Sunday, December 7, 2008

Why citizens need to express their opinion (and maintain hope)

Painting by Aafke Steenhuis
Everyone who is in a position to do so, should get involved with thinking and discussing ways to solve the current international financial crisis. “Don’t leave it to the economists!” warned Robert Triffin when I interviewed him more than twenty years ago in Louvain-la-Neuve. “Just as Clemenceau once said that war is much too serious a thing to be left to the generals, I think the economy is far too serious a thing to be left to the economists.”

Talking to friends and people I meet I notice disbelief and distrust that “normal citizens” can contribute to addressing the financial and “real” economic turmoil. Others, who write critically about the crisis in articles and blogs, seem to be absorbed by anger and a feeling of powerlessness and describe as gloomy a picture as possible – without hope.

We will not get a more stable, just and democratic system if citizens around the world keep feeling powerless. We better increase their (our) empowerment by imagining alternatives. The policymakers need democratic guidance; they need our views. Even though they might have some good ideas as to how to solve the crisis, we still need much more democracy in economic policymaking.

To keep things simple, I see three levels at which citizens can contribute. First, at the level of daily conversations with friends and others – stimulate each other to increase your knowledge and express your opinion. Second, at the level of public opinion – contribute to public debates in meetings and in media (including blogs). Third, at the level of discussions among economists – explore strategies that are broader and/or more in-depth than mainstream opinion among colleagues, and dare to be non-confirmist.

Citizens around the world, awake, and don’t feel powerless. Ask around, read, be informed and express your opinion.

Wednesday, December 3, 2008

The credit crisis and the crisis of capitalism

The credit crisis is a sign of deep problems of the capitalist world. But these deep problems are hardly considered by mainstream economists and policymakers trying to solve the crisis. Both groups tend to limit their scope and view. They see the resolution of the credit crisis mainly in terms of improved regulation and, possibly, some minor changes in the global monetary and financial system.

However, this is not the best way to find a long-lasting solution. Even though earlier crises were solved in the same way and even though the capitalist system has proven to be able to adapt itself to new circumstances, a broader approach is needed.

"Capitalism" and "capitalist" societies show different varieties. Capitalism in Germany is different from that in France, and capitalism in the US is different from that in China. The US is often seen as a "pure" or neoliberal capitalist society, but it has many governmental business-supporting institutions and mechanisms. Private companies are grateful for these mechanisms and have no problem in asking for government support, neither yesterday nor today. On the contrary, commercial banks and other companies have asked for massive government support and still continue to do so. And both the US government and European governments have been willing to provide the hundreds of billions of dollars private companies asked for.

The above illustrates two serious problems with the current steering of capitalist economies. First, there is a lack of vision in the policies pursued so far and envisaged tomorrow. Second, there is a lack of ideas and institutional mechanisms to make the economic policymaking more democratic.

The resolution of the credit crisis still lies in the hands of a very limited group of economists and policymakers. The rest of the world is merely bystander – hoping for the best.

"Dreaming" about ways to tackle the democratic deficit in economic policymaking is not a childish hope (see my post of November 27). It is an ideal politicians and citizens around the world should energetically defend. Addressing the democratic deficit in economic policymaking is one of the great challenges of our times. Citizens and politicians should take this challenge much more seriously.

Monday, December 1, 2008

Bill White: "The current financial system is inadequate"

On this blog I have included on various occasions the views of Avinash Persaud and Bill White (see e.g. posts of June 29, May 7, and May 4, 2008). A few days ago, Avinash sent me an e-mail to thank me and others for the support we gave to his work "on the inevitable failure of banking regulation". He referred to a column by Martin Wolf in the Financial Times who had praised, among others, Bill White and Avinash for their excellent writings on the dangers of a credit crisis.

I would like to draw your attention to a speech made by Bill White on the prevention and management of financial crisis. In the speech he addresses the important issue of whether the current international financial architecture is adequate.

"My answer must be that it is not," says Bill White. "Financial crises are generally enormously costly, and we have been faced with them repeatedly over the course of the last few decades. Indeed, we are currently in the midst of a crisis which, being at the heart of the global financial system, could turn out to be the worst of them all."

If you want to read Bill's analysis you can click here.

Thursday, November 27, 2008

Childish hope

When making coffee in my Bialetti Venus 4 I thought: the reason I have difficulty in writing that long article which includes the views of Triffin, Witteveen, D'Arista, Kenen, Williamson, Sheng, Persaud, Woo and others is that I realise too many written pieces are waiting to be read, and long articles will never be read seriously, I mean seriously by people who should read them as they are the ones taking decisions about the future course of the world economy.

I also thought: the plea, the longing in my post of yesterday is too idealist, too childish, because how can you expect or hope (esperar expresa ambas cosas) that we may live one day in a world where everybody has equal chances?

However, it is that hope or longing that inspires my work.

Wednesday, November 26, 2008

Is it too early?

Who has a vision of the future of global finance and the global economy? It seems that most social scientists and other thinkers are absorbed by crisis management.

Is it too early to think about a different world, a world where everybody is enjoying economic stability and the benefits of economic welfare?

Is it too early to envision the vision, the global institutions and the global and national institutional attitudes needed to realise such world?

Monday, October 13, 2008

My uncle Gino's advice

When I look at my face in the mirror while shaving my beard, I always think of my uncle Gino from Toronto, who used to give investment advice (he had his own investment letter for many years). One morning, the only morning I stayed at his home near Toronto, he told me that I did not need to hurry when shaving, as this would not finish the job more quickly. "Just do it quietly," he suggested.

This morning I had to think of my uncle Gino's advice when I was hurrying back to my computer to finish a post I've wanted to write for a long time, about visions of the future of finance in the global system. Why should I be in a hurry, I said to myself, if it won't speed the writing of a good piece?

The picture shows my uncle Gino in his youth, in the Netherlands. He died a couple of years ago, in Canada, the country that had become his new home when he emigrated in the late 1940s or early 1950s. I know him as one of my many uncles and aunts in Canada (my brother also lives in Canada). Gino was a successful investment adviser until he lost his money, not because of an international credit or debt crisis but because of something else.

PS: I see that the original date of drafting the first two paragraphs of this post appears as the date of this post. However, today it's 25 November 2008 and not 13 October 2008, so "normally" I would have felt that I should hurry to finally finish that post on visions of the future. But, listening to my uncle Gino's advice and seeing the speed of information and the speed of financial transactions as one of the problems of global finance and development, I know that slow writing (and slow financial transactions) may make a better contribution to world stability than all this frenzy chasing after financial news and financial opportunities.

Es esa locura de "breaking news" y "today's financial opportunities" (Act now!) en que vivimos que es una de las causas de la crisis... It is this madness of "breaking news" and "today's financial opportunities" in which we are living that is one of the origins of the crisis...

Monday, October 6, 2008

Solving the credit crisis: we need a visionary view

To understand the functioning of the global financial system, prevent its crises and propose a better system, is a tremendously challenging job. No economist alone or group of economists would be able to do that job. In order to do it properly, one needs an overview and comprehensiveness of knowledge (including that of the other social disciplines) that economists alone cannot possess. Thinkers from other disciplines are needed as well.

Most officials working at ministries of finance and central banks see it differently. They still think they can do the job. However, we do not only need technical expertise but also a broad and in-depth view that takes into account how the system works for all citizens, rich and poor.

