Archive for June, 2009

Regulators had powers but chose not to do anything

June 22, 2009

Eliot Spitzer, former Attorney General and Governor of New York makes some interesting comments in this interview. On Obama’s new finance plan he says:

“Rearranging the deck chairs does not fundamentally alter the fact that the regulators had the power over the past few years.”

:-)

KATHERINE LANPHER: Hang on a minute, where were those tools that people could’ve used? There’s been a lot of reporting, for instance on the Office of Thrift Supervision, saying that in fact they didn’t have oversight over some of the areas like with the credit security departments.

ELIOT SPITZER: Unfortunately, those reports are wrong. If you look at what, and I hate to point back to the office when I was Attorney General a number of years ago, what we were able to do with a very simple fraud provision in a state law. We were able to delve into the fundamental financial workings of every one of these companies, from AIG to the major banks to the hedge funds on occasion. All you needed was a simple anti-fraud provision in a statute, and the Fed, the SEC, the OCC had all the power they needed to look at these entities and to set credit ratios, capital ratios, liquidity requirements. They just