Friday, November 27, 2009

Boomtime politicians will not rein in the bankers

By Avinash Persaud**
Published: November 26 2009 (Financial Times)

One of the features that singles out the Warwick Commission on International Financial Reform, which publishes its final report on Friday, is that while other expert groups tiptoe around it, we have been able to point to the true source of the worst financial crisis since the 1930s: regulatory capture and boomtime politics.

Today regulators are working conscientiously to address the issue of banks being too big to fail; the lack of responsibility that can follow securitisation; imperfections in credit ratings; capital requirements which accentuate boom and bust; regulators which were global champions for their local banks; and more. But we should not forget that just a few years ago, regulators, with few exceptions, wanted big banks to have lower capital requirements if they had sophisticated risk models; they were cheerleaders for securitisation and asset sales by banks because, they said, this spread risks; they hard-wired credit ratings into bank risk assessment; they promoted home country regulation over host country control; and they dismissed the idea that regulation was dangerously pro-cyclical.

These and other regulatory mistakes all pushed financial institutions in the same direction. Large international banks compete better on “process” and “models” than credit assessment, and reap economies of scale when rules that segment finance within and between countries are liberalised. As I wrote here in 2002, financial regulation had all the hallmarks of being captured by banks, to the detriment of financial stability.

Separate but related to regulatory capture is the politics of booms. A boom persists because no one wants to stop it. The government of the day wants it to last until the next election. The early phase of a boom brings extra growth, low inflation and falling defaults. Governments tout this as a sign of their superior performance. Bankers argue such alchemy justifies their golden handshakes and excuses their golden handcuffs. Booms spread cheer by providing finance to the previously unbanked. Donations to worthy causes and universities temper traditional channels of criticism. How easily can the underpaid regulator stick his hand up and say it is all an unsustainable boom?

The capture and influence is subtle and there is always a genuine reason, if a wrong one, for why it is different this time. Indeed, one of the key challenges not yet seriously addressed is why the universities and press, falling over themselves to kick bankers today, did not play a more effective counterveiling force to this capture.

One indirect consequence of capture is the mistaken treatment of risk that lies at the heart of regulation. Many politicians and watchdogs think of risk as a single fixed thing inherent in instruments. As a result they put faith in processes that link capital to measures of risk, or in committees charged with determining what is safe and what is risky and banning the risky. But risk is a chameleon: it changes depending on who is holding it. Declaring something safe can make it risky and vice versa. Investment scams are attracted to booms, but booms are in fact built on the belief that some new thing has increased the return or reduced the risk of the world: motor cars, railroads, electricity, the internet or financial innovation. There is often a large element of truth about the original proposition – the world will be different – but the over-investment creates new risks.

In a world in which risk is poorly measured and regulators are vulnerable to political influence, we cannot rely as a defence against a crisis on the regulation of financial instruments, statistical measures of risk, systemic risk committees or the foreign “home country” regulator.

It is not financial instruments but behaviour we need to change. A better defence will come from increasing capital buffers at financial institutions, making these buffers counter-cyclical, and focusing on structural – not statistical – measures of risk capacity. Liquidity risk is best held by institutions that do not require liquidity, such as pension funds, life insurers or private equity. Credit risk is best held by institutions that have plenty of credit risks to diversify, such as banks and hedge funds. No amount of extra capital will save a system that, because measured risks in a boom are low, sends risk where there is no capacity for it.

**The writer is chair of the Warwick Commission, chairman of Intelligence Capital and an emeritus professor of Gresham College

Thursday, November 26, 2009

Game Over?

The following graph demonstrates the percent change from a year ago of the bi-weekly adjusted monetary base.

As can be seen, the change has been dramatic over the recent past. In particular, since August it has been on a longer, sustained decline in comparison to previous periods.

Given the fiat monetary system that underpins our economy, this fall is simply a signal that the economic stability is on its last legs. Unless more money is pumped into the system, thereby reversing the fall we are witnessing in the graph, the so-called stability cannot be sustained.

The excess money printed provided support to strained markets. In other words, the consequence of such policy was to give the impression of low asset risk, thereby inflating their value. No doubt this was achieved. The problem is that when the monetary pump is closed (or the flow of funds decline), values cannot keep up. Policymakers don’t believe this, of course. It is why they are blindsided as to the true risks in our economy.

