case with Sweden, this is likely insufficient. "Merrill Lynch has advised its clients to take "short" positions against the leu. "The fundamental picture suggests that Romania may face a currency crisis in the near term, similar to what Hungary has gone through over the last week," it said. The bank also warned that Turkey and the Philippines are vulnerable."

Things look pretty grim for emerging markets and western Europe. "Stephen Jen, currency chief at Morgan Stanley, says the emerging market crash .. threatens to become “the second epicentre of the global financial crisis”, this time unfolding in Europe rather than America.:

• "Austria’s bank exposure to emerging markets is equal to 85pc of GDP – with a heavy concentration in Hungary, Ukraine, and Serbia."
• Exposure is 50pc of GDP for Switzerland, 25pc for Sweden, 24pc for the UK, and 23pc for Spain.
  
• Spanish banks have lent $316bn to Latin America, almost twice the lending by all US banks combined ($172bn). Hence the growing doubts about the health of Spain’s financial system as Argentina spirals towards another default, and Brazil’s currency, bonds and stocks all go into freefall.
• The US figure is just 4pc.

IMF Rising

Another phase of the global credit crisis has begun; developing nations are running to the IMF for emergency aid.   And finance ministers across the world don't see many other options for how to survive a crisis created by developed credit markets.  Capital flight, wide-swinging currency fluctuations, tightening private market credit - we've seen this all before.  

Now the IMF has begun talks to increase their lending capabilities to as much as $1 trillon.  Considering the bank has $200 million in collateral, they'll need quite a bit of supplemental cash.  Perhaps most telling of how weak the US economy is, the IMF has failed to even approach the Fed for support.  Instead, the bank is in talks with Japan and oil-producing companies.

So, is the IMF poised for a renaissance?  Gordon Brown certainly hopes so (interesting that Brown chaired the IMF's policymaking committee for several years).  The IMF's leader, Dominique Strauss-Kahn, stresses that the Fund will eliminate many of the loan conditions that made leaders such as Hosni Mubarak of Egypt refer to the IMF as the International Misery Fund.  However, new conditions have not yet been outlined and a recent study in the Harvard Medical Review found that IMF lending in the post-communist European Bloc directly led to decreased health conditions in recipient nations.  

Check out this map of Eastern European Countries and their debt load (source: www.economist.com):

The Politics of Farm Subsidies

In honor of tomorrow's exam in POLI 442, I bring you a segment from last week's 20/20 with John Stossel on Agricultural subsidies. He's a libertarian, and does not pretend to be unbiased.



My favorite quote (by a legislator): "I would say to you, then, you don't want to push us." It comes right at the end.

Live by the crude, die by the crude

The NY Times has a nice article on how collapsing oil prices are starting to affect the ambitions of Hugo Chavez, Mahmoud Ahmadinejiad, and Vladimir Putin. As oil prices sky-rocketed, these leaders found plenty of cash for building international alliances and shoring up domestic support through lavish social spending programs. This domestic support in turn provided these leaders with the flexibility to pursue more aggressive foreign policies with the hopes of expanding their international influence, particularly in opposition to the U.S. But it now appears that they may have over-reached: inflation is over 30% in both Venezuela and Iran, and the Russian stock market has dropped by two-thirds in recent months. Meanwhile oil prices, and thus revenues, continue to decline. If the trend continues, these leaders may have to start making hard choices between populist domestic social programs and expansionary foreign policy.

Even so, there are still some signs that the relative economic power of the U.S. may be in decline. European leaders have been at the forefront of the response to the financial crisis, and some of the U.S. government's actions are partially explained by international concerns (e.g. the Fannie/Freddie conservatorship was necessary because of heavy Chinese investment; the AIG bailout had major international implications). And does anyone remember the strong words the U.S. had for China regarding currency manipulations? There've been crickets coming from that corner for awhile.

Still, as Daniel Drezner notes, it doesn't appear that any other country is quite ready to fill the U.S.'s shoes:

However, this interdependence cuts both ways. Because of its slowing growth, China has no choice but to continue purchasing dollar-denominated debt in order to goose its export earnings. As for Russia, $500 billion in reserves has not prevented the crash of its own equity markets.

The bottom line seems to be this: the U.S. may be incapable of continuing to run the international finance system entirely on its own as it has done since the end of WWII, but the rest of the world is incapable of controlling the system without the U.S. So the story may not be de-coupling, as some had thought; Indeed, we may see more interdependence rather than less in the near future.

Reassurance

I don't see that they've achieved what they should have been trying to achieve. So my verdict on this present Fed leadership is that they have not really done their job.

That is Anna Schwartz, one of the foremost economic historians in America, particularly in the areas of the Fed, the Great Depression, and monetary policy in general. More here.

(ht: Mankiw)

To Grandmother's House We Go

If banks are the bridges of the financial industry, and world governments are able to prop them up sufficiently well as to avoid any more major collapses, then where do we find ourselves? According to Gordon Brown, the next step is the development of a new Bretton Woods system. Nevermind the poor historical analogy; if Bretton Woods I was formally constructed as an international security measure while WWII was still raging, and if Bretton Woods II was informally constructed by the U.S. running current account deficits in order to finance cheap current consumption, which in turn boosted export-biased growth in developing countries (with the U.S. dollar as the de facto reserve currency for the world), then I'm interested in what Bretton Woods III would look like. What formal or informal structure will emerge in the coming years as the controlling mechanism for the world economy? Or, more specifically, what institutions might be developed which would prevent future crises from resembling the present one? I see several possibilities, none of which strike me as being especially likely.

1. The development of a new international agency, with the scope and resources of the IMF, dedicated to providing short-term liquidity directly to major banks (or investment firms with large counter-party obligations?) in any country, without the approval of that bank's host country. This agency would have the authority to demand structural changes to lending or investment practices of the banks they aid. In other words, the loans would be tied to some actions. These demanded actions may include things like higher reserve requirements, equity stakes in the banks in exchange for the capital, preclusion from engaging in credit default swap markets or taking on other investments with large exposure to system risk. It's possible that this could be done under the auspices of the IMF if certain changes were made to its charter, tho considering the P.R. problems facing the IMF, it may be better to develop an entirely new agency.

2. The development of a global version of the Securities and Exchange Commission, which closely regulates the balance sheets of major banks, and has strict restrictions on what types of investments certain banks may make. Although, given that these sorts of regulatory agencies had no real positive preventative effect on the current crisis, it seems unlikely that a global agency would've done much better. There are also corruption problems in many countries. And would countries with a nationalized banking system accept foreign control? Of course not.

3. The development of a global FDIC, which guarantees depositors in traditional bank accounts and money market funds. This, however, is a rather mild symptom of the global contagion; it isn't the disease itself. And many countries in the developing world have incredibly corrupt banking systems. It would require a massive reform of a corrupt political culture in order to make such a plan feasible in those countries; that, obviously, would be quite hard to do.

What else? In my opinion, #2 and #3 would have little effect on the international financial system, plus enforcement would be mostly impossible even if enaction weren't. #1 is essentially the same as recapitalization of banks, and this can already be done by private investors or local governments in most cases. When that proves problematic, the IMF (see: Hungary, Ukraine) or neighboring countries (see: Iceland, Pakistan) are capable of pitching in.