OK, I agree, the most urgent job for officials is now to manage the crisis as good as they can, and make steps towards a better regulation of financial markets. But even accepting the adagio that “only small steps are possible”, we still need a broad, visionary view of the system.

Can we create such visionary view? How?

Saturday, October 4, 2008

The last laugh

In the media and the bakery shop around the corner, I hear more and more people say that the global financial system is ludicrous. Yesterday, in my daily newspaper NRC Handelsblad Dutch writer Willem van Toorn said, "It is amusing for the outsider that the army of economists, who always have said to us with serious scientific economic faces that we should not stop growing, now do not seem to have any scientific text available and instead speak with deep concern about 'the emotion of the market'."

Willem van Toorn's concern (and amusement) with economists was shared the day before in the same NRC Handelsblad in a column by Jan Sampiemon, a former Chief Editor for Foreign Affairs and former Deputy Chief Editor of NRC Handelsblad. He said:

"European politics followed until the beginning of this week European business, which was captured by the new US managerial capitalism. … Among other things, you recognise an ideology by the commonness of opinion among nearly all those who are dealing with the issue as economist, politician, CEO or journalist. Relevant questions were not raised. 'Fundamentals' could not be debated and scientists who raised critical questions were turned to the corner where they could puzzle over their stalled career."

I circulated these two quotes among a number of economists of my FONDAD Network (the group is larger than the link indicates) and in response one of them sent me a nice video clip. I think it will make you either smile, burst out in laughter, or laugh like "een boer met kiespijn" (a farmer with toothache), as the Dutch expression goes. According to my dictionary the English would say, "laugh on the wrong side of your face (mouth)".

Thursday, September 25, 2008

Fixing the financial crisis: an agenda for regulatory reform

I read a paper I like a lot. It has been written by Jane D’Arista and Stephany Griffith-Jones, two experts in international finance, both concerned with the functioning of the global financial system, its current crisis and its (likely) effects on people less fortunate than the rich.

The paper is called “Agenda and criteria for financial regulatory reform” -- a key issue that needs to be addressed urgently. In my view, all policymakers, officials, opinion-makers (any academic teaching or writing is an opinion-maker) or other person interested in the current financial crisis should read the paper and, if possible, do something with it.

The first introductory paragraph is worth quoting fully:

“The severe turmoil in the most “advanced” financial markets that started in the summer of 2007 follows many deep and costly financial crises in the developing economies during the last twenty five years. This more recent crisis, like previous ones, is the result of both:
(a) inherent flaws in the way financial markets operate – such as their tendency to boom-bust behaviour – and
(b) insufficient, incomplete and sometimes inappropriate regulation.
Financial crises tend to be very costly from a fiscal point of view (i.e., that of the taxpayer), from their impact on lost output and investment, and from their impact on people, many of whom are both innocent bystanders and poor.”

The second introductory paragraph is also worth quoting fully:

“It is therefore urgent and important to reform financial regulation, so that it makes financial crises less likely in the future. Those new systems of financial regulation should attempt to deal with the old unresolved problem of inherent pro-cyclicality of banking as well as financial markets. They should also deal with such new features as the growing scale and complexity of the financial sector, the emergence of new, as yet unregulated actors and instruments, as well as the increased globalization of financial markets. To do this adequately and to avoid regulatory arbitrage, regulation has to be comprehensive.”

As the remainder of the paper is 25 pages long, I cannot continue quoting every paragraph I like. So let me just highlight a few of the insights the paper provides.

“A key market failure in the financial system is the pro-cyclical behaviour of most financial actors, which leads to excessive risk-taking and financial activity in good times, followed by insufficient risk-taking and financial activity in bad times. As a consequence, a key principle and desirable feature for efficient regulation is that it is counter-cyclical, to compensate for the inherent pro-cyclical behavior of capital and banking markets.”

“After the eruption of the sub-prime mortgage crisis in the summer of 2007, criticisms of past and present policies of the Federal Reserve and other regulatory authorities became more frequent. (…)The Fed’s monetary influence weakened as it gave priority to deregulation and innovation and abandoned credit flows to the procyclical pressures of market forces, ignoring ways in which monetary policy itself had lost its ability to stabilize financial markets and the economy. It paid no attention to the way that foreign capital inflows drove up the supply of credit and failed to notice the explosion of debt that unchecked credit expansion produced. And, as debt soared, the Fed ignored the asset bubbles it fueled. (…). Together with its failure to criticize and curb abusive lending practices, the Fed’s passivity in responding to major changes in financial structure and regulation contributed to the prolonged and pervasive reach of the credit crunch that the sub-prime mortgage defaults unleashed.”

“Over the past 30 years, the US financial system has been transformed by a shift in household savings from banks to pension and mutual funds and other institutional investment pools. (…) The implications of these shifts in saving and credit flows have radically altered the way the financial sector functions, reducing the role of direct lending in favor of trading, investment and asset management.”

“At [a] 1993 conference, former Bundesbank Vice President Hans Tietmeyer’s … argued that, in a number of countries, deregulation and financial innovation had altered the transmission mechanisms for monetary policy to the real economy and had “generally made it more difficult for monetary policy makers to fulfill their stability mandate”.

Subsequent events have underscored the accuracy of these remarks. In the 15 years since they were made, however, the major central banks have taken no steps to improve the monetary transmission mechanism. On the contrary, they countenanced further innovation and deregulation and promoted the view that market-based solutions … could replace the quantity controls (reserve and liquidity requirements, lending limits and capital controls) that had been targeted for removal by the advocates of liberalization.”

When Jane and Stephany come, on page 12, to their criteria and principles for financial regulatory reform, the paper turns too detailed that it allows for quoting. You can read the full paper on the Fondad website, under “Other Publications”.

There is one concluding remark with which I like to finish this post:

“The discussion of a global financial regulator needs to be put urgently on the international agenda. In the meantime, efforts at increased co-ordination amongst national regulators requires top priority. It is also urgent that developing country regulators participate fully in key regulatory fora, such as the Basle Committee. Given their growing systemic importance, it is absurd and inefficient if they do not.”

Sunday, June 29, 2008

Three schools of thought on crisis prevention

A few months ago Bill White, chief economist of the Bank for International Settlements (BIS), made an interesting speech stressing that "the first and crucial point" for proposing solutions to the credit crisis is "agreement on the nature of the problem". I think that the lack of such agreement is one of the reasons the credit crisis still lingers on. It also tells us that the risk is great the crisis will not be tackled in a fundamental way -- not even in the moderate way suggested by Bill White and some of his colleagues at BIS.

What are the underlying causes of the current financial turmoil? Bill White sees at least two schools of thought: one that asks itself "what is different", and the other, "what is the same". Most analysts follow the first school of thought, but Bill and some of his colleagues at BIS see more value in the second school. Why? Because the financial system "is inherently procyclical and thus chronically prone to bubble-like behaviour", argues Bill. To remedy this procyclicality we need a "new macrofinancial stability framework" (see also Bill's chapter in a recent Fondad book, "The Need for a Longer Policy Horizon: A Less Orthodox Approach").

Bill White observes that the school of "what is different" focuses on new developments in financial markets. Emphasis is put on the massive expansion of the subprime mortgage market in the United States, the growing use by banks of the originate and distribute model, the reliance on off-balance sheet vehicles, the development of new structured products, and the reliance on ratings agencies in marketing them.

