MINISTERIO DE ECONOMÍA Y HACIENDA

SECRETARIA DE ESTADO DE ECONOMÍA,

SECRETARÍA GENERAL DE POLÍTICA ECONÓMICAY ECONOMÍA INTERNACIONAL SUBDIRECCIÓN GENERAL DE ECONOMÍA INTERNACIONAL

CUADERNO DE DOCUMENTACION

Número 86-20º (alcance)

Alvaro Espina Vocal Asesor

21 Noviembre de 2008 (19 horas)

CD 86-20º de alcance 20 de Noviembre de 2008

“We are now close to the deadly ‘Bermuda Triangle’ of a liquidity trap, price deflation, debt deflation and sharply rising defaults”.

Nouriel Roubini ¡Es la deflación, estúpido!, como diría Bill Clinton si estuviera en campaña. Menos mal que en términos anuales la inflación se sitúa todavía en el 3,7%. Cualquiera diría hace tan sólo uno o dos meses que nos alegraríamos de que EE.UU. tuviese una inflación más de un punto por encima del objetivo declarado por la Fed (que se sitúa en el 2,5%), pero así es. Ciertamente, una golondrina no hace verano, y más si se toma en cuenta el efecto petróleo. Pero la inflación subyacente cayó en octubre un 0,1% mensual, por primera vez desde 1982, situándose ya en el 2,2% en tasa anual, tres décimas por debajo del objetivo de la Fed. Por eso, la caída record de los precios en octubre causa miedo. Sobre todo, porque existe la certeza de que la desaceleración de los precios proseguirá en los próximos meses de forma autónoma: a la vista del mercado de la gasolina, en términos anuales la inflación general se encuentra en noviembre en torno al 2%, lo que en Norteamérica significa estabilidad de precios, con ligero riesgo de deflación. Desde Economist’s Voice, Janine Aron y Johon Muelbauer proporcionan sólidas razones econométricas y estructurales para argumentar que el próximo colapso será el de los precios (lo que significa que el efecto de contagio se habrá trasmitido con carácter difuso hacia toda la economía, en sentido inverso a como antes había ocurrido con las burbujas). Edwin G. Dolan se pregunta desde ese mismo medio si Bernanke todavía tiene la certeza de que lo de Japón no puede ocurrir en Estados Unidos, por mucha agresividad que emplee la Fed. Por el lado de las perspectivas de inflación-deflación, pues, la regla de Taylor diría que en EE. UU. el tipo de interés regulador debería estar, como máximo, en el 4%, y probablemente bastante más abajo. Pero el output-gap se encuentra, como mínimo, en el

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3%, por lo que, para neutralizarlo y situarse en posición neutral, el tipo de interés regulador debería reducir aquella cifra en 4,5 puntos. Lo que sucede es que no puede bajar de cero –y, aunque oficialmente esté situada en 1%, en la práctica la Fed ya está aplicando un tipo del 0,3%, prácticamente nulo-. De modo que la herramienta de la política económica convencional se está volviendo inservible (aunque en su próxima reunión la Fed haga una reducción pro forma de 100 pb. y declare oficialmente el agotamiento de su margen). Esto es lo que se está cotizando ya en los mercados de bonos, como dice RGE. ¿Cual es la perspectiva? Piénsese que, de llegar la deflación a una tasa anual del 2%, el público se instalaría confortablemente en ella, porque en esa situación basta con mantener el dinero en el calcetín para obtener una confortable rentabilidad real del 2%, que es la remuneración “natural” de los activos sin riesgo (y, a más a más, si los bonos o los depósitos siguen rentando algo). Pero en tal situación hay que olvidarse de los activos de riesgo, por lo que la depresión se perpetúa. Y, lo mismo ocurriría con la adquisición de bienes de consumo duradero, cuya posposición resultaría enormememente rentable, sobre todo porque, una vez cebada la bomba del retraso en una primera ronda, el desequibilibrio entre oferta y demanda en el mercada impulsaría nuevas caídas de precios, en espiral interminable (inversa a la del período de la burbuja). Volatilidad, o sociedad líquida, como dice Zygmunt Bauman. Esto es ya de por sí una característica de la modernidad radicalizada en que nos movemos, pero, como sucedía con la autopoiesis y la reflexividad financiera, también aquí la carrera hacia la liquidez se agudiza con los giros vertiginosos que retroalimentan la gran crisis: recuérdese la metáfora del halcón y el halconero, que se convierte en la peor de las pesadillas cuando ni siquiera hay halconero. Y éste es el caso, porque, como dice Krugman, todo está ocurriendo, además, en medio de un enorme vacío de poder, causado por la inoperancia absoluta de Bush y por la obligada transición, que acentúa la desconfianza. Y en en los próximos dos meses el daño derivado de la inoperancia puede resultar gravísimo (Krugman lo ilustra con lo ocurrido tan sólo desde la quiebra de Lehmann: la carrera

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hacia la deflación y la amenaza de colapso de Detroit agudizan el sentido de la urgencia). Es de la máxima importancia evitar por todos los medios llegar al punto en que la demanda de liquidez se hace prácticamente insaciable. De modo que, aun cuando la polítca monetaria convencional agote su campo de acción en EE.UU., la Fed no debe dejar de actuar. Como afirma Tim Duy y reza la síntesis de RGE, existe la política monetaria de tipo de interés cero (zero-interest rate policy: ZIRP), lo que nos conduce a la zona de las políticas de gobierno “sistemática y racionalmente irresponsables” (pero irresponsables, sólo respecto a la lucha contra la inflación): ¿Y qué más da, si ésta se ha ido y, si se le ocurriera volver, sería fácil desandar el camino y cercenarla? Pero responsables respecto al bienestar general, que es lo que importa, porque esa es la única forma conocida y probada (en Japón) de salir del triángulo de las Bermudas de Roubini, de la que hablaremos más abajo siguiendo la lógica de Krugman. Baste aquí decir que la idea básica de esa política “irresponsable” (crazy, dice Roubini, aunque sea perfectamente meditada y selectiva, para rentabilizar todo su potencial) consiste en que la Fed se dedique a intervenir en el mercado abierto, adquiriendo tantos valores como resulte necesario para proporcionar al mercado recursos suficientes en orden a satisfacer su demanda casi infinita de liquidez; y, cuando llegue a ese punto, debe seguir haciéndolo algo más, hasta que la propensión a invertir y a consumir reaparezca y se restablezca el crédito. Esto parece absurdo, pero no lo es. No otra cosa significa haber entrado en la economía de la depresión, en la que buena parte de los efectos económicos al uso invierten su signo. Y, hablando de depresión, y puesto que estamos en Europa, el BCE debería hacer el máximo esfuerzo para evitarla, ahora que todavía estamos a tiempo; porque la ventana de tiempo disponible es muy breve, ya que, si la transmisión funciona aquí como en EE. UU., existirá un desfase de seis meses entre las medidas monetarias y su impacto sensible sobre los mercados. Piénsese, por ejemplo en el Euribor y las mensualidades de las hipotecas: hacen falta seis meses para que las medidas de descenso de tipos en ese mercado afecten al 50% de las hipotecas a tipo variable

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vigentes. Cualquier medida monetaria adoptada ahora no producirá su pleno impacto hasta dentro de doce meses (que es cuando lo más optimistas piensan que se producirá el comienzo de la recuperación. Pero cuanto más tarde el BCE en actuar, más se retrasará la recuperación). Y más vale que no tarde mucho porque, si se retrasa, quizás tenga que actuar sobre una economía europea atrapada también en la trampa de liquidez, y entonces sí que será el llanto y crujir de dientes para Trichet y su Consejo. Porque en tal caso deberían practicar una política “irresponsable”, so pena de soportar la responsabilidad de ver a Europa arrastrarse por la depresión, como le sucedió a Japón. Pero, a todo esto, ¿entran estas cosas dentro de los cometidos del BCE? Y aun si ese no es su mandato directo, ¿llegaremos paradójicamente a legitimar la actuación del BCE en favor de la actividad económica justificándola como vehículo para evitar que el objetivo de inflación se vaya al traste, aunque no por arriba, sino por abajo? ¿No sería más lógico ampliar su mandato e incluir en él –como reclama Stephen Roach para la Fed- la estabilidad económica y financiera? (por no hablar del pleno empleo, que es algo que Europa ni siquiera se plantea como ente colectivo). ¿Tiene el BCE facultades para intervenir en los mercados de forma no convencional? Porque, si no es así, en los tiempos en los que estamos entrando ésa podría ser una nueva fuente de incertidumbre típicamente europea. Pero ya hablaremos de eso. Sin que suponga afán alguno de persecución, ¡a Hank Paulson le han vuelto a pillar (wrong-way Paulson)! Tan ofuscado ha estado con darle el dinero del plan sólo a sus financieros que a veces se le sigue cruzando el cable y parece seguir pensando que el plan vigente es su Plan I: ¡no se ha leido el Plan II, que se dirige tambien hacia la prevención de deshaucios! En realidad, la autoridad total que Bush le confirió, en cuanto vió lo que se le venía encima, ha permitido a Paulson adquirir una experiencia de “general en jefe en tiempos de guerra”, para él impensable y muy poco republicana, como dice David Chao en WP. Esto le ha ido transformando poco a poco, al observar que “aunque no tengas atribuciones, si tomas el mando la gente te sigue”, como él mismo dice. Pero en el fondo Paulson se sigue viendo a sí mismo

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como el CEO de un banco de inversión, Government & Sachs, y su negocio consiste en comprar y vender papelitos, por mucho que ahora haya ampliado el mercado en que opera, extendiéndolo a los valores asociados a la titulización de la deuda de las tarjetas de crédito, la compra de automóviles y los préstamos para estudiantes. Pero todavía se niega en rotundo a “dar subvenciones”...... por el momento ¿Hasta cuando? Porque, como explicó la Presidenta de la FDIC, Sheila Bair, tan sólo con destinar un gasto de 24.000 millones de dólares a avales y refinanciación de hipotecas para prevenir deshaucios podría evitarse una caída adicional de los precios de la vivienda de un 3%, y eso significaría mejorar la solvencia financiera de las familias en una cifra que se estima en medio billón de dólares. Dejemos a un lado por el momento el punto exacto en que los precios de la vivienda habrán expulsado todo el gas de la burbuja (porque con la caída en flecha de los precios y de las nuevas construcciones y la paralización actual del mercado eso está más que garantizado). Ahora, el riesgo no se encuentra en la burbuja, sino en contener los efectos de su estallido, estabilizar lo más rápidamente posible los mercados y contener la hemorragia de la confianza de los consumidores (o sea, se trata de hacer más o menos lo mismo que se hizo antes, aunque sin emplear instrumentos tóxicos, para producir el efecto contrario, porque entonces la burbuja estaba inflándose y ahora está desinflándose). Es a eso a lo que debe dedicarse Paulson, como le dijeron los líderes mundiales el pasado fin de semana. Pero parece que este hombre todavía no ha asimilado que estamos en la economía de la depresión y, como decía Krugman el pasado día 14, eso implica abandonar el recurso fácil a las cosas que se dan por sabidas y resultan juiciosas en circunstancias normales, para concentrarse en resolver los problemas de la depresión, que son cualquier cosa menos normales, aunque para ello haya que emplear herramientas no convencionales (siempre a vueltas con la misma idea, hasta que se les meta en la cabeza a Paulson y a Trichet). Además, a Paulson hay que darle a leer el papel de Jan Hatzius et al, publicado por su gente de Goldman Sachs (GS), sobre la macroeconomía de la trampa de liquidez. Krugman piensa que el

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enfoque de Hatzius es más acertado que el suyo. Pero, incluso empleando sólo sus propios esquemas y partiendo de las previsiones de precios de la vivienda de GS, Krugma prevé que el aumento de la demanda de ahorro derivado exclusivamente de esa causa equivaldrá a finales de 2009 al 6% de los balances de los hogares, de modo que el plan de la FDIC, presentado por Bair y que está discutiendo el Congreso, reduciría tal efecto a la mitad ¡Y eso, por poco más de la treintava parte del coste del Plan Paulson! Mientras que, si no se hace frente directamente a los deshaucios y a la inundación de casas embargadas en venta, el plan de estímulo debería aumentar en aquella misma cantidad para rellenar el agujero que registrará la demanda –sólo por esa causa- y evitar la depresión (o, si ya estuviéramos en ella, para contribuir a salir del pozo). Además, como señala Amity Shlaes en Bloomberg, el estudio de Slemrod y Shapiro (basado en encuestas a los consumidores tras el plan de reactivación de 2001) indica que lo que influye verdaderamente sobre las pautas de gasto del consumidor es la percepción acerca de su renta permanente, por lo que resulta mucho más efectiva una medida como la de Bair que un plan de estímulo temporal, porque la primera eleva de forma permanente el equilibrio del balance financiero de los hogares. Ciertamente, el que la teoría del consumo basada en la renta permanente lleve la firma de Friedman no autoriza a Shlaes a concluir que la teoría keynesiana no sea aplicable ahora, ya que el propio Friedman reconocía que en este tiempo todos somos keynesianos. En realidad, Keynes sólo confiaba en el efecto real del estímulo monetario si existía “espejismo monetario” (si el público confundía aumento de precios con aumento de riqueza). Krugman traduce todo esto a la situación actual señalando que no sería muy difícil para el gobierno de Zimbabwe convencer al público de que la inflación va a ser elevada por largo tiempo, por lo que en un sitio como ese no existe amenaza de deflación. Pero en las principales economías de nuestro tiempo salir de la trampa de liquidez es mucho más difícil porque la promesa de adoptar políticas “irresponsables” (en materia de inflación) de forma duradera suele resultar escasamente creíble cuando la hace un

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gobierno o un banco central serios: En Japón, por ejemplo, el BoJ era poco creíble en esta faceta y, después de intentarlo durante todo un decenio (con el país arrastrándose por el triángulo de las Bermudas), por fin, en marzo de 2001 consiguió que la gente se creyera que su política de relajación monetaria (quantitative easing) iba a mantenerse en el tiempo, de modo que (dos años y medio más tarde) Japón logró salir de su trampa de liquidez particular, aunque sólo después de elevar el valor de sus reservas desde cinco ¡hasta treinta y dos billones de yenes! Pero, por fin, tras semejante “demostración de irresponsabilidad”, el pozo de la sed de liquidez se llenó, empezó a rebosar, y el flujo de crédito se restableció. Sería deseable que no llegásemos a eso ahora en EE.UU. ni en Europa. Pero para evitarlo hay que actuar deprisa. Y, sobre todo, llegados a este punto y coyuntura, hay que fustigar con todos los látigos de conocimiento disponibles a los miembros de los Bancos Centrales (como hacen Tim Duy, Mark Thoma, Paul Krugman, Nouriel Roubini y tantos otros economistas americanos beneméritos con su banco central). Porque los banqueros centrales muestran una propensión -encomiable en tiempos normales, pero detestable bajo la economía de la depresión- a preservar al máximo su margen de maniobra (a no llegar demasiado pronto al tipo de interés cero, como decía The Economist), aunque sea ésa la única receta aplicable. Esta propensión se acentúa cuando presienten que la recesión es de aúpa y va para largo, porque saben que a partir de ese punto ya no tienen con qué responder en el terreno de las políticas convencionales –que son las que los banqueros centrales consideran respetables-. A partir de ahí, si necesario fuere, tendrían que practicar “políticas irresponsables”, y eso va contra el sentido de la decencia de todo banquero central que se precie. Y, sin embargo, eso es lo que tiene que hacer ahora la Fed, y probablemente también enseguida el BCE. Y si no lo hiciera (por indecisión, o, simplemente porque no está facultado para hacerlo), más nos valdría ponernos a pensar en cómo modificar su mandato para hacerlo posible, e incluso aconsejárselo, aunque con el mayor respeto hacia su autonomía. De entrada, lo que sí puede hacer el BCE ahora –y es deseable que lo haga cuanto antes- es bajar sus

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tipos no menos de 100 pb. En este CD hay una buena cosecha de estudios acerca de las políticas mucho más agresivas que tendría que emplear si la trampa de liquidez atrapase a la economía europea (o, más bien, a la economía global, porque toda ella va en el mismo tren, aunque sea en vagones rigurosamente ordenados). En ese sentido, no cabe la menor duda de que Paulson cederá (Getting to yes, titula su editorial NYT, que ya le va conociendo), porque en su papel de “general en jefe en tiempo de guerra”, el Secretario del Tesoro ha aprendido a ser flexible y a adaptarse al terreno y a las circunstancias. Cuando se equivoca (wrong-way Paulson) y le ataca por el flanco débil la caballería del conocimiento, termina por replegarse y tomar la buena senda (wright-way Paulson), tratando además de aprovechar el impulso para reconducir sus esfuerzos hacia el cumplimiento de sus propios planes a un nivel superior (new-right-way Paulson). Todo esto lo explica de forma mucho más elegante el propio Paulson en la racionalización ex-post que publicaba NYT el día 18, bajo el leit motiv de que la crisis financiera sólo puede resolverse acometiendo los problemas uno a uno (“Fighting the Financial Crisis, One Challenge at a Time”). Es su particular versión de la estrategia de andarse por las ramas, o de salir del paso, de Charles E. Lindblom (“The Science of ‘Muddling Through’) que es la preferida por el “General en jefe Paulson”. El Presidente L. B. Johnson lo expresaría diciendo que Paulson no sabe mascar chicle y...... al mismo tiempo. Pero cuando lea el espléndido trabajo de Jonathan Carmel en Economist’s Voice, seguramente se persuadirá de que todo el dinero que queda del Plan Paulson II puede “invertirse” adecuadamente implantando una reducción fiscal dirigida exclusivamente a corregir los balances hipotecarios deteriorados, a sanear las deudas de tarjetas de crédito preexistentes o a acudir a nuevas ampliaciones de capital de los bancos. Como dice Carmel: en lugar de contraer deuda pública para hacer todo eso mal (por cuenta del contribuyente), es preferible dejar que sea el contribuyente quien lo haga por sí mismo (Brown ya anda en eso). Porque, además del efecto-renta permanente, hay que considerar el efecto que tendría sobre los animal spirits de los norteamericanos percibir una estabilización del mercado de la

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vivienda, que se encuentra en el origen de todo este embrollo. En el libro que aparece este mes con ese mismo título, Shiller y Akerlof conceden más importancia a todo lo que pueda afectar actualmente al optimismo vital de los americanos que a cualquier otra cosa. Porque, dado que el consumidor americano se convirtió durante el último decenio en el motor del crecimiento global, sus pulsiones, instintos, movimientos irracionales -o como queramos traducir la expresión de Keynes- son actualmente el termómetro de la depresión. Ciertamente, esta no es una situación deseable ni sostenible, pero mientras no se vayan recomponiendo los equilibrios perdidos bajo el régimen que se ha dado en denominar “Bretton Woods II”, esa es la realidad en la que nos movemos. Brad Setser le da un susto esta semana a Paul Krugman al recordarle que la balanza por cuenta corriente de EEUU –que parecía estar empezando a corregir aquellos desequilibrios- está volviendo a empeorar, como consecuencia, entre otras cosas, de la recuperación del dólar, una vez que se descuenta el efecto del petróleo. Mala cosa, porque toda la gente seria en el oficio de la economía política del sistema global (desde Bernanke a Summers, pasando por Roubini, Setser, Buiter o Martin Wolf) sabe que ahí es donde se encuentra la raiz de la gran inestabilidad, como señala con gran precisión John B. Judis en The New Republic: esa es la causa última de que Norteamérica –y no sólo Norteamérica- se vea hoy poblada por una nueva especie, a la que Judis denomina Debt man walking. Y a todo esto, los chinos protestan por las ayudas que suponen se van a conceder a la industria de automocíon norteamericana, porque ellos ya están preparando su desembarco allí, y las ayudas les pondrían las cosas más difíciles. Sería más cómodo para ellos que les dejasen el terreno libre. Está visto que de China no se puede esperar una contribución positiva a la corrección del desequilibrio global. Habrá que ponérselo duro, exigiéndole que para seguir compitiendo reconozca los derechos de sus trabajadores. Summers –futuro chief economist- está en ello. En cualquier caso, tampoco tiene desperdicio el espectáculo de los tres CEO’s de Detroit en la House y en el Senado, implorando el dinero del contribuyente sin poder pergeñar ni siquiera el más

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somero plan de viabilidad futura, en el que es evidente que no han pensado, sencillamente porque les dá pánico y ellos no serían capaces de llevarlo a cabo (porque para hacer la reconversión industrial de todo un sector tan maduro hacen falta muchos arrestos; de eso sabemos algo aquí en Europa, y especialmente en España, en donde todo esto se agolpó en el decenio de los ochenta). El Ex-gobernador de Massachusetts Mitt Romney habla de una quiebra bien pilotada por el gobierno, y eso parece ser lo mejor. Joshua Rauh y Luigi Zingales diseñan un plan de siete puntos para la quiebra y reestructuración dirigida y financiada por el gobierno (en calidad de debtor-in-possession) –aunque ejecutada a través de un banco comercial- para garantizar que se salva todo lo salvable, sin precipitación y sin derroche, pero evitando que cierre cualquier cosa que resulte sostenible. El problema es que queda el tiempo justito, y la administración republicana no está por la labor ¡Que dios nos coja confesados! Al menos, Barron’s y RGE dan una buena noticia: el establecimiento de una central de compensación para los CDS, que estará activa a finales de 2008, tras el acuerdo firmado el viernes pasado por la Fed, la CFTC (mercado de futuros) y la SEC, para llevar a cabo la supervisión de este tipo de productos, sobre los que descansa buena parte de la cobertura del riesgo financiero actual, y cuya absoluta opacidad (incluso estadística) viene funcionando como la gran espada de Damocles pendiente sobre nuestras cabezas. Probablemente con exceso de optimismo, Barron’s concluye su análisis diciendo que al soldado nunca lo mata la bala que espera, sino la que llega por sorpresa, y la incertidumbre de esta bala está a punto de despejarse. Ojala (en árabe: “si Alá quisiera”). Porque los fondos de alto rendimiento (¡!), como era previsible, siguen encogiéndose cual piel de zapa. Y todo, porque se ha perdido la confianza. La llegada de Obama da pie a Paul C. Light para apelar a la necesidad de recomponer la erosión casi irreversible a la que varias décadas de hegemonía republicana han llevado a la Administración y a todo lo público (the tragedy of the commons): bomberos con vocación de cumplir su función por dignidad; fiscales movidos “por el orgullo de clavar una estaca de madera en el corazón de los malos” (Fracture).., etc.

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0BBACKGROUND PAPERS:

1. 1BThe Lame-Duck Economy, by PAUL KRUGMAN... 15 2. Falling Prices Raise a New Fear: Deflation, by Steven Mufson

and Michael S. Rosenwald... 18 3. 2BCitigroup Tries to Stop the Drop in Its Share Price, by ERIC

DASH and LOUISE STORY...20 4. 3BStocks Are Hurt by Latest Fear: Declining Prices, by VIKAS

BAJAJ...22 5. 4BThe Deadly Dirty D-Words: “Deflation”, “Debt Deflation” and

“Defaults”. And How Central Banks Will Have to Resort to “Crazy” Policies as We Have Reached Such Bermuda Triangle of a “Liquidity Trap”, by Nouriel Roubini...26

7. The Shrinking Hedge Fund Industry: From $2 Trillion to $1 Trillion By 2009?, RGE...32

8. 146BGlobal Credit Markets In Crisis Mode, RGE...33 10. 147BThe Latest Bear Market Sucker’s Rally Has Gone Bust as

We Are Headed Towards Stag-Deflation, by Nouriel Roubini...35

12. U.S. Inflation Trends: Disinflation or Deflation Ahead?, RGE...37

13. Welcome to Planet ZIRP: Conducting Monetary Policy at Low Interest Rates, RGE...38

14. Breakevens: U.S. Bond Markets Price in Deflation, RGE...39 15. Commodity Headwinds , by Mikka Pineda, Rachel Ziemba,

Arpitha Bykere , Italo Lombardi and Vitoria Saddi...40 16. 94BFed Watch: Policy Adrift, byTim Duy...44 17. Comprehensive strategy to address the lessons of the

banking crisis, by the Basel Committee...48 18. 5BLet Detroit Go Bankrupt, by MITT ROMNEY...50 19. 6BA bankruptcy to Save GM, by Joshua Rauh , and Luigi

Zingales...52

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20. Auto Execs in the Hot Seat, by David Kiley...56 21. Automakers Press High-Stakes Plea for Aid Senators Greet

CEOs' Request With Skepticism, by Lori Montgomery...59 22. 7BFacing a Slowdown, China’s Auto Industry Presses for a

Bailout From Beijing, by KEITH BRADSHER...61 23. Investors Dump LBO Debt To Raise Cash; Anticipate

Defaults, RGE...64 24. 8BFighting the Financial Crisis, One Challenge at a Time, by

HENRY M. PAULSON Jr....65 25. Getting to Yes, NYT editorial...67 26. A Skeptical Outsider Becomes Bush's 'Wartime General', by

David Cho...68 27. 140BA Conversion in 'This Storm', by David Cho...72 28. Obama Will Take Us Backward By Channeling Keynes, by

Amity Shlaes...77 29. Coaxing a turnabout in our 'animal spirits', by ROBERT J.

SHILLER...79 30. 9BGeorge W. Hoover? , by WILLIAM KRISTOL....81 31. 10B’Not since the Great Depression...', by Vanessa Drucker...83 32. 11BHow Should We Help Underwater Home Owers ?, by Barry

Ritholtz...85 33. Kennedy Announces Plan to Submit Bill For Universal Care,

by Shailagh Murray...87 34. Argentina and the contractionary effects of expansionary

fiscal policy, by Nicolas Magud...88 36. 12BDefusing the Credit-Default Swap Bomb, by JONATHAN R.

LAING...90 37. Central Clearinghouse By The End Of 2008 To Reduce

Counterparty Risk in the Credit Default Swap (CDS) Market, RGE...94

38. 13BDeregulator Looks Back, Unswayed, by ERIC LIPTON and STEPHEN LABATON...96

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39. 14BGramm and the ‘Enron Loophole’, by ERIC LIPTON...101 40. 15BBlowing the Whistle.Which External Controls Best Reveal

Corporate Fraud?, by Adair Morse and Luigi Zingales...103 41. 16BFacing Deficits, States Get Out Sharper Knives, by

JENNIFER STEINHAUER...106 42. 66BAfter the stimulus, by Paul Krugman...109 43. 156BPanic in Detroit This is not your father's Oldsmobile we're

rescuing, by Jonathan Cohn...110

44. Fannie Freddie data, by Paul Krugman...114 45. Once Again, It Wasn't Fannie and Freddie, by Russ

Roberts...115 46. Barry Ritholtz: What Caused the Financial Crisis?...118 47. It Wasn't Fannie and Freddie, by Mark Thoma...126 48. 67BAdministrative Virtues: The Case of Larry Summers, by

Stanley Fish...127 49. Obama Has a Chance to Reverse Long Erosion of the

Federal Service, by Paul C. Light...129 50. Brad Setser is scaring me, by Paul Krugman...131 51. 68BUt-oh …. exports are starting to fall fast, by Brad Setser...131 52. 69BDebt Man Walking, by John B. Judis...134 53. 95BMacro policy in a liquidity trap (wonkish), by Paul

Krugman...139 54. 96BDid Quantitative Easing By The Bank Of Japan Work?,

RGE...141 55. 97BShould We Worry About Deflation?, by Doug French...142 56. 98BThe G-20 communiqué, by Brad Setser...144 57. 99BTEXTO ÍNTEGRO DE LA DECLARACIÓN DE LA

CUMBRE DE WASHINGTON...147 58. 100BEl G-20 impulsa el mayor esfuerzo regulador en décadas, por

A. BOLAÑOS...156

14

59. 101BZapatero anuncia un gran plan de recuperación basado en la inversión, por MIGUEL GONZÁLEZ...159

60. 102BEl G-20 acuerda una acción pública masiva, por A. BOLAÑOS...162

61. 103BAcordaos de la economía real, por PAUL A. SAMUELSON... 165

62. 104BLa crisis se cuela en los resultados, por DAVID FERNÁNDEZ... 167

63. 105BUna cumbre en el fondo de un hoyo, por CRISTINA DELGADO... 169

64. 17B"Puede que el G-20 se convierta en un G-22", EFE...171 65. 18BFall of the Funds of Funds, by David Henry and Matthew

Goldstein...172 66. 19BDivorcing Money from Monetary Policy (abstract), by Todd

Keister, by Antoine Martin, and James McAndrews...174 67. Paulson's Latest and an Alternative: Why the Treasury

Should Buy Common, Not Preferred, Stock and Why LIBOR Deposit Guarantees Could Backfire, by Jonathan Carmel...176

68. The Next Collapse: U.S. Price Inflation, by Janine Aron and John Muellbauer...184

69. Stocks for the Long Run, by J. Bradford Delong...188 70. Deflation: Are We Still Sure "It" Cannot Happen Here?, by

Edwin Dolan...190 71. Letter: Comment on Stiglitz's "Turn Left for Sustainable

Growth", by P. K. Rao...194 72. Letter: Should Liberals (or Anyone Else) Really Support

Social Security "Personal Accounts"?, by Max J. Skidm...196 73. 20BDivorcing Money from Monetary Policy Todd Keister, by

Antoine Martin, and James McAndrews...198

15

Opinion

November 21, 2008

OP-ED COLUMNIST

21BThe Lame-Duck Economy By PAUL KRUGMAN

Everyone’s talking about a new New Deal, for obvious reasons. In 2008, as in 1932, a long era of Republican political dominance came to an end in the face of an economic and financial crisis that, in voters’ minds, both discredited the G.O.P.’s free-market ideology and undermined its claims of competence. And for those on the progressive side of the political spectrum, these are hopeful times.

There is, however, another and more disturbing parallel between 2008 and 1932 — namely, the emergence of a power vacuum at the height of the crisis. The interregnum of 1932-1933, the long stretch between the election and the actual transfer of power, was disastrous for the U.S. economy, at least in part because the outgoing administration had no credibility, the incoming administration had no authority and the ideological chasm between the two sides was too great to allow concerted action. And the same thing is happening now.

It’s true that the interregnum will be shorter this time: F.D.R. wasn’t inaugurated until March; Barack Obama will move into the White House on Jan. 20. But crises move faster these days.

How much can go wrong in the two months before Mr. Obama takes the oath of office? The answer, unfortunately, is: a lot. Consider how much darker the economic picture has grown since the failure of Lehman Brothers, which took place just over two months ago. And the pace of deterioration seems to be accelerating. Most obviously, we’re in the midst of the worst stock market crash since the Great Depression: the Standard & Poor’s 500-stock index has now fallen more than 50 percent from its peak. Other indicators are arguably even more disturbing: unemployment claims are surging, manufacturing production is plunging, interest rates on corporate bonds — which reflect investor fears of default — are soaring, which will almost surely lead to a sharp fall in business spending. The prospects for the economy look much grimmer now than they did as little as a week or two ago.

Yet economic policy, rather than responding to the threat, seems to have gone on vacation. In particular, panic has returned to the credit markets, yet no new rescue plan is in

16

sight. On the contrary, Henry Paulson, the Treasury secretary, has announced that he won’t even go back to Congress for the second half of the $700 billion already approved for financial bailouts. And financial aid for the beleaguered auto industry is being stalled by a political standoff.

How much should we worry about what looks like two months of policy drift? At minimum, the next two months will inflict serious pain on hundreds of thousands of Americans, who will lose their jobs, their homes, or both. What’s really troubling, however, is the possibility that some of the damage being done right now will be irreversible. I’m concerned, in particular, about the two D’s: deflation and Detroit. About deflation: Japan’s “lost decade” in the 1990s taught economists that it’s very hard to get the economy moving once expectations of inflation get too low (it doesn’t matter whether people literally expect prices to fall). Yet there’s clear deflationary pressure on the U.S. economy right now, and every month that passes without signs of recovery increases the odds that we’ll find ourselves stuck in a Japan-type trap for years.

About Detroit: There’s now a real risk that, in the absence of quick federal aid, the Big Three automakers and their network of suppliers will be forced into liquidation — that is, forced to shut down, lay off all their workers and sell off their assets. And if that happens, it will be very hard to bring them back. Now, maybe letting the auto companies die is the right decision, even though an auto industry collapse would be a huge blow to an already slumping economy. But it’s a decision that should be taken carefully, with full consideration of the costs and benefits — not a decision taken by default, because of a political standoff between Democrats who want Mr. Paulson to use some of that $700 billion and a lame-duck administration that’s trying to force Congress to divert funds from a fuel-efficiency program instead.

Is economic policy completely paralyzed between now and Jan. 20? No, not completely. Some useful actions are being taken. For example, Fannie Mae and Freddie Mac, the lending agencies, have taken the helpful step of declaring a temporary halt to foreclosures, while Congress has passed a badly needed extension of unemployment benefits now that the White House has dropped its opposition.

But nothing is happening on the policy front that is remotely commensurate with the scale of the economic crisis. And it’s scary to think how much more can go wrong before Inauguration Day.

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November 20, 2008, 7:15 pm

106BDon’t panic about the stock market By HPaul Krugman

Panic about the Hcredit marketsH instead. Interest rate on 3-month Treasuries at 0.02%; interest rate on Hhigh-yield (junk) bonds H over 20%.

This is an economic emergency.

November 19, 2008, 2:21 pm

107BCorporate cost of borrowing The data monthly, from HSt. Louis Fed. H, shows the real interest rates on corporate bonds, with the expected rate of inflation from the spread between 20-year TIPS and 20-year Treasury rates.

The surge in real borrowing costs reflects the combination of rising risk spreads — even for AAA borrower (500 pb. Vs 700 BAA borrower) — and falling expectations of inflation. This is why deflation is a problem.

And the high cost of capital is going to be one more reason for enormous downward pressure on the economy. This just keeps looking uglier.

108BAmity Shlaes strikes again When you hear Hclaims H that the New Deal made the depression worse, they often come directly or indirectly from the work of Amity Shlaes, whose misleading statistics have been widely disseminated on the right.

Now, Ms. Shlaes has found a new target: John Maynard Keynes. There’s a lot to critique in Hthis pieceH, but this one takes the cake:

But the most telling fact about the new rush to spend is that its advocates have insisted on invoking the New Deal. They tend to gloss over the period when the phrase, “We are all Keynesians now,” was actually first uttered: the mid-1960s. (Uttered by Friedman, in fact, though he meant only that we all work in the terms of the Keynesian lexicon.)

The Great Society of that period was the ultimate Keynesian experiment, and it didn’t work very well.

Grr. Keynesianism says that deficit spending can help create jobs when the economy is depressed. The Great Society wasn’t deficit spending, it wasn’t intended to create jobs, and the economy of the 1960s wasn’t depressed. It was social engineering; we can talk about how well or badly it worked, but it had nothing whatsoever to do with Keynesian economics.

Now, LBJ did engage in some Keynesian economics: namely, he imposed a contractionary fiscal policy in the form of a Htax surchargeH in an effort to cool an overheating economy.

Alas, pretty soon we’ll have all the usual suspects saying that the Great Society proves that Keynesian economics doesn’t work — after all, the “experts” told them so.

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Falling Prices Raise a New Fear: Deflation By Steven Mufson and Michael S. Rosenwald Washington Post Staff Writers Friday, November 21, 2008; A01

With the stock market crumbling and the economy shrinking, a whiff of deflation is in the air.

Oil prices yesterday slid below $50 a barrel to the lowest level since May 2005; stores are advertising sales on the eve of what should be peak holiday shopping season; and worldwide demand for items as varied as steel, petrochemicals and clothing plunged in October.

This week's news of a drop in consumer prices may sound on the surface like a good deal for financially strapped U.S. households. But economists warn that sustained deflation -- a period of falling overall prices -- would deepen the nation's economic troubles. Such a period would make it harder for people to repay debts and would prompt consumers to delay purchases in anticipation of lower prices and harder times.

"Everyone is having these huge sales, and consumers know if they wait longer, the chances of them not having a good selection is fairly small and the chances are that the prices will be lower," said HCharles McMillionH, an economist who runs HMBG Information ServicesH. "So why buy today? This is exactly why economists are always scared to death of deflation."

Other economists cautioned that one month's swoon in prices -- concentrated in areas linked to plunging energy prices -- was not cause for alarm and that the HFederal ReserveH possessed the weapons needed to combat falling prices.

The mere specter of a prolonged deflationary period, which hasn't happened in the United States since the Great Depression, is likely to steer Fed policy toward lower interest rates in the coming weeks. HFed Chairman Ben S. BernankeH warned about the dangers of deflation in 2002 when he was a Fed member and HAlan GreenspanH was chairman.

HEd Yardeni H, a financial strategist and head of Yardeni Research, predicted that the Fed will move soon to force interest rates down and make it cheaper to borrow money to buy homes and finance other purchases, thus jump-starting the economy. "How do I know all this?" Yardeni said in a report this week. "Ben told me. He told everyone. He said he would do this under certain dire circumstances, which are rapidly unfolding right at this time."

But deflation could make borrowing unattractive for companies even if lending rates hit zero. Executives would not want to take on debt while prices and profits are falling.

The Labor Department's consumer-price figures for October, released Wednesday, showed the steepest drop since publication of figures began in 1947 and added to the anxiety in markets this week. And retailers are feeling the pinch.

Apparel makers have been hit hard. The recent consumer price index report showed that apparel prices fell 1 percent last month, the latest in a long history of problems for the industry. McMillion said apparel prices have been under severe pressure for 15 years as lower-cost imports have entered the market.

"Now, in addition to facing very low-priced imports, they are also facing a sharp cutback in demand," he said.

Retail prices for apparel -- even without adjusting for inflation -- were lower last month than in 1989. Overall consumer prices are up 76 percent in the same time.

19

"A $20 shirt today, that same shirt in 1989 was $20," McMillion said. "That's fairly amazing."

Crude oil prices have also defied expectations. Only a few months ago, oil experts and oil ministers from the HOrganization of the Petroleum Exporting CountriesH asserted that prices had reached a new plateau and that high-cost exploration areas would prevent prices from dropping much below $65 a barrel, the approximate cost of extracting oil from Canada's tar sands, the most expensive oil being produced.

But oil prices slipped below that level as consumption around the world stalled or fell. Now companies have announced delays in Canadian tar-sands projects. Last week, HPetro-Canada H joined Suncor in postponing expansion plans, citing credit market conditions and oil prices. OPEC plans to meet Nov. 29 to consider output cuts aimed at bolstering prices.

But propping up prices could prove difficult when industrial activity is sagging. Crude steel production for the 66 countries reporting to the World Steel Association was 100.5 million metric tons in October, 12.4 percent lower than in October last year and 6.9 percent below September 2008.The declines were particularly severe in China, down 17 percent from last October, and in Russia, down 27 percent.

"I think that the prognosis for November and December will be more of the same," said Nicholas Walters, spokesman for the association. "That's what we're hearing from the industry."

Used-car prices are also plunging -- down 2.4 percent in October after a 1.8 percent drop in September, according to the government's price report. While that could create bargain opportunities for shoppers, lower used-car prices mean that people hoping to trade in vehicles are also getting lower prices, said Mike Linn, chief executive of the National Independent Automobile Dealers Association. That could make it difficult to pay off loans on the cars and give people less money for a down payment on a shiny new car.

U.S. farmers have also been hit hard by deflationary trends. And it has all happened extremely fast. This summer, the price of a bushel of corn climbed to about $8, boosted by the growing economy, soaring gas prices that fueled demand for corn-based ethanol and floods in Iowa. Higher corn prices rippled through the economy, nudging up prices on everything from Corn Flakes to steak at Morton's.

But with the economy in a tailspin, prices have crashed. A bushel of corn is now around $4. This week's consumer price index report showed that five of six grocery-store food-group prices fell last month. Fruits and vegetables fell 2.2 percent, on top of a 0.5 percent decrease in September. Dairy fell 1 percent, after a 0.6 percent decline in September.

"It's hard to see any prices that haven't fallen," said HIowa State UniversityH agricultural economist Chad Hart. Some of farmers' costs haven't fallen as quickly, however. Fertilizer prices are still high. So are prices on seeds and insurance for crops. And for corn growers, prices offered by ethanol makers have fallen with gasoline prices.

"They are definitely now seeing that pinch," Hart said. "I would say things are more scary now than in the past."

Some economists argue that what's really causing consumers to hold back isn't the deflation mentality but broader fears about their economic security.

"The issue is less price cutting, it seems to me, than no sales," said Edwin M. Truman, a longtime Fed and Treasury official who is now a senior fellow at the HPeterson Institute for International Economics H. He said that people were holding back on buying goods today "not in order to spend tomorrow, but because they're worried about having a job tomorrow."

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Business

November 21, 2008

22BCitigroup Tries to Stop the Drop in Its Share Price By ERIC DASH and LOUISE STORY For months, the nation’s largest banks have struggled to regain investors’ trust. In the center of the vortex is HCitigroupH, whose precipitous stock-market plunge accelerated on Thursday, sending shock waves through the financial world.

The shares slumped 26 percent Thursday; the bank has lost half its value in just four days. The chief executive, HVikram S. PanditH, will hold a meeting for senior managers Friday to update them on the bank’s condition.

Investors and analysts have long pressured the bank to consider ways to lift its stock price, including splitting the company or selling pieces. While a few also say the company should consider selling itself outright, there is no certainty that any change would happen soon. Senior executives say the company is financially strong and has ample financing options. Moreover, there are few buyers who would be willing to pay a price that Citigroup would want for its most valuable assets.

Citigroup executives are seeking to stabilize the stock price, but at this point they are not actively exploring selling or splitting up the company, according to two people with direct knowledge of the discussions.

The bank has posted four consecutive quarters of losses, caused by billions in write-downs. Nine of its investment funds have cratered this year. And now the bank could face a tsunami of new losses in its once-lucrative consumer loan business as the global economy weakens.

Within the bank’s Manhattan offices, television screens have stopped displaying the company’s stock price. Traders have begun making jokes comparing Citigroup to the Titanic.

But there is a wide gap between what Wall Street investors and Citigroup’s executives believe about the company’s financial condition. Senior executives feel that Mr. Pandit has followed through on plans to aggressively shrink the company and control costs. The bank has sold tens of billions of dollars’ worth of risky assets, improved its capital position and announced plans to eliminate 52,000 jobs by next June. “We are entering 2009 in a strong position, much stronger than we entered in 2008,” Mr. Pandit said in a speech to employees this week. “We will be a long-term winner in this industry.”

Yet as the drumbeat of bad news about the bank grows louder, investors remain unconvinced. Even a decision by Prince HWalid bin TalalH of Saudi Arabia, who bailed out Citicorp in the 1990s, to raise his stake to 5 percent Thursday failed to restore confidence in the bank. Two senior Citigroup executives said the bank had not approached him about raising his investment. The Saudi prince’s initial investment soared as Citigroup turned out record profits, only to evaporate over the last year.

“The earnings power is there,” said Charles Peabody, a financial services analyst at Portales Partners. “It’s a question of getting through the credit issues.”

21

Other big banks, like HBank of AmericaH and HJPMorgan ChaseH, also tumbled Thursday as the broad stock market sank again, wiping out more than a decade’s worth of gains. And HGoldman Sachs H, once the most sterling American investment bank, fell below the $53 price at which it went public in 1999.

Investors have long feared that the bad news for banks will get worse as the economy slows. But this latest rout in financial shares, which are now plumbing their lowest depths since the economic crisis broke out, reflects growing concern that banks like Citigroup will require vast sums of additional capital, possibly from the government, to cope with the pain to come.

Home mortgages, credit card loans, commercial real estate debt — all are likely to deteriorate further now that a recession is at hand. Banks that have already lost billions of dollars could lose billions more. “All the danger signs are flashing red,” said Simon Johnson, a professor at the Sloan School of Management at the HMassachusetts Institute of TechnologyH.

Much of the fear centers on the unknowable. It is unclear just how bad banks’ losses on consumer loans, credit cards and mortgages will be as the economy weakens. Commercial real estate loans are deteriorating, and it is unclear whether banks have sold the worst of their holdings. Then there are all the investments that lurk off of banks’ balance sheets, in the so-called shadow banking system. And a new uncertainty has leapt to the forefront as the automotive industry teeters, sending investors scrambling to calculate how much banks are exposed to these loans.

Several big banks hit record lows. Bank of America fell 13.86 percent to $11.25, JPMorgan slid 17.88 percent to $23.38 and Goldman Sachs slumped 5.76 percent to close at $52. HMorgan StanleyH neared a record low, closing down 10.24 percent at $9.20, while HWells FargoH fell 7.66 percent to $22.53.

In a bid to calm nerves, Citigroup officials are meeting with other large shareholders. Last week, Citigroup’s chairman, Winfried Bischoff, traveled to Dubai and met with Sheik Ahmed bin Zayed al-Nahyan, the director of the Abu Dhabi Investment Authority, according to two executives briefed on the situation.

The renewed assault on financial stocks led the Financial Services Roundtable, an influential lobby group for the industry, to press regulators Thursday for another ban on short-selling, a strategy in which investors bet against declines in a share price.

The current rout appeared to have gained momentum after Treasury Secretary HHenry M. Paulson Jr.H announced last week that the government would abandon its original plan to purchase troubled bank assets. That sent prices of commercial mortgage bonds and other loans into a nosedive. Mr. Paulson also said the Treasury would let the incoming administration determine how to deploy the remaining $350 billion left in the program.

Yet investors have grown increasingly nervous about the appearance of a leadership vacuum in Washington as the financial markets burn, and some have begun saying that President-elect HBarack Obama H should move more rapidly to release a plan.

“We really need somebody to step in and show leadership,” said HWilbur L. Ross Jr.H, chairman of WL Ross and Company, an investment firm that has been looking for bargains in the banking sector. “Every day that’s wasted and that we stay in freefall is going to make the recession that much deeper and longer.” That has workers in the financial industry bracing for more pain.

“Major financial institutions have been taking write-downs all year, and what do you do next? You lay people off, and that decreases your need for office space,” said Harold Bordwin of the real estate group at KPMG Corporate Finance. “It’s very scary.”

22

Economy

November 20, 2008

23BStocks Are Hurt by Latest Fear: Declining Prices By VIKAS BAJAJ

After gyrating wildly for weeks, the stock market lurched lower on Wednesday, falling to its lowest point in nearly six years, as concern spread that the economy might be facing a chronic and debilitating decline in prices.

The Dow Jones industrial average closed below 8,000 for the first time since early 2003 after new reports painted a grim picture of the economy and raised the spectre of HdeflationH, which would put more strain on hard-pressed businesses and workers.

The Labor Department reported that prices of consumer goods and services fell by a record amount in October, while another report showed that a measure of home building fell for the

23

fourth straight month, to its lowest level in the 49 years that the government has kept that data.

While most consumers might welcome the idea that things are getting cheaper, deflation is an economists’ nightmare. It was a hallmark of the Depression and Japan’s so-called lost decade in the 1990s. A big worry is that deflation would blunt the impact of interest rate cuts by the HFederal ReserveH, forcing policy makers to use other tools to try to revive the economy.

The HConsumer Price IndexH, a measure of how much Americans pay for groceries, entertainment and other goods and services, fell by 1 percent in October, to an annualized rate of 3.7 percent, according to the Labor Department. It was the biggest one-month drop in the 61-year history of the index and the lowest annualized gain since October of last year.

Much of the decline could be traced to a 14 percent drop in the price of gasoline, but the cost of other goods — including clothes, milk and vegetables — also fell sharply.

The vice chairman of the Fed, Donald L. Kohn, said that the risk of deflation, defined as a “general decline in prices,” remained slight but had increased. “Whatever I thought that risk was, four or five months ago, I think it is bigger now even if it is still small,” Mr. Kohn said in response to a question after a speech. The Fed, he added, would be aggressive, if necessary, to prevent a broad drop in prices.

Stocks started falling shortly after 10 a.m. and ground their way down for much of the day before tumbling sharply in the last hour of trading. The broad Standard & Poor’s 500-stock index closed down 6.1 percent, to 806.58, falling below a low it set on Oct. 27. The index is now only 37 points above its October 2002 low. The Dow dropped 427.47, or 5.1 percent, to 7,997.28.

Financial shares led the market down, with HCitigroupH falling by more than 23 percent and HBank of America H closing down 14 percent. HGeneral MotorsH and the HFord Motor Company H also tumbled as prospects for a federal aid packaged looked grim. “That spooked investors quite a bit,” said Sam Stovall, chief equity strategist at Standard & Poor’s Equity Research. “G.M. and Citigroup, two venerable companies, are right now on the ropes.”

In the credit market, the price of corporate debt and bonds backed by commercial mortgages plummeted, while government bonds rallied as investors sought safe havens. The yield on the 10-year Treasury, which moves in the opposite direction from its price, fell to 3.32 percent, from 3.53 on Tuesday.

Analysts say a sustained decline in consumer prices would be terrible for the economy. Businesses that cut prices to attract buyers are likely to have to lay off workers as well. They may also have little left over to pay lenders or shareholders.

Prices are falling outside the United States too. Consumer prices declined in Britain, France, Germany and elsewhere in Europe in October, and prices were flat in September in Japan, which has fought deflation on and off for nearly two decades.

The decline in consumer prices is all the more remarkable because this summer many economists were concerned about inflation and the prospect for stagflation, in which inflation and unemployment rise simultaneously, contrary to their usual relationship. “It’s funny that just a few months ago everyone was wringing their hands over inflation,” said Nariman Behravesh, chief economist at Global Insight. “It’s gone. It’s over.”

But that concern has been quickly dashed, in large part because of a steep drop in commodity prices. Crude oil prices, for instance, have fallen more than 63 percent from their July peak of

24

$145.29 a barrel, to $53.62 on Wednesday. The national average price for unleaded gasoline is now $2.05 a gallon, down from $2.92 a month earlier, according to AAA, the auto club.

In fact, it now seems clear that the nation is entering a more frugal era after several years of conspicuous consumption.

For instance, room rates at luxury hotels fell 5.4 percent in the 28 days ending on Nov. 15 — in contrast to a 1.3 percent increase in rates at midscale hotels that do not serve food, estimated Smith Travel Research, a firm that studies the industry. Over all, hotel prices fell 1.6 percent in October, according to the Labor Department.

High-end retailers are resorting to drastic discounting to lure customers into stores. Executives at HNordstromH, the department store chain, said on a recent conference call with analysts that the company had lowered prices on more than 800 clothing styles by an average of 22 percent.

Airfares, which were rising along with energy prices this summer, are now sliding as airlines struggle to fill seats on many popular routes. The average price of a one-way ticket is down about 20 percent from July, to $107 in mid-November, according to Harrell Associates, a firm that tracks the airline industry.

Still, the so-called core price index — which excludes energy and food — was down a more modest 0.1 percent. The prices of goods and services like meat, alcohol, medical care and education increased in October.

“It would take significant and persistent contraction in the economy to push core inflation into negative territory,” said Dean Maki, an economist at HBarclays H Capital in New York. “We do not think that is likely, especially given the aggressive policy response on the part of the Fed and Treasury.”

The Fed has already cut its benchmark interest rate to 1 percent from 5.25 percent last year, and it has been lending hundreds of billions of dollars to banks and corporations in recent months to revive credit markets. The Treasury has also pumped nearly $300 billion into banks and other financial firms.

The Fed is anticipating significant further slowing in the economy. A report released on Wednesday shows that the Fed now expects 2009 growth to be 1.8 percent to minus 1 percent, down from a previous forecast of growth of 1.9 percent to 3 percent.

Even though the Fed’s target interest rate is close to zero, economists say there is much more the central bank and the government can do to revive the economy. In a speech in 2002, before he was the chairman of the Fed, HBen S. BernankeH said central banks could combat deflation by buying longer-term Treasury and mortgage-backed securities to drive down interest rates.

“The Fed is going to ram liquidity into the financial system whether it is asking for it or not, just going out and buying assets and printing money in order to do it,” said Alan D. Levenson, chief economist at HT. Rowe PriceH. “If you jam money into everyone’s pocket, they will spend it.”

Furthermore, lawmakers in Washington are also expected to pass a significant fiscal Hstimulus packageH in January after the new administration and Congress take power. Policy makers could head off deflation by spending hundreds of billions of dollars on tax breaks, infrastructure projects and other initiatives.

Jack Healy and Stephanie Rosenbloom contributed reporting.

25

Business

Economix November 19, 2008, 6:15 pm

70BDeflation: A Primer By R.M. Schneiderman

This morning, the Bureau of Labor Statistics HannouncedH the steepest single-month drop in the 61-year history of the consumer price index, an indication that inflation was Hin retreat H.

Clearly that is welcome news to people who were worried about rising prices. But some HeconomistsH and HreadersH fear that prices will continue to fall, causing a Hdeflationary spiralH.

Put simply, deflation means that prices decrease. On the surface, that may seem like a good thing but decreasing prices can spin out of control. A slowing economy causes demand to ease and prices to fall; consumers then assume that prices will continue to decline and put off buying, which hurts demand even more and causes more price reductions. As prices decrease even more, debts become more difficult to pay back because incomes begin to decline. Companies and household are then both at risk of defaulting on the debts.

That is partly what happened to Japan in the 1990s. A banking crisis led to a tight credit market, which was dragging down the economy. In response, the Bank of Japan lowered interest rates to zero. Still, banks refused to lend.

“Prices for pretty much everything declined, following a bust in the real estate and stock markets…” Hwrote Bill Powell in a recent article for Time magazine.

“The country entered a decade of stagnation.”

So will that happen in the United States? Not necessarily.

Already, the Fed has been more aggressive than Japan’s central bank was in the 1990s, lowering its benchmark interest rate, bailing out various companies and injecting money into the financial system.

“To go so quickly from having concerns about inflation to thinking there is a massive deflation problem is jumping the gun a bit,” Jim O’Neil, chief economist at Goldman Sachs, Htold The Financial TimesH.

Even Nouriel Roubini, an economist at New York University, Hwho foresaw much of the financial crisisH, told my colleague Peter Goodman in Ha recent articleH that American policymakers can prevent Japanese style deflation, so long as they continue to be aggressive.

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24BThe Deadly Dirty D-Words: “Deflation”, “Debt Deflation” and “Defaults”. And How Central Banks

Will Have to Resort to “Crazy” Policies as We Have Reached Such Bermuda Triangle of a “Liquidity Trap” Nouriel Roubini | Nov 21, 2008

I have been warning Hsince January 2008 that the biggest risk ahead for the US and the global economy is one of a stag-deflation, the deadly combination of an economic stagnation/recession and deflationH.

Let me discuss the details of this toxic mixture of deflation, liquidity trap, debt deflation and rising household and corporate defaults:

We Are Close to Deflation and Stag-Deflation

First of all, signs of Hstag-deflation now are clearH: we are in a severe recession and now the recent readings of both the PPI and the CPI are showing the beginning of deflation. Slack in goods markets with demand falling and supply being excessive (because of years of excessive overinvestment in new capacity in China, Asia and emerging market economies) means lower pricing power of firms and need to cut prices to sell the burgeoning inventory of unsold goods; slack in labor markets with sharp fall in employment and sharp rise in the unemployment rate means lower wage pressures and lower labor cost pressures; and slack in commodity markets – that have already fallen by 30% from their summer peaks and will fall another 20-30% in a global recession – means lower inflation and actual deflationary forces. Given a severe US and global recession deflation will soon be a reality in the US, Japan, Switzerland, UK and, down the line, even in the Eurozone and other economies.

The Risk of a Liquidity Trap When deflation sets in central banks need to worry about it and worry about a liquidity trap. Take the example of the 2001 recession: that was a mild 8 months recession in the US and over by end of 2001. But by 2002 the US inflation rate had fallen towards 1% (effectively 0% or negative given imperfect measurement of hedonic prices) that the Fed was forced to cut the Fed Funds rate to 1% and Ben Bernanke - then a Fed Governor – Hwas writing speeches titled “Deflation: Making Sure “It” Does Not Happen Here”H meaning it would not happen in the US as Japan was already in a deflation at that time. So if a mild recession – that was not even global – led to deflation worries how severe deflation could be in a recession that even the IMF is now forecasting to be global in 2009?

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When economies get close to deflation central banks aggressively cut policy rate but they are threatened by the liquidity trap that the zero bound on nominal policy rates implies. The Fed is now effectively already in a liquidity trap: the target Fed Funds rate is still 1% but expected to be cut to 0.5% in December and down to 0% by early 2009. Also, while the target rate is still 1% the effective Fed Funds rate has been trading close to 0.3% for several weeks now as the Fed has flooded money markets with massive liquidity injections; so we are effectively already close to the 0% constraint for the nominal policy rate.

Why should we worry about a liquidity trap? When policy rates are close to zero money and interest bearing short term government bonds become effectively perfectly substitutable (what is a zero interest rate bond? It is effectively like cash). Then further open market operations to increase the monetary base cannot reduce further the nominal interest rate and therefore monetary policy becomes ineffective in stimulating consumption, housing investment and capex spending by the corporate sector: you get stuck into a liquidity trap and more unorthodox monetary policy actions (to be discussed below) need to be undertaken.

The Costs and Dangers of Price Deflation Before we discuss the monetary policy options in a deflation and liquidity trap let us consider the costs and dangers of deflation.

First, if aggregate demand falls sharply below aggregate supply then price deflation sets in (and indeed there is already massive price deflation in the US in the sectors – housing, autos/motor vehicles and consumer durables – where the excess inventory of unsold goods is huge). The fall in prices and the excess inventory of unsold goods forces firms to cut back production and employment; the ensuing fall in incomes leads to further fall in demand and induce another vicious cycle of falling prices and falling production/employment/income and demand.

Second, when there is deflation there is no incentive to consume/spend today as prices will be lower tomorrow: buying goods today is like catching a falling knife and there is an incentive to postpone spending (consumption and investment spending) until the future: why to buy a home or a car today if its price will fall another 15% and purchasing today would imply having one’s equity in a home or a car fully wiped out in a matter of months? Better to postpone spending. But this postponing of spending exacerbates the vicious cycle of falling demand and supply/employment/income and prices.

Third, when there is deflation real interest rate are high and rising in spite of the fact that nominal policy rates are zero. If the policy rate is zero and there is a 2% deflation the real short term policy rate is actually a positive 2% that further depresses consumption and investment; and real long-term market rates are even higher with deflation – as discussed in detail below – as market rates at which firms and households borrow are much higher than short term policy rates.

The Deadly Deeds of Debt Deflation Fourth, deflation also leads to the nightmare of debt deflation, a situation well analyzed by Fisher during the Great Depression. If debt liabilities are in nominal terms (D) and at a fixed long term interest rate (i) a reduction in the price level (P) increases the real value of such nominal liabilities (D/P goes up); so debtors that are already distressed in a recession and deflation become even more distressed as the real burden of their liabilities (D/P) sharply rises.

Another complementary way to see the perverse effects of debt deflation is to notice that the ex-post – as opposed to the ex-ante –real interest rate faced by borrowers sharply rise.

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Suppose you are a firm or household that had borrowed – say a 10 year mortgage or a 10 year corporate bond – at an interest rate (i) of 5% at the time when inflation (dP/P) was expected to remain at 3%; then the real ex-ante real cost of borrowing (r= i – dP/P) was only 2% (the difference between 5% and the expected inflation of 3%). Now suppose that, ex-post, the economy falls into a deflation trap and prices are now falling at 2% annual rate and expected to fall as much for a number of years. Now the ex-post real interest rate (r= i – dP/P) on that borrowing rises from 2% ex-ante to an actual ex-post 7% (5% - (-2%)). Thus, ex-post unexpected deflation sharply increases the real interest rate faced by borrowers or, equivalently, sharply increases the real ex-post value of their real liabilities (D/P).

Things are even worse if the debtor had borrowed to finance the leverage purchase of assets whose prices is now falling. Suppose you are a household who borrowed at a 5% mortgage rate to purchase a home whose price is now falling at an annual rate of 15%. Then the effective real interest rate that you are facing on your debt is not 5% but a whopping 20% (the sum of the 5% mortgage rate plus the 15% fall in the price of the underlying asset) that soon leads you into the depth of negative equity into your home. Thus, leveraged purchase of assets whose price is falling is an even more deadly form of debt deflation.

In all of its forms and manifestations debt deflation sharply increases the risk that borrowers will be forced to default on real obligations that they cannot service. Thus, debt deflation is associated with a sharp rise in corporate defaults and household defaults that creates a spiral of deflation, debt deflation and defaults.

High Market Real Interest Rates and Costs of Borrowing in a Deflation/Liquidity Trap In situations of deflation and liquidity trap traditional monetary policy becomes pathetically ineffective. Consider now why monetary policy is ineffective. The real long-term interest rate faced by borrowers (say a mortgage holders who has a 10 year fixed rate mortgage or a corporate who issues a 10 year nominal rate bond) is given by the following expression:

Real Long Term Market Rate = (Nominal Long Term Market Yield – Inflation Rate) = (Nominal Long Term Market Yield – Long Term Government Bond Yield) + (Long Term Government Bond Yield – Fed Funds Rate) + Fed Funds Rate - Inflation Rate

Similarly the real short-term interest rate faced by borrowers (say a mortgage holder who has a variable rate mortgage or a consumer with credit card debt or a corporate who issues short term commercial paper) is given by the following expression:

Real Short Term Market Rate = (Nominal Short Term Market Yield – Inflation Rate) = (Nominal Short Term Market Yield – 3 month Libor rate) + (3 month Libor rate – Fed Funds Rate) + Fed Funds Rate - Inflation Rate

The first expression above shows clearly that even if the policy rate (the Fed Fund rate) is 0% the long term real interest rate faced by market borrowers can be very high for three reasons:

1. For any given nominal market rate there is deflation that increases real rates

2. The spread between the nominal market rate and the long term nominal yield on safe government bonds (representing the credit spread) can be high and rising

3. The spread between the nominal government bond yield and the policy rate (the yield curve spread) can be high and rising

A similar three-part decomposition holds for the short term real market rate that depends on deflation, on the spread between market rates and the short –term Libor rate and the spread between short term Libor and the policy rate.

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Now, in a situation of a liquidity trap all three factors described above keep real long term market rates high and rising in spite of falling policy rates (that end up with the Fed Funds rate down to zero). First, the credit spread has widened for high yield corporates from 250bps in June of last year to a whopping 1600bps in recent days; even the credit spread for high grade corporate has gone from 50bps to 400-500bps. Second the spread between long term government bonds and the Fed Funds rate has sharply increased as the Fed Funds rate has been reduced from 5.25% to 1% (soon 0%) while long bond yields have fallen very little (about 100bps). Third, inflation is sharply falling and deflation is over the horizon.