Perhaps I'm missing something obvious, but Bretton Woods I picked the low-hanging fruit in a time when the Western economic powers were capable of forcing the agenda. Bretton Woods II was an informal mechanism in which the world voluntarily tied its sails to the fortunes of the dominant economic powers by organizing their economies to sell to the world's biggest markets. I don't really see a realistic place for a third organizational system at present. If folks have ideas, put them in the comments. Or, if folks have things they'd like to see in a BWIII, even if they aren't realistic, put those ideas in the comments also (I'm looking specifically at you, Emmanuel).

Americans are saving?!

What?! Since when do Americans save? Well, according to the latest figures, the personal savings rate in the United States was up to almost 3% for the second quarter of '08, the highest its been in at least five years, and is predicted to at the very least stay at this level for a while. This is an interesting development. 

This news bodes well for the American economy in the long run, as "domestic savings create a pool of money from which companies can borrow to invest in new plants and equipment, creating the jobs that push living standards higher over time. A growing domestic savings pool could also reduce America's need to borrow money overseas - which would make the U.S. less beholden to foreign creditors who now supply us with hundreds of billions of dollars in financing every year."

However, in the short run, "saving more means spending less - which translates into more hard times in retail and other consumer-driven businesses like the auto industry. The latest evidence of the shift came in Wednesday's steeper-than-expected pullback in retail sales. They dropped 1.2% in September, in their first year-on-year decline in six years and only their third drop in the past 16 years. Given that two-thirds of economic activity is consumer spending, today's thrift [may] exacerbate a general downturn and [may] weaken the impact of the massive interventions the government has made in the financial markets."

This development has consequences for the predicted (or actual, depending on your definition of the term) recession and recovery.  If Americans aren't willing to go out and do what they do best (shop and eat) and instead stuff their money under the mattress, it is a signal that the American economy may be in for a longer and deeper recession than originally predicted. Furthermore, the recovery from the Great Financial Crisis of 2008 (catchy huh?!) and its ensuing recession may take longer than we thought it would. (We may be sitting here in the 3rd and 4th quarter of 2010, still awaiting the recovery to begin.) 

So I say unto you America, shop, baby, shop!

Next?

"Ukraine, Hungary, and Serbia are all in emergency talks with the International Monetary Fund, raising fears that an exodus of foreign investors will set off a systemic crisis across Eastern Europe."

The worst may be yet to come in euroland as well: "the ECB is now deeply alarmed by the crunch facing European banks as a violent unwinding of debt leverage across the world forces them to repay huge sums in dollars. Goldman Sachs estimates that non-US banks have liabilities of $12 trillion on dollar balance sheets. The European, British, and Swiss banks make up the lion's share, and they have used leverage far more aggressively than US banks. Analysts say the European banks will need to raise $400bn in fresh capital – no easy feat at a time when burned investors are keeping their distance.

Meanwhile, Gordon Brown is "Calling for "very large and very radical changes," ... nothing less than "a new Bretton Woods."Speaking at a summit of European Union leaders in Brussels, Mr Brown said the recent crisis proves the need for much more international co-operation on the regulation of banks and other financial institutions. "We now have global financial markets, global corporations, global financial flows. But what we do not have is anything other than national and regional regulation and supervision." More thoughts on this later.

Explaining the Mess

Crisis explainer: Uncorking CDOs from Marketplace on Vimeo.



Untangling credit default swaps from Marketplace on Vimeo.

Here are a couple of videos from Marketplace that explain the financial relationships at the center of the current crisis.

Institutions Matter

UPDATE: Congratulations, Paul Krugman, winner of 2008 Nobel Prize in Economics (okay, The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel).

Paul Krugman lauds Gordon Brown's weekend efforts: "you don’t expect to see Britain playing a leadership role. But the Brown government has shown itself willing to think clearly about the financial crisis, and act quickly on its conclusions. And this combination of clarity and decisiveness hasn’t been matched by any other Western government, least of all our own."

Fair enough; yet Krugman offers little explanation for this puzzle beyond his distaste for the Bush administration--"I also wonder how much the Femafication of government under President Bush contributed to Mr. Paulson’s fumble. All across the executive branch, knowledgeable professionals have been driven out; there may not have been anyone left at Treasury with the stature and background to tell Mr. Paulson that he wasn’t making sense." Yet, just a few column inches above, Krugman notes how Bernanke favored the capital injection approach--surely Ben mentioned this to Paulson?

Perhaps institutions account for the difference. Gordon Brown did not need to testify before the legislative branch, nor did he need to build a majority in the upper and lower houses. Instead, parliamentary government and strong party discipline enabled Gordon Brown to formulate a concise plan and "act quickly on its conclusions." Not so in the U.S., where Paulson must plead for the necessary authority and resources and required two votes in the House to pass a much altered version of the plan he proposed. I am not sure how that institutional process promotes clarity of thought or rapidity of response.

Indeed, Paulson's initial proposal might be seen in this light: more about gaining broad authority to do what was necessary and less about the specific details. Sell the request for authority based on vague details that would sell; once you have the authority use it to do what is needed to stabilize the system (including recapitalization, now in vogue). Hence, the plan was short on details about how to solve the crisis, and explicit about Treasury authority. Yet, Krugman was no big fan of that plan, in part because it gave Treasury so much unchecked authority.

Maybe we can't have our cake and eat it too? If we want clear thought and quick action, we need unfettered executive power. If we want to constrain executive power, we must accept policymaking through a slow process in which outcomes often fail to embody clarity of thought.

Beyond the Blow-by-Blow

Most of the talk of the financial crisis has rightly focussed on the breaking news and new developments. Even on a Saturday the news is significant: the Bush administration has reversed course and is now committed to partially nationalizing major banks rather than just providing liquidity (which begs the question: is it legal to use the cash in a way not approved by Congress?). Meanwhile, the much-ballyhooed G7 meeting has been underwhelming. A joint statement was issued, but it only included platitudes in place of actual concrete plans of action.

But it is sometimes helpful to step back, look at this crisis in context, and try to find ways to improve the future performance of the financial system. For example, everyone is calling for changes to the regulatory system, although those calls tend to vary along partisan lines. Left-leaning commentators are keen to increase any and all regulation, while those on the right tend to ask for "better" regulation, as if the system in place before the crash was intentionally or predictably deficient. Both views are understandable, but Avinash Persuad thinks they are both misguided:

This is the seventh international financial crisis I have lived through. At the end of each the focus on avoiding the next one has always been the same trinity: more transparency, more disclosure and more risk management. This is an inadequate response to systemic crises. At the heart of new, internationally co-ordinated regulatory initiatives, must be counter-cyclical capital charges a la Goodhart and Persaud. Crises do not occur randomly; they always follow booms. This is my fourth policy initiative. But there also needs to be shift in the focus of regulation, away from sensitivity to the market price of risk and notions of equal treatment for all institutions, to a greater sensitivity to risk capacity and a better appreciation that diversity is the key to liquidity. This is the fifth step. Systemic resilience requires different risks being held in places where there is a natural capacity for that type of risk. In the name or risk-sensitivity and equal treatment we ended up with institutions who had no liquidity, holding liquidity risk and those with little capacity to hedge or diversify it, owning credit risk.