"These new elements, originally thought likely to produce a welcome spreading and diversification of risk bearing," observes Bill White, "seem instead to have materially reduced the quality of credit assessments and also led to increased opacity. The result has been the generation of enormous uncertainty both about how large the prospective losses from defaults might be, and about where those losses might be concentrated. In this environment, everyone has become suspect, including the large banks at the heart of the financial system. Market liquidity and funding liquidity dried up, and the interbank term market effectively closed down. Moreover, there were significant knock-on effects, initially on other markets that rely on the interbank market for price fixing, but subsequently on a whole host of other markets where asset prices were considered to be richly valued."

"If it is these new market developments that have been responsible for the observed turmoil," says Bill, "then this suggests solutions that seek to preserve the benefits of the new products while reducing the unwelcome side effects. In the short term, this would imply injections of liquidity by central banks, and potentially other government agencies, to reliquify markets."

Bill's concern is that, in the aftermath of most historical bubbles, the focus of attention shifted to new instruments and techniques and the role they played in the process, while the key factor - leveraged speculation - was commonly ignored. "Evidently, it is more comfortable for all concerned to blame the essentially unpredictable side effects of new developments than to admit to having failed to see the build-up of all too traditional exposures."

Following the second school of thought Bill White asks himself what is the same about the current market turmoil compared to previous financial crises. His answer is "that in virtually every case, the crisis was preceded by very rapid credit expansion, which manifested itself in part in higher asset prices." These gains provided the collateral to justify even more lending and increased the appetite for risk-taking, on the side of both lenders and borrowers. As a result, leverage increased even as the general quality of credits deteriorated, and investment and consumption went beyond long-term trends. "At a certain point, usually when earlier expectations about profits or future income growth began to look unrealistic, this whole endogenous process went into reverse. In effect, boom turned to bust."

Based on the historical evidence
Bill makes two observations. "The first is that the moment of change generally arrived completely unexpectedly, with the trigger for the event commonly being far too inconsequential to explain the resulting mayhem. This is precisely because a "trigger" is not the underlying "cause" of the problem. A second observation is that the turning point was almost never preceded by any significant degree of inflation. In particular, prices were falling in the United States in the late 1920s, were rising only very slowly in Japan in the late 1980s, and averaged only around 4% in Southeast Asia when that crisis hit in 1997."

What are the characteristics of the "new macrofinancial stability framework" suggested by Bill White?

"The first characteristic of such a framework would be a primary focus on systemic developments. In particular, attention would be paid to the dangers associated with many people and institutions having similar exposures to possible common shocks. The recognition of endogenous forces with potentially non-linear outcomes would be a further important theme. Evidently, this would not reduce the attention paid to the good health of individual institutions, but it would put such concerns into a broader context.

A second characteristic would be still closer cooperation between central bankers and regulators in assessing the build-up of systemic risks and in deciding what to do to mitigate them. What is needed is to find the point of optimal interaction between the more top-down approach of central bankers and the traditionally (though this is changing) more bottom-up approach of the regulators. Each perspective has much to offer. As an aside, such closer cooperation need not, though it could, imply a reversal of recent trends towards setting up independent regulatory agencies with responsibilities for both financial institutions and financial markets.

A third characteristic would be a much more "symmetrical" or countercyclical use of policy instruments. In this regard, the new framework would simply mirror the accepted wisdom for the conduct of fiscal policy: namely, that the good times should be used to prepare for the bad.

More specifically, monetary policy would lean against "booms" in the growth of credit and asset prices, particularly if accompanied by distorted spending patterns that opened up a real risk of subsequent reversal. This latter point is crucial if we are to distinguish between what is being recommended here and the quite different proposition of "targeting asset prices". Regulatory policy would have a similar bias, with risk spreads (for expected losses), provisioning (for subsequent changes in expected losses), and capital (for unexpected losses) being built up in good times and run down in bad."

Hervé Hannoun, the deputy general manager of BIS, added in a recent speech that there are three schools of thought on financial crisis prevention:

– The first school of thought considers that it is illusory to "lean against the wind". Asset price and credit booms are not preventable, and the real policy issue is to be ready to "clean up the mess" when the bubble bursts.
– The second school of thought considers that it is desirable to lean against the buildup of serious financial excesses. But monetary policy cannot deal with financial bubbles and asset price exuberance. Prudential and supervisory policy is instead the right tool for that.
– The third school considers that both monetary policy and macroprudential policy can and should be used to lean against the wind. A macrofinancial stability framework should be implemented to pre-empt financial excesses and "serial bubbles".

Hannoun emphasises that the third school of thought, the "macrofinancial stability framework" school, recommends leaning against the wind by making use of both monetary and supervisory instruments to pre-empt serious financial excesses.

"In this conception, macroprudential policy (the supervisory tool) has a crucial role to play in reducing the procyclicality in the financial system. But monetary policy also has a role to play in that respect. The recent financial turmoil suggests that monetary policy may have to counteract excessive credit expansion and asset price booms even if price stability were achieved. The key argument is that central banks should not rule out leaning against the wind by raising interest rates to stop asset price bubbles and credit booms from getting out ofhand: in other words, prevention is better than cure."

Bill White warns that the difficulties we face today in financial markets, with their potential to have significant effects on the real economy, indicate clearly that the costs of not having a new macrofinancial stability framework could be large.

Tuesday, May 20, 2008

Asset Bubbles and Inflation

Wing Thye Woo sent me a piece on the state of the US and global economy identifying the financial markets as the flashpoint of the problem and asked if I could post it on the Fondad website (you can find it there under “Other Publications”) and circulate it among friends to get feedback. The first thing I did was circulate it among a small group of the Fondad Network and this prompted a debate among a few of them on which I report.

The first one commenting on Wing’s piece was John Williamson. He said that he was in general agreement with Wing’s paper, except that he did not think Wing had made the case for departing from targeting inflation as an objective.

“His argument can equally well be taken,” said John, “to suggest that central banks should examine phenomena like what is happening in asset markets when they assess the implications of current policies for future inflation levels. One might still have times when the criterion suggests the desirability of tightening monetary policy despite a current inflation rate that looks under control. But if in fact the assessment is that asset markets are inflating for rational reasons that cannot be expected to blow up, then surely it is appropriate to let it happen. (And I am not persuaded that one should rule out this possibility by assumption.)”

Wing responded, “I agree totally that it is not always possible to separate asset bubbles from fundamentals-driven asset price increases. I do think, however, that there are some occasions where many reasonable observers could identify bubbles, e.g. the Chinese stock market in 2007. Of course, unanimous agreement is not possible because, if it were possible then there would be no trade in the asset. The Fed's job has just gotten a lot harder now that it finds that procedural simplicity is foolish when hard-to-identify events do occur.”

Then Andrew Sheng came in, commenting, “However difficult that a judgement has to be made, those in position of responsibility are paid to make that judgment. To say that it is difficult and you don’t have theory to help you make that judgment seems to be a cop out. The dilemma is that the cost of making a wrong call has either huge personal consequences or huge social costs.

The issue is whether you think monetary policy is interfering with the free market. If you believe that the market will take care of itself, let’s have no central banks and regulators. But if you have such institutions, someone must make the judgment call when a bubble is forming and when you have to lean against the wind.