The same holds for the sharp increase in real short term market rates since the beginning of the liquidity crunch in money markets and short term debt markets: a rise in the spread between market rates (say credit cards or commercial paper) and 3 month Libor; a rise in the spread between 2 month Libor and the policy rate (or variants of the same such as the TED spread or the Libor-OIS spread); a fall in inflation and the onset of deflation.

“Crazy” Monetary Policy to Address the Liquidity Trap and a Severe Liquidity and Credit Crunch To address the increase in real short term market rates the Fed and other central banks have already undertaken quite unorthodox monetary policy moves. To address the even more severe increase in real long term market rates the Fed and other central banks will have to undertake even more radical and unorthodox policy actions.

The widening of the real short term market rates has been addressed by creating a whole series of new liquidity facilities (the TAF, the TSLF, the PDCF, the swap lines with foreign central banks, the new commercial paper facility). Some of these facilities have been aimed at reducing the sharply rising TED spread, Libor-OIS spread, Libor-Fed Funds spread. While other of these facilities – such as the new commercial paper facility (that has the acronym of ABCPMMMFLF) have had the aim of reducing the sharply rising spread between short-term market rates (such as commercial paper rates) and the policy rate (or the 3 month T-bill rate). Flooding money markets with massive amounts of liquidity and with a massive swap of illiquid assets sitting on the balance sheet of banks and broker dealers (MBS, etc.) for safe Treasuries has finally started – after 12 months of rising spreads – to reduce such Libor versus safe assets spread.

Indeed, the Fed and other central banks that used to be the “lenders of last resort” have become the “lenders of first and only resort” as banks don’t lend to each other, banks don’t lend to non-bank financial institutions and financial institutions don’t lend to the corporate and household sectors.

However, in spite of the Fed becoming the lender of first and only resort (even the corporate CP market is now being propped by the new Fed facility) there are still major problems that remain seriously unresolved in short term money markets and short term credit markets:

- Such Libor spreads are rising again in recent days; and they are still very high – at the 3 month maturity – compared to what they were before this liquidity crunch;

- banks and other financial institutions are still not lending to each other in spite of lower spreads as they need the liquidity received by the Fed and they worry about the solvency of their counterparties;

- only banks and major broker dealers have access to these facilities and thus most of the shadow banking system does not have access to this Fed liquidity;

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- market spreads as still rising and the availability of short term credit is becoming tighter as banks increase interest rates on credit cards, student loans and auto loans and make such loans in scarcer supply;

- only rated investment grade corporate have access to the commercial paper facility leaving millions of speculative grade or non-rated firms in an even bigger liquidity and credit squeeze;

- securitization of credit cards, auto loans, student loans is currently dead.

This is why now a desperate Treasury is starting to think about using the remaining TARP funds to directly unclog the unsecured consumer debt (credit cards, student loans, auto loans) market and the securitization of such debt. Desperate times required desperate and extreme actions.

Even “Crazier” Policy Actions Are Required to Reduce Long Term Market Interest Rates

But even more desperate or “crazier” monetary actions are needed to address the increase in real long term market rates. These actions are needed to prevent deflation from setting in, to reduce the credit spread (the difference between long term market rates and long term government bond yields) and to reduce the yield curve spread (the difference between long term government bond yields and the policy rate).

There are a number of tools that the Fed could use to reduce the yield curve spread when the Fed Funds rate is already done to zero. First, the Fed could commit to maintain the Fed Funds rate down to zero for a long period of time: since long term government bond yields are – based on the expectation hypothesis – equal to a weighted average of current short term government bond yields and current expectations of what those short term bond yields will be for the foreseeable future a commitment to keep the Fed Funds rate down to zero for a long time will affect expectations of future expected short rates and could reduce long term government bond yields. Even this action may not be sufficient to reduce long yields on safe assets as such long yields also depend on liquidity premia and risk premia that will not be affected by expectation of future short rates. Greenspan discovered the “bond market conundrum” when raising the Fed Funds rate from 1% to 5.25% did not change much long rates and Bernanke rediscovered this conundrum when reducing the Fed Funds rate down to 1% failed to significantly reduce long rates. Such long rates depend in part on the global supply of savings relative to the demand for investment; thus they are not likely to be strongly affected by current and future expected policy rates.

Second, the Fed could do what it last did in the 1950s: directly purchase long term government bonds as a way of pushing downward their yield and thus reduce the yield curve spread. But even such action may not be very successful in world where such long rates depend as much as anything else on the global supply of savings relative to investment. Thus, even radical action such as outright Fed purchases of 10 or 30 year US Treasury bonds may not work as much as desired.

Next, the Fed could try to directly affect the credit spread (the spread between long term market rates and long term government bond yields). Radical actions could take the form of: outright purchases of corporate bonds (high yield and high grade); outright purchases of mortgages and private and agency MBS as well as agency debt; forcing Fannie and Freddie to vastly expand their portfolios by buying and/or guaranteeing more mortgages and bundles of mortgages; one could decide to directly subsidize mortgages with fiscal resources; the Fed (or Treasury) could even go as far as directly intervening in the stock market via direct purchases

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of equities as a way to boost falling equity prices. Some of such policy actions seem extreme but they were in the playbook that Governor Bernanke described in his 2002 speech on how to avoid deflation. They all imply serious risks for the Fed and concerns about market manipulation. Such risks include the losses that the Fed could incur in purchasing long term private securities, especially high yield junk bonds of distressed corporations. In the commercial paper fund the Fed refused to purchase non-investment grade securities. Even high grade corporate bonds are not without risk as their spread have massively widened in recent months from 50bps over Treasuries to levels in the 500bps plus range. Also pushing the insolvent Fannie and Freddie to take even more credit risk may be a reckless policy choice. And having a government trying to manipulate stock prices would create another whole can of worms of conflicts and distortions.

Finally, the Fed could try to follow aggressive policies to attempt to prevent deflation from setting in: massive quantitative easing; flooding markets with unlimited unsterilized liquidity; talking down the value of the dollar; direct and massive intervention in the forex to weaken the dollar; vast increase of the swap lines with foreign central banks (an indirect and disguised form of forex intervention) aimed to prevent a strengthening of the dollar; attempts to target the price level or the inflation rate via aggressive preemptive monetization; or even a money-financed budget deficit (Han idea suggested by Bernanke in 2002 that he termed to be the equivalent of an “helicopter drop” of money in the economy H). The problem with many of these “extreme” policy actions – as well as some of the ones described above to affect the relevant spreads – is that they were tried in Japan in the 1990s and the last few years and they miserably failed: once you are in a liquidity trap and there are fundamental deflationary forces in the economy as the excess aggregate supply of goods is facing a falling aggregate demand it is very hard even with extreme policy actions to prevent deflations from emerging.

Some very aggressive policy actions – such as letting the dollar weaken sharply – may do the job but they may also be beggar-thy-neighbor policies that would export even more deflation to other countries: a much weaker dollar would mean a much stronger value of other currencies that would reduce aggregate demand abroad and exacerbate their deflationary pressures as their import prices would sharply fall.

And indeed with global – rather than U.S. alone – deflationary forces setting in the global economy dealing with global deflation becomes much harder. The world economy has been massively imbalanced for the last decade with the U.S. being the consumer of first and last resort, spending more than its income and running ever larger current account deficits while creating a massive excess productive capacity via overinvestment; while China and other emerging markets have been the producers of first and last resort, spending less than their income and running ever larger current account surpluses. With U.S. spending (consumption, residential investment, capex spending) now faltering and structural rigidities to a rapid growth of domestic consumption demand in China and emerging market economies, a global glut of unsold goods may lead to persistent and perverse deflationary forces that may last for a longer time unless proper policy actions – mostly non-necessarily monetary – are undertaken.

Thus, dealing with this deadly combination of deflation, liquidity traps, debt deflation and defaults that I termed as global stag-deflation may be the biggest challenge that U.S. and global policy makers may have to face in 2009. It will not be easy to prevent this toxic vicious circle unless the process of recapitalizing financial institutions via temporary partial nationalization of them is accelerated and performed in a consistent and credible way; unless such actions are combined with massive fiscal stimulus to prop up aggregate demand while private demand is in free fall; unless the debt burden of insolvent households is sharply

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reduced via outright large debt reduction (not cosmetic and ineffective “loan modifications”); and unless even more unorthodox and radical monetary policy actions are undertaken to prevent pervasive deflation from setting in.

Thus, while the Fed may pursue radical, “crazy” and “crazier” monetary policy actions the true policy responses to the risk of deflation may lie elsewhere: when monetary policy is in a liquidity trap a properly-targeted fiscal stimulus is more appropriate and effective; cleaning up the financial system and properly recapitalize it is necessary; and debt deflation and debt overhang problems are more directly and properly resolved through debt restructuring and debt reduction than by trying to reduce the real value of such liabilities via higher inflation.

The Shrinking Hedge Fund Industry: From $2 Trillion to $1 Trillion By 2009? Nov 20, 2008

Economist: Between 1990 and last year the industry’s assets under management grew almost 50-fold, to nearly $2 trillion. Now industry executives predict that assets could fall by 30-40%, as clients stampede for the exit. The number of funds, which climbed to over 7,000 as a generation of financiers headed for the gold-paved streets of Mayfair in London and Greenwich, Connecticut, could fall by half.

o Nov 20 Hedge Fund Research (via FinWeek): Hedge fund assets worldwide shrank by 9 percent to $1.56 trillion in October, the lowest level in two years, after investors withdrew cash and stock markets declined.

o Investors pulled $40 billion from hedge funds in October, according to Chicago-based Hedge Fund Research Inc., while market losses cut industry values by $115 billion. Investors withdrew $22 billion from funds of funds, which pool money to invest in hedge funds.

o About 350 hedge funds shut down in the first half of 2008, up 16 percent from 303 a year earlier, according to data compiled by Chicago-based Hedge Fund Research Inc.

o Hedge funds fell by an average 6 percent last month, pushing the year-to-date decline through October to 16 percent (S&P decreased 17 percent last month, and 34 percent this year through October.)

o Levkovich (Citigroup): "‘It is possible hedge fund assets will drop 40%-50% from their peak by mid-09’ given 20%-like losses in existing funds this year, and another 20% of redemptions.

o cont.: plus the potential for a number of hedge funds to shut down in the next several weeks, given possibly insurmountable “high water marks” (i.e. requirement to recover losses before management can retain 20% performance fee) and talent retention costs.

o cont.: On the positive side, the industry’s estimated 40% cash positions should accommodate a smooth deleveraging

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o cont.: we also wouldn’t rule out a late-year hedge fund driven rally, as most likely will try to participate to limit annual losses beyond which, a humbler, smaller industry should evolve, with longer investment time horizons.

o cont.: leverage will not be used as aggressively, partially due to recent losses but also as the prime brokers will not provide it as easily.'

o Economist: A recovery will be hardest for smaller funds, which have higher fixed costs relative to their assets, and which some clients already worry have poor risk controls. Firms with less than $500m under management account for about three-quarters of the world’s 7,000-odd hedge funds, although they manage less than a tenth of the industry’s assets. The outlook for start-ups without records is particularly bleak--> compound a trend that started in 2006, of clients consolidating their hedge-fund holdings with a few big managers (see also Congress hearing transcripts with Andrew Lo, George Soros, James Simons, Philip Falcone, Kenneth Griffin on Nov 13)

o Attari/Ruckes: When arbitrageurs are fi…nanced with short-term debt by multiple lenders and markets are relatively illiquid, they may be forced to prematurely liquidate por…table positions. This can occur even though lenders correctly anticipate the pro…tability of the arbitrageurs strategies. The reason is that in illiquid markets early loan terminations are costly and lenders may respond analogously to a bank run by terminating their loans early to avoid default. This may cause arbitrageurs that are invested in pro…table strategies to collapse and has implications for the optimal level of debt …nancing of arbitrageurs.

o Ang/Bollern: We estimate a two-year lockup with a three-month notice period costs investors 1.5% of their initial investment. The magnitude is sensitive to a fund's age, expected return, and the liquidation cost upon failure. The cost of illiquidity can exceed 10% if the hedge fund manager suspends withdrawals.

Global Credit Markets In Crisis Mode Nov 20, 2008

o Nov 20: The cost of protecting corporate bonds from default surged to records around the world as the prospect of U.S. automakers filing for bankruptcy protection fueled concern of more bank losses and a deeper recession.

o Nov 19: - O/N LIBOR at 40bp; - TED spread (3m LIBOR - T-bill): still above 210bp; - 3m USD LIBOR - OIS: up again to 176; - 3m EUR LIBOR - OIS: still at 166

o Nov 18: European CDS spreads in HY and IG previous record at 880 and 172; U.S. CDX IG hits record highs above 226bp; HY at record 1248bp

o FT Nov 12:The Federal Reserve and other central banks managed to drive down interest rates on short-term lending, but that is not bringing private money back into commercial-paper and money-market lending. Instead, private financial institutions are struggling to

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bolster their balance sheets and reduce leverage, effectively turning central banks into "lenders of sole resort."

o Nov 10 Calculated Risk: Thanks to heavy central bank interventions, credit and money market spreads have come down from their October highs but interbank lending rates as measure by LIBOR-OIS spreads remain too high amid little trading volume.

o Nov 10 BNP: Watch commercial paper, high yield spreads that refuse to recede.

o George Magnus: Deleveraging in the financial and householders sector will continue. As a result, four big battlegrounds remain. First, there is a high possibility of further bouts of financial stress and failures. Money markets are still broken and recovery will take time. Second, illiquidity, a preference for cash-type instruments, even over government bonds, and a considerably expanded supply of government bonds raise the threat of an untimely increase in bond yields. Third, the global recession that has started may yet turn out to be sharper than expected – and certainly longer. This will bring sustained, and some new, credit risks. Fourth, much slower growth and the risk of some home-made financial crises in emerging markets warrant close scrutiny.

o Roubini: To make the Wall Street rescue sustainable Main Street must be helped as well. The US government will need to implement a clear plan to reduce the face value of mortgages for distressed home owners and avoid a tsunami of foreclosures (as in the Great Depression HOLC and in my HOME proposal: Hhttp://www.rgemonitor.com/roubini-monitor/253739/home_home_owners_mortgage_enterprise_a_10_step_plan_to_resolve_the_financial_crisisH).

o cont.: A fiscal stimulus plan is essential to restore – on a sustained basis – the viability and solvency of many impaired financial institutions. If Main Street goes bust in the next six months rescuing in the short run Wall Street will still lead Wall Street to go bust again as the real economy implodes further.

o cont.: To do: 1) the federal government should have a plan to immediately spend in infrastructures and in new green technologies; 2) also unemployment benefits should be sharply increased together with a 3) targeted tax rebates only for lower income households at risk; and 4) federal block grants should be given to state and local government to boost their infrastructure spending (roads, sewer systems, etc.).

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25BThe Latest Bear Market Sucker’s Rally Has Gone Bust as We Are Headed Towards Stag-Deflation Nouriel Roubini | Nov 19, 2008

With major US equity indices free falling over 6% today Wednesday, ending below their October lows and now being back to 2003 levels the latest bear market sucker’s rally is now officially over. A cacophony of delusional bulls – including allegedly savvy investors such as the Sage of Omaha and other luminaries – were spinning for the last month the fairy tale that markets – especially equity markets – had fallen so much that a bottom had been reached and that this was the time to start buying equities. Some of us never believed this self-serving spin and warned repeatedly that both equity markets and credit markets had further severe downside risks (20% to 30% lower for equities).

Let’s flesh out the details of this bust of the latest bear market sucker’s rally and consider the future outlook for risky assets…

As HI wrote over a month ago in mid-OctoberH:

So serious risks and vulnerabilities remain and the downside risks to financial markets (worse than expected macro news, earnings news and developments in systemically important parts of the global financial system) will dominate over the next few months the positive news (G7 policies to avoid a systemic meltdown, and other policies that – in due time – may reduce interbank spreads and credit spreads). So beware of those who tell you that we reached a bottom for risky financial assets. The same optimists told you that we reached a bottom and the worst was behind us after the rescue of the creditors of Bear Stearns in March, after the announcement of the possible bailout of Fannie and Freddie in July, after the actual bailout of Fannie and Freddie in September, after the bailout of AIG in mid September, after the TARP legislation was presented, after the latest G7 and EU action. In each case the optimists argued that the latest crisis and rescue policy response was “THE CATHARTIC” event that signaled the bottom of the crisis and the recovery of markets. They were wrong literally at least six times in a row as the crisis - as I consistently predicted here over the last year – became worse and worse. So enough of the excessive optimism that has been proven wrong at least six times in the last eight months alone.

A reality check is needed to assess the proper risks and take the appropriate actions. And reality tells us that we barely literally avoided only a week ago a total systemic financial meltdown; that the policy actions are now finally more aggressive and systematic and more appropriate; that it will take a long while for interbank markets and credit markets to mend; that further important policy actions are needed to avoid the meltdown and an even more severe recession; that central banks instead of being the lenders of last resort will be for now the lenders of first and only resort; that even if we avoid a meltdown we will experience Ha severe US, advanced economy and most likely global recessionH, the worst in decades; that we are in the middle of a severe global financial and banking crisis, the worst since the Great Depression; and that the flow of macro, earnings and financial news will significantly

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surprise (as during the last few weeks) on the downside with significant further risks to financial markets.

And as I repeated right before and Hafter the electionH:

…in the meanwhile the brief bear market sucker’s rally in the equity market has lost its steam and U.S. and global equities are starting to plunge again. As I argued for the last few weeks this was a bear market rally and markets could not defy the laws of gravity: a slew of ugly and worse than expected macro news, earnings news and financial news was bound to take a toll on equities and other risky assets. And now, after a brief rally markets are starting to plunge again. For 2009 the consensus estimates for earnings are delusional: current consensus estimates are that S&P 500 earnings per share (EPS) will be $90 in 2009 up 15% from 2008. Such estimates are outright silly and delusional. If EPS fall – as most likely – to a level of $60 then with a multiple (P/E ratio) of 12 the S&P500 index could fall to 720, i.e. 20% below current levels; if the P/E falls to 10 – as possible in a severe recession, the S&P could be down to 600 or 35% below current levels. And in a very severe recession one cannot exclude that the EPS could fall as low as $50 in 2009 dragging the S&P500 index to as low as 500. So, even based on fundamentals and valuations, there are significant downside risks to U.S. equities.

So the brief sucker’s rally is over and a reality check is now dawning on markets and investors. Expect this financial crisis and economic recession to get much worse in the next 12 months before it gets any better. We are nowhere near a bottom for housing, the U.S, economy, the global economy and financial markets. The worst is ahead of us rather than behind us.

Now the latest brief bear market sucker’s rally has gone fully bust and conditions are getting again “fugly and fuglier” in the real economy - US and globally - and in financial markets, both equity and credit markets. Other shorter and shorter-lived bear market rallies may occur again as desperate policy authorities – especially monetary ones - try to get out of their policy hat other voodoo rabbits of more desperate and unorthodox policy measures as we have already effectively reach the zero-bound for the policy rate and a liquidity trap (the effective Fed Funds rate has already around 0.3% for weeks now while the target rate is formally still at 1%). And Hthe risks of a stag-deflation – that I have been warning about since JanuaryH – are now becoming conventional wisdom as even Don Kohn is now talking about the risks of deflation.

And in this downward race between equities and credit it is not even clear anymore which asset class is undervalued in relative terms: both are free falling so fast with credit spreads rising through the historical roof for both high grade and high yield (and CDS spread also headed towards new heights) while equities are falling to new lows. Credit still looks cheap relative to equities as a massive surge in corporate defaults as currently priced by credit spreads would certainly wiped out common equity even more than debt.

HIn early October I predicted – in an interview for Tech Ticker – that the Dow could fall towards the 7000 level by next year and that US equities would fall by 50% relative to their 2007 peakH. Such predictions were considered too bearish and extreme at that time but, at the rate at which equities are falling now with this acceleration of a savage deleveraging by leveraged institutions (and even disorderly sell-off by many unlevered players too), the Dow may reach the 7000 before year end rather than in 2009 and we are getting close to a 50% drop in overall equity prices from their peak.

In my next piece I will discuss in more detail how we are now close to the deadly “Bermuda Triangle” of a liquidity trap, price deflation, debt deflation and sharply rising defaults.

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U.S. Inflation Trends: Disinflation or Deflation Ahead? Nov 19, 2008

Inflation Indicators:

o Core CPI unexpectedly fell for the first time since 1982 by 0.1% m/m in Oct. Core inflation (excl. food and energy) slowed to 2.2% y/y in Oct after a 2.5% y/y rate in Sep. Headline prices plunged 1% m/m in Oct, the biggest monthly drop since records began in 1947. Headline inflation slowed to 3.7% y/y Oct, from 4.9% in Sep. The steep decline in gasoline prices and favorable base effects imply annual headline inflation will drop below 2% in Nov

o Core PPI rose 0.4% m/m and 4.4% y/y in Oct (fastest since 1989), suggesting the declines in raw material costs have yet to feed through to other products. Headline PPI for finished goods decelerated sharply to -2.8% m/m and 5.2% y/y in Oct from 9.8% in Jul (fastest since 1981). Among finished goods, energy prices (-12.8% m/m) contributed most to the headline inflation deceleration. Crude goods prices fell most sharply: -1.4% y/y. Keeping retail prices in check is flattening growth in average hourly earnings in retail trade: 0.3% y/y Oct

o Import prices inflation plunged to 6.7% y/y in Oct after jumping 21.3% y/y in June (biggest rise since the index was first published in 1982). The 4.7% m/m drop was largest drop since 1988. Inflation deceleration is broad-based - petroleum, food, capital goods and consumer goods - but oil price plunge accounts for bulk of deceleration. The decline in consumer goods import prices reflects the firmer U.S. dollar

o Core PCE deflator increased 0.18% m/m in Sep while the y/y rate moderated to 2.40% from 2.50% in Aug (fastest since Feb 2007, due to pass-through from producer prices). Headline PCE inflation increased 0.1% m/m Sep and the y/y rate dropped to 4.2% from a high of 4.5% in Jul and Aug. Core PCE remains outside Fed comfort zone but should slow further

o Inflation Expectations: According to Michigan Consumer Sentiment Survey, median 1-year inflation expectations rose to 4.5% in Oct from 4.3% in Sep. Five- to ten-year inflation expectations are down to 2.8% in Oct from 3.4% in Jun - their highest level since 1996

o GDP deflator (1.2% y/y Q2, 2.6% y/y Q1) rising slower than headline PCE deflator b/c of increasing oil imports and decreasing residential investment. If headline CPI were used to deflate GDP instead, US would have already posted 2 quarters of negative growth - a recession

o Wage Inflation: Earnings growth eased to 3.4% y/y in Sep from 3.6% in Aug. Employment Cost Index maintained a steady 3% y/y growth rate in Q3. Businesses are likely to keep labor costs down as the unemployment rate increases and economy suffers a recession. Workers will have much less bargaining power in regards to wages

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Outlook: o MS: Reflecting commodity price declines and emerging slack in both product and labor

markets, CPI inflation will decline from 3.9% to -0.2%. Headline inflation likely to fall by 2% or so in October and November and to go negative by mid-2009, with prices then falling by 1.5% from mid-2008

o BNP: Substantial economic slack suggests core CPI should remain subdued, averaging 2.0% y/y in 2009 and 1.9% y/y in 2010

o Goldman Sachs (not online): CPI to peak at 6.5% if oil supply shock occurs (e.g. hurricane). Core CPI to slow to 1.9% y/y by end-2009. Technical deflation expected in 2009 due to falling commodity & asset prices, high spare capacity, tightened constraints on growth, and easing inflation expectations

o Hoisington/Hunt: HStagflationH unlikely b/c inflation is a lagging indicator that peaks before recession starts, no sign of wage/price spiral, Fed policy is restrictive in terms of M2 velocity

o JPMorgan, Citigroup: Commodity prices affect retail prices with a lag—which is brief for energy but as long as a year for food. Gasoline price affects real income more negatively than food price. Housing and services deflation to dampen core CPI growth

Welcome to Planet ZIRP: Conducting Monetary Policy at Low Interest Rates Nov 19, 2008

o FT: US and UK rates are negative in real terms – by at least 3% and 1.5% respectively – while eurozone rates are still positive by a whisker. So is the global economy headed towards zero interest rates? The answer is that, in real terms, it has already arrived

o JPMorgan (not online): Fed will most likely cut the target fed funds rate 50bps at the Dec 16 meeting, followed by an additional 50bp cut at the Jan 28 meeting, then conduct a zero-interest rate policy (ZIRP) for the remainder of 2009 due to the high risk of deflation when labor market slack is building and financial tightening ongoing

o CIBC: Cut the funds rate to zero, and there's nothing left to do. Not so. Central banks could move out the curve, buying longer-dated securities and forcing their rates down to zero. They could lend money in higher volumes directly to economic participants, as the Fed is doing in the commercial paper market

o Mishkin (via Thoma): One common view is that when a central bank has driven down short-term nominal interest rates to near zero, there is nothing more that monetary policy can do to stimulate the economy. That view is false. Expansionary monetary policy to increase liquidity in the economy can be conducted with open market purchases, which do not have to be solely in short-term government securities

o Goldman Sachs (not online): With riskless short-term interest rates now close to zero, conventional monetary policy is becoming ineffective. What are the alternatives? Three options with a relatively high likelihood of near-term implementation by the Fed: 1) a large-scale fiscal stimulus program, 2) more proactive use of Fannie Mae and Freddie

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Mac for purchasing and securitizing mortgages, and 3) a precommitment by Fed officials to keep the federal funds rate low for a "considerable period"

If these policies fail to result in an economic pickup, Fed officials might 4) purchase long-term Treasury and Agency securities. The Treasury might 5) decide to purchase risky assets outright, and this could again perhaps be financed by Fed money creation

Breakevens: U.S. Bond Markets Price in Deflation Nov 19, 2008

o Morningstar: Breakevens are trading below historical levels. 10-year TIPS spread was below 1% and has been bouncing negative from time to time over the past few weeks

o Scotia: US inflation breakeven rates have now gone negative at the short-end of the curve and are very low in the belly. This is no longer just a result of a flight to nominal bonds as opposed to real bonds. Since mid-June, two-year inflation break-even rates have plunged from a peak of about 2.92% to -1.57%. The two-year nominal Treasury yield has fallen from 3.45% to about 1.56%. Clearly the 4.5 percentage point swing in break-evens swamps the 1.89 percentage point drop in nominal yields that owes itself to the flight-to-quality premium. This is deflation risk pure and simple

o Merrill Lynch (not online): Increased Treasury borrowing needs will not lead to increases in the supply of TIPs

o BNP: Commodity price decline saps demand for linkers. However TIPS remain cheap vs. most measures (Treasuries, carry, CPI, core, history and even oil)

o MS: TIPS have not been a good inflation hedge. Safe-haven buying of nominal Treasury bonds had kept yields low and breakevens tight. Investors are waiting for core inflation volatility to show signs of moving higher, which expansionary monetary policy and global inflationary forces make very likely

o Cavalieri: Temporary move of TIPS and Treasuries from positive to negative real yields in Q1 reflected the combined effect of lower expected real growth in US, increased expectations of Fed easing, and increased short-term demand from flight to quality during credit crisis

o Gross: TIPS under-predict actual inflation because CPI measure used to adjust principal is biased to the downside

o FT: Yield difference b/w TIPS and Treasuries tells us more about liquidity conditions in those markets than about future inflation

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RGE Analysts' EconoMonitor

26BCommodity Headwinds Mikka Pineda, Rachel Ziemba, Arpitha Bykere , Italo Lombardi and Vitoria Saddi | Nov 19, 2008

Today we turn our attention to HcommoditiesH, which have been badly battered by the global financial crisis, deleveraging and a worsening economic outlook, with commodity indices having lost50% of their value since the July peak. With the G10 in recession and many emerging economies slowing sharply, further demand destruction is likely, and it may continue to outpace production cuts. Once the price adjustment filters through to producers, they may account for another source of slower aggregate output.

Despite the steep price declines so far, commodities as a group have only fallen halfway to their 2001-02 trough, meaning they may have farther to fall. Among individual commodities, those that grew the most expensive in the shortest period of time have suffered the sharpest and fastest price drops. In fact, some investors are pricing in a temporary drop in the price of oil below $30 per barrel, far below marginal production costs.

Metals and energy led recent declines, after breaching nominal and inflation-adjusted highs earlier this year. Agricultural commodities took smaller hits as their price climbs were not as excessive – their peak prices this year remained 2-3x below their inflation-adjusted highs in the 1970s. Only newsprint has yielded positive returns this year as of November but its resilience seems unsustainable in the medium-term. Across the commodities group, inventory buildup and falling demand creates conditions ripe for a continuing current bear market despite the fact that some commodities, such as oil, seem to have fallen below production costs.

WTI Hcrude oilH futures have fallen from a peak of $147/barrel in mid July to around $55/barrel, well below the 2007 average price. U.S. government data suggest that Hdemand for oil productsH is about 6-7% lower than last year, with the sharpest declines in jet fuel. Despite the fact that gas prices are now hovering at $2 a gallon and energy costs fell 18% nationwide in October, demand continues to fall. Forecasts from the EIA and OPEC suggest that 2009 might mark make the largest contraction in Hoil demandH in decades, despite the recent price correction. EM oil demand will be insufficient to offset growing declines in the OECD countries. For now, financial market trends and macro HfundamentalsH might point in the same direction, towards weaker energy prices.

Yet, output cuts are reducing supply, removing the surplus reached earlier this year, even as HOPECH’s surplus capacity increases. HNon-OPECH supplies continue to disappoint. Oil production has declined in Russia, the North Sea and Mexico while new production in Kazakhstan and Brazil has yet to come on stream. In the short-term, it might take a major supply shock - say one that cuts off Iran’s oil supply or major output from the GCC - to really boost prices. The HSomaliH pirate hijacking of a Saudi tanker might raise transport costs as insurance premia rise and routings increase, and reminds observers of the energy supply

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chain’s HvulnerabilitiesH, but it may not have a major affect on oil market fundamentals. HOPEC’sH willingness to comply with current (and future?) production cuts may be the most significant supply side factor. Yet the elevated cost of new oil supplies may lead to future supply crunches. Canada’s Hoil sandsH are woefully expensive at today’s prices and projects are being deferred if not cancelled

Lower global energy demand, in the face of increasing supply, is also affecting current and expected Hnatural gasH prices. EIA has noted that the Henry Hub natural gas spot price projection for 2009 has fallen from $8.17 per Mcf to $6.82. The front month contract price of natural gas on NYMEX has steadily declined and the futures curve has sloped downward. Demand for Halternative energyH tends to move inversely to fossil fuel prices, so the deep cuts in oil and coal prices could pose a headwind for alternative energy, unless counteracted by climate change mandates. Fortunately for producers, falling grain prices will help relieve the profit margin squeeze, even if the credit crunch impairs borrowing for expansion.

HBase metalsH prices have actually suffered steeper drops than oil. This commodity group is the most sensitive to the slowdown in industrial production. Nickel and zinc initially led the group’s decline, but were succeeded by copper and aluminum. Expectations that supply gluts will mount next year brought metals prices back to levels closer to operating costs. At 50% below historical averages, in real terms, nickel and zinc prices are already triggering production cuts. These two metals’ strongest sources of demand - stainless steel for nickel, auto parts for zinc – are withering, and the supply glut will be exacerbated by output from new mines. Meanwhile, HcopperH and HaluminumH prices have yet to undershoot their historic breakeven levels. But, slowing housing and infrastructure construction activity worldwide, plus lower automobile demand, may more than offset the supply issues (i.e. labor disputes for copper, power shortages for aluminum) that kept copper and aluminum inventories from building up like other base metals.

HSteelH prices have nose-dived from above US$1,200/ton in June to below US$300/ton. Prices will likely resume crashing next year, on weakening demand, particularly from China, falling freight costs and lower cost of inputs (coal and Hiron oreH). Like other base metals, the demand collapse has left Hsteel producersH with high order books, expensive inventory and limited near-term flexibility. Producers have begun cutting production, but lead times in the steel industry are around 8 weeks, which means production cuts will not materialize until around the turn of the year, meaning stockpiles might increase further.

Inflation hedging and flight-to-safety bids drove HgoldH to a nominal all-time high price of $1033.90 per ounce on March 17, but faded away on HdeflationH fears and broader commodity selloffs. The gold rally stopped far short of the inflation-adjusted high of $2115-2200/oz reached in 1980 and gold languished below $700/oz this summer. After a brief rally in autumn, gold now trades between $700-750, about 28% below the March peak. Slowing inflation and the U.S. dollar’s uptrend sapped support for gold as a store of value despite the possible inflationary consequences of massive fiscal expansion and monetary policy easing to counteract the economic and financial effects of the global credit crisis. Though gold tends to be less sensitive to a global economic slowdown than industrial metals or energy commodities, deflation is a clear and present danger for gold prices. Even physical demand for gold – mostly for decorative use – looks likely to weaken alongside consumer confidence.

HAgricultural commoditiesH have outperformed metals and oil, although that just means their prices dropped the least. Agriculturals are the commodity sub-sector least sensitive to the economic cycle, but have nonetheless suffered from the deleveraging which has seen investors move into cash. Cotton prices have fallen the most (-45.29% ytd Nov 14), and sugar the least (-3.96%). Livestock prices plunged on faltering protein demand as the global

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growth slowdown reduces incomes. While metals and energy prices struck both nominal and real all-time high prices, agricultural prices just rose above the historical lows of the 1980s, remaining far below the inflation-adjusted highs of the 1970s. HFundamental driversH such as biofuel production, population growth, and the rising income and protein demand of developing countries, argue for a secular bull market. In the medium-term though, the exit of speculators and the supply overhang from production growth may bring downward pressure – especially in grains. As the global economy recovers, agricultural prices should speed their uptrend, tempered by the fact that agricultural commodities are renewable resources unlike metals and fossil fuels.

Long-run fundamentals of supply and demand suggest a resumption of the uptrend in commodity prices in a few years, but a global recession, a strong dollar and forced fund liquidations in the medium-term will keep prices under pressure until late 2009. True, the commodity slump sows the seeds of its own destruction, by causing producers to cut back or delay investments, thereby raising the risk of a future supply crunch. This Hpro-cyclicalityH is nothing new. Nonetheless, the anticipated price recovery will be gradual if the current financial crisis permanently restricts the ability to leverage, which was key to the world’s high growth rates posted in the past few years.

Slowing Chinese economic growth has contributed to the collapse in Hcommodity H prices, just as expectations of Chinese demand growth drove the recent bubble. Imports of key metals have slowed sharply since July, and the slackening industrial production growth – 8.2% in October, a 7-year low – indicates no reversal. Meanwhile, Chinese electricity production actually fell in October, the first such contraction in a decade, suggesting that China’s slowdown might be more pronounced and that the price of coal, the prime fuel for Hpower plantsH, could fall further.

While the infrastructure focus of China’s recent Hfiscal stimulusH may support commodity demand, especially for some base metals, it may only offset the reduction in demand from the HpropertyH and manufacturing sectors. Meanwhile, Chinese stockpiles of many commodities may take time to absorb, meaning that Chinese commodity demand might remain weak until the second half of 2009. This changing dynamic has, however, changed the pricing power in the Hiron oreH market, a reversal from some months ago when global companies like Rio Tinto, BHP Billiton and Vale sought very large iron ore price hikes from China and other Asian customers.

The reduction in global commodity demand is now providing headwinds for shipping. The Commodity boom of recent years sparked a global trade and shipping boom, reflected in the surge in the HBaltic Dry IndexH which almost doubled between 2006 and 2007. In spite of easing global manufacturing trade since early-2008, global freight and the Baltic Index proceeded to hit an all time high in May 2008, buoyed by high commodity prices. But since then, easing food shortages, commodity price correction, and the slowdown in industrial activity across the G-7 and in EMs have reduced demand for key industrial commodities and raw materials, pulling down the Baltic Dry Index by over 90% ytd. Moreover, the escalation of the credit crisis has blocked access to trade credit for commodity importers and exporters, posing the risk of stalling the movement of goods across the global manufacturing supply chain.

Capacity shortages in bulk and Hoil drillingH, shipping, inadequate Hport facilitiesH and longer shipping duration between commodity importers and exporters have raised transportation costs, boosting the final price of commodities. Even as shipping companies face the credit crunch and high oil prices, existing investment in ship building by commodity-related firms and countries might somewhat improve shipping capacity by 2010 to match the demand.

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Moreover, Hglobal tradeH and shipping face an impending demand slowdown in the coming quarters, as output slows further and recovery may lag the global economic recovery. The reduction in demand from commodity producers for other goods may accentuate the effect of the commodity correction on global manufactured goods.

The recent sharp decline in the price of oil is now starting to hit the Hfiscal bottom lineH of key oil exporting economies, meaning some of them could run fiscal deficits next year, if oil prices remain at yesterday’s ($55) level. On average, Middle Eastern oil exporters require a $50-55 a barrel oil price to balance their budgets – and countries like Russia, Iran, Iraq and Venezuela require a higher price. As a result, to maintain current spending (a likely political necessity) several oil exporters might have to issue more domestic debt or spend their accumulated savings. Oil output cuts only raise the break-even price, a fact of which OPEC members are no doubt very aware, as they prepare for yet another meeting later this month. Further production cuts seem (again) to be almost a foregone conclusion though. Meanwhile, with current oil prices, Hoil exportersH may no longer be a surplus region next year. The erosion of their current account surpluses, sparked in part by the pressure to spend more at home to support HdomesticH asset markets, should reduce their purchases of foreign assets. It may be no surprise that GCC oil exporters have been lukewarm in their support of Gordon Brown’s IMF fundraising.

The fall in commodity prices has varied effects on HLatin AmericaH. Chilean exports have been hit by the Hfalling price of copper H, of which it is the world’s top supplier Copper exports fell 28.6% y/y to USD 2.7bn in October, consistent with the downward trend and the sharp drop in copper prices of 29.5% y/y. HChile's pesoH has felt the pinch of the sliding global economy and copper prices.

Current oil prices will curtail ambitious plans to cushion the impact of a U.S. recession through public Hinfrastructure investment in MexicoH. Estimates show that a $10 drop in the price of Mexico’s crude oil mix leads to a drop in public sector revenues of approximately 0.3% of GDP . Using a price forecast of $60.0 for the WTI in 2009, the shortfall in revenues, relative to budget estimates, would be equivalent to 0.7% of GDP, or roughly $7.6bn. Meanwhile, the oil price collapse will also hamper Venezuela's wide-ranging Hpetro-diplomacyH. Venezuela's capacity to borrow abroad to finance Hambitious social programsH may well atrophy, reinforcing the decline in President Hugo Chavez's standing at home on the eve of local elections.

The downward trend in commodity prices will clearly affect HBrazilH, through a decrease in exports. Unlike commodity driven countries like Chile and Peru, Brazil has a more diversified export base. Meanwhile, the decrease in commodity prices should reduce inflationary pressures, which in turn may give more freedom to the Brazilian Central Bank, which may not need to hike interest rates at the same rate as in 2008. The expected further reduction in growth or negative growth in emerging and developed economies, rather than the fall in commodity prices alone will have more effect on Brazil’s economic outlook.

Major exporters like HCanada H and HAustraliaH which experienced major terms of trade bumps during the commodity boom are also vulnerable, even if commodities make up a smaller portion of their growth and exports than the fuel exporters in the emerging world.

If commodity prices remain weak, producers will lower consumption over time, removing a source of aggregate demand that offset slowing growth earlier this year. For example, export growth from Middle Eastern, Latin American and African economies helped Asian goods exporters to offset slowing demand from the U.S., and more recently the EU. If that demand slows, it may be the final straw for many HAsian exportersH.

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27BHEconomist's View 109BNovember 20, 2008

110BFed Watch: Policy Adrift Tim Duy lets loose:

Policy Adrift, by Tim Duy: I understand the Federal Reserve Chairman Ben Bernanke is considered something of a sacred cow, our one point of light in an uncertain world. An academic who cannot be questioned by other academics. A smart person who has mastered the Great Depression and therefore “knows” what to do, and is providing the leadership to do it.

I am beginning to question all of these assumptions.

I am hoping Bernanke can step forward and clarify the direction of policy. At this moment, he has the best perch from which to guide policy between administrations. He has the opportunity to show leadership. But for now, I see a distinct lack of leadership from the Federal Reserve, and it suggests that Bernanke has used up his bag of tricks. And I don’t think that he knows what to do next. Indeed, Fedspeak is now littered with confusing statements that leave the true policy of the Federal Reserve in question.

First, policymakers appear uncertain about what to do with the Fed Funds target. The minutes of the most recent meeting tell the story:

Some members were concerned that the effectiveness of cuts in the target federal funds rate may have been diminished by the financial dislocations, suggesting that further policy action might have limited efficacy in promoting a recovery in economic growth. And some also noted that the Committee had limited room to lower its federal funds rate target further and should therefore consider moving slowly. However, others maintained that the possibility of reduced policy effectiveness and the limited scope for reducing the target further were reasons for a more aggressive policy adjustment; an easing of policy should contribute to a beneficial reduction in some borrowing costs, even if a given rate reduction currently would elicit a smaller effect than in more typical circumstances, and more aggressive easing should reduce the odds of a deflationary outcome.

Considering the forest of trees killed in studying the Japanese experience with ZIRP, one would have imagined that the Fed had already answered the question of how low can they go with the target rate. The answer is zero, and they will head there because they need to look like they are doing something. And we already know that that next 100bp are meaningless in support of economic activity; Jim Hamilton persuasively explained why this is the case HhereH and Hhere H. Simply put, debates about the Fed Funds target are nothing more than academic masturbation. I can only imagine the flurry of memos flying around Constitution Avenue as staffers debate the last 100bp as if it was meaningful from a policy perspective. Just cut to zero. Stop the madness already and let the Fed staff go home to see their families.

With the Fed Funds target effectively a nonissue, policy needs to take a different direction. And here again I am supremely perturbed by Fedspeak as policymakers throw around the term “quantitative easing” as if it were candy on Halloween. The minutes seem to make

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clear that quantitative easing is not the current policy. There is no mention of the quantitative easing in the minutes themselves. The only mention is in the forecast summary:

Some participants noted that further monetary policy easing could eventually become constrained by the lower bound of zero on nominal interest rates, in which case an elevated degree of uncertainty might be associated with gauging the magnitude and stimulative effects of other policy tools such as quantitative easing.

It appears to make clear that the Fed has not yet officially initiated quantitative easing; it is relegated to the status of “other policy tools.” Indeed, no target has been announced. Nothing to the effect of “we are going to make unsterilized purchases of Treasuries until the rate on the 10 year bond declines to x%.” Or “we are making $xx billion of unsterilized bond purchases each week until the policy objective xx is achieved.” Those are explicit quantitative easing policies. What we have now is an expansion of the balance sheet to accommodate liquidity measures. This may pave the way to quantitative easing, but still maintains the Fed Funds rate as the primary target.

But then why do they keep saying they have a policy of quantitative easing? This first crossed my radar when reviewing a recent interview with Dallas Federal Reserve President Richard Fisher. I discounted his reference to quantitative easing as Fisher is something of a colorful character who often talks before he thinks. But subsequent policymakers repeated the term. Earlier this week New York Fed President Gary Stern was quoted by Stephen Beckner:

Asked whether the doubling in size of the balance sheet represents "quantitative easing," Stern said "I don't think that's a bad statement. I think the world is a little more complicated than that, but I don't think that's a bad statement."

Federal Reserve Vice Chairman Donald Kohn was more somewhat more noncommittal today. Or not. Via HMark ThomaH:

Meanwhile, Kohn added that the Fed has “already” engaged in forms of quantitative easing, and “we should be looking carefully” at the effect that could have “as a contingency plan should that still-remote possibility, but I think less remote than it was, occur.” ... He said the Fed hasn’t abandoned monetary policy in favor of quantitative easing, noting the Fed’s recent reduction in its target federal funds rate. “I don’t think we’ve given up on one in favor of the other,” Kohn said. He also said there’s no “arithmetic” reason why the Fed can’t “blow up” the size of its balance sheet, which has already swelled in recent weeks to over $2 trillion.

Apparently what Fed officials think is that they 1.) already engaged in quantitative easing, 2.) doing something like quantitative easing, or 3.) might be doing quantitative easing or interest rate targeting, but are not sure which. One can only conclude that Fed officials do not understand their own policies. Policy is adrift. Be afraid; be very afraid.

Mark Thoma also points Hus to Rebecca WilderH, who points us to former St. Louis Federal Reserve President William Poole. Poole suggests that the Fed has already committed to quantitative easing,

William Poole … accuses the Fed of not being transparent and shifting monetary policy without announcement. Although he does not speculate as

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to what the new policy is, he does state that by not announcing its new policy, the Fed is breaking the law.

According to Poole: “Something is happening at the Fed that has not been announced.”

Could the Fed really be hiding a policy shift in some bizarre attempt to generate an unanticipated positive shock? If so, yet another forest of trees was killed to disseminate research on the importance of transparency in policymaking, only to have that research ignored by the policymakers who wrote it.

Ironically, I would be somewhat comforted to learn that the Fed does have a coherent, albeit unannounced, policy change. The alternative is what I suspect – Bernanke cannot elucidate a coherent policy strategy to his organization because no such strategy exists. What does exist is a potpourri of policy responses that amounts to providing liquidity at all costs, the outcome of Bernanke’s research on the Great Depression. Beyond this, the Fed is stuck in a netherworld of dual policy targets – not ready to admit the loss of the interest rate target, not ready to adopt a formal policy of quantitative easing.

Moreover, what is absolutely maddening is that Bernanke had an opportunity to dictate a course of policy that had some hope of bringing resolution to this mess – the now dead TARP. While Treasury Secretary Henry Paulson is rightfully criticized for his erratic policy choices, remember that Bernanke was Paulson’s handmaiden throughout the process. Recall HPaul Krugman H:

So now the whole rationale for the plan is “price discovery”: we’re going to throw lots of taxpayer funds into the pot because that will let us find the true values of troubled assets, which are higher than the fire sale prices out there, and so balance sheet will improve, confidence will return, etc, etc..

So I just did a Nexis search trying to find out when Paulson and Bernanke started talking about price discovery, which we’re now told are at the core of the plan’s logic. And the answer is …

Yesterday.

I can’t find any use of the term, or even a hint of the argument, until yesterday’s Senate hearings.

One possible explanation. It wasn’t until yesterday that they realized that it would actually be necessary to explain themselves.

But there’s another possible explanation, which I find terrifyingly plausible: the plan came first, and all this stuff about price discovery is an after-the-fact rationalization, invented when people started asking questions.

It has seemed very strange to me that such a supposedly crucial economic program would be based on such an exotic argument. My sneaking suspicion is that they started with a determination to throw money at the financial industry, and everything else is just an excuse.

This attempt at financial engineering, using auctions to allow “price discovery,” could only have come from an economist who spent more time dealing with equations than people. Unnecessarily complicated.

I think that the basic element of the original TARP plan – the removal of bad assets from the financial system – was a part of an appropriate policy path, but needed to be combined with equity stakes and recognition that the taxpayer would likely bear a cost. For example,

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the Treasury purchases mortgage assets at a high price, thereby recapitalizing the financial firm. In return, the Treasury receives an equity stake that dilutes that of existing shareholders to zero. Replace existing boards and top management; bar management from future employment in financial services. Treasury then auctions off the troubled assets into the financial markets (just forget about managing the portfolios until prices recover; let the assets reenter the system at a price that almost ensures an upside). The taxpayer eats the difference, but will be at least partially compensated in the future when the Treasury floats the equity stakes back into the market. This process is legislatively dictated; financial firms who hope to be allowed to continue to operate in the US would be effectively forced to participate.

To be sure, I make no promise that the taxpayer will walk away clean, but compared to the risk that the financial sector hobbles along forever, it would be a reasonable cost. Instead, the Treasury, apparently with the Fed’s blessing, use the TARP options of equity infusion (forced onto Paulson and Bernanke), and did only a portion of the job with a partial recapitalization. The nonperforming assets remain trapped in the system, threatening to create zombie banks. Bernanke might not be making the same mistakes as the Fed in the Great Depression, but it is starting to look like he is not willing to fundamentally address the problem of sour assets. Doing just enough to keep banks alive looks a lot like a mistake made in Japan. I am surprised that New York Federal Reserve President Timothy Geithner would accept such a plan; he understands Japan’s lost decade as well as anyone.

I think it is high time some real critical attention was placed on Bernanke. How complicit was the Fed Chairman with designing and implementing a clearly failed policy? Yes, one could argue that the ball was in Treasury’s court. But didn’t Bernanke have a duty to make TARP work, after he begged Congress for the plan? And isn’t he the one person who could stand up and say “No, Paulson is screwing this up”? Paulson will not be Treasury Secretary in January, but Bernanke will still be Fed Chairman. Bernanke can and should step into what is so clearly a leadership void. What does he owe this administration at this point?

In short, we need policy leadership. Bernanke is positioned to provide it. But will he? As of now, policy is adrift. FOMC members don’t seem to agree on the role of effectiveness of the Federal Funds target. Some think they are already engaged in a policy of quantitative easing. Some think they may be in something that looks sort of like quantitative easing. Kohn seems to think they are following two policies. Ex-FOMC member Poole is certain that they are hiding a policy change. In the meantime, while Fed officials publically debate the intent of their own policies, investor confidence is collapsing. Bernanke needs to step forward and define policy. We need to pressure him into providing that leadership - or to step aside for someone else to do it.

28BHhttp://economistsview.typepad.com/economistsview/2008/11/fed-watch-polic.htmlH

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29BComprehensive strategy to address the lessons of the banking crisis announced by the Basel Committee 111B20 November 2008

The Basel Committee on Banking Supervision today announced a comprehensive strategy to address the fundamental weaknesses revealed by the financial market crisis related to the regulation, supervision and risk management of internationally-active banks.

Nout Wellink, Chairman of the Basel Committee said that "the Basel Committee's work programme is well advanced and provides practical responses to the financial stability concerns raised by policy makers related to the banking sector."

Mr Wellink added that "the primary objective of the Committee's strategy is to strengthen capital buffers and help contain leverage in the banking system arising from both on- and off-balance sheet activities." It will also promote stronger risk management and governance practices to limit risk concentrations at banks. "Ultimately, our goal is to help ensure that the banking sector serves its traditional role as a shock absorber to the financial system, rather than an amplifier of risk between the financial sector and the real economy," Mr Wellink said.

The key building blocks of the Committee's strategy are the following:

• strengthening the risk capture of the Basel II framework (in particular for trading book and off-balance sheet exposures);

• enhancing the quality of Tier 1 capital;

• building additional shock absorbers into the capital framework that can be drawn upon during periods of stress and dampen procyclicality;

• evaluating the need to supplement risk-based measures with simple gross measures of exposure in both prudential and risk management frameworks to help contain leverage in the banking system;

• strengthening supervisory frameworks to assess funding liquidity at cross-border banks;

• leveraging Basel II to strengthen risk management and governance practices at banks;

• strengthening counterparty credit risk capital, risk management and disclosure at banks; and

• promoting globally coordinated supervisory follow-up exercises to ensure implementation of supervisory and industry sound principles.

Mr Wellink further noted that the Basel Committee expects to issue proposals on a number of these topics for public consultation in early 2009, focusing on the April 2008

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recommendations of the Financial Stability Forum. The other topics will be addressed over the course of 2009.

Mr Wellink emphasised that the Committee's efforts will be "carried out as part of a considered process that balances the objective of maintaining a vibrant, competitive banking sector in good times against the need to enhance the sector's resilience in future periods of financial and economic stress".

112BAbout the Basel Committee:

The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. It seeks to promote and strengthen supervisory and risk management practices globally. The Committee's members come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States.

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Opinion

November 19, 2008

OP-ED CONTRIBUTOR

30BLet Detroit Go Bankrupt By MITT ROMNEY, Boston

IF HGeneral MotorsH, HFordH and HChryslerH get the bailout that their chief executives asked for yesterday, you can kiss the American automotive industry goodbye. It won’t go overnight, but its demise will be virtually guaranteed.

Without that bailout, Detroit will need to drastically restructure itself. With it, the automakers will stay the course — the suicidal course of declining market shares, insurmountable labor and retiree burdens, technology atrophy, product inferiority and never-ending job losses. Detroit needs a turnaround, not a check.

I love cars, American cars. I was born in Detroit, the son of an auto chief executive. In 1954, my dad, George Romney, was tapped to run American Motors when its president suddenly died. The company itself was on life support — banks were threatening to deal it a death blow. The stock collapsed. I watched Dad work to turn the company around — and years later at business school, they were still talking about it. From the lessons of that turnaround, and from my own experiences, I have several prescriptions for Detroit’s automakers.

First, their huge disadvantage in costs relative to foreign brands must be eliminated. That means new labor agreements to align pay and benefits to match those of workers at competitors like HBMWH, HHonda H, Nissan and HToyotaH. Furthermore, retiree benefits must be reduced so that the total burden per auto for domestic makers is not higher than that of foreign producers.

That extra burden is estimated to be more than $2,000 per car. Think what that means: Ford, for example, needs to cut $2,000 worth of features and quality out of its Taurus to compete with Toyota’s Avalon. Of course the Avalon feels like a better product — it has $2,000 more put into it. Considering this disadvantage, Detroit has done a remarkable job of designing and engineering its cars. But if this cost penalty persists, any bailout will only delay the inevitable.

Second, management as is must go. New faces should be recruited from unrelated industries — from companies widely respected for excellence in marketing, innovation, creativity and labor relations.

The new management must work with labor leaders to see that the enmity between labor and management comes to an end. This division is a holdover from the early years of the last century, when unions brought workers job security and better wages and benefits. But as Walter Reuther, the former head of the HUnited Automobile WorkersH, said to my father, “Getting more and more pay for less and less work is a dead-end street.”

You don’t have to look far for industries with unions that went down that road. Companies in the 21st century cannot perpetuate the destructive labor relations of the 20th. This will mean a new direction for the U.A.W., profit sharing or stock grants to all employees and a change in Big Three management culture.

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The need for collaboration will mean accepting sanity in salaries and perks. At American Motors, my dad cut his pay and that of his executive team, he bought stock in the company, and he went out to factories to talk to workers directly. Get rid of the planes, the executive dining rooms — all the symbols that breed resentment among the hundreds of thousands who will also be sacrificing to keep the companies afloat.

Investments must be made for the future. No more focus on quarterly earnings or the kind of short-term stock appreciation that means quick riches for executives with options. Manage with an eye on cash flow, balance sheets and long-term appreciation. Invest in truly competitive products and innovative technologies — especially fuel-saving designs — that may not arrive for years. Starving research and development is like eating the seed corn.

Just as important to the future of American carmakers is the sales force. When sales are down, you don’t want to lose the only people who can get them to grow. So don’t fire the best dealers, and don’t crush them with new financial or performance demands they can’t meet.

It is not wrong to ask for government help, but the automakers should come up with a win-win proposition. I believe the federal government should invest substantially more in basic research — on new energy sources, fuel-economy technology, materials science and the like — that will ultimately benefit the automotive industry, along with many others. I believe Washington should raise energy research spending to $20 billion a year, from the $4 billion that is spent today. The research could be done at universities, at research labs and even through public-private collaboration. The federal government should also rectify the imbedded tax penalties that favor foreign carmakers.

But don’t ask Washington to give shareholders and bondholders a free pass — they bet on management and they lost.

The American auto industry is vital to our national interest as an employer and as a hub for manufacturing. A managed bankruptcy may be the only path to the fundamental restructuring the industry needs. It would permit the companies to shed excess labor, pension and real estate costs. The federal government should provide guarantees for post-bankruptcy financing and assure car buyers that their warranties are not at risk.

In a managed bankruptcy, the federal government would propel newly competitive and viable automakers, rather than seal their fate with a bailout check.

Mitt Romney, the former governor of Massachusetts, was a candidate for this year’s Republican presidential nomination.

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31Bvox 32BResearch-based policy analysis and commentary from leading economists

33BA bankruptcy to Save GM 34BJoshua Rauh , and Luigi Zingales, 19 November 2008

A GM bailout would delay restructuring and ultimately destroy jobs. Restructuring under Chapter 11 is the best solution, but credit market conditions require the US government to provide transitional, “Debtor in Possession” financing. To avoid political interference, the actual lending decisions should be made by a commercial bank with a stake in the outcome

Not long ago, Alitalia was one of the largest airline companies in the world. Today it is a shadow of its former self, having burned massive amounts of taxpayer money before finally entering bankruptcy with few assets remaining. The principal culprit of this debacle was the Italian government. Trying to avoid the political pain a bankruptcy would have caused, the government continued providing subsidised financing to the money-losing airline, delaying the necessary restructuring. Not only was a gigantic waste of taxpayers’ money, but it was a death sentence for the very company it wanted to save. Postponing the day of reckoning weakened Alitalia’s competitive position, making it lose market share it will never regain as a reorganised company.

35BGM is broke, how to fix it? General Motors is quickly going down the same path. There is no doubt that it needs a serious restructuring. It burned through $9 billion of cash in the first 9 months of 2008. It has a labor cost 50% higher than U.S.-based Toyota plants, and it produces cars nobody wants. It is saddled with massive pension and healthcare obligations and it is essentially insolvent: its total liabilities are more than 50% greater than the book value of its assets.

Critically, GM’s position on the verge of bankruptcy is not because of the severity of the current financial and economic crisis. The current crisis is simply the proverbial straw that breaks the camel’s back. Without the crisis, the camel would not have lasted long anyway.

36BBailout: Cash for a drug addict If the US government provides GM with a $25 billion loan that allows it to continue operating under current conditions for another year or two, the money would simply be wasted and the problem postponed. GM would still be completely unable to survive in the long term. We are very sympathetic towards the pain of the hundreds of thousands of workers whose jobs are at stake. It is precisely because we are concerned about their long term welfare that we oppose a bailout. Throwing money at a drug addict only enables the addict to continue abusing drugs and ultimately shortens his life. Similarly, government money aimed at a company that needs restructuring enables it to avoid taking responsibility of its future, condemning it to a certain death.

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37BA debt for equity swap won’t work Unfortunately, in this case the transformation of part of the debt into equity, as proposed by one of us for banks, is not a solution either. GM’s problem is not a short-term liquidity crisis. A debt-for-equity swap would provide temporary relief from GM’s short term obligations, but at the cost of continuing the bleeding and delaying the restructuring. GM would just continue to run down the value of its assets. The only difference with respect to a government bailout would be that investor money instead of taxpayer money would be wasted.

38BChapter 11 is the way forward We believe that a Chapter 11 bankruptcy filing for GM is the only possible solution. However, we recognise that in the current environment, there are several likely inefficiencies associated with the bankruptcy process. In particular, if we do nothing and wait for GM to file for bankruptcy, which would likely happen in a month or so, we would risk a bad outcome of the proceedings, namely an inefficient liquidation of the company and a substantial amount of social disruption from the sudden loss of jobs. We therefore propose that the government oversee a prepackaged bankruptcy for GM that would give the company the restructuring it badly needs and avoid inefficient liquidation. To be successful, this restructuring requires several elements.

39BBeware Chapter 11 without DIP financing 1. First, financing must be available during the restructuring. In normal times, this debtor-in-

possession (DIP) financing would typically be provided by financial institutions. However, obtaining DIP in the current environment is a risky business. The market for the provision of DIP is dominated by a few players, and it is not clear how many of them are willing to lend now. JP Morgan, for instance, has several billion of DIP financing tied up with Delphi, GM’s main supplier of parts, which has been in bankruptcy since 2005. It is doubtful that JP Morgan will be willing or able to double up its exposure to the automobile industry. At the same time, GE Capital and Citigroup, who provided the DIP finance for the Chapter 11 bankruptcy of United Airlines, are unlikely to become the financiers of GM because they have problems of their own. Without DIP financing, however, Chapter 11 would lead immediately to liquidation — not a liquidation driven by market forces, but a firesale due to the current dislocation of the financial markets.

In this case, given the frictions on the credit market, it would be justified for the government to provide DIP financing. This loan would be very different from the one proposed by GM executives and unions. By being senior to all the existing debt it would be relatively safe for the government.

40BEnergising restructuring 2. Second, the financing must aim to minimise the risk the company remains passive and

continues wasting resources. A cautionary tale is found in the DIP financing of Eastern Airlines, which kept flying in bankruptcy until the value of its assets had been driven almost to zero. To avoid this problem, we propose that while the government provides the funding for the loans and the guarantee for most of the losses, the actual lending decision should be made by a commercial bank. In exchange for the underwriting fees, the private bank could be held liable for some percentage of the last losses on the value of GM’s debt. In this way, we impose a limit on GM’s ability to waste resources. When the value of its assets has been impaired, GM will be unable to get any new financing, because the private institutions will pull the plug. In this way we avoid the risk that GM will die of premature death in Chapter 11, but we also prevent GM from exploiting the government guarantee to

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delay the restructuring.

3. Third, the GM bankruptcy must avoid setting off a costly chain reaction of other bankruptcies. In particular, the bankruptcy of related suppliers must be avoided. If GM were to default on its payments to these suppliers, many of them would be broke, with negative consequences for the other manufacturers of cars in the United States. DIP financing must therefore be sufficient to allow GM to make its payments to suppliers. Furthermore, bankruptcies of foreign subsidiaries should also be avoided. As the Lehman bankruptcy has shown, foreign proceedings are more rigid and would contribute to the possibility of excessive liquidation.

4. Fourth, GM must emerge from Chapter 11 as a smaller company. This necessitates shutting down the most money-losing segments of the company, while also providing incentives to foreign manufacturers to buy some of GM’s assets without union contracts attached.

5. Fifth, GM must emerge from Chapter 11 without massive pension obligations. Legally, the US government is on the hook for any underfunding of accrued pension benefits for US workers, with a cap of $51,750 per person year. Much of the unloading of GM’s pension will therefore happen mechanically and unfortunately will come at a substantial cost to taxpayers. As showed by the United Airlines bankruptcy, it is impossible to know exactly what the magnitude of the government liability will be before the bankruptcy itself happens, due to uncertainty about the value of the assets and also the fact that the government turns the pension liability into a hard riskless claim. Our best estimate is that the underfunded US pensions themselves could cost taxpayers $23 billion. The alternative, however, is worse: to waste money propping up GM and hope that the government pension liability shrinks going forward through a miraculous performance of GM’s pension fund (and risking it might get even larger).

6. Sixth, GM must emerge from Chapter 11 without enormous retiree medical care liabilities. By negotiating with its white-collar employees, GM has been able to get the unfunded part of this liability down to a “mere” $34 billion. Furthermore, GM and the United Auto Workers (UAW) have agreed to a special fund for a Voluntary Employee Beneficiaries Association (VEBA). Under this agreement, however, billions of dollars of additional cash contributions are due from GM in the next several years. The agreement will have to be revisited in Chapter 11. We recommend that some of the liability be funded with shares in the reorganised company. This is how United Airlines pilots were compensated for some of their losses from uncovered pension benefits in the UAL bankruptcy.