Meanwhile, Arvind Subramanian wants China to give the U.S. an IMF-style "tied loan" in exchange for some structural adjustment. That'd be a bitter pill to swallow, but we may end up having no choice. Meanwhile Michael Clemens takes the long view and thinks that we'll be alright:

This is the best estimate of real income per capita in the United States since 1820. Over these years we had violent financial crashes of various types, bank panics, piles of recessions and a huge depression, many foreign wars and one enormous domestic war, had a central bank and didn’t, were on the gold standard and weren’t, had governments topple in scandal and multiple leaders assassinated, and what did it all amount to in the medium to long run? In per-capita income terms: Nothing. The overall trend does not bend or shift. Every bad year was followed by a good year that returned us to trend. The US average growth rate of real per capita incomes over the last 190 years has been 1.8% a year, and the same rate over the last 10 years has been…. 1.8% a year. Stare at that graph: The Great Depression was traumatic in countless ways, but astonishingly, it’s not clear that we are any worse off today than we would be if the whole thing never occurred. Anyone who made such a claim in the 1930s would have been scoffed at, but that’s what happened.

Here's his graph:

Drugs: The Anti-Drug

The PSA above is infamous for its, er, lack of subtlety. But there is an underlying issue at stake: one of the unintended consequences of the convergence of the War on Drugs with the War on Terrorism in Afghanistan is that we have incentivized poor Afghan farmers to grow poppy. It is easy grow, has quick yields, and many farmers have no other viable alternative. It's either grow poppy or live in even greater destitution. And so Afghanistan now produces 93% of the world's opium supply. The illicit opium trade generates an estimated $4bn in yearly exports in a country with an official GDP (PPP) of $35bn. Much of this opium money finds its way into the hands of the Taliban, who use it to fund their insurgency. It is clear that a direct means of fighting the Taliban is to cut off their funding. To that end, NATO forces will now begin to directly attack opium production facilities in the hopes of destroying crops. If the history of the War on Drugs is any indication, this new strategy tactic strategy will have lackluster success at best (see: Colombia).

So what to do? Christopher Hitchens proposes a new strategy: if you can't beat 'em, co-opt 'em. In other words, rather than trying to shut down the drug trade, buy the opium and use it in the production of prescription painkillers, of which there is a global shortage, particularly in the developing world. In fact, Turkey has government-controlled opium production, and it sells its crop to the U.S. and other countries for the development of medicines. There are issues of policing, but if the U.S. is willing to pay a high price than the Taliban, then we may be able to weaken the Taliban, improve the security and economy of Afghanistan, improve the standards of living for some of the most destitute people on earth, increase access to pharmaceutical drugs in the developing world, and lower the global costs of the same drugs, and (potentially) prevent the loss of life that a NATO attack might occur. In fact, much of the success of the Anbar Awakening can be attributed to the shift in U.S. policy from fighting local leaders to (ahem) bribing them. Perhaps it's worth trying something similar in Afghanistan. We may improve the security situation and the local economy in one fell swoop, while reducing the global supply of illicit street drugs, thus raising their price and reducing the quantity demanded.

Yes, this is a bit of a pie-in-the-sky view. Yes, there are certainly complications, not least of which are domestic political feasibility issues. The Canadian government is one dissenter from this view. A summary of their arguments is here. But alternative scenarios are even less rosy. For more in-depth analysis in support of making the illicit Afghani drug trade licit, see Poppies for Medicine, a years-in-the-making study conducted by the Senlis Council, which examines feasibility issues and proposes an economic and policy model for enaction.

Rescue?

As G7 finance ministers gather in DC this weekend in connection with the annual IMF and World Bank meetings, one can't help but notice the increasingly strident pleas for concerted and coordinated action coming from economists I greatly respect. Their stridency makes me worried.

One hopes that finance ministers will take concrete steps this weekend. One hopes that someone will emerge as a leader. One hopes, at the very least, that they are not unable to do something. The disaster of this week suggests quite clearly, I think, how markets react when governments prove themselves incapable of coordinated action. One also worries, however, as Sarah and Alex express below, that governments really don't know what they are doing, and lack the conviction to act forcefully anyway.

Financial Contagion?

Iceland is near bankruptcy. Credit crisis hits Canada. Belgium, France, Luxembourg intervening to save bank after bank. The Euro falls to 14 month low as credit crisis spreads throughout Europe. Asian equity markets continue their deep slide.

$700 billion bailout. 50 basis point emergency global coordinated rate cut. Banking deposit guarantees. Governments taking equity stakes in banks (yes, including here in the US). 

Is there any further action that can stem the spread? Can the government do anything? Is this too little too late? Is a global recession inevitable? 

Shock and Awe

Reading the news feeds, one can't help but wonder if governments know what the heck they're doing.  New three-point plans, rate cuts, and proposals are exploding onto the scene like the finale in a fireworks display, often to no avail at stemming the depressing tail-spin of global equity markets.  Now, we have a whole lot of smart people working on a whole lot of stop gap solutions, and a very capable Bernanke using his knowledge of the Great Depression to try to make sure monetary policy doesn't make things worse.

Still, it seems through all the noise, the policy makers are missing the core problem - you can cut interest rates and provide increased government funds for short-term lending all you want, but banks still are simply not lending to one another.  Robert Pozen of MSF Investments has an opinion piece in the Wall Street Journal today calling for governments to guarantee short-term interbank lending.  This, in turn, will provide the time and space for the Economic Stabilization Act to generate more liquidity through the absorption of toxic debt.

It's clear from the increased international cooperation that governments understand and are willing to act (to varying extents) in concert to avoid the worst of the worst scenarios of deep and protracted global depression.  But, willingness to act is not enough.  Let's hope that global leaders are willing to cut through the noise and the panic to enact the correct combination of stop-gap and systemic measures to limit the damages and strengthen global credit and equity markets for the long term.

More Overnight/Early Morning Developments

The Federal Reserve, along with the European Central Bank, the Bank of England and the Swiss, Canadian and Swedish central banks enacted, a coordinated, emergency cut in their benchmark interest rates early this morning. This comes in response to massive stock market declines in Japan, Russia, Indonesia and many other global indexes overnight along with further market interventions by European governments and central banks to prop up failing institutions, as Tom observed. The cut's timing also shows the urgency of central bank officials attempting to stem the fear of the aforementioned developments from further battering European and American markets during today's trading.

This is purely and clearly a psychological move by the world's central banks. Something needed to be done, in a coordinated way, to show the markets that the central banks were ready and able to intervene to stem any remote possibility of global financial collapse and the central banks believed further liquidity was the answer. But the problem is not liquidity, its confidence. How lowering a target rate that does not actually really matter (check out the data on the effective FFR over the past 3 weeks), will fix the problem, I can not see. Lowering the target as a purely psychological tool to attempt to impact investor confidence, may have an impact. How much of an impact and will the impact be enough? I have no idea but, I guess we'll see.

Overnight Developments

Britain announced a three-part multibillion-dollar bailout for its beleaguered banks, and Spain moved to mount a separate rescue of its own banking sector.

And the Fed is now in the commercial paper business.

Meanwhile...

In Moscow, the Micex index plunged 15.5 percent at the opening and exchange officials suspended trading until Friday.

Japanese stocks plunged 9.4 percent Wednesday, leading the Nikkei 225 to at 9,203.32, the lowest since 2003. It was the biggest single-day loss in the index since October 1987. The selloff followed Tuesday’s drop of more than 3 percent. The index is now down 40 percent in 2008.

Indonesia’s stock exchange halted trading after a morning plunge of 10.4 percent.

Looks like another bumpy day. Anybody have any idea about what to do? If so, post them in the comments section. I will offer some further thoughts later. Gotta go teach now.

Now What?

European governments appear "dazed and confused," said Jim Reid, a strategist at Deutsche Bank. "And this isn't helping confidence and will probably end up costing them more in the long run." Not surprising that they are dazed and confused, given the sharp about face that has occurred in most EU members in the last two days. Seems that guaranteeing bank deposits is not such a bad idea after all.