Saturday, November 14, 2009

Money & Inflation

To gain an understanding of what is happening in the economy, we must carefully review the Federal Reserve actions. The following is a brief overview of the monetary statistics I follow, which I believe give a good summary into the world of price inflation risk.

1. Adjusted Monetary Base (AMB): this is the liabilities of the FED that can be transformed into money in the economy. It includes currency held by the public and bank reserves. The FED affects the fed funds interest rate, which used by domestic banks to price reserve loans to each other, through the monetary base.

Since September 2008, the level of the monetary base on a bi-weekly basis has been expanding like no other time in history. It went from about $900 billion to approximately $2 trillion as of 11/13/2009.

Considering the continuous compounded rate of change, it is currently expanding at a rate close to 100% annually.

2. M1 (money supply): monetary aggregate made up primarily of currency and checking account balances.

Mathematically = [{(currency/deposits)+1)}/{(currency/deposits)+(reserves/deposits)}]*AMB

The level of the (weekly) money supply has been elevated during the most recent recession and unlike any other time since data have been compiled.

Focusing on the last five years, we note the extent of the monetary expansion.

3. Money Multiplier: the number of dollars that can be created out of thin air from each dollar in the adjusted monetary base.

Mathematically = [{(currency/deposits)+1)}/{(currency/deposits)+(reserves/deposits)}]

The money multiplier decreases when the currency/deposit ratio or the reserve/deposit ratio increases.

As can be noted from the graph, the multiplier (computed on a bi-weekly basis) has declined significantly during the recent financial crisis.

4. Excess Reserves: Reserves are deposits of depository (i.e. banks) institutions. After accounting for the FED imposed requirement, excess reserves are loaned out.

Excess reserves have ballooned during the crisis. Bank are not lending as a result of decreased loan demand and an abundance of unworthy borrowers. As a result, financial firms have decided to lend the money to the FED. Reserves stand close to $1 trillion.

Wednesday, November 11, 2009

Powerful interests are trying to control the market

By John Kay (Financial Times, Published: November 10 2009)

You can become wealthy by creating wealth or by appropriating wealth created by other people. When the appropriation of the wealth of others is illegal it is called theft or fraud. When it is legal, economists call it rent-seeking.

Rent-seeking takes many forms. On Europe’s oldest highway, the Rhine river, the castles on rocky outcrops date from the time when bandits with aristocratic titles extracted tolls from passing traffic. In poor countries the focus of political and business life is often rent-seeking rather than wealth creation. That helps explain why some countries are rich and others poor.

Rent-seeking drives the paradoxical resource curse. Oil or mineral wealth mostly reduces the population’s standard of living because it diverts effort and talent from wealth creation to rent-seeking. Sadly, foreign aid often has a similar effect.

Rent-seeking can be effected through rake-offs on government contracts, or the appropriation of state assets by oligarchs and the relatives of politicians.

But in more advanced economies, rent-seeking takes more sophisticated forms. Instead of 10 per cent on arms sales, we have 7 per cent on new issues. Rents are often extracted indirectly from consumers rather than directly from government: as in protection from competition from foreign goods and new entrants, and the clamour for the extension of intellectual property rights. Rents can also be secured through overpaid employment in overmanned government activities.

Rent-seeking is found whenever economic power is concentrated – in the state, in large private business, in groups of co-operating and colluding firms. Private concentrations of economic power tend to be self-reinforcing. This problem was widely recognised in America’s gilded age. The well-founded fear was that the new mega-rich – the Rockefellers, Carnegies, Vanderbilts – would use their wealth to enhance their political influence and grow their economic power, subverting both the market and democracy. Today it is Russia that exemplifies this problem.

But America has a new generation of rent-seekers. The modern equivalents of castles on the Rhine are first-class lounges and corporate jets. Their occupants are investment bankers and corporate executives.

