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)