Press reports hint that Sarkozy is seeking an emergency G8 meeting this week. Not obvious that this is a good idea. Market reactions to the non-agreement EU-4 summit and post-non-agreement scramble to bailout Hypo Real Estate and other European financial institutions suggest that market participants do not believe that EU governments fully appreciate the stakes. "Until now the solutions have appeared to be uncoordinated, so perhaps it's time for a more coordinated approach globally," said Torsten Slok, an economist at Deutsche Bank AG in New York. Indeed. Yet, calling an emergency G8 summit merely adds fuel to the fire unless EU governments have a meaningful coordinated response to announce at its conclusion. (H/T to Calculated Risk).

Krugman posted a short paper elaborating his thoughts on contagion. He makes a concise argument about why the EU can't hide.

Update: Just noticed that Tuesday's NY Times has a piece that (finally) criticizes EU governments for their head-in-the-sand attitudes and failure to embrace a coordinated response. “It’s mind-boggling that the Europeans have coordinated so little up until this point” (Simon Johnson, former Chief economist at the IMF).

Sauve Qui Peut

French President Nikolas Sarkozy, in his capacity as EU President, called an emergency summit this weekend among the four largest EU members to discuss EU cooperation in face of the financial crisis.

The gathering failed to produce a constructive response. They agreed on the need to work together, but proved unable to agree on how this cooperation might be best pursued.

EU leaders seem torn between two unproductive orientations.

Along one path, EU governments seem determined to see this as an American crisis that they can somehow avoid, rather than a global financial crisis that they cannot. Gordon Brown said pointedly that the crisis “has come from America.” Mr. Berlusconi claimed that “Europe is not facing and never faced the risks in the American system.” Europeans, he said, “set aside money in savings.”

Along the other path, EU leaders have pursued uncoordinated national responses and then criticized each other for the half measures each takes (see how EU governments have reacted to Ireland's decision to guarantee 100 percent of deposits). Such behavior has prompted Peter Mandelson to warn of the dangers of a “new wave of economic nationalism”, which would create “distortions” and lead to an approach of “every man for himself”.

I fear that this approach reflects a failure to comprehend how the world has changed, and is more likely to aggravate than mitigate the crisis in which we find ourselves.

The End of an Era?

We've been mostly focusing on the domestic aspects of the financial crisis, but it's important to remember that this is a global crisis. In Europe, the major leaders are coming together to coordinate their responses:

French President Nicolas Sarkozy along with Germany's Chancellor Angela Merkel said Saturday that the "global financial crisis needs a global response."

Ms. Merkel and Mr. Sarkozy were speaking to the press ahead of a summit in Paris of leaders of the European members of the Group of eight leading countries, along with Eurogroup Chairman Jean-Claude Juncker and European Commission President Jose-Manuel Barroso, to discuss the financial turmoil.

"It's a global crisis that requires a global response. In today's world, Europe must show the will for a solution. That will reassure everyone, including savers," Mr. Sarkozy said.

Ms. Merkel said that all countries must take responsibility in sorting out the financial crisis and added that "those who caused the damage will have to contribute to the global effort.

In the past, this sort of coordinated European action would have been undermined by the U.S., and without U.S. support such a proposal would wither on the vine. As Drezner notes, both Japan and Europe tried something similar following the Asian financial crisis a decade ago, but the U.S. scuttled the efforts. If Europe is successful this time around, it may signal the decline of America as the hegemon of the global financial system.

And, the Rebuttal

Americans don't like the idea of our tax dollars going to bailout a bunch of companies run by massively rich executives.  Chris Dodd's plan is a reflection of the American voters' affinity for fairness (and punitive measures).  While fairness is a laudable goal, it isn't always the best guide for policy creation, and here's why:

At the heart of Dodd's proposal is the belief that taxpayers will invest too much in this bailout to be satisfied with assuming all of the risky debt with none of the potential upside that equity ownership conveys.  I'd first like to remind readers that there is an entire (profitable) industry that buys bad debt at reduced rates and then finds ways to cajole debtors into paying back that debt - ever heard of a collection agency?  Now, I'm not suggesting that the government start making harassing calls to debtors, but I am pointing out that you can make lots of money by buying bad debt obligations.

More importantly is that critics of Paulson's plan fail to recognize all the positive externalities that this bailout will afford.  Those externalities (basically, the propping up of the economy which keeps jobs from being cut, keeps pensions and retirement savings accounts secure, keeps access to credit relatively cheap) will provide taxpayers much more economic gains then equity positions in the finance industry could ever afford. And we can access those external gains without all the headaches of legislating the terms of a government equity position (how much equity?, what type of voting rights?, when can the government sell its holdings?, potential for increased lobbying from companies in which the government is invested? etc.).

The reason why Wall Street needs bailing out is because the market cannot adequately and independently self-correct due to a preponderance of externalities.  That is why the government needs to step in - because the government doesn't have a free-rider incentive and the government has the clout and the capital to actually get something done.  It would be a mistake to limit the government to behavior of firms - because the government's ability to bolster the economy at this point comes directly from its ability to NOT act like a firm.

Of course, I am not without criticism of Paulson's plan (I'm a grad student for God's sake, it's my job to criticize everything as much as humanly possible), but I'll save those criticism for another post - I'm well beyond my 50 word limit.

Will - tell me why I'm wrong . . . .

In Favor of the Dodd Plan

(Sarah posted a great comment to my post earlier today. At the bottom of my post, I linked to Sebastian Mellaby's citation of several academic proposals which bear some similarities to Sen. Dodd's counter-proposal to the Paulson plan. In the next few posts, Sarah and I are going argue the merits and demerits of the Dodd and Paulson plans. All of this is off-the-cuff, but hey: it's a blog. Apologies for the length.)

Dodd's plan accepts the basic assumptions of Paulson's: that massive government intervention has become necessary in order to stabilize markets and prevent financial market contagion from sinking the real economy. But Dodd's plan differs from Paulson's in several key areas. In my view Dodd's plan improves Paulson's on balance, but I have caveats. The list:

1. Paulson wants unilateral authority, with no review from Congress or the courts. This is insane, undemocratic, illegal, etc. Dodd wants an oversight committee comprised of the Chairmen of the Fed, FDIC, and SEC, plus two representatives from the financial industry. Paulson would still essentially serve as the CEO of United States, Inc., but his board of trustees would be comprised of this committee, which would presumably report to Congress and be subject to the judicial process if necessary. Dodd's proposal alleviates concern along two fronts: first, that too much discretion would be given to Paulson with too little accountability; second, that potential for moral hazard will be lessened because Paulson's actions will be more transparent and authority will be more dispersed.

2. Paulson wants broad discretion to use the cash in any way he sees fit, and has intimated that this will mostly entail buying "bad debt" so that banks won't have to carry them on their balance sheets any longer. This basically means one thing:

Anyway, I wanted to let you know that, behind closed doors, Paulson describes the plan differently. He explicitly says that it will buy assets at above market prices (although he still claims that they are undervalued) because the holders won't sell at market prices. Anna Eshoo pressed him on how the government can compel the holders to sell, and he basically dodged the question. I think that's because he didn't want to admit that the government would just keep offering more and more.