41BAssuring consumers: Insuring warranties 7. Finally, the bankruptcy plan would have to address perhaps the biggest challenge of a

Chapter 11 filing: the risk that the customers will desert GM because of concerns about the value of its car warranties. People were not afraid to fly United Airlines when it was in Chapter 11. However, a trip is a relatively short-lived transaction and a customer does not care about the fate of the airline once he has arrived home. With cars, the fear of losing the warranty might be large enough that the potential customers will shy away. Even worse, this fear might become self-fulfilling: if enough customers avoid GM, the survival of the company is at risk.

To avoid this problem, we propose that GM be required to purchase insurance for its warrantees, and to do so in such a way that its incentives to improve quality are not diminished. There are already well-established third party providers of car warranties.

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To avoid the moral hazard, both the workers and the managers could be asked pay for the deterioration of car quality. For example, both required contributions to the VEBA and executive bonuses could be indexed to the cost of servicing the warranty.

42BHow much will it cost? The restructuring cost at GM will of course be high, both in human and financial terms. But the alternative is worse: to spend $25 billion on aggravating and postponing the problem. It would be better to give away that money directly to the workers rather than let GM decide how to dissipate it. At over $200,000 for each of GM’s 123,000 North American employees it would a very nice gift. The taxpayers’ cost would be the same, but at least the money would help secure a future to hard-hit households.

Overall, however, we believe that paying off workers and liquidating the company is equivalent to putting the patient out of his misery before attempting to administer the best economic medicine. Some may argue that GM has been receiving medicine from taxpayers for quite some time, but clearly it has been receiving the wrong medicine. A Chapter 11 bankruptcy gives a firm that needs to restructure the chance to recover. If Chapter 11 cannot save GM, then nothing can.

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43BBusinessWeek 44BAuto Execs in the Hot Seat 71BGM, Ford, and Chrysler CEOs face tough Senate questions over why the U.S. should hand them billions, and whether it'll do any good By David Kiley

November 19, 2008, 12:01AM

WASHINGTON—Chief executives of the three U.S. automakers tried to persuade key members of the Senate that they deserve at least $25 billion in government loans to help the industry survive the current economic recession, and that the taxpayers can expect to be repaid in the future. From the response they got, it will be a tough sell.

For two weeks, since General Motors (GM) revealed that it lost $4.2 billion in the third quarter and might not have enough cash to last the year (BusinessWeek.com, 11/7/08), Republicans have voiced opposition to helping Detroit. Democrats, meanwhile, have been angling to help either by using a portion of the $700 billion Wall Street bailout approved by Congress in October or a new $25 billion attached to an economic stimulus package.

All of that ramped up the anticipation for the Nov. 18 appearance of the Big Three CEOs—GM's Rick Wagoner, Ford's (F) Alan Mulally, and Chrysler's Robert Nardelli—before the Senate Banking Committee. The auto executives will continue their lobbying campaign Nov. 19 at the House of Representatives.

113BSee You Next Year But Capitol Hill staffers and key leaders said the chances of passing new legislation to help the automakers during the lame-duck congressional session were scant. "I don't think we can get the votes," said Senator Chris Dodd (D-Conn.), chairman of the banking committee. Senator Bob Corker (R-Tenn.) told the CEOs, "Nothing will get done this week, and I suspect you'll be back in January."

Still, the company CEOs and United Auto Workers President Ron Gettelfinger used the hearing to try to knock down some extremely negative perceptions about how they got to this point. And they took pains to make clear that they consider the situation dire.

GM and Chrysler indicated that without loans from the government, they will be below minimum cash requirements by end of the first quarter of 2009. GM's Wagoner said his company will have about $15 billion in cash at the end of the year. Nardelli said Chrysler has $6.1 billion now. "That is getting very close to our minimum needs of liquidity to operate," Nardelli told the Senate committee.

Ford said it can last into 2010, unless the market gets appreciably worse. But it worries that a GM or Chrysler failure will trigger the failure of hundreds of auto suppliers, freezing Ford's production and thus driving all three companies and an array of suppliers into Chapter 11 reorganization. GM is asking for $10 billion to $12 billion in loans. Chrysler has asked for $7 billion, and Ford, $7 billion to $8 billion.

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Still, all three companies say their outlook beyond the immediate financial crisis is much brighter than generally understood. The auto execs say that dozens of plant closures and deals with unions should cut costs enough to make them profitable when the economy and auto sales turn up again. Many analysts expect sales to rebound by mid-2010.

114BIs Detroit to Blame? But it was clear from the statements and questions posed by Senators to Wagoner, Mulally, and Nardelli that many think Detroit's problems are self-inflicted, and that the companies lack the innovation to climb out of their hole.

Dodd pulled no punches: "They have derided hybrid vehicles as making 'no economic sense.'…They have dismissed the threat of global warming…their boardrooms and executive suites have been famously devoid of vision." Even so, Dodd said, "I support efforts to assist the industry." Republican Senators Richard Shelby of Alabama and Elizabeth Dole of North Carolina were among the vocal critics of the car companies. Both Alabama and North Carolina have benefited from investment from European and Asian automakers and their suppliers.

115BCongress Is Partly to Blame Senators closer to Detroit's home turf, such as Sherrod Brown (D-Ohio) and Debbie Stabenow (D-Mich.), came to the automakers' defense. Not helping the industry, said Brown, "is the surest way to turn our recession into a depression." He said the Congress should take some blame for not passing tougher fuel-economy legislation that would have better prepared the companies for $4-per-gallon gasoline that decimated sales of sport-utility vehicles that Detroit has relied on for profits: "We are on shaky ground when we shake our finger at the industry."

Though all three CEOs were present, much of the focus was on GM Chairman and CEO Wagoner because the company is the largest of the three, and is closest to having to file for bankruptcy if government loans don't come through. Last week, GM told members of Congress that its chances were "50-50" to have enough money to operate beyond the New Year.

Wagoner leaned on the argument that it would be cheaper to help GM and the other companies with loans than allow a cascading failure of the companies. "The societal costs of a GM failure," said Wagoner, "would be catastrophic, with 3 million jobs lost within the first year…and a government tax loss of $156 billion in three years."

116BCredit Crunch Is a Culprit The companies themselves are not the only target of derision on Capitol Hill. The UAW has been singled out by many critics of Detroit for being a bloated, spoiled, and overpaid workforce that has bullied the automakers into paying wages and benefits far out of line from what Japanese companies like Toyota (TM) pay their U.S. workers.

Gettelfinger focused his testimony on attacking criticism from Congress and several media commentators who have opposed the bailout in the past few weeks. "The current crisis can't be blamed on the Detroit-based companies producing gas-guzzling vehicles," said Gettelfinger. "Nor can it be blamed on overly rich union contracts." The union chief emphasized the negative effect of the credit crunch on the ability of consumers to get car loans, and the subprime mortgage and credit crisis that has skewered the broader economy.

Several Capitol Hill staffers this week said the measure that stands the best chance of passing during the lame-duck session of Congress is a revision of the 2007 energy bill that would immediately free up $25 billion in loans to retool plants. That money might otherwise take

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years to flow to the companies. But Gettelfinger surprised some by saying the union is against speeding up those funds. "This program was not designed to address the type of immediate cash-flow crisis that the Detroit-based auto companies are now facing as a result of the sudden drop in auto sales," Gettelfinger said.

117BCounting on Obama That position, shared by Speaker of the House Nancy Pelosi (D-Calif.) and House Financial Services Committee Chairman Barney Frank (D-Mass.), may be dangerous. Advancing the green factory funds might provide enough liquidity to keep GM operating until the Obama Administration can act directly to help the auto industry in late January. Democrats and the auto companies are counting on Obama's willingness to tap some of the $400 billion that will be left in the Wall Street bailout fund in January.

"I reject that this is the only way we can help the auto industry, just because it's the way Republicans want to get it done," Frank told BusinessWeek. Frank also says he is not in favor of using the Wall Street funds for the auto industry. But his support may not be needed.

The union president also said he would not support tying immediate loan help to tougher fuel-efficiency standards. "It is not appropriate to hold emergency assistance hostage to broader fuel economy/environmental initiatives," Gettelfinger said.

118BFord's "Bright Future" Ford's Mulally acknowledged that some critics want to see a new business model in Detroit before putting billions of taxpayer dollars in play. "I completely agree…what many commentators and critics fail to recognize, however, is that we at Ford are on our way to realizing a complete transformation of our company—building a new Ford that has a very bright future," Mullaly said. On the same day, other Ford executives were in Los Angeles unveiling two gas-electric hybrid vehicles that get better mileage than rival Toyota products.

Ford has closed 17 plants in North America—including one third of its assembly plants—in the last five years. The company has reduced its workforce by 51,000 people in three years, and its hourly workforce has fallen from 83,000 to 44,000. Salaried headcount is down to around 12,000, from 33,000 in 2004.

"Speaking only for Ford, we are hopeful that we have enough liquidity based on current planning assumptions and planned cash improvement actions, but we also know we live in tumultuous times," said Mulally, who came to Ford two years ago after 37 years at Boeing (BA).

119BFear of Helping Hedge Funds But, Mulally said, "If any of the domestics should fail, we believe there is a strong chance that the entire industry would face severe disruption."

The presence of Chrysler in the hearing presented problems for some members of the committee. The automaker is owned by hedge fund Cerberus Capital Management, and some worry that taxpayer money will be used to enrich the billionaires who run it.

Chrysler CEO Nardelli attacked that concern. "Cerberus Capital Management has made it clear that it will forgo any benefit from the upside that would in part be created from any government assistance that Chrysler may obtain." Nardelli tried to convince the lawmakers that bankruptcy would be a dangerous unknown that could cost some 3 million jobs and the futures of all three companies. "We cannot be confident that we will be able to successfully emerge from bankruptcy," he said.

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Automakers Press High-Stakes Plea for Aid Senators Greet CEOs' Request With Skepticism

By Lori Montgomery, Wednesday, November 19, 2008; A01 The chieftains of Detroit's Big Three automakers made a desperate appeal to skeptical lawmakers yesterday for $25 billion in emergency loans to forestall the possible collapse of the domestic auto industry, offering to cut their own salaries in exchange for government aid. But the chances were looking increasingly bleak that Congress would quickly approve a lifeline to help the firms survive some of the most devastating economic conditions since HHenry FordH founded the HFord Motor Co.H in 1903.

In testimony before the Senate Banking Committee, the chief executives of Ford, HGeneral MotorsH and HChryslerH blamed the failure of the global credit system for driving down auto sales and plunging their firms into crisis. Chrysler chief executive HRobert L. NardelliH revealed that his company had considered filing for bankruptcy protection, but decided it would take too long to reach an accord with suppliers, lenders and labor. "We're in a very fragile position," Nardelli said. Even Ford, the strongest of the three, is worried about its long-term survival. Ford chief executive HAlan R. MulallyH said in written testimony that because the auto industry is "uniquely interdependent" on a nationwide chain of suppliers, the failure of even one of the companies could cause a "severe disruption" that would be felt by every auto plant in the country "within days, if not hours."

"In the face of incredibly fragile economic conditions and the interdependence of our industry, we believe it is appropriate at this time to join our competitors in asking for your support to protect against an uncertain economic future," Mulally wrote.

The stakes are high, the executives argued. The U.S. auto industry employs 240,000 workers. It is the largest purchaser of American-made steel, aluminum, iron, copper, plastics, rubber and electronic chips. Last year, it bought $156 billion in U.S. auto parts, supporting jobs in all 50 states. Auto sales typically account for 4 percent of the gross national product.

Several senators in both parties said they recognize the industry's importance to the national economy and the severity of the crisis that has left GM and Chrysler in danger of running out of money within months. But the patience of even some sympathetic lawmakers was tested by evasive answers from the executives about whether $25 billion would be enough to restore them to financial health or whether Congress, having approved one bailout, would be asked to approve another next year.

"I voted for $25 billion to help you restructure," said Sen. HRobert MenendezH (D-N.J.), referring to a package of low-interest loans Congress approved earlier this year to help the car companies retool factories to produce more fuel-efficient vehicles. "But when I hear you not being able to give us how this $25 billion will take you to that place in time in which you will be able repay the taxpayers of the country . . . well, it's a difficult proposition."

In one particularly testy exchange, Sen. HBob CorkerH (R-Tenn.) demanded to know how the three companies plan to divide the cash if Congress is persuaded to approve it. "Obviously, you've all created a pact," Corker said. "I just want the numbers."

Nardelli quickly replied that Chrysler would seek $7 billion. Mulally said Ford wants about the same. And, after an initial vague response, HGM Chairman G. Richard Wagoner Jr.H, confessed to hoping for as much as $12 billion.

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When Corker raised the prospect of a prearranged bankruptcy with the government offering to help one or more of the firms restructure under court supervision, Wagoner snapped back that the idea is "pure fantasy." A bankruptcy, he said, "would ripple across this economy like a tsunami we haven't seen. It seems to me like a huge roll of the dice."

The auto companies say a bankruptcy filing would trigger fears that warranties would not be honored and that parts and service would be hard to come by, driving away customers. Suppliers, who count on each of the companies for a huge portion of their business, could be crippled. And there would be no assurance, Nardelli said, that once a company entered bankruptcy protection it would be able to emerge, given the state of the credit market.

Sen. HJon TesterH (D-Mont.) asked the executives whether they would be willing to cut their own salaries to $1 a year to avoid that outcome, following in footsteps of HLee IacoccaH, former chairman of Chrysler, which received a government bailout in 1979. All three said yes.

"I'm willing to be part of the solution," Wagoner said. Mulally said it would be "a symbolic gesture," because Ford had eliminated merit raises and bonuses for this year.

The automakers may come away empty-handed. At the close of the four-hour hearing, HSenate Banking Committee Chairman Christopher J. Dodd (D-Conn.) H acknowledged that a Democratic proposal to carve $25 billion in emergency loans out of the $700 billion financial rescue program Congress enacted last month does not have sufficient support to win approval during this week's session of Congress.

HThe White HouseH adamantly opposes the idea, saying it would raid money needed to stabilize the financial system. HPresident Bush H has urged lawmakers to modify and accelerate the existing $25 billion loan program to build fuel-efficient vehicles, but the car companies, House Speaker HNancy PelosiH (D-Calif.) and other key Democrats are unwilling to divert the money from its original purpose.

A test vote on the Democratic measure in the Senate could come tomorrow, but Dodd said he will revisit that idea with HSenate Majority Leader Harry M. Reid (D-Nev.)H. "Trying to jam something through, I think, would be a mistake," Dodd said.

Faced with an apparent impasse and the Thanksgiving break fast-approaching, Reid and Pelosi must decide whether to try again in December or put the matter off until January, when Democrats will have stronger majorities in both chambers of the Capitol, as well as control of the Oval Office.

While Reid and HHouse Majority Leader Steny H. Hoyer (D-Md.)H yesterday raised the prospect of a December session, Pelosi told reporters she knows of "no likelihood of us being in session in December."

No action would leave the car companies in a grim position. GM has said it could run out of cash next year, and Nardelli said yesterday the same was true for Chrysler. This comes despite their efforts to produce better, more fuel-efficient cars and to dramatically cut costs by slashing workers, trimming salaries and benefits, and dumping nonperforming assets. Yesterday, Ford continued its campaign, announcing that it would raise about $540 million by selling part of its stake in Japanese affiliate HMazda H today. Mulally noted that Ford had even made a profit during the first quarter of this year.

"What exposes us to failure now is not our product lineup or our business plan or our long-term strategy," Wagoner said. "What exposes us to failure now is the global financial crisis, which has severely restricted credit availability and reduces industry sales to the lowest per capita level since World War II."

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World Business

141BNovember 19, 2008

45BFacing a Slowdown, China’s Auto Industry Presses for a Bailout From Beijing By KEITH BRADSHER

GUANGZHOU, China — Do Chinese automakers need a bailout?

China’s car industry is quietly pressing Beijing for government help as it copes with a jarring slowdown, top Chinese auto executives said in interviews here on Tuesday.

This autumn, after six years of 20 percent or more annual growth, vehicle sales were flat or slightly negative, a shock to an industry that has borrowed heavily to build ever more factories for a market that had once seemed insatiable.

Citing the $25 billion in loans that Congress has already approved to help American automakers increase green research, and the additional $25 billion in loans the American industry is seeking this week to cope with a hobbled economy, Chinese executives are now telling the government here that they also need emergency measures. They are seeking lower taxes on new cars, lower fuel prices and increased grants for research into hybrid cars and new technology.

“The Chinese government will undoubtedly support us,” said She Cairong, the general manager of JAC Motors, adding that state-owned Chinese banks had already become more willing to lend money to Chinese automakers in recent weeks as bank regulators have eased restrictions on loans to heavy industry. Still, Mr. She and other industry leaders said that while government officials have voiced concern to them about the industry’s deteriorating condition, Beijing has not committed to any specific help.

“They’re asking the questions but they haven’t said anything yet” on how aid might be structured, said Frank Zhao, vice president and chief technology officer of Geely Automobile Holdings. “We really hope the Chinese government will come and help us.”

Michael Dunne, the managing director for China at J. D. Power, said in a telephone interview from Shanghai that the executives’ remarks here represented a shift in the position of the Chinese auto industry.

“This is the first I’ve heard of it,” he said, adding that “as the market slows down, Chinese automakers are going to face competition as they never have before.”

Lots across China became increasingly crowded with unsold cars as sales were slightly lower in August and September than a year earlier. Yet manufacturers unexpectedly increased their shipments of new vehicles to dealerships last month by 10 percent compared with a year earlier, seeking to keep new factories busy and avoid layoffs.

Retail sales figures for October are due this week, and are likely to show a further decline that could set off another round of price cuts in a market where discounting is already becoming increasingly common.

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Detroit has repeatedly found that raising production in the face of weak retail sales is a recipe for financial trouble, and there is little reason to think that will be different in China.

The Chinese auto industry faces several threats simultaneously. Weakening economic growth, falling real estate prices and a yearlong plunge in the stock market have made consumers leery of spending money. Fuel prices in China are still high despite the recent decline in world oil prices. And Chinese auto exports, mostly to developing countries in Eastern Europe, Southeast Asia, Africa and Latin America, are starting to crumble.

China’s car industry is already bigger than Japan’s, and is approaching in sales the industries of the United States and all of Europe. China is on track to sell 10 million vehicles this year, while demand in the United States is dropping toward 14 million vehicles.

Automobiles have played a central role in Beijing’s recent plans to move up the manufacturing chain, from making cheap goods that require unskilled or low-skilled workers to more advanced products.

To that end, the Chinese government has provided considerable help to China’s nascent auto industry with research and development spending, as well as loans from state-owned banks.

But there is some disagreement within the Chinese auto industry now about how the government can be most helpful.

Some companies, like Geely, are looking for more government grants to help them develop hybrid gasoline-electric cars and other cutting-edge technologies for which research spending may be cut if sales do not recover.

But Zheng Qinghong, the general manager of Guangzhou Auto, one of China’s largest and fastest-growing automakers, said that the Chinese industry needs the government to help consumers become enthusiastic again about buying cars. Retail sales have dipped a couple percentage points to 750,000 a month; sales were still rising at an annual pace of 24 percent a year ago. “The best way is to boost growth in demand” for cars, through steps like lower car taxes and lower fuel prices, he said in an interview.

Western multinationals would probably benefit at least indirectly from any government initiative to help China’s auto industry, because Western companies are required to do business through joint ventures with Chinese automakers, most of which are partly or entirely government owned.

Jeffrey Shen, the chief executive and president of one of these joint ventures, the Changan Ford Mazda Automobile Company, said that he did not know how the government would help, but that some steps were inevitable. “I’m sure it will come,” he said, with both extra assistance for research and greater availability of loans.

The renewed willingness of state-owned banks to lend money to the auto industry this autumn is in contrast with the United States, where General Motors, Ford and Chrysler have found banks and other investors leery of lending to them.

Government-mandated lending quotas, not interest rates, tend to be the most important limit on bank lending in China. Regulators have begun easing the quotas this fall after four years of fairly tight quotas imposed in an effort to control the growth of the money supply and limit inflation.

Direct loans from the government of the sort under discussion in Washington are not needed in China, Mr. Zheng said. “For now, the Chinese auto industry doesn’t need saving” in the same way as the American industry, he said.

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Chinese automakers began facing real difficulties only in the third quarter, and have not yet released results for that period; many release their results only twice a year.

Gas prices have not fallen in China because the government pushed up regulated retail gasoline and diesel prices at service stations to more than $3 a gallon over the last year, but has not lowered retail prices as oil prices have plunged.

The government is trying to encourage energy conservation and allow oil refiners to recover financially from sometimes being forced to sell gasoline and diesel below cost earlier this year during the spike in oil prices.

China’s top three export markets for fully assembled vehicles are Russia, Ukraine and Vietnam, all of which are struggling with the global financial crisis.

Great Wall Motor has had a 40 percent plunge in its monthly exports to Russia in the last three months, said Steven Wang, the deputy manager of the company’s international trade division. But Great Wall Motor has still managed to avoid any layoffs because domestic sales remain strong enough to maintain employment, Mr. Wang said.

With China’s largest automakers involved in joint ventures with American automakers, and with the entire Chinese auto industry now seeking its own forms of government help as well, criticism of any bailout for Detroit has been muted. Producers elsewhere in Asia, facing declining markets at home as well, have also been hesitant to criticize.

“We support vigorous competition in the automotive market place and recognize there may be extraordinary situations when such a vital sector of the American economy may require unprecedented actions to assure its long-term viability and a healthy American economy which benefits everyone,” said Jake Jang, a spokesman for Hyundai Motor in South Korea.

But managers at some of the smaller Chinese manufacturers, especially those with hopes of entering the American market some day, are unhappy about the prospect of assistance for Detroit from Washington.

“If G.M., Ford and Chrysler get a lot of support from their government, it’s not fair,” said Gordon Chen, the international business manager of Changfeng Motor, which has displayed cars at the last two Detroit auto shows in preparation for entering the American market in 2011 or 2012.

Choe Sang-hun contributed reporting from Seoul.

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Investors Dump LBO Debt To Raise Cash; Anticipate Defaults, Nov 19, 2008

Fitch: The U.S. high yield market suffered the worst quarterly performance in its history during the third quarter of 2008, going all the way back to the market’s infancy in 1985. The total return on the Merrill Lynch High Yield Master II Index was −9.57%, or −32.63% on an annualized basis, reversing the modestly positive total return of 1.81% seen in second-quarter 2008. On a performance basis, the U.S. leveraged loan market fared a little better than the high yield market, but generated the worst quarterly return in its history as well, with a total return of −5.91% in Q3, as measured by the Credit Suisse LeveragedLoan Index (CSLL Index). The current sell-off is driven by margin clauses, an increase in anticipated LBO defaults, and H hedge fundH clients' withdrawals.

o Nov 19: HY Blog: Record spreads are not only due to firesales but find some justification in the deterioration of credit quality down the rating scale.

o cont.: Similarly, the spike in the projected default rate is in line with the deterioration of credit quality of outstanding debt down the rating scale.

o Nov 19 Bloomberg: The price of the average actively traded leveraged loan fell 2.6 cents to 71.2 cents on the dollar since Nov. 13, according to Standard & Poor's LCD.

o cont.: As of mid-2007, hedge funds became one of the main players in the leveraged debt market. Declining prices are forcing investors to sell loans because of clauses in their funds' borrowing agreements that require them to raise money when prices drop below a set level. Investors sold a record $3.3 billion of high-yield, high risk debt in October in the form of portfolio auctions, according to Standard & Poor's.

o Nov 17: Investors accuse Goldman Sachs to be engaging in leverage loan short sales to the disadvantage of their custormers.

o Fitch: New leveraged loan issuance of $90.1 billion during third-quarter 2008 was relatively flat with the second-quarter 2008 adjusted total of $91.3 billion, but was down sharply from the comparable third-quarter 2007 level of $129.8 billion.

o the 12-month trailing default rate as measured by the Fitch U.S. High Yield Default Index increasing to 3.3% at Sept. 30, 2008, up only slightly from 3.1% at June 30, 2008. Default volume for Q3 was $2.77 billion, well below the $18.3 billion experienced during Q2, as 12 separate companies defaulted on their debt obligations.

o BIS: Defaults on leveraged-buyout loans may rise to 4% this year as firms struggle to refinance about $500 billion of debt used to fund the takeovers--> ``The risk of a significant increase in LBO firm defaults in the next few years may have risen substantially.''

o Oct 3: Positive: LBO companies are able to buy back their outstanding leveraged debt at lower prices (e.g. Charter, Freescale)

o Fitch: Between 2004 and 2007 approximately$450 billion of sponsored US LBO related leveraged loans came to market.

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Opinion

November 18, 2008 OP-ED CONTRIBUTOR

46BFighting the Financial Crisis, One Challenge at a Time By HENRY M. PAULSON Jr. WE are going through a Hfinancial crisisH more severe and unpredictable than any in our lifetimes. We have seen the failures, or the equivalent of failures, of HBear StearnsH, IndyMac, HLehman BrothersH, HWashington MutualH, HWachoviaH, HFannie MaeH, HFreddie MacH and the HAmerican International GroupH. Each of these failures would be tremendously consequential in its own right. But we faced them in succession, as our financial system seized up and severely damaged the economy.

By September, the government faced a systemwide crisis. After months of making the most of the authority we already had, we asked Congress for a comprehensive rescue package so we could stabilize our financial system and minimize further damage to our economy.

By the time the legislation had passed on Oct. 3, the global market crisis was so broad and so severe that we needed to move quickly and take powerful steps to stabilize our financial system and to get credit flowing again. Our initial intent was to strengthen the banking system by purchasing illiquid mortgages and mortgage-related securities. But the severity and magnitude of the situation had worsened to such an extent that an asset purchase program would not be effective enough, quickly enough. Therefore, exercising the authority granted by Congress in this legislation, we quickly deployed a $250 billion capital injection program, fully anticipating we would follow that with a program for buying troubled assets.

There is no playbook for responding to turmoil we have never faced. We adjusted our strategy to reflect the facts of a severe market crisis, always keeping focused on our goal: to stabilize a financial system that is integral to the everyday lives of all Americans. By mid-October, our actions, in combination with the HFederal Deposit Insurance CorporationH’s guarantee of certain debt issued by financial institutions, helped us to accomplish the first major priority, which was to immediately stabilize the financial system.

As we assessed how best to use the remaining money for the Troubled Asset Relief Program, we carefully considered the uncertainties around the deteriorating economic situation in the United States and globally. The latest economic reports underscore the challenges we are facing. The gross domestic product for the third quarter (which ended Sept. 30, three days before the bill passed) shrank by 0.3 percent. The unemployment rate rose in October to a level not seen since the mid-1990s. Home prices in 10 major cities have fallen 18 percent over the previous year. Auto sales numbers plummeted in October and were more than a third lower than one year ago. The slowing of European economies has been even more drastic.

I have always said that the decline in the housing market is at the root of the economic downturn and our financial market stress. And the economy, as it slows further, threatens to prolong this decline, as well as the stress on our financial institutions and financial markets.

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A troubled-asset purchase program, to be effective, would require a huge commitment of money. In mid-September, before economic conditions worsened, $700 billion in troubled asset purchases would have had a significant impact. But half of that sum, in a worse economy, simply isn’t enough firepower.

If we have learned anything throughout this year, we have learned that this financial crisis is unpredictable and difficult to counteract. We decided it was prudent to reserve our TARP money, maintaining not only our flexibility, but also that of the next administration.

The current $250 billion capital purchase program is strong medicine for our financial institutions. More capital enables banks to take losses as they write down or sell troubled assets. And stronger capitalization is essential to increasing lending, which is vital to economic recovery.

Recently I’ve been asked two questions. First, Congress gave you the authority you requested, and the economy has only become worse. What went wrong? Second, if housing and mortgages are at the root of our economic difficulties, why aren’t you addressing those problems? The answer to the first question is that the purpose of the financial rescue legislation was to stabilize our financial system and to strengthen it. It is not a panacea for all our economic difficulties. The crisis in our financial system had already spilled over into the overall economy. But recovery will happen much, much faster than it would have had we not used TARP to stabilize our system. If Congress had not given us the authority for TARP and the capital purchase program and our financial system had continued to shut down, our economic situation would be far worse today. The answer to the second question is that more access to lower-cost mortgage lending is the No. 1 thing we can do to slow the decline in the housing market and reduce the number of foreclosures. Together with our bank capital program, the moves we have made to stabilize and strengthen Fannie Mae and Freddie Mac, and through them to increase the flow of mortgage credit, will promote mortgage lending. We are also working with the HDepartment of Housing and Urban DevelopmentH, the F.D.I.C. and others to reduce preventable foreclosures.

I am very proud of the decisive actions by the Treasury Department, the Federal Reserve and the F.D.I.C. to stabilize our financial system. We have done what was necessary as facts and conditions in the market and economy have changed, adjusting our strategy to most effectively address the crisis. We have preserved the flexibility of President-elect HBarack Obama H and the new secretary of the Treasury to address the challenges in the economy and capital markets they will face.

As policymakers face the difficult challenges ahead, they will begin with two considerable advantages: a significantly more stable banking system, one where the failure of a major bank is no longer a pressing concern; and the resources, authority and potential programs available to deal with the future capital and liquidity needs of credit providers.

Deploying these new tools and programs to restore our financial institutions, financial markets and the flow of lending and credit will determine, to a large extent, the speed and trajectory of our economic recovery. I am confident of success, because our economy is flexible and resilient, rooted in the entrepreneurial spirit and productivity of the American people.

Henry M. Paulson Jr. is the secretary of the Treasury.

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Opinion November 19, 2008 EDITORIAL

47BGetting to Yes At one point during a hearing on the bank bailout in the House of Representatives on Tuesday, Treasury Secretary Henry M. Paulson Jr. said that he was being misunderstood about why he refused to use any of the $700 billion bailout fund to prevent foreclosures.

He has made it clear that he knows the housing bust is at the root of the financial crisis and the economic downturn. But he said at the hearing that using the bailout money for foreclosure relief would violate the intent of the rescue approved by Congress because it would be a “direct subsidy” rather than an “investment.”

Direct subsidy is a synonym for government spending, which the Bush administration seems to believe promises no chance of ever yielding a return. Investing, on the other hand, say in stocks, holds out the hope of getting one’s money back.

In an exchange with Representative Barney Frank, the Massachusetts Democrat who is chairman of the House Financial Services Committee, it quickly became apparent that it was Mr. Paulson who did not understand the intent of Congress as expressed in the bailout bill. And in subsequent testimony by another witness — Sheila Bair, the chairwoman of the Federal Deposit Insurance Corporation — Mr. Paulson’s simplistic distinction between direct spending (bad) and investing (good) was demolished. If Mr. Paulson wants to persist in withholding bailout funds for foreclosure relief, he will have to come up with a new set of justifications.

Mr. Frank pointed out several sections of the bailout law that direct the treasury secretary to engage in foreclosure prevention. Perhaps the most important of those provisions authorizes the treasury secretary to “use loan guarantees and credit enhancements to facilitate loan modifications to prevent avoidable foreclosures.”

There you have intent and even a recommended course of action — guaranteeing modified loans. It could not be clearer.

Ms. Bair, who is pushing a plan to use $24 billion of the bailout fund to prevent foreclosures, pointed out that such spending could yield a far bigger return than the investments Mr. Paulson favors.

Under the plan, lenders who modify troubled loans according to specific criteria would be insured against some of the losses they would incur if the modified loan were to default. That would give lenders an incentive to rework bad loans and in so doing, slow the pace of foreclosures and house-price declines.

In her testimony, Ms. Bair noted that if the program kept home prices from falling by 3 percentage points less than would otherwise be the case, more than half-a-trillion dollars would remain in homeowners’ pockets. The effect on consumer spending, conservatively estimated, would exceed $40 billion. That would be a big economic stimulus, worth nearly double the original “investment.”

Congress intended Mr. Paulson to use some of the bailout money to prevent foreclosures. The F.D.I.C. calculations show that it would be money well spent. What is Mr. Paulson waiting for?

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A Skeptical Outsider Becomes Bush's 'Wartime General' By David Cho Washington Post Staff Writer Wednesday, November 19, 2008; A01 Second of two articles

The pressure on HHenry M. PaulsonH Jr. in early September was greater than at any other time during his tenure as Treasury secretary. As he pored over the books of mortgage giants HFannie MaeH and HFreddie MacH, he discovered that they were about to collapse and that the financial markets would experience what he called "a meltdown to end all meltdowns."

The federal government would have to seize the firms. But the law said their management would have to agree, and his own staff had reservations about whether Paulson had the legal authority to force them to surrender.

"Trust me," came Paulson's curt answer. "I'll get it done."

During his 28 months at the Treasury, Paulson has accumulated more power than nearly any of his predecessors and has wielded it boldly, even brazenly at times, in a bid to tame the financial crisis of a lifetime. He has burst through the customary boundaries that separate federal agencies, bent regulations to his will and pushed up against legal limits. As financial firms tumble and traditional oversight agencies prove impotent, Paulson has filled the void with his 6-foot-1 frame, summoning the rest of Washington and HWall StreetH to get in line.

"Even if you don't have the authorities -- and frankly I didn't have the authorities for anything -- if you take charge, people will follow," Paulson said in an interview. "Someone has to pull it all together." He said regretfully that the financial upheaval has forced him to be a modern Robert Moses, the controversial 20th-century urban planner who acquired minor government posts and stretched their authority to reshape New York City as he saw fit. Though Moses never held elected office, he remade the landscape of New York through the cunning exercise of power.

Paulson had twice rebuffed the Bush administration by the time it offered him the post of Treasury secretary in April 2006. Paulson finally agreed but insisted on some terms. He would answer only to HPresident BushH and not be subject to meddling by the president's economic policy advisers. And, Paulson recalled, he wanted it in writing.

The agreement laid the foundation. After the financial crisis erupted last year, Bush privately dubbed Paulson his "wartime general" on the economy, essentially telling him he would have HWhite House H backing for whatever measure he pursued, Paulson recalled in a series of interviews. That commitment endured even as Paulson steered the administration far from Republican orthodoxy on free markets. Paulson used his influence within the administration to win even broader powers from Congress, allowing him to nationalize major financial institutions, either in part or entirely. The bills were sweeping in scope and gave him the latitude to spend hundreds of billions of dollars as he saw fit.

And Paulson unilaterally pushed his authority to craft initiatives even when, according a senior government official, he was not sure he had an airtight legal basis.

Confronted with the implosion of Fannie Mae and Freddie Mac, he didn't hesitate in identifying his course for the firms. He gave the companies' management just one day to

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review the Treasury's assessment of their situation, which revealed that each was on the verge of collapse. Then he summoned individually the two chief executives, HRichard F. SyronH of Freddie Mac and HDaniel H. Mudd H of Fannie Mae, to the third-floor conference room near his office in the Treasury building. Paulson sat across from them, along with HFederal Reserve Chairman Ben S. BernankeH and the companies' regulator, HJames B. Lockhart IIIH.

Paulson put it bluntly: "We are going to [take you over] and we want you to agree to it, and you will have a board meeting tomorrow and you are going to agree to it at your board meeting." Paulson never acknowledged that, under law, the companies had a choice in the matter.

Within days, Paulson had compelled them to agree that they would be nationalized.

"Not that I think it's a good thing; it should never work that way," he said. "But this was an extraordinary time period, and as much as I didn't want to do it . . . I knew what would happen if we didn't do it."

* * *

When President Bush first settled on a chairman of HGoldman Sachs H named Hank Paulson to be his new Treasury secretary, the administration couldn't seal the deal.

Nearly everyone Paulson talked to advised him not to do it. He spoke to family. He spoke to colleagues. They raised concerns about whether his reputation would be tarnished, as happened to Bush's first two Treasury secretaries, Paul H. O'Neill and HJohn W. SnowH. They proved ineffective, some political analysts said, because their authority had been undercut by the White House.

Even one of Bush's Cabinet secretaries counseled Paulson against coming to Washington, Paulson said. "Don't come down here; you can't trust them," he recalled being told. He declined to identify the Cabinet member.

Paulson was afraid of failing. "I will get down here and I won't be able to work with these people, and I'll leave with a bad reputation, and look at what people said about Snow and O'Neill," he said.

After the second time Paulson turned down the job offer, White House HChief of Staff Joshua B. BoltenH, invited Paulson and his wife for lunch with Bush and President HHu JintaoH of China. Paulson recalled feeling melancholy as he left the White House, reflecting on what he was about to pass up. He reconsidered.

Paulson sought out Allan B. Hubbard, director of the National Economic Council at the time, who guaranteed that the White House team would not undermine Hthe Treasury DepartmentH.

Bolten said the toughest job was convincing Paulson that he could still accomplish important goals as Treasury secretary in the last years of the Bush administration. But giving Paulson written assurances that he would have broad authority at the Treasury was not hard for the White House.

"The real problem was getting Hank to be willing to do the job -- he was sitting on top of the world in early 2006," Bolten said. "He had heard that this is a very White House-centric operation, which in some respects it has been, and the secretary of Treasury did not have much authority and so on, and he wanted to be assured he would be leader of the economic team. To me that stuff was easy. The president would be in charge, but yes, you are the leader of the economic team."

The third time Paulson was asked, he accepted.

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As turmoil in the financial markets escalated, Paulson's influence grew so great that he eclipsed the White House on economic policy. And when Paulson sought new authority from lawmakers to rescue the mortgage markets and financial companies, Bush told him he would "hang back" rather than risk that his poor popularity jeopardize Treasury's efforts on HCapitol HillH, according to two sources familiar with the president's discussions with Paulson.

"I think the president of the United States was willing to defer to him and give him authority and liberate him from the constraints that the White House had forced on his predecessors," a senior government official said. "That was hugely important because it made him credible and able to negotiate with Congress." In the summer, President Bush warned that he would block a landmark housing bill in Congress that in part would revamp the agency regulating Fannie Mae and Freddie Mac. That change was vital to Paulson. He persuaded the president to drop his veto threat, according to senior government officials.

"If you look at Paulson," said Rep. HBarney FrankH (D-Mass.), one of Paulson's key allies on Capitol Hill, "the one thing that's irreplaceable is his ability to bring George Bush along, and throughout this effort, the work . . . to persuade the president to do things that he otherwise would have resisted was important."

When Paulson went to Capitol Hill in September, asking for the authority to spend $700 billion to bail out financial firms, he said, he never worried that Bush would oppose him, though the plan was an unprecedented intrusion in the marketplace. The measure was initially defeated in the HHouse of RepresentativesH, primarily by Republican votes. But Bush never abandoned the proposal -- officially called the HTroubled Asset Relief ProgramH, or TARP, but better known around Washington as the Paulson plan -- instead intensifying lobbying efforts to get it passed.

"When the president stepped up big was when we lost the vote on the House," Paulson said. "He said, 'We will get it done, and we won't change one bit of your TARP. . . . the only thing we'll do is [think of] what sweetener do we have to add, and anything we add, will it gain more votes or lose more votes?' And the only thing he said is, 'We will run that process from the White House.' "

Under the plan, Paulson was granted sweeping discretion to decide how to use the $700 billion and which financial firms would get the money. He could hire firms to manage the program without having to obey the standard government rules for contractors. He could even decide how to place conditions on companies receiving government help, including limits on executive compensation.

In the end, Congress granted Paulson every authority he asked for.

* * *

Paulson acknowledges that such broad powers have a downside. It would be him -- not the White House -- who would be blamed if the emergency response to the crisis went awry.

"We may do things that are unpopular," Paulson said. "We may do things that we are forced to do. There may be things we have to do to respond to a systemic event, and there is no other authority to deal with it other than TARP. Then I will take one for the nation and take the criticism."

That uproar has already started. Yesterday, during a hearing on Capitol Hill, Paulson endured a barrage of criticism, mainly from Democratic congressmen, for repeatedly shifting

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directions on how the bailout billions will be used and for refusing to spend any of it on struggling homeowners or the ailing auto industry.

Treasury secretary is "fundamentally a lonely job," said a former senior Treasury official who advises Paulson. "It's very hard for anybody to know what goes into these kinds of judgments, and I'm sure he's dramatically changed by that. He has to live with all that second-guessing all the time."

Paulson said he always has tried to define his job expansively and plans to encourage his successor to do the same.

Senior government officials said Paulson helped craft rescue programs for financial firms, though he was not sure he had an unquestionable legal basis for the initiatives, including the bailouts of the failing investment bank Bear Stearns in March and the wounded insurance giant HAmerican International GroupH in September.

One senior official said similar legal doubts also applied to the Treasury's decision in September to grant a tax break to banks to help stabilize the financial system by encouraging them to merge. Treasury officials have said publicly that the tax-policy change is legal.

Paulson also supported the HFederal Reserve Bank of New YorkH in organizing the market for complex financial derivatives known as credit-default swaps. Some familiar with the effort said officials from the HFedH and Treasury never knew whether they had the legal authority to interfere with the market for such derivatives but did so anyway because the opaque trading threatened the wider financial system.

At the same time, Paulson has muscled independent regulatory agencies to adopt his ideas. Several regulators said he often applied enormous pressure to get them to fall in line, for instance pushing the HSecurities and Exchange Commission H to adopt a temporary ban on short selling and the HFederal Deposit Insurance Corp.H to introduce a new program to guarantee debt issued by banks. Paulson himself acknowledged that he had been the driving force behind a guidance document released this month by four regulatory agencies urging banks to use bailout money to increase their lending.

"Hank has taken his leadership role seriously," one of the regulators said. "And if he thinks he knows the right answer for a bank regulator, particularly for the HOffice of Thrift SupervisionH or the HOffice of the Comptroller of the CurrencyH or Fannie and Freddie, he will not hesitate to express his views. To that extent, he's the benevolent dictator. He wants an answer, and he wants it yesterday."

Paulson said times forced him to take that role. Every major call in confronting the financial crisis, Paulson said, was his. No other regulator had the authority or will to do it, he said.

When the investment bank HLehman BrothersH released disastrous second-quarter earnings this summer, shortly before it went bankrupt, Paulson asked its chief executive, HRichard S. Fuld Jr.H, what the next quarter would look like. Fuld said it might be worse. Paulson demanded that he find a buyer for the company.

Fuld balked, looking for other ways to save the firm. So Paulson moved ahead himself and tried, ultimately unsuccessfully, to engineer a deal.

"I was the only guy who drove that," Paulson said. "I called two banks when none of them were interested. I tried to get them interested. I urged them to do it. . . . That's what a Treasury Secretary needs to do when you are in a war."

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142BA Conversion in 'This Storm' By David Cho Washington Post Staff Writer Tuesday, November 18, 2008; A01

First of two articles

Treasury Secretary HHenry M. Paulson H Jr. had a stern message for more than two dozen of the nation's most powerful hedge fund managers gathered in the third-floor conference room near his office.

Paulson told them it was time to begin regulating the opaque realm of hedge funds, reversing his long-held opposition. "You should not be thinking about how to fight it but how to make it work," he recounted telling them at the meeting last month.

They were stunned. One manager recalled muttering as he walked out: "What happened to the Hank Paulson we knew?"

With his 30-month tenure nearing its end, Paulson is leaving behind a legacy of federal interventionism that few would have expected from this former head of the investment giant HGoldman Sachs H.

When he arrived in Washington as one of HWall StreetH's most successful bankers, he was skeptical of government meddling. But as a regulator facing the worst financial crisis in nearly a century, he engineered a series of massive federal intrusions into the markets while persuading reluctant bank executives and influential politicians to fall in behind him.

His evolution in thinking has extended even beyond these government programs to a set of new beliefs that he has yet to trumpet publicly or, in most cases, even share privately with colleagues on Wall Street and in the HWhite House H. While they, too, have changed some of their views on regulation, Paulson disclosed that he has traveled an even greater distance.

"My thinking has evolved a lot to the point where I've seen regulation up close and personal," he said in a series of interviews. It wasn't just the crisis that changed him. It was every bit as much sitting behind the desk where he fashioned new regulation. "I've realized how flawed it is and how imperfect, but how necessary it is," he added.

Even though HPresident BushH has been warning the next administration in speeches not to over-regulate the markets, Paulson said he will unveil proposals in coming weeks urging President-elect HBarack ObamaH and the new Congress to endow the federal government with broad new authorities to take over any failing financial institution, not just banks.

A Republican, Paulson would bring government into some of Wall Street's most private quarters. He said banking regulators should have a major say in how financial firms compensate their executives and that the HFederal ReserveH should have the power to regulate any financial company it considers crucial, including hedge funds and private-equity firms. He added that the policy statement he crafted on hedge funds in January 2007, which stated they should not be regulated, was wrong.

In reshaping his philosophy, he has had to feel his way even as the once-familiar financial landscape shifted around him. Some senior government officials who worked with him said he invented much of the government's response on the fly.

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In reflecting on his term, which comes to an end in January, Paulson said his biggest regret was not seeing the extent of the financial crisis as it developed. But he defended every major action he took.

"We were always behind. We saw the problem, but it took us a while to see the severity of the problem," he said. "But even if we had been more clairvoyant, we wouldn't have been able to do much differently that what we have done."

* * *

Paulson had long believed that free markets work only if companies, no matter how big or vital to the financial system, could pay for their mistakes by failing. Nothing is as powerful a motivator as the possibility of a collapse, he would say.

He articulated this philosophy in a July speech in London and continued to maintain this viewpoint in public even as troubled Wall Street giant HLehman BrothersH edged toward the brink in September. In interviews at the time, he warned of the dangers of repeatedly offering government guarantees to companies. Just three days before Lehman failed, Paulson reinforced the point, telling reporters and Wall Street executives that no government money would be used to save the 158-year-old investment bank.

But behind the scenes, Paulson had already shifted his position. He communicated a different message to executives at HBarclaysH, a British bank that he had recruited to buy Lehman and save it from collapse.

"I said, 'There wouldn't be government support,' " Paulson said. "They said they wouldn't buy it without government support."

"Then I said, 'Well, give us your best deal with government support, and let me try to figure out how to make it work.' " Though he had concluded that Hthe Treasury DepartmentH did not have the authority to give Lehman money, he was willing to see whether the Federal Reserve would help bail out the bank, much as the Fed had provided crucial guarantees for the sale of the ailing investment bank Bear Stearns in March.

In the end, Barclays's British regulator blocked the Lehman deal. The Fed, in turn, refused to prop up a company without a buyer from private industry.

Ultimately, Lehman failed, not because of Paulson's convictions about how free markets should work but because he could not arrange a deal to save the firm, even with taxpayer money.

The fallout from Lehman's bankruptcy filing Sept. 15 was severe. The firm had relationships with a wide range of hedge funds and financial firms. Some could not get their money back. Suddenly, investors on Wall Street could no longer be assured that their money was safe in any investment bank.

Just a day later, Paulson dropped publicly any pretense that large firms would be allowed to fail. Along with HTimothy F. GeithnerH, president of the HFederal Reserve Bank of New YorkH, Paulson put together an $85 billion loan for the insurance titan HAmerican International GroupH. Before the end of the week, Paulson headed to HCapitol HillH to ask for the authority to spend $700 billion on an unlimited number of banks and financial firms whose troubles could put the entire financial system in jeopardy.

A former Wall Street chief executive who knew Paulson would try to save Lehman with public money said this exemplified his pragmatism. He had made the tough call to do what was necessary for the financial system even if this meant betraying his earlier convictions, said the executive, who spoke on condition of anonymity.

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While critics on Wall Street now accuse Paulson of inconsistency, some senior government officials said he has been ideally suited to grapple with a fast-moving and complicated financial meltdown. His shifting views, while startling, are not that surprising because his beliefs have never been grounded in ideology, these officials said.

"These are unprecedented times," said HSheila C. BairH, chairman of the HFederal Deposit Insurance Corp.H, who has worked closely with Paulson and occasionally clashed with him. "He doesn't have an ideological bias one way or the other. He's tried to be receptive as he developed responses, and to his credit, he is willing to go where folks have dared not to go in terms of regulation."

It was Paulson, for instance, who pressed the HSecurities and Exchange CommissionH to temporarily ban short selling of financial stocks in September, according to three sources familiar with the matter.

"If you had asked me, that was one thing in 100 years I would have never done before I came down here," Paulson recalled. "But in the middle of this storm with everything going on, I said, 'Whatever we are doing right now isn't working, so go ahead and do it.' "

A short sale allows an investor to profit when the price of a stock declines. Wall Street bankers traditionally avowed that short selling is a fundamental part of stock trading and crucial to proper pricing. But the chieftains of the big banks, including HJohn J. MackH of HMorgan StanleyH, HJohn A. ThainH of Merrill Lynch and HRichard S. Fuld Jr. H of Lehman Brothers, were telling Paulson they were convinced that traders were using the practice to drastically drive down the share prices of their companies, Paulson said.

Paulson said in an interview that the decision to ban short selling belonged to SEC Chairman HChristopher CoxH. But Paulson said he strongly supported it.

"Cox wanted to do it, but he wanted to do it only with the support of me and the Fed," Paulson said. "For me, it was a little like book burning."

* * *

Paulson also came around to the idea of massively intervening in the markets to prevent the failures of financial firms, despite his worries that such a bailout would motivate companies to take excessive risks because of the prospect of a government backstop -- a problem known as moral hazard.

As far back as January, Paulson said, he began to discuss the outlines of this plan with HFed Chairman Ben S. BernankeH.

After Bear Stearns nearly imploded in March, Paulson asked his staff to start sketching out the initiative on paper, said two federal sources familiar with the matter.

Then, on the eve of Lehman's bankruptcy filing in September, Paulson thought it was time to move ahead. He was alarmed not only by the plight of AIG but by the possibility of HWashington Mutual H, HWachoviaH and several large banks in Europe failing all at once, he recalled. He ordered his staff to draft legislation that would give the Treasury new authority, including the ability to buy toxic assets from banks and inject capital directly into financial companies in exchange for ownership stakes, a senior government official said. The stakes for the world economy had escalated, and he hoped Congress would recognize the peril.

In the hallways of Capitol Hill and before the television cameras, Paulson emphasized the first proposal, which involved the government buying troubled assets and allowing the market to set their prices. But even though he had already developed contingency plans to make direct capital injections, he disparaged the idea during congressional hearings. In late

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September, he told the Senate: "There were some that said we should just go and stick capital in the banks. . . . But we said the right way to do this is not going around and using guarantees or injecting capital, and there's been various proposals to do that, but to use market mechanisms."

Yet before the rescue package had been enacted by Congress, this free marketeer had already decided that a bigger bang for the federal buck would be direct capital infusions, in essence a partial nationalization of the country's banks.

Last week, he announced that the program to buy toxic assets would be shelved altogether in favor of a proposal to inject capital into a wider range of financial firms, in an effort to loosen the markets that finance auto, student and other consumer loans.

Some corporate executives said Paulson's on-the-job education was costly. It would have been better, they said, if the Treasury had never volunteered to buy the troubled securities. Once Paulson abandoned this plan, their values plummeted, burning bigger holes in the balance sheets of some financial firms.

* * *

When the Bush administration asked Paulson to be Treasury secretary in 2006, many of Paulson's closest friends questioned whether he could adapt to life inside the Beltway.

Paulson exuded confidence as he moved through Wall Street's inner circles, but not eloquence in front of the podium. And some said they raised doubts about whether he could handle the heat of Capitol Hill hearings -- or whether the White House would simply undercut his authority.

Paulson said he has become far more comfortable in Washington than in New York. An Illinois farm boy, he never adapted to the New York lifestyle, never enjoyed swinging deals along a golf course.

Even from the beginning of his tenure at the Treasury, it was clear that Paulson might break the mold. When he accepted the administration position in the summer of 2006, his allies on Wall Street urged him to revise the Sarbanes-Oxley Act, which was adopted in 2002 in response to a string of accounting scandals at HEnronH and other firms. The legislation had increased accountability for public companies but at some expense to their bottom line.

Upon reviewing the act closely, Paulson said, "I could not find a single idea in it that was wrong."

Some who worked with him during the early part of his tenure said his thinking on regulation appeared surprisingly amorphous.

"Unlike most 60-year-olds, he came to Washington with less formed views on policy," said one senior government official who is close to Paulson. "So if you wanted to be generous, you could say he has developed policy responses that fit each problem, that he is pragmatic. If you wanted to be critical, you would say these are policy responses that are without rhyme or reason. And I think there's some truth in both of those."

Paulson said he never imagined when he took the post that he would end up proposing far-reaching regulatory programs.

And in the coming weeks, he is planning to announce a valedictory set of proposals to modernize Washington's aging regulations and extend their reach into matters that traditionally have fallen beyond the purview of federal officials.

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Paulson said he will urge Congress and the administration to grant the Fed broad discretion to examine the books of any firm, regulated or unregulated. This would require large hedge funds, private-equity firms and other now-unregulated financial entities to accept a charter from the Fed and open their financial records to its officials.

He added that executive compensation for financial firms also needs substantial reform, which could be accomplished partly through banking regulation.

Paulson said he pushed the five major federal banking agencies over the past weeks to release a guidance document that would require firms to eliminate compensation that encourages risky behavior by traders and executives.

Paulson said the document, which was issued last week, has not "gone far enough" in reforming executive compensation but he was optimistic that the document "creates a vehicle" to tackle the issue in the future.

Moreover, he said he is also working on a proposal that would grant the federal government broad new powers to take over a wide range of financial firms whose collapse could endanger the financial system. Currently, this authority exists only for banks.

The companies could be required to contribute to a fund that would help cover the cost of closing them in an orderly fashion if they cannot be saved.

Paulson said Congress would have to define which companies meet the criteria and determine how much they would contribute.

None of these measures, however, will be as much debated by history as his most significant legacy: the $700 billion rescue for the financial system. Paulson said he regretted that his tenure "will be viewed as so controversial" because of this program.

But the allies he has won in Washington -- including fellow regulators and some lawmakers from both sides of the aisle -- predicted that he would be judged more kindly.

"If the rescue does work, that will be a huge part of his legacy," said Bair, the FDIC chairman. "Even if it doesn't and we have to do other measures . . . I think history will view him favorably as someone who tried programs and took some risks and tackled this crisis with the best information that was available to him."

Paul Krugman

November 15, 2008, 7:27 am

120BChange it’s hard to believe in Because it’s such good news. Elizabeth Warren, expert on personal bankruptcy, crusader against credit card industry lobbyists, and founder of the extremely useful blog HCredit SlipsH, to be a member of the Hbailout oversight boardH.

Elections have consequences.

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Obama Will Take Us Backward By Channeling Keynes Commentary by Amity Shlaes

Nov. 19 (Bloomberg) -- Every crisis has its heroes. For months now we've all been hearing about HWalter BagehotH, whose 19th-century injunction to lend ``freely'' in a panic was cited by the Federal Reserve in its bailouts.

Now another Englishman, HJohn Maynard KeynesH, has been pulled on the stage. Keynes taught that spending, especially spending by consumers, is the way out of a slowdown. From last summer's small stimulus checks to the infrastructure projects under consideration by President-elect HBarack ObamaH and congressional Democrats, almost everything the government has done or wants to do is justified by Keynes.

That's problematic. For Keynesian solutions often fail to deliver good or even acceptable results.

The limits start showing up with the tiniest of stimuli, those government checks Americans received in the mail last spring. The idea was that having the cash would cheer up consumers so that they would start shopping again, helping retailers. That in turn would revive wholesalers, shippers, suppliers -- on up the production line.

But that stimulus failed, as the University of Michigan's HJoel SlemrodH and HMatthew ShapiroH noted. Interviews with consumers showed that only a fifth said they would spend their cash. Savings rates tracked by the Bureau of Economic Analysis seemed to confirm that, with Hpersonal savings ratesH rising about the time the checks were mailed. Slemrod and Shapiro weren't surprised. They have spent much of their careers documenting failed stimulus plans. Their Hstudy H of the effects of the 2001 Bush stimulus was so damning you might think that Washington would never repeat it. But Washington did. Long View

One reason consumers don't want to spend is that they don't react instantaneously, as Keynes posited they would. They follow, rather, the theory of an economist oft-presented as the anti-hero of the moment, HMilton FriedmanH. Friedman's Hpermanent- income hypothesisH said that consumers consider their entire future, and not just their mood, when they shop. If expectations of lifetime earnings drop, then so will spending. That too tracks reality. Many of us are beginning to wonder if we will ever get back the price we paid for our houses. But what about the larger stimulus plan, the kind President-elect Obama is considering? The idea is to revive HFranklin D. RooseveltH's New Deal and create jobs by building new bridges or

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roads. Obama has also spoken of a kind of corps for the young, which, you get the sense, might be involved in some of these projects. That comes out of the New Deal and FDR's Civilian Conservation Corps.

Keynesians would say such moves will bring the economy to life, creating jobs and replacing crumbling infrastructure.

Point-to-Point

Others would argue that the productivity gains to be had from an infrastructure program also are significant. That's the view of scholar Alexander Field, who studied the New Deal and found that the private sector benefited enormously from its construction projects. After all, when the government supplies a bridge from Point A and Point B, the private trucking company can deliver goods between A and B faster. The project may be public, but its ``spillover'' yields profits too.

The best evidence for the infrastructure spending case comes not from a Democrat but from a Republican: Eisenhower's HNational Highway SystemH. The rebuttal there is that emphasis on government in the 1950s made the decade a dull one that stifled innovation.

And you also have to ask: What is lost when Washington puts resources into such road projects? One problem is that a stimulus project and an earmark are dangerously similar. Sometimes the government will waste its resources on bridges that truckers won't use -- the new Bridges to Nowhere.

Gloss Job

But the most telling fact about the new rush to spend is that its advocates have insisted on invoking the New Deal. They tend to gloss over the period when the phrase, ` H̀We are all Keynesians nowH,'' was actually first uttered: the mid-1960s. (Uttered by Friedman, in fact, though he meant only that we all work in the terms of the Keynesian lexicon.)

The HGreat SocietyH of that period was the ultimate Keynesian experiment, and it didn't work very well. One example is VISTA, the domestic Peace Corps from that period. VISTA had mixed results and has been renamed and reshaped many times since. Its full name, ``Volunteers in Service to America,'' fits perfectly as a description of the youth programs the Obama camp has described.

The leaders of the 1970s and 1980S -- Nixon, Ford, Carter, Reagan and HPaul VolckerH -- were left to live with the Great Society aftermath. The jobs that Keynes emphasized were AWOL: America became accustomed to high levels of HunemploymentH.

Were they alive, both Bagehot and Keynes would defend themselves. Bagehot, for example, would say that he saw the central bank as the lender of last resort, not the lender of first resort. Keynes would note he operated in a gold-standard world, or tried to, not in our free-float-except-for-China arrangement.

The important thing to recognize is that the record of actions taken in economists' name is mixed. Try this sentence: We're not all Keynesians now.

( HAmity ShlaesH, a senior fellow in economic history at the Council on Foreign Relations and author of ``The Forgotten Man: A New History of the Great Depression,'' is a Bloomberg News columnist. The opinions expressed are her own.)

To contact the writer of this column: Amity Shlaes at Hamityshlaes@hotmail.comH

Last Updated: November 19, 2008 00:01 EST

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Nov. 18, 2008

Coaxing a turnabout in our 'animal spirits' By ROBERT J. SHILLER

NEW HAVEN, Conn. — The world's fundamental economic problem today is a staggering loss of business confidence. Commercial banks, investment banks and hedge funds all owe their ongoing trouble to its decline, which in turn is jeopardizing the plans of companies and entrepreneurs to launch enterprises and make investments, and of households to consume.

Our "animal spirits," to borrow a phrase made famous by John Maynard Keynes, are weakening. George Akerlof and I have just written a book by the same name, but by the time Animal Spirits appears later this winter, the world economy may be even worse than it is now.

Nations everywhere are starting to implement aggressive stimulus and bailout packages. Yet the economic outlook still looks grim. The International Monetary Fund's latest forecast predicts that the world's advanced economies will contract 0.3 percent in 2009 — the first such shrinkage since the end of World War II.

Part of the difficulty of contending with a crisis of confidence is that it is hard to quantify confidence in the first place. The Conference Board Consumer Confidence Index in the United States, begun in 1967, fell in October to its lowest value ever. The latest Nielsen Global Consumer Confidence Index, which covers 52 countries, fell to 84, from 137 when it was launched in 2005. But these surveys do not tell us how deeply held these opinions are, how new circumstances might change confidence, or what people will really do when they make important decisions in coming months or years.

This decline in confidence is fundamentally related to the chaos in the financial markets that started in 2007 and accelerated this September. The specter of collapsing financial institutions around the world, and desperate government bailouts to try to save them, has created a general sense of alarm.

Then there is the effect of memory on today's animal spirits. People know enough about the Great Depression to understand that there are parallels with today. Many know that interest rates on three-month U.S. Treasury bills became slightly negative in September 2008 — for the first time since 1941. People are also aware that the stock market has not been this volatile since the Great Depression — with the single exception of October 1987. Beyond that, national leaders are defending extraordinary bailout measures by not-so-veiled comparisons to the Great Depression.

Animal spirits are not always shattered by extraordinary economic events. But then, not all economic convulsions are alike. For example, the October 19, 1987, stock market crash was the biggest one-day drop ever. The Standard & Poor's Composite fell by 20.5 percent, the FTSE 100 by 12.2 percent and the Nikkei 225 by 14.9 percent the next day. The crisis spread around the world, but there was no recession. Instead, world stock markets recovered, creating a colossal bubble that peaked 13 years later, in 2000.

In a survey that I conducted immediately after the 1987 crash, I found that the biggest concern expressed by individual and institutional investors in the U.S. was essentially that the stock market had been overpriced. After the crash corrected that problem, many people apparently did not feel there was much more to worry about. The only parallel to the Great Depression was the stock market drop itself. Moreover, many financial experts blamed the 1987 crash on a kind of programmed trading called "portfolio insurance," which most thought would stop.

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But recent events do not carry such a rosy interpretation. The stunning magnitude of recent declines cannot be dismissed as a one-day anomaly caused by a technical trading glitch.

The week of Oct. 3-10 was the worst stock market week in the U.S. since the Great Depression, while Japan's stock market performed worse than it did in the worst week of the Asian financial crisis 10 years ago. Similarly, Mexico's stock market performed about as badly as it did during the worst week of the Mexican financial crisis in 1995, and Argentina's stock market roughly matched the worst weekly drop during the country's financial crisis of 1997-2002. Extraordinary stock market volatility, both up and down, has continued since.

The current stimulus and bailout plans were hatched in reaction to that dreadful week. The Group of Seven countries announced a coordinated plan to fix the world economy on Oct. 10, and that weekend the G20 countries endorsed the plan. But stock markets were barely higher in early November. In China and India, they were lower.