What I have never understood is why the margin tool (lowering the loan to value ratio) was never used if there was reluctance to use the interest rate tool. We have seen it all before. When the bubble forms, we all say that this time it’s different. No, it’s not.”

Avinash Persaud added, “It is one thing to say that monetary policy should be mindful of not inflating asset market bubbles and another to say that it should try to prick bubbles. (Geneva Report 2 on Asset markets and central banks tackled this issue well.) While I believe policy as a whole should lean against asset market bubbles (the costs and consequences of not doing so are severe) it is not clear to me that it should be monetary policy that shoulders the burden or that it can do so well.”

Avinash went on, saying, “The level of interest rates required to prick a bubble in its most expansive state would be intolerable for the rest of the economy. (What level of interest rates would be required to prick a bubble based on a belief that property prices rise by at least 10% per year and where investors are 95% leveraged?)

Better then for regulatory policy to carry a large part of this burden.

Indeed, given that the principal purpose of regulation is to avoid systemic crises and the root of most of these crises is a prior asset market bubble, it would seem appropriate for regulatory policy to try to temper the increase in leverage that goes with bubbles. It would also mean that we would be “adding instruments” to macro policy at a time when liberalization and globalization has had the side effect of reducing instruments.

At the heart of most financial crises is leverage, the rise in leverage prior to the crisis based on some confidence that risk has fallen, and the subsequent deleveraging. Charles Goodhart and I have been working on a proposal to add a capital charge based on the rise in the leverage ratio above a pre-determined level. This may act as an added brake and a source of higher capital and reserves that can be used when the crisis hits.”

This prompted Andrew Sheng to say, “Avinash, I couldn’t agree with you more. Irrespective of regulators or central bankers or the division of responsibilities, a key issue is the choice of tools. You have either a price tool (interest rate) or the quantitative tool (leverage or credit supply). Hence, if you don’t want to use one, you may have to use the other.

The central bank is in charge of macro tools, but one of our dilemmas is that there is no accepted measure of macro-leverage. So, if you add the philosophy of minimally interferring with the market, then you are unlikely to use the leverage tool. Add in the confusion of responsibility whether the central bank is both a regulator and monetary policy agency, then the specialist regulators are waiting for signals from the central bank and individually in silos, they may not be able to stop the bubble forming.

Hence, you have to have a unified view whether a bubble is forming and someone has to take a lead in that judgement and decision. This is a matter of will, the willingness to make a judgment call and be evaluated by the market whether you avoided the bubble or not. What you and Charles have suggested is the micro-regulatory tool to ensure that individual institutions fine-tune their risk management. This is very useful but as we have learnt, these tools do not prevent greed of bankers from making all kinds of excuses, such as accounting and Basle rules, not to make the precautionary measures against taking on excessive leverage. The best rules do not stop bad behaviour. Strict and clear enforcement does.

Ultimately, it is the greed factor and the incentive structures, particularly personal interests, that drive the bubble and leverage forward. Central bankers have a fiduciary duty to somehow stop the ordinary crowd from allowing themselves to go mad. From time immemorial, leaders have to make personal sacrifices for the public good, this includes being blamed for taking or not taking key decisions. C’est la vie.”

Then Stephany Griffith-Jones commented, “I totally agree with Avinash. Particularly for developing countries it is crucial of course to include exchange rates as a key asset price.”

John Williamson rejoined the debate and said, “Bubbles are by definition movements in prices that cannot be explained by fundamentals like interest rates, so I agree hat it would be foolish to rely on monetary policy pricking bubbles. That might easily involve intolerable strains on the rest of the economy. I think this consideration adds a reason as to why monetary policy should not follow the Woo formula of targeting a price level that includes asset prices, but that it leaves intact my version which says that the implications of any bubbles for future inflation should be taken on board by the central bank in formulating its monetary policy.

Where I do agree with the subsequent discussion is that regulation and not monetary policy should bear the main burden of curbing bubbles. Without having read the Goodhart-Persaud paper, it seems to me that their proposal is very much along the right lines and not primarily directed at microeconomic factors.”

Stephany's second comment was, “As I wrote, I strongly agree with Avinash and now John on the centrality of regulation to limit the increases in asset prices. It is very encouraging to see that so senior a policy maker like Mishkin is moving along similar lines that several of us have been developing for some time, (as reflected in today's FT, of 17 May, where he is quoted as arguing in favour of countercyclical regulation). It would be great for this group to come up with specific proposals on this aspect, building on the Goodhart-Persaud FT article, and their other work, on John's book, and on the work that José Antonio and I have done on countercyclical regulation, on the Spanish provisioning system, etc.

I think a key precondition for doing this effectively is far more complete information for regulators on what is happening in financial and banking markets, e.g. derivatives, so they can see where excessive TOTAL leverage is developing, including in areas with no capital requirements. Ideas like that of Soros to bring OTC derivatives on the exchanges- could be helpful to identify total leverage.”

The discussion goes on. Comments are welcome. You can also send them to my email address, to be found on the Fondad website under "Contact".

Wednesday, May 7, 2008

Dogmatic thinking

I don't like dogmatic thinking and dogmatic statements, but in several posts I have spoken about ministers of finance and central bank presidents as if they would be dogmatic thinkers by definition. Or, at least, that's the impression you may have gotten.

However, I'd like to stress that I do not think all ministers of finance and all presidents of central banks or all managing directors of the IMF, are dogmatic in their thinking, writing and speaking. Or that they are always dogmatic. How would I dare to think that!

I have high esteem for several (former) ministers of finance and central bank presidents (or their deputies) and I am happy that a few of them "belong" to the FONDAD international network. I don't need to mention their names, most of them you can find in the list of the FONDAD Network on our website.

Let me make one exception: Bill White (his official name is White, William). I have high esteem for his thinking and his commitment. I remember vividly how he shared with me many, many years ago, long before the subprime and credit crisis emerged, his concern about US credit markets. At the time, I understood that his public statements were more careful and less articulate, and I still understand that. For many years, I have also been more careful and less articulate than before I created FONDAD.

To finish this brief thought, I think you have to take into account certain roles you have to play. Being careful in your words does not mean you are a conformist. It may just mean that you apply a bit of self-censorship, for certain reasons. Whether those reasons are good, depends on your own assessment. Others have nothing to do with that -- unless you are interested in hearing their opinion.

Tuesday, May 6, 2008

A passionate view

There is one thing I'd like to add to the previous post, not an extremely important thing for those who like "pure" economic arguments, but a significant thing for those who like to look beyond numbers.

In the previous post, I only highlighted the gist of Avinash Persaud's article, not the flavour. I mean, he wrote the article in a personal way, with a personal voice, and I not only like that but also think it is significant when you make an argument. Let me illustrate my point by quoting the first paragraph of Avinash’s article:

"Flash back 10 years to May 1998. The Asian financial crisis is unfolding. I am sitting on the J.P. Morgan dealing floor in Singapore. My trip to Jakarta has been cancelled because of rioting. Students have been killed and women raped. Regional currencies are in free fall. Local equity markets are imploding. Credit-rating agencies are 'helpfully' responding by slashing credit ratings. The region's vaunted political and economic stability is collapsing before my eyes. On the Morgan dealing floor, we can't tear ourselves away from the electronic screens transmitting the bloodbath tick by tick. I feel the primordial pull and guilt of passersby to get a closer look at a ghoulish car accident."