Why? Well, most of the "toxic debt" is still in the form of CDOs, especially mortgage-backed securities (MBS). These things were never intended to be bought-and-sold like other securities. As such, they don't really have a "market price" in the same way that stocks and T-bonds have. Even if they did, that "market price" is effectively $0 at present; simply put, nobody will buy these MBS at any real price. If the problem for banks is that they are short on capital, selling MBS at a massive loss to the Treasury (or anybody else) isn't going to do any good. In order to balance their sheets, they'd still have to sell more equity or dump assets at fire-sale prices. As Krugman has noted, the Treasury will essentially have to over-pay in order to create the desired effect. But that means that the U.S. government and its shareholders (i.e. taxpayers) will be essentially guaranteeing a pretty major loss for itself in order to reduce losses for banks who made bad decisions. This is corporate welfare in the extreme. If Bush and Paulson want that sort of action, then they should have to properly sell it to the American people and her Congress. They don't want to do that, for obvious reasons, so they shouldn't be allowed to get away with it.

3. One way around this problem is to force banks to stop paying dividends and/or to issue more equity (see the Mellaby piece linked in my first post). No banks will do this on their own, because that is a powerful market signal that that bank is failing, a sell-off will ensure, and the firm's value will fall. If the government forces all banks to do it, then credibility can be maintained. But not all banks are on the brink, so why punish those who managed their money well? You could put downward pressure on an already reeling market. And if you only mandate that "sick" banks act in this way, then that will be a strong signal as well, and firm value will still plummet.

So what to do? Dodd proposes that the Fed provide the needed liquidity for firms to roll over their paper. In exchange, those firms will provide equity equal to the size of the government's "investment". In other words, U.S. taxpayers will get equal value for their dollar by paying present market value for partial ownership. We will still be taking on some risk, but now we have a share of the upside and not just the downside. If the firms do well, we may make money. If the firms do poorly... well, the Paulson plan has us taking on that risk anyway.

This is not ideal, in my view. There are still a lot of questions to be asked and answered, and I expect Sarah to spell them out in more detail in her post. But we aren't dealing with "first-best" scenarios here. This may be the best we can do in a bad situation.

As an alternative, Arnold Kling proposes instead to drop the capital requirements for banks. He acknowledges that this will still mean more risk exposure for U.S. government since they insure banks. Not only that, but his proposal doesn't kick in for another year and the crisis is more immediate than that. Lastly, if one of the main problems in this financial trouble is too little risk-aversion by banks (or poor risk judgment, if you prefer), then it seems a bit presumptuous to give more casino credit to these banks and practically dare them to gamble with it. Which leads to...

4. CEO compensation. A loaded topic, to be sure. Dodd's plan, contra Paulson, has provisions for punitive damages for CEOs whose firms have done poorly. Executive compensation and severance packages could be arbitrarily reduced, presumably by Paulson's oversight committee (or Congress?) if it "is in the public interest". Well, what does that mean? What is the public interest? What levels of reduction? Matthew Yglesias wants "punitive measures". John McCain says that CEOs of bailed-out firms shouldn't be paid more than the U.S. President ($400k/year). I automatically recoil at vague language like that in the Dodd plan, but even ignoring that for the moment: what's the incentive facing executives if that clause remains? It's for CEOs and their boards to keep gambling and not seek help from the government if that action would mean that their personal compensation is going to fall from millions to mere thousands. It effectively creates moral hazard for these executives, and that's a really dumb thing to do right now. The government can only respond in four ways to executives who choose to take the gamble: do nothing and let the firms collapse, which defeats the point of this whole exercise; unilaterally violate compensation contracts, which would violate centuries of legal tradition; forcibly nationalize firms which don't want to be nationalized, which is a step (or twelve) further than anyone really wants to go; or appeal directly to shareholders. But shareholders are incentivized to gamble too since they will probably lose everything if the government bails out the firm (see AIG). In any case, such a move would likely take too long when firm survival is measured hour-to-hour.

In the grand scheme of things, CEO compensation is not a big deal. A few dozen million might sound like a lot, until you realize that we're really talking about hundreds of billions right now, at the least. Democrats and progressives would be wise to save that fight for another day; it just doesn't matter right now, and might actually be counter-productive. I'm guessing that these CEOs won't be getting salaries quite so big at their next job anyway.

Deal or No Deal (U.S. Congressman Edition)

Hate to make this place all-bailout, all-the-time, but that's the biggest issue of the day.

If I'm a U.S. Congressman, and I'm being asked to give $700bn to the Treasury Department with no string attached, I say "no deal" whether I'm a Republican or a Democrat. If I'm a Republican, I'm ideologically opposed to massive government programs with essentially no oversight. I'm concerned about the fact that the current Treasury Secretary will likely be replaced in five months, and will presumably be seeking a job on Wall Street at that time. The term "moral hazard" has been tossed around a lot in recent weeks; this plan, if enacted, would immediately go in the Guinness book. If I'm a Republican, I'm also worried that I don't know who the new Treasury Secretary is going to be in five months, he's probably going to be appointed by President Obama (still the favorite according to the betting markets), and if the Congress gives up power to the Treasury Department now it may not get to change its mind later. I'm also wary of the provisions which will be added by Congressional Democrats in exchange for their votes. I note that right-leaning economists are very skeptical of this plan, and not just the far-right libertarians.

If I'm a Democrat, I'm thinking that I'm generally not happy with the way the Bush administration has used the unilateral authority it's had in the past. I'm thinking about Iraq (and not just the decision to invade), a host of civil liberties issues, lack of transparency in general, and corporatist tendencies. I'm thinking about the fact that while McCain is still an underdog he still has a 48% chance of winning (per Intrade), and his most notable executive decision so far has been to appoint Palin as his running-mate, which doesn't give me much confidence about his ability to pick capable technocrats in his administration. I'm very worried about the lack of oversight, since in this proposal Treasury decisions are non-reviewable by the Congress or the courts, essentially making Sec. Paulson the Supreme Monarch of Wall Street, and am even more cynical about moral hazards than my Republican counterpart. I'm concerned that President Obama will be constrained in his ability to enact social spending programs in January if all the money is spent today. I note that left-leaning economists are almost united in opposition to this plan, and not just the far-left anticapitalists.

If I'm a non-partisan wonk, I wonder what the point of this is. If the broader problem is still liquidity, then the Fed can fight that on its own. It's true that Treasuries were actually trading negative for a moment or two last week, but they were still trading, so it doesn't yet look like the Fed is "pushing on a string". In other words, it doesn't yet appear that the Fed has used up all its bullets. Additionally, there is still private and foreign capital out there to be had; if it's become difficult to get that capital, then the Fed and/or Treasury can do some regulatory tweaking on the margins to improve the situation without nationalizing all the risky assets in the world*.

If the problem is solvency, then I'm questioning the wisdom of putting the solvency of the U.S. government at risk. If that's too much Chicken Little for you, then I'm wondering why the government should, without oversight or even a structure of decision-rules, be nationalizing investment losses while keeping investment gains private. We've all heard of corporate welfare, but this may take the cake. And yes, some pension funds and retirement accounts will go down with the ship. That sucks, but that's what we've got a safety net for. Maybe the $700bn would be better spent shoring up those safety nets rather than bailing out Wall Street?

for more from the right, see Mankiw, Cowen, and Naked Capitalist.

for more from the left, see Krugman and DeLong.

Nadav Manham defends the plan here. Let's say that I think his view is best-case, and we have no reason to think that we're in best-case territory here.