Control of rent-seeking requires decentralisation of economic power. These policies involve limits on the economic role of the state; constraints on the concentration of economic power in large business; constant vigilance at the boundaries between government and industry; and a mixture of external supervision and internal norms to limit the capacity of greedy individuals in large organisations to grab corporate rents for themselves. Vigorous pursuit of these is the difference between a competitive market economy and a laisser-faire regime, and it is a large difference.

Privatisation and the breaking up of statutory monopolies has reduced rent-seeking by organised groups of public employees. But the scale of corporate rent-seeking activities by business and personal rent-seeking by senior individuals in business and finance has increased sharply.

The outcomes can be seen in the growth of Capitol Hill lobbying and the crowded restaurants of Brussels; in the structure of industries such as pharmaceuticals, media, defence equipment and, of course, financial services; and in the explosion of executive remuneration.

Because innovation is dependent on new entry it is essential to resist concentration of economic power. A stance which is pro-business must be distinguished from a stance which is pro-market. In the two decades since the fall of the Berlin Wall, that distinction has not been appreciated well enough.

The story is told of the Russian policymaker, visiting the US after the Soviet Union collapsed, who asked: “Who is in charge of the supply of bread to New York?” The bureaucrat had not learnt how markets work, and we are in danger of forgetting it. The essence of a free market economy is not that the government does not control it. It is that nobody does.

Tuesday, November 10, 2009

Not All Bubble Present a Risk To The Economy (And I have a Bridge for Sale)

With respect to our current economic woes, we have long passed the point of no return. The sad part of it is not the loss wealth, which could be recuperated, but the loss of intellectual rigor and economic wisdom. This is quite evident in a recent Op-Ed (“Not all bubbles present a risk to the economy”…FT, 11/9/2009) by Frederic Mishkin, former FED governor and current Professor of finance & economics at Columbia University. Some of the stuff he writes is absolute silliness, which only a bureaucrat, politician, and most professional economists would believe.

Let’s digest a little bit of what he says. My comments are in bold

There is increasing concern that we may be experiencing another round of asset-price bubbles that could pose great danger to the economy. Does this danger provide a case for the US Federal Reserve to exit from its zero-interest-rate policy sooner rather than later, as many commentators have suggested? The answer is no.

The introduction is just setting the stage of his argument: happy days do not have to end.

Are potential asset-price bubbles always dangerous? Asset-price bubbles can be separated into two categories. The first and dangerous category is one I call “a credit boom bubble”, in which exuberant expectations about economic prospects or structural changes in financial markets lead to a credit boom. The resulting increased demand for some assets raises their price and, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more, creating a positive feedback loop. This feedback loop involves increasing leverage, further easing of credit standards, then even higher leverage, and the cycle continues.

Prof. Mishkin omits important variables necessary to answer the following questions: who creates money? How is money created? The omitted variables are Federal Open Market Committee and fractional reserve banking. Leverage, without concomitant increase in the supply of money, cannot by itself cause the effects Prof. Mishkin outlines.

Eventually, the bubble bursts and asset prices collapse, leading to a reversal of the feedback loop. Loans go sour, the deleveraging begins, demand for the assets declines further and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets. The resulting deleveraging depresses business and household spending, which weakens economic activity and increases macroeconomic risk in credit markets. Indeed, this is what the recent crisis has been all about.

This is malinvestment repriced to reflect the true (subjective and imputed) value by the market. In this environment, prices decline.

The second category of bubble, what I call the “pure irrational exuberance bubble”, is far less dangerous because it does not involve the cycle of leveraging against higher asset values. Without a credit boom, the bursting of the bubble does not cause the financial system to seize up and so does much less damage. For example, the bubble in technology stocks in the late 1990s was not fuelled by a feedback loop between bank lending and rising equity values; indeed, the bursting of the tech-stock bubble was not accompanied by a marked deterioration in bank balance sheets. This is one of the key reasons that the bursting of the bubble was followed by a relatively mild recession. Similarly, the bubble that burst in the stock market in 1987 did not put the financial system under great stress and the economy fared well in its aftermath.

Mr. Mishkin is a trademark politician. Notice the terms he throws out there: “does much less damage” or “not accompanied by a marked deterioration in bank balance sheet.” He fails to mention his standard of comparison. But, why would he? Doing so might expose his dillusion.