In my view, writing style is more than style. It reveals emotions. Thinking about (financial) globalisation requires a passionate and a dispassionate view. The one without the other reduces economics to either numbers – in the case of a purely dispassionate view – or emotions.

Economics is not about numbers but about people. In another post, I'll say something about the need for a passionate view.

The photograph of the man on his chair comes from "U.S. Camera 1939", Edited by T.J. Maloney, and published by William Morrow & Company, New York.

Sunday, May 4, 2008

Bad economics

I like sound analysis and sound reasoning. I dislike "sound economic policies" as they usually refer to dogmas.

I like discussions in which good arguments are explained if needed, and I dislike discussions in which good arguments are dismissed (usually by economists vested with power) without considering them seriously.

I like simplicity where possible, and I dislike simplicity when complex analysis is needed.

With this, I would like to introduce Avinash Persaud, whom I see as a sound thinker whose thoughts should be taken more seriously by policymakers.

Avinash Persaud has written an article, “Financial Regulation: Sending the Herd over the Cliff. Again”, that he sent to me saying it will appear in the June 2008 issue of the IMF's Finance & Development. Its basic argument is that risk models of banks create a false sense of safety and make crises worse when they emerge. In 1998, when the Asian financial crisis unfolded, and Avinash still worked with J.P. Morgan, he “learned first hand that whereas risk-sensitive systems may help banks manage their risk during quiet times, they are not crisis-prevention measures: they make crises worse.”

In 1999, Avinash wrote a Prize winning essay, “Sending the Herd off the Cliff Edge: The Disturbing Interaction of Herding Behaviour and Market-Sensitive Risk Management Practices”, and noticed it was dismissed by regulators as “too theoretical or extreme”.

In his recent article, Avinash disagrees with the regulators’ charm with market risk models that banks use and their proposal to incorporate these models in the new rules of Basel II.. “The reason we regulate markets over and above normal corporate law,” says Avinash, “is that markets fail from time to time, with devastating systemic consequences. If the purpose of regulation is to avoid market failures, we cannot then use risk models that rely on market prices as the instruments of financial regulation. (…) Risk sensitivity as a regulatory principle sounds sensible only until you think about it.”

Avinash stresses that market failure relates to the economic cycle. Banks and markets underestimate risk in the up cycle and overestimate risk in the down cycle. “In an up cycle, market participants always see some new paradigm that tells them the cycle is dead or that it’s ‘different’ this time. (…) At the top of a boom, the risk models prescribed in Pillar 1 of Basel II, whether using market prices or the ratings of credit-rating agencies, will be telling banks that they are running less risk and are better capitalized than they will in fact turn out to be when the credit cycle turns.”

In Avinash’s view, Basel II is bad economics. “It tries to use market prices to predict market failures and destroys the natural, liquidity-inducing diversity in risk assessments. What it ends up doing is precisely what regulation should be designed to avoid: acting procyclically.”

Friday, April 25, 2008

The economy is too serious a thing to be left to the economists

A better management of the current financial crisis requires a profound analysis of its causes, a wise consideration of possible responses and a visionary view on how the global financial system could be improved to prevent, as much as possible, future problems.

This is not an easy task and is not what happens today.

Today we are seeing central bank presidents, whom we have given the responsibility to maintain a healthy national and international monetary system, and ministers of finance, whom we have given the responsibility to propose the best possible financial policies nationally and internationally, making statements that are proof of powerlessness or lack of vision, or both.

How to change this dangerous incompetence?

We, the peoples of the world who, when we are living in democracies, have vested responsibility and authority with ministers of finance and central bank presidents (to name just the highest in "authority"), are the only ones who can give the answer.

Economists should help us, with their technical knowledge and insights, to develop a vision of a global financial and economic system that would enable a fair chance and fair living for all, now and in the future.

Robert Triffin, a famous analyst of the global financial system, once said to me: “Just as Clemenceau once said that war is much too serious a thing to be left to the generals, I think the economy is far too serious a thing to be left to the economists.” (see the second para in my article "The International Monetary Crunch: Crisis or Scandal?")

Tuesday, April 22, 2008

Managing the crisis (1)

"Central banks have kept interest rates very low for many years. This has led many banks to seek juicy returns – to protect shareholder value, as they say – by taking unreasonable risks. This has also led to massive foreign exchange reserves accumulation all over the world. The great unwinding must now take place," said Charles Wyplosz in the Financial Times of 21 December 2007.

Yesterday, the Bank of England presented a rescue plan of 62.5 billion euros for commercial banks affected by the credit crisis, the largest rescue plan ever by England's central bank. One of the banks in trouble, the Royal Bank of Scotland, last year still celebrated its conquering of ABN Amro.

"The central banks have done everything they can to keep financial markets orderly. They have taken the risk of feeding the moral hazard beast and what did they achieve? So far, they have avoided the much feared Big Crunch, but the end of the tunnel is not yet in sight," said Charles Wyplosz in the FT of 21 December 2007.

Charles warned that "further cash injection (by central banks) will not provide the permanent solution – the return of interbank lending. For that to happen, banks need to be reassured about each other. Recapitalisation is the only solution."

He added, "If a company has suffered, or is about to suffer, heavy losses, its shareholders will have to partake in the trouble. Delaying tactics prolong the misery without solving the problem, which will not go away. We now see that the willingness of central banks to provide liquidity at reasonably low cost is only allowing the shareholders to delay the time of reckoning. (...) The message must now go out: unless banks take up their losses and raise the required amount of capital, there will be no more liquidity."

Charles saw a simple solution: let the Sovereign Wealth Funds buy the shares needed to recapitalise the banks.

Stephany Griffith-Jones and José Antonio Ocampo have written an interesting paper on Sovereign Wealth Funds (SWFs) from a developing country perspective. They observe that these funds "have helped calm fears about banks' solvency and helped contain the inevitable reduction of share prices."

"A reason why SWF investment in banks has been welcomed," they observe, "is because they tend to take relatively small shares in banks, and none of them sit on bank boards. Additionaly, SWFs are perceived as having longer term horizons (for example as compared with private equity or hedge fund investors) which makes them less sensitive to market volatility."

In a next post, I will highlight other points in José Antonio and Stephany's paper. I will also report on an insightful article, "Financial Regulation: Sending the Herd over the Cliff. Again", I just received from Avinash Persaud and of which a version will appear in the June edition of the IMF journal Finance & Development.

What do you think of the Bank of England's rescue plan? Is it good? Is it bad? Is it nor good nor bad?

Sunday, April 20, 2008

Let's help the poor in the US and elsewhere

Sometimes I feel we are so busy with our own business that we forget to think about what is happening in the world. Or we think that we are dealing with what is happening in the world, but are doing so in a little effective or wrong way.

Last week I was shocked by a small article on page two of an Amsterdam journal, Het Parool, which said that 28 million people in the United States will need food stamps and that the number of people needing these stamps had increased by 30 percent since the beginning of the credit crisis.

Only in New York 1.1 million depend on food stamps. The victims are people with low-earning jobs in shops, the cleaning industry, kitchens of restaurants and workers in the construction sector. These 'working poor,' as the article observes, often spend 10 percent of their earnings on gasoline (petrol) and a substantial proportion of their income on food.