*Sebastian Mellaby channels some academics proposing other solutions:

Raghuram Rajan and Luigi Zingales of the University of Chicago suggest ways to force the banks to raise capital without tapping the taxpayers. First, the government should tell banks to cancel all dividend payments. Banks don't do that on their own because it would signal weakness; if everyone knows the dividend has been canceled because of a government rule, the signaling issue would be removed. Second, the government should tell all healthy banks to issue new equity. Again, banks resist doing this because they don't want to signal weakness and they don't want to dilute existing shareholders. A government order could cut through these obstacles.

Meanwhile, Charles Calomiris of Columbia University and Douglas Elmendorf of the Brookings Institution have offered versions of another idea. The government should help not by buying banks' bad loans but by buying equity stakes in the banks themselves. Whereas it's horribly complicated to value bad loans, banks have share prices you can look up in seconds, so government could inject capital into banks quickly and at a fair level. The share prices of banks that recovered would rise, compensating taxpayers for losses on their stakes in the banks that eventually went under.

Credible Credibility in Credit Markets

Alex's earlier post posed an interesting question:

If the United States is not going to follow its own advice of not intervening in its own financial market to bail out failing domestic firms when staring down one of the biggest financial crises in its history, why should/would any other nation follow the non-intervention policy when a similar financial panic occurs in their economy?

Has the United States lost all credibility to prescribe strict free-market, non-interventionist solutions to financial panic around the world?

It is certainly a question worth asking. But there's another way to look at it. First, consider that there is a difference between the IMF and the US government. They often act in tandem, but that doesn't mean that the actions of one can be conflated as an implicit act of the other. I know Alex didn't mean that, and was instead looking at broader philosophies, but it's still an important distinction.

Secondly, there is a major difference between one country using its own assets to bail out local companies and another country using borrowed money for domestic corporate welfare. Loans always come with strings attached, and the IMF has traditionally taken a pretty strong line: IMF loans are to be used for short-term balance of payments deficits, not for domestic welfare spending. In exchange, the IMF demands structural adjustments in the hopes of preventing a reoccurrence of whatever problem they are trying to fix. (I'm not defending the history of the IMF here; there's plenty to criticize. My point is simply to make distinctions.)

So the proper analogy isn't between IMF loans and domestic US policy, but rather between the terms of the IMF loans as compared to the terms of the Fed/Treasury loans. The Fed/Treasury loans have all come at a high price: Bear Sterns is dead; Fannie Mae and Freddie Mac cease to exist in their previous form, and appear likely to be broken up and liquidated in a fire sale; Lehman Brothers is dead; AIG is still alive, but their problem was liquidity and not insolvency. In all cases, the shareholders lost almost their entire investments. The Fed/Treasury loans, like the IMF loans, came at a heavy price: the way that these entities had previously done business has been completely eliminated, with major losses for the parties involved. In most cases, these business don't even exist anymore. In short, I can see more similarity than difference between the terms of IMF and Fed/Treasury loans.

As for credibility in the eyes of foreign governments and investors: if I were the manager of a sovereign wealth fund which was highly leveraged in US credit markets, recent actions by the Fed and the Treasury would increased their credibility in my eyes. By granting an implicit guarantee to practically the entire U.S. financial system, U.S. investments now look less risky than they would have if all these businesses were simply allowed to collapse without any further thought, with devastating repercussions for the domestic and global economies. If these moves by the Fed/Treasury work out, then future investors can look at U.S. credit markets with some reassurance, knowing that if their investments are on the verge of completely failing the U.S. government will likely step in provide some relief.

Does that create a moral hazard? Like the world has never seen before. These short-term fixes could prove to be incredibly costly down the line, and that's the worry, which is why Lehman was allowed to collapse, Merrill Lynch was forced into selling to Bank of America: the Fed had to draw the line somewhere. After all, a lot of the current troubles were aided by massive inflows of foreign capital into U.S. markets, which made loans so affordable in the first place. The U.S. credit markets were already perceived as being the safest in the world; with an explicit government guarantee, that safety might look even more appealing to foreign investors, and dramatic flows of foreign capital might keep coming. Right now, we need the liquidity, but in the future if money stays as cheap as its been in the past 5-7 years we might face another crisis similar to this one. Unless we get a lot better at assessing risk, of course.

UPDATE: Ken Rogoff is thinking along similar lines:

One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 54-year lows. It is almost as if the more the US messes up, the more the world loves it. ...

It is a very good thing that the rest of the world retains such confidence in America’s ability to manage its problems, otherwise the financial crisis would be far worse.

Let us hope the US political and regulatory response continues to inspire this optimism. Otherwise, sharply rising interest rates and a rapidly declining dollar could put the US in a bind that many emerging markets are all too familiar with.

Export-biased foreign countries know that their economic fortunes are tied to ours, so it's likely that they'll keep pumping money into our markets as long as they have no better alternative, keeping interest rates low and the dollar relatively high. If they ever stop, it'll hurt us badly, but it might hurt them worse. Another key: U.S. debt is dollar-denominated, so we don't have to worry about exchange-rate fluctuations when servicing this debt. Indeed, we can just inflate the debt away if it comes down to it. Foreign central banks and sovereign wealth funds know all this; they are incentivized to keep the U.S. markets afloat by providing capital to ease liquidity trouble, just as the U.S. government is.

Live Together, Die Together....?

Remember that factoid of money markets "breaking the buck" the other day?  Well, central banks around the world didn't take the news lightly, as the NY Times reports today.

Wow, look at all the tacit cooperation going on!  And the turn towards government regulation doesn't stop there.  The SEC has brought back rules against naked shorts, which are basically a strong bet on a stock going to zero.  Now there's talk of making all hedge funds publish their short positions - all in the hopes that those pesky speculators won't be able to destroy stock prices so fully and so quickly.  (Really, though, the most effective regulation might be to take a page from Russia's playbook and just shut down the whole exchange for a week.)

On last interesting tidbit - is anyone else struck by the news that Morgan Stanley (the investment bank that advised the government in the AIG deal) is now looking for buyers, possibly in China?

Looks Like America's Got A Credibility Problem

The United States, the champion of the free market, "the beacon of unfettered, free market capitalism", has implemented a policy "that the most liberal Democratic administration would [have never implemented] in its wildest dreams," says Ron Chernow, a leading American financial historian in today's NY Times. Interesting observation. But even more interesting is the effect that this bailout policy may have on global perceptions of American free market capitalism and America's ability to dictate a global economic response to a future international financial crisis. 

I was in the process of putting together a post on the American paradox of nationalization and its effect on the global economy, when the NY Times stole the idea from my head and beat me to it by posting an article highlighting this effect on their website. I sat thinking earlier this evening about the financial policies that the United States has currently implemented in its financial market when facing a crisis, while at the same time prescribing to developing nations facing financial panic/crisis, a radically different approach. Essentially, the United States has instructed the developing world to deregulate, privatize their financial markets and not intervene during financial crises, even in the face of financial disaster. For example:

In parts of Asia, the bailouts [yesterday of AIG] stirred bitter memories of the different approach the United States and the International Monetary Fund adopted during the economic crises there a decade ago.

When the I.M.F. pledged $20 billion to help South Korea survive the Asian financial crisis of the late 1990s, one of the conditions it imposed was that the Korean government allow ailing banks and other companies to collapse rather than bail them out, recalled Yung Chul Park, a professor of economics at Korea University in Seoul, who was deeply involved in the negotiations with the I.M.F.

If the United States is not going to follow its own advice of not intervening in its own financial market to bail out failing domestic firms when staring down one of the biggest financial crises in its history, why should/would any other nation follow the non-intervention policy when a similar financial panic occurs in their economy?