The reason prior bubbles did not have the level of impact as the current one has to do where the printed money by the FED made its way through the economy. Money enters through the financial system. Financial firms dealt with each other in the form of opaque instruments, which had little genuine economic value. When the implosion occurred, there was a high level of expected risk that financial firms would go belly-up. As a result, credit in essence stopped flowing. Since other non-financial (as well as financial) companies rely on a smooth flow of credit to finance their day-to-day operations, the result was catastrophic. Prior bubbles did not have this dimension magnified to the extent we recently experienced.

Because the second category of bubble does not present the same dangers to the economy as a credit boom bubble, the case for tightening monetary policy to restrain a pure irrational exuberance bubble is much weaker. Asset-price bubbles of this type are hard to identify: after the fact is easy, but beforehand is not. (If policymakers were that smart, why aren’t they rich?) Tightening monetary policy to restrain a bubble that does not materialise will lead to much weaker economic growth than is warranted. Monetary policymakers, just like doctors, need to take a Hippocratic Oath to “do no harm”.

Mr. Mishkin states that if policymakers were clairvoyant and “smart, why aren’t they rich?” In fact, they are rich in comparison to median household income. More egregious is the fact that monetary policymakers are the culprits of the economic crisis we are enduring presently. Summers, Geithner, Bernanke, et. al. are jus a few names who were around in policymaking circles while the current bubble was being inflated. Of course, let us not omit Mr. Mishkin. They never saw it coming. But, somehow today we are led to believe that they see “green shoots” and that everything is and will be just fine. If this is not a contradiction, then I don’t know what is.

Nonetheless, if a bubble poses a sufficient danger to the economy as credit boom bubbles do, there might be a case for monetary policy to step in. However, there are also strong arguments against doing so, which is why there are active debates in academia and central banks about whether monetary policy should be used to restrain asset-price bubbles.

Here is one that is almost never considered, let alone even think: abolish the Federal Reserve.

But if bubbles are a possibility now, does it look like they are of the dangerous, credit boom variety? At least in the US and Europe, the answer is clearly no. Our problem is not a credit boom, but that the deleveraging process has not fully ended. Credit markets are still tight and are presenting a serious drag on the economy.

Mr. Mishkin, who is providing credit right now? The Federal Reserve System. Simply look at the size of its balance sheet. Yes, I know, it is technically part of the money supply in the form of the monetary base. But the effects are the same as credit. The bubble that is being inflated is in Treasury debt.

Tightening monetary policy in the US or Europe to restrain a possible bubble makes no sense at the current juncture. The Fed decision to retain the language that the funds rate will be kept “exceptionally low” for an “extended period” makes sense given the tentativeness of the recovery, the enormous slack in the economy, current low inflation rates and stable inflation expectations. At this critical juncture, the Fed must not take its eye off the ball by focusing on possible asset-price bubbles that are not of the dangerous, credit boom variety.

La! La! La! I am selling the George Washington Bridge…any takers? Mr. Mishkin?

Tuesday, November 3, 2009

US GDP Growth: A Myth

Pundits and market cheerleaders hailed the reported third quarter GDP figures. Strong growth, said some! We have turned the corner, said others. But amidst this nonsense, there is perspective. As a Financial Times Editorial put it:

Americans rediscovered their taste for consumption: personal expenditures
grew by an annualised 3.4 per cent after falling in four of the previous six
quarters. Durable goods were swept up, with sales higher by an annualised 22 per
cent, but services and nondurables as well grew at respectable if modest speeds.
Businesses and households also started investing again: although non-residential
construction fell for the fifth quarter in a row, equipment spending rose for
the first time since 2007, and residential investment jumped by an annualised 23
per cent.

But this spending spree is brittler than one would like. The durable goods
spurt – even as disposable incomes fell – was powered by a car scrappage scheme
that borrowed GDP from the future more than anything else. With motor vehicles
excluded, output grew by only 1.9 per cent. Up to half of that in turn consisted
of businesses rebuilding depleted inventories – a sign of optimism, but also,
like cash-for-clunkers, a one-off boost to output that will not persist.

There you have it folks. Suddenly the numbers are not so stellar, as first reported. Those who have ears, let them hear.