I have a revolutionary thought: let our European ministers of international development cooperation advocate a change of neoliberal policies in the United States and other countries affected by neoliberal policies, to combat poverty in the US and elsewhere including our own countries.

Doing just that our development aid industry would make a healthy turn away from too much a focus on bookkeeping of money given or lent to developing countries to, what in my view is the essence of international development cooperation, economic and social policies for the well-being of all.

The picture comes from a book I spent hours and hours looking at in my youth, "U.S. Camera 1939", Edited by T.J. Maloney, and published by William Morrow & Company, New York.

Thursday, April 17, 2008

Preventing the crisis (4)

To be able to prevent a crisis one has to know its origins or possible causes. As with previous financial crises, the current crisis is generally treated in a too simple way, not taking into account more fundamental causes than the problem with mortgages and new financial instruments.

Jane D'Arista is one of those economists who have a broader and more profound view on crisis emergence and crisis prevention. Commenting on emails by John Williamson and Stephany Griffith-Jones, Jane applauds “the discussion of the yen carry trade and its role in both financing excesses and supporting balance of payments imbalances”. The yen carry trade is a topic discussed by John in his paper and Stephany suggested that macroeconomic action would be one way to curb it, but that it should be accompanied by regulatory actions, to ease the task of monetary authorities, “who if not face a wall of money, that makes their interventions more difficult and expensive.”

Jane adds, “Leverage, too, was a critical ingredient in the crisis”, and notes, “national regulators completely ignored the BIS and IMF warnings about the amount of speculation in the global financial system and the threat it posed for a systemic meltdown.”

Jane disagrees with Stephany's view “that there is no link between (global) imbalances and the financial crisis and that US budget deficits were the cause of the inflows that funded the consumption spree. The inflows were particularly strong during the period of the budget surpluses in the late 90s when the spending spree was shifted from the government to the household sector and took off from there. Policy was part of the problem - including the strong dollar policy supported by the Fed's attention to the interest rate differential between the dollar and other major currencies in that period - but the capital flows problem has been a mixture of many contributing factors.”

Jane stresses, “So far, the IMF has contributed good analyses of developments and has - like the BIS - called attention to both macro and financial excesses but without effect. Bill White and the BIS have also offered prescriptions for a macroprudential framework (including in the FONDAD volume) that need further exploration. The need to redirect central banks is, in my view, key to reviving stability and I am working on a paper for the Minsky conference at the Levy Institute (April 17-18) that deals with that issue.”

I look forward to seeing Jane’s paper, which should be ready by now, April 17, and hope to report on it in a next post.

I hope Bill White and others (Mark Allen? Charles Wyplosz?) will join the discussion.

There are more papers I will discuss on the blog like the ones I received from Jan Kregel, José Antonio Ocampo (co-authored by Stephany) and Rob Vos.

Wednesday, April 16, 2008

Preventing the crisis (3)

One possible way to prevent crisis is regulation. It is the regulator’s hope that good regulation will prevent trouble.

In response to John Williamson’s paper Stephany Griffith-Jones said in an email that she particularly liked John’s emphasis on “regulatory failure and need for improved regulation, including the possibility of forbidding certain transactions or activities.”

Stephany added, “This sounds radical, but if the social benefits are clearly below the social costs of certain activities, it seems the role of regulators should be to curb them.”

With “certain activities”, she referred to new financial instruments such as collateralised debt obligations (CDOs) and asset-backed commercial paper (ABCP), which lay at the heart of the crisis that erupted in 2007. Would better regulation of these new financial instruments have prevented the crisis?

This is difficult to say. With hindsight, it’s always easy – compare marital conflict and war. But if the rules had been different, would a crisis not have happened?

I don’t know if Stephany thinks that with better regulation of “certain activities” a crisis would have been prevented. There are other causes as well, I think. Anyway, I will ask her what she thinks.

Stephany reported that Joe Stiglitz and others are advocating an agency that would review financial instruments from this perspective: its social benefits and costs. She compares the job to one of an agency that reviews medicines “to check before they are released that they have no unintended negative effects that would outweigh their positive impacts.”

This is an interesting thought. Can it be but into practice?

Stephany went on saying that it would be interesting to discuss in a planned FONDAD workshop the regulatory implications of the current crisis. She suggested that we should look at more accepted ideas that need a strong push for something to happen. For example, we might consider regulating rating agencies, and modifying Basle 2 “to eliminate procyclicality of capital requirements, or even postpone Basle 2 introduction so it does not deepen the current slowdown (an idea mentioned briefly at a recent G24 meeting and hinted at in the Financial Times).”

This all sounds very interesting. I will ask Bill White what he thinks.

The question remains whether good regulation can prevent crisis.

(to be continued)

Preventing the crisis (2)

Every crisis between men can be prevented, be it a marriage crisis, a strike, a war, or a financial crisis.

Yesterday I read that someone considered the current international credit crisis "man-made". A non-sensical statement, because it could not be otherwise.

How could the current crisis have been prevented? That's a more difficult issue. It requires analysis, and opinion. Yes, without opinion, no explanation. And, usually, there is not one explanation but several.

Some people assume that facts explain. You need them, but you should never believe you have them all. There is always more.

Explaining requires reduction or abstraction, that's what makes it attractive and convincing – up to a certain degree.

Complex matters can be made crystal clear but sometimes the beauty (aesthetics) of explanation obfuscates reality, particularly in social sciences (economics) and politics where reality is subject to opinion and willingness of change.

The current financial crisis is complicated and simple at the same time. Not because it’s about numbers, figures – as I said before – but because it is man made. All made by men is simple and can be understood, even though it sometimes seems complicated.

But preventing a crisis remains difficult.

In the next post we will see what some of you say about it.

Monday, April 14, 2008

Preventing the crisis (1)

Those who suffer from a crisis wish the crisis would have been prevented. This applies to the debt crisis of the 1980s and all other crises that preceded (e.g. the crisis of the 1930s) and followed it (e.g. the Mexican crisis and the Asian crisis of the 1990s).

So the question is: could a crisis have been prevented?

Thousands, if not millions, of pages have been written about crises of the past to answer this question. On the current crisis, less has been written about its possible prevention. Many observers seem to find this hardly an interesting question, but I think that in five or ten years the literature on the possibility of preventing this crisis will be equally voluminous.

In the previous posts both John Williamson and Andrew Sheng have spoken explicitly or implicitly about the question of whether the current crisis could have been prevented. In a next post, I will highlight their thoughts and that of others.

Many of you have sent me their thoughts and it is high time that I include them in this blog, which is mine but aims to be yours as well.

Early this morning, at about 5am, I thought I should have on the blog a series of thoughts about (1) explaining the crisis, (2) preventing the crisis, (3) managing the crisis, (4) reforming the system.

The first series (explaining the crisis) has started already and will continue. This post starts the second series.

Explaining the crisis (4)

"With due respect to John and Andrew," says Zdenek Drábek in an email, "what their interesting exchange demonstrates is that it is time to clarify the role of regulators. There seems to me to be two separate issues under discussion - regulating for 'market stability' (monetary policy) and 'bank supervision' (against fraud, 'tunnelling' etc.). I know it is sometimes difficult to distinguish between both activities - viz. Bear Sterns, Northern Rock - but the distinction is important for the debate about the role of regulators."