Has the United States lost all credibility to prescribe strict free-market, non-interventionist solutions to financial panic around the world? Has it lost its ability to place conditions, including massive privatization and deregulation, on its development loans even though it seemingly nationalizes and regulates when it deems it necessary? It sure looks like it. 

Finally the Truth is Out....

"Congress is unlikely to pass new legislation to overhaul financial regulations this year because ``no one knows what to do,'' Senate Majority Leader Harry Reid said today. ``We are in new territory, this is a different game,'' Reid said at a briefing in Washington. Neither Federal Reserve Chairman Ben Bernanke nor Treasury Secretary Henry Paulson ``know what to do but they are trying to come up with ideas,'' Reid said."

Reid's remark prompted a masterfully understated response from Senator Mel Martinez (R-FL), who noted that Reid's comment is unlikely "to inspire confidence or begin to turn the tide on some of this.''

Unwilling to do nothing, however, Reid instead proposes a second fiscal stimulus package and a $25 billion loan to the US auto industry.

Gallows Humor

Does this mean that the central bank of the United States is now the main sponsor of Manchester United? As a Liverpool supporter, I'd certainly hope not. But if so, can the Fed be considered independent any longer?

If the Fed's next action is to lend money at low rates to the Chicago Cubs so they can re-finance their exorbitant free agent acquisitions, then I'm joining the Ron Paul rEVOLution in calling for the abolishment of the Fed. That would be the last straw for this St. Louis Cardinals fan.

Risky Business

Continuing the incredulous unraveling of the financial markets, AIG has become the latest recipient of US Fed and Treasury orchestrated and US tax-payer funded bailout (see here - NY Times free account needed - and here).  Adding to mass hysteria is knowledge that a prominent money market fund dipped below a $1 NAV yesterday (it sounds mundane, but basically realizes risk in the traditionally most riskless and liquid asset class available).

It's hard for most to conceptualize just how recent events on Wall Street will effect the global financial environment, mostly because the financial instruments that got us into this mess by failing to accurately assess risk are so hard to understand (see here for a basis primer on derivatives).  The proliferation of esoteric credit derivatives on the global financial market has made a lot of people a lot of money, but it's also contributed to increased opacity of information and a decrease in the ability of governments to regulate.  And now, the chickens are coming home to roost.

As Alex mentioned in his previous post, the events of the past few weeks (and really the past six months) beg the question of what appropriate regulation looks like and how to get there.  In an interconnected financial world, how much space are we willing to give to free market machinations?  When do you think the government, governments, or institutions should step in, if at all?  How will the effects of a systemic under-estimation of risk change investor behavior going forward (especially large investors like oil-rich countries and sovereign wealth funds)?

Cooperation in the International Financial System

As you may already know, Lehman Brothers, one of the largest investment banks in the world, filed for bankruptcy today after a very long weekend of negotiations that included the main power players of American (world) finance, could not save the investment bank from failing. The Federal Reserve Bank and the US Treasury drew the line this time around and firmly held that they would not provide tax payer money to rescue the investment bank or facilitate a takeover of the troubled firm by another institution (as they did in the Bear Stearns collapse in March) and that the market itself would have to find a solution to the problem or allow the bank to fail.

The New York Times had some interesting analysis on the around the clock negotiations that occurred over the weekend. They paralleled the weekend negotiations with a similar round of talks that occurred during a bank run in the early 20th century:

Over the weekend, the Federal Reserve Bank of New York called together the leaders of most major financial firms in an effort to get them to act collectively to stem any possible panic, but could not force a deal.

In a way, that was similar to what happened a little more than a century ago, when the financier J.P. Morgan called the heads of all the trust companies in New York to a meeting in his library, and demanded that they agree to put up money to stop the bank run at another trust company.

The bankers did not want to do so, in part because they would need that money if the panic spread. Morgan locked the door, and kept the presidents in the library until morning, when they finally gave in. No such coercion exists this year.

This very interesting narrative got me to thinking. How does cooperation come about in the international (or domestic) financial system? Does a coercive mechanism have to be in place to in a sense force the hands of other firms to produce the liquidity necessary to save another financial institution? Do these institutions have to be coerced by the government, a central bank or another mechanism to take over a failing entity? Is it in the best interest of competing financial firms to bail out a competitor in order to ensure confidence in the financial market? Does the government have any responsibility to bail out a failing firm? How do we deem when a firm is too big to fail? Who deems it to big to fail and who saves it from failing? Fascinating questions that would make for an interesting research program (ahh dissertation!)

What do you think? Discuss!

Good Discussion of the U.S. Economy

Robert Rubin and Lawrence Summers were on Charlie Rose a couple of nights ago. The conversation was very good, although Rubin and Summers are both more pessimistic than some other economists. They spent most of their time discussing ways to improve the U.S. economy in the future, and the dangers of playing political games while the nation's economy burns. The entire episode may be watched here, but a snippet is below.

Big Win for Russia? Nyet.

(red line: U.S. stock index S&P 500; blue line: Russian stock index RTSI)

The Russia/Georgia conflict has gotten a lot of attention from IR scholars and public commentators. Some have noted that Friedman's "Golden Arches Theory of Conflict Prevention" has now been definitively disproved, others have questioned whether or not "democratic peace" theories should also be cast aside. Still others see a return to the Cold War on the horizon, and think that the redux may be a bit hotter than the original.

But not very many people are talking about the economic consequences of the conflict for Russia and Georgia. They are... not good. The Financial Times has been doing a lot of good reporting on the Russian side, and things are not going well:

An exodus of foreign capital is forcing Russian banks to slash lending as the international reaction to the country’s military standoff with Georgia starts to affect the real economy.

Bankers say Russia is facing its worst crisis since the August 1998 default. The Russian stock market has plummeted more than 40 per cent since May. A flight of capital estimated by analysts at up to $20bn (€14bn, £11bn) since the start of the conflict is drying up liquidity. The Russian Trading System index fell another 7.5 per cent on Tuesday to its lowest level since June 2006.

The rouble fell to its lowest point since the Russian financial crisis of 1998. Putin and Medvedev are in a public squabble over whether this trouble is related to the Russia-Georgia conflict, but I know of no neutral observer which doesn't think that some, not all, of the recent financial and economic trouble in Russia can be blamed on a lack of investor confidence caused in part by the Caucasian Conflict.

What's striking is that this is going on while the price of oil is still fairly high and while there are major concerns about the safety of U.S. bonds and securities. Russia, along with other commodity-rich countries, should be benefitting from the U.S.'s troubles. Indeed, some of them are, but Russia isn't. Georgia isn't doing very well, either.

What does it all mean? Daniel Drezner thinks that a more globalized world makes war more costly, and therefore less likely. Russia and Georgia both acted belligerently, and both are paying a big price, despite the fact that there have been no economic sanctions placed on either. It is true that wars are more costly if the opportunity costs (i.e. lost trade and investment) are greater, but is that enough to prevent wars that might otherwise occur? A wiser man that I will have to answer that question.

Fannie, Freddie, and International Relations

Fannie Mae and Freddie Mac, the quasi-private investment groups that own or guarantee roughly half of the U.S. mortgage market, have now effectively been nationalized. The purpose of this blog isn’t to run-down all of the domestic effects of this (for that, see Brad DeLong and Calculated Risk, and keep in mind that Fannie & Freddie own or guarantee about $6 trillion in American mortgages), but there are implications for IPE study as well.