The erosion of animal spirits feeds on itself. Immense market volatility serves only to reinforce people's sense that something is really wrong. A volatility feedback loop begins: the more volatility, the more people feel they must pay attention to the market, and hence the more erratic their trades.

Perhaps the saving grace in this situation is that animal spirits can and sometimes do change direction. Confidence is a psychological phenomenon, and can make seemingly capricious jumps up as well as down. The most promising prospect for a return of business confidence now would be some kind of public inspiration. In the U.S., President-elect Barack Obama seems to have the charisma to create this, and his status as the first minority president marks a major historical transition that might have great positive psychological impact in the U.S. and around the world.

Whatever the near future holds, the multitude of plans now being discussed to deal with this global crisis need to be judged with attention to the elusive and inexplicable effects they might have on confidence. The animal spirits that Keynes identified generations ago remain with us today.

Robert J. Shiller is professor of economics at Yale University. His latest book is "The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do about It." © 2008 Project Syndicate (Hwww.project-syndicate.orgH)

The Japan Times: Tuesday, Nov. 18, 2008

(C) All rights reserved

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Opinion

143BNovember 17, 2008

OP-ED COLUMNIST

48BGeorge W. Hoover? By WILLIAM KRISTOL Last week, assembled at Miami’s InterContinental Hotel for a meeting of the Republican Governors Association, the governors seemed cheerful. The G.O.P. had lost only one statehouse on Election Day. The prospects for a Republican pickup in Virginia in 2009 were decent, and good candidates were plotting runs in states like California, Pennsylvania and Ohio in 2010.

There was even a sense of liberation in the air. For the last 14 years, there has been either a Republican Congress or a Republican White House, or sometimes both. Now the Republican governors are free of those heavy taps on the shoulder from their “betters” in Washington. So for these governors, this seems a moment of opportunity, in which their policies, their examples and their successes can help shape the future of the G.O.P.

The governors will be important. But there was an almost-never-mentioned elephant in the Versailles Ballroom (yes, that’s its name) full of Republicans: George W. Bush. For the hard fact is this: The worst financial crisis in almost 80 years has happened on his watch. The Bush administration will leave behind probably the most severe recession in at least a quarter-century. Fairly or unfairly, this will be viewed as George Bush’s economic meltdown.

If Republicans and conservatives don’t come to grips with what’s happened — and can’t develop an economic agenda moving forward that seems to incorporate lessons learned from what’s happened — then they could be back, politically, in 1933.

From 1933 to 1980, Republicans repeatedly failed to convince the country they were no longer the party of Herbert Hoover — the party, as it was perceived, of economic incompetence, austerity and recession (if not depression).

Only two Republicans won presidential elections in that half-century, Dwight D. Eisenhower and Richard M. Nixon. Both were able to take the White House only because we were mired down in difficult wars, in Korea and Vietnam. And Ike and Nixon were unable — they didn’t really try — to change the generally liberal course of domestic and economic policy. The G.O.P.’s fate on Capitol Hill was worse. The party controlled Congress for only 4 of those 47 years.

That’s what happens when a depression begins on your watch and when you can’t offer a coherent explanation of how and why it occurred and what you are going to do differently. That’s what happens when instead of having such an explanation, you spend decades in quarrels between pragmatic but unimaginative moderates who seek to be better tax collectors for the liberal welfare state, and principled but fanciful conservatives who hope for a wholesale rejection of that welfare state. And the fact that there were many successful Republican governors in those years didn’t much change the party’s status nationally.

Then there was a real moment of economic rethinking in the 1970s. Supply-side economics challenged demand-side Keynesians and austerity-minded conservatives by putting growth, entrepreneurship and incentives at the center of economic policy. Supply-side economics gave

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Ronald Reagan’s G.O.P. a new and different economic agenda in 1980, and Republicans were able to become a governing party.

Republicans and conservatives today face a similar challenge to that of 1976. A hawkish foreign policy, social conservatism and middle-American populism aren’t the problems. Those elements, as embodied on the Republican ticket by John McCain and Sarah Palin, produced a respectable 46 percent of the national vote — in the midst of an economic meltdown, with the Bush administration flailing and House Republicans rebelling and the Republican ticket lacking any coherent economic message.

I don’t pretend to know just what has to be done. But I suspect that free-marketers need to be less doctrinaire and less simple-mindedly utility-maximizing, and that they should depend less on abstract econometric models. I think they’ll have to take much more seriously the task of thinking through what are the right rules of the road for both the private and public sectors. They’ll have to figure out what institutional barriers and what monetary, fiscal and legal guardrails are needed for the accountability, transparency and responsibility that allow free markets to work.

And I don’t see why conservatives ought to defend a system that permits securitizing mortgages (or car loans) in a way that seems to make the lenders almost unaccountable for the risk while spreading it, toxically, everywhere else. I don’t see why a commitment to free markets requires permitting banks or bank-like institutions to leverage their assets at 30 to 1. There’s nothing conservative about letting free markets degenerate into something close to Karl Marx’s vision of an atomizing, irresponsible and self-devouring capitalism.

If conservatives do some difficult re-thinking in the field of political economy, they can come back. If they don’t — well, there were a lot of admirable conservative thinkers and writers, professors and novelists, from 1933 to 1980. But conservatives didn’t govern.

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Published: 17-11-2008

'Not since the Great Depression...'

Vanessa Drucker, Fund Strategy's American editor in New York

This year America's main television networks have compared the country's economy today to the big slump of the 1930s more than 200 times. But do the parallels really bear examination? It must be the most the hackneyed hyperbole of 2008. The phrase punctuates every financial article, while photos of breadlines hint at a dire future. Just try Googling "not since the Great Depression" and you will strike gold. But, says Jim Grant, the editor of the trenchant Grant's Interest Rate Observer: "Those glib comparisons ignore the reality of the economic backdrops. In the Thirties, nominal GDP was sawed in half, while today it is down less than a percentage point."

I ran into Grant at the Museum of American Finance on Wall Street, which houses a diverting collection of financial artefacts. If you have a few minutes to spare, check out the antique stock and bond certificates, cash registers, bank notes and an original Edison light bulb. Note especially that the front page editions of the October 20, 1987 Wall Street Journal and New York Times explicitly state that the previous day's crash is not an echo of the 1929 plunge. My favourite display is a typed note dated November 8, 1929 from Matt, a Wall Street worker. He writes to a girlfriend that the sight of a woman jumping from a window has destroyed his appetite for his lunch.

In any case, during the week of the 1929 crash, positive daily news stories surprisingly outnumbered negative reports by four to one. From March 13 to March 19 this year, as Bear Stearns crumbled, coverage on the main American television networks was six to one negative, according to a study by the conservative-leaning Business & Media Institute. The networks compared today's economy to the Depression 70 times in the first six months of 2008 and a further 157 times from July to October. Time magazine featured Franklin D Roosevelt (FDR) on its October 27 cover. Despite FDR's New Deal, it was only World War II that finally revived the American economy. We are seeing, after all, an end to the banking system as a more or less privately run enterprise. People are disorientated that the familiar markers of the post-war period have teetered or toppled or lost their haloes. Yet the differences between then and now are stark: the federal government now represents 20% of the economy, not 3% as in 1929, and its spending acts as a stabiliser. Consider that from 1929 to 1933 real output fell by 30%, real consumption by 20% and investment by about 90%. And even by 1940 unemployment still hovered around 15%.

Yet Grant's comment caused me to ponder how far analysts during previous recessions had carried comparisons with the Depression. There have been 10 recessions since the second world war. The worst two began in 1973 and 1981, and each lasted 16 months, with unemployment hitting 9.0% and 10.8% respectively. So I turned to Howard Sherman, an old-timer who joined Lehman Brothers in 1958, and has survived several bear markets. Sherman, currently chief investment officer at Ruggie Wealth Management, in Tavares, Florida, recalls

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the gloomy environment in 1975. Then, too, the press and his own demoralised clients often referred to the Great Depression.

The economy had stagnated, with no growth in volumes. Only price increases were driving earnings. Inflation and tax rates were sky-high. President Nixon was about to be impeached. "My clients all said, why invest when I can get 15% in money markets? So they kept selling stocks," Sherman recalls.

Yet he does not regard today's references to the 1930s as wholly overblown, nor does he blame the media for its breathless coverage. "A few weeks ago, we were steps from the abyss," he says. "It could have been worse than the Depression!"A common threadAside from the calamitous market outcomes, there is at least one distinct common root cause between then and now. Bob McTamaney, chairman of the corporate law department at Carter Ledyard & Milburn, traces both crises to excessive wealth disparities. In the 1920s, assembly lines and mechanisation had led to explosive increases in productivity, yet workers still earned pitifully low wages and 30% of Americans eked out an existence below the poverty line. The top 5% of the population was enjoying a third of all income, and low wages were keeping a lid on consumer demand. Flash forward to the 1990s, when the internet was the catalyst for productivity surges around the world. Once again, the wealth drifted disproportionately to the higher end of the spectrum.

"If you can't make money by going to work every day, you look for different ways to do it, by relying on other assets for your future," says McTamaney. In 2000, real estate began to plug that gap. In August 2006 homeowners counted on an anticipated escalation in house prices for repaying subprime mortgages. Property prices started to head south. Speculators who could not sell at inflated prices found themselves in a trap similar to 1929, when investors were buying stocks on 10% margins. Then a sudden and modest dip in the equity markets set off a call on margin loans, forcing them to sell out, which caused a further depressing effect and accelerated the spiral.

Those who cannot learn from history are doomed to repeat it, warned the philosopher George Santayana. In this case, excess credit and leverage, regulatory errors and borrowing by those who did not have the wherewithal to repay their debts, led to terrible dislocations. But before we draw too many parallels between very different epochs, add one more Santayana quotation: history is a pack of lies about events that never happened told by people who weren't there.

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How Should We Help Underwater Home Owers ?

Posted By Barry Ritholtz On November 18, 2008 @ 7:40 am In Credit, Markets, Politics, Psychology/Sentiment, Real Estate, Taxes and Policy | H39 Comments

Martin Feldstein has another plan to fix housing. It is a variation of the [1] H30/20/10 plan H I proposed earlier in the year, in that it pulls a portion of the original mortgage aside from the corpus of the existing loan.

Feldstein’s solution? Replace part of the non-recourse mortgages with a new, immediately due, recourse loan:

“More than 12 million homeowners now have mortgage debt that exceeds the value of their homes. These negative-equity homeowners have an incentive to default because mortgages are generally “no recourse” loans. That means creditors can take the property if the individual defaults, but cannot take other assets or income to make up the difference between the unpaid loan balance and the lower value of the house. As a result, mortgage default rates are now rising rapidly and are expected to go much higher.

The no-recourse mortgage is virtually unique to the United States. That’s why falling house prices in Europe do not trigger defaults. The creditors’ ability to go beyond the house to other assets or even future salary is a deterrent.”

This is a partial solution, one that fails to address several key issues — mostly price.

But as currently described, it is doomed to failure.

First, because most home owners — even the ones that signed on for really bad mortgages — are simply not that stupid. I cannot imagine many attorneys saying: “Sure, replace your non-recourse mortgage that you can easily walk away from with this one that will follow you for years and years, garnish your paycheck, and be non-dischargeable in bankruptcy! Sign here, here and here, and initial here and here. Congratulations! You are a moron!” Aside from that one fatal flaw, there are several other issues with Feldstein’s proposal.

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The big one is it preventing houses from dropping to their natural price level. It fails to write down enough of the overpriced housing market. Current prices, as measured by price to income ratios, or rent/buy costs, are still significantly elevated relative to their historic means. From a 40,000 foot view, defaults and foreclosures leading to distressed sales are what allows prices to normalize again. Until entry level homes are affordable to young families, the entire Housing chain will remain partially frozen. Note: This isn’t a call for affordable housing projects — rather, it is a demand to allow market prices to revert to their historic means. Anything DC does to thwart that mean reversion is ultimately destined to failure. The sooner the powers that be figure out that, the sooner Housing will normalize.

The third issue with these mortgages is that many have been sold and resold, securitized and tranched. Even if a few million people are foolish enough to accept this bad deal offered by Feldstein, how are you going to get the locate the mortgages’ owners to revamp the deal? *

The Feldstein proposal doesn’t resolve the issue, is unworkable for many securitized mortgages, but mostly and is against the interests of the homeowners. It is, in short, a non-starter.

My alternative suggestion is to develop a plan that recognizes this simple truism: People paid too much for houses, and banks lent too much against value that simply isn’t there. The LTV needs to be adjusted to reflect this simple reality.

That’s why carving out a new realistic mortgage relative to home values, plus a 10 year balloon payment for some of the balance, can work.

•It shares the pain of bad decision making of both the buyer and the lender; • It create an incentive for home owers (not a typo) to stay in their homes; • It gives the banks an immediate write down of the balloon, and a possible recovery down the road;

• It drops the price of homes back towards something realistic

Consider a $500k mortgage on a home purchased for $550k that is now worth $400k. I would have the parties negotiate something like the following: A new mortgage for $350k plus a $50k 10 year balloon. The $350k mortgage is affordable, the $50k balloon is interest free, tax free and can be folded into the main mortgage 10 years hence.

You can play with the numbers, for example, doing a $375k and a $50k balloon. The bottom line is both parties have to have an incentive to take some o the hit, and prevent an even worse outcome.

>*Further, as detailed in our [1] HproposalH, we can enact notice provisions to turn securitized mortgages into an opt out plan, one where the owner of the mortgages must actively refuse to participate int he new plan.

>Previously: [1] HFixing Housing & Finance: 30/20/10 ProposalH (September 22nd, 2008) http://www.ritholtz.com/blog/2008/09/fixing-housing-finance-302010-proposal/

Source: [2] HHow to Help People Whose Home Values Are UnderwaterH MARTIN FELDSTEIN WSJ, NOVEMBER 18, 2008 Hhttp://online.wsj.com/article/SB122697004441035727.html

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Kennedy Announces Plan to Submit Bill For Universal Care By Shailagh Murray Washington Post Staff Writer Tuesday, November 18, 2008; A03

Sen. HEdward M. KennedyH (D-Mass.), making his second appearance on HCapitol HillH since he began treatment for a malignant brain tumor in June, told reporters yesterday that he would advance a bill early next year calling for universal health care.

Some Democrats, including members of President-elect HBarack ObamaH's circle, have begun to view expanded coverage as a longer-term goal.

The brief appearance by Kennedy, who made a surprise return in July to vote on a HMedicareH bill, represented an opportunity for him to show colleagues that he remains energetic and engaged, and that he intends to reclaim his committee post in January and take charge of the Obama health-care agenda. Some Democrats had speculated that HSen. Hillary Rodham Clinton (D-N.Y.) H would attempt to assume the chairmanship of the Senate Health, Education, Labor and Pensions Committee.

Senate Finance Committee Chairman HMax Baucus H (D-Mont.) rolled out his own health-care bill days after Obama was elected, and Sen. HRon WydenH (D-Ore.) also expects to be a leading participant in the effort to establish universal health care.

Kennedy has a head start on them all. Despite his illness, he directed his staff months ago to begin work on legislation that would vastly expand health coverage, a career-long goal of his.

But as the economy has worsened, attention has shifted to measures aimed at creating jobs and stabilizing the housing market. Obama is particularly eager to advance his alternative energy agenda.

Kennedy acknowledged the competition. "There's some major issues, obviously, the economy and also environmental issues," Kennedy said on his way to a staff meeting, where he was greeted with cheers.

"But the president-elect has indicated that this is going to be a priority, and I certainly hope it will."

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A 49Brgentina and the contractionary effects of expansionary fiscal policy Nicolas Magud| Nov 18, 2008

In an article published in HThe Journal of MacroeconomicsH[1] I show how information frictions could lead to asymmetric business cycles both in terms of magnitude and of the length of the return to trend. Negative shocks are amplified more than positive ones; also, negative shocks depict rapid contraction while the recovery is more

protracted.

The Argentine government finally found out that the international crisis will affect the country—the more so due to its poorly managed macroeconomy (although they will not recognize the latter). Good for them—better late than never.

In response to the expected increase in unemployment, worsening of the current account (to get even worse and affect the exchange rate), and thus fiscal stance (debt default possible?), the government apparently intends to increase public expenditure, unemployment subsidies, and protection (subsidies?, tax deductions?, closing the economy?) for inefficient sectors to smooth the volatility. In one way or another it implies a deterioration of the fiscal and the current account balances. And both could fall sharply…

Of course, I believe the argument would go, this is what developed countries (as well as Chile and Brazil among others) are doing to ameliorate the slump. However, in the above mentioned paper I show not only the asymmetric nature of business cycles, but also that counter-cyclical fiscal policy is only effective provided the level of debt to GDP is sufficiently low. Translating that from the model to every day economics it basically means that, all else equal, you can engineer standard Keynesian fiscal policy provided you can finance it.

Moreover, the transmission channel includes the fact that an increase in government expenditures increases the risk premium (think on the effects of Argentina’s country risk!). In turn, this generates a contractionary effect on output. Thus, unless the government has plenty of room to finance an increase in aggregate demand without affecting the interest rate much, that will be able to offset the mentioned contractionary effect, on the contrary, increasing government expenditures will end up being contractionary in terms of output.

To have a simple picture, compare the ability of the U.S. (or Chile and Brazil) to issue debt in order to finance government expenditures with that of Argentina. Consider not only the country risk differential, but the reputation of honoring debts, responsible intertemporal macroeconomics (U.S.) instead of pro-cyclical fiscal policy (Argentina), already high interest rates, higher unemployment, lower productivity, high default probabilities, a political administration highly dependent on unions, expectations of a depreciated exchange rate (the more so if the increase in government expenditures appreciates the real exchange rate), credibility of institutions(!), and the list, unfortunately, can grow longer and longer.

Notice also that Argentina has been manipulating the statistics and using creative accounting to show a supposedly strong fiscal surplus (the flow, not its sustainability though), financing

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increased expenditures based on temporary revenues that are now, as I posted on many times in this blog, decreasing: commodities’ prices have been (and will probably continue) contracting, as well as the VAT as the economy self-corrects the government’s pro-cyclicality. The economy is not only expected to suffer from lower international prices, but quantities produced and exported are also likely to keep on falling. I wouldn’t be surprised if this exerts pressures on the exchange rate with inflationary implications despite the expected lower domestic and foreign demand.

Now the administration wants to increase expenditures much more but, where will the financing come from? And, at what price? International financial markets are virtually closed and tax revenues will tend to contract. The nationalization of private retirement funds (AFJP), the government claims, will not be used to finance its expenditures. Will that still be the case? I do hope so.

Even if AFJP’s funds are used directly or indirectly (through financial intermediation, fiduciary funds, etc.), given all of the above, more likely the expansionary fiscal policy will end up being contractionary in terms of output. This will exacerbate the crises, especially given the “initial conditions” on which (and when) the policy is put to work. This just adds to worsen the overall situation, not only the real side of the economy, but could potentially be expanded to the monetary side—hopefully the increase in expenditures will not be monetized, because if it is, bye-bye…

Let me clarify that I do not necessarily mean that counter-cyclical fiscal policy is a bad thing; it depends. But in the case of Argentina, where the ‘good times’ had been wasted, it does not make much sense now. The more so since the government has been praising its policy of de-indebtedness since 2003, while the debt has actually increased. It can even be considered unfair for those (countries) that did behave “properly” and saved in good times for the bad times. But I guess the (sophisticated) market, unlike Argentina’s government, will internalize this.

To sum up, Argentina’s government put the country into an unsustainable path during the Kirchners’ administration. Now, the day of reckoning is approaching. The government, again, does not quite understand the sources of the problem and the way to address it. Furthermore, the economic crises-mode that the government put the country in can be compounded by the political crises that seems to be already in motion—which looks likely to worsen during the election year (2009).

The saddest part of this is the long terms effects. Poverty, if appropriately measured reached levels similar to the 2001-2002 collapse. Education and health did not improve in these years with all the supposed abundance. Thus, the correction that the economy will need to go through will only re-enforce this, worsening the country’s income distribution. But let’s be clear: it is not the market’s fault; it is solely the effects of the Kirchners’ administration that is forcing the market to internalize this mismanagement. Of course, we will see how this story ends as more information is made available—hopefully non-massaged data, though.

[1] “On Asymmetric Business Cycles and the Effectiveness of Counter-Cyclical Fiscal Policy,” Journal of Macroeconomics, Volume 30, Issue 3, September 2008, 885-908 and reproduced here with the author’s permission

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Monday, November 17, 2008

FEATURES MAIN

50BDefusing the Credit-Default Swap Bomb

By JONATHAN R. LAING

72BReforms are defusing the danger in the credit-default swap market. AS THE GLOBAL CREDIT CRISIS GRINDS ON WITHOUT seeming relief, worries grow that a mishap in the once obscure credit-default swap market could trigger an even more lethal financial meltdown. But changes in the marketplace, including Friday's agreement among regulators to create a central clearinghouse for these swaps, are reducing the dangers they pose.

It's easy to understand why credit-default swaps, which have been called financial weapons of mass destruction, can engender hysteria. These quasi-insurance policies allow buyers to insure all manner of debt instruments, including corporate and sovereign-nation bonds, various bond indexes and securitizations, against any credit losses from defaults. Demand for them grew explosively during the past decade's credit boom. According to the International Swaps & Derivatives Association, or ISDA, the outstanding "notional" value of debt insured by these swaps soared from under $1 trillion in late 2000 to a peak around $62 trillion at the end of 2007.

The sheer reported size of the market, many multiples of the actual total value of corporate, mortgage and government debt outstanding, has led many to conclude that a lot of folks who don't even own the underlying debt are buying the swap insurance as cheap lottery tickets to bet on the demise of some debt issuers. The swaps are default-insurance policies, and their prices rise when it appears that the issuer of the stock or bond being insured is in trouble. Swaps thus have become handy tools for short sellers seeking to drive down the prices of equity or debt securities by convincing investors that the issuers are going belly up. New York Attorney General Andrew Cuomo and the U.S. Attorney's office in Manhattan are investigating whether shorts artificially drove up swap prices by reporting bogus trades that were never completed, in order to push down the prices of stocks they were short, particularly financial issues.

Doomsday scenarios revolve around a credit disaster starting a daisy chain of defaults by CDS sellers unable to make good on their insurance obligations. Institutions that owned the securities would then suffer mightily.

Just such a meteor strike hit two months ago when major CDS dealer Lehman Brothers filed for bankruptcy on Sept. 15. A hasty federal bailout of insurance giant HAmerican International GroupH (ticker: AIG) followed two days later. The Federal Reserve's swift action might have averted a catastrophe. Without it, AIG couldn't fully satisfy some $50 billion in collateral calls to counterparties on $447 billion in CDS coverage it had sold. But now, the $250 billion in

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capital that the Treasury has infused into the U.S. banking system, along with the $150 billion in backing that AIG ultimately received from Uncle Sam, argues against any major hit to the CDS market.

In addition, the CDS market isn't remotely as large as the ISDA numbers indicate it is. For one thing, in that organization's surveys, both sides of every trade are counted, effectively doubling the notional value. Values are further pumped up by including all hedging by CDS sellers; a single trade could figure in 10 or more related transactions.

In fact, the ISDA itself contends that the money at risk in the market, much of it collateralized, is likely just 1% to 2% of the outstanding notional value. That means that the peak value would have been $622 billion to $1.24 trillion.

Indeed, while the notional value of the credit-default swaps in Lehman debt exceeded $400 billion, only about $6 billion changed hands among various counterparties when the trades were settled last month. That sum was spread among more than 300 participants, so none took a crippling loss even though each had to cough up about 92 cents on the dollar on the notional value of their contracts. (The week before Lehman's demise, annual CDS premium rates on Lehman debt yielded only eight cents on the dollar.)

Furthermore, the major dealers like HJPMorgan Chase H (JPM), HCitigroupH (C), HDeutsche BankH (DB), HGoldman SachsH (GS), HMorgan StanleyH (MS), HMerrill LynchH (MER), HBank of America H(BAC), HCredit Suisse H(CS) and HUBSH (UBS), which typically take one side of some 90% of all CDS trades, are careful to run balanced books. Like Las Vegas bookies, they lay off the risk of any position with an offsetting trade.

A NUMBER OF REFORMS have reduced risk in the virtually unregulated CDS private market. The dealer community has dramatically increased the margin, mark-to-market and collateral requirements for hedge funds and other investment institutions on the other side of any trade. And at the behest of the New York Federal Reserve and other regulators, record-keeping has improved; trade confirmations, for example, now must be tendered quickly. Buyers of CDS protection now also must formally approve any switch of their coverage from one insurer to another. Previously, the insured might not know who was its latest counterparty.

Redundant hedged trades and lapsed positions are now being quickly netted out by participants, resulting in substantial compression in notional amounts outstanding. As a result, the ISDA's June 30 survey showed that CDS trades outstanding had dropped for the first time, to $54 trillion from the $62 trillion reported at year-end 2007. Currently, the figure stands at $32.7 trillion, according to the securities industry's clearing entity, the Depository Trust & Clearing Corp.

The New York Fed and regulators in Europe want to move credit-default swaps to an exchange. A central clearinghouse -- which would have the collective financial backing of all its members -- would aggregate all trades, impose stringent margin and mark-to-market requirements and be the single counterparty that all players must deal with.

Friday, the Fed, SEC and Commodity Futures Trading Commission signed an accord aimed at setting up a system to provide consistent oversight of credit-default swaps. The agreement calls for establishment of at least one clearinghouse by year-end. Among the exchange operations that would love to run a CDS marketplace are Eurex, an arm of Deutsche Boerse

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(DB1.Germany); the HCME Group H (CME), which runs the Chicago Mercantile Exchange and the Chicago Board of Trade, and Atlanta's HIntercontinentalExchangeH (ICE).

ICE might stand the best chance because it plans to acquire Clearing Corp., a Chicago clearinghouse owned by the major CDS dealer firms. That would give the dealers skin in the game in return for sacrificing the fat bid-asked spreads they currently charge outside customers to participate in the CDS market. The dealers are worried over rising pressure from the New York Fed to clean up their act, plus threats by New York State insurance regulators to take over supervision of much of their market.

During an Oct. 30 conference call with analysts, ICE CEO Jeff Sprecher observed: "I think a pivotal thing happened at the time of the collapse of Lehman Brothers. ...For the first time in the market, both the buy side and sell side and the regulators recognized that it was possible for a major dealer to collapse...and so, as a result of that, very senior people at the nine major banks listening to our pitch, frankly, concluded that it was time to actually put this OTC business into an open clearinghouse of the type that you're used to seeing operating at ICE."

Particularly scary: Like most dealers, Lehman ran a largely hedged, properly margined book. Moody's analyst Alexander Yavorsky found last month when he surveyed major banks and insurance companies active in the CDS market that some had suffered losses of "hundreds of millions of dollars," largely because they had to replace credit-default swaps that Lehman had sold them at considerably higher prices since CDS protection became far more costly on news of Lehman's bankruptcy. Other counterparties took smaller losses on Lehman receivables that were insufficiently collateralized.

Yavorsky asserts that a meltdown might've ensued had American International Group not been bailed out two days after Lehman's filing. The insurer was running an unhedged book with CDS protection written on $447 billion of debt paper. And its positions were woefully under-margined, as it had been a triple-A credit up until 2005 and therefore wasn't required to post collateral against its risky credit-default swap obligations.

AIG'S FATAL MISSTEPS OCCURRED in 2005 and early 2006 when the head of its financial-products unit, Joe Cassano, pushed the insurer into writing credit insurance on some $60 billion of subprime collateralized debt obligations. The premiums on these CDOs were somewhat fatter than for other classes of credit risk, but AIG's risk models indicated that there

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was no chance of any loss claims being filed on them. After all, they were insuring only the super senior triple-A portion of the securitization, and many risk layers below that would have to be burned through before any loss reached AIG.

Cassano, the son of a New York City cop who grew up in Brooklyn, had a big incentive to make his case. Top management in his unit got 30% of the operating earnings they produced for the parent company. And in the wake of the management upheaval that had hit American International Group in early 2005, when longtime CEO Hank Greenberg was ousted, new management was counting on the more than $1 billion in operating earnings that Cassano promised to deliver.

By early 2006, even Cassano was nervous over the widespread rumors and reports of slipshod underwriting and fraud in the subprime-mortgage market. AIG stopped insuring subprime paper. But it was too late. Prices on 2005 vintage subprime mortgage paper began to drop in earnest in the secondary market by 2007, forcing AIG to mark down the value of its obligations, even though it had next to no insurance claims on the $60 billion. Over four quarters, the writedowns exceeded $33 billion.

EVEN WORSE, THE STEADY drumbeat of writedowns led to several credit downgrades that permitted AIG's counterparties to demand ever more collateral, starting in the summer of 2007. The margin calls eventually rose to $50 billion by September when AIG was downgraded to single-A.

At that point, American International Group had no choice but to seek a government bailout. The company was frozen out of the commercial paper market and so couldn't meet its short-term liquidity needs. It also had suffered losses of about $20 billion on $40 billion of cash collateral that hedge funds and other traders had left with it in return for borrowing stocks and bonds from its life-insurance units to sell short.

To earn a fatter return, AIG had invested the cash in subprime and Alt-A mortgage paper, which promptly crashed in value. The short-sellers, who had covered their positions and returned the stock, were clamoring for their money.

Thus for AIG, it was no longer just a matter of illiquidity. The company was effectively insolvent. It lacked the money to even make payroll or keep the lights on without aid from Uncle Sam. A once- proud company was laid low by bad bets in the credit-default-swap market by an obscure, 300-person unit. Cassano, by the way, was fired by AIG in February, but kept on for a while as a $1-million-a-month consultant, according to testimony last month from AIG executives before an incredulous congressional panel looking into the insurer's near-collapse.

The cautionary tale of American International Group and reforms taking place in the CDS market argue that these once-obscure products are subsiding as a potential trigger of further mayhem.

Trouble usually arises from unexpected quarters. As the old army saw goes, a soldier never hears the round that gets him. Where the next bullet will come from -- and whose name will be on it -- is unknown. But it probably will be from someplace other than the credit-default-swap market.

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Central Clearinghouse By The End Of 2008 To Reduce Counterparty Risk in the Credit Default Swap (CDS) Market Nov 16, 2008

Nov 14: U.S. regulators said at least one central clearinghouse for will be running by year-end after they agreed on a plan to regulate the entities. The Federal Reserve, Commodity Futures Trading Commission and Securities and Exchange Commission signed an accord they said will provide consistent oversight of credit-default swaps, which are unregulated contracts that are traded privately.

o President's Working Group (PWG): In light of recent developments, the PWG is issuing broader objectives than those that motivated the PWG's previous OTC derivatives recommendations in the HMarch 13 PWG Policy Statement on Financial Market DevelopmentsH. The PWG has established the following policy objectives: 1) improve the transparency and integrity of the credit default swaps market; 2) enhance risk management of OTC derivatives; 3) further strengthen the OTC derivatives market infrastructure; 4) strengthen cooperation among regulatory authorities.

o BIS: Total single- and multiname CDS market (latter incl. indices and index tranches) is $57T, down from $62T in 2007 ISDA reports $54T gross CDS notional.) The gross market value of theses contracts reached $3.172T in 2008.

o Technically, a clearinghouse, capitalized by its members, all but eliminates the risk of trading partner default by being the buyer for every seller and the seller for every buyer. It employs daily mark-to-market pricing where margin calls are made if a trader's position has lost money that day. Traders who can't pay have their positions are liquidated.

o Four groups have been vying to operate clearing operations, including a partnership between Chicago-based CME Group Inc. and Citadel Investment Group LLC and a group that includes dealer- owned Clearing Corp., Intercontinental Exchange Inc. and credit swap index owner Markit Group Ltd. Eurex and NYSE Euronext have also submitted proposals. (Bloomberg).

o Europe insists on at least one EU-based CDS clearinghouse.

o nc: Some CME members are now objecting to the offer, arguing that the additional risk of CDS clearing on top of their existing CME obligations is more than the members can realistically support. Moreover, they contend that putting together CDS and futures under the same umbrella is too much risk in one venue, and will increase, not reduce systemic risk. Moreover, Citadel went down 38% YTD.

o Cecchetti: Amaranth and LTCM impact comparison shows that regulated exchange trading should be the norm. Advantages: smaller counterparty risk with centralized

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clearing house and margin calls; asset valuation certainty; standardized products. -->However: on- and off-exchange trading not perfect substitutes: investors appreciate customized products; banks earn fees and have advantage of back-office infrastructure vis-a-vis securities exchanges.

o Drawbacks: Central clearinghouse requires margins from previously exempted transactions. Also: viability questioned once bid-ask spreads return to normal: If exchanges are successful this drains a lot of fees from i-banks.

o Jorion/Zhang: Standard credit risk models cannot explain the observed clustering of default, sometimes described as “credit contagion” See also: HWas it a mistake to let Lehman fail?

o Minneapolis Fed president Gary Stern suggest supervisors should be given authority to stop institutions outside the safety net from building up gross positions that create systemic interconnectedness.

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Economy

November 17, 2008

152BTHE RECKONING

51BDeregulator Looks Back, Unswayed 144BBy ERIC LIPTON and STEPHEN LABATON

WASHINGTON — Back in 1950 in Columbus, Ga., a young nurse working double shifts to support her three children and disabled husband managed to buy a modest bungalow on a street called Dogwood Avenue.

HPhil GrammH, the former United States senator, often told that story of how his mother acquired his childhood home. Considered something of a risk, she took out a mortgage with relatively high interest rates that he likened to today’s subprime loans.

A fierce opponent of government intervention in the marketplace, Mr. Gramm, a Republican from Texas, recalled the episode during a 2001 Senate debate over a measure to curb predatory lending. What some view as exploitive, he argued, others see as a gift.

“Some people look at subprime lending and see evil. I look at subprime lending and I see the American dream in action,” he said. “My mother lived it as a result of a finance company making a mortgage loan that a bank would not make.”

On Capitol Hill, Mr. Gramm became the most effective proponent of deregulation in a generation, by dint of his expertise (a Ph.D in economics), free-market ideology, perch on the Senate banking committee and force of personality (a writer in Texas once called him “a snapping turtle”). And in one remarkable stretch from 1999 to 2001, he pushed laws and promoted policies that he says unshackled businesses from needless restraints but his critics charge significantly contributed to the Hfinancial crisisH that has rattled the nation.

He led the effort to block measures curtailing deceptive or predatory lending, which was just beginning to result in a jump in home foreclosures that would undermine the financial markets. He advanced legislation that fractured oversight of Wall Street while knocking down Depression-era barriers that restricted the rise and reach of financial conglomerates.

And he pushed through a provision that ensured virtually no regulation of the complex financial instruments known as HderivativesH, including credit swaps, contracts that would encourage risky investment practices at Wall Street’s most venerable institutions and spread the risks, like a virus, around the world.

Many of his deregulation efforts were backed by the Clinton administration. Other members of Congress — who collectively received hundreds of millions of dollars in campaign contributions from financial industry donors over the last decade — also played roles.

Many lawmakers, for example, insisted that HFannie MaeH and HFreddie MacH, the nation’s largest mortgage finance companies, take on riskier mortgages in an effort to aid poor families. Several Republicans resisted efforts to address lending abuses. And Congressional committees failed to address early symptoms of the coming illness.

But, until he left Capitol Hill in 2002 to work as an investment banker and lobbyist for HUBSH, a Swiss bank that has been hard hit by the market downturn, it was Mr. Gramm who most effectively took up the fight against more government intervention in the markets.

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“Phil Gramm was the great spokesman and leader of the view that market forces should drive the economy without regulation,” said James D. Cox, a corporate law scholar at HDuke UniversityH. “The movement he helped to lead contributed mightily to our problems.”

In two recent interviews, Mr. Gramm described the current turmoil as “an incredible trauma,” but said he was proud of his record.

He blamed others for the crisis: Democrats who dropped barriers to borrowing in order to promote homeownership; what he once termed “predatory borrowers” who took out mortgages they could not afford; banks that took on too much risk; and large financial institutions that did not set aside enough capital to cover their bad bets.

But looser regulation played virtually no role, he argued, saying that is simply an emerging myth.

“There is this idea afloat that if you had more regulation you would have fewer mistakes,” he said. “I don’t see any evidence in our history or anybody else’s to substantiate it.” He added, “The markets have worked better than you might have thought.”

Rejecting Common Wisdom

Mr. Gramm sees himself as a myth buster, and has long argued that economic events are misunderstood.

Before entering politics in the 1970s, he taught at HTexas A & M UniversityH. He studied Hthe Great DepressionH, producing research rejecting the conventional wisdom that suicides surged after the market crashed. He examined financial panics of the 19th century, concluding that policy makers and economists had repeatedly misread events to justify burdensome regulation.

“There is always a revisionist history that tries to claim that the system has failed and what we need to do is have government run things,” he said.

From the start of his career in Washington, Mr. Gramm aggressively promoted his conservative ideology and free-market beliefs. (He was so insistent about having his way that one House speaker joked that if Mr. Gramm had been around when Moses brought the Ten Commandments down from Mount Sinai, the Texan would have substituted his own.)

He could be impolitic. Over the years, he has urged that food stamps be cut because “all our poor people are fat,” said it was hard for him “to feel sorry” for Social Security recipients and, as the economy soured last summer, called America “a nation of whiners.”

His economic views — and seat on the Senate banking committee — quickly won him support from the nation’s major financial institutions. From 1989 to 2002, federal records show, he was the top recipient of campaign contributions from commercial banks and in the top five for donations from Wall Street. He and his staff often appeared at industry-sponsored speaking events around the country.

From 1999 to 2001, Congress first considered steps to curb predatory loans — those that typically had high fees, significant prepayment penalties and ballooning monthly payments and were often issued to low-income borrowers. Foreclosures on such loans were on the rise, setting off a wave of Hpersonal bankruptciesH.

But Mr. Gramm did everything he could to block the measures. In 2000, he refused to have his banking committee consider the proposals, an intervention hailed by the National Association of Mortgage Brokers as a “huge, huge step for us.”

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A year later, he objected again when Democrats tried to stop lenders from being able to pursue claims in bankruptcy court against borrowers who had defaulted on predatory loans.

While acknowledging some abuses, Mr. Gramm argued that the measure would drive thousands of reputable lenders out of the housing market. And he told fellow senators the story of his mother and her mortgage.

“What incredible exploitation,” he said sarcastically. “As a result of that loan, at a 50 percent premium, so far as I am aware, she was the first person in her family, from Adam and Eve, ever to own her own home.”

Once again, he succeeded in putting off consideration of lending restrictions. His opposition infuriated consumer advocates. “He wouldn’t listen to reason,” said Margot Saunders of the National Consumer Law Center. “He would not allow himself to be persuaded that the free market would not be working.”

Speaking at a bankers’ conference that month, Mr. Gramm said the problem of predatory loans was not of the banks’ making. Instead, he faulted “predatory borrowers.” The American Banker, a trade publication, later reported that he was greeted “like a conquering hero.”

At the Altar of Wall Street

Mr. Gramm would sometimes speak with reverence about the nation’s financial markets, the trading and deal making that churn out wealth.

“When I am on Wall Street and I realize that that’s the very nerve center of American capitalism and I realize what capitalism has done for the working people of America, to me that’s a holy place,” he said at an April 2000 Senate hearing after a visit to New York.

That viewpoint — and concerns that Wall Street’s dominance was threatened by global competition and outdated regulations — shaped his agenda.

In late 1999, Mr. Gramm played a central role in what would be the most significant financial services legislation since the Depression. The Gramm-Leach-Bliley Act, as the measure was called, removed barriers between commercial and investment banks that had been instituted to reduce the risk of economic catastrophes. Long sought by the industry, the law would let commercial banks, securities firms and insurers become financial supermarkets offering an array of services.

The measure, which Mr. Gramm helped write and move through the Senate, also split up oversight of conglomerates among government agencies. The Securities and Exchange Commission, for example, would oversee the brokerage arm of a company. Bank regulators would supervise its banking operation. State insurance commissioners would examine the insurance business. But no single agency would have authority over the entire company.

“There was no attention given to how these regulators would interact with one another,” said Professor Cox of Duke. “Nobody was looking at the holes of the regulatory structure.”

The arrangement was a compromise required to get the law adopted. When the law was signed in November 1999, he proudly declared it “a deregulatory bill,” and added, “We have learned government is not the answer.”

In the final days of the Clinton administration a year later, Mr. Gramm celebrated another triumph. Determined to close the door on any future regulation of the emerging market of derivatives and swaps, he helped pushed through legislation that accomplished that goal.

Created to help companies and investors limit risk, swaps are contracts that typically work like a form of insurance. A bank concerned about rises in interest rates, for instance, can buy a

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derivatives instrument that would protect it from rate swings. HCredit-default swapsH, one type of derivative, could protect the holder of a mortgage security against a possible default.

Earlier laws had left the regulation issue sufficiently ambiguous, worrying Wall Street, the Clinton administration and lawmakers of both parties, who argued that too many restrictions would hurt financial activity and spur traders to take their business overseas. And while the HCommodity Futures Trading Commission H — under the leadership of Mr. Gramm’s wife, Wendy — had approved rules in 1989 and 1993 exempting some swaps and derivatives from regulation, there was still concern that step was not enough.

After Mrs. Gramm left the commission in 1993, several lawmakers proposed regulating derivatives. By spreading risks, they and other critics believed, such contracts made the system prone to cascading failures. Their proposals, though, went nowhere.

But late in the Clinton administration, Brooksley E. Born, who took over the agency Mrs. Gramm once led, raised the issue anew. Her suggestion for government regulations alarmed the markets and drew fierce opposition.

In November 1999, senior Clinton administration officials, including Treasury Secretary HLawrence H. Summers H, joined by the Federal Reserve chairman, HAlan GreenspanH, and HArthur Levitt Jr.H, the head of the Securities and Exchange Commission, issued a report that instead recommended legislation exempting many kinds of derivatives from federal oversight.

Mr. Gramm helped lead the charge in Congress. Demanding even more freedom from regulators than the financial industry had sought, he persuaded colleagues and negotiated with senior administration officials, pushing so hard that he nearly scuttled the deal. “When I get in the red zone, I like to score,” Mr. Gramm told reporters at the time.

Finally, he had extracted enough. In December 2000, the Commodity Futures Modernization Act was passed as part of a larger bill by unanimous consent after Mr. Gramm dominated the Senate debate.

“This legislation is important to every American investor,” he said at the time. “It will keep our markets modern, efficient and innovative, and it guarantees that the United States will maintain its global dominance of financial markets.”

But some critics worried that the lack of oversight would allow abuses that could threaten the economy.

Frank Partnoy, a law professor at the University of San Diego and an expert on derivatives, said, “No one, including regulators, could get an accurate picture of this market. The consequences of that is that it left us in the dark for the last eight years.” And, he added, “Bad things happen when it’s dark.”

In 2002, Mr. Gramm left Congress, joining UBS as a senior investment banker and head of the company’s lobbying operation.

But he would not be abandoning Washington.

Lobbying From the Outside

Soon, he was helping persuade lawmakers to block Congressional Democrats’ efforts to combat predatory lending. He arranged meetings with executives and top Washington officials. He turned over his $1 million political action committee to a former aide to make donations to like-minded lawmakers.

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Mr. Gramm, now 66, who declined to discuss his compensation at UBS, picked an opportune moment to move to Wall Street. Major financial institutions, including UBS, were growing, partly as a result of the Gramm-Leach-Bliley Act.

Increasingly, institutions were trading the derivatives instruments that Mr. Gramm had helped escape the scrutiny of regulators. UBS was collecting hundreds of millions of dollars from credit-default swaps. (Mr. Gramm said he was not involved in that activity at the bank.) In 2001, a year after passage of the commodities law, the derivatives market insured about $900 billion worth of credit; by last year, the number hadswelled to $62 trillion.

But as housing prices began to fall last year, foreclosure rates began to rise, particularly in regions where there had been heavy use of subprime loans. That set off a calamitous chain of events. The weak housing markets would create strains that eventually would have financial institutions around the world on the edge of collapse.

UBS was among them. The bank has declared nearly $50 billion in credit losses and write-downs since the start of last year, prompting a bailout of up to $60 billion by the Swiss government.

As Mr. Gramm’s record in Congress has come under attack amid all the turmoil, some former colleagues have come to his defense.

“He is a true dyed-in-the-wool free-market guy. He is very much a purist, an idealist, as he has a set of principles and he has never abandoned them,” said HPeter G. FitzgeraldH, a Republican and former senator from Illinois. “This notion of blaming the economic collapse on Phil Gramm is absurd to me.”

But Michael D. Donovan, a former S.E.C. lawyer, faulted Mr. Gramm for his insistence on deregulating the derivatives market. “He was the architect, advocate and the most knowledgeable person in Congress on these topics,” Mr. Donovan said. “To me, Phil Gramm is the single most important reason for the current financial crisis.” Mr. Gramm, ever the economics professor, disputes his critics’ analysis of the causes of the upheaval. He asserts that swaps, by enabling companies to insure themselves against defaults, have diminished, not increased, the effects of the declining housing markets.

“This is part of this myth of deregulation,” he said in the interview. “By and large, credit-default swaps have distributed the risks. They didn’t create it. The only reason people have focused on them is that some politicians don’t know a credit-default swap from a turnip.”

But many experts disagree, including some of Mr. Gramm’s former allies in Congress. They say the lack of oversight left the system vulnerable. “The virtually unregulated over-the-counter market in credit-default swaps has played a significant role in the credit crisis, including the now $167 billion taxpayer rescue of A.I.G.,” HChristopher CoxH, the chairman of the S.E.C. and a former congressman, said Friday.

Mr. Gramm says that, given what has happened, there are modest regulatory changes he would favor, including requiring issuers of credit-default swaps to demonstrate that they have enough capital to back up their pledges. But his belief that government should intervene only minimally in markets is unshaken.

“They are saying there was 15 years of massive deregulation and that’s what caused the problem,” Mr. Gramm said of his critics. “I just don’t see any evidence of it.”

Griff Palmer contributed reporting from New York.

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Economy

November 17, 2008

52BGramm and the ‘Enron Loophole’ By ERIC LIPTON In 2000, Senator HPhil GrammH played a central role in writing the Commodity Futures Modernization Act, a law that would open the door to unregulated trading of Hcredit default swaps H, the financial instruments blamed, in part, for the current economic meltdown.

But there was another aspect of this legislation that, earlier this decade, helped produce another financial meltdown: the collapse of HEnronH, the Texas energy company.

The commodity futures act, in addition to allowing unregulated trading of financial derivatives, included language advocated by Enron that largely exempted the company from regulation of its energy trading on electronic commodity markets, like its once-popular Enron Online. The provision came to be known as the Enron Loophole.

E-mail written by Enron executives and lobbyists — which became public as part of a federal investigation after Enron collapsed — shows how top Enron officials closely monitored negotiations on the bill. They paid particular attention to Mr. Gramm, who before a final agreement in late 2000 was trying to press other key figures on Capitol Hill and at the White House to agree to concessions that would further curtail regulation of trading.

Enron’s primary concern was that Mr. Gramm’s insistence at getting these additional free-market concessions — most of which were unrelated to Enron’s business — might scuttle the whole deal, killing Enron’s chance of getting the loophole it sought.

Enron was a major contributor to Mr. Gramm’s political campaigns, and Mr. Gramm’s wife, Wendy, served on the Enron board, which she joined after stepping down as chairwoman of the HCommodity Futures Trading CommissionH.

Although not directly related to the current economic crisis, the Enron e-mail provides a window into how much clout Mr. Gramm had as chairman of the Senate Committee on Banking, Housing and Urban Affairs, and the ways lobbyists intervened to advance and defend their interests during negotiations on the bill.

The Commodity Futures Modernization Act was approved in December 2000, just before HBill ClintonH’s term as president ended. Mr. Gramm, in a recent interview, said he was not responsible for inserting the language into the bill that established the Enron Loophole. But once the Commodity Futures Modernization measure — with this provision included — reached the Senate floor, Mr. Gramm led the debate, urging his fellow senators to pass it into law.

Following are excerpts from some of the e-mail pulled from the Enron files that discuss Mr. Gramm and this legislation. All of the e-mail is available at HEnron ExplorerH, a site that has put the Enron e-mail into a searchable format. More information on the Enron Loophole is available HhereH. Aug. 10, 2000: ‘We Need Senator Gramm’

Christopher M. Long, an Enron lobbyist, writes to other Enron executives, updating the status of the negotiations over the Commodity Futures Modernization Act and urging Enron’s chief executive,

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HKenneth Lay H, to call Senator Gramm to nudge him on the topic. As an Enron board member, Wendy Gramm is playing a part in the debate as well. Two Enron executives write Mr. Long back, endorsing the idea of having Mr. Lay call Mr. Gramm.

Chris Long@ENRON

08/10/2000 05:12 PM

To: Mark E Haedicke/HOU/ECT@ECT, Steven J Kean/HOU/EES@EES, Richard Shapiro/HOU/EES@EES, Mark Taylor/HOU/ECT@ECT, Joe Hillings/Corp/Enron@ENRON, Cynthia Sandherr/Corp/Enron@ENRON, Tom Briggs/NA/Enron@Enron

cc: raislerk@sullcrom.com, Allison Navin/Corp/Enron@ENRON

Subject: CFTC Reauthorization

At his request, I met Lee Sachs, Assistant Treasury Secretary, who had requested the meeting after a brief conversation recently. Lee said that senior-level negotiations led by Secretary Summers were initiated last week between the CFTC and SEC and that progress was being made on the single stock futures issue (the major issue postponing movement of the legislation).

The Senate Agriculture Committee passed out the Senate version in July. However, the bill is not moving quickly in the Senate due to Senator Phil Gramm’s desire to see significant changes made to the legislation (not directly related to our energy language). Last week at the Republican Convention, I asked the Senator about the bill and he said they were working on it, but much needs to be changed for his support. More telling perhaps, were Wendy Gramm’s comments that she would rather the current bill die if a better bill can be passed next year. What this means is that we must, at the least, remove Senator Gramm’s opposition to the bill to move the process and more importantly seek to gain his support of the legislation.

However, with less than 20 or so legislative days left, we need Senator Gramm to engage. A call from Ken Lay in the next two weeks to Senator Gramm could be an impetus for Gramm to move his staff to resolve the differences. Gramm needs to fully understand how helpful the bill is to Enron. Let me know your thoughts on this approach. I am prepared to assist in coordinating the call and drafting the talking points for a Ken Lay/Sen. Gramm call.

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53BBlowing the Whistle 73BWhich External Controls Best Reveal Corporate Fraud? 121BResearch by Adair Morse and Luigi Zingales 148BAdair Morse is assistant professor of finance at the University of Chicago Graduate School of Business. 149BLuigi Zingales is Robert C. McCormack Professor of Entrepreneurship and Finance at the Universtiy of Chicago Graduate School of Business 145BNew research suggests that the best way to promote fraud detection is to extend the Federal Civic False Claims Act to corporate fraud. As the new millennium dawned, so did a spate of U.S. corporate scandals. The names Enron, WorldCom, and numerous others are tainted by cases of corporate fraud and malfeasance. These frauds and the accompanying outrage spurred the passage of the Sarbanes-Oxley Act (SOX). The underlying premise of SOX was that institutions charged with uncovering fraud had failed in their duties, and their incentives and monitoring needed to be enhanced. In the haste to pass SOX into law, however, little attention was paid to the premise of the new regulation. Few stopped to ask: Who plays a role in detecting and deterring corporate fraud, and what is their motivation? Did reforms target the right people and fix the problem? Furthermore, can fraud detection be improved in cost-effective ways? These questions are addressed in the new study “Who Blows the Whistle on Corporate Fraud?” by University of Chicago Graduate School of Business professors Adair Morse and Luigi Zingales, and Alexander Dyck of the University of Toronto’s Rotman School of Management. Morse, Zingales, and Dyck found fraud detection relies not on a single person or institution, but on the actions of a wide range of sometimes unlikely heroes. In particular, they find that when there exists a monetary reward for fraud revelation— as is the case for fraud against the U.S. government— employees become much more active in revealing fraud. Since the authors do not find that monetary rewards increase frivolous lawsuits (suits dismissed or settled for less than $3 million), they conclude that it could be beneficial to extend the same regime to publicly traded companies.

Multiple Sources Morse, Zingales, and Dyck began their research by gathering a comprehensive sample of corporate fraud perpetrated in companies with more than $750 million in assets in the United States between 1996 and 2004. After screening for frivolous lawsuits, their final dataset contained 230 cases of corporate fraud, including the highprofile Enron, HealthSouth, and WorldCom cases. For each case, the authors identified who revealed the fraud, the circumstances leading to detection, the timing of the revelation, the sources of information, and the incentives that led detectors to bring the fraud to light. To help identify the role of short sellers (traders who sell borrowed stock in the hope of a decline in price) the authors searched for unusual levels of short positions (i.e., sales of borrowed stock) before the emergence of a fraud.

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Their results demonstrate that fraud revelation comes from many sources. For example, the Securities and Exchange Commission (SEC) accounts for only 6 percent of detected frauds; short sellers and equity holders account for 9 percent; and financial analysts and auditors account for 14 percent. As intriguing as who detects corporate fraud is who does not. Almost completely absent from the roster of detectors are stock exchange regulators, commercial banks, and underwriters. The authors also identified several unlikely detectors: the media uncovered 14 percent of the fraud, non-financial market regulators found 16 percent, and employees detected 19 percent. One might expect private security litigation to play a large role in fraud detection, but in fact less than two percent of fraud cases are brought to light in this manner. Private litigation is not necessarily ineffective. It can be a mechanism to force those committing fraud to pay for their misdeeds. But far from operating on its own, private security litigation requires the assistance of an assortment of institutions to uncover the presence of fraud. “The most surprising result was the relatively small role of the SEC,” says Zingales. “I had assumed that the SEC and class action suits were very important in bringing frauds to light, but they don’t seem important overall. It takes a village to detect fraud because not only are there many different players involved, but the process by which this fraud emerges rests on interaction between these players.”

Quick to Respond The average speed with which fraud is detected is another yardstick of the comparative effectiveness of these detectors. Financial analysts and short sellers are the quickest to uncover fraud, with each needing 9.1 months on average. Frauds that slip by these individuals are unmasked by external stockholders (15.9 months); suppliers, clients, competitors, and nonfinancial market regulators (13.3 months); auditors (14.7 months); and employee whistle blowers (20.9 months). Those with relatively minimal access to the company manage to catch frauds later in the process. These include the media (21 months), the SEC (21.2 months), and plaintiff lawyers (31.4 months). Turning next to the risk/benefit equation, the authors looked at motives to ferret out fraud. For instance, financial analysts are viewed as agents of professional investors, giving them strong motives to uncover fraud. However, this incentive may be diluted by the potential conflict of interest between their advising and their firms’ investment banking services. Similarly, journalists face tradeoffs between boosting their careers and jeopardizing advertising income from the firms they write about. The authors found that analysts, journalists, auditing firms, and employees who uncover fraud do not appear to benefit from either a career or financial standpoint. Auditing firms are more likely to lose the client when they reveal fraud than when they do not. In 82 percent of cases in which named employees blow the whistle, these employees end up being fired, quitting under pressure, or shifting duties. The prospect of monetary or career gain also does not spur younger go-getters to look for fraud, despite the lingering legacy in the government arena of a youthful Woodward and Bernstein blowing the lid off the Watergate scandal. Sixty percent of the corporate fraud revelations by analysts are uncovered by senior analysts at top-10 investment banks. Among the media players detecting fraud, the majority of cases are uncovered by experienced reporters from the most highly regarded newspapers.

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The paradox is that those with little or no incentives to reveal fraud, such as employees, tend to be the most active, while those with greater motivations, such as short sellers, are far less involved. The key is access to important information. “Some people become aware of fraud in the course of their normal business dealings,” says Zingales. “Not only do they not have a positive incentive to reveal the fraud, they have an extremely large disincentive to reveal.” Zingales adds: “These employees are usually fired or completely ostracized by their officemates. The culture of loyalty is important, but it can lead to fraud being concealed.”

Mandatory versus Market In the course of their research, the authors examined the relative merits of two different approaches to detecting fraud. The first, or “mandatory” approach, generally relies on auditors, the SEC, and nonfinancial market regulators to detect fraud. An alternative, or “market” approach, rewards individuals such as short sellers and financial analysts with monetary or career rewards when they uncover corporate fraud. The authors found that 73 percent of corporate frauds were revealed via the market approach prior to July 2002, but that number plunged to 46 percent thereafter. That decline likely resulted from new regulations (including SOX) that boosted incentives and penalties for those participants in the mandatory approach to detection. The authors then examined an alternative to the mandated approach of SOX—that of providing monetary rewards to detectors. In particular, they studied the effect of the Federal Civil False Claims Act, which promise people who bring to light frauds against the government between 15 to 30 percent of the money recovered. In the health care industry, where the government comprises a substantial percentage of revenues, 46.7 percent of frauds are ferreted out by employees—a much larger figure than the 16.3 percent detected by employees in all other industries. The obvious conclusion is that monetary rewards do spur people with information about fraud to come forward with their findings. “The greatest benefit of this approach is that you can create competition,” says Zingales. “Once there’s a reward, there is an incentive to speak up and to be the first to do so. It’s very difficult for a large company to stop that. You can bribe one or two guys, but not an entire company.” One criticism of adopting such a policy is that it may result in frivolous lawsuits. However, the authors find this argument without merit. There is a lower, not higher, percentage of frivolous suits in the health care industry than other industries. Another concern is that rewarding whistle blowers may foster distrust among employees and subvert working relationships that benefit employers. While failing to find evidence of such a problem in sectors that reward the reporting of fraud, the authors acknowledge this is an area that merits further study. “Since the qui tam approach has worked very well in combating fraud against the federal government, there’s no reason why we shouldn’t try to extend this approach to corporate fraud as well,” says Zingales. “Who Blows the Whistle on Corporate Fraud?” Alexander Dyck, Adair Morse and Luigi Zingales. Hhttp://www.chicagogsb.edu/capideas/jan08/1.aspxH

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U.S.

November 17, 2008

54BFacing Deficits, States Get Out Sharper Knives By JENNIFER STEINHAUER LOS ANGELES — Two short months ago lawmakers in California struggled to close a $15 billion hole in the state budget. It was among the biggest deficits in state history. Now the state faces an additional $11 billion shortfall and may be unable to pay its bills this spring.

The astonishing decline in revenues is without modern precedent here, but California is hardly alone. A majority of states — many with budgets already full of deep cuts and dependent on raiding rainy-day funds or tax increases — are scrambling to find ways to get through the rest of the year without hacking apart vital services or raising taxes.

Some governors, including HArnold SchwarzeneggerH in California and HDavid A. PatersonH in New York, have called special legislative sessions to deal with the crisis.

Others are demanding hiring freezes and across-the-board cuts. A few states are finding their unemployment insurance funds running dry, just as the ranks of out-of-work residents spike.

The plunging revenues — the result of an unusual assemblage of personal, sales, capital gains and corporate taxes falling significantly — have poked holes in budgets that are just weeks and months old and that came about only after difficult legislative sessions.

“The fiscal landscape,” said H. D. Palmer, a spokesman for the California Department of Finance, “is fundamentally altered from where it was six weeks ago.”

In Michigan, to reduce overtime costs, fewer streets will be salted this winter. In Ohio, where the unemployment rate is above 7 percent, the state may need a federal loan for the first time in 26 years to cover unemployment costs. In Nevada, which is almost totally dependent on sales taxes and gambling revenues, a health administrator said the state may be unable to pay claims in a few months.

In California, Mr. Schwarzenegger, a Republican, and state legislators are preparing to do battle over a proposed 1.5-cent sales tax increase, while in New York, Mr. Paterson, a Democrat, has proposed $5.2 billion worth of savings, principally cuts to HMedicaidH and education.

Even states where until recent months natural resource production has provided a buffer — and fat surpluses — are experiencing a sudden reversal of fortunes as oil prices have declined.

“Frankly, I thought 2001 was really awful,” said Scott D. Pattison, the executive director of the National Association of State Budget Officers, referring to the last big economic downturn. “It is even worse now.”

He added, “This fiscal year will be really bad, and what is unfortunate is that I can’t see how 2010 won’t be bad too.”

In keeping with recent economic trends, the states with the worst problems are those where housing booms morphed into a large-scale mortgage crisis over the last two years.

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The current-year budget gap in Rhode Island represents over 11 percent of the state’s entire general fund, in large part because of the high number of subprime loans. The story is similar in Arizona, California, Florida and Nevada.

In addition, the crisis in the financial markets had immediate and widespread impact on state budgets. States have lost revenues from capital gains taxes and bonuses that have evaporated, and growing job losses have reduced state income taxes while draining unemployment funds.

“What we are seeing is when fewer people are working there is less income tax and less spending,” said Keith Dailey, a spokesman for Gov. Ted Strickland of Ohio, a Democrat.

Americans have also stopped shopping, which has hurt states that are heavily reliant on sales taxes, like Florida and Arizona. States that rely on tourism, like Nevada and Hawaii, have also been hurt by less consumer spending.

Further, the national credit crunch makes it harder for businesses to get loans, which trickles back into losses to states. When California was temporarily unable to gain access to the credit markets in the days leading up to the federal Hbailout packageH, state budget directors across the country noted the moment with horror.

The state’s brief inability to pay bills because it could not get credit — California, like many states, regularly borrows money when it is short of cash in anticipation of revenue flowing in later — has since been largely interpreted as an outgrowth of the much larger national and international Hcredit crisisH. Still, some budget experts said the problem could be a harbinger: cities and counties with poor credit ratings could be cut off in the coming year, and there could be higher costs for issuing bonds.

“Just the fact that this was an issue at all is a big concern for every state,” Mr. Pattison said. “Long-term bonds may be at risk. And I think states are going to have to accept that cost of debt is going to be higher.”

In most states, budget directors and legislators have said that tax increases are not likely. A notable exception is California, where Mr. Schwarzenegger is seeking a 1.5-point increase to the state’s 6.25-percent sales tax, although he is unlikely to get the necessary approval of Republican legislators.

In Oregon, moreover, Gov. Ted Kulongoski, a Democrat, has proposed a $1 billion economic stimulus plan centered on infrastructure improvements, which he envisions would be paid for by raising the state’s Hgas taxH by 2 cents per gallon and increasing a host of vehicle fees.

When regular legislative sessions resume in many states in January, other states will be more likely to look to rainy-day funds, when they are available, and deeper cuts to services, most notably to K-12 education, which is generally a last-resort option among lawmakers.

“Most states have tried to protect K-12 and even higher ed,” said Raymond Scheppach, the executive director of the HNational Governors AssociationH, “but I think they are both going to be on the block.”

Many states are expected to go to a second round of earlier cuts.