Another thought I heard recently is a proposal to have two types of banks or investment institutions, one investing safely and the other speculatively. I don't know who has suggested this and if my reporting is correct, but it made me think about the viability of such proposal. Is it thinkable that we would have the first type as the dominant financial institution and the second type as the play game for speculators? Obviously, those engaged in the speculative business should not have their losses covered by the community. But where do you draw the line between safe and speculative investments? Is gold a safe investment? Isn’t its price as volatile as that of newly created financial instruments?

Don't get me wrong, in my view the "viability" argument should not be used to reject fruitful ideas. It should be used for refining and sharpening proposals. If there is anything we need now, it is creative proposals. Unfortunately, most policymakers tend to be very little creative and not willing to discuss the thinkable.

The "viability argument" is one obstacle that blocks solutions, vested interests and power is another.

Saturday, April 12, 2008

Explaining the crisis (3)

In the draft version of my previous post, I had written that Andrew Sheng absolved central bankers from blame for the international credit crisis.

Asking Andrew if he agreed with my judgment of his paper, Andrew replied that he thought the word “absolved” was too strong. “Regulators do share some of the blame,” he said, “but they were neither equipped nor structured to deal with a macro crisis, because they are fettered in silos. The real problem lies in mindsets. The market knows best mindset does not mean that the market is always right. Triffin is right. Who wants to go against the crowd in a feeding frenzy and take away the punchbowl? Central banking and regulation are not in the popularity business. When they are, or when they are captured by the vested interests (who may prefer that they are in silos) then the collective action of private greed at public cost must inevitably lead to crisis. The self-organized and reflexive nature of markets mean that central bankers and regulators must lean against the wind. They may not be able to stop the tide, but they would be doing their jobs.”

In a subsequent exchange of emails, John Williamson replied that he was not suggesting that the regulators could be expected to deal with a financial crisis, “but that if they had acted differently we would not have had a crisis at all. Admittedly it is not unambiguous where regulation ends and central banking begins, but the ‘financial authorities’ encouraged the trends that culminated in the crisis instead of leaning against them. And such leaning would have involved different regulation rather than higher interest rates. That is what I meant.”

John’s reply prompted Andrew to observe, “I recognize that it is difficult to separate completely where central banking ends and where supervision or regulation begins. The real issue is the mindset – are you liberal on market entry and financial innovation, and where do you begin to tighten regulation when you think that the financial institutions are skating on thin ice?”

Andrew continued: “The mindset of ‘market knows best’ is that you allow liberal financial innovation, without checking, since the prime brokers are supposed to look after their own money well. Greenspan explained that house-owning democracy is good (per his biography) and did not look into the quality of the lending nor the due diligence. By refusing to lean against the wind at the central bank level, he allowed the bubble to form. He could have tackled the excess leverage through imposing higher margins, but he refused to do so in 2000 and also the 2004/2006 mortgage excesses. He also allowed interest rates to go too low.

Using the present structured examination techniques, the bank regulators in US,. UK and EU were not able to detect these excesses. Everyone worried at the macro level, and no one did the forensic examination at the micro-level. So, if you do not think there is a problem at the macro-level, and do not do enough examination at the micro-level, how can the regulators have "leant against the wind"? Worse, there are so many silos in the regulatory structure (which Paulsen is trying to consolidate) that no individual regulatory authority could have leant. The last time CFTC tried to impose some restraints on derivative trading, it was beaten back by Congress.

The point I was trying to make is that the central bank is in charge of overall monetary policy and systemic financial stability. Greenspan was at the helm in charge of bank examination also. There is no excuse for him, to blame the lack of judgement on whether a bubble exists, nor on the inadequacy of risk management tools. The central bank is paid to make these judgements. If monetary policy denies that core inflation should include asset prices, then monetary policy was in fairy land.

I recognize that there is a problem with the techniques that regulators use to try to stop market excesses. But if the overall philosophy is to allow the market to take care of itself, then the regulators on their own, in their silos, cannot do that much. The fact is that no one wants to stop a bubble on the way up, but everyone wants to blame the regulators after the bubble implodes.”

John Williamson responded: “Andrew, I was not attempting to defend Alan Greenspan, who (as you point out) was also a principal regulator. It is in the latter capacity that I would mainly criticize him. Yes, certainly one wants someone to think about “whether a bubble exists” (the idea that central bankers should not try to identify bubbles because they cannot be 100% certain is dreadful). But having reached that conclusion one does not break a bubble by raising interest rates (since by definition a bubble is a price rise that is not explained by things like interest rates), but by telling people to stop doing certain things. I call that regulation (though it may be supplemented by things like raising margin requirements, even if this probably would have been ineffective). Yes, it involves recognizing that the market does not always know best, because they go on dancing until the music stops. In economist’s language, this is to acknowledge there may be differences between private and social costs.

The job of regulators is surely to do well-directed forensic examinations at the micro level. I agree that you cannot blame individual low-level regulators who are not well directed. I hope no one thinks I suggested otherwise.”

John’s clarification prompted Andrew to add, “I don't think we disagree. Leaving interest rates too long was a problem, and raising margin rates would have helped, as long as someone cried Cassandra. Unfortunately few did. Makes me think that the self-organized nature of markets and incentives are such that the cycle of boom bust is inevitable. I think Greenspan has been chastized enough by the media to remind all leaders to do what they feel is right.”

(to be continued)

On the picture you see the Amsterdam office of FONDAD. I feel privileged that I can work now all days (and nights) from home rather than commuting daily between Amsterdam and The Hague, as I did during 21 years. The address is Nieuwendammerdijk 421, 1023 BM Amsterdam. The house stands on a dike and at the back slowly sinks in peat-soil. It has a garden and you are most welcome to drink a cup of tea or glass of wine in the garden if the weather permits. Behind the shop window was a vegetable shop; now it is crowded with books. I'm afraid I won't have the time to read them all (again). Never mind, life is beautiful and I do read a book picked from the shelves every now and then. "Economics in Perspective: A Critical History" (1987) by John Kenneth Galbraith is one of the books waiting to be taken from the shelves. I think Andrew recently read it (again). Who of you has read it? What did you think of it? Another book waiting to be taken from the shelves is "History of Economic Analysis" by Schumpeter. I'd like to reread the chapter on Money, Credit, and Cycles (pp. 1074-1135 in my edition of 1967, printed in Japan). Robert Triffin was a student of Schumpeter. Triffin told me, “The great thing is not to choose a topic at the university but to choose a man. At that time at Harvard the greatest man undoubtedly was Joseph Schumpeter and I learned my economics from Schumpeter.”

Monday, April 7, 2008

Explaining the crisis (2)

Before I get to the papers Andrew Sheng and John Williamson sent me, I'd like to quote from a conversation I had with Robert Triffin a long time ago.

Entering Triffin’s room at the University of Louvain-la-Neuve on that crisp, blue-sky morning of 30 January 1985, I saw papers piled up everywhere, making me feel at home immediately. Triffin asked, "Why don't you have anymore in the Netherlands people like Jan Tinbergen? Where are the new Tinbergens?"

I tried to answer his question, prompting Triffin to observe, “People tend to be too conformist. Economists, by trying to explain the policies that happen, tend to whitewash and justify them.”
“Why?” I asked.
“They want to be ready to move from academics to political jobs.”

I don’t think that is the only, or major reason for being conformist… Anyway, let’s turn to Andrew and John, and see if they are "whitewashing and justifying" the policies that led to the international credit crisis.