For example, central banks, sovereign wealth funds, and other international investors bought heavily into Fannie Mae and Freddie Mac, because they were under the impression that the investments were as close to riskless as one could get*. As Treasury Secretary Paulson noted, nearly $5 trillion in Fannie/Freddie debt and securities are owned by investors all over the world. To put that into perspective, the combined GDP of the U.K. and Italy in 2007 was less than $5 trillion. There is simply no way that the U.S. Treasury could let the companies fail and allow those nations (and other investors) to take a hit that big. If they did, says Tyler Cowen, the effects would be catastrophic:

The flow of capital from them and from other central banks, sovereign wealth funds, and plain old ordinary investors would shut down very quickly. The dollar would fall say 30-40 percent in a week, there would be payments system gridlock, margin calls at the clearinghouses would go unmet, and only a trading shutdown would stop the Dow from shedding half its value. Most of the U.S. banking system would be insolvent. Emergency Fed/Treasury action would recapitalize the FDIC but we would lose an independent central bank and setting the money supply would be a crapshoot. The rate of unemployment would climb into double digits and stay there. Many Americans would not have access to their savings. The future supply of foreign investment would be noticeably lower. The Federal government would lose its AAA rating and we would pay much more in borrowing costs. The deficit would skyrocket.

Tyler Cowen isn't known as a pessimist, but considering that “when the U.S. sneezes, the world gets a cold,” the prospects for international financial markets as a whole could have been catastrophic if the U.S. had not acted. In short, it’s likely that international political concerns, such as maintaining the credibility of the U.S. government in the eyes of other foreign nations, have essentially forced the Treasury Department to step in, even if they didn’t want to.

The news of nationalization was greeted warmly by nearly everyone. The announcement was made yesterday for the benefit of foreign financial markets trading overnight, and those markets responded by posting large gains. The heads of the European and Japanese central banks spoke positively of the take-over. There is still some pain ahead, especially for domestic banks, but by nationalizing Fannie and Freddie the U.S. Treasury may have dodged a bullet. At least temporarily.

*As it turns out, they were right: these investments were largely riskless since the implicit guarantee of the debt by the U.S. government has now turned into an explicit guarantee. Are there moral hazard concerns? You betcha. But, as the saying goes, "in the long run, we're all dead."

[UPDATE: U.S. markets posted huge gains today in response to the bail-out news. The dollar gained against the Euro, Pound, Swiss Franc, and Yen.]

The Ford ECOnetic is on sale, but not in America

Business Week has a very interesting article this week detailing an often overlooked consequence of the relatively weak US dollar. The Ford ECOnetic, a 65 mpg vehicle that goes on sale in Europe this November, is part of a new line of clean diesel engine vehicles that are roughly 30% more fuel efficient and as clean or cleaner than traditional gasoline engine vehicles. However, don’t expect to see this more efficient, clean diesel car at your local Ford dealership anytime soon.

The reason? The Ford ECOnetic’s diesel engine is manufactured in England, where labor costs are significantly higher than other vehicle manufacturing countries such as Mexico and Brazil. The higher labor costs coupled with the weakness of the dollar relative to the British pound, has led Ford to conclude that the vehicle would not be price competitive with cars already available on the US market. The relative strength of the British pound (the exchange rate is currently 1.7687 USD to 1 GBP) has significantly increased the cost of importing the vehicle into the United States, thus increasing the price tag that consumers would have to pay.

When analyzing the impact of currency levels on trade, most analysts simply point to the fact that the weakness in the dollar has led to a decrease in total imports and an increase in total exports. However, the most interesting consequence of this phenomenon is not that the weak dollar has increased net exports, but that there is evidence to suggest that the dollar’s weakness has constrained the variety and quality of goods available in US consumer markets. International economic theory is in line with what we are currently seeing with the Ford ECOnetic. Economic theory would imply that a relatively weak currency will constrain the variety of goods available in the domestic market as goods that normally would be imported would be priced out of the domestic market because of the weakening domestic currency. This is a consequence that is often overlooked by American consumers who typically tend to believe that the same goods will be available in their grocery stores or their automobile dealerships regardless of the level of exchange rates. 

Check out the article here: Ford ECOnetic

I Walk the Line...

The Fed's job is to create moral hazard. Discuss.

Export Boom Helps Factories Too

The NYT recently ran a misleading story about US exports. The Washington Post today compounded the error by publishing an opinion piece that cites the misleading Times article to justify skepticism about trade. This seems to offer the opportunity to see if I remember how to do this.

The take away point from the NY Times' story is that good news about exports is actually troubling news. For [although] "exports are the bright spot this year in an otherwise bleak economy...the world is not suddenly snapping up made-in-America goods like aircraft, machinery and staplers. The great attraction is decidedly low-luster commodities like corn, wheat, ore and scrap metal."

It turns out, however, that the world is actually buying more planes, machinery, and staplers from the US this year than it did last year. (Okay, I don't know about staplers specifically (which I don't think have been produced in the US for ten years), but consumers goods more broadly) The graph below makes this point explicitly by comparing non-agricultural exports each month in 2007 and 2008. It clearly indicates that American exports of manufactured goods are unambiguously greater in each month of 2008 than in the same month of 2007.




If you were the curious sort, you could go to the BEA website and download the data required to conduct comparisons for civilian aircraft, capital goods (machinery), and consumer goods (and maybe even automobiles). Were you to do so, you would find that in each of these categories, the world has purchased more from the US in 2008 than it did in 2007. Thus, the export boom is helping American factories, too.

Running on Empty

Macroeconomic stability, reserve accumulation, and debt relief in emerging market economies is creating budget problems for the IMF. As The Economist reports, "Its $1 billion budget is traditionally funded by the small profit it makes on lending money to cash-strapped countries. But IMF lending has collapsed in recent years as developing countries have improved their economic management. As a result, the fund looks set to run a deficit of some $400m a year for the foreseeable future."

One might think, "Right then, job well done. Last one out please turn off the lights." After all, the current placid environment reflects in many respects the end of an era that began 35 years ago with the first oil shock. Developing countries developed balance of payments problems in part (though not solely) as a consequence of the negative shocks directly and indirectly generated by the first oil shock. Governments turned to the IMF for assistance and reform. In a very broad sense, one might conclude that although it did take a long time for these problems to work their way through the system, they have finally done so.

This final working out has had two consequences. On the one hand, governments in developing societies have reflected (if that is possible) on the lessons and concluded "never again." Their response has been to recognize the importance of a stable macroeconomic environment and to accumulate foreign exchange reserves as insurance against external shocks. This is especially the case in East Asia, but ever more so in other parts of the world too. Hence, less demand for IMF resources and macroeconomic stabilization. On the other hand, because of these changes, the IMF has a vastly reduced role to play in the global economy.

If ever there were a time at which one could restructure the IMF, this is it. Yet, organizations persist. So, rather than liquidating the fund, or finding ways to fundamentally reduce its scale to bring it in line with current demand for its services, the Fund and the G7 governments are searching for alternative sources of revenue. The most popular source is the sale of some of the IMF's gold holdings (of which it holds 103.4 million ounces, currently valued at around $92 billion). The proceeds would then form a fund that would generate an annual revenue capable of contributing to the budget.

It will be interesting to watch this unfold over the next couple of months. Gold sales require Board approvals, and last time the issue arose (1999) the US Congress was not so keen to see this development. Let's see if they are any more keen this time around.