“We’ve cut universities, we’ve cut our infrastructure spending, we’ve prorated schools and asked employees for concessions twice,” said Leslee Fritz, the spokeswoman for the Michigan State Budget Office. “All the different options out there we have already done more than once.”

States are also looking to create large-scale infrastructure projects and other construction works as a means of stimulating the local economy.

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The Washington governor, HChristine GregoireH, a Democrat, is asking the federal government for hundreds of millions of dollars more for state and federal construction projects.

Ohio officials have already passed a stimulus package of $1.5 billion in bonds, to be used largely for public works, advanced and renewable energy projects, and the biomedical industry.

“States don’t have a lot of economic stimulus tools,” said Mr. Pattison of the budget officers’ association, “but they have infrastructure.”

Fewer than a dozen states have remained in the black this fiscal year, according to the Center on Budget and Policy Priorities, a liberal-leaning economic research group in Washington that tracks state budgets, and they are largely those in the West with oil and mineral resources at the ready.

“The oil-producing states were doing very well with oil at $120 a barrel,” said Iris Lav, the deputy director of the center. “They may not do as well now.”

More generally, Ms. Lav said, state budgets are “moving from the damaged to the devastated.”

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150BPaul Krugman November 17, 2008, 4:38 pm

74BAfter the stimulus For the coming year, and probably well beyond, the economy will be on life support — sustained by massive fiscal stimulus. (Either that, or we’ll be in a very deep slump.) But eventually the economy will have to come off life support. What will take the place of the stimulus?

I don’t really know the answer, but one thing that may be useful is to compare the sources of demand in 2007 with those over a longer period. Here’s a table showing C (consumer spending), N (nonresidential investment), R (residential investment), G (government purchases), and NX (net exports) as percentages of GDP in 2007 and on average over the period 1979-2007.

Sources of demand

2007 155BAverage

154BC 70,3 66,7

N 10,9 11.3

R 4,6 4,5

G 19,4 19,4

NX -5,1 -2,4

What stands out is the combination of high consumption and a large trade deficit. By 2007 residential investment had already fallen to normal levels, and non residential investment was also fairly normal.

Consumption probably isn’t going back to a 2007 share of GDP — savings are back. So what will fill the gap, once the stimulus is gone? Housing? Not for a long time. Business investment? Hard to see why. The natural thing would be to trade lower consumption for a smaller trade deficit.

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157BBut that’s going to be hard if the rest of the world is also in a slump, and in particular if emerging markets are facing currency crises.What all this suggests — and it’s a very rough cut — is that our emergence from the era when massive fiscal stimulus is needed may hinge crucially on getting the world financial situation, not just our own, under control.

158BCars 159BJonathan Cohn has the best statement I’ve seen of the case for a rescue. No illusions — these are companies that, to a large extent, drove themselves into a ditch. If the economy as a whole were in reasonably good shape and the credit markets were functioning, Chapter 11 would be the way to go. Under current circumstances, however, a default by GM would probably mean loss of ability to pay suppliers, which would mean liquidation — and that, in turn, would mean wiping out probably well over a million jobs at the worst possible moment.

160BPanic in Detroit This is not your father's Oldsmobile we're rescuing. Jonathan Cohn, The New Republic Published: Friday, November 14, 2008

General Motors has come to Washington, begging for a $25 billion bailout to keep it and its ailing Detroit counterparts going next year. But nobody seems too thrilled about the prospect. Liberals dwell on the companies' gas-guzzling sport-utility vehicles. Conservatives obsess over all the well-paid union members with gold-plated benefits. And people of all ideological backgrounds remember how they used to buy domestic cars, years ago, but stopped because the cars were so damn lousy. "The downfall of the American auto industry is indeed a tragedy," the Washington Post editorial board sermonized recently, "but the automakers and the United Auto Workers have only themselves to blame for much of it." And, if they have only themselves to blame, the argument goes, why do they deserve taxpayer help? Let them fail and file for bankruptcy. In the long run, the economy will be stronger and the workers better off. It'd be worth?the short-term pain, which might not even be so severe.

In normal times, with another company, that might be correct. But these are not normal times, just as GM is not any old company. Nor is the simple economic morality tale everybody repeats about the auto industry accurate. Detroit has come a long way since the days of wide lapels and disco. GM, Ford, and Chrysler are taking precisely the sorts of steps everybody says are necessary--or, at least, they were taking those steps until an unexpected trifecta of high gas prices, vanishing credit, and a deep recession hit. Rescuing the auto industry is not, as so many people suppose, a question of giving Detroit one extra shot at transformation. It's a question of giving Detroit a chance to finish a transformation that was already underway.

One reason for the casual support for letting GM fail is the assumption that bankruptcy would be no big deal: As USA Today editorialized recently, "Bankruptcy need not mean that the company disappears." But, while it's worked out that way for the airlines, among others, it's unlikely a GM business failure would play out in the same fashion. In order to seek so-called Chapter 11 status, a

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distressed company must find some way to operate while the bankruptcy court keeps creditors at bay. But GM can't build cars without parts, and it can't get parts without credit. Chapter 11 companies typically get that sort of credit from something called Debtor-in-Possession (DIP) loans. But the same Wall Street meltdown that has dragged down the economy and GM sales has also dried up the DIP money GM would need to operate.

That's why many analysts and scholars believe GM would likely end up in Chapter 7 bankruptcy, which would entail total liquidation. The company would close its doors, immediately throwing more than 100,000 people out of work. And, according to experts, the damage would spread quickly. Automobile parts suppliers in the United States rely disproportionately on GM's business to stay afloat. If GM shut down, many if not all of the suppliers would soon follow. Without parts, Chrysler, Ford, and eventually foreign-owned factories in the United States would have to cease operations. From Toledo to Tuscaloosa, the nation's?assembly lines could go silent, sending a chill through their local economies as the idled workers stopped spending money.

Restaurants, gas stations, hospitals, and then cities, counties, and states--all of them would feel pressure on their bottom lines. A study just published by the Michigan-based Center for Automotive Research (CAR) predicted that three million people would lose their jobs in the first year after such a Big Three meltdown, swelling the ranks of the unemployed by nearly one-third nationally and leading to hundreds of billions of dollars in lost income. The Midwest would feel the effects disproportionately, but the effect would reach into every community with a parts supplier or factory--and, to a lesser extent, into every town and city with a dealership. In short, virtually every community in the country would be touched.

This is, admittedly, a worst-case scenario--the sort of dire projection you'd expect from a Michigan-based think tank that receives a small amount of industry money. (And, as a Michigan resident, I should disclose my own small conflict: My wife, an?engineering professor, once directed a research project funded by Ford.) But the economists and industry analysts I tracked down this week vouched for CAR's integrity and suggested the group's estimate was in the right ballpark. Susan Helper, an economist at Case Western University and a specialist on the automobile industry, told me her rough calculations suggest the most optimistic outcome would be "just" half a million jobs lost--and that's only if the failures are contained to GM. But she expects much worse, given the likely spillover effects: Her best estimate is that between 1.5 and two million jobs would be lost. The price of addressing such human misery with unemployment benefits, Medicaid, and other services would be huge, making a $25 billion loan seem like a bargain-particularly if the companies pay it back, just as Chrysler did after its bailout in the 1980s.

Still, not everybody finds such arithmetic compelling. Critics of a bailout note, rightly, that bankruptcy isn't simply about giving distressed companies financial protection to get through rough patches. It's also about letting the free market do its work--about forcing inefficient companies to reorganize or, failing that, to make way for others. If the government spares Detroit from failure, the government might end up supporting obsolete companies while rewarding both management and labor for their oafish behavior.

Make no mistake: The Big Three deserve some scorn. For decades, they were complacent about foreign competition and the need to make more fuel-efficient cars; then they responded by seeking government protection in the form of trade barriers and lax mileage standards. The United Auto Workers (UAW) were willing accomplices to these acts, insisting upon rigid work rules defining who could do what job and under what conditions. That, plus their fierce protection of jobs even at unprofitable plants, made it difficult for the Big Three to adapt as consumer desires changed. Detroit steadily lost business to companies like Honda and Toyota that managed to make cars more efficiently--and figured out, early on, that rising gas prices would increase?demand for more fuel-efficient vehicles.

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But what's missing in the tsk-tsk editorials is any recognition that the culture of Detroit has been changing, however belatedly, starting with its labor relations. Ford led the way years ago by reaching site-specific "competitive operating agreements" with locals at different plants, rather than sticking to one national agreement, thereby enabling it loosen work rules and engage in the sort of collaborative quality management on which industry leader Toyota made its reputation. Then, last year, the UAW reached a breakthrough agreement in which it granted the companies similar flexibility, agreed to a two-tier wage structure for new hires, and set up a separate trust fund to finance future retiree health benefits. The companies would provide the initial money for this trust, but, henceforth, the unions would manage it--thereby taking off the companies' books a tremendous burden that had, on its own, accounted for about half the gap in compensation between unionized workers for the Big Three and non-unionized workers for foreign-owned automakers. "I think they've shown unprecedented ability to change and transform the union," says Kristin Dziczek, who directs CAR's Automotive Labor and Education program. "They understand what is at stake."

So far, the results are promising. According to the most recent Harbour Report, the benchmark guide for manufacturing prowess, Chrysler's factories now match Toyota's for the most productive, while both Ford's and GM's are improving. (A Toledo Jeep factory was actually named the nation's most efficient.) Consumer Reports now says Ford's reliability is approaching that of perennial leaders Honda and Toyota, whose ratings actually slipped last year. In late 2010, GM will introduce the Chevrolet Volt, a plug-in hybrid that can go 40 miles without gas, and the Chevrolet Cruze, a compact that relies solely on gas but that gets 45 miles to the gallon. The Volt would represent a rare leap ahead of the Japanese, who never embraced plug-in technology with the same enthusiasm. It's also typical of the better cars that observers say Detroit has in store. "There's a lot of accumulated negativity about these companies out there," says Wharton's John Paul MacDuffie, who directs the International Motor Vehicle Program. "U.S. consumers gave the Big Three the benefit of the doubt for a long time before turning away from them, and now their reputation is worse than their actual performance and progress toward needed reforms."

MacDuffie would be the first to say the progress is incomplete. As proof that Detroit still has a lot to learn, he points to recent strategic mistakes like its overreliance on deep sticker-price discounts and large rebates, which dilute brand reputation and resale value. But Chapter 11 seems like a particularly poor way to fix these sorts of lingering problems. Bankruptcy is a messy, expensive process that would likely do more for lawyers than for the automaker, which has already taken the most obvious steps toward efficiency. "With the airlines, it was to get out of their labor contracts and to get out from under the underfunded pension positions they created," says Mark Oline, a highly regarded automotive analyst with Fitch Ratings. "But, in the case of GM and Ford, they have done a very good job with the UAW to address those problems of wages and benefits."

If anything, Chapter 11 might reinforce some of Detroit's worst habits--starting with its tendency to seek the lowest prices from parts suppliers, even if that means switching companies frequently and paying relatively little attention to part quality. Toyota is famous for taking the opposite approach: It eschews easy savings in order to maintain long-term relationships with suppliers; these relationships, in turn, allow Toyota and its suppliers to collaborate on design and quality. It's precisely the sort of production technique that the Big Three should be adopting. But, in a Chapter 11 filing, under pressure to improve the bottom line as fast as possible, they'd be unlikely to do that.

And that's assuming they even make it to Chapter 11. In the more likely event that GM had to shut down altogether under Chapter 7, as most experts I consulted predict, the company's institutional knowledge would end up on the proverbial shop floor. Among the casualties could be the Volt--and any near-term hopes of a marketable plug-in for the domestic auto industry. "Maybe those engineers get rehired, maybe not," says Case Western's Susan Helper. "But you lose those working relationships; you lose all the time invested. ... [People] don't really have a sense of the things that

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have to get put in motion, when you have ten-year planning horizons for new engines. When you disrupt that, it's very costly."

Those are among the reasons most analysts and economists, however reluctantly, have concluded that a better solution would be another government bailout--albeit one with lots of conditions attached. Those conditions would include limits on executive compensation, as in the Wall Street rescue, but also more specific requirements designed to push the Big Three toward greater innovation and fuel efficiency. The bailout might also require more concessions from the unions, perhaps over the relatively generous health benefits UAW workers enjoy. And it would?probably mean cleaning house in GM's executive suites. (Vice Chairman Bob Lutz, a notorious skeptic of climate-change theory, should be the first to go.)

It appears as if President-elect Obama and the Democratic leadership in Congress are thinking along those lines already (although it'll be surprising if they demand concessions from unions that just played such a big role in electing them). But, if the government demands that the Big Three and its workers live up to more obligations, the government--which is to say, the taxpaying public--must live up to some obligations of its own. Companies like Honda operate out of countries that made health and retirement benefits a national responsibility. And the perennially high price of gasoline, a product of high gas taxes in virtually all other highly developed countries, has ensured a steady market for their smaller, more fuel-efficient vehicles. There's no reason not to treat U.S. car companies, and car owners, the same way.

For now, that would mean government would assume some health and pension obligations (which it would have to do in a bankruptcy anyway, though its Pension Benefit Guaranty Corporation) while subsidizing the purchase of fuel-efficient cars (something it is already planning to do, thanks to recent tax changes). But the debate over a Detroit bailout should begin a larger political conversation, one that sprawls beyond the Midwest and the intellectual confines of lean production techniques and workers' legacy costs. Whatever mistakes the Big Three and the UAW have made, their struggles are a pretty good indicator of why the government--not employers--should be responsible for providing health insurance and why, without broader action to fight climate change, improving fuel efficiency will be a struggle. Naturally, the Big Three should enthusiastically promote these reforms, something they haven't done in the past.

Nothing can stop the revolution in auto-making and drivetrain technology; even under the best of circumstances, the Big Three need to become smaller, more efficient, and more environmentally conscious. But if the government manages that change and uses it as a springboard for discussion of broader economic reforms, everybody can benefit.

Jonathan Cohn is a senior editor of The New Republic.

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151BPaul Krugman November 17, 2008, 4:10 pm

122BFannie Freddie data Some readers have asked for data showing that Fannie and Freddie did not play a key role in the housing bubble. HMark ThomaH has a good picture, link Hhere H.

The two lines to track are the ones at the top. One shows the share of mortgages accounted for by S&Ls, the other the share accounted for by agency-backed pools — i.e., Fannie/Freddie mortgages. Fannie and Freddie did get very big in the 90s, basically filling the hole left by the S&Ls. But they pulled back sharply after 2003, just when housing really got crazy.

So who drove the bubble? The blue line, “asset-backed securities issuers.” Notice, by the way, that these were not depository institutions — and therefore not subject to the Community Reinvestment Act.

Once again, the whole Fannie/Freddie/liberal mandates story is phony.

November 16, 2008, 5:36 pm

123BFannie Freddie Phony So I was listening to Arnold Schwarzenegger before doing the This Weak round table, and he was mostly making sense — except for one thing. He asserted, as a simple matter of fact, that “government created the housing bubble”, because Fannie and Freddie made all these loans to people who couldn’t afford to pay them.

This is utterly false. Fannie/Freddie did some bad things, and did, it turns out, get to some extent into subprime. But thanks to the accounting scandals, they were actually withdrawing from the market during the height of the housing bubble — the vast majority of the loans now going bad came from the private sector.

Yet it’s now clear that the phony account of the crisis — that it’s all due to Fannie, Freddie, and nasty liberals forcing poor Angelo Mozilo to make loans to Those People — is setting in as Republican orthodoxy, part of what you have to believe to be a respectable member of the party. November 16, 2008, 5:08 pm

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75BEconomist's View 76BSeptember 25, 2008

124BOnce Again, It Wasn't Fannie and Freddie Russ Roberts:

Krugman gets the facts wrong, by Russell Roberts: Back in July, as Fannie and Freddie were starting to implode, Krugman concluded that Fannie and Freddie weren't part of the subprime crisis:

But here’s the thing: Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago, an explosion that dwarfed the S.& L. fiasco. In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble.

Partly that’s because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn’t do any subprime lending, because they can’t: the definition of a subprime loan is precisely a loan that doesn’t meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.

So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works.

His conclusion is quoted approvingly by HEconomist's View H, a couple of days ago.

Alas, Krugman has his facts wrong. As the Washington Post has reported:

In 2004, as regulators warned that subprime lenders were saddling borrowers with mortgages they could not afford, the HU.S. Department of Housing and Urban DevelopmentH helped fuel more of that risky lending.

Eager to put more low-income and minority families into their own homes, the agency required that two government-chartered mortgage finance firms purchase far more "affordable" loans made to these borrowers. HUD stuck with an outdated policy that allowed HFreddie MacH and HFannie MaeH to count billions of dollars they invested in subprime loans as a public good that would foster affordable housing.

Housing experts and some congressional leaders now view those decisions as mistakes that contributed to an escalation of subprime lending that is roiling the U.S. economy.

The agency neglected to examine whether borrowers could make the payments on the loans that Freddie and Fannie classified as affordable. From 2004 to 2006, the two purchased $434 billion in securities backed by subprime loans, creating a market for more such lending.

$434 billion isn't zero, and that's just from 2004 to 2006.

I'm a bit confused about the part pointing to this blog. I don't quote that passage. In fact, I don't quote that column. In fact, I don't even link that column myself - it's only linked within a post from Jim Hamilton that I echo, and that's a post disagreeing with Krugman. So, saying I "quoted approvingly" is not exactly accurate.

The title of the post was "It Wasn't Fannie and Freddie." The HpointH from Krugman I was referring to is (and yes, I do approve of it, and I'll explain why):

...I stand by my view that Fannie and Freddie aren’t the big story in this crisis.

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Fannie and Freddie did not cause the credit crisis and nothing in the article quoted by Cafe Hayek, or anything since the article came out last June changes that.

There are two questions that are being confused in the debate over the source of the financial crisis:

1. What caused Fannie and Freddie to fail?

2. What caused the financial crisis?

Answering the first question does not necessarily answer the second. Showing that some politician, some policy, some legislation, lack of effective regulation, whatever, caused Fannie and Freddie to fail is important, we need to know why they were vulnerable when the system got in trouble, but Fannie and Freddie did not cause the crisis, they were a consequence of it.

How do we know this?

Fannie and Freddie became fairly large players in the subprime market, and they got that way by following the rest of the market down in lowering lending standards, etc. But they did not lead it down. Their actions came in response to a significant loss of market share, and it is this loss of market share that motivated them to take on more subprime loans.

We need to understand why the overall market - the part outside of Fannie and Freddie's domain - was able to lower lending standards (and increase their risk exposure in other ways as well), and how regulation which had worked up to that point failed to keep Fannie and Freddie from dutifully responding to the market pressures on behalf of shareholders by duplicating the strategy themselves, but again, they were followers, not leaders.

HTantaH (via Heconbrowser H) describes the downward plunge of the GSEs:

Fannie and Freddie .... didn't like losing their market share, and they pushed the envelope on credit quality as far as they could inside the constraints of their charter: they got into "near prime" programs (Fannie's "Expanded Approval," Freddie's "A Minus") that, at the bottom tier, were hard to distinguish from regular old "subprime" except-- again-- that they were overwhelmingly fixed-rate "non-toxic" loan structures. They got into "documentation relief" in a big way through their automated underwriting systems, offering "low doc" loans that had a few key differences from the really wretched "stated" and "NINA" crap of the last several years, but occasionally the line between the two was rather thin. Again, though, whatever they bought in the low-doc world was overwhelmingly fixed rate (or at least longer-term hybrid amortizing ARMs), lower-LTV, and, of course, back in the day, of "conforming" loan balance, which kept the worst of the outright fraudulent loans out of the pile. Lots of people lied about their income (with or without collusion by their lender) in order to borrow $500,000 to buy an overpriced house in a bubble market. They weren't borrowing $500,000 from the GSEs.

HMichael CarlinerH continues, explaining how Fannie and Freddie took on the extra subprime debt:

Fannie and Freddie are ... subject to Hregulation by HUDH under mandates to serve low- and moderate income households and neighborhoods. As originators and investors with more energy than brains expanded their (subprime) lending to those borrowers and neighborhoods, it was difficult for Fannie and Freddie to increase their shares. They didn't want to buy or guarantee subprime loans, correctly perceiving them to be insanely risky. Instead they purchased securities created by subprime lenders, taking only the supposedly-safe tranches. Those portfolio purchases were counted toward their obligations to lend to lower-income home buyers, but are now part of the write-downs.

Until Republicans started trying to claim that Fannie and Freddie caused the financial meltdown as a means of tying Obama to the crisis - a strategy that backfired badly when all of the embarrassing connections to Fannie and Freddie within the McCain campaign were revealed - nobody was saying Fannie and Freddie caused the crisis. Republicans simply worked backwards - they found connections between Democrats and Fannie and Freddie (never thinking to ask about their own connections), then

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tried to blame the crisis on Fannie and Freddie so as to make people think it was the Democrat's fault. And it's still going on despite the fact that the data doesn't support this story.

There is no excuse for the actions of the management of Fannie and Freddie, and I'm not trying to defend them or their choices, but the idea that Fannie and Freddie caused the general credit crisis is wrong.

Richard Green is dismissive of the whole notion:

Charles Calomiris and Peter Wallison blame Fannie Mae for the Subprime Mess:

Hmmmm. The loan performance on Fannie's book of business is substantially better than the overall mortgage market. And starting in 2002, Fannie Freddie (pink line) lost market share to ABS (light blue line). [The data underlying the graph is from the Federal Reserve, Table 1173. Mortgage Debt Outstanding by Type of Property and Holder.]

It wasn't Fannie and Freddie.

[Update: Follow-up argument: HBarry Ritholtz: Fannie Mae and the Financial CrisisH, HWhat Caused the Financial Crisis? H. For a recent academic paper at odds with the claim, see: HIt Wasn't Fannie and FreddieH.]

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77BEconomist's View Mark Thoma Department of Economics University of Oregon

78BOctober 05, 2008

125BBarry Ritholtz: What Caused the Financial Crisis? Here's Barry Ritholtz' view on the cause of the financial crisis. HWe agreeH on a lot of points regarding the cause, though I call the lending standards issue an "agency problem," and we agree that a source of liquidity was needed to inflate the bubble, though we disagree a bit on the source. He has the Fed playing a larger role than I do (though I agree low interest rates contributed), I would cite the importance of international sources of liquidity as well:

HFannie Mae and the Financial Crisis, by Barry RitholtzH: The HSunday New York Times H has a very interesting article on Fannie Mae and the current financial crisis. They do a decent job at delving into the complexities of the GSEs, and the many factors that went into the decision making at the senior level of the company. This includes pressure from clients such as Coutrywide CEO Angelo Mozilla, pressure from Congress, and the demands from investors for the company to be more aggressive. Most of all, it looks at the ongoing competitive demands of the market place that Fanny was in.

The key to understanding the GSE story is grasping their role within the bigger picture of the economy and housing sector. While there are some pundits who prefer talking points over reality (HCharlies GasparinoH, HLawrence KudlowH, HJames PethoukoukisH, and HJeff Saut H all toed the GOP line) I prefer to keep all of my analyses based on the data and facts. Rather than creating historical revisions for partisan reasons, I prefer to keep it reality based. (I'm an independent, and that's how I roll).

The current housing and credit crises has many, many underlying sources. Its my opinion there were two primary causes leading to the boom and bust in Housing: A nonfeasant Fed, that ignored lending standards, and ultra-low rates.

This nonfeasance under Greenspan allowed banks, thrifts, and mortgage originators to engage in all manner of lending standard abrogations. We have detailed many times the I/O, 2/28, Piggy back, and Ninja type loans here. These never should have been permitted to proliferate the way they did.

The most significant element were the 2/28 APRs, and their put back provision. Just about all of these gave the securitizer/repackager the right to return the loans within 6 (or 12) months if they went into default. Hence, our HpropositionH that the 2002-07 period was unique in the history of finance. If any of these mortgages went bad within 6 months, the undewriter was on the hook.

HOW DIFFERENT WERE LENDING STANDARDS IF YOU ONLY NEED TO ENSURE THE BORROWER WOULDN'T DEFAULT FOR 6 MONTHS VERSUS FINDING BORROWERS WHO WOULDN'T DEFAULT FOR 30 YEARS.

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In a rising price environment, 99% of the mortgages were not returned by the securitizers to the originator. From 2001 to 2005, the mortgage firms thrived. However, once prices peaked and reversed, things changed. From 2006-08, Wal Street began putting back mortgages to originators in greater numbers. This led to nearly H300 mortgage firms imploding H.

We can blame the lenders, the securitizers, the borrowers, amd Fannie/Freddie, but it doesn't matter much.By the time Fannie and Freddie began changing their mortgage buying rules, the Housing boom was already in full gear, and the crash was all but inevitable.

[Update: Some people (especially the political hacks) are focusing their energies in the wrong places. According to a recent investigation by Barron's, Fannie's biggest problem was not the subprime mortgages they bought -- it was the better quality Alt A mortgages that caused their demise:

"As Freddie Mac Chairman and CEO Richard Syron recently put it, the GSEs have been hit by a "100-year storm" in the housing market, accentuated by some higher-risk mortgages that they were forced to buy to meet government affordable-housing targets.

The latter contention is more than disingenuous. A substantial portion of Fannie's and Freddie's credit losses comes from $337 billion and $237 billion, respectively, of Alt-A mortgages that the agencies imprudently bought or guaranteed in recent years to boost their market share. These are mortgages for which little or no attempt was made to verify the borrowers' income or net worth. The principal balances were much higher than those of mortgages typically made to low-income borrowers.

In short, Alt-A mortgages were a hallmark of real-estate speculation in the ex-urbs of Las Vegas or Los Angeles, not predatory lending to low-income folks in the inner cities."

Only pure partisans take as gospel the statements of an embattled CEO whose own words are belied by the firm's balance sheet and P&L statements.]

What about the ultra low rates? Consider that the Greenspan Fed maintained a 1.75% Fed fund for 33 months (December 2001 to September 2004), a 1.25% for 21 months (November 2002 to August 2004), and lastly, a 1% Fed funds rate for 12+ months, (June 2003 to June 2004). That was fuel for the fire, and fed the boom even more, sending prices skyward.

Update: And not just here . . . As the central bank for the largest economy in the world, the Fed's rate action had repercussions in Housing markets everywhere. Rate cuts here richocheted around the world, sending home prices upwards globally.

Note the circled area of detail is the chart above, in its historical context

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Fed Fund Rates, 1974-2008

Hhttp://bigpicture.typepad.com/photos/uncategorized/2008/10/05/19742008.gifH

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Fed Fund Rates, 2000-2008

Hhttp://bigpicture.typepad.com/comments/files/2000-08.gifH

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As to the credit crisis, it too, has many many proximate causes, but the two I focus upon as having the greatest impact was exempting CDOs from any sort of regulatory scrutiny (Commodities Futures Modernization Act of 2000) and the payola scandal of the rating agencies Moody's, Fitch, S&P slapping Triple AAA ratings on all manner of junk paper.

In order to fully understand the housing and credit crisis, one needs to understand a bit of history in the housing market. To that end consider this timeline: 1987 Federal Reserve cuts rates 1989 Housing Market peaks 1996 Prior purchases get to breakeven 1997 Housing Taxpayer Relief Act 1998 3 Rate Cuts 1995-2000 -- Big stock market gains 2001 Rate cuts from 6% down to 1.75% 2002 More rate cuts to 1.25% 2003 one final cut to 1%

Follow the timeline: Home sales and prices cycled up post '87 market crash -- they peaked in 1989, and for the next 7 years, they slid down to sideways. A 1989 house buyer did not get back to break even until 1996/97. (See chart above)

A few other factors impacted housing: In 1997, the Taxpayer Relief Act that dropped capital gains to 20% from 28%, and also exempted the first $500,000 for married couples selling house (allowable once every two years).

Around that time, the stock market boom and tech dot com bubble was in full throat. That put A LOT of money in people's hands in 1997, 98, 99 and Q1 of 2000. In the late 1990s, I had many discussions with clients, real estate agents and traders about the equities into house rotation: Take some equity profits off the table and then trade up in real estate. Consider these S&P500 gains in the markets: 1995=34%, '96=20%, '97=31%, '98=27%, and from Oct '99 to March 2000, the Nasdaq was up 100%.

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The folks who want to place the entire crisis at FNM/FRE 's doorstep miss the point -- and let me hasten to add that I was never a fan of the company, and Hwe were short FNM from over a year agoH, at $42+ -- these people seem to miss all of the big picture issues, and are focusing on minor factor and outright irrelevancies. This was not a "social engineering" experiment, as the radical right has called it. This was extreme short sightedness.

Fannie Mae was not a government entity, they were an independent, publicly traded, private sector firm. They were allowed to borrow at better rates than banks as a GSE. They bought what they did in an attempt top grab share and profits. If they came under pressure from Congress -- or Angelo Mozilla, or hedge fund investors -- it was because they were trying to capture market share and profits and maintain an advantageous position in the marketplace.

Consider:

"The chief executive of the mortgage giant Freddie Mac rejected internal warnings that could have protected the company from some of the financial crises now engulfing it, according to more than two dozen current and former high-ranking executives and others.

That chief executive, Richard F. Syron, in 2004 received a memo from Freddie Mac’s chief risk officer warning him that the firm was financing questionable loans that threatened its financial health.

Now consider the key points from the NYT article today:

• Company was in disarray after an accounting scandal;

• New CEO came on board in 2004;

• Competitors were "snatching lucrative parts" and market share away;

• Between 2001-04, the subprime mortgage market grew from $160 to $540 billion

• Between 2005-08, Fannie purchased or guaranteed at least $270 billion in loans to risky borrowers.

• By 2004, Fannie had lost 56% of its loan-reselling business to Wall Street;

• Angelo Mozilo, Countrywide Financial CEO, the nation’s largest mortgage lender, threatened to end their partnership unless Fannie started buying Countrywide’s riskier loans;

• Congress was pressuring for more loans to low-income borrowers;

• Hedge fund managers and other investors pressured Fannie executives that the company was not taking enough risk in pursuing profits;

• Like many other firms, Fannie’s computer systems did a poor job of analyzing risky loans;

• Between 2005-07 -- after the market's peak -- Fannie's acquisitions of mortgages with less than 10% down payments almost tripled;

• Fannie expanded in hot real estate areas like California and Florida;

• From 2004-06, Fannie operated without a permanent chief risk officer;

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As I have said repeatedly, Fannie and Freddie were cogs in the great housing machinery, and they bear some responsibility for the current debacle. But to argue they were the most significant factor misses the true tale of the Housing and credit debacle.

Fannie has been around since 1938, Freddie since 1968, the CRA has been around since 1977 -- suddenly, all of housing goes to hell in 2005, and then credit collapses 2 years after -- and the best explanation some people can come up with is Fannie, Freddie and CRA? Gee, isn't that rather odd -- especially after 70 years?

Update: Then there is the international issue: If Fannie and Freddie and the 1977 CRA are to blame for the US boom and bust, how did the rest of the world end up with a housing boom too? Why did prices and sales go skyward in the UK, France, Spain, Ireland, Australia, etc.? They had no CRA, or a Fannie Mae, or a Freddie Mac, -- so then what caused their housing boom?

The short answer: Ultra low rates, securitization, and perhaps some of our homegrown, innovative lending standards.

While I understand that reducing the complexities of economic history into bumper sticker phrases is politically expedient, it does not help us understand the root cause of the problems. And, it gets in the way of helping us fashion a solution for the future. Hence, why I hold the weasels who are attempting to obscure reality and rewrite history in such disdain.

Update: For the non-partisan, non hacks amongst you, for the policy makers and academics and economists who are truly interested in how this came to pass, and what we can do to fix it, the bottom line remains: The CRA was irrelevant to the current crisis, and Fannie Mae and Freddie Mac are mere cogs in a complex machine.

But the primary cause of the mess? Not even close . . .

Previously:

How Washington Failed to Rein In Fannie, Freddie (September 14, 2008) Hhttp://bigpicture.typepad.com/comments/2008/09/how-washington.html

Freddie's Risk Officer: CEO Ignored Warning Signs (August 05, 2008) Hhttp://bigpicture.typepad.com/comments/2008/08/freddies-risk-o.html His Name is Mudd (August 20, 2008) Hhttp://bigpicture.typepad.com/comments/2008/08/perilous-pursui.html Fannie Mae Looks Like Hell (November 16, 2007) Hhttp://bigpicture.typepad.com/comments/2007/11/fannie-mae-look.htmlH Sources: Pressured to Take More Risk, Fannie Hit a Tipping Point CHARLES DUHIGG NYT, October 5, 2008 Hhttp://www.nytimes.com/2008/10/05/business/05fannie.htmlH At Freddie Mac, Chief Discarded Warning Signs CHARLES DUHIGG NYT, August 5, 2008 Hhttp://www.nytimes.com/2008/08/05/business/05freddie.htmlH

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79BEconomist's View Mark Thoma Department of Economics University of Oregon 80BOctober 01, 2008

126BIt Wasn't Fannie and Freddie More evidence:

HColeman, Lacour-Little and Vandell argue that house prices made sense until 2004, by Richard GreenH: HThe abstract of their new paper:

The cause of the "housing bubble" associated with the sharp rise and then drop in home prices over the period 1998-2008 has been the focus of significant policy and research attention. The dramatic increase in subprime lending during this period has been broadly blamed for these market dynamics. In this paper we empirically investigate the validity of this hypothesis vs. several other alternative explanations. A model of house price dynamics over the period 1998-2006 is specified and estimated using a cross-sectional time-series data base across 20 metropolitan areas over the period 1998-2006. Results suggest that prior to early 2004, economic fundamentals provide the primary explanation for house price dynamics. Subprime credit activity does not seem to have had much impact on subsequent house price returns at any time during the observation period, although there is strong evidence of a price-boosting effect by investor loans. However, we do find strong evidence that a credit regime shift took place in late 2003, as the GSE's were displaced in the market by private issuers of new mortgage products. Market fundamentals became insignificant in affecting house price returns, and the price-momentum conditions characteristic of a "bubble" were created. Thus, rather than causing the run-up in house prices, the subprime market may well have been a joint product, along with house price increases, (i.e., the "tail") of the changing institutional, political, and regulatory environment characteristic of the period after late 2003 (the "dog").

This result is hardly consistent with the charge that the GSEs were the principal source of the problem. It also says something about having a purely private mortgage market.

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Opinion

81BAdministrative Virtues: The Case of Larry Summers 82BBy Stanley Fish 83BNovember 16, 2008, 10:00 pm Now that the election has been decided, pundits and commentators, desperate to have something to talk about, have been obsessing about the formation of President-elect Obama’s cabinet. In recent days much of the speculation has centered on Larry Summers, who served as Secretary of the Treasury in Bill Clinton’s second term and who is, we are told, a candidate for an encore.

The discussions of Summers I have seen display a pattern. Mention is made of his stormy tenure as the president of Harvard, but the topic and its relevance are quickly dismissed with a few off-hand references to egomaniacal and over-sensitive professors (certainly a breed that exists) and the lingering bad effects of political correctness. Summers is said to have gotten into trouble just because he was being provocative and, after all, isn’t that what should be going on in a university?

The question fails to distinguish between what is appropriate to the role of a faculty member and what is appropriate to senior administrators. Yes, it is expected that professors will be raising questions that challenge received wisdom. Professors get high marks when what they say disturbs the complacency of their students or their peers. But administrators don’t get high marks when the constituencies they engage with -– faculty, donors, trustees, legislators, potential hires -– are upset or even repelled by something they say.

It doesn’t matter what the something is. It is not the content of the remarks that is at issue; what matters is that if, in making them, the administrator generates a form of publicity that detracts from the university’s public image. It was perfectly O.K. for Summers to be concerned that even high-profile faculty members fulfill their pedagogical and research responsibilities. It was not O.K. -– it was clumsy and ham-fisted -– to call Cornel West on the carpet and interrogate him in a way that led West to go to the press, which then broadcast a story that then led to a public melodrama (complete with protests, campaigns, threatened resignations and divisions among the faculty) that ended with West going to Princeton and taking with him the superstar philosopher Kwame Anthony Appiah.

In the course of this spectacle, Summers became a hero to The Wall Street Journal, the Weekly Standard, The New Republic (in the person of Leon Wieseltier) and the enemies of French theory and multiculturalism. But these were not the interests to which he was responsible as an administrator and pleasing them did nothing for the university he led.

And later when Summers speculated (at a conference) on the possibility that the under-representation of women in the sciences might have a genetic basis, the speculation itself (perfectly respectable as an academic topic) was not the problem.

The problem was that it was offered by the president of Harvard and therefore seemed to bear Harvard’s imprimatur. Had a faculty member said the same thing (to be sure,

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Summers himself was a faculty member, but that identity was overridden by his administrative identity as long as he was in office), it might have rubbed some in the audience the wrong way, but it wouldn’t have been news, and it certainly would not have been the kind of news that caused many women scientists to say (before they were asked) that they would never set foot in Harvard Square.

I take no position on the substantive issues raised by Summers’s interventions. I’m not saying that his criticism of West was justified or unjustified, or that his speculations about women and science were right or wrong. I’m just saying that his interventions were performed with insufficient sensitivity to the effect they might have on the discharge of his presidential duties.

Those who defended him said that he was performing a service by shaking things up in an institution that had grown complacent. But while shaking things up might well be a good thing for a new university president to do, he should do it diplomatically, behind the scenes, through surrogates and in ways that disguise his footprint. Plain speaking may be a virtue in some communicative contexts (although not in as many as is sometimes thought), but more often than not a plain-speaking university president is simply setting himself and his university up as a target, and if the university is Harvard, the target is likely to prove irresistible, as it did in this case.

The myth persists that Summers was forced to resign because he said things that offended lefties and feminists on the campus and in the greater world. No, he was forced to resign because the things he said had the effect of making the university into the object of an unflattering attention. Controversy may be what fuels the academic enterprise, but controversy is what a university administrator should try to avoid, and certainly should not court.

What has all this to do with Larry Summers as a potential Secretary of the Treasury in the Obama administration? It depends on how much of the job involves what are usually called “people skills,” the skills that bring men and women of diverse views together in a spirit of optimism and co-operation (two words Obama has often invoked). A cabinet secretary must interact with other secretaries, with the White House staff, with the vice president, with congressional committees, with leaders of industry, with the representatives of other sovereign states and with the media.

It is not a question of intelligence and competence -– everyone agrees that Summers is very smart and very accomplished as an economist; it is a question of tact, patience, poise, self-restraint, deference, courtesy and other interpersonal virtues. Little that he did as president of Harvard suggests that Summers possesses these virtues. It may be that their absence would be less of a liability in a political setting than it was in an academic setting, but that is an argument that has not yet been made and I have doubts that it could be

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Obama Has a Chance to Reverse Long Erosion of the Federal Service By Paul C. Light Special to The Washington Post Wednesday, November 19, 2008; A19 As HThe Washington PostH reported this week, President-elect HBarack ObamaH wrote HAmerican Federation of Government EmployeesH in October promising that he would do everything in his power to rebuild the federal service. He also promised to protect collective bargaining rights and to restore funding cuts that have eviscerated the federal government's ability to faithfully execute the laws. The past eight years have been a horror to many federal employees. The Bush administration has rarely missed an opportunity to criticize, cut and meddle, and it dismissed the notion that federal employees need more freedom to innovate and learn. As former vice president HAl GoreH rightly argued, federal employees are not the problem in poor performance. It is the bureaucracy in which they are trapped.

The Bush administration, however, decided that the best way to reform government was to outsource it. From 2001 to 2005, civilian employment remained at 1.8 million, more or less, while the estimated number of contractor jobs surged from 4.4 million to 7.6 million. Contractors are now responsible for tasks that include writing requests for proposals, monitoring contract performance and providing management analysis. Contractors are also front and center in disbursing the $700 billion bailout, in no small measure because the Bush administration made no effort to strengthen the government's core capacity to monitor the complicated instruments that caused the financial meltdown. The impact of the criticism and outsourcing are unmistakable in survey after survey of federal employees. Morale is down, while complaints about the lack of resources are up. Most federal employees rate their middle- and upper-level managers as mediocre at best and not improving. The frustration cuts across every agency. The vast majority of federal employees want to make a difference for their communities and country but report shortages in virtually every resource needed to succeed, not the least of which is enough employees to enforce the laws. Obama has a chance to reverse the long erosion of the federal service. His campaign letters are a start but must be expanded in three ways.

First, Obama should speak directly to all 1.8 million federal employees about the need for action. HGeorge W. BushH mostly ignored the federal service. He made dozens of speeches to uniformed officers involved in the war on terrorism but never asked for sacrifice from federal employees as a whole. Interviewed in 2002, 65 percent of HDefense Department H civil servants said they felt a new sense of urgency after Sept. 11, 2001, while 35 percent of their colleagues in the domestic departments agreed.

Second, Obama should cut the number of political appointments at the top of government. He has promised to cut middle managers but needs to remember that between a quarter and two-fifths of the stultifying management layers in

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government are occupied by political appointees, including more than 2,000 that he will appoint without Senate confirmation. There are plenty of career senior executives who could fill these positions. Doing so would signal that bloat is bloat, even at the top of government.

Third, Obama should ask Congress for authority to hire at least 100,000 front-line servants for beleaguered agencies that no longer have enough staff to handle their responsibilities. The HFood and Drug AdministrationH needs enough inspectors to intercept counterfeit drugs and tainted produce; the HSocial Security AdministrationH needs enough representatives to handle the surge in disability claims; the HInternal Revenue ServiceH needs enough agents to collect more than $300 billion in delinquent taxes. And they are hardly alone. Name a front-line agency -- such as the Veterans Benefits Administration -- and the shortages are palpable. They need new employees and fast.

Obama could write his speech by merely cribbing from HGeorge H.W. BushH, who met with senior executives immediately after his inauguration in 1989. The first president Bush considered himself a product of the federal service, and he made every effort to engage the federal service in his agenda. He took tough stands in favor of civil service reform but never framed his plans as an attack on the bureaucrats in Washington, which is how his son talked about pay for performance. The sooner Obama calls on the federal service for commitment, the sooner they will respond. At a minimum, he should tell his to-be-named director of presidential personnel to cut the number of lower-level political appointees in half and should add the 100,000 front-line jobs to his stimulus package.

Paul C. Light is a professor at New York University's Robert F. Wagner School of Public Service and author of "A Government Ill Executed." He is writing an occasional column on the transition for The Washington Post.

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127BPaul Krugman November 15, 2008, 6:08 pm

128BBrad Setser is scaring me Brad’s blog is the go-to place for all balance-of-payments-related data analysis. Now he has a post up about HUS exportsH. Why is this important? Exports have been the one good thing about the US economic situation; in fact, the reason the economy didn’t fall off a cliff immediately when the housing bubble burst was that, for a while, export growth took up the slack.

But Brad says that the export boom is over — in fact, it now looks like an export slump. Like he says, ut-oh.

November 15, 2008, 8:00 am

84BUt-oh …. exports are starting to fall fast Posted on Thursday, November 13th, 2008

By bsetser For the US trade deficit to fall (setting the effect of falling oil prices aside), exports have to grow faster than imports — or imports have to fall faster than exports.

If exports fall faster than imports, the deficit will stay large.

In September, the headline deficit fell because the petrol deficit fell. The petrol deficit has gone from $43 billion In July to $35.6b in August and $32.1b in September as the average price of imported oil fell from $125 a barrel to $108 a barrel. That alone generated a $10 billion improvement in the trade balance — and there is more good news to come. Especially if the US continues to import 5% less oil even after the prices come down.

But the non-petrol goods deficit is now moving in the wrong direction. It increased from $29.3b in June to $35.6b in August. Non-petrol exports fell by $9.9b over the last two months, while non-petrol imports fell by “only” $3.7 billion. The sharp fall in exports shows up clearly in a chart showing “real” non-petrol goods exports and imports. Real data tries to show what is happening if changes in price are taken out of the equation — it is meant to measure the actual quantity of stuff that is traded.

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The fall in real goods exports has been steep enough to push the real non-petrol trade deficit back up.

And remember this is the September data. Since then the global outlook has deteriorated — and the dollar has strengthened substantially. That isn’t going to help US exports. The main reason why the US should support more emergency lending to the worlds’ emerging economies is pure self-interest: if their currencies continue to fall, the US isn’t going to be able to rely on exports to help it get out its own domestic troubles.

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There is one small bit of hope. The monthly data jumps around a lot. Two months do not a trend make — though in this case, the falloff in exports is almost certainly directionally right. But the pace of the fall could reflect some month-to-month noise. Civil aircraft exports fell from $5.5b in August to $2.2b in September (Boeing strike?). So long as the Gulf and India and China don’t cancel their Boeing orders, civil aircraft exports shouldn’t fall by quite that much. Average monthly aircraft exports this year have been around $4b.

Two other things to watch:

One, will US exports to Latin America hold up. Y/y growth for the first three quarters of 2008 was 37% …

Two, what will happen to the US deficit with China. Y/y exports are up $17% while imports are only up 7%. But given the gap between what the US imports from China and what it exports to China, that works out to $16b in new imports and a little over $8b in new exports, so the bilateral deficit is still growing. However, if both import and export growth turn down, the fact that the US doesn’t sell much to China (absolutely) would start to work in the United States favor.

Or to put it differently, a fall in US demand hurts China more than a fall in Chinese demand hurts the US.

At least directly. Watch out for the rebound. Falling Chinese demand for Brazilian iron ore and soybeans could mean less Brazilian demand for US manufactured goods …

Thanks to Arpana Pandey for help on the graphs.

November 13th, 2008 at 2:56 pm Howard Richman responds:

Brad,

This is exactly what I have been predicting in my comments on your blog. For example on October 27, in response to your piece, “The Soaring Yen,” I wrote:

“There is no reason to expect that the U.S. trade deficit will fall during the worldwide depression, given that Central Banks around the world will be buying dollars with their currencies and lend them to the United States so that they can steal market share from the United States in the diminishing global markets. This will cause American exports to fall sufficiently to prevent the movement toward trade balance that you expect.”

By the way, I also predicted the worldwide depression and explained its cause both here on this blog on October 6 ( Hhttp://blogs.cfr.org/setser/2008/10/06/the-damage-spreads/H ) and in my own blog on October 7 ( Hhttp://tradeandtaxes.blogspot.com/2008/10/worldwide-depression-started-this-week.htmlH ).

In a commentary with my father and son, I also proposed a solution (Waren Buffett’s Import Certificates to balance trade) which would get the U.S. out of the worldwide depression ( Hhttp://www.enterstageright.com/archive/articles/1008/1008buffet.htmH ).

Import Certificates (ICs) would save Detroit, as well as the rest of the American manufacturing sector, without requiring government bailouts. American exporters would get ICs whenever they sold products abroad. Importers would have to buy ICs from American exporters in order to sell foreign products in the United States. Detroit vehicles would be profitable when sold abroad and would be profitable when sold in the United States.

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161BDebt Man Walking Economists know the fatal flaw in our system--but they can't agree how to fix it. John B. Judis, The New Republic Published: Wednesday, December 03, 2008 For those Americans who are not daily readers of the Financial Times, the past few months have been a crash course in the abstract and obscure instruments and arrangements that have derailed the nation's economy. From mortgage-backed securities to credit default swaps, the financial health of the country has undergone a gory public dissection. And yet, as Barack Obama prepares to take office, one particularly frightening problem has escaped public notice; indeed, it may not even make the agenda of the global summit being held this weekend, dubbed "Bretton Woods II" after the postwar system of currency controls. The international monetary system is in big trouble. For decades, the United States has relied on a tortuous financial arrangement that knits together its economy with those of China and Japan. This informal system has allowed Asian countries to run huge export surpluses with the United States, while allowing the United States to run huge budget deficits without having to raise interest rates or taxes, and to run huge trade deficits without abruptly depreciating its currency. I couldn't find a single instance of Obama discussing this issue, but it has been an obsession of bankers, international economists, and high officials like Federal Reserve Chairman Ben Bernanke. They think this informal system contributed to today's financial crisis. Worse, they fear that its breakdown could turn the looming downturn into something resembling the global depression of the 1930s. The original Bretton Woods system dates from a conference at a New Hampshire resort hotel in July 1944. Leading British and American economists blamed the Great Depression and, to some extent, World War II on the breakup of the international monetary system in the early 1930s and were determined to create a more stable arrangement in which the dollar would replace the British pound as the accepted global currency. The new system, devised by economists Harry Dexter White and John Maynard Keynes, fixed the dollar's value at $35 for an ounce of gold. National governments, rather than speculators, were to set the value of their currencies in relation to the dollar and would have to disclose any changes in advance to the new International Monetary Fund (IMF). The dollar became the accepted medium of international exchange and a universal reserve currency. If countries accumulated more dollars than they could possibly use, they could always exchange them with the United States for gold. But, with the United States consistently running a large trade surplus--meaning that countries always needed to have dollars on hand to buy American goods--there was initially little danger of a run on the U.S. gold depository.

TNRtv: Judis discusses "Debt Man Walking" Bretton Woods began to totter during the Vietnam war, when the United States was sending billions of dollars abroad to finance the war and running a trade deficit while deficit spending at home sparked inflation in an overheated economy. Countries began

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trying to swap overvalued dollars for deutschmarks, and France and Britain prepared to cash in their excess dollars at Fort Knox. In response, President Richard Nixon first closed the gold window and then demanded that Western Europe and Japan agree to new exchange rates, whereby the dollar would be worth less gold, and the yen and the deutschmark would be worth more relative to the dollar. That would make U.S. exports cheaper and Japanese and West German imports more expensive, easing the trade imbalance and stabilizing the dollar. By imposing a temporary tariff, Nixon succeeded in forcing these countries to revalue, but not in creating a new system of stable exchange rates. Instead, the values of the currencies began to fluctuate. And, as inflation soared in the late 1970s, the system, which still relied on the dollar as the universal currency, seemed ready to explode into feuding currencies. That's when a new monetary arrangement began to emerge. Economists often refer to it as "Bretton Woods II"--not to be confused with the name given this weekend's gathering--but it was not the result of a conference or concerted agreement among the world's major economic powers. Instead, it evolved out of a set of individual decisions--first by the United States, Japan, and Saudi Arabia, and later by the United States and other Asian countries, notably China. Bretton Woods II took shape during Ronald Reagan's first term. To combat inflation, Paul Volcker, the chairman of the Federal Reserve, jacked interest rates above 20 percent. That precipitated a steep recession--unemployment exceeded 10 percent in the fall of 1982--and large budget deficits as government expenditures grew faster than tax revenues. The value of the dollar also rose as other countries took advantage of high U.S. interest rates. That jeopardized U.S. exports, and the U.S. trade deficit grew even larger, as Americans began importing underpriced goods from abroad while foreigners shied away from newly expensive U.S. products. The Reagan administration faced a no- win situation: Try reducing the trade deficit by reducing the budget deficit, and you'd stifle growth; but try stimulating the economy by increasing the deficit, and you'd have to keep interest rates high in order to sell an adequate amount of Treasury debt, which would also stifle growth. At that point, Japan, along with Saudi Arabia and other opec nations, came to the rescue. At the end of World War II, Japan had adopted a strategy of economic growth that sacrificed domestic consumption in order to accumulate surpluses that it could invest in export industries--initially labor-intensive industries like textiles, but later capital-intensive industries like automobiles and steel. This export-led approach was helped in the 1960s by an undervalued yen, but, after the collapse of Bretton Woods, Japan was threatened by a cheaper dollar. To keep exports high, Japan intentionally held down the yen's value by carefully controlling the disposition of the dollars it reaped from its trade surplus with the United States. Instead of using these to purchase goods or to invest in the Japanese economy or to exchange for yen, it began to recycle them back to the United States by purchasing companies, real estate, and, above all, Treasury debt. That investment in Treasury bills, bonds, and notes--coupled with similar purchases by the Saudis and other oil producers, who needed to park their petrodollars somewhere--freed the United States from its economic quandary. With Japan's purchases, the United States would not have to keep interest rates high in order to attract buyers to Treasury securities, and it wouldn't have to raise taxes in order to reduce the deficit. As far as historians know, Japanese and American leaders never explicitly agreed that Tokyo would finance the U.S. deficit or that Washington would allow Japan to maintain an undervalued yen and a large trade surplus. But the informal bargain--described brilliantly

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in R. Taggart Murphy's The Weight of the Yen--became the cornerstone of a new international economic arrangement. Over the last 20 years, the basic structure of Bretton Woods II has endured, but new players have entered the game. As Financial Times columnist Martin Wolf recounts in his new book, Fixing Global Finance, Asian countries, led by China, adopted a version of Japan's strategy for export-led growth in the mid-'90s after the financial crises that wracked the continent. They maintained trade surpluses with the United States; and, instead of exchanging their dollars for their own currencies or investing them internally, they, like the Japanese, recycled them into T-bills and other dollar-denominated assets. This kept the value of their currencies low in relation to the dollar and perpetuated the trade surplus by which they acquired the dollars in the first place. By June 2008, China held more than $500 billion in U.S. Treasury debt, second only to Japan. East Asia'scentral banks had become the post-Bretton Woods equivalent of Fort Knox. Until recently, there have been clear upsides to this bargain for the United States: the avoidance of tax increases, growing wealth at the top of the income ladder, and preservation of the dollar as the international currency. Without Bretton Woods II, it is difficult to imagine the United States being able to wage wars in Iraq and Afghanistan while simultaneously cutting taxes. For their part, China and other Asian countries enjoyed almost a decade free of financial crises; and the world economy benefited from low transaction costs and relative price stability from having a single currency that countries could use to buy and sell goods. But there have been downsides to Bretton Woods II. Often noted was how the accumulation of dollars in foreign hands--particularly those of a potential adversary like China--threatens America's freedom of action. A hostile nation could blackmail the United States by threatening to cash in its dollars. Of course, if a nation like China actually began to unload its dollars, it would jeopardize its own financial standing as much as it would jeopardize America's. But economists Brad Setser and Nouriel Roubini argue that even the implicit threat of dumping dollars--or of ceasing to purchase them--could limit U.S. maneuverability abroad. "The ability to send a 'sell' order that roils markets may not give China a veto over U.S. foreign policy, but it surely does increase the cost of any U.S. policy that China opposes," they write. To date, however, that strategic impact has been chiefly theoretical. The more tangible drawbacks of Bretton Woods II have been social and economic. Bretton Woods II has perpetuated the U.S. trade deficit, particularly in manufactured goods. Forced to compete against foreign products kept cheap not only by low wages abroad but by the dollar's high value, U.S. manufacturers have had little incentive to expand or even retain their operations in the United States. Since the early '80s, the United States has lost about five million manufacturing jobs. True, the United States has gained some highly skilled manufacturing jobs, but most of the lost jobs have been replaced by low- wage service sector employment. This has been a factor in creating a U.S. workforce with an overpaid financial sector at one extreme and a sprawling low- wage service sector at the other. In Japan, China, and other Asian countries, there has been a similar downside to the grand bargain. The surplus dollars gained from trade with the United States have not been used to raise the standard of living, but rather have been squirreled away in Treasury securities--"sterilized" is the technical term. Writes Wolf, "China has about 800 million poor people, yet the country now consumes less than half of GDP and exports capital to the rest of the world. " In an odd way, the contrast between the concentration of new wealth in China's coastal cities and the grating poverty of its countryside has mirrored the contrast between the lavish lifestyle of the Wall Street wizard and the plight

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of immigrant and illegal-immigrant workers in America's barrios. Of more immediate concern, Bretton Woods II contributed to the current financial crisis by facilitating the low interest rates that fueled the housing bubble. Here's how it happened: In 2001, the United States suffered a mild recession largely as a result of overcapacity in the telecom and computer industries. The recession would have been much more severe, but, because foreigners were willing to buy Treasury debt, the Bush administration was able to cut taxes and increase spending even as the Federal Reserve lowered interest rates to 1 percent. The economy barely recovered over the next four years. Businesses, still worried about overcapacity, remained reluctant to invest. Instead, they paid down debt, purchased their own stock, and held cash. Banks and other financial institutions, wary of the stock market since the dot-com bubble burst, invested in mortgage-backed securities and other derivatives. The anemic economic recovery was driven by growth in consumer spending. Real wages actually fell, but consumers increasingly went into debt, spending more than they earned. Encouraged by low interest rates--along with the new subprime deals--consumers bought houses, driving up their prices. The "wealth effect" created by these housing purchases further sustained consumer demand and led to a housing bubble. When housing prices began to fall, the bubble burst, and consumer demand and corporate investment ground to a halt. The financial panic quickly spread not only from mortgage-backed securities to other kinds of derivatives but also from the United States to other countries, chiefly in Europe, that had purchased these American financial products. And that's not all. As American demand for Chinese exports has stopped growing, China's economy has begun to suffer. Roubini has argued that, if China's export-dependent growth drops from 12 percent to 5 or 6 percent per year, China will be unable to provide jobs to the 24 million new workers that join the labor force each year. China would experience the equivalent of a recession, with repercussions throughout Asia. More importantly for the United States, China would no longer have the surplus dollars to prop up the market for U.S. Treasury bills. The Obama administration could, of course, reduce its dependence on China by reducing the budget deficit, but doing that now would deepen the recession, as well as preventing the new president from pursuing many of his domestic initiatives. The consequences could be even more dire. In the past, countries in recession could count on countries with growing economies to provide outlets for their exports and investments. The hope this time is that economic growth in Asia and particularly China can backstop a U.S. and European recession. But, as a result of Bretton Woods II, prosperity in the United States is intertwined with prosperity in Asia. China depends on exports to the United States, and the United States depends on capital from China. If that special economic relationship breaks down, as it seems to be doing, it could lead to a global recession that could morph into the first depression since the 1930s. Economists and Treasury officials might dispute specific parts of this analysis, but the bulk of it is neither original nor controversial. For the last three years, if not longer, Bernanke, former Treasury secretary Larry Summers, Roubini, Setser, Wolf, and other economists have been making similar points. Their concerns did not penetrate the presidential campaign, but the Obama administration will have to address the breakdown of Bretton Woods II in January, if not earlier. Wrote Summers this August, "The next administration faces the prospect of having to make the most consequential international economic policy choices in a generation at a time when the confidence of governments in free markets is being increasingly questioned."

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In making these choices, policymakers have to recognize that, while Bretton Woods II is not the product of an international agreement, it is not a "free market" system that relies on floating currencies, either. Rather, it is sustained by specific national policies. The United States has acquiesced in large trade deficits--and their effect on the U.S. workforce--in exchange for foreign funding of our budget deficits. And Asia has accepted a lower standard of living in exchange for export-led growth and a lower risk of currency crises. Some of the policies that Obama championed during the presidential campaign can help move us to a new system--as long as they are not seen merely as temporary palliatives to get the United States out of a recession. These steps include public investments that would make U.S. industries more competitive; subsidies under strict conditions to U.S. automobile manufacturers; and the encouragement of new "green" industries. (By contrast, Obama's principal proposal--a tax cut for the middle class--would not necessarily improve America's economic standing.) But China, Japan, and other Asian countries--either on their own or with prodding from the new administration--will also have to play a part. Indeed, China may have already begun to do so by announcing a $586 billion stimulus plan of public investment in housing, transportation, and infrastructure. If China plows its trade surplus back into its domestic economy, it will increase demand for imports and put upward pressure on the yuan, reducing China's trade surplus with the West. This kind of adjustment--in which the United States commits itself to reducing its trade deficit and China, Japan, and other Asian countries abandon their strategy of export-led growth--is what many American policymakers favor. But there is also growing sentiment, particularly in Europe, that beyond these measures, the world's leading economies have to agree on a new international monetary system--or at least dramatically reform the existing one. British Prime Minister Gordon Brown has explicitly called for a "new Bretton Woods--building a new international financial architecture for the years ahead." Brown would strengthen the IMF so it functions as "an early warning system and a crisis prevention mechanism for the whole world." He would also have it or a new organization monitor cross-border financial transactions. French President Nicolas Sarkozy would go further, replacing the dollar as the single international currency. "The time when we had a single currency, one line to be followed, that era is over," he declares. Brown's proposals for regulatory reform make sense and are likely to be considered in the new Obama administration, but Sarkozy's are premature. The dollar isn't going anywhere in the short term. The euro has little presence in Asia; and the Chinese don't want the yen to dominate Asia, let alone the world. The current crisis has, if anything, strengthened the dollar as the least untrustworthy of global currencies. But adjustments to the dollar's role are certainly needed. The era of the dollar may not be over, but the special conditions under which it reigned during the last decades are being dashed on the rocks of the current recession and financial crisis. In the worst case, the system could descend into chaos, as it did in the 1930s. More likely a new Bretton Woods (call it "III") will emerge, but the question will be whether it does so willy-nilly, as its predecessor did, and invite repeated crises, or whether, like the original Bretton Woods, it will be the product of deliberate agreement and lay the basis for stable growth. Which it is will depend a good deal on the choices the new Obama administration makes.

John B. Judis is a senior editor at The New Republic.

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Paul Krugman

129BMacro policy in a liquidity trap (wonkish) 130BNovember 15, 2008, 8:00 am That’s the title of a new report from Jan Hatzius et al at Goldman Sachs (not available online). The Goldman guys, like me, come up with scary figures about the size of the gap in demand that needs to be filled — figures that suggest the need for a fiscal stimulus that’s enormous by historical standards. Their appUroachU is different, and probably better than mine; I’ll get to that in a bit. But I want to talk conceptual stuff for a moment.

It’s a curious thing that even now, when we are clearly in a liquidity trap, we still have a lot of economists denying that such a thing is possible. The argument seems to go like this: creating inflation is easy — birds do it, bees do it, Zimbabwe does it. So it can’t really be a problem for competent countries like Japan or the United States.

This misses a key point that I and others tried to make for Japan in the 90s and are trying to make again now: creating inflation is easy if you’re an irresponsible country. It may not be easy at all if you aren’t. A decade ago, when I tried to make sense of Japan’s predicament, I used a simple, unrealistic model (Hhttp://web.mit.edu/krugman/www/trioshrt.html H) to ask what we really know about the relationship between the money supply and the price level. We normally say that an increase in the money supply, other things equal, leads to an equal proportional increase in the price level: double M and you double the CPI. But that’s not actually right. What a model with all the i’s dotted and t’s crossed actually says is that the CPI doubles if you double the current money supply and all future expected money supplies. And how do you do that? No matter how much Japan increases the monetary base now, expectations of future money supplies won’t move if people believe that the Bank of Japan will move to stabilize the price level as soon as the economy recovers. And once you realize that central banks may not be able to move expectations about future money supplies, it becomes a real possibility that the economy will be in a liquidity trap: if interest rates are near zero, money printed now just gets hoarded, and monetary policy has no traction on the real economy.