In his paper, John blames the supervisors. “The prime responsibility for the financial turbulence that is currently afflicting much of the world is to be found in inadequate supervision. The authorities welcomed the process of financial intermediation, rather than recognizing its dangers and imposing rules that would have provided a counterweight to the greed that drives the private financial sector.”

Andrew, on the other hand, himself a former financial regulator, recognises that regulators do share some of the blame, but thinks that their problem is that they lack understanding of what happened in the financial markets. And, he observes, they may have contributed to the emergence of crisis by providing a too stable financial environment. “Prolonged stability of values of risks, liquidity and prices may lull market participants into leverage behaviour that escalates until the system becomes more and more unstable.”

In a subsequent discussion by email, Andrew stressed he does not think it is fair that regulation is to bear the brunt of the blame. “Regulators do not create bubbles and individually, there is very little that they can do to stop them appearing. Central bankers, on the other hand (and I am a former central banker) have a lot of responsibility on that front, but the prevailing mood is that they can't predict them nor can they determine when they can peak, so they prefer to deal with the aftermath.”

I think Robert Triffin would have loved to participate in the debate. Would he have accused John or Andrew of whitewashing and justifying the policies that led to the international credit crisis?

(to be continued)

Monday, March 31, 2008

Stock prices

This morning I looked for an hour at CNBC -- a channel for those who love to talk about prices. They talk about changing prices as if it is the largest joy in life, and the most important matter in the world.

To be more precise: they talked about stock prices. What do you think of stock prices? Do you like them? Do you read them?

I've always skipped stock prices in newspapers, I don't even saw them really. But now I was looking at them, for an hour, and they couldn't escape my eye as they moved on and on on the screen, and as the men and women on the screen seemed to have the most lively and amusing conversations about them.

Suddenly someone pops in from France. A nice looking man, typical Frenchman, impeccable English, with a nice French accent. Then an Italian businessman, the businessman of the year !, pops in, also in impeccable English, with less of an accent than the Frenchman. He is a bit older than the Frenchman and does not wear a tie but a black pullover. The Italian is more relaxed -- he seems to have made his fortune already. Or do those who have gained a fortune always want more?

Then a lady walks back and forth on the screen, not doing exercises but pointing vividly at man-size graphics with... prices ! She seems to enjoy them, and seems to think that we enjoy then too. Do you?

My brother (Herman) said in a comment to my previous post that he was not amused when he saw the prices of his stocks fall. He lost (a lot of?) money. I promised him to write a comment on his comment.

The above is, in part, my comment. I could say more about it but hesitate to say too much as it has already become clear how I think about stock prices. Gaining and losing -- it's all in the game.

What about pensions and pension funds. I obviously hope that my pension will not be wiped away by a crisis. That's why I'm engaged with crisis prevention for already more than 25 years...

No, I was kidding. The real reason I'm engaged in crisis prevention is that I am concerned about people whose living conditions are much less fortunate than mine. I don't have any reason to be concerned about my own fate. I do worry, however, about other people's fate.

I remember vividly a letter from a (poor) Chilean friend of mine who lost his savings in a banking crisis in Chile. I also remember vividly my worries about my brother who had to face exorbitant high interest rates after the change of monetary policy in the United States at the end of the 1970s, just after he had emigrated to Canada and had to indebt himself to set up a dairy farm.

So here you have my thoughts, brother.

On the picture you see my brother and me, not yet discussing stock prices.

Thursday, March 27, 2008

A critical mind

My son and I are driving to the Rotterdam office of Fondad, to fix some IT problems (he, not me). My son studies physics but still has a keen interest in economics.

"I find it ridiculous that banks can let public institutions pay when they incur large losses," says my son.
"You are right," I say.
"I find it ridiculous that people make such a problem about falling stock prices."
"You are right," I say.

My son considered studying economics. Next year he wants to study theoretical physics. To what use will he put his critical mind?

The picture of him and me is of about ten years ago, during a holiday in France. I read today the article in Le Monde Diplomatique and will refer to it in one of my next posts.

Tuesday, March 25, 2008

Explaining the crisis (1)

The global financial system looks complicated, but is simple, even though it does not present itself as simple. True, it's not easy to grasp its simplicity. Once I made an effort, in a long article, "The Monetary Crunch: Crisis or Scandal?" (to be put soon on the Fondad website), and I was not fully satisfied.

I have received several papers in response to my request for articles about the international credit crisis (which started last year as a subprime mortgage crisis in the US). In the first two posts on explaining the crisis, I'd like to discuss unpublished papers by John Williamson and Andrew Sheng.

The first time I came across John's name was in the early 1980s, when I spoke to Robert Triffin who referred to him. Ten years later, I had the pleasure of inviting him to a Fondad conference about "The Functioning of the International Monetary System" (see Fragile Finance). Since then John has been a great contributor to Fondad conferences and books.

I saw Andrew's name for the first time in the early 1990s. Last year I invited him to a Fondad conference in Kuala Lumpur about "Globalisation, Asian Economic Integration, and National Development Strategies: Challenges to Asia in a Fast-Changing World". I enjoyed Andrew's contributions in the conference and our private conversations.

My assertion that the global financial system is, or ought to be, a simple matter departs from the idea that the crucial variable in the system is prices: prices of assets (houses, for example) and prices of loans (payment of interest and repayment of principal), or whatever else that carries prices. What is there more simple than prices?

It is the essence of prices that they can rise and fall, and so do the prices of assets and loans. Nothing complicated.

The complication begins when people expect prices to be stable. Then you are in for trouble. As John says, "trouble started when house prices [in the US] stopped rising and started falling".

However, bankers and central bankers should have expected the falling of house prices since booms do not go on for ever. "The existence of a boom must have been clear even to central bankers (some of whom assert that they cannot be expected to identify bubbles)," says John.

Again, this has nothing to do with "complicated" economics, it's just the simple behaviour of commercial bankers (lenders), house owners (borrowers), and central bankers (regulators and supervisors).

Where then is the complication in the subprime mortgage loan crisis? In the slicing, dicing and packaging of the subprime mortgages into new financial instruments such as "special investment vehicles", says John.

As a result, "financial intermediaries did not know where many of the losses would end up, and to avoid unpleasant surprises they aimed to stop lending even to counterparties that would normally have been regarded as rock-solid."

So it is the panic and uncertainty that led to the subprime mortgage crisis in August 2007.

Then, as with previous financial crises, the crisis quickly spread and deepened. "While the first impact was on the mortgage and interbank markets, many additional assets have now been affected," observes John.

This is also nothing new. From previous crises we know that chain reactions happen.

As John says, "A fall in the value of certain assets triggers calls for increased collateral ... by those who have used those assets as collateral ... the affected institutions are forced to sell other assets, whose prices therefore fall; and that in turn sets the stage for the further propagation of the crisis."

Instead of chain reaction you can also call it "contagion" -- not a very complicated economic notion either.

So it seems that financial crises have more to do with (mass) psychology than anything else: expectations, uncertainty, fear, herd behaviour, contagion, etcetera.

In the next posts, I will continue discussing John's ideas and I will include thoughts of Andrew as well as those of others. I just glanced at the opening lines of a front page article in Le Monde Diplomatique, "Crises financières, n'en tirer aucune leçon..." Will it contain interesting thoughts?