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Zimbabwe wouldn’t have this problem: people believe that any money it prints will stay in circulation. But the likes of Japan, or the United States, print money for policy purposes, not to pay their bills. And that, perversely, is what makes them vulnerable to a liquidity trap. Back in 1998 I argued that the Bank of Japan needed to find a way to “credibly promise to be irresponsible.” That didn’t go down too well, but it was what sober, careful economic analysis prescribed.

Or as I said in the linked paper,

The whole subject of the liquidity trap has a sort of Alice-through-the-looking-glass quality. Virtues like saving, or a central bank known to be strongly committed to price stability, become vices; to get out of the trap a country must loosen its belt, persuade its citizens to forget about the future, and convince the private sector that the government and central bank aren’t as serious and austere as they seem.

OK, so now back to Hatzius et al. They emphasize the role of the disruption of credit markets in pushing us into a liquidity trap. They then turn to an estimate of likely changes in the “private sector balance” — the difference between private sector saving and private sector investment. And it’s stunning:

The GS house price forecast combined with current equity prices and credit spreads implies a rise in the private sector balance from +1% of GDP in the second quarter of 2008 to +10% in the fourth quarter of 2009— - a rise of 9 percentage points, or 6 points at an annual rate.

What’s the answer? Huge fiscal stimulus, to fill the hole. More aggressive GSE lending. Maybe a “pre-commitment” by the Fed to keep rates low for an extended period — that’s a more genteel version of my “credibly promise to be irresponsible.” And maybe large-scale purchases of risky assets.

The main thing to realize is that for the time being we really are in an alternative universe, in which nothing would be more dangerous than an attempt by policy makers to play it safe.

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Did Quantitative Easing By The Bank Of Japan Work? Nov 14, 2008

In March 2001, the Bank of Japan (BoJ) began an historic new monetary policy known as 'quantitative easing' in an effort to revive Japan’s economy and end the deflationary decline in consumer prices. Five years later, the BoJ ended the policy, satisfied that the Japanese economy was on the path to stable, reflationary growth

o The primary policy innovation of quantitative easing was that the outstanding balance of current accounts held by Japanese commercial banks at the BOJ replaced the overnight call interest rate as the main target for monetary operations

o John Makin of AEI: BoJ decided to purchase assets directly from the banking system in order to increase cash held by the nation’s private banks and by households. With deflation intensifying in 2001 and a liquidity trap (an insatiable demand for cash) emerging, the BoJ elected to satisfy that demand by printing money. Over a period of two and a half years starting in Mar 2001, the BoJ boosted bank reserves from the usual level of about ¥5 trillion, equal to required reserves, to just over ¥32 trillion, or by ¥26 trillion (about $240 billion)

o There is some controversy over the success of quantitative easing in reviving the economy

Why Some Say Quantitative Easing Did Work

o Masanao of PIMCO/Makin: Quantitative easing policy worked and made easy money available for many borrowers in Japan

o Makin: Though the policy did not lead to much more lending by Japan’s banks, it amounted to a signal from the BoJ that it was prepared to maintain an extraordinarily accommodative liquidity policy until it judged the Japanese economy to be on the path to a sustainable recovery. That policy signaled to investors wishing to finance purchases of bonds, stocks, land, or other assets that financing would be available at very low (zero) short-term rates

o There appears to be evidence that the program aided weaker Japanese banks and generally encouraged greater risk-tolerance in the Japanese financial system (FRBSF)

Why Some Say Quantitative Easing Did Not Work

o Richard Koo of BusinessWeek: One could argue that the BOJ agreed to quantitative easing only because it could do little harm when there was virtually no demand for funds from the private sector; companies with impaired balance sheets simply aren't interested in borrowing more, regardless of the interest rate. As a result, there was no acceleration in bank lending or money supply during the five years of the policy - indicating that quantitative easing didn't work

o Minutes of the Policy Board meeting reveal that some members were particularly motivated to embark on the quantitative easing policy as a vehicle to maintain the rate of credit creation by Japanese commercial banks. However, many have pointed to the actual declines in bank lending that occurred after the program's launch to argue that it was unsuccessful. Still, it is hard to know whether the pace of credit creation would have been even slower in the program's absence (FRBSF)

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55BShould We Worry About Deflation? Daily Article by Doug French | Posted on 11/18/2008

This essay originally appeared on LewRockwell.com

There is now worldwide worrying about price deflation again. After all, real estate prices have sunk, stock prices have hit the ditch, the price of oil has the sheiks concerned, and even Las Vegas hotel room rates have plunged. Sounds like all good news for those of us who buy things, at the same time being a bit of a bummer for heavily indebted sellers.

But former Federal Reserve Governor Rick Mishkin told an early-morning CNBC audience that "inflation could be too low." On the same program, James K. Galbraith, who teaches economics at the Lyndon Baines Johnson School at the University of Texas at Austin, chimed in that there has been "a huge deflationary shock" to the economy, and of course the government needs to step in and stabilize the markets and bail out businesses.

"The Fed did not allow the money base to expand, and we had a panic in the liquid markets," supply-side guru Arthur Laffer told a Las Vegas audience last week, "which caused this financial panic, pure and simple."

Across the pond, Ambrose Evans-Pritchard, writing for the Telegraph, warns "Abandon all hope once you enter deflation." Fine wines and white truffles have dropped in price and these price drops could "spread through the broader economy, lodging like a virus in the British and global monetary systems."

"The curse of deflation is that it increases the burden of debts," frets Evans-Pritchard, who goes on to contend, "Deflation has other insidious traits. It causes shoppers to hold back. They wait for lower prices. Once this psychology gains a grip, it can gradually set off a self-feeding spiral that is hard to stop."

Yes, the current economics brain trust is worried that consumers will collectively show the good sense to delay purchases, pay down debt, and increase their savings. After all, this liquidation of malinvestments will likely take a while. The prudent thing to do in times of uncertainty is not to ramp up debt and spend money you don't have.

But now, all of a sudden, "saving" is a dirty word. According to Evans-Pritchard, savings "also redistributes wealth-the wrong way. Savings appreciate, which is nice for the 'rentiers' with capital. The effect is a large transfer of income from working people with mortgages to bondholders."

Of course sounder-thinking economists don't see deflation as evil, as Jörg Guido Hülsmann points out in his just-published HDeflation & LibertyH: "it fulfills the very

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important social function of cleansing the economy and the body politic from all sorts of parasites that have thrived on the previous inflation."

And although Hülsmann's definition of deflation is the proper one-a reduction in the quantity of base money, while what the mainstream blathers on about is a drop in prices-the point remains: "There is absolutely no reason to be concerned about the economic effects of deflation-unless one equates the welfare of the nation with the welfare of its false elites," explains Hülsmann.

But to say governments and their friends are concerned about deflation is an understatement. Professor Peter Spencer from York University says the Bank of England has learned many hard lessons since its founding in 1694. And with no gold standard to get in the way, that central bank is "cutting rates very fast, and if necessary they too will turn to the helicopters," referring to Milton Friedman's (or Ben Bernanke's) idea that governments are capable of dropping bundles of banknotes from helicopters to stop deflation.

This printing of money "will keep the [deflation] wolf from the door," according to Professor Spencer. But creating more money doesn't create more goods and services. There is no wolf at society's door. "From the standpoint of the commonly shared interests of all members of society, the quantity of money is irrelevant," Hülsmann makes clear. And if the overindebted and the overlent go bankrupt, that's fine. The fact is, these liquidations have no effect on the real wealth of a nation, and as Hülsmann stresses, "they do not prevent the successful continuation of production."

Meanwhile the Bernanke Fed has gone on an unprecedented growth spurt, more than doubling its balance sheet-out of thin air-in an attempt to bail out the financial community. Formerly the asset side of the American central bank's balance sheet was Treasury securities with a dash of gold. Now the Fed, despite being double the size, has fewer Treasury securities, with the rest being the toxic securities that have buckled the big Wall Street banks. It's as if Bernanke is channeling John Law, the architect of France's Mississippi Bubble back in 1720. Law couldn't keep his bubble inflated and neither will Bernanke and his fellow central bankers.

While central bankers furiously try to reinflate, cheered on by the mainstream financial media, monetary authorities should deflate the money supply, pulling in their horns as consumers are doing. Deflation is a "great liberating force," writes Hülsmann, "because it destroys the economic basis of the social engineers, spin doctors, and brain washers."

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The G-20 communique Posted on Monday, November 17th, 2008

The HG-20’s communiqué H offered Ha surprisingly robust work program for regulatory reformH. HMIT’s Simon Johnson even worries Hthat it may be too robust – and push banks to scale back their lending in a pro-cyclical way. I am a little less worried about this risk. I assume regulators recognize that a sensible macro-prudential regulatory framework requires raising capital charges in good times (to lean against the boom), not forcing banks to squeeze lending to conserve capital in bad times.

The G-20’s ability to reach agreement on a detailed work program on regulatory reform – just think, the US President has signed off on an effort to evaluate whether compensation practices in the financial sector contributed to excessive risk taking — presumably reflects Hthe groundworkH done by the Financial Stability Forum. Many of the G-20’s proposals reflect reforms that key countries have already agreed on there.*

It also reflects another reality: agreement on regulatory changes only required a deal among the G-7 countries, not a deal between the G-7 and the emerging world. The big internationally-active banks are still primarily in the US, Europe and Japan – and are still regulated (and bailed out) by these countries. Emerging economies of course feel the impact of a fall in lending if the financial sector in the US and Europe is hobbled – so they aren’t just bystanders. They should want the US and European regulators to do their jobs effectively, so they aren’t sideswiped by a sudden fall in lending. And no doubt regulation in the emerging world is influenced by practices in the US and Europe. But most emerging market banks already held a bit more capital than US or European banks, as the emerging world didn’t bet on the notion that the fall in macroeconomic and financial volatility associated with the “Great Moderation” was permanent. The Great Moderation never really made it to most of the emerging world: they had a lot more recent experience with macroeconomic volatility. The “regulatory” deal consequently hinged far more on the US and Europe than the emerging world. And they stepped up. I was struck by how robust the G-20 language describing the short-comings in the advanced economies financial systems was. The G-20 leaders:

During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.

But I was also struck my how quiet the G-20 was on the macroeconomic imbalances that facilitated the expansion of leverage in the US and Europe. Remember, the US had a low savings rate – and required inflows from the rest of the world. If those inflows had fallen off as US household debts – and the financial sector’s balance sheet leverage

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– increased, the US might not have dug itself into a hole. The communiqué language here was remarkably diplomatic. No mention was made of macroeconomic imbalances across countries – or misaligned exchange rates. The communique language remained very vague: “Major underlying factors to the current situation were, among others, inconsistent and insufficiently coordinated macroeconomic policies, inadequate structural reforms, which led to unsustainable global macroeconomic outcomes.” I consequently am surprised (or perhaps I should say less than impressed) that the HWhite House H believes that the G-20 reached “a common understanding of the root causes of the global crisis.” Paulson was quite clear on Thursday that the macroeconomic imbalances the G-20 avoided mentioning had something to do with the current mess.

HPaulson observedH:

“If we only address particular regulatory issues – as critical as they are – without addressing the global imbalances that fueled recent excesses, we will have missed an opportunity to dramatically improve the foundation for global markets and economic vitality going forward. The pressure from global imbalances will simply build up again until it finds another outlet.” I agree. The unwillingness of the G-20 to even mention Hthe policies that led to large surpluses in the emerging world Hwas noticeable. Part of the logic of meeting in the G-20 rather than the G-7 is a recognition that financial difficulties in the G-7 matter for the entire global economy. But part of the logic of the G-20 is that the G-7 isn’t the right group for addressing macroeconomic imbalances – or doing macro-economic coordination – as it leaves out the key surplus countries and adjustment ultimately requires policy changes in the surplus as well as the deficit countries (Hsee Martin WolfH). If China (I assume) blocks any reference to misaligned ex change rates and the resulting reserve buildup as a source of the imbalances, it is hard to see how the G-20 can become a forum for helping to coordinate the policy changes needed to bring these imbalances down.

There is another area where the G-7 and the emerging world need to cooperate: the provision of crisis financing to cash-strapped emerging economies. The G-20 leaders statement recognized the need to reform the IMF – and didn’t rule out expanding its size “We should review the adequacy of the resources of the IMF, the World Bank Group and other multilateral development banks and stand ready to increase them where necessary”).

That was a bit more than I was expecting. But it also falls short of what is needed.

Last week the US was indicating that it thought the IMF had all the resources it needs. HMark LandlerH reports:

“The White House, officials told The Times, does not support proposals for a giant increase in financing for the International Monetary Fund, which is lending money to Iceland, Hungary and Ukraine and recently set up a credit line for countries with liquidity shortages. Noting that the fund had $200 billion on hand to lend, another senior official said, “The I.M.F. seems quite well-funded.””

I would be interested in seeing the underlying calculations that support that conclusion. Consider the following:

The short-term external debt of the emerging world (per the BIS) is around $1.3 trillion – far more than the $200-250b the IMF can mobilize.

Korea started the crisis with about $250b in reserves. Brazil started the crisis with about $200b in reserves. Both now believe – I suspect – that they needed more reserves than

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they had to be in a position to protect themselves from the recent financial shock. A $200 billion reserve pool in the IMF is clearly too small to be able to substitute for large national reserves.

In the month of October alone, emerging Asian economies (setting China aside) spent at least $45b defending their currencies.** Russia spent another $45b – and that total likely leaves out a lot of commitment to the state banks. Brazil’s intervention was done through swaps so it didn’t show up as an outright fall in reserves. But — according to HOtaviano Canuto,H Brazil’s intervention in the spot market still topped $5b, and it did another $25b in currency swaps. That sums up to a $100 billion plus outflow from the emerging world. A $200 billion IMF couldn’t even cover than kind of global outflow for two months …

Allowing the emerging world to borrow more is in the self-interest of the US and Europe. The shortage of foreign exchange in the emerging world has already led to a strong rally in the dollar – a rally that will cut into US export growth at a time when the US needs exports. That rally is also creating pressure on China to devalue its currency against the dollar – something that would make Chinese products more competitive in the US market and hinder the needed adjustment in Sino-American trade.

If emerging borrowers all have Hto cut back because of concerns about a lack of financingH that would be a further blow to global demand. That should worry Europe – and Germany. If Eastern Europe cannot borrow, Germany (and others) cannot export ( HPettis’ argument H about China also applies to surplus countries inside Europe).

And longer-term, the last thing the US and Europe should want is a world where the emerging world concludes that it only way it can integrate safely in the international financial system is by maintaining undervalued currencies and building up enormous reserves. Those policies just would perpetuate the imbalances that helped generate the current crisis. The Council on Foreign Relations’ Sebastian Mallaby writes:

“In the absence of a larger IMF, Brazil and its equivalents have two options. They can plan to rely on powerful central banks for emergency loans — during this crisis, the U.S. Federal Reserve has provided $30 billion apiece to Brazil, South Korea, Singapore and Mexico. The problem is that financing from a central bank may come with political conditions. That might sound fine if the central bank is the Fed. But what if it’s the People’s Bank of China, which has more than enough reserves to play the IMF surrogacy game? A weak IMF could hand a powerful foreign policy tool to China.

The other option for countries such as Brazil is to self-insure — to be a driver with an $80,000 bank account. Again, this is already beginning to happen: After the IMF imposed unpopular conditions on crisis countries a decade ago, many emerging economies built up their reserves to avoid repeating that experience. But this every-country-for-itself reserve accumulation is not only wasteful. The savings that pile up in central bank vaults will largely take the form of dollar bonds — that is, lending to Americans. If the past few years are any guide, the resulting whoosh of capital into the United States will inflate the next bubble. “

Much as the US Treasury needs financing now, surely there is a better long-term use of the emerging world’s savings than lending huge sums to the US Treasury. *The G-20 calls for expanding Hthe membership of the Financial Stability ForumH to include a broader set of emerging economies – not just Hong Kong and Singapore. ** My number is adjusted for valuation changes; the unadjusted fall in reserves Htopped $100 billionH.

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85B TEXTO ÍNTEGRO DE LA DECLARACIÓN DE LA CUMBRE DE WASHINGTON

56B"Nosotros, los líderes" 16/11/2008

1. Nosotros, los líderes del grupo de los 20, hemos celebrado una reunión inicial en Washington el 15 de noviembre entre serios desafíos para la economía y los mercados financieros mundiales. Estamos decididos a aumentar nuestra cooperación y trabajar juntos para restablecer el crecimiento global y alcanzar las reformas necesarias en los sistemas financieros mundiales.

2. Durante los últimos meses nuestros países han tomado medidas urgentes y excepcionales para apoyar la economía mundial y estabilizar los mercados financieros. Estos esfuerzos deben continuar. Al tiempo, debemos poner las bases para una reforma que nos ayude a asegurarnos de que una crisis global como esta no volverá a ocurrir. Nuestro trabajo debe estar guiado por la creencia compartida de que los principios del mercado, el régimen de libre comercio e inversión y los mercados financieros efectivamente regulados fomentan el dinamismo, la innovación y el espíritu emprendedor que son esenciales para el crecimiento económico, el empleo y la reducción de la pobreza.

Causas profundas de la crisis actual 3. Durante un periodo de fuerte crecimiento global, crecientes flujos de capitales y prolongada estabilidad en esta década, los actores del mercado buscaron rentabilidades más altas sin una evaluación adecuada de los riesgos y fracasaron al ejercer la adecuada diligencia debida. Al mismo tiempo, las poco sólidas prácticas de gestión del riesgo, los crecientemente complejos y opacos productos financieros y el consecuente excesivo apalancamiento se combinaron para crear debilidades en el sistema. Las autoridades, reguladores y supervisores de algunos países desarrollados no apreciaron ni advirtieron adecuadamente de los riesgos que se creaban en los mercados financieros, no siguieron el ritmo de la innovación financiera ni tomaron en cuenta las ramificaciones sistémicas de las acciones regulatorias locales.

4. Importantes causas subyacentes de la situación actual fueron, entre otras, las políticas macroeconómicas insuficientes e inconsistentemente coordinadas, e inadecuadas reformas estructurales que condujeron a un insostenible resultado macroeconómico global. Estos desarrollos, juntos, contribuyeron a excesos y finalmente dieron lugar a un grave trastorno del mercado.

Medidas adoptadas y a adoptar 5. Hasta la fecha hemos tomado potentes y significativas acciones para estimular nuestras economías, proporcionar liquidez, fortalecer el capital de las instituciones financieras, proteger los ahorros y depósitos, corregir las deficiencias regulatorias, descongelar los mercados de crédito. Estas medidas están funcionando para asegurar que las entidades financieras internacionales puedan proporcionar apoyo crítico a la economía global.

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6. Pero hace falta hacer más para estabilizar los mercados financieros y apoyar el crecimiento económico. El ritmo económico se está frenando sustancialmente en las principales economías y las perspectivas globales se han debilitado. Muchas economías emergentes, que han ayudado a sostener la economía mundial esta década, están experimentando todavía un notable crecimiento pero cada vez más sufren el impacto del frenazo mundial.

7. Frente a este contexto de deterioro de las condiciones económicas en todo el mundo, estamos de acuerdo en que hace falta una respuesta más amplia de las autoridades basada en una mayor cooperación macroeconómica para restaurar el crecimiento, evitar contagios negativos y apoyar a las economías de los mercados emergentes y en vías de desarrollo. Como pasos inmediatos para lograr estos objetivos, así como para hacer frente a los desafíos a largo plazo:

- Continuaremos nuestros esfuerzos enérgicos y tomaremos cualquier acción adicional necesaria para estabilizar el sistema financiero.

- Reconoceremos la importancia de la ayuda de la política monetaria, en la medida en que se considere apropiado para las condiciones domésticas.

- Usaremos medidas fiscales para estimular de forma rápida la demanda interna, al tiempo que se mantiene un marco propicio para la sostenibilidad fiscal.

- Ayudaremos a los países emergentes y en desarrollo a lograr acceso a la financiación en las difíciles condiciones financieras actuales, incluyendo instrumentos de liquidez y programas de apoyo. Subrayamos el importante papel del FMI en la respuesta a la crisis, saludamos el nuevo mecanismo de liquidez a corto plazo y urgimos a la continua revisión de sus instrumentos para asegurar la flexibilidad.

- Animaremos al Banco Mundial y a otros bancos multilaterales de desarrollo a usar su plena capacidad en apoyo de su agenda de ayuda, y saludamos la reciente introducción de nuevos instrumentos por parte del Banco Mundial en la financiación de infraestructuras y de comercio.

- Nos aseguraremos de que el FMI, el Banco Mundial y los otros bancos multilaterales de desarrollo tengan los recursos suficientes para continuar desempeñando su papel en la resolución de la crisis.

Principios comunes para la reforma de los mercados financieros

8. Además de las acciones señaladas arriba, aplicaremos reformas que fortalecerán los mercados financieros y los regímenes regulatorios para evitar futuras crisis. La regulación es primero, y ante todo, responsabilidad de los reguladores nacionales, que constituyen la primera línea de defensa contra la inestabilidad del mercado. Sin embargo, nuestros mercados financieros son de ámbito global. Por ello, la cooperación internacional reforzada entre reguladores y el fortalecimiento de los estándares internacionales, donde sea necesario, y su aplicación consistente es necesaria para la protección contra acontecimientos transfronterizos, regionales o globales, que afecten a la estabilidad financiera internacional. Los reguladores deben asegurarse de que sus acciones fomentan la disciplina de mercado, evitan potenciales efectos adversos en otros países, incluyendo el arbitraje regulatorio, y apoyan la competencia, el dinamismo y la innovación en el mercado. Las instituciones financieras deben también asumir su responsabilidad por las turbulencias y deben poner de su parte para superarlas, reconociendo las pérdidas, mejorando la transparencia y reforzando sus prácticas de gobierno y control del riesgo.

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9. Nos comprometemos a poner en marcha políticas con los siguientes principios reformistas en común:

- Fortalecer la transparencia y la responsabilidad: reforzaremos la transparencia en los mercados financieros, incluyendo la mejora de los productos financieros complejos y asegurando la completa y adecuada revelación de las empresas y sus condiciones financieras. Los incentivos deben ser alineados para evitar excesivos riesgos.

Mejora de la regulación: nos comprometemos a fortalecer y examinar prudentemente nuestros regímenes regulatorios según convenga. Ejercitaremos una fuerte vigilancia sobre las agencias de crédito, con el desarrollo de un código de conducta internacional. También haremos regímenes regulatorios más efectivos a lo largo del ciclo económico, mientras que nos aseguramos de que la regulación es eficiente, sin ahogar la innovación, y anima el crecimiento del comercio de productos financieros y servicios. Nos comprometemos a evaluar de forma transparente nuestros sistemas regulatorios nacionales.

- Promover la integridad de los mercados financieros: nos comprometemos a proteger la integridad de los mercados financieros del mundo reforzando la protección del inversor y el consumidor, evitando conflictos de intereses, previniendo la manipulación ilegal del mercado, las actividades fraudulentas y avisos y protegiendo contra los riesgos financieros ilícitos procedentes de jurisdicciones no cooperativas. También promoveremos el intercambio de información, incluyendo las jurisdicciones que se han comprometido con los estándares internacionales respecto al secreto y la transparencia bancarios.

- Fortalecer la cooperación internacional: llamamos a nuestros reguladores nacionales y regionales a formular sus reglas y otras medidas de cooperación a través de todos los segmentos de mercados financieros, incluyendo los que afectan al movimiento de capitales entre fronteras. Los reguladores y otras autoridades relevantes deben fortalecer la cooperación en la prevención, gestión y resolución de crisis.

- Reformar las instituciones financieras internacionales. Estamos comprometidos a avanzar en la reforma de las instituciones de Bretton Woods de forma que puedan reflejar los cambios en la economía mundial para incrementar su legitimidad y efectividad. En este sentido, las economías emergentes y en desarrollo, incluyendo a los países más pobres, deberán tener más voz y representación. El Foro de Estabilidad Financiera (FSF) tiene que acoger urgentemente a más miembros de los países emergentes, y otras instituciones deberían revisar su participación en breve. El FMI, en colaboración con el FSF ampliado y otras instituciones, deberá cooperar para identificar puntos vulnerables, anticipar peligros potenciales y actuar rápidamente para jugar un papel fundamental en la respuesta a la crisis.

La labor de ministros y expertos 10. Estamos comprometidos a tomar acciones rápidas para poner en marcha estos principios. Instamos a nuestros ministros de Finanzas, en coordinación con los líderes de 2009 del G-20 (Brasil, Reino Unido y Corea del Sur) a iniciar el proceso y un calendario para ello. Una lista inicial de medidas específicas se incluye en el Plan de Acción adjunto, incluyendo las acciones de alta prioridad para que se completen antes del 31 de marzo de 2009.

En cooperación con otras instituciones económicas, centrándose en las recomendaciones de expertos independientes, pedimos a nuestros ministros de Finanzas que formulen recomendaciones adicionales, incluyendo las áreas específicas siguientes:

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- Atenuar la política procíclica de los reguladores.

- Revisar los estándares de responsabilidad, particularmente para los títulos complejos en tiempos de turbulencias.

- Fortalecer la elasticidad y transparencia de los mercados de derivados de crédito y reducir sus riesgos sistémicos, incluyendo la mejora de las infraestructuras de los mercados no organizados (over the counter).

- Revisar las prácticas compensatorias cuando están relacionadas con los incentivos por tomar riesgos e innovar.

- Revisar los mandatos, formas de gobierno y necesidades de personal de las instituciones financieras internacionales.

- Definir el ámbito de las instituciones importantes para el sistema y determinar si su regulación y supervisión es adecuada o no.

11. A la vista del papel de la reforma de los sistemas financieros del G-20, nos reuniremos de nuevo el 30 de abril de 2008 para revisar la puesta en marcha de los principios y decisiones tomadas hoy.

Compromiso con una economía global abierta 12. Admitimos que estas reformas sólo tendrán éxito si se basan en un compromiso con los principios del libre mercado, incluyendo el imperio de la ley, respeto a la propiedad privada, inversión y comercio libre, mercados competitivos y eficientes, y sistemas financieros regulados efectivamente. Estos principios son esenciales para el crecimiento económico y la prosperidad y han hecho que millones de personas abandonen la pobreza y han contribuido significativamente al aumento de calidad de vida en el mundo. Reconociendo la necesidad de aumentar la regulación del sector financiero, debemos evitar la sobrerregulación que podría dañar el crecimiento económico y exacerbar la contracción de los flujos de capital, incluyendo a los países en desarrollo.

13. Subrayamos la importancia vital de rechazar el proteccionismo y de no volver atrás en tiempos de incertidumbre financiera. En este sentido, en los próximos 12 meses nos abstendremos de imponer barreras a la inversión y al comercio de bienes y servicios, imponer nuevas restricciones a las exportaciones o poner en marcha medidas para estimular las exportaciones que choquen con la Organización Mundial del Comercio (OMC). Además, nos esforzaremos para llegar este año a un acuerdo para cerrar la ronda de Doha de la OMC con un resultado ambicioso y equilibrado. Daremos instrucciones a nuestros ministros de Comercio para que consigan este objetivo y para que estén listos para asistir directamente, si es necesario. También estamos de acuerdo en que nuestros países tienen la mayor proporción en el reparto del comercio mundial y por lo tanto cada uno debe hacer contribuciones positivas para lograr nuestro objetivo.

14. Somos conscientes del impacto de la actual crisis en los países en desarrollo, particularmente en los más vulnerables. Nos reafirmamos en la importancia de los Objetivos del Desarrollo del Milenio, los compromisos para la ayuda al desarrollo que hemos realizado e instamos a los países desarrollados y las economías emergentes a asumir compromisos en consonancia con sus capacidades y funciones en la economía mundial. En este sentido, confirmamos el desarrollo de los principios acordados en 2002 en la Conferencia de Naciones Unidas sobre la Financiación para los países en

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Desarrollo celebrada en Monterrey, México, que hizo hincapié en la movilización de todas las fuentes de financiación titularidad estatal para el Desarrollo.

15. Mantenemos el compromiso para afrontar otros desafíos críticos, como la seguridad energética y el cambio climático, la seguridad alimentaria, el cumplimiento de la ley, la lucha contra el terrorismo, la pobreza y las enfermedades.

16. Mientras avanzamos, estamos seguros de que mediante la colaboración, la cooperación y el multilateralismo superaremos los desafíos que tenemos ante nosotros y nos permitirá restablecer la estabilidad y la prosperidad en la economía mundial.

PLAN DE ACCIÓN PARA LA APLICACIÓN DE LOS PRINCIPIOS DE LA REFORMA Este plan de acción establece un plan de trabajo para aplicar los cinco principios acordados para la reforma.

Los ministros de Finanzas trabajarán para garantizar que las tareas mencionadas en el presente plan de acción sean puestas en marcha con energía.

Los ministros de Finanzas son los responsables de elaborar y aplicar estas recomendaciones sobre la base del trabajo de instituciones pertinentes, como el Fondo Monetario Internacional (FMI), el Foro para la Estabilidad Financiera y los órganos reguladores.

Fortalecimiento de la transparencia y la responsabilidad

Medidas inmediatas para el 31 de marzo de 2009. - Los principales reguladores mundiales de normas de contabilidad deben trabajar para mejorar la adecuada valoración de los activos, incluyendo los activos complejos, los productos líquidos, especialmente durante periodos de volatilidad.

- La normalización contable debe representar un avance importante en la labor para identificar las deficiencias contables y divulgar las normas fuera de balance.

- Los reguladores y la normalización contable deben mejorar la identificación de los instrumentos financieros más complejos emitidos por las empresas a los actores del mercado.

- Con vistas a promover la estabilidad financiera, los órganos reguladores de las normas internacionales de contabilidad deben mejorarlas aún más, incluso mediante una renovación de sus miembros, para garantizar la transparencia, la rendición de cuentas y fomentar una relación adecuada entre este organismo independiente y las autoridades pertinentes.

- Los órganos del sector privado que ya han desarrollado las mejores prácticas para fondos privados de capital y fondos de cobertura deben presentar propuestas para unificarlas en una norma.

- Los ministros de Finanzas deben evaluar la viabilidad de estas propuestas en base a los análisis de los reguladores, la FSF ampliada y otros órganos competentes.

Medidas a medio plazo - Las principales órganos mundiales de contabilidad deben trabajar para crear una sola norma de alta calidad mundial.

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- Los reguladores, supervisores y órganos que establecen las normas de contabilidad deben trabajar entre ellos y conjuntamente con el sector privado para garantizar la aplicación coherente y la ejecución de las normas contables de alta calidad.

- Las instituciones financieras deberían mejorar la información sobre los riesgos en sus informes y mostrar todas las pérdidas de forma permanente, en consonancia con las buenas prácticas internacionales.

- Los reguladores deberán trabajar para garantizar que los estados financieros de una institución financiera contengan información completa, incluyendo las actividades fuera de balance, y que informen de éstas regularmente.

Mejora de la regulación

Medidas inmediatas para el 31 de marzo de 2009. - El FMI y el FSF ampliado y otros reguladores y órganos deberán desarrollar recomendaciones para atenuar las políticas procíclicas, incluyendo la revisión de la valoración de los apalancamientos, bancos de capital, retribuciones de ejecutivos, y prácticas de provisiones que pueden resultar exageradas para las tendencias del ciclo.

Medidas a medio plazo - Los países que aún no lo hayan hecho deberán comprometerse a examinar e informar sobre la estructura y los principios de su sistema de regulación para garantizar que es compatible con un moderno y cada vez más globalizado sistema financiero. Con este objetivo, todos los miembros del G-20 se comprometen a realizar un análisis del Programa de Evaluación del Sector Financiero (FSAP) informar y apoyar la transparencia de la regulación de los supervisores nacionales.

- Los órganos competentes deben revisar las diferencias de la regulación en la banca, valores, y seguros del sector y elaborar un informe sobre la cuestión y formular recomendaciones sobre las mejoras necesarias.

- Un examen del alcance de la regulación financiera, con un especial énfasis en las instituciones, instrumentos y mercados que no están actualmente reguladas, y asegurar que se llevan a cabo las medidas para que todas las instituciones importantes del sistema estén debidamente reguladas.

- Las autoridades nacionales y regionales deben revisar las normas de resolución y las leyes de quiebra a la vista de la experiencia reciente para asegurarse de que permiten la ejecución ordenada de los grandes complejos financieros transfronterizos.

- Las definiciones de capital deben ser armonizadas para alcanzar la coherencia de las medidas de capital y la adecuación del capital.

Supervisión prudencial

Medidas inmediatas para el 31 de marzo de 2009 - Los reguladores deben dar pasos para asegurarse de que las agencias de calificación crediticia cumplen los estándares más altos de la organización internacional de reguladores de valores y que evitan los conflictos de interés, proporcionan un mayor grado de información a los inversores y emisores, y diferencian las calificaciones para los productos complejos. Esto ayudará a asegurar que las agencias de calificación crediticia tienen los incentivos correctos y la supervisión apropiada que les permita desempeñar su importante papel en proporcionar asesoramiento e información no sesgada a los mercados.

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- La organización internacional de reguladores de valores debe revisar la adopción por las agencias de calificación de los estándares y mecanismos para supervisar el cumplimiento.

- Las autoridades deben asegurar que las entidades financieras mantienen capital en las cantidades necesarias para suscitar confianza. Los estándares internacionales deben fijar requerimientos de capital reforzados para las actividades de créditos estructurados y titulización de los bancos.

- Los supervisores y reguladores, ante el inminente lanzamiento de servicios de contrapartida central para permutas contra impago (credit default swaps o CDS) en algunos países deben: acelerar los esfuerzos para reducir los riesgos sistémicos de los CDS y las transacciones con derivados fuera de mercados organizados (over the counter), insistir en que los participantes del mercado respalden plataformas de contratación electrónica para los contratos con CDS, impulsar la transparencia de los derivados OTC y asegurarse de que la infraestructura para derivados OTC puede aguantar los crecientes volúmenes.

Medidas a medio plazo - Las agencias de calificación crediticia que asignen calificaciones públicas deben estar registradas.

- Los supervisores y los bancos centrales deben desarrollar aproximaciones sólidas y consistentes internacionalmente para la supervisión de la liquidez de los bancos transfronterizos y de sus operaciones de liquidez con los bancos centrales.

Gestión de riesgos

Medidas inmediatas para el 31 de marzo de 2009 - Los reguladores deberían desarrollar guían mejoradas para aumentar los refuerzos sobre las prácticas de control de riesgo bancario, en la línea de las mejores prácticas internacionales, y deben animar a las firmas financieras a reexaminar sus controles internos y a implementar políticas mejoradas para el control de riesgos.

- Los reguladores deberían desarrollar y aplicar procedimientos para asegurar que las firmas financieras implementan políticas para mejorar la gestión del riesgo de liquidez, lo que incluye la creación de potentes amortiguadores de la falta de liquidez.

- Los supervisores deberían asegurar que las firmas financieras desarrollan procesos que provean de oportunos y exhaustivas medidas de concentración de riesgo y una extensa contrapartida de las posiciones de riesgo a lo largo de productos y geografías.

- Las firmas deberían volver a examinar sus modelos de gestión de riesgo para salvaguardarse contra la presión y reportar a los supervisores sus esfuerzos.

- El Comité de Basilea debería estudiar las necesidades y ayudar a las firmas a desarrollar los nuevos modelos de examen de riesgo, tal y como sea apropiado. - Las instituciones financieras deberían clarificar los incentivos internos para promocionar la estabilidad así como las acciones que sean necesarias para ser llevadas a cabo, a través de un esfuerzo voluntario o una acción regulatoria, para evitar esquemas de compensación con recompensas excesivas para retornos a corto plazo o riesgos elevados

- Los bancos deberían llevar a cabo una gestión de riesgos efectiva y mostrar diligencia sobre los productos estructurados y la garantía.

Medidas a medio plazo

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- Organismos internacionales, que trabajen con un amplio rango de economías y otros organismos adecuados que deberían asegurarse que los responsables de realizar las políticas son conscientes y capaces de responder con rapidez a la evolución y la innovación de los mercados financieros y sus productos.

- Las autoridades deberían monitorizar los cambios sustanciales en los precios de las acciones y sus implicaciones para la macroeconomía y los sistemas financieros.

Promover la integridad de los mercados financieros

Medidas inmediatas para el 31 de marzo de 2009 - Las autoridades nacionales y regionales deberían trabajar juntas para mejorar la cooperación entre jurisdicciones a nivel regional e internacional.

- Las autoridades regionales y nacionales deberían trabajar para promocionar el intercambio de información sobre amenazas domésticas y transfronterizas para contribuir a la estabilidad del mercado y asegurar que la legalidad nacional (regional si es aplicable) es la adecuada para dirigirse a esas amenazas.

- Las autoridades regionales y nacionales deberían además revisar las reglas de las reglas de conducta en los negocios para proteger a mercados e inversores especialmente contra la manipulación del mercado y el fraude y afianzar su cooperación transnacional para proteger el sistema financiero internacional de actores ilícitos. En caso de conductas inadecuadas, debe existir un régimen de sanciones apropiado.

Medidas a medio plazo - Las autoridades nacionales y regionales deberían aplicar medidas nacionales e internacionales para proteger el sistema financiero global de las jurisdicciones con falta de cooperación y la falta de transparencia que plantean riesgos o actividades financieras ilícitas.

- El Grupo de Trabajo de Acción Financiera debería continuar su importante labor contra el blanqueo de dinero y el terrorismo financiero.

- Las autoridades fiscales, centrándose en el trabajo de las principales organizaciones como la OCDE, deberá continuar con su esfuerzo de promoción de intercambio de información fiscal. La falta de transparencia y los fallos en el intercambio de información fiscal debería ser vigorosamente redirigida.

Reforzar la cooperación internacional

Medidas inmediatas para el 31 de marzo de 2009 - Los supervisores deberían colaborar para establecer compañeros supervisores para todas las grandes instituciones financieras transnacionales. Los altos cargos de bancos globales deberían reunirse regularmente con sus colegas supervisores para discutir sobre la actuación de las actividades que llevan a cabo las firmas y los posibles riesgos a los que se enfrentan.

- Los reguladores deberían llevar a cabo los pasos necesarios para mejorar los protocolos de gestión y actuación ante riesgos, incluyendo los de cooperación y comunicación con cada una de las autoridades apropiadas, y desarrollar la lista de contactos adecuada y preparar la simulación de ejercicios.

Medidas a medio plazo

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- Las autoridades, centrándose principalmente en el trabajo de los reguladores, deberían recolectar información en áreas donde convergen las prácticas regulatorias, como los estándares de contabilidad, la auditoria o los depósitos, que necesitan un proceso más rápido.

- Las autoridades deberían asegurarse de que las medidas temporales para reestablecer la estabilidad y la confianza ocasionan una distorsión mínima y oportuna, y se suceden de una manera coordinada.

Reformar las instituciones financieras internacionales

Medidas inmediatas para el 31 de marzo de 2009 - El Foro de Estabilidad financiero deberá expandirse a los miembros de las economías emergentes.

- El FMI, con su foco puesto en la vigilancia, y el Foro de Estabilidad ampliado deberán ampliar su colaboración, aumentando los esfuerzos para una mayor integración regulatoria y reacciones dentro de las políticas de prudencia y llevar a cabo conductas de avisos tempranos.

- El FMI, dada su situación internacional y su núcleo de expertos financieros, debería, en una cercana coordinación con el foro y otro, tomar un papel de liderazgo en el diseño de lecciones a partir de esta crisis actual, de forma coherente con su mandato.

- Deberíamos revisar la adecuación de los recursos del FMI, el Banco Mundial y otros bancos de desarrollo, y estar preparados para incrementarlos cuando sea necesario. El Foro debería además continuar con la revisión y la adaptación de sus instrumentos de préstamo, adecuadamente con las necesidades de sus miembros, y revisar su papel de prestamista a la luz de la actual crisis.

- Deberíamos explorar los modos para reestablecer el acceso de los países emergentes y en desarrollo a los créditos y reanudar los flujos privados de capital que son críticos para la sostenibilidad del desarrollo y el crecimiento, incluyendo las inversiones en infraestructuras en marcha.

- En casos donde los severos trastornos del mercado hayan limitado el acceso a la financiación necesaria para poner en marcha políticas fiscales contra-cíclicas los bancos de desarrollo multinacional deberán asegurarse de que ofrecen soporte, tal y como necesitan, a los países con buenos antecedentes y políticas sanas.

Medidas a medio plazo - Subrayamos que las instituciones de Breton Woods deben ser adecuadamente reformadas de tal manera que reflejen de forma adecuada los cambios de peso en la economía mundial y ser más receptivos con los retos del futuro. Las economías emergentes y en desarrollo deberían tener una mayor voz y representación en esas instituciones.

- El FMI debería realizar una revisión de la vigilancia rotunda y justa sobre todos los países, así como prestar mayor atención a sus sectores financieros integrando las revisiones y la articulación de los programas de evaluación del FMI y el Banco Mundial. Con este fin, el papel del banco del FMI de proveedor de información macrofinanciera deberá ser fortalecido.

- Las economías avanzadas, el FMI y otras organizaciones internacionales deberán proveer de programas de fortalecimiento a los mercados de las economías emergentes y

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de los países en desarrollo con la formulación y la implementación de nuevas regulaciones nacionales, coherentes con los estándares internacionales.

86BCumbre en Washington - Los efectos prácticos 57BEl G-20 impulsa el mayor esfuerzo regulador en décadas A. BOLAÑOS 131BA corto plazo deberán establecerse incentivos fiscales, rebajas de aranceles y recortes a los excesos de los bancos A. BOLAÑOS (ENVIADO ESPECIAL) - Washington - 17/11/2008 Las delegaciones de las principales economías del mundo abandonaron Washington tras una cumbre que apenas sumó seis horas de debates, pero que auguran muchas horas más de aceleradas negociaciones. Nada de lo que se acordó en la noche del sábado tendrá un efecto automático contra la recesión. Las delegaciones de las principales economías del mundo abandonaron Washington tras una cumbre que apenas sumó seis horas de debates, pero que auguran muchas horas más de aceleradas negociaciones. Nada de lo que se acordó en la noche del sábado tendrá un efecto automático contra la recesión. Pero los Gobiernos reunidos por el G-20 evitaron la imagen de inacción al fijar plazos para medir el éxito de sus promesas: deben poner en marcha nuevos incentivos fiscales en semanas, pactar una nueva de rebaja de aranceles antes de diciembre y acordar en cinco meses las medidas que lleven a una regulación efectiva del sistema financiero. Si los ministros de Economía logran traducir los principios para ampliar la vigilancia del sector financiero en medidas concretas, el acuerdo del G-20 daría lugar al mayor esfuerzo de coordinación internacional en las últimas décadas. De hecho, la decisión de que toda la superación de la crisis pivote sobre el G-20 y no el G-7 ya supone un cambio radical de planteamiento frente al tradicional orden mundial. El impulso a la regulación de las finanzas que se propone, se podría comparar con lo que supusieron los acuerdos de Bretton Woods para el comercio internacional hace medio siglo. - ¿Habrá dinero para todo? Recién acabada la cumbre, el FMI reclamó que se destine un 2% del PIB a rebajas de impuestos o más inversiones públicas. En España eso llevaría a una inyección de 20.000 millones en la economía real. Si se atiende a la definición estricta del Fondo, aquí se incluiría la desgravación de 400 euros en el IRPF, valorada en 6.000 millones. Pero España, como muchos otros Gobiernos, ya han comprometido cantidades multimillonarias para ayudar al sistema financiero. Con el déficit y la deuda pública al galope, el comunicado da también una coartada al afirmar que se garantice la "sostenibilidad fiscal" de las medidas. - El nudo de la Ronda de Doha. Si hay un mandato urgente en el comunicado final es el que se hace a los ministros de Comercio para que reanimen una ronda de negociaciones que acumula siete años de desencuentros. Reino Unido, Brasil y Australia porfiaron por poner un plazo tan exigente como el de llegar a un acuerdo antes de fin de año. La

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negociación está encallada en la negativa de EE UU a la propuesta de India de permitir medidas proteccionistas para proteger la agricultura familiar de los países pobres. - Los sueldos de la banca. Los Gobiernos urgen a las entidades financieras "a adoptar medidas para evitar esquemas de retribución que recompensen decisiones a corto plazo o arriesgadas". Pero la presión francesa y alemana para que el poder público establezca criterios sobre cómo pagar a los ejecutivos de la banca no fructificó. El comunicado da a cada país la oportunidad de lograr este objetivo "mediante esfuerzo voluntario o mediante acción regulatoria". - Normas para todos. La crisis ha desvelado que hay créditos cuyo pago depende de individuos o empresas insolventes, algo que quien los adquirió no sabía. Por eso los Gobiernos han dicho que "nos aseguraremos de que todos los mercados, productos y agentes financieros están regulados o sujetos a supervisión". - Agencias bajo la lupa. Uno de los cometidos más detallados es el que hace referencia a las agencias de calificación de riesgos, las mismas que avalaron la solvencia a derivados que tenían en su origen hipotecas basura. "Los reguladores tomarán las medidas para asegurarse que las agencias evitan conflictos de intereses, dan información suficiente a inversores y emisores y dan una calificación específica para cada producto financiero". Habrá que ver si la UE logra que se prohíba asesorar a las agencias. - Cómo domar el riesgo. El mercado de los títulos que cubren el riesgo de impago en los préstamos (CDS en sus siglas en inglés) es ahora el mayor foco de preocupación del sector financiero. Es un mercado que ha escalado hasta los 50 billones de euros en unos pocos años. Y en el que los intercambios se hacen de forma bilateral, sin apenas garantías de que se pagará la cantidad comprometida si hay morosidad, algo mucho más frecuente en épocas de recesión. El G-20 urge a crear cámaras de compensación, que dan visibilidad a los intercambios y que, mediante el cobro de una cantidad a los participantes en el mercado, aumentan las garantías. - Control a los hedge funds. Los fondos que más se aprovecharon del endeudamiento fácil escapan de una supervisión pública más estricta. El G-20 se contenta con que desarrollen y propongan buenas prácticas, asesorados por las autoridades. - Contabilidad homogénea.Funcionarios del Tesoro de Estados Unidos reafirmaron que la norma que obliga a valorar los activos cada trimestre según su valor de mercado no está en discusión. Sí se debatirá qué hacer cuando el mercado no funciona y la ausencia de compradores hunde los precios, como ahora. - Bancos a cubierto. La insuficiente capitalización de los bancos para cubrir riesgos, llevará a los reguladores a "asegurarse de que las entidades mantienen la cantidad de capital necesaria para sostener la confianza". Se obligará a los bancos a destinar capital para cubrir el riesgo de la deuda que titulicen y la coloquen en el mercado. Y se apuesta por provisiones anticíclicas, al estilo de las del Banco de España. - Paraísos fiscales. "Promovemos la puesta en común de la información financiera, lo que incluye a las jurisdicciones que todavía no cumplen con las normas internacionales sobre secreto bancario y transparencia". - Cláusula de salida. Como en todo acuerdo internacional, se garantiza la opción de dar marcha atrás. En este caso, a petición de EE UU y Canadá, se recalca que "se debe evitar una sobrerregulación que dañaría el crecimiento económico y el flujo de capitales".

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132BLos compromisos de la cumbre - El G-20 divulgó tras la reunión del sábado un documento de conclusiones que expone las causas de la crisis, así como una serie de acciones y medidas, unas a aplicar a corto plazo (antes del 31 de marzo) y otras pensando en el largo plazo. - Medidas inmediatas. El G-20 se comprometió a poner en marcha de forma inmediata políticas monetarias según la situación de cada país y medidas fiscales para estimular de forma rápida la demanda interna, teniendo en cuenta la sostenibilidad fiscal de las economías. El grupo se compromete además a ayudar a las economías emergentes y en desarrollo mediante acceso a financiación y a asegurar que el FMI, el Banco Mundial y los organismos internacionales y de desarrollo tengan recursos suficientes para desempeñar su papel en la resolución de la crisis. - Reformas del sistema financiero. "Aplicaremos reformas que fortalecerán los mercados financieros y los regímenes regulatorios para evitar futuras crisis". Se basan en el fortalecimiento de la transparencia, la regulación, la cooperación internacional y la creación de estándares internacionales. - Los ministros de Finanzas serán quienes trabajen para garantizar que las tareas del plan se lleven a cabo. - Acciones para la transparencia. Se basan en la normalización de normas de contabilidad. "Los órganos reguladores de las normas internacionales de contabilidad deben mejorarlas, incluso mediante una renovación de sus miembros". Además, los órganos del sector privado que ya hayan desarrollado las mejores prácticas para fondos privados de capital y fondos de cobertura deben presentar propuestas para unificarlas en una norma. A largo plazo, se aspira a que los principales órganos mundiales de contabilidad trabajen para crear una sola norma de alta calidad mundial. Además, se indica que las instituciones financieras deberán mejorar la información sobre los riesgos en sus informes y mostrar todas las pérdidas. - Acciones para la regulación. El FMI y el Fondo de Estabilidad Financiera y otros reguladores deberán desarrollar recomendaciones para atenuar las políticas procíclicas, "incluyendo la revisión de la valoración de los apalancamientos, bancos de capital, retribuciones de ejecutivos, y prácticas de provisiones que pueden resultar exageradas para las tendencias del ciclo". A largo plazo, los países que aún no lo hayan hecho deberán comprometerse a examinar e informar sobre la estructura y los principios de su sistema de regulación para garantizar que es compatible con una economía global. Por último, las autoridades nacionales y regionales deben revisar las normas de resolución y las leyes de quiebra. - Acciones de supervisión. Los reguladores de cada país, deben dar pasos para asegurarse de que las agencias de calificación crediticia cumplen los estándares más altos de la organización internacional. Las autoridades deben asegurarse de que las entidades financieras mantienen capital "en las cantidades necesarias para suscitar confianza". Además, se deberán acelerar los esfuerzos para reducir los riesgos sistémicos de los CDS y las transacciones con derivados fuera de mercados organizados (over the counter). A largo plazo, el G-20 se compromete a que las agencias que asignen calificaciones públicas deban estar registradas y recomiendan que los supervisores y los bancos centrales desarrollen "aproximaciones sólidas y consistentes internacionalmente para la supervisión de la liquidez de los bancos transfronterizos y de sus operaciones de liquidez con los bancos centrales". - Acciones de gestión de riesgos. Los reguladores deberán crear guías mejoradas para aumentar los refuerzos sobre las prácticas de control de riesgo bancario y animar a las firmas financieras a reexaminar sus controles internos. Las instituciones financieras, por

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su parte, deberían clarificar los incentivos internos para evitar "esquemas de recompensas excesivas" para quienes toman posiciones con demasiado riesgo. Los bancos deberán llevar a cabo "una gestión de riesgos efectiva y mostrar diligencia sobre productos estructurados y las garantías". - Acciones para la integridad de los mercados. Las autoridades nacionales y regionales deberán trabajar para mejorar la cooperación entre jurisdicciones a nivel regional e internacional, fomentando el intercambio de información para proteger al sistema financiero internacional de "actores ilícitos". "En caso de conductas inadecuadas, debe existir un régimen de sanciones apropiado". A largo plazo, se deben "aplicar medidas" contra "jurisdicciones con falta de cooperación y de transparencia que plantean riesgos o actividades financieras ilícitas", es decir, de los paraísos fiscales. - Medidas para reforzar la cooperación. Se pide la presencia de reguladores en instituciones financieras, que sean capaces de mejorar los protocolos de gestión y actuación ante riesgos. A largo plazo, se debe tener cuidado con las medidas aplicadas para evitar "distorsiones". - Reforma de las instituciones financieras internacionales. "Las instituciones de Breton Woods deben ser adecuadamente reformadas de tal manera que reflejen de forma adecuada los cambios de peso en la economía mundial y ser más receptivos con los retos del futuro. Las economías emergentes y en desarrollo deberían tener una mayor voz y representación". Con este fin, a corto plazo, el Foro de Estabilidad Financiera se expandirá a los miembros emergentes, el FMI, deberá reforzar su papel de "proveedor de información macrofinanciera", y ambas instituciones mejorar su coordinación.

87BCumbre en Washington - La visión española

58BZapatero anuncia un gran plan de recuperación basado en la inversión 133BEl presidente defiende la necesidad de estimular el consumo - Brasil aboga por constituir un G-22 con España y una potencia emergente MIGUEL GONZÁLEZ (ENVIADO ESPECIAL) - Washington - 16/11/2008

José Luis Rodríguez Zapatero anunció ayer, al término de la cumbre financiera mundial celebrada en Washington, un plan de reactivación económica, basado en la inversión pública, que presentará el próximo día 27 en el Congreso y llevará al Consejo Europeo de diciembre, para coordinarlo con los de los demás países de la UE.

José Luis Rodríguez Zapatero anunció ayer, al término de la cumbre financiera mundial celebrada en Washington, un plan de reactivación económica, basado en la inversión pública, que presentará el próximo día 27 en el Congreso y llevará al Consejo Europeo de diciembre, para coordinarlo con los de los demás países de la UE. El jefe del Gobierno español salió satisfecho de su primera reunión de este nivel, aunque se mostró cauto sobre su participación en la próxima cumbre de este tipo, que se celebrará antes de

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final de abril en Londres. "Yo siempre me fío del señor Sarkozy", respondió, cuando se le preguntó por las declaraciones del jefe del Estado francés, que dio por sentada la continuidad de España en las cumbres del G-20.

"Lo que me importa de haber asistido a esta cumbre es que se ha reconocido el papel de España", subrayó José Luis Rodríguez Zapatero, respecto de la posible participación española en próximo encuentro.

En su intervención ante los líderes mundiales, a puerta cerrada y por unos 10 minutos, Zapatero abogó por "una acción coordinada de los Estados para reactivar la economía mediante el instrumento de las políticas fiscales". Aunque Zapatero no descartó expresamente rebajas de impuestos, aclaró en la posterior rueda de prensa que aludía a la necesidad de apoyar con inversiones públicas a la economía productiva, especialmente en ámbitos como la investigación y el desarrollo, la innovación, las infraestructuras o la energía.

"Se trata de que el sector público lidere en este momento y con carácter coyuntural la acción económica", explicó. Tras poner el ejemplo de China, que destinará medio billón de euros a inversiones públicas, insistió en que "el incremento de la inversión pública es el instrumento más sólido para combatir una situación de estancamiento o recesión económica".

Hasta ahora, el vicepresidente y ministro de Economía Pedro Solbes, que ayer se sentó a la derecha de Zapatero en el salón del Museo Nacional de Arquitectura y a quien éste encomendó que mantenga un "diálogo continuado" con las entidades financieras para asegurar la concesión de créditos, se había resistido tanto a nuevas rebajas fiscales como al aumento del gasto público, por su incidencia en el déficit, que este año rondará el 1,5% del PIB.

Pero, como explicó ayer Zapatero, "la crisis de los mercados se ha transformado en una crisis económica global que afecta a las necesidades reales de los ciudadanos", ante la cual los Estados no pueden cruzarse de brazos.

Subrayó la necesidad de coordinar los planes nacionales, especialmente en el marco de la UE, "pues se ha demostrado que las medidas país a país tienen escasa eficacia", y recordó que la Comisión Europea presentará el próximo día 26 de noviembre un plan de reactivación de la economía continental.

Aunque desde las filas del PSOE se había anunciado que daría la batalla ideológica a los postulados neoliberales, el presidente tuvo interés en subrayar que el Estado "no debe coartar la libertad económica" y que su responsabilidad es "poner orden en los mercados financieros, no sustituirlos". Rechazó la adopción de medidas proteccionistas, que a su juicio constituirían un "gravísimo error"; abogó por poner límites a los paraísos fiscales, e incluso por su eliminación; y defendió la necesidad de regular las "astronómicas retribuciones" y "beneficios injustificados" que han proliferado entre los ejecutivos del sector financiero en los últimos años.

En esa línea, se mostró partidario de implantar un "código de derechos" de los usuarios de las entidades financieras, ante la opacidad de muchos de sus productos. Zapatero aprovechó su intervención en la cena del viernes, en la Casa Blanca, para presumir del eficaz funcionamiento del sistema español de supervisión bancaria, aunque eludió proponer la extensión de la fórmula de las provisiones anticíclicas, clave de su éxito.

Respecto a las instituciones financieras, abogó por reformar el Fondo Monetario Internacional (FMI) y el Banco Mundial (BM), para que reflejen el peso real de cada

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país en la economía mundial (en la actualidad están controladas por EE UU) y cuenten con recursos suficientes para apoyar a los países en dificultades. En cambio, atribuyó la coordinación de los planes de reactivación económica a la presidencia del G-20, el club bajo cuyo paraguas se convocó la cumbre de Washington y al que no pertenece España.

Al menos, todavía, pues el jefe de la diplomacia brasileña, Celso Amorim, propuso que el G-20 se convierta en el G-22, con la incorporación de España y alguna otra economía emergente. Brasil, que ocupa este año la presidencia rotativa del G-20, será sustituida en enero por el Reino Unido,zar la cumbre financiera que dé continuidad a la celebrada ayer.

Un primer paso Zapatero agradeció a Brasil su invitación, pero evitó echar las campanas al vuelo. "Hemos dado un primer paso muy importante y seguiremos haciendo las cosas bien para consolidar nuestra posición", afirmó. Sobre la participación de expertos españoles en los grupos de trabajo que deben abordar aspectos específicos de la reforma financiera, señaló que España "está a disposición" de la troika del G-20 (integrada por Brasil, Reino Unido y Corea del Sur), a la que se ha encomendado su coordinación.

De todos los líderes reunidos en Washington, Zapatero fue seguramente uno de los más optimistas. Aseguró que las perspectivas de recuperación económica son "hoy mejoreseconómica son "hoy mejores que hace una semana" y que la foto de familia de la cumbre se recordará como la de "el día que las cosas empezaron a cambiar". El único cambio seguro es que en la próxima foto ya no estará Bush, a quien agradeció su "actitud de cortesía" pese a las "diferencias" que ha habido entre ambos.

134BSin bandera española La ausencia de la bandera española en Washington levantó suspicacias. Fuentes de La Moncloa se apresuraron a explicar que, debido a la presencia del viceprimer ministro checo en la delegación española y del ministro de Finanzas holandés en la francesa (el jefe de Gobierno de Holanda, Jan Peter Balkenende, no pudo asistir por la muerte de su padre) ambos países acordaron renunciar a sus enseñas nacionales y comparecer bajo la común de la UE. En realidad, España nunca tuvo el derecho a asistir con su propia bandera, al no formar parte del G-20.

Como a los demás mandatarios, Bush recibió a Zapatero, tanto el viernes por la noche en la puerta de la Casa Blanca como ayer por la mañana al inicio de la cumbre, con una sonrisa y un apretón de manos. Ayer incluso le obsequió con un "encantao" en español. No hay constancia de que su huésped articulase palabra. El protocolo quiso que, en la foto de familia, Zapatero se situase justo detrás de Bush.

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88BCumbre en Washington - Las decisiones

59BEl G-20 acuerda una acción pública masiva 135BLa cumbre fija que los Gobiernos usen estímulos fiscales a la economía - Se crean grupos de trabajo para la reforma financiera - Impulso a la liberalización comercial A. BOLAÑOS (ENVIADO ESPECIAL) - Washington - 16/11/2008

La amenaza de una depresión mundial, proclamada por una avalancha de tenebrosas estadísticas, surtió efecto. Los líderes de las principales economías del mundo, ricas y emergentes, aparcaron sus múltiples diferencias para afrontar de forma conjunta, al menos, la cuestión más apremiante: cómo parar la recesión que irradia desde Estados Unidos y Europa.

La amenaza de una depresión mundial, proclamada por una avalancha de tenebrosas estadísticas, surtió efecto. Los líderes de las principales economías del mundo, ricas y emergentes, aparcaron sus múltiples diferencias para afrontar de forma conjunta, al menos, la cuestión más apremiante: cómo parar la recesión que irradia desde Estados Unidos y Europa.

El G-20 acordó ayer en Washington dar vía libre a una nueva ola de incentivos públicos, mucho más ambiciosos que los desarrollados hasta ahora, para reanimar la economía. Además, dio un primer paso para la reforma del sistema financiero mundial, abrió el debate sobre el papel futuro del FMI y del Banco Mundial y lanzó un mensaje contra el proteccionismo y en favor de la liberalización comercial.

El comunicado final que sintetizó cuatro horas de debates, sin luz ni taquígrafos, urge a los Gobiernos "al uso de medidas fiscales para estimular la demanda interna de forma rápida". Y acalla las sonoras divergencias entre Europa y Estados Unidos sobre la reforma del sistema financiero, origen de la crisis, desplazando la discusión a grupos de trabajo. Los líderes mundiales, además, resucitaron la moribunda ronda de Doha para alejar cualquier fantasma de proteccionismo y buscar nuevos acuerdos de rebajas de aranceles en algunos mercados clave antes de fin de año.

Las notables diferencias de criterio con las que los líderes mundiales acudían a Washington pusieron en duda incluso el acuerdo de mínimos sobre la necesidad de una mayor intervención pública. "La solución nunca ha sido más Gobierno", clamó el presidente de Estados Unido, George Bush, en la víspera de la reunión. "Puedo decir ahora que hemos contestado con éxito a la pregunta de si países con intereses tan diferentes podíamos ponernos de acuerdo", dijo ayer tras clausurar la cita del G-20. La propuesta de generalizar los incentivos estatales fue ganando adeptos conforme se desarrollaba la cumbre. "La crisis financiera puede llegar a convertirse en una crisis humanitaria si no actuamos", sintetizó el secretario general de la ONU, Ban Ki-Moon".

El espaldarazo definitivo a la propuesta vino del líder ausente en la cumbre, pero determinante para lo que venga en el futuro. Barack Obama hizo acto de presencia en una intervención radiofónica que coincidió con el arranque de la reunión. Y su mensaje

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fue nítido. "Al tiempo que actuamos de forma concertada con otros países, debemos intervenir aquí con urgencia", dijo el presidente electo de EE UU. "Si el Congreso no aprueba ya un plan que dé a la economía el empujón que necesita, ésa será mi primera orden ejecutiva como presidente", añadió.

La propuesta de Obama no se queda ahí. En los primeros meses de su mandato desarrollará un ambicioso plan de inversiones públicas en infraestructuras. Y fuentes demócratas agregaron que se estudia también un recorte en el impuesto que grava los resultados de las empresas del 35% al 28%.

La clara apuesta del nuevo líder norteamericano por utilizar los incentivos fiscales a conciencia para frenar la crisis da credibilidad a la conclusión del G-20 de que "es necesaria una respuesta política mucho más amplia para reestablecer el crecimiento económico". "Veremos a muchos países seguir esta recomendación en los próximas semanas", vaticinó el primer ministro británico, Gordon Brown. "Reactivaremos la economía, ésa es la señal que mandamos a los mercados", añadió el presidente francés, Nicolas Sarkozy al término de la cumbre.

Casi agotada ya la vía monetaria -sólo en Europa hay margen para recortes de tipos de interés significativos-, la alternativa que queda a los Gobiernos es usar sus presupuestos, aun a expensas de más endeudamiento y déficit público. Son medidas que ya han sido ensayadas en los últimos meses, pero que ahora deberán tener una dimensión mucho mayor.

China acaba de aprobar un plan de inversiones públicas valorado en medio billón de euros. España y EE UU, por ejemplo, ya han devuelto dinero a los contribuyentes. Pero la deriva de la crisis ha dejado claro que esos recortes (en el caso español, la deducción de 400 euros en el IRPF) apenas sirvieron para reactivar el consumo. Brown, uno de los más fervientes partidarios de nuevos incentivos fiscales, confirmó ayer que su paquete de medidas estará listo en dos semanas. El presidente español, José Luis Rodríguez Zapatero, defendió también la necesidad de nuevas medidas fiscales, según fuentes de la delegación española. Europa trtará de coordinar esas medidas el próximo 26 de noviembre y Zapatero expondrá en el Congreso su plan al día siguiente.

A la espera de comprobar si el mandato del G-20 sobre incentivos a la economía real tiene la misma eficacia que tuvo hace un mes la recomendación del G-7 sobre la necesidad de inyectar dinero público en la banca, queda por resolver un debate peliagudo: hasta dónde debe llegar la reforma del sistema financiero, ojo del huracán que abate la economía mundial.

Las posiciones encontradas sobre cómo regular mercados y agentes financieros que hasta ahora campaban por el préstamo fácil, la rentabilidad alta y el riesgo excesivo se deberán lidiar ahora en grupos de trabajo, que tendrán que presentar sus conclusones "antes del 31 de marzo". Unas diferencias que centraron buena parte de las intervenciones de los líderes mundiales en el Museo Nacional de Arquitectura, sede del encuentro.

Según fuentes de la delegación española, Bush abrió fuego con una nueva defensa del libre mercado. El siguiente turno fue para Abdullah Bin Abdulaziz, rey de Arabia Saudí, que dejó la reunión nada más acabar su intervención. Todo lo que llegó de la cumbre -a la prensa se la concentró en el Departamento de Estado, a dos kilómetros de la sede- hasta el comunicado final fue un goteo de información filtrada por las delegaciones.

Sin esclarecer qué rumbo tomará la nueva regulación, el comunicado sí asume que el origen de la crisis se debió a la actuación irresponsable de varios agentes financieros y

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que hubo claros fallos del lado del sector público: "Políticos, reguladores y supervisores en algunos países avanzados (una alusión velada a Estados Unidos), no apreciaron de forma adecuada los riesgos de algunos mercados ni siguieron el ritmo de la innovación financiera".

El resto del comunicado es un amplio listado de los deberes que quedan por hacer. Los ministros de Economía, con el apoyo de expertos y bajo la coordinación de la troika del G-20 (Brasil, Reino Unido y Corea del Sur) tendrán que hacer recomendaciones sobre cómo regular los complejos productos derivados financieros (que sirvieron para trocear el riesgo de las hipotecas basura de EE UU) o cómo coordinar las diversas normas nacionales.

El comunicado del G-20 da pistas de cómo se resolverán algunas de las incógnitas planteadas. Hay un llamamiento a reflejar el poder de las economías emergentes en el Fondo Monetario Internacional y a ampliar su capacidad para prestar dinero a países en desarrollo. Pero no hay ninguna mención a su papel como supervisor de las finanzas mundiales, una iniciativa europea que EE UU rechaza. Este cometido que parece reservado al Foro de Estabilidad Financiera, un organismo creado por el G-7, que reúne a los supervisores de las principales plazas financieras. Los líderes mundiales dan prioridad a la ampliación de este organismo para hacer sitio a países como China o India, una oportunidad que España quiere aprovechar para lograr representación.

También se considera una prioridad la creación de colegios de supervisores para seguir la pista a grandes entidades que operan en varios países (también iniciativa europea). Las recomendaciones sobre cómo supervisar las agencias de calificación de riesgos(ahora un monopolio de tres firmas estadounidenses), los sueldos de los ejecutivos, nuevos criterios contables que hagan más transparente el valor de los activos financieros o las medidas para garantizar que la banca tenga capital suficiente para afrontar los riegos formarán parte de esa primera ronda de propuestas. Se hace mención expresa a la necesidad de poner en marcha regulaciones "anticíclicas", una alusión que da protagonismo a la propuesta española de extender su modelo de supervisión, en el que el Banco de España obliga a las entidades a dotar provisiones en tiempos de bonanza para utilizar en época de crisis.

"Ésta es sólo la primera de varias cumbres, ya hemos tomado medida importantes, pero es necesario tomar más", afirmó Bush. La próxima cita de los líderes mundiales será en abril de 2009, con Obama ya al frente de EE UU y, previsiblemente, en Londres. Un tiempo que servirá para medir la eficacia del llamamiento a "una respuesta política más amplia contra la crisis". Y para comprobar si, como sostuvo Brown, éste es el inicio de un camino que llevará "a un nuevo Bretton Woods, a las instituciones internacionales del futuro".

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89B TRIBUNA: Primer plano 90BPAUL A. SAMUELSON

60BAcordaos de la economía real PAUL A. SAMUELSON 16/11/2008

El actual caos en todo el mundo recuerda mucho a la Gran Depresión de 1929-1939. Ambos periodos empezaron con desplomes de las bolsas en la mayor parte de los centros financieros mundiales.

Del mismo modo que se culpa con razón al presidente George Bush por la mala liberalización económica llevada a cabo entre 2000 y 2008, al presidente Herbert Hoover (1929-1933) y a su multimillonario secretario del Tesoro, Andrew W. Mellon, se les considera, por su inacción y sus ideologías ultraliberales, responsables de permitir durante mucho tiempo que la economía real se sumiera en un estancamiento cada vez mayor.

Tras un considerable ejercicio de ensayo y error, el activista New Deal de Franklin Roosevelt salvó el capitalismo. Los bancos centrales -la Reserva Federal estadounidense, el Banco de Inglaterra y los demás- se volvieron impotentes para invertir la marea de la depresión profunda. ¿Por qué? Desde el momento en que la deflación del nivel de precios redujo casi a cero el rendimiento de las menos arriesgadas letras del tesoro, todo el dinero nuevo que se crease no haría más que ser acaparado. (¡Los economistas estadounidenses se adelantaron al inglés J. M. Keynes al reconocer y dar nombre a la trampa de liquidez descrita más arriba!). Lo que en última instancia consiguió que casi se alcanzara el pleno empleo en Estados Unidos en 1939 fue, a fin de cuentas, el enorme gasto estatal deficitario. La Agencia para la Mejora del Trabajo entregó a los trabajadores en paro más pobres miles de millones de dólares en salarios gastables. Además, la Administración de Obras Públicas del New Deal gastó miles de millones más en obras públicas. Nada de esto fue suficiente.

La aceleración de los pagos públicos a los agricultores apuntaló los precios de los cereales y aumentó el poder adquisitivo. Por fin, algo nuevo: la sociedad de financiación de la reconstrucción (RFC, en sus siglas en inglés), que ayudó a sostener a los bancos con problemas. Esta RFC asumió las inversiones arriesgadas que podrían no llegar nunca a ser plenamente amortizadas.

De igual modo que es mejor amar y perder que no haber amado nunca, en tiempos de gran depresión toda la sociedad sale ganando incluso si la rentabilidad esperada no llega nunca. Recuerdo que durante el segundo mandato de Roosevelt en la Casa Blanca se construyó un útil crucero de la Armada. Resulta que en la Segunda Guerra Mundial resultó ser valiosísimo. ¿Cuál fue su verdadero coste documentado cuando se construyó?

Una contabilidad minuciosa calculaba que el coste de este barco había sido de hecho negativo para la sociedad. Lo que los contables consideraban dinero en efectivo perdido, la macroeconomía de la depresión propiamente dicha lo calcula como una compensación por los miles de millones de dólares de nueva producción y salarios que este barco había aportado al producto interior bruto.

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Nada de lo dicho anteriormente es una crítica a los dólares que Bernanke y Paulson han dedicado a rescatar bancos, aseguradoras y balances de las grandes empresas. Este equipo llevó a cabo con rapidez la importante labor que el equipo de Hoover-Mellon nunca llegó a hacer. Parte de la grandeza de Franklin Roosevelt fue su voluntad de explorar nuevos programas contra los vientos de la depresión. Probó el malhadado experimento de la administración para la reconstrucción nacional que consistió en dejar que los ejecutivos de la lana reorganizaran su sector, junto con otros planes empresariales de Mussolini igualmente descabellados. Pero pronto abandonó esos experimentos.

En las ocasiones en que el Tribunal Supremo cortó las alas de Roosevelt, redundó en beneficio de la sociedad. Es de esperar que cuando el joven y activo presidente Obama dé un paso en falso, los controles y equilibrios de nuestro sistema de democracia puedan ayudar a moderar los giros excesivos hacia la izquierda o hacia la derecha del sagrado centro.

En política, el tiempo es esencial. Los nuevos presidentes tienen periodos de gracia limitados para innovar. Por eso, recordando 1933 y 1934, animo a la próxima Casa Blanca y al próximo Congreso a improvisar para la economía real nuevas y grandes inyecciones de gasto directo que ayuden a debilitar las espirales descendentes que las recesiones son tan propensas a desarrollar.

Gasten así, recordando que en tiempos como éstos la deflación puede convertirse en un enemigo peor que la inflación. Ningún economista sensato lamenta hoy que Roosevelt rompiese las promesas electorales de "equilibrar el presupuesto" que hizo en 1932. En aquel momento, con una jugada por sorpresa, Roosevelt devaluó el dólar, sacando así a Estados Unidos del cruel patrón oro. Mis profesores estaban escandalizados. Dado que Estados Unidos era un refugio seguro para el amedrentado capital europeo, no había necesidad de tomar en aquel momento decisiones tan poco ortodoxas.

Por una vez, los jóvenes sabíamos más del asunto que nuestros mayores. Mientras que ellos pensaban que eran unas medidas egoístas por parte de Estados Unidos para "empobrecer al vecino", a nosotros Keynes nos había convencido de que devaluar el dólar para hacerlo coincidir con la devaluación de la libra británica era precisamente lo que nos permitiría a los dos mantener un gasto de déficit presupuestario expansionista.

A las pruebas me remito. Los cautos belgas depreciaron su franco. En Francia, el Frente Unido se mantuvo en el patrón oro. Bélgica se recuperó antes. La débil Francia fue la primera conquista fácil de los tanques alemanes. Sólo después de que hayamos iniciado la recuperación habrá llegado el momento de que los bancos centrales vuelvan a "centrarse en la inflación". Cuando llegue el feliz día de la recuperación, sospecho que los niveles de precios estarán hasta un 10% por encima de los de 2007. Es una pena. Pero habrá sido el precio necesario de salvar a la economía real y a las clases medias.

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91B REPORTAJE: Empresas & Sectores

61BLa crisis se cuela en los resultados 136BLos beneficios de las empresas del Ibex 35 caen un 10,1% en el tercer trimestre DAVID FERNÁNDEZ 16/11/2008

La crisis económica y financiera se ha colado en los resultados de las compañías cotizadas. Los grupos que integran el Ibex 35, el principal indicador bursátil español, ganaron de enero a septiembre de este año 41.009 millones de euros, un 9,79% más que en el mismo periodo del año anterior. Sin embargo, en el tercer trimestre, periodo en el que la desaceleración económica se ha agravado, las ganancias conjuntas cayeron un 10,15%. El deterioro de la actividad empresarial, más que en las cifras absolutas de las cuentas, que suelen verse afectadas a veces a favor y otras en contra por los resultados extraordinarios, se observa con claridad en la letra pequeña de las presentaciones.

En el sector financiero, por ejemplo, la crisis se hace notar sobre todo en el considerable repunte de los préstamos no cobrados. La tasa de morosidad media al cierre del tercer trimestre de los seis bancos que forman parte del Ibex 35 se situó en el 1,51%, más del doble que en el mismo periodo del año anterior (a 30 de septiembre de 2007 la morosidad media era sólo del 0,62%). Las dificultades de empresas y ciudadanos para hacer frente a sus compromisos han provocado que la tasa media de cobertura frente a la mora de estas entidades caiga del 301% al 136% en los últimos 12 meses. Banco Popular es la entidad con la mayor tasa de morosidad (2,19%), mientras que Bankinter presenta la menor (0,91%).

Tras un periodo donde el acceso al crédito era fácil y barato, familias y empresas se encuentran ahora con el escenario opuesto y cargadas de deudas. Las compañías del Ibex 35 han logrado reducir ligeramente (un 2,5%) su endeudamiento en los últimos 12 meses, pero sus compromisos bancarios siguen pesando como una losa. A 30 de septiembre la deuda financiera neta de las empresas del índice selectivo ascendía a 216.267 millones de euros, cantidad que equivale al 54% de su capitalización bursátil. Sacyr Vallehermoso es quizá uno de los principales exponentes del excesivo apalancamiento. Con una deuda de 18.550 millones de euros, sus gastos financieros durante los nueve primeros meses de 2008 han sido de 675 millones de euros (un 18% más que en 2007). Esta cantidad equivale al 83% de su beneficio bruto de explotación (Ebitda). La venta de Itínere aliviará en algo la situación financiera de Sacyr Vallehermoso.

El parón del gasto familiar pasa factura a las compañías ligadas al consumo. Inditex es el caso más claro. Las ventas totales del grupo textil en el primer semestre de su ejercicio fiscal (abarca de febrero a julio) crecieron un 11% frente al ritmo de mejora del 19% en el mismo periodo del año anterior. Además, las ventas en superficie comparable de Inditex sólo mejoraron un 1%. En los resultados de Telefónica también se observa un recorte de gastos en sus clientes. Por ejemplo, los minutos de uso del móvil en España han caído casi un 3% en los últimos 12 meses.

Otras compañías del Ibex con fuerte exposición al consumo son las compañías de transporte. En sus cuentas también se deja ver con claridad el impacto de la desaceleración económica en el bolsillo familiar. Iberia, por ejemplo, ha visto cómo el tráfico aéreo, con especial incidencia del mercado doméstico, ha caído en 2,4 puntos en

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el tercer trimestre y 1,4 puntos en el acumulado del año. Por lo que se refiere a las concesionarias de autopistas, Abertis y Cintra, el tráfico de vehículos ha sufrido una considerable caída, incentivada en su caso por el alto precio de los carburantes. En el caso de Abertis el tráfico hasta septiembre cayó un 2,4%, mientras que Cintra ha visto cómo el tráfico en la M-45, una de sus principales concesiones en España, ha caído un 22%.

El sector industrial no es tampoco ajeno a la brusca desaceleración económica mundial. "La demanda de acero inoxidable se ha visto muy afectada en el tercer trimestre por la crisis financiera internacional", reconoce Acerinox en la presentación de resultados remitida a la CNMV. El grupo siderúrgico ha registrado de julio a septiembre unas pérdidas de casi 30 millones de euros debido a la caída del precio del níquel (la cotización del metal está en su nivel mínimo desde 2003). "Todas las fábricas del grupo están, en la actual coyuntura de contracción de la demanda, adecuando su producción a la cartera de pedidos", reconocen desde Acerinox. Otra compañía industrial que también está sufriendo el parón de la demanda es Gamesa. El fabricante vasco de aerogeneradores anunció al presentar sus resultados que las 32 fábricas que tiene en el mundo realizarían un parón de siete días para "adaptarse a la producción".

En el caso de los medios de comunicación la crisis se manifiesta en una importante caída de la inversión publicitaria. Telecinco, cuyo beneficio neto de enero a septiembre se ha contraído casi un 8%, ha visto cómo sus ingresos publicitarios han sido un 6,5% inferiores a los de 2007. La caída de los anuncios ha sido especialmente brusca desde el mes de mayo. Antena 3 por su parte ha sufrido un bajón del 11% en su factura publicitaria.

El parón económico en España ha sido mucho más brusco que en la mayor parte de las economías y eso se nota también en las cuentas de resultados. Al menos la aventura exterior emprendida por las compañías sirve ahora para compensar la caída de la actividad en el negocio doméstico. Las ventas de Telefónica en España hasta septiembre sólo han crecido un 1,6% (en Europa han caído un 0,8%), mientras que su división latinoamericana ha mejorado su facturación en un 11%. Otro caso parecido se da en el Banco Santander. Mientras que el beneficio atribuido de sus negocios en Europa sólo creció un 9%, las ganancias de la entidad en Latinoamérica mejoraron un 20%.

Estas cifras no incluyen el impacto de la fuerte depreciación que han sufrido las monedas latinoamericanas en el último mes, por lo que puede que el impulso en las cuentas desde el otro lado del Atlántico en los trimestres venideros sea inferior.

La diversificación emprendida en los últimos años por las constructoras ha amortiguado la desaceleración de la construcción, tanto residencial como de obra civil. ACS, por ejemplo, ha declarado un crecimiento del beneficio neto del 34% hasta septiembre aunque las ganancias de su división de construcción han sido un 5,8% peores que en 2007. Los negocios industriales, logísticos y de medio ambiente han salvado los muebles a la compañía presidida por Florentino Pérez. Otro ejemplo es FCC. La compañía controlada por Esther Koplowitz ha visto cómo la facturación de su negocio de construcción en España ha caído un 1,2% hasta septiembre. En el caso de FCC, ha sido el área de construcción internacional la que ha resuelto la papeleta con un crecimiento del 38,3% hasta septiembre.

Lo peor de los resultados que han presentado las compañías no está quizá en los datos facilitados sino en las previsiones que manejan para 2009. Pocas son las empresas que se aventuran a hacer proyecciones en relación con el próximo ejercicio, y las que se atreven lo hacen con la mayor de las cautelas. "En 2009 el grupo se verá afectado por la

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ralentización del consumo en el mercado de viajes y por la consolidación de los principales grupos de inversión", ha explicado Sol Meliá. Entre las medidas que aplicará la cadena hotelera para paliar este impacto se encuentra la "reducción del capex [inversiones]".

Los que empiezan a ajustar sus previsiones al escenario de recesión global que se plantea para el próximo ejercicio son los analistas. Desde el pasado mes de enero el consenso de mercado, recopilado por la consultora Factset, ha recortado en un 14% la previsión de beneficios en 2009 para el conjunto del Ibex. Si hace 11 meses las casas de Bolsa auguraban unas ganancias de 54.787 millones, ahora sólo aventuran un resultado de 47.125 millones. Las compañías que mayores revisiones a la baja del beneficio han sufrido son, por este orden, Iberia, Ferrovial, Acerinox, Telecinco, Sacyr, FCC, Acciona y Gamesa. En tan sólo cinco casos (Mapfre, Grifols, Abengoa, Gas Natural y Red Eléctrica) la revisión ha sido al alza.

Las compañías cotizadas de tamaño medio y pequeño están sufriendo en mayor medida la crisis económica que las grandes. Las empresas del mercado continuo que no pertenecen al Ibex 35 ganaron de forma conjunta hasta septiembre 932 millones, un 80% menos que durante el mismo periodo del año anterior debido sobre todo a la crisis de las inmobiliarias. En el continuo ex Ibex hasta 40 compañías han registrado un resultado inferior al de los nueve primeros meses de 2007. -

92BREPORTAJE: Cumbre en Washington - Crisis mundial

62BUna cumbre en el fondo de un hoyo 137BLos países ricos viven la primera recesión conjunta desde la II Guerra Mundial CRISTINA DELGADO - Madrid - 16/11/2008

Crisis hipotecaria. Ese fue el primer nombre otorgado a las turbulencias por el estallido de las hipotecas basura en Estados Unidos. Todavía no estaba claro su alcance. Ni sus consecuencias. Cuando las vibraciones del epicentro estadounidense viajaron a Europa y a Asia, ya era una crisis financiera. Caídas en las Bolsas, primeros impactos en bancos y firmas de inversión, quiebras y rescates millonarios. Ahora que las dificultades en los mercados han terminado por contagiar a la economía real, la crisis ha perdido su apellido. Es crisis. A secas. Mientras los gobernantes se reúnen para intercambiar recetas de austeridad, los organismos internacionales hablan ya sin tapujos de un mundo en recesión.

"En las economías avanzadas, el PIB interanual se contraerá en 2009. Es la primera vez que ocurre tal disminución desde el periodo de la posguerra [II Guerra mundial]. En las economías emergentes, el crecimiento sufrirá una disminución apreciable". Así comienza el último informe presentado hace unos días por el Fondo Monetario

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Internacional, en el que se rebajan las perspectivas de crecimiento mundial. En 2009 no se avanzará el 3%, sino el 2,2%. Y si se retrocede hasta abril, la brecha aumenta, ya que por aquel mes el FMI pensaba en una subida del 3,9%. No son los únicos en pintar un futuro cada vez más complejo. En sólo diez días también la OCDE y la CE han rectificado a la baja sus previsiones. ¿Qué ha oscurecido tanto las perspectivas en los últimos seis meses?

Tomando España como ejemplo, el deterioro de las cifras previstas ha ido parejo con un aumento del paro, que ha pasado del 8,2% de media en 2007 al 10,5% este trimestre. La matriculación de automóviles ha caído un 23% entre julio y septiembre con respecto al año anterior. La compraventa de casas el 40%. La iniciación de nueva vivienda ha quedado prácticamente congelada y los expedientes de regulación de empleo (ERE) en la construcción han crecido un 360% hasta septiembre. Consecuencias: según el FMI la economía española se contraerá un 0,7% de media en 2009. El paro llegará al 15,5% según cálculos de Bruselas.

Si abrimos el objetivo a la Unión Europea, la radiografía no es muy diferente. La zona euro ha entrado en recesión por primera vez desde su creación en 1999. El conjunto de los 15 países de la moneda única ha registrado en el tercer trimestre del año una contracción del PIB del 0,2%. Ya van dos. La Comisión Europea calcula nueve meses de depresión este año. En los seis primeros de 2009 el avance será casi nulo. Y es que Alemania, motor de la economía del Viejo Continente, encadena dos caídas del crecimiento, la última de cinco décimas. Italia, tercera economía de la zona, también está en recesión formal. Irlanda fue el primero en retroceder. Holanda lleva dos trimestres en la cuerda floja del estancamiento. España se asoma ya al abismo y Francia ha logrado esquivarla por los pelos, con un 0,14% de crecimiento. El paro en la Europa de los 15 se acercaba al 7,5% en octubre, dos décimas más que un año antes.

Una panorámica aún más amplia, y siguen los problemas. "La economía del área de la OCDE [los 30 países más industrializados del mundo] parece haber entrado en recesión, y el paro está creciendo en varios países". Así justifica el organismo su rectificación. "Viviremos un extenso periodo de viento en contra hasta finales de 2009, con una posterior recuperación progresiva", vaticina. Según sus cálculos la eurozona en 2009 retrocederá el 0,5%, en lugar de crecer el 1,7% como se dijo en junio.

La economía de Estados Unidos se contraerá el entre 0,9% y el 0,7%, según quien haga las previsiones. En cualquier caso, nadie espera crecimiento hasta 2010. En este país fue donde apareció la mancha de aceite que se ha ido extendiendo por todo el mundo. Hacia allí señalan quienes hablan de falta de regulación y exceso de ingeniería financiera, cuna de la especulación. Las hipotecas basura han causado de momento en sus firmas de inversión y bancos unos 500.000 millones de dólares de pérdidas. Más de 100.000 personas han perdido su empleo en Wall Street y demás centros neurálgicos de los negocios. Y la llegada de estos golpes a la economía real dejó en octubre una tasa de desempleo del 6,5%, la mayor desde 1993.

Las economías emergentes tampoco se salvan. "Los mercados se encuentran en un círculo vicioso", dice el FMI, y los nuevos mercados están sometidos "a una presión aún más aguda". Calculan que en conjunto crecerán el 5,1%, eso sí, después de recortar ocho décimas el avance de China y seis el de India.

En medio de este panorama, al tiempo que recortan los organismos financieros reparten doctrina. El FMI apuesta por "nuevas políticas de estímulo", en especial, fiscales y monetarias. La OCDE aboga por "cooperación" para evitar "medidas que distorsionen la

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competencia". Pide además la revisión de las políticas de regulación y supervisión. La Comisión Europea sólo ve la luz si hay una "acción común".

63B"Puede que el G-20 se convierta en un G-22" 138BEl ministro de Exteriores de Brasil, país que preside el G-20, apuesta por la presencia de España en la próxima cumbre

EFE - Washington - 15/11/2008

Brasil, que ejerce la presidencia del G-20, ha respaldado la participación de España en la próxima cumbre, prevista para antes de finales de abril, y ha mencionado la posibilidad de su integración formal en este Grupo.

"España es bienvenida" al siguiente encuentro, ha dicho a la prensa el Ministro de Relaciones Exteriores brasileño, Celso Amorim. Sin embargo, Amorim ha aclarado que quien hará las invitaciones para la próxima cumbre será el Reino Unido puesto que presidirá el G-20 el próximo año.

Amorim ha recordado que el presidente de Brasil, Luiz Inácio Lula da Silva, apoyó la participación de España en la cumbre que tiene lugar hoy en Washington. Lula también mencionó que sería importante incluir a otro país en desarrollo, por lo que Amorim ha señalado que "puede ser que desde ahora hasta la reunión en Reino Unido, el G20 se convierta en un G22".

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64BBusinessWeek 65BFall of the Funds of Funds 93BFunds of funds were supposed to be the safe choice for wealthy investors and big institutions. But they were leveraged beyond the max By David Henry and Matthew Goldstein

November 13, 2008, 5:00PM

Hedge funds, already suffering from an ill-fated love affair with leverage, are finding themselves haunted by another problem. It turns out many so-called funds of hedge funds, portfolios with stakes in multiple hedge funds, also depended on borrowed money. Now, with lenders retracting credit, fund-of-funds managers are being forced to dump assets, putting further pressure on the hedge funds and the markets generally. It's "a vicious circle," says Kate Hollis, director of fund research at Standard & Poor's (MHP).

As the great edifice of leverage crumbles, funds of funds are faring worse than hedge funds. They're off 18.7% this year, vs. 15.5% for individual hedge funds. Among the funds of funds hit hard: some run by Fix Asset Management, Ontario Partners, and HRJ Capital, co-founded by former football star Ronnie Lott. All declined to comment for this story.

Funds of funds were supposed to be the safer choice for high-net-worth individuals and big institutions. By spreading their bets across dozens of investments, managers assured clients they didn't have to worry about a blowup in any single portfolio. It was the sort of flawed diversification argument used to justify many speculative investments during the boom, including those notorious collateralized debt obligations stuffed with subprime mortgage securities. The pitch fueled explosive growth: By the end of 2007, funds of funds accounted for 43%, or $747 billion, of the hedge fund industry, up from 19%, or $103 billion, in 2001, according to Hedge Fund Research.

139BOVERLOADED Roughly half of that universe employed leverage. Some funds of funds borrowed directly from banks to buy $2 of assets for every $1 of investors' money. Brokers, meanwhile, encouraged wealthy customers to finance their fund-of-funds purchases on credit. Big banks sold "principal protection products," derivatives that supposedly guaranteed clients wouldn't lose a cent of their initial investment—and the banks in effect used leverage to create those insurance policies.

The funds of funds were layering leverage upon leverage. They owned hedge funds already loaded up with debt, roughly $6 for each $1 of capital. When credit seized up, the process began to reverse. "Once things start to delever, everything contracts," says Andrea S. Kramer, a lawyer at McDermott Will & Emery who represents hedge funds.

To protect themselves, such big global banks as France's BNP Paribas, KBC Group of Belgium, and the Royal Bank of Canada are now charging higher fees on loans they extended to funds of funds, or pulling the loans entirely. The tight credit is compelling

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fund-of-funds managers to sell their holdings, which is driving individual funds to dump stocks, bonds, and commodities.

The situation shows no sign of stabilizing. Consider CMA Global Hedge PCC, a $360 million fund of funds. The portfolio, which over the years used financing from JPMorgan Chase (JPM), Société Générale, and HSBC (HBC), is currently relying on credit from Citigroup (C) . Its holdings—47 hedge funds—are down 11%. Add in leverage, which amplifies losses, and CMA Global is off 25%.

Wary of Citi charging more for the fund's loan, manager Sabby Mionis is trying to sell hedge fund stakes to reduce debt. But a number of the funds have suspended redemptions, making it tough. Mionis is now working on a plan to return some money to investors: "For the foreseeable future, leveraged funds of funds are dead."

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153BE C O N O M I C P O L I C Y R E V I E W E X E C U T I V E S U M M A R Y

162BDivorcing Money from Monetary PolicyRecapping an article from the September 2008 issue of the Economic Policy Review, Volume 14, Number 216 pages / 217 kb Authors: Todd Keister, Antoine Martin, and James McAndrews

Many central banks implement monetary policy in a way that maintains a tight link between the stock of money and the short-term interest rate. These procedures require the central bank to set the supply of reserve balances precisely in order to implement the target interest rate.

Because reserves play other important roles in the economy, the link can create tensions with other objectives of central banks. For example:

The imbalance between the intraday need for reserves for payment purposes and the overnight demand leads central banks to provide low-cost intraday loans of reserves to participants in their payments systems, exposing central banks to credit risk and potential moral hazard problems.

The link between money and monetary policy prevents central banks from increasing the supply of reserves to promote market liquidity in times of financial stress without compromising their monetary policy objectives.

The link also relies on banks facing an opportunity cost of holding excess reserves, which leads them to expend effort to avoid holding these reserves and thereby makes the monetary system less efficient.

Keister, Martin, and McAndrews consider an alternative approach to monetary policy implementation—a “floor system”—that can eliminate these tensions by “divorcing” the central bank’s quantity of reserves from its interest rate target.

By paying interest on reserve balances at its target interest rate, a central bank can increase the supply of reserves without driving market interest rates below the target.

The authors explain that a floor system allows a central bank to set the supply of reserve balances according to the payment or liquidity needs of financial markets. By removing the opportunity cost of holding reserves, the system also encourages the efficient allocation of resources in the economy.

A version of the floor system was recently adopted by the Reserve Bank of New Zealand; this option for monetary policy implementation will be available to the Federal Reserve beginning in 2011.

[Ver artículo completo al final del CD]

November 20, 2008

New Articles

The Economists' Voice http://www.bepress.com/ev

The Berkeley Electronic Press is pleased to announce the following new articles recently published in The Economists' Voice. To view any of the articles in question, simply click on the links below:

Columns

Paulson's Latest and an Alternative: Why the Treasury Should Buy Common, Not Preferred, Stock and Why LIBOR Deposit Guarantees Could Backfire Jonathan Carmel

The Next Collapse: U.S. Price Inflation Janine Aron and John Muellbauer

Stocks for the Long Run J. Bradford Delong

Deflation: Are We Still Sure "It" Cannot Happen Here? Edwin Dolan

Letters

Letter: Comment on Stiglitz's "Turn Left for Sustainable Growth" P. K. Rao

Letter: Should Liberals (or Anyone Else) Really Support Social Security "Personal Accounts"? Max J. Skidmore

http://www.bepress.com/ev/announce/20081120

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It’s been a scary time in the markets. Stock indices around the world have plunged in the days since the announce-ment of the Paulson bailout plan. Con-gressional approval of the plan did little

to restore confidence. Clearly more (and better) action was re-

quired. We’ve just seen the Treasury’s next move: the purchase of preferred stock to di-rectly inject equity capital into various banks and the Federal guarantee of some forms of new short-term bank debt as well as extending unlimited insurance to business deposits.

To get some understanding of the roles of the various parts of the Treasury’s new plan and

to see what can go wrong, let’s start by thinking about what would happen if the Treasury went with a simpler plan that just contained unlim-ited insurance for bank deposits.

We often hear the term “global bank run” applied to the situation currently besetting the banking sector. The standard remedy for a bank run is deposit insurance. On the face of it, this seems like the direct, sensible approach to re-store confidence. Unlimited deposit insurance by itself, however, would likely back-fire.

nowhere to run

Suppose there was a run on a bank. Where would fleeing depositors take their money?

Most likely to another bank. So overall banking balances might be little affected.

Suppose instead there were a run on the whole global commercial banking system.

How would you run? Where would you go? You’re not going to put it in another bank. You would go to Treasuries. Treasuries are easier to store and protect than cash and they typically offer some interest.

The global “bank run” we are seeing is really a flight to quality which means that capital rush-es into Treasuries. But the supply of Treasuries is fixed. There simply is no way for all investment capital to fit into the fixed supply of Treasuries.

Typically, the next safest and most liquid al-ternative to Treasuries is to deposit money in the safest, least entrepreneurial sectors of the bank-ing system. U.S. banks actually see their depos-its increase during global financial panics!

Here’s the danger. Unlike Treasuries, in-sured bank deposits are not in fixed supply. The banking sector can absorb large amounts of capital. Think about what happens to that

Jonathan Carmel is a Visiting Assistant Professor of Finance at the Stephen Ross School of Business, University of Michigan, and worked in the Fixed Income Division at Lehman Brothers from 1999 to 2004.

Paulson’s Latest and an Alternative: Why the Treasury Should Buy Common, Not Preferred, Stock and Why LIBOR Deposit Guarantees Could Backfire

JONAThAN CArmEL

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capital. The bank will value its reputation for safety and conservatism. This is the source of its deposit windfall and will help keep regula-tors at bay. Even the most modest return on investments will be more than enough to cover the cost of deposits and fundamental risks are high. Thus the preponderance of this new capi-tal will be invested in the safest possible loans.

But to soften the upcoming recession, we need investment capital to be risk capital sup-porting viable, well-run businesses. We need capital to invest in new equity and corporate bond offerings. The more money that is safely parked in FDIC-insured deposits, the less there is available to invest in stock and corporate bonds. It is true that money in insured depos-its does get recycled into the real economy, but, under a prudent commercial banking regime operating during a high-risk period, these de-posits only get recycled into the safest segments of the investment universe.

The bank run we are experiencing first hit the money-center banks and investment banks at the core of the system the corpo-rate world depends on to underwrite new eq-uity and bond offerings. Now it has spread to the corporate bond market and the equity

market, grinding primary issuance in these markets almost to a halt.

While there is some concern about other sectors of the banking system, they have not been hit. In fact, their deposits have increased. Unrestricted deposit insurance would simply increase the global “bank run” from the viable but risky sectors of the economy to the safest sectors of the economy.

To the extent it insures LIBOR loans, the new Treasury plan should avoid most of the dangers described above. Insuring LIBOR loans allows money to be invested in the money-center banks involved in financing the corporate world at the same level of safety as money invested in sleepy, conservative banks at the periphery of the financial system. This part of the package should alleviate the pros-pect of capital draining from the center of the financial system but is likely to introduce other problems discussed below.

treasuries: a double-edged sword

The same reasoning implies that we should be careful about having the government

try to spend our way out of this crisis. Every dollar that the government uses to buy tainted

assets, bailout banks, or cut taxes creates an extra dollar of safe Treasury securities which inevitably diverts a dollar of private investment capital from risk-bearing securities.

This is not intended as an argument to do nothing. Instead it points out that there is a real importance to using Federal dollars wisely and efficiently in efforts to rebuild the banking system. Even in a capital crisis, throwing money at the problem can actually make the problem worse. We have to be care-ful that the money the government spends to rebuild the financial system does more good than the harm done by creating an extra dollar of Treasury securities which will absorb a dol-lar of capital that could have otherwise borne some of the economy’s risks.

deposit insurance & bank capitalization

The largest financial bailout prior to this year’s events, the 1980s Savings & Loan

Crisis, was due to deposit insurance. Even the current crises is, in part, due to something akin to deposit insurance: implicit guaran-tees given to Fannie Mae & Freddie Mac debt. These implied guarantees were essentially un-limited insurance for bondholders, rather than

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depositors, but the underlying economics are the same. The inferred guarantee attempted to maintain bond market confidence that Fannie & Freddie would always be able to rollover their short-term debt. We see where that ended.

The attractive feature of deposit insurance is that it greatly diminishes the prospects of a bank run. But the examples above indicate that it can also lead to financial crises. What deter-mines the likelihood that deposit insurance will turn out badly? Capitalization.

Consider a bank that owes more than its assets can possibly be worth under responsible management such that, if the bank were able to sell off its assets at true market value, the pro-ceeds would not come close to that required to pay off its debt obligations.

What can the bank do to try to stay alive and generate positive equity value? If it could borrow at cheap rates, it would borrow as much as it could and invest the money in very risky investments. If it were able to, it would take the money and put it on Lucky 7, even though the casino provides a negative expect-ed return on investment. If the bet pays off, then the bank can pay off its debt and keep the rest for the equity holders. If it doesn’t payoff,

well, the bank was insolvent anyway and this was the equity holders only shot.

For efficient capital allocation, we need banks to care about the expected return on in-vestment relative to systematic risk. But a des-perate bank cares little about the investment’s expected return. What a desperate bank really cares about is the magnitude and likelihood of extremely high returns which is governed primarily by the volatility of the investment payoff. Feasible expected returns typically can only cause a moderate shift up or down to the whole distribution of returns.

Without deposit insurance, a bank in the above circumstances would not be able to raise capital at cheap rates. But with deposit insurance, even an insolvent bank can at times get access to large amounts of capital at cheap rates. While regulatory requirements put the roulette wheel at Vegas off limits and protect against other risks, there are plenty of risky subprime mortgages out there and it would be easy for a bank to bet every-thing on a near-term economic recovery or an un-expectedly slow rise in the level of subprime de-faults. It might even issue new subprime loans!

The current Treasury plan greatly increases these dangers in that it appears to insure, not

just bank deposits, but also short-term loans in the LIBOR market. If the Treasury plan is suc-cessful in restoring the LIBOR market, banks will be able to raise tremendous amounts of cash very quickly by borrowing in the LIBOR market. The money-center banks that bor-row in this market have a wide array of risky investment opportunities available to them, much wider than was available to Fannie Mae or Freddie Mac.

Most banks have a franchise value that makes their overall value greater than the market value of their assets. Banks with strong equity capitalization are less willing to risk their franchise value by taking a spin at the roulette wheel. The danger comes when bank equity capitalization is low. Then the temp-tation to play roulette is the greatest. Most economists agree that the banking system currently is extremely under capitalized. Is this really the time to introduce government insurance of the LIBOR market and expand ordinary deposit insurance?

dead banks walking

Why is the combination of deposit in-surance and low levels of equity

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capitalization so combustible? Low equity capitalization implies that, under prudent op-eration, equity holders are unlikely to gain any benefit from the bank’s assets. The assets will all go to the bank’s bondholders and depositors.

However, until regulators actually seize the bank, its operations are controlled by the equity holders who get to bet with other peo-ple’s money. If they win, the equity holders get a share of the winnings. If they lose, they were going to get nothing anyway.

The tension comes from the period in which the equity holders retain control of as-sets that are destined for others. During this period the bank is insolvent. It should be dead and yet it is still operating. It is a “zombie.” Anything, such as deposit insurance or govern-ment insurance of LIBOR loans, that increases the capital available to these “zombies” and the length of time they walk the earth creates a po-tential nightmare for the banking system.

what would warren do?

The latest Treasury plan seems to partially be a response to the growing consensus

that the banking system needs to be recapital-ized. The question is how to do it? Many are

enamored of injecting government funds into distressed banks in exchange for a combination of preferred stock and equity warrants where the preferred stock has a face value equal to the capital injected and pays a nice coupon. This is what the Treasury did with AIG, Fannie Mae, and Freddie Mac. It’s what Warren Buf-fet did with Berkshire Hathaway’s investment in Goldman Sachs. This same approach, poten-tially without warrants, is at the heart of the Treasury’s most recent program.

The idea has a lot of appeal. The preferred stock component guarantees the government will get its money back (plus interest) before the bailed-out equity holders get anything, and the government also gets to enjoy the upside through the warrants if the firm takes off. How can something that feels so right, possibly be wrong?

The problem is that, if the government takes a big slug of preferred in front of equity holders that already have too much debt, there is the real danger of creating a zombie: A firm in which management and equity holders con-trol assets that, under efficient operation, are destined for the debt holders and preferred holders, but not the equity holders.

The inevitable response is: “You’re not smarter than Buffet and this is what he does with his own (or Berkshire Hathaway’s) mon-ey.” While the first part of such a rejoinder is certainly true, the second part isn’t. Buf-fet does not invest in dead companies using preferred stock and warrants or in any other manner. He identifies companies, like Gold-man Sachs, that he thinks will be healthy companies with viable equity stakes after his investment. If he has doubts, he can protect himself by taking board seats, but that would be a mistake for the government.

The warrants part of the package does lessen the equity holders’ gains from taking large unjustifiable risks and hoping they hit. But if the prospect of paying off the preferred under proper operation is minimal, then the warrants do little to generate good incen-tives. If the only way to pay off the debt and preferred is to play the lottery, then the firm will play the lottery even if the warrants mean that it would have to share some of its lottery winnings with the government.

Thus care must be taken even with a pack-age of preferreds and warrants to make sure that the equity of the resulting firm is viable.

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Otherwise, such a program would directly damage, rather than rebuild, the markets.

The Treasury plan may be trying to balance these concerns by structuring the preferred on terms “favorable to the banks.” While this re-duces the zombie problem to some extent, it does so at direct cost to the taxpayers. To the extent the Treasury forgoes warrants, it will both be sweetening the deal for the banks at the expense of taxpayers and increasing the potential for injudicious risk-taking behavior. At the present date, it is not possible to tell whether the resulting capital infusion will be sufficient to create healthy banks.

If we need to invest public capital into the financial markets, it is generally safest and best to inject the funds directed in firms that al-ready are well-capitalized. With increased eq-uity capital, well-run firms that currently have strong equity positions would be able to greatly increase their borrowings and expand into the parts of the capital market left vacant by banks which have fallen. This also ameliorates the moral hazard problem since the healthy well-capitalized banks that would directly benefit from such a plan are unlikely to have been the main culprits that caused the initial crisis.

Any use of public funds will necessarily create an increase in the supply of Treasuries. If we are not careful we could get the worst of both worlds, in which the public funds create zombies rather than healthy banks while the extra Treasuries issued to fund the zombies end up moving equal amounts of capital out of risky asset classes and into the additional Treasuries.

how to get more capital to good banks

Rather than using public funds, I would greatly favor using Luigi Zingales’s expe-

dited Chapter 11 proposals to recapitalize the financial sector. If we do need to invest public money, the best route would be to use a large tax rebate on the order of $5000 a family as a vehicle to recapitalize the banking system.

The tax rebate would have several special features that would serve to infuse cash back in the banking system. For anyone with a mort-gage with a current loan-to-value ratio greater than 80%, the rebate would be sent to the mort-gage holder and credited against the taxpayer’s mortgage balance. This would add $5000 of cash to the institution holding the mortgage while at the same time providing an equivalent

reduction in the taxpayer’s mortgage obliga-tions. For those who do not have mortgage debt of the type described above but do have past due credit card balances, the $5000 would be put against past due credit card balances.

To protect against fraud, taxpayers would be asked to list their mortgage holders and credit card accounts. Similarly mortgage servicers and credit card companies would be asked to list balances owed and original property value (for mortgages) by Social Security number. A match would provide good confidence that the money is being sent to the right institution and credited to the right accounts.

For individuals who do not have past due credit card balances or mortgage debt of the type described above, the entire $5000 would be cred-ited to an account in their name which would be invested in new common stock issues from the banking sector. Rebates would be denied to any-one who defaulted on a mortgage since 2003, reducing the moral hazard problem.

The plan has several advantages. The first is that the entire rebate would end up as cash in the banking system. For those owing past due credit card balances or mortgages with high loan-to-value ratios, the cash goes straight

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to the creditor and, at the same time, gives the taxpayer some relief from debt balances. For the remaining taxpayers, the tax rebate is new equity invested in bank stocks.

The second advantage is that all taxpay-ers get the same benefit: the same reduction of debt or the same wealth increase. The cash is not directed to those who “misbehaved” in the past. In fact those who defaulted lose the rebate. This reduces moral hazard problems and makes the plan fairer and more palatable politically than some others.

It also decreases the incentive for mort-gage holders to default in the future. In de-fault, debtors don’t get reimbursed for past amounts spent to pay down principal on the now defaulted loan. The only way for a high loan-to-value borrower to enjoy the benefit of the tax rebate is to eventually pay off the entire mortgage.

The extent of the bailout is also limited since, while taxpayers receive rebates of past taxes, the likelihood of future tax liabilities increases due to the increase in the public debt. The plan’s long-term wealth redistribu-tion primarily follows the progressivity of the federal income tax code.

It is true that Wall Street gets a bit more than their share in that they will receive cash sooner than otherwise and will receive cash on some debt balances that might have defaulted otherwise. The plan also increases demand for bank shares. No practical plan that uses pub-lic monies can be completely neutral. Of the plans that use public funds to recapitalize the banking system, this one keeps the favoritism toward Wall Street to a minimum.

The plan also has minimal impact on the nation’s overall debt. The increase in public debt is matched dollar for dollar with decreases in private debt and increases in private sector equity investment. How much would public debt increase? On the order of $500 billion, well within the current $700 billion budget.

To the extent there is a bailout, the bailout does not all go to Wall Street. Main Street also sees its debt balances reduced. Others on Main Street receive stock investments. Politically it is not tenable to have a Wall Street bailout with-out a Main Street bailout. One needs to increase the price tag for any plan that creates a bailout only for Wall Street with the cost of the inevita-ble follow-on bailout for Main Street. This plan combines the two into one.

getting bank shares to the taxpayers

There are a variety of possible mechanisms for making equity investments in banks shares:

• Auctions, as proposed by Ausubel and Crampton.

• The Treasury could announce its willing-ness to participate in any private deals that purchase new equity and the Treasury could see what offers it is invited to join.

• Asset managers could make the purchase decisions or these decisions could be made by the individuals receiving the rebate.

• Banks could be compelled to accept equity contributions at some discount to recent (or future) market prices.I’m sure there are many other possibilities

as well. Regardless of the method chosen, there

is no reason for the Treasury to hold the pur-chased securities. Instead the securities should be put in a closed-end fund that would be spun off from the Treasury as a private investment fund which would simply hold the purchased assets and pass-through any cash flows from these securities.

The fund would make no further purchases (except perhaps to exercise rights offerings that

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references and further reading

Solomon, Deborah, D. Paletta, and J. Hilsenrath

may have come with its equity securities). The shares of the closed-end fund would initially be valued at cost and distributed to the taxpay-ers that are entitled to take their rebate in the form of bank equity.

A feature of this plan is that, while public funds are used to recapitalize the banking sec-tor, no public ownership results. Instead the public, rather than the government, receives the shares.

The taxpayers that receive shares in the closed-end fund would then be free to sell their shares in the market if they desire, ef-fectively giving them a cash rebate which can then be spent on goods and services. If they choose to sell, it would be in the secondary market. No capital would leave the banking sector. At some point in the future, the closed-end fund would be terminated and its con-tents distributed to shareholders.

Common stock, rather than preferred, should be the instrument of choice since it does not increase the bank’s debt overhang problem.

A plan of this sort could be implemented very quickly. The Treasury could purchase eq-uity shares at whatever pace it thinks is best using whatever procedure it prefers. The scale

of the resulting purchases would then be used to estimate the size of the necessary tax rebate.

Finally, there is no point putting capital into the banking system just to have it paid right out in the form of dividends or share repur-chase. However, as many commentators have pointed out, firms may fear to cut their divi-dend since this might lead others to infer that they are desperate for capital: a classic asym-metric information problem.

Right now the economy needs debtors to build up their equity capital. The above asym-metric information problem applies to indus-trial firms as well as banking firms. While the need for equity recapitalization is greatest in the banking sector, leverage ratios are quite high by historical standard in a wide variety of industries.

Firms with publicly-traded equity that have debt payments due within two years should be prohibited from paying dividends or engaging in any form of repurchase of eq-uity instruments (other than preferred stock) unless it establishes a sinking fund that fully funds the debt payments due over the next two years. All-equity firms would be free to set their dividend and share repurchase policy as

they like. These restrictions would be lifted, of course, once the crisis has passed.

While the Treasury’s new plan to make pre-ferred stock investments is a step in the right direction, it still involves unwarranted subsi-dies for the banking sector and, by taking pre-ferred stock rather than common, makes lim-ited progress in addressing the debt overhang problem plaguing the banking sector.

To the extent that the plan insures LIBOR loans, the interbank market may well be re-vived but at the cost of creating the poten-tial for a second debacle on the scale of Fan-nie Mae and Freddie Mac. A better approach would be to directly address the debt over-hang system through a system of expedited Chapter 11 as proposed by Luigi Zingales supplemented, if need be, with the tax rebate plan described in this piece.

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(2008) “U.S. to Buy Stakes in Nation’s Largest Banks,” The Wall Street Journal, October 14, A1. Available at: http://online.wsj.com/article/SB122390023840728367.html.Zingales, Luigi (2008) “Plan B,” Economists’ Voice, 5(6): Art. 4. Available at: http://www.bepress.com/ev/vol5/iss6/art4/.

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The Fed and other central banks can now stop worrying about in-flation. Price deflation is much more likely in the near term. How-ever, deflation for a time need not

be the terror central bankers’ fear, at least if the banking system is recapitalized and if indus-trial countries’ interest rates fall sharply.

recent inflation worries

The Federal Reserve Bank minutes released on October 7, 2008, disclosed that as recently

as September 16th, the Fed officials thought the

risks to U.S. growth and inflation were roughly equally balanced. Moreover, the Federal Reserve Chairman, Ben Bernanke, acknowledged on the same day that, although the inflation outlook had improved somewhat, it remained uncertain. Central banks’ caution about inflation risks and reluctance to decrease interest rates is under-standable given the experiences of 2008.

The financial markets may have taken the Fed’s view on U.S. inflation as representative of other central banks’ outlook on inflation, rein-forced by the surprising ECB decision of October 2nd not to reduce interest rates. Following the Fed release, the Dow Jones index fell by 6.5 percent, as the markets discounted the internationally co-ordinated interest rate cut that they had expected. However, this sharp decline and the knock-on effects on world markets then helped precipitate the expected coordinated cut on October 8th.

We argue that the U.S. is now on the cusp of the most significant turning point for infla-tion in the last 20 years, so that many of the standard models are likely to go badly wrong. Forecasting inflation is notoriously difficult. There have been large structural shifts in the world economy (e.g. trade and financial glo-balisation) as well as in individual economies (such as the decline in trade union power). Monetary policy itself has shifted to a far great-er focus on inflation. Energy and food price shocks can be large and very hard to predict, and indeed, the speed of price changes tends to increase with big shocks. Most forecasting models used by central banks therefore put a large weight on recent inflation. This approach tracks inflation quite well, except at turning points, because the models miss key underly-ing or long-term influences.

Janine Aron is a Research Fellow in the CSAE, Department of Economics, Oxford. John Muellbauer is an Official Fellow of Nuffield College and Professor of Economics, Oxford University. He is a CEPR Research Fellow and has been a consultant to the Bank of England, HM Treasury and the Office of the Deputy Prime Minister.

The Next Collapse: U.S. Price InflationJaNiNE aroN aNd JohN MuEllBauEr

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The economics of this turning point are straightforward. Global output is probably falling faster than at any rate since the war, except perhaps for 1974–5. Under these circumstances, large ex-cess capacity develops and commodity prices fall.

Many continue to believe that emerging markets will provide a stabilizing influence on the world economy: in fact the opposite is likely to be true. Countries such as China are highly geared to exports and above all to investment, which in China accounts for a larger fraction of GDP than does consumer spending. Apart from investment in infrastructure, health care and education, China’s investment is highly geared to growth. This makes the recent IMF forecast of 9.3 percent growth in China in 2009 unrealistic. If growth falls more sharply, as is plausible, the consequent reduction in invest-ment will amplify the growth reduction in China, exceeding the percentage reduction in other drivers of global economic activity, such as U.S. consumer spending.

It seems unlikely that governments in China and similar emerging markets can compensate swiftly enough to boost domestic consumption. And with growing over-capacity, investment in goods production may fall even further, with

serious implications for GDP. Hence the de-mand for commodities, which has been driven by emerging market growth, will fall sharply, and help decrease global inflation. Eventually through this channel, lower commodity prices and lower inflation will act like a huge tax cut for households, allowing interest rates to fall further and thus stabilise economic activity. Paradoxically, the faster oil prices now fall, the shorter will be the subsequent period of defla-tion, as further damage to the economies of in-dustrial countries is avoided.

The more than 10% fall in oil prices on Oc-tober 10 is very likely a signal that the OPEC car-tel will not be able to cut output fast enough to maintain the price at anywhere near the $90 a barrel level. This is thought to be the target price favoured by the Saudis and indeed the price has hovered around this level for some weeks, despite all the bad economic news. History suggests that cartel discipline in conditions of collapsing de-mand is unlikely to be sustained. There are prob-ably still hedge funds carrying the ‘long oil, short financials’ trade which has been so popular in the last year. As they unwind their positions, oil pric-es could fall below $50. (Note added in proof: by October 30, oil prices had fallen to close to $60.)

our econometric research

In a recent Oxford University discussion paper, we have designed new forecasting models for

U.S. inflation, improving further on our earlier research which successfully forecast the 2001 U.S. recession (Financial Times, May 1 2001, p.19) and the subsequent recovery. Our infla-tion models for the U.S. consumer price index (as measured by the PCE deflator preferred by the Fed) build in a wide range of factors includ-ing oil and food prices, house prices, producer prices, unit labour costs, import prices, prices in other countries and the exchange rate, trade union density and the unemployment rate.

Our models have been tested out of sample on monthly data from 2000 to the present, and surpass standard models by wide margins. A key element of these models is the long-run ad-justment in consumer prices to costs and other prices. The model suggests a long-run solution for U.S. consumer prices as a function of unit labor costs (with a weight of over 50%), U.S. house prices and foreign consumer prices con-verted into Dollars. Unit labor costs in the U.S. are central to the model and have remained low despite higher goods price inflation. House prices have a powerful effect in the model,

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entering with a long lag. Their importance lies in the role of rents in the consumer price in-dex, but probably also reflect other macroeco-nomic influences. House price falls have offset some of the recent inflation from higher oil and food prices, and we expect lower and still falling house prices now to be a major defla-tionary force. Declining foreign inflation and recent Dollar appreciation suggest little pros-pect of imported inflation. Since oil and food prices are falling sharply, and have further to fall, while unemployment is shooting up, our models suggest that U.S. consumer price infla-tion must fall at record rates over the next 6–12 months. Our models of the underlying com-ponents, durable and non-durable goods and services inflation, further reinforce this view. It is entirely credible that the U.S. inflation rate, measured over 12 months, will become nega-tive within the next 18 months.

the policy debate

While some observers are still worried about inflation risk, others are con-

cerned that the usual monetary transmission mechanism is not working and that a Japanese-style ‘lost decade’ for the U.S. is in prospect,

while others worry about a 1930s style slump in the industrial countries.

With sharply falling U.S. inflation, the de-bate about whether monetary policy can stem deflation and whether the ‘zero lower bound’ on interest rates is a constraint, will really be-gin. The zero lower bound arises because nomi-nal interest rates cannot fall below zero unless Aaron Edlin’s Dr. Strangeloan effects become profound. But if nominal interest rates stay pos-itive, while inflation is negative, then real inter-est rates may become too high for an economy in recession, causing recession to become more severe and prolonged.

These deflation fears were mistakenly raised in 2001–3, when the strong U.S. re-sponse of credit, the housing market and con-sumer spending to lower interest rates should have made the debate redundant. Influenced by a misreading of the Japanese experience (see Muellbauer, 2007 and Muellbauer and Murata, 2008) this led to excessive protection against the ‘tail risk’ of deflation. Ironically, that policy response helped to fuel the credit and housing bubble, whose collapse has trig-gered the current recession, which may actu-ally bring about deflation.

There are important differences between the structure of the Japanese and the U.S. econ-omies. Among these is the enormously high level of liquid assets held by Japanese house-holds, which tends to lead to lower consump-tion when interest rates fall. These differences, and the fact that lessons have been learnt from Japan’s ‘lost decade’ on the need to refinance the banking system, suggest that a ‘lost decade’ for the U.S. is most unlikely.

The policy implications outside the U.S. and Japan are that central banks can safely cut policy rates and continue aggressive liquidity support operations with little inflation risk. With the Fed funds rate at 1%, there is only a small scope in the U.S. for doing more with this instrument. In any case, with so little confidence in the finan-cial system, and credit constrained by concerns about falling housing prices, the usual transmis-sion channels from the policy rate have been blocked. Hence the emerging emphasis on re-capitalizing the banking system seen in Europe-an and U.S. policy announcements on October 13th and 14th is properly placed.

We predict that as some confidence returns in an eventually recapitalized banking system, and long bond yields decline with the fall in inflation,

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mortgage and other borrowing rates will fall and monetary transmission will come back to life, supporting economic activity and stabilizing real house prices, albeit at a substantially lower level.

Finally, on the question of a 1930s style slump in the industrial countries, there are two major differences between now and then. The industrial world is now far more dependent on (mostly foreign) oil than it was then. The ex-treme rise in real oil prices was a major cause of the current recession, and its reversal will be a major factor in the recovery. The other crucial difference is that we know enough about what is at stake not to repeat the errors of the 1930s.

Letters commenting on this piece or others may be submitted at http://www.bepress.com/cgi/submit.cgi?context=ev.

references and further reading

Aron, Janine and John Muellbauer (2008) “New methods for forecasting inflation and its sub-com-ponents: application to the USA,” Dept. of Eco-nomics, Oxford University, Discussion Paper 406, October. Available at: http://www.economics.ox.ac.uk/index.php/papers/details/new_methods_406/.

Edlin, Aaron, (2008) “Dr. StrangeLoan: or How I Learned to Stop Worrying and Love the Financial Collapse,” Economists’ Voice, 5(5): Art 3. Available at: http://www.bepress.com/ev/vol5/iss5/art3.Muellbauer, John (2007) “Housing, Credit and Consumer Expenditure,” in Housing Finance, and Monetary Policy: a Symposium sponsored by the Federal Reserve Bank of Kansas City, Jack-son Hole, Wyoming, August 30–September 1. Available at: http://www.kc.frb.org/publicat/sympos/2007/PDF/Muellbauer_0415.pdf.Muellbauer, John and Keiko Murata (2008) “Consumption, Land Prices and the Monetary Transmission Mechanism in Japan,” presented at a joint ESRI and Center on Japanese Econo-my and Business workshop on Japan’s lost de-cade, Columbia University, March 21. Available at: http://www.esri.go.jp/en/workshop/080321/pdf/08_Muellbauer_Japan_paper_ESRI_f.pdf.

acknowledgments

This column is an extended version of “U.S. price deflation on the way,” available at: http://www.voxeu.org/index.php?q=node/2384. We thank the ESRC for financing our econometric research.

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Stocks for the Long RunJ. BRadfoRd dELoNg

BERKELEY—After the second 40% decline in America’s Standard & Poor’s composite index of common stocks in a decade, global inves-tors are shell-shocked. Funds in-

vested, and reinvested, in the S&P composite from 1998–2008 have yielded a real return of zero: the dividends earned on the portfolio have been just enough to offset inflation. Not since 1982 has a decade passed at the end of which investors would have been better off had they placed their money in corporate or United States Treasury bonds rather than in a diversified portfolio of stocks.

So investors are wondering: will future de-cades be like the past decade? If so, shouldn’t investments in equities be shunned?

The answer is almost surely no. At a time horizon of a decade or two, the past perfor-mance of stocks and bonds is neither a reliable guarantee nor a good guide to future results. Periods like 1998–2008, in which stocks do relatively badly, are preceded by periods—like 1978–1988 and 1988–1998—in which they do relatively well, and are in all likelihood fol-lowed by similar periods.

Do the math. At the moment, the yield-to-maturity of the ten-year U.S. Treasury bond is 3.76%. Subtract 2.5% for inflation, and you get a benchmark expected real return of 1.26%.

Meanwhile, the earnings yield on the stocks that make up the S&P composite is fluctuating

around 6% of stock price: that is how much money the corporations that underpin the stocks are making for their shareholders. Some of that money will be paid out in dividends. Some will be used to buy back stock—thus concentrating the equity and raising the value of the stock that is not bought back. Some will be reinvested and used to boost the company’s capital stock.

You can argue that the corporate executives have expertise and knowledge that allows them to commit the funds they control to higher-return projects than are available in the stock market. Or you can argue that they are corrupt empire-builders who dissipate a portion of the shareholders’ money that they control.

The sensible guess is that these two factors cancel each other out. Thus, the expected fun-damental real return on diversified U.S. stock

J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a former Assistant U.S. Treasury Secretary.

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portfolios right now is in the range of 6% to 7%. The expected market return is that amount plus or minus expected changes in valuation ra-tios: will stocks return more as price-earnings ratios rise, or return less as price-earnings ratios fall? Once again, the sensible guess is that these two factors more or less cancel each other out. Compare the 6% to 7% real return on stocks to a 1.25% real return on bonds.

But aren’t stocks risky? Couldn’t earnings collapse? Couldn’t the market undergo another 40% decline in the near future? Aren’t bonds safer? The answers to these questions are yes, yes, yes, and yes.

Remember: we already had another 40% decline in 2000–2003, and are in another one right now. We also had the long slide from 1977–1982 that followed a 40% collapse from 1973–1975. Before that, we had declines in 1946–1949, 1937–1942, and the biggest of them all in 1929–1933.

But stock market declines that are not ac-companied by steep and persistent collapses in earnings are by their nature temporary: they are provoked by steep rises in perceived risk, and if those risks turn out to be overblown, stocks rebound when the perception of risk falls.

And how about stock market declines that are accompanied by a steep and persistent col-lapse in earnings—by depressions?

In the pre-World War II era, when govern-ments held fast to the gold standard, depressions were times of deflation. But in the post-World War II era, in which social democratic govern-ments maintain welfare spending and Keynes-ian economic advisers seek to use fiscal policy to boost output, an earnings depression is much more likely to be accompanied by inflation.

True, a steep and persistent collapse in earnings will erode wealth invested in stocks. But the inflation that accompanies it will pro-duce a steeper and larger erosion of real wealth invested in nominal bonds. As Edgar L. Smith wrote in The Atlantic Monthly back in 1924, when the principal risks are macroeconomic, bonds are no safer than diversified portfolios of stocks—in fact, they are riskier.

All these arguments apply only to long-term investors who can afford to wait out another 40% decline in values and keep their money invested until perceived risk drops. (And if per-ceived risk never drops than you have worse things to worry about than the performance of your portfolio.) For retirees and other people

who need to spend soon, the year-to-year vari-ability of the stock market commands caution.

But for those who do not need to spend soon, the recent decline in equity values is more an opportunity than a catastrophe. We liked the stocks in our portfolio a year ago for their long-term prospects. Today’s short-term crisis does not materially alter their long-term prospects. And now we have an opportunity to buy more, and cheaply.

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In November 2002, as a recently-ap-pointed governor of the Federal Re-serve System, Ben Bernanke gave a talk to the National Economists Club enti-tled “Deflation: Making Sure ‘It’ Doesn’t

Happen Here.” “Fortunately,” he concluded, “for the foreseeable future, the chances of a serious deflation in the United States appear remote indeed.”

Bernanke’s talk has been widely cited by those who think a protracted, Japanese-style deflationary episode simply cannot happen in the United States. How well do Bernan-ke’s arguments of 2002 stand up in light of recent events?

Bernanke makes two kinds of arguments in his talk. First, he emphasizes certain dif-ferences between the United States and Japan. Second, he lists a number of instruments, ranging from the conventional to the highly aggressive, that the Fed could use to stop de-flation before it starts, and reverse it in the unlikely case it did start. Let’s look at some of his specific points.

why the united states is different

Bernanke begins his case with the observation that “Over the years, the U.S. economy has

shown a remarkable ability to absorb shocks of all kinds, to recover, and to continue to grow…A particularly important protective factor in the current environment is the strength of our financial system: Despite the adverse shocks of the past year [2001-2002], our banking system

remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape.”

That was then, this is now. Bernanke, of course, was right about the critical importance of healthy balance sheets in the financial, busi-ness, and household sectors. He cites Irving Fisher, who pointed out, as early as 1933, “the potential connections between violent financial crises, which lead to ‘fire sales’ of assets and fall-ing asset prices, with general declines in aggre-gate demand and the price level.”

In order for monetary policy to do its job, there must be a smooth transmission mecha-nism from the operating targets that the Fed can directly control—chiefly short-term interest rates and bank reserves—to the money stock, to credit, and on to aggregate demand. When asset values are falling and balance sheets are

Edwin G. Dolan teaches economics at the University of Economics in Prague and the Stockholm School of Economics in Riga.

Deflation: Are We Still Sure “It” Cannot Happen Here?

EDWIn G. DolAn

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over-leveraged, the transmission mechanism breaks down. The Fed pumps reserves into the banking system, but banks remain reluctant to lend because there is inadequate dependable collateral to support the needed level of credit.

Even when banks are willing to lend, firms and households are reluctant to borrow because they are uncertain of cash flows from sales and wages. As everyone piles up liquid assets, the central bank finds itself “pushing on a string.” Data from Japan in the late 1990s show this clearly. The monetary base, composed of bank reserves and currency, soars. As it does so, the money multiplier falls, so the quantity of mon-ey rises only sluggishly. And, as the non-bank public accumulates liquid balances, velocity de-creases, so that nominal GDP actually falls.

the anti-deflation arsenal

Even so, Bernanke argues, the Fed has nearly limitless powers to push on the string, and

if it uses them, the real economy must budge sooner or later. He outlines a sequence of policy actions that begins with conventional open-market operations at the short-term end of the government securities market, moves on to pur-chases of longer-term government securities,

then progresses to indirect operations with pri-vate securities through swaps or in cooperation with the Treasury. It culminates with “helicopter drops” of money that are executed through ex-pansionary fiscal policy, backed by central bank purchases of government bonds to keep the growing deficit from pushing up interest rates.

The list of potential weapons must have been impressive to Bernanke’s 2002 audience. Today, the sobering thing is how far down that list the Fed has already moved.

Under Bernanke’s leadership, the Fed began aggressively lowering the federal funds target in mid–2007, within weeks after the government’s housing price index crossed the line from in-crease to decrease. True to the spirit of the 2002 blueprint, as the target rate fell, the gap between it and the discount rate, at which banks borrow from the Fed, was narrowed first to 50 and then to 25 basis points. Together with earlier relax-ation of administrative restrictions on discount borrowing, the Fed was almost begging banks to borrow reserves. It was still not enough.

The Fed quickly moved on down the list, lengthening the term of its lender-of-last-resort operations, broadening the range and lower-ing the quality of acceptable collateral, and

reaching beyond commercial banks, deep into the financial sector. It was hard to keep up with the new terminology—Term Auction Facility, Section 13(3) loans to non-bank companies, Primary Dealer Credit Facility, Term Securities Lending Facility (TSLF), even auctions of op-tions on TSLF loans. The Fed could certainly not be accused of sitting on its hands, but it still was not enough.

Then it became harder to move farther down the 2002 list. There were a couple of big guns left to fire, but no one wanted to pull the trigger.

One of the big guns would be foreign ex-change operations. Bernanke noted the awesome impact of Roosevelt’s 1933 decision to take the country off the gold standard, which reversed deflation in a matter of months. But already in 2002, Bernanke recognized that this was an area where the Fed needed to tread carefully. It was not just that international monetary policy, in the United States, is Treasury turf. More im-portantly, there was a risk of unintended conse-quences. If it was right in 2002 to be cautious about driving the dollar down to stimulate do-mestic demand, it is doubly right to be cautious today, when the dollar is already weak relative to the euro, and when even a hint of intervention

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by the Fed could set off a stampede of divest-ment of dollar assets by foreign central banks. So that gun remains in the holster.

However, there was still the fiscal policy gun. “A broad-based tax cut,” Bernanke told his 2002 audience, “accommodated by a program

of open-market purchases to alleviate any ten-dency for interest rates to increase, would almost certainly be an effective stimulant to consump-tion and hence to prices.”

Bernanke saw the availability of the fis-cal policy weapon as one of the key differ-ences between Japan and the United States. “Japan’s economy faces some significant bar-riers to growth besides deflation,” he wrote, “including massive financial problems in the banking and corporate sectors and a large overhang of government debt. Plausibly, pri-vate-sector financial problems have muted the effects of the monetary policies that have been tried in Japan, even as the heavy over-hang of government debt has made Japanese policymakers more reluctant to use aggres-sive fiscal policies.”

Unfortunately, although U.S. government finance in 2002 was much healthier than that of Japan in the same year, the comparison is no longer as favorable to the United States. Chart 1 superimposes a plot of the U.S. gov-ernment surplus or deficit over the same data for Japan. The U.S. series is offset by ten years, so that the data for 2008 in the U.S. coincide with the data for Japan in 1998, the first year

of Japan’s long deflation. The similarity of the two plots is startling. The same thing is true of chart 2, which shows government debt as a percentage of GDP. (The data used for this exercise came from the Annex of the OECD’s Economic Outlook 83.)

Chart 2

0

10

20

30

40

50

60

70

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1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

US offset 10

Japan real time

Debt/GDP RatioJapan vs. US offset 10 yrs

Source: OECD Outlook 83

US 2008

Chart 1

-10

-8

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US offset 10

Japan real time

Fiscal Balance/GDP RatioJapan vs. US offset 10 yrs

Source: OECD Outlook 83

US 2008

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the secret weapon

The more one looks at the situation, the more it is clear that many of the safe-

guards that made deflation a remote danger in 2002 have since eroded. It is true that survey data on inflation expectations for the United States are still safely positive, but in Japan, they remained positive as late as 1999, when deflation was already well underway. Deflation seems to have a way of sneaking up on its victims.

It may be that HR 1424, the Emergency Economic Stabilization Act of 2008, will save us. Although Bernanke, in 2002, did not en-vision the need for such a massive operation, the $700 billion Troubled Asset Relief Plan is in the spirit of his talk, which advocated quick, decisive action before “it” started. So is the Fed’s recently announced Commercial Paper Funding Facility.

In addition to TARP, there is a secret weapon buried in Section 128 of HR 1424 that may prove to be helpful. Unnoticed by anyone but specialists, and without ever mentioning the Federal Reserve, banks, or interest rates, Section 128 gives the Fed

immediate authority to pay interest on the reserve deposits of commercial banks. In fact, as much interest as it likes.

A recent paper by Todd Keister, Antoine Martin, and James McAndrews of the New York Fed explains why this interest is poten-tially important. If the Fed can pay interest on reserves, it can inject unlimited quantities of reserves into the banking system without pushing the federal funds rate all the way to zero. Such a policy is called quantitative eas-ing. As implemented in Japan, it had mixed results, but still, it provides an additional weapon against deflation. The Fed wasted no time making use of its new authority and an-nounced that it would begin paying interest on reserves immediately.

When all is said and done, I still doubt that the U.S. economy will succumb to a prolonged deflation. But the possibility is no longer as remote as it was.

There is at least the comforting thought that we have a chairman of the Federal Re-serve who knows what the risks are, knows what weapons are in the arsenal, has already proved his willingness to use many of the

Letters commenting on this piece or others may be submitted at http://www.bepress.com/cgi/submit.cgi?context=ev.

references and further reading

Bernanke, Ben (2002) “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” Remarks be-fore the National Economists Club, Wash-ington, D.C. November 21. Available at: http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm.Keister, Todd, Antoine Martin, and James McAn-drews (2008) “Divorcing Money from Monetary Policy,” FRBNY Economic Policy Review. Sep-tember. Available at: http://www.newyorkfed.org/research/EPR/08v14n2/exesummary/exesum_keis.html.

instruments listed in his 2002 talk, and, not stopping there, is prepared to improvise new ones as the need arises.

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Letter: Comment on Stiglitz’s “Turn Left for Sustainable Growth”

P. K. Rao

© The Berkeley Electronic Press

Dear Editors:

Stiglitz is very accurate in pointing to the hollowness of assessments of eco-

nomic growth that do not reflect loss of envi-ronmental assets, and excessive debt burdens, and related features. If people are not valued as the important assets in a society, economic growth is neither inclusive nor sustainable.

Since markets are never ‘complete’ nor ‘perfect’, undue reliance on the effi-ciency implications of markets and on their socially conducive economic consequences will be a costly mistake. The costs of oper-ating a market economy are never small, if only we care to recognize the pitfalls and short-sightedness of principals and agents in market institutions.

However, the experiences of using a so-called Left have not always been posi-tive either. The recent failures of regulatory oversights in the U.S. Bureau of Mines (in dealing with oil sector, as pointed out in the Inspector General’s Report) is merely an illustration of the regulatory costs associated with non-market institutions.

The irony is that there seems to exist a phenomenon of equilibrating collusion of vested interests that operates whichever route Left or Right a governance system chooses. On the balance, the total transac-tion costs of governance, aimed at an inclu-sive, sustainable growth and development, tend to be minimal when there exists mech-anisms of citizen and stakeholder over-sight, in addition to regulatory oversight.

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This would imply, for example, sharehold-ers holding control on the size of executive compensation, reflecting citizen voices in rapid expansion of cell tower networks in the name of promoting commerce, and so on. Who, other than Telecom firms, would like to support the stipulation in the 1996 Telecommunications Act that expressly pro-hibits public health concerns in any judicial review? This could not arise as an outcome of inclusive growth nor under any total cost minimizing objective of the society.

P. K. Rao

Princeton, NJ, U.S.A.

references and further reading

Stiglitz, Joseph (2008) “Turn Left for Sus-tainable Growth,” Economists’ Voice, 5(4): Art. 6. Available at http://www.bepress.com/ev/vol5/iss4/art6.

note

P. K. Rao is the author of several books includ-ing: Development Finance (Springer), The Economics of Transaction Costs (Palgrave Macmillan), and The IMF: How to Fix It, forthcoming.

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Letter: Should Liberals (or Anyone Else) Really Support Social Security “Personal

Accounts”?MAx J. SkidMoRE

Dear Editor:

Konstantin Magin adds little to the un-persuasive argument for Social Security

privatization, except the claim that liberals should accept it enthusiastically. His main point is a commonplace assertion: the market produces huge returns with minimal risk, but his calibration of that risk in Black-Scholes terms will not convince liberals and should not convince others of the merits of priviti-zation. Richard Serlin’s response noted that huge investments could make the market a very different, and much less attractive, thing from the one of the past. Also, what might a privatized Social Security program do when the baby boomers retire and the market faces enormous withdrawals?

Magin seems almost to promise guar-anteed, risk free, returns. Even if this were correct, it is irrelevant. Social Security is not an investment scheme; it offers more than retirement benefits, and its low administra-tive expenses make it more efficient than any private scheme.

It has a mildly redistributive effect: workers who earn less receive a greater portion of their earnings in benefits than do those who earn more. It also pays a spousal benefit, and provides both disability coverage and survivors benefits.

Its benefits are designed to keep pace with inflation. Moreover, no beneficiary can outlive his or her benefits; this insurance against long life is very valuable, and private annuity markets appear to be quite costly.

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Nearly one third of all Social Security checks go to children, and to others younger than retirement age. Converting the program to an investment scheme would not only place retirement benefits at risk, but would eliminate all these other protections, wiping out benefits that now go to nearly a third of all those who receive Social Security.

Calculations of return on investment ignore much of Social Security’s value, some of which is indirect. Because of the indepen-dence it gives to seniors, young couples now rarely are required to support their elderly relatives, as documented by Kathleen Mcgarry and Robert Schoeni.

So, should liberals support Social Security personal accounts? Certainly not.

Max Skidmore

University of Missouri-Kansas City

references and further reading

Mcgarry, Kathleen M. and Robert F. Schoeni (1998) “Social Security, Economic Growth, and the Rise in Independence of Elderly Wid-ows in the 20th Century,” NBER Working Paper No. W6511. Available at http://www.nber.org/papers/w6511

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Divorcing Money from Monetary Policy

1. Introduction

onetary policy has traditionally been viewed as the process by which a central bank uses its influence over

the supply of money to promote its economic objectives. For example, Milton Friedman (1959, p. 24) defined the tools of monetary policy to be those “powers that enable the [Federal Reserve] System to determine the total amount of money in existence or to alter that amount.” In fact, the very term monetary policy suggests a central bank’s policy toward the supply of money or the level of some monetary aggregate.

In recent decades, however, central banks have moved away from a direct focus on measures of the money supply. The primary focus of monetary policy has instead become the value of a short-term interest rate. In the United States, for example, the Federal Reserve’s Federal Open Market Committee (FOMC) announces a rate that it wishes to prevail in the federal funds market, where overnight loans are made among commercial banks. The tools of monetary policy are then used to guide the market interest rate toward the chosen target. For this reason, we follow the common practice of using the term monetary policy to refer to a central bank’s interest rate policy.

It is important to realize, however, that the quantity of money and monetary policy remain fundamentally linked under this approach. Commercial banks hold money in the form of reserve balances at the central bank; these balances are used to meet reserve requirements and make interbank

Todd Keister, Antoine Martin, and James McAndrews

Todd Keister and Antoine Martin are research officers and James McAndrews a senior vice president at the Federal Reserve Bank of New York.<todd.keister@ny.frb.org><antoine.martin@ny.frb.org><james.mcandrews@ny.frb.org>

The views expressed are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System.

M• Many central banks operate in a way that

creates a tight link between money and monetary policy, as the supply of reserves must be set precisely in order to implement the target interest rate.

• Because reserves play other key roles in the economy, this link can generate tensions with central banks’ other objectives, particularly in periods of acute market stress.

• An alternative approach to monetary policy implementation can eliminate the tension between money and monetary policy by “divorcing” the quantity of reserves from the interest rate target.

• By paying interest on reserve balances at its target interest rate, a central bank can increase the supply of reserves without driving market interest rates below the target.

• This “floor-system” approach allows the central bank to set the supply of reserve balances according to the payment or liquidity needs of financial markets while simultaneously encouraging the efficient allocation of resources.

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42 Divorcing Money from Monetary Policy

payments. The quantity of reserve balances demanded by banks varies inversely with the short-term interest rate because this rate represents the opportunity cost of holding reserves. The central bank aims to manipulate the supply of reserve balances—for example, through open market operations that exchange reserve balances for bonds—so that the marginal

value of a unit of reserves to the banking sector equals the target interest rate. The interbank market for short-term funds will then clear with most trades taking place at or near the target rate. In other words, the quantity of money (especially reserve balances) is chosen by the central bank in order to achieve its interest rate target.

This link between money and monetary policy can generate tension with central banks’ other objectives because bank reserves play other important roles in the economy. In particular, reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions. The quantity of reserves needed for payment purposes typically far exceeds the quantity consistent with the central bank’s desired interest rate. As a result, central banks must perform a balancing act, drastically increasing the supply of reserves during the day for payment purposes through the provision of daylight reserves (also called daylight credit) and then shrinking the supply back at the end of the day to be consistent with the desired market interest rate.

Recent experience has shown that central banks perform this balancing act well most of the time. Nevertheless, it is important to understand the tension between the daylight and overnight need for reserves and the potential problems that may arise. One concern is that central banks typically provide daylight reserves by lending directly to banks, which may expose the central bank to substantial credit risk. Such lending may also generate moral hazard problems and exacerbate the too-big-to-fail problem, whereby regulators would be reluctant to close a financially troubled bank.

The tension is clearest during times of acute stress in financial markets. In the days following September 11, 2001, for example, the Federal Reserve provided an unusually large quantity of reserves in order to promote the efficient

functioning of the payments system and financial markets more generally. As a result of this action, the fed funds rate fell substantially below the target level for several days.1

During the financial turmoil that began in August 2007, the tension was much longer lasting. Sharp increases in spreads between the yields on liquid and illiquid assets indicated a classic liquidity shortage: an increased demand for liquid assets relative to their illiquid counterparts. By increasing the supply of the most liquid asset in the economy—bank reserves—the Federal Reserve could likely have eased the shortage and helped push spreads back toward more normal levels. Doing so, however, would have driven the market interest rate below the FOMC’s target rate and thus interfered with monetary policy objectives. Instead, the Federal Reserve developed new, indirect methods of supplying liquid assets to the private sector, such as providing loans of Treasury securities against less liquid collateral through the Term Securities Lending Facility.

Recently, attention has turned to an alternative approach to monetary policy implementation that has the potential to eliminate the basic tension between money and monetary

policy by effectively “divorcing” the quantity of reserves from the interest rate target. The basic idea behind this approach is to remove the opportunity cost to commercial banks of holding reserve balances by paying interest on these balances at the prevailing target rate. Under this system, the interest rate paid on reserves forms a floor below which the market rate cannot fall. The supply of reserves could therefore be increased substantially without moving the short-term interest rate away from its target. Such an increase could be used to provide liquidity during times of stress or to reduce the need for daylight credit on a regular basis.2 A particular version of the “floor-system” approach has recently been adopted by the Reserve Bank of New Zealand.

It should be noted that adopting a floor-system approach requires the central bank to pay interest on reserves, something

1 Intraday volatility of the fed funds rate remained high, with trades being executed far from the target rate, for several weeks. See McAndrews and Potter (2002) and Martin (forthcoming) for detailed discussions.2 This approach has been advocated in various forms by Woodford (2000), Goodfriend (2002), Lacker (2006), and Whitesell (2006b).

[The] link between money and monetary

policy can generate tension with central

banks’ other objectives because bank

reserves play other important roles

in the economy.

It is important to understand the tension

between the daylight and overnight need

for reserves and the potential problems

that may arise.

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FRBNY Economic Policy Review / September 2008 43

Exhibit 1

Monetary Policy Implementation in the United States

Target rate

Penalty rate

Interest rate

ReservebalancesTarget

supply0

Demand forreserves

Requiredreserves

the Federal Reserve has historically lacked authorization to do. However, the Financial Services Regulatory Relief Act of 2006 will give the Federal Reserve, for the first time, explicit authority to pay interest on reserve balances, beginning on October 1, 2011. A floor system will therefore soon be a feasible option for monetary policy implementation in the United States.

In this article, we present a simple, graphical model of the monetary policy implementation process to show how the floor system divorces money from monetary policy. Our aim is to present the fundamental ideas in a way that is accessible to a broad audience. Section 2 describes the process by which monetary policy is currently implemented in the United States and in other countries. Section 3 discusses the tensions that can arise in this framework between monetary policy and payments/liquidity policy. Section 4 illustrates how the floor system works; it also discusses potential issues associated with adopting this type of system in a large economy such as the United States. Section 5 concludes.

2. An Overview of Monetary PolicyImplementation

In this section, we describe a stylized model of the process through which many of the world’s central banks implement monetary policy. Our model focuses on the relationship between the demand for reserve balances and the interest rate in the interbank market for overnight loans. Following Poole (1968), a variety of papers have developed formal models of portfolio choice by individual banks and derived the resulting aggregate demand for reserves.3 Our graphical model of aggregate reserve demand is consistent with these more formal approaches. We first discuss the system currently used in the United States and then describe a symmetric channel system, as used by a number of other central banks.

2.1 Monetary Policy Implementation in the United States

We begin by examining the total demand for reserve balances by the U.S. banking system. In our stylized framework, this demand is generated by a combination of two factors. First, banks face reserve requirements. If a bank’s final balance is

3 Recent contributions include Furfine (2000), Guthrie and Wright (2000), Bartolini, Bertola, and Prati (2002), Clouse and Dow (2002), Whitesell (2006a, b), and Ennis and Weinberg (2007).

smaller than its requirement, it pays a penalty that is proportional to the shortfall. Second, banks experience unanticipated late-day payment flows into and out of their reserve account after the interbank market has closed. A bank’s final reserve balance, therefore, may be either higher or lower than the quantity of reserves it chooses to hold in the interbank market. This uncertainty makes it difficult for a bank to satisfy its requirement exactly and generates a “precautionary” demand for reserves.

For simplicity, we abstract from a number of features of reality that, while important, are not essential to understanding the basic framework. For example, we assume that reserve requirements must be met on a daily basis, rather than on average over a two-week reserve maintenance period. Alternatively, one can interpret our model as applying to average reserve balances (and the average overnight interest rate) over a maintenance period. In addition, we do not explicitly include vault cash in the analysis, using the terms reserve balances and reserves interchangeably.4

Exhibit 1 presents the aggregate demand for reserves in our framework. The horizontal axis measures the total quantity of reserve balances held by banks while the vertical axis measures the market interest rate for overnight loans of these balances. The penalty rate labeled on the vertical axis represents the interest rate a bank pays if it must borrow funds at the end of

4 Required reserves should therefore be interpreted as a bank’s requirement net of its vault cash holdings. To the extent that vault cash holdings are independent of the overnight rate, at least over short horizons, including them in our model would have no effect. We also abstract from the Contractual Clearing Balance program, which allows banks to earn credit for priced services at the Federal Reserve by holding a contractually agreed amount of reserves in excess of their requirement; these contractual arrangements, once set, act much like reserves requirements.

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44 Divorcing Money from Monetary Policy

the period to meet its requirement. One can interpret this penalty rate as the interest rate charged at the Federal Reserve’s primary credit facility (the discount window), adjusted by any “stigma” costs that banks perceive to be associated with

borrowing at this facility. The important feature of the penalty rate is that it lies above the FOMC’s target interest rate.5

To explain the shape of the demand curve in the exhibit, we ask: given a particular value for the interest rate, what quantity of reserve balances would banks demand to hold if that rate prevailed in the interbank market? First, note that if the market interest rate were above the penalty rate, there would be an arbitrage opportunity: banks could borrow reserves at the (lower) penalty rate and lend them at the (higher) market interest rate. If the market interest rate were exactly equal to the penalty rate, however, banks would be willing to hold some reserve balances toward meeting their requirements. In fact, each bank would be indifferent between holding reserves directly and borrowing at the penalty rate as long as it is sure that late-day payment inflows will not leave it holding excess balances at the end of the day. As a result, the demand curve is flat—reflecting this indifference—at the level of the penalty rate for sufficiently small levels of reserve balances.

For interest rates below the penalty rate, each bank will choose to hold a quantity of reserves that is close to the level of its requirement; hence, aggregate reserve demand will be close to the total level of required reserves. However, as described above, banks face uncertainty about their final account balance that prevents them from being able to meet their requirement exactly. Instead, each bank must balance the possibility of falling short of its requirement—and being forced to pay the

5 The interest rate charged on discount window loans has been set above the FOMC’s target rate since the facility was redesigned in 2003. The gap between the two rates was initially set at 100 basis points, but has since been lowered to 50 basis points (in August 2007) and to 25 basis points (in March 2008). In addition, there is evidence that banks attach a substantial nonpecuniary cost to borrowing from the discount window, as they sometimes borrow in the interbank market at interest rates significantly higher than the discount window rate. These stigma costs may reflect a fear that other market participants will find out about the loan and interpret it as a sign of financial weakness on the part of the borrowing bank.

penalty rate—against the possibility that it will end up holding more reserves than are required. As no interest is paid on reserves, holding excess balances is also costly. The resulting demand for reserve balances will vary inversely with the market interest rate, since this rate represents the opportunity cost of holding reserves. The less expensive it is to hold precautionary reserve balances, the greater the quantity demanded by the banking system will be. This reasoning generates the downward-sloping part of the demand curve in the exhibit.

If the market interest rate were very low—close to zero—the opportunity cost of holding reserves would be very small. In this case, each bank would hold enough precautionary reserves to be virtually certain that unforeseen payment flows will not decrease its reserve balance below the required level. In other words, each bank would choose to be “fully insured” against the possibility of falling short of its requirements. The point in Exhibit 1 where the demand curve intersects the horizontal axis represents the total of this fully insured quantity of reserve balances for all banks. The banking system will not demand more than this quantity of reserve balances as long as there is some opportunity cost, no matter how small, of holding these reserves.

If the market interest rate were exactly zero, however, there would be no opportunity cost of holding reserves. In this limiting case, there is no cost at all to a bank of holding additional reserves above the fully insured amount. The demand curve is therefore flat along the horizontal axis after this point; banks are indifferent between any quantities of reserves above the fully insured amount when the market interest rate is exactly zero.

Needless to say, our model of reserve demand abstracts from important features of reality. Holding more reserves, for example, might require a bank to raise more deposits and subject it to higher capital requirements. Nevertheless, the model is useful because it lays out, in perhaps the simplest way possible, the basic relationship between the market interest rate and the demand for reserves that results from the optimal portfolio decisions of banks. Moreover, small changes in the shape of the demand curve would have no material effect on the analysis that follows.

The equilibrium interest rate in our model is determined by the height of the demand curve at the level of reserve balances supplied by the Federal Reserve. If the supply is smaller than the total amount of required reserves, for example, the equilibrium interest rate would be near the penalty rate. If, however, the supply of reserves were very large, the equilibrium interest rate would be zero. Between these two extremes, on the downward-sloping portion of the demand curve, there is a liquidity effect of reserve balances on the market interest

The . . . demand for reserve balances will

vary inversely with the market interest

rate, since this rate represents the

opportunity cost of holding reserves.

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FRBNY Economic Policy Review / September 2008 45

rate: a higher supply of reserves will lower the equilibrium interest rate.6

As shown in the exhibit, there is a unique level of reserve supply that will lead the market to clear at the FOMC’s announced target rate; we call this level the target supply. Monetary policy is implemented through open market operations that aim to set the supply of reserves to this target level. This process requires the Fed’s Open Market Desk to accurately forecast both reserve demand and changes in the existing supply of reserves attributable to autonomous factors

such as payments into and out of the Treasury’s account. Forecasting errors will lead the actual supply to deviate from the target and, hence, will cause the market interest rate to differ from the target rate. In our simple model, the downward-sloping portion of the demand curve may be quite steep, indicating that relatively small forecasting errors could lead to substantial interest rate volatility. In reality, a variety of institutional arrangements, including reserve maintenance periods, are designed to flatten this curve and thus limit the volatility associated with forecasting errors.7

The key point of this discussion is that monetary policy is implemented in the United States by changing the supply of reserves in such a way that the fed funds market will clear at the desired rate. In other words, the stock of “money” is set in order to achieve a monetary policy objective. This direct relationship between money and monetary policy generates the tensions that we discuss in Section 3.

6 See Hamilton (1997), Carpenter and Demiralp (2006a), and Thornton (2006) for empirical evidence of this liquidity effect.7 See Ennis and Keister (2008) for a detailed discussion of interest rate volatility in this basic framework. See Whitesell (2006a) for a formal model of the “flattening” effect of reserve maintenance periods.

2.2 Symmetric Channel Systems

Many central banks use what is known as a symmetric channel (or corridor) system for monetary policy implementation. Such systems are used, for example, by the European Central Bank (ECB) and by the central banks of Australia, Canada, England, and (until spring 2006) New Zealand. The key features of a symmetric channel system are standing central bank facilities that lend to and accept deposits from commercial banks. The lending facility resembles the discount window in the United States; banks are permitted to borrow freely (with acceptable collateral) at an interest rate that is a fixed number of basis points above the target rate. The deposit facility allows banks to earn overnight interest on their excess reserve holdings at a rate that is the same number of basis points below the target. In this way, the interest rates at the two standing facilities form a “channel” around the target rate.

Exhibit 2 depicts the demand for reserve balances in a symmetric channel system. The curve looks very similar to that in Exhibit 1. There is no demand for reserves in the interbank market if the interest rate is higher than the rate at the lending facility.8 For lower values of the market rate, the demand is decreasing in the interest rate—and hence the liquidity effect is present—for exactly the same reasons as before. Banks choose their reserve holdings to balance the potential costs of falling short of their requirement against the potential costs of ending with excess reserves. When the opportunity cost of holding reserves is lower, banks’ precautionary demand for reserves will be larger.

8 The lending facility in a channel system is typically designed in a way that aims to minimize stigma effects. For this reason, we begin the demand curve in Exhibit 2 at the lending rate instead of at a penalty rate that includes stigma effects, as was the case in Exhibit 1.

Exhibit 2

A Symmetric Channel System of Monetary Policy Implementation

Target rate

Lending rate

Interest rate

ReservebalancesTarget

supply0

Requiredreserves

Deposit rate

Demand forreserves

Monetary policy is implemented in the

United States by changing the supply of

reserves in such a way that the fed funds

market will clear at the desired rate.

In other words, the stock of “money”

is set in order to achieve a monetary

policy objective.

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46 Divorcing Money from Monetary Policy

The new feature in Exhibit 2 is that the demand curve does not decrease all the way to the horizontal axis, but instead becomes flat at the deposit rate. In other words, the deposit rate forms a floor below which the demand curve will not fall. If the market rate were below the deposit rate, an arbitrage opportunity would exist—a bank could borrow at the (low) market rate and earn the (higher) deposit rate on these funds, making a pure profit. The demand for reserves would be unbounded in this case; such arbitrage activity would quickly drive up the market rate until it at least equals the deposit rate.

The demand curve is flat at the deposit rate for the same reason it was flat on the horizontal axis in Exhibit 1. If the market rate were exactly equal to the deposit rate, banks would

face no opportunity cost of holding excess reserves. Holding additional funds on deposit and lending them would yield exactly the same return. Banks would therefore be indifferent between any quantities of reserves above the fully insured amount. In other words, paying interest on excess reserves raises the floor where the demand curve is flat from an interest rate of zero (as in Exhibit 1) to the deposit rate (as in Exhibit 2).

The equilibrium interest rate is determined exactly as before, by the height of the demand curve at the level of reserve balances supplied by the central bank. Monetary policy is thus implemented in much the same way as it is in the United States. The target interest rate determines, through the demand curve, a target supply of reserves, and the central bank aims to change total reserve supply to bring it as close as possible to this target. Importantly, the link between money and monetary policy remains: the quantity of reserves is set in order to achieve the desired interest rate.

The symmetric channel systems used by various central banks differ in a variety of important details. The Bank of England and the ECB operate relatively wide channels, with the standing facility rates 100 basis points on either side of the target. Australia and Canada, in contrast, operate narrow channels, where this figure is only 25 basis points. Australia and Canada have no required reserves; in this case, the demand curve in Exhibit 2 shifts to the left so that the “required

reserves” line lies on the vertical axis. The important point here, however, is that regardless of these operational details, a symmetric channel system links the quantity of reserves to the central bank’s interest rate target, exactly as in the U.S. system.

3. Payments, Liquidity Services, and Reserves

The link between money and monetary policy described above can generate tension with central banks’ other objectives, particularly those regarding the payments system and the provision of liquidity. Reserve balances are useful to banks, and to the financial system more generally, for purposes other than simply meeting reserve requirements. Banks use reserve balances to provide valuable payment services to depositors. In addition, these balances assist the financial sector in allocating other, less liquid assets. Since reserves are a universally accepted asset, they can be exchanged more easily for other assets than any substitute. Finally, reserve balances serve as a perfectly liquid, risk-free store of value, which is particularly useful during times of market turmoil. Because reserves play these other important roles, the quantity of reserve balances consistent with the central bank’s monetary policy objective may at times come into conflict with the quantity that is desirable for other purposes. In this section, we describe some of the tensions that can arise.

3.1 Payments Policy

The value of the payments made during the day in a central bank’s large-value payments system is typically far greater than the level of reserve balances held by banks overnight. (In the United States, for example, during the first quarter of 2008 the average daily value of transactions over the Fedwire Funds Service was approximately 185 times the value of banks’ total balances on deposit at the Federal Reserve.) The discrepancy has widened in recent decades as most central banks have adopted a real-time gross settlement (RTGS) design for their large-value payments system, which requires substantially larger payment flows than earlier designs based on netting of payment values.9

As a result, banks’ overnight reserve holdings are too small to allow for the smooth functioning of the payments system

9 See Bech and Hobijn (2007) for an analysis of the adoption of RTGS systems by various central banks.

[In a symmetric channel system,] the

target interest rate determines, through

the demand curve, a target supply of

reserves, and the central bank aims to

change total reserve supply to bring

it as close as possible to this target.

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FRBNY Economic Policy Review / September 2008 47

during the day. When reserves are scarce or costly during the day, banks must expend resources in carefully coordinating the timing of their payments. If banks delay sending payments to economize on scarce reserves, the risk of an operational failure or gridlock in the payments system tends to increase. The combination of limited overnight reserve balances and the much larger daylight demand for reserves thus creates tension

between a central bank’s monetary policy and its payments policy. The central bank would like to increase the total supply of reserve balances for payment purposes, but doing so would interfere with its monetary policy objectives.

This tension has led to a common practice among central banks of supplying additional reserves to the banking system for a limited time during the day. These daylight reserves (also called daylight credit) are typically lent directly to banks. Many central banks provide daylight reserves against collateral at no cost to banks. The Federal Reserve currently supplies daylight credit to banks on an uncollateralized basis for a small fee.10 In providing daylight reserves, a central bank aims to allow banks to make their payments during the day smoothly and efficiently while limiting its own exposure to credit risk.

Under normal circumstances, this process of expanding the supply of reserves during the day and shrinking it back overnight works well; banks make payments smoothly and the central bank implements its target interest rate. However, this balancing act is not without costs. Lending large quantities of reserves to banks each day exposes the central bank to credit risk. While requiring collateral for these loans mitigates credit risk, it is an imperfect solution. If collateral is costly for banks to hold or create, the requirement imposes real costs.

10 See Board of Governors of the Federal Reserve System (2008b) for a proposal to change the Federal Reserve’s method of supplying daylight reserves. Under this proposal, banks would be able to obtain daylight reserves either on a collateralized basis at no cost or on an uncollateralized basis for a higher fee. For a general discussion of the Federal Reserve’s policies on daylight credit, see Board of Governors of the Federal Reserve System (2007).

Moreover, collateralizing daylight loans simply moves the central bank’s claims ahead of the deposit insurance fund in the event of a bank failure, without necessarily reducing the overall risk of the consolidated public sector.

Routine daylight lending by the central bank may also create moral hazard problems, leading banks to hold too little liquidity and, perhaps, take on too much risk. In addition, such lending might make regulators more reluctant to close a financially troubled bank promptly, exacerbating the well-known too-big-to-fail problem. Even if each of these costs is relatively small in normal times, their sum should be considered part of the tension generated by the link between money and monetary policy.

3.2 Liquidity Policy

In times of stress or crisis in financial markets, the tension between monetary policy and central banks’ other objectives can become acute. After the destructive events of September 11, 2001, the Federal Reserve recognized that the quantity of overnight reserves consistent with the target fed funds rate was too small to adequately address banks’ reluctance to make payments in a timely manner. The FOMC released a statement on September 17, 2001, that, in addition to lowering the target fed funds rate, stated:

The Federal Reserve will continue to supply unusually large volumes of liquidity to the financial markets, as needed, until more normal market functioning is restored. As a consequence, the FOMC recognizes that the actual federal funds rate may be below its target on occasion in these unusual circumstances.11

In this statement, the FOMC explicitly recognized the tension between maintaining the market interest rate at its target level and supplying more reserves to meet the demand for financial market settlements. On September 18 and 19, the effective fed funds rate was close to 1¼ percent while the target rate was 3 percent.

Exhibit 1 is again useful to help illustrate what happened. To meet the demand for reserves for financial settlements in various markets, the Fed increased the supply of reserve balances. A shift in the supply curve to the right implies that intersection with the demand curve will occur at a lower interest rate.12 In this case, it was not possible to achieve simultaneously the interest rate target and the increase in overnight reserves necessary to ensure the efficient functioning

11 See <http://www.federalreserve.gov/boarddocs/press/general/2001/20010917>.

The value of the payments made during

the day in a central bank’s large-value

payments system is typically far greater

than the level of reserve balances held by

banks overnight . . . . As a result, banks’

overnight reserve holdings are too small

to allow for the smooth functioning

of the payments system during the day.

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48 Divorcing Money from Monetary Policy

of financial markets in conditions of stress. The exact same tension would arise under a symmetric channel system. Note, however, that the channel places a limit on how far the market interest rate can deviate from the target—it cannot fall below the deposit rate.

During the events of September 2001, the fed funds rate was below its target for only a few days and thus likely had no impact on monetary policy objectives, as expectations were

that the target rate would quickly be reestablished. It is an instructive episode, however, in that it demonstrates how increasing the supply of reserve balances available to the banking system can support market liquidity, and how this objective can interfere with the maintenance of the target interest rate.

The Federal Reserve faced a different type of liquidity issue during the financial market turmoil that began in August 2007. In this case, there was a sharp decline in what Goodfriend (2002) calls broad liquidity: the ease with which assets in general can be sold or used as collateral at a price that appropriately reflects the expected value of the asset’s future dividends. Goodfriend argues that increasing the supply of bank reserves can also support the level of broad liquidity in financial markets. This is especially true if the central bank uses the newly created reserves to purchase (or lend against) relatively illiquid assets, thereby increasing the total quantity of liquid assets held by the private sector. However, once again the link between money and monetary policy generates a tension; the central bank cannot pursue an independent “liquidity policy” using bank reserves. Any attempt to increase reserve balances

12 Needless to say, the disruption in financial markets would also tend to increase the demand for reserves, shifting the curve in Exhibit 1 to the right. The FOMC’s statement indicates a desire to more than compensate for this shift, that is, to increase reserve supply beyond the point that would maintain the target interest rate given the increased reserve demand.

for the purpose of providing additional liquidity would lead to a lower short-term interest rate and, hence, would change the stance of monetary policy.

Goodfriend (2002, p. 4) points out that central banks can use other, less direct methods of managing broad liquidity:

To some degree, the Fed can already manage broad liquidity under current operating procedures by changing the composition of its assets, for example, by selling liquid short-term Treasury securities and acquiring less liquid longer term securities. However, the government debt injected into the economy in this way would not be as liquid as newly created base money. More importantly, the Fed’s ability to affect broad liquidity in this way is strictly limited by the size of its balance sheet.

Interestingly, one of the new facilities introduced by the Fed in response to the market turmoil closely resembled the policy described by Goodfriend. The Term Securities Lending Facility, introduced in March 2008, provides loans of Treasury securities using less liquid assets as collateral.13 These loans increase broad liquidity by raising the total supply of highly liquid assets (reserves plus Treasury securities) in the hands of the private sector and decreasing the supply of less liquid assets. However, as Goodfriend observes, the amount of broad liquidity that can be provided through such a facility is strictly limited by the quantity of Treasury securities owned by the central bank. Thus, while a central bank can pursue a policy based on changes in the composition of its assets, such a policy has inherent limitations. As we discuss in Section 4, alternative methods of monetary policy implementation allow the central bank to overcome this limitation by pursuing a liquidity policy based directly on bank reserves.

3.3 Efficient Allocation of Resources

Another tension generated by the typical methods of monetary policy implementation described earlier relates to efficiency concerns. These methods rely on banks facing an opportunity cost of holding reserves; their balances earn no interest in the U.S. system and earn less than the prevailing market rate in a symmetric corridor. This opportunity cost helps generate the downward-sloping part of the demand curve that the central bank uses to implement its target interest rate. The fact that

13 The Fed also introduced other facilities, including the Term Auction Facility and the Primary Dealer Credit Facility. Those facilities make loans of reserve balances. In order to maintain the target interest rate, however, the Fed uses open market operations to “sterilize” these loans, leaving the total supply of reserve balances unaffected.

The Federal Reserve faced a different

type of liquidity issue during the

financial market turmoil that began in

August 2007. In this case, there was

a sharp decline in . . . broad liquidity:

the ease with which assets in general

can be sold or used as collateral at a price

that appropriately reflects the expected

value of the asset’s future dividends.

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FRBNY Economic Policy Review / September 2008 49

holding reserves is costly, however, conflicts with another central bank objective: the desire to promote the efficient functioning of financial markets and the efficient allocation of resources more generally.

Remunerating reserve balances at a below-market interest rate is effectively a tax on holding these balances. (Box 1 discusses how this tax is distortionary when applied to required reserves.) Similar logic shows that a distortion arises when banks face an opportunity cost of holding excess reserves. In this case, the tax leads banks to invest real resources in economizing on their holdings of excess reserves, but these efforts produce no social benefit.

Reserve balances are costless for a central bank to create through open market operations, for example, that exchange newly created reserves for Treasury securities. If banks perceive an opportunity cost of holding reserves (relative to Treasury

securities, say), then they will engage in socially inefficient efforts to reduce their use of reserves. In other words, the tax places a wedge between a private marginal rate of substitution and the corresponding social marginal rate of transformation. This type of distortion was emphasized by Friedman (1959, pp. 71-5), who argues that the central bank should pay interest on all reserve balances at the prevailing market interest rate.14

One might be tempted to suppose that the distortions created by this tax must be small because the quantity of excess reserves held by banks is currently fairly small in the United States, around $1.5 billion. Such a conclusion is not warranted, however: the fact that the tax base is small does not imply that the deadweight loss associated with the tax is insignificant. The deadweight loss includes all efforts banks expend to avoid holding excess reserves, including closely monitoring end-of-day and end-of-maintenance-period balances so that any

14 This logic is central to the well-known Friedman rule, which calls for the central bank to eliminate the opportunity cost of holding all types of money (see especially Friedman [1969]). One way to implement this rule is by engineering a deflation that makes the real return on holding currency equal to the risk-free return. In this case, no interest needs to be paid on any form of money; the deflation generates the required positive return. In practice, there are a variety of concerns about deflation that keep central banks from following this approach. When applied to the narrower question of reserve balances held at the central bank, however, Friedman’s logic simply calls for remunerating all reserve balances at the risk-free rate.

Another tension generated by the

typical methods of monetary policy

implementation . . . relates to

efficiency concerns.

Box 1

Required Reserves

Although this article emphasizes the similarities in monetary

policy implementation procedures across countries, there are a

number of differences. One notable difference is in the use of

reserve requirements. Banks in the United States and the Euro zone

are required to hold reserves in proportion to certain liabilities. In

other countries, including Australia and Canada, banks are not

required to hold any reserves; the only requirement is that a bank’s

reserve account not be in overdraft at the end of the day.

In the simple framework we describe, it is immaterial whether

banks face a positive reserve requirement or the requirement is

effectively zero. In reality, however, there are important differences

between these approaches. One such difference is that reserve

requirements allow the central bank to implement reserve

averaging, whereby banks are allowed to meet their requirement

on average over a reserve maintenance period rather than every

day. As shown in Whitesell (2006a), reserve averaging tends to

flatten the demand curve for reserves around the central bank’s

target supply on all days of a maintenance period except the last

one; this flattening tends to reduce volatility in the market interest

rate.a Another important difference is the extent of the distortions

associated with bank reserve holdings. When required reserve

balances do not earn interest, as is currently the case in the United

States, the requirement acts as a tax on banks. This reserve tax raises

banks’ operating costs and drives a wedge between the price of

banking services and the social cost of producing those services,

creating a deadweight loss. The reserve tax also gives banks a strong

incentive to find ways to decrease their requirements, such as by

sweeping customers’ checking account balances on a daily basis

into other accounts not subject to reserve requirements. The

efforts invested in these reserve-avoidance activities are clearly

wasted from a social point of view.

Paying interest on required reserves at the prevailing market

rate of interest, as the European Central Bank does, eliminates

most of these distortions. The Bank of England goes a step further

by having banks set voluntary balance targets. Once set, these

targets can be used to implement monetary policy exactly the same

way that reserve requirements are. However, because the targets

are chosen by the individual banks, rather than being determined

administratively, their creation generates none of the distortions

associated with traditional reserve requirements.

a See Ennis and Keister (2008) for a detailed discussion of reserve averaging in the type of framework used here.

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50 Divorcing Money from Monetary Policy

excess funds can be lent out, as well as actually lending the funds out. A substantial fraction of activity in the fed funds market is precisely of this type, and it is not clear whether these indirect costs associated with the tax are small.

The issues created by the reserve tax are sometimes described as a “hot potato” problem. Participants all try to get rid of excess reserves because holding them is costly. However, the supply of excess reserve balances is fixed by the central bank and, at any point in time, someone must be holding them. Extending this analogy a bit, the fact that the potato itself (that is, the quantity of excess reserve balances) is small does not imply that that the efforts spent passing it along are also small. This is especially true if the potato is very hot, that is, if excess reserve balances earn much less than the market rate of interest.

Lucas (2000, p. 247) describes the deadweight loss associated with the inflation tax in a similar way:

In a monetary economy, it is in everyone’s private interest

to try to get someone else to hold non-interest-bearing

cash and reserves. But someone has to hold it all, so all

of these efforts must simply cancel out. All of us spend

several hours per year in this effort, and we employ

thousands of talented and highly trained people to help

us. These person-hours are simply thrown away, wasted

on a task that should not have to be performed at all.

Any system of monetary policy implementation that relies on banks facing an opportunity cost of holding reserves necessarily creates deadweight losses. The approaches described in the previous section thus conflict with a central bank’s desire to promote an efficient allocation of resources in the economy.

We summarize by noting that a central bank’s payments

policy, liquidity policy, and desire to promote efficient

allocation may all come into conflict with its monetary policy

objectives. The tension created by these conflicts tends to be

particularly strong during periods of stress in financial

markets. These tensions would be reduced or would disappear

altogether if banks did not face an opportunity cost of holding

overnight reserves that leads them to economize on their

holdings. In the next section, we describe an approach to

implementing monetary policy that removes this opportunity

cost and discuss some of its implications.

4. Divorcing Money from Monetary Policy

The tensions we described all arise from the fact that, under either current U.S. practice or a symmetric channel system, the quantity of reserve balances must be set to a particular level in order for the central bank’s interest rate target to be achieved. There are, however, other approaches to monetary policy implementation in which this strict link between money and monetary policy is not present. Here we discuss one such approach, which can be described as a floor-target channel system, or simply a floor system. This approach is a modified version of the channel system described above and has been advocated in various forms by Woodford (2000), Goodfriend (2002), Lacker (2006), and Whitesell (2006b). A particular type of floor system has recently been adopted by the Reserve Bank of New Zealand.

4.1 The Floor System

Starting from the symmetric channel system presented in Exhibit 2, suppose that the central bank makes two

The issues created by the reserve tax are

sometimes described as a “hot potato”

problem. Participants all try to get rid of

excess reserves because holding them

is costly. However, the supply of excess

reserve balances is fixed by the central

bank and, at any point in time, someone

must be holding them.

A central bank’s payments policy, liquidity

policy, and desire to promote efficient

allocation may all come into conflict

with its monetary policy objectives.

The tension created by these conflicts

tends to be particularly strong during

periods of stress in financial markets.

207

FRBNY Economic Policy Review / September 2008 51

modifications. First, the deposit rate is set equal to the target rate, instead of below it. In other words, in this system the central bank targets the floor of the channel, rather than some point in the interior. Second, the reserve supply is chosen so that it intersects the flat part of the demand curve generated by the deposit rate (Exhibit 3), rather than intersecting the downward-sloping part of the curve. Supply and demand will then cross exactly at the target rate, as desired.15

The key feature of this system is immediately apparent in the exhibit: the equilibrium interest rate no longer depends on the exact quantity of reserve balances supplied. Any quantity that is large enough to fall on the flat portion of the demand curve will implement the target rate. In this way, a floor system “divorces” the quantity of money from the interest rate target and, hence, from monetary policy. This divorce gives the central bank two separate policy instruments: the interest rate target can be set according to the usual monetary policy concerns, while the quantity of reserves can be set independently.

If the quantity of reserves is no longer determined by monetary policy concerns, how should it be set? In general, the supply of overnight reserve balances could be used to ease any of the tensions described earlier. For example, Lacker (2006) suggests that increasing the supply of overnight reserves could reduce banks’ use of daylight credit without impairing their ability to make timely payments. In fact, he argues that if

15 The fact that these supply and demand curves cross at the target rate does not imply that trades in the interbank market would occur at exactly this rate. A bank would require a small premium, reflecting transaction costs and perhaps credit risk, in order to be willing to lend funds rather than simply hold them as (interest-bearing) reserves. As a result, the measured interest rate in the interbank market would generally be slightly above the deposit rate. The target rate could instead be called the policy rate in order to make this distinction clear.

overnight reserve balances are increased by the maximum amount of current daylight credit use, then “in principle, any pattern of intraday payments that is feasible under the current policy would still be feasible” even in the extreme case where access to daylight credit is eliminated altogether. Note that restricting access to daylight credit will tend to increase the demand for overnight reserves, shifting the curve in Exhibit 3 to the right. The proposal in Lacker (2006) thus calls for increasing the supply of reserves enough to ensure that it falls on the flat portion of the demand curve even after this shift is taken into account.16

Goodfriend (2002) takes a different view, proposing that the supply of reserve balances could be used to stabilize financial markets. The central bank could, for example, “increase bank reserves in response to a negative shock to broad liquidity in banking or securities markets or an increase in the external finance premium that elevated spreads in credit markets” (p. 4). More generally, he suggests that the supply of reserves could be set to provide the optimal quantity of broad

liquidity services.17 It should be noted that there may be complementarity between payments policy and liquidity policy with respect to reserve balances; increasing the reserve supply to support broad liquidity can simultaneously reduce the use of daylight overdrafts, which might be particularly desirable during times of market turmoil.

The floor system also promotes a more efficient allocation of resources. Not only does this approach eliminate the reserve tax, it also removes the opportunity cost of holding excess

16 See Ennis and Weinberg (2007) for a formal analysis of the relationship between daylight credit and monetary policy implementation, including the ability of a floor system to reduce daylight credit usage.17 Determining this optimal quantity is a nontrivial task, however, and would likely require more research on the notion of broad liquidity and its role in the macroeconomy. The quantitative easing policy in place in Japan from 2001 to 2006 can be viewed as an attempt to use the supply of bank reserves to influence macroeconomic outcomes.

A floor system “divorces” the quantity of

money from the interest rate target and,

hence, from monetary policy. This divorce

gives the central bank two separate policy

instruments: the interest rate target can be

set according to the usual monetary policy

concerns, while the quantity of reserves

can be set independently.

Exhibit 3

A Floor System of Monetary Policy Implementation

Deposit rateequals

target rate

Lending rate

Interest rate

Supply ofreserves is not linked to target rate

ReservebalancesTarget

supplyTargetsupply

or

0

Requiredreserves

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52 Divorcing Money from Monetary Policy

reserve balances. This is true for any quantity of reserve balances large enough to lie on the flat portion of the demand curve in Exhibit 3. At such points, banks are indifferent at the margin between reserves and other risk-free assets. As a result, they no longer have an incentive to invest real resources in order to economize on their reserve holdings, and the deadweight loss associated with the systems described in Section 3 disappears.

Woodford (2000) points to another advantage of the floor system. Suppose that innovation in financial markets were to

undermine the demand for reserve balances that is at the heart of our model in Section 2. In particular, suppose that a perfect substitute for central bank reserves were developed and that banks were able to avoid reserve requirements completely. In such a situation, the demand for reserves would fall to zero if there were any opportunity cost of holding them; banks would instead use the substitute private instrument for payment and other liquidity purposes. If the central bank supplied a positive quantity of reserves, under the current system in the United States the market interest rate would fall to zero.

Woodford argues that even in this extreme situation, the central bank can still implement its target interest rate by using a floor system. Banks would again demand zero reserves at any interest rate higher than the target rate in this situation. However, under a floor system, the demand curve would be flat at the target rate for exactly the same reasons as described above. By setting a positive supply of reserves, therefore, the central bank could still drive the market interest rate to the target value. In this way, a floor system would enable the central bank to meet its monetary policy objectives even if technological changes eliminated the special role currently played by reserves; the key once again is divorcing money from monetary policy.

The Reserve Bank of New Zealand recently became the first central bank to implement a floor system (Box 2). While it is too early to evaluate the effects of this change properly, some

benefits—such as improved timeliness of payments—have already been observed. To be sure, the experience of a smaller country like New Zealand with this type of system may not be directly applicable to other central banks. Nevertheless, it will be instructive to observe this experience and, in particular, to see how it compares with the simple framework we present.

4.2 Discussion

While a floor system could potentially relieve or even eliminate the tensions between central bank objectives, there are several important concerns about how such a system would operate in practice and its potential effects on financial markets. One concern is that a floor system would likely lead to a substantial reduction in activity in the overnight interbank market, as banks would have less need to target their reserve balance precisely on a daily basis. In particular, since banks with excess funds can earn the target rate by simply depositing them with the central bank, the incentive to lend these funds is lower than it is under the other approaches to implementation discussed above. Nevertheless, an interbank market would still be necessary, as institutions will occasionally find themselves short of funds. How difficult it would be for institutions to borrow at or near the target rate is an important open question.

In addition, some observers argue that the presence of an active overnight market generates valuable information and

that some of this information would be lost if market activity declined. For example, market participants must monitor the creditworthiness of borrowers. If the overnight market were substantially less active, such monitoring may not take place on a regular basis; this in turn could make borrowing even harder for a bank that finds itself short of funds. Such monitoring may also play a socially valuable role in exposing banks to market discipline. It is important to bear in mind, however, that the

The Reserve Bank of New Zealand

recently became the first central bank

to implement a floor system. While it is

too early to evaluate the effects of this

change properly, some benefits—such as

improved timeliness of payments—have

already been observed.

While a floor system could potentially

relieve or even eliminate the tensions

between central bank objectives, there

are several important concerns about

how such a system would operate

in practice and its potential effects

on financial markets.

209

FRBNY Economic Policy Review / September 2008 53

In July 2006, the Reserve Bank of New Zealand (RBNZ) began

the transition from a symmetric channel system of monetary policy

implementation to a floor system. We describe some reasons for

the change and some features of the new regime, drawing heavily

on Nield (2006) and Nield and Groom (2008).

From 1999 to 2006, the RBNZ operated a symmetric channel

system with zero reserve requirements. It targeted a supply of NZD

20 million overnight reserve balances every day. All reserve

balances were remunerated at a rate 25 basis points below the

RBNZ’s target interest rate, called the official cash rate (OCR).

Payments system participants could borrow reserves overnight

against collateral at the overnight reserve repurchase facility

(ORRF), at a rate 25 basis points above the OCR. Finally,

participants could obtain reserves intraday, against collateral,

at an interest rate of zero using a facility called Autorepo.

The RBNZ’s decision to change the framework for monetary

policy implementation followed signs of stress in the money

market. The Government of New Zealand had been running a

fiscal surplus for a number of years and government bonds had

become increasingly scarce. The scarcity of government securities

available to pledge in the Autorepo facility led to delayed payments

between market participants. For the same reason, there had been

an increase in the levels of underbid open market operations

and, consequently, in the use of the bank’s standing facilities at the

end of the day. Finally, the implied New Zealand dollar interest

rates on overnight credit in the foreign exchange (FX) swap

market—the primary market by which banks in New Zealand

traded overnight—were volatile and often significantly above

the target rate desired to implement monetary policy.

The Reserve Bank of New Zealand conducted a review of its

liquidity management regime in 2005 and announced the new

system in early 2006. Under this system, the RBNZ no longer

offers daylight credit. In other words, there is no distinction

between daylight and overnight reserves. The target supply of

reserves has been vastly increased to allow for the smooth

operation of the payments system; the new level currently

fluctuates around NZD 8 billion. This represents an increase of

400 times the level under the previous regime. Reserves are now

remunerated at the OCR. It is still possible to obtain overnight

funds at the ORRF, but at a rate 50 basis points above the OCR.

The bulk of the transition to this new system occurred in four

steps over a twelve-week period between July 3 and October 5,

2006. During that time, the target supply of reserves increased

gradually to its current level. At each step, the rate earned on

reserves and the rate at which funds could be borrowed at the

ORRF were increased relative to the OCR in increments of 5 basis

points up to their current levels. The set of securities eligible as

collateral for Autorepo was reduced until the facility was

discontinued on October 5.

Since the new framework was introduced, the RBNZ has

implemented two changes. First, banks are now allowed to use a wider

set of assets to raise cash from the central bank. In particular, a limited

amount of AAA-rated paper is eligible.a Second, a tiered system of

remuneration was introduced in response to episodes in which the

market interest rate rose substantially above the OCR. The RBNZ now

estimates the quantity of reserves a bank needs for its payment activity

and, based on this estimate, sets a limit on the quantity that will be

remunerated at the OCR. Any reserves held in excess of that limit earn

a rate 100 basis points below the OCR. This policy is designed to

provide an incentive for banks to recirculate excess reserve positions

and to prevent them from “hoarding” reserves.

In principle, the RBNZ could have addressed this problem by

increasing its supply of reserves instead of by implementing a

tiered system. If the market interest rate is significantly higher than

the policy rate in a floor system, increasing the supply of reserves

should drive the market rate down (see Exhibit 3 in the text).

However, the RBNZ uses FX swaps to increase the supply of

reserves, and it found that the price in this market was moving

against it; the more reserves the RBNZ created, the more costly

it became to create those reserves. It is worth noting that this

problem would not arise in a country with a large supply of

government bonds or with a central bank that can issue its own

interest-bearing liabilities. In such cases, increasing the supply of

reserves need not be costly and could be an attractive alternative

to a tiered system.

While it is too early to evaluate with great confidence all of the

effects of the RBNZ’s changes, it appears that the transition went

smoothly overall. There were, of course, occasional signs of stress

in money markets, mostly attributable to the learning process

experienced by the Bank and its payments system participants.

There are, however, definite positive signs that the liquidity of the

interbank market has improved. Notably, payments have been

settling significantly earlier since the transition began, suggesting a

reduction in the constraints previously attributable to the scarcity

of collateral available to pledge in the Autorepo facility. In

addition, the implied New Zealand dollar interest rates in the FX

swap market are now much less volatile and are well within the

50 basis point band between the official cash rate and the ORRF.

Finally, the RBNZ conducts open market operations much less

frequently, and the operations are no longer subject to the

underbidding that had led to excessive use of overnight facilities.

a See the Reserve Bank of New Zealand’s May 2008 Financial Stability Report for more details.

Box 2

The Reserve Bank of New Zealand’s Floor System

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54 Divorcing Money from Monetary Policy

market for overnight loans of reserves differs from other markets in fundamental ways. As we discussed, reserves are not a commodity that is physically scarce; they can be costlessly produced by the central bank from other risk-free assets. Moreover, there is no role for socially useful price discovery in this market, because the central bank’s objective is to set a particular price. Weighing the costs and benefits of a reduction in market activity is therefore a nontrivial task and an important area for future research.

If desired, the floor system could be modified in ways that encourage higher levels of activity in the overnight interbank market. For example, the central bank could limit the quantity of reserves on which each bank earns the target rate of interest and compensate balances above this limit at a lower rate. Such limits would encourage banks that accumulate unusually large balances over the course of the day to lend them out. By setting lower limits, the central bank would encourage more activity in the interbank market while marginally increasing the distortions discussed above.18 Whitesell (2006b) presents a

system in which banks are allowed to determine their own limits by paying a “capacity fee” proportional to the chosen limit. In this case, the central bank would set the fee schedule in a way that balances concerns about the level of market activity with the resulting level of distortions.

Another interesting issue is the extent to which a floor system would allow the central bank to restrict access to daylight credit, if it so desired. If access to daylight credit is substantially restricted or removed, the smooth functioning of the payments system may require banks to acquire funds in the market on a timely basis during the day. In principle, this could be accomplished by the development of either an intraday market for reserve balances or a market for precise time-of-day delivery of reserves (see McAndrews [2006] for a discussion of such possibilities). Whether such markets would actually

18 Ennis and Keister (2008) describe a related approach based on “clearing bands,” where banks face a minimum requirement and earn the target rate of interest on balances held up to a higher limit. This approach could be used to encourage activity in the interbank market on the borrowing side (by banks that find themselves below the minimum requirement) as well as on the lending side (by banks that find themselves above the higher limit).

develop and how efficiently they would operate are important open questions.

Going forward, the experience of New Zealand’s floor system will provide valuable information on these issues and others that might arise. However, the differences between the financial system of New Zealand and those of economies like the United States will make it difficult to draw definite conclusions. For this reason, it is important to employ the tools of modern economic theory to develop models that are capable of addressing these issues.

5. Conclusion

This article highlights the important similarities in the

monetary policy implementation systems used by many central

banks. In these systems, there is a tight link between money and

monetary policy because the supply of reserve balances must be

set precisely in order to implement the target interest rate. This

link creates tensions with the central bank’s other objectives.

For example, the intraday need for reserves for payment

purposes is much higher than the overnight demand, which has

led central banks to provide low-cost intraday loans of reserves

to participants in their payments systems. This activity exposes

the central bank to credit risk and may generate problems

of moral hazard. The link also prevents central banks from

increasing the supply of reserves to promote market liquidity in

times of financial stress without compromising their monetary

policy objectives. Furthermore, the link relies on banks facing

an opportunity cost of holding reserves, which generates

deadweight losses and hinders the efficient allocation of

resources.

Our study also presents an approach to implementing

monetary policy in which this link is severed, leaving the

quantity of reserves and the interest rate target to be set

independently. In this floor-system approach, interest is paid

on reserve balances at the target interest rate. This policy allows

the central bank to increase the supply of reserves, perhaps even

significantly, without affecting the short-term interest rate.

While the floor system has received a fair amount of attention

in policy circles recently, there are important open questions

about how well such a system will work in practice. Going

forward, it will be useful to develop theoretical models of the

monetary policy implementation process that can address

these questions, as well as to observe New Zealand’s experience

with the floor system it implemented in 2006.

If desired, the floor system could be

modified in ways that encourage higher

levels of activity in the overnight

interbank market.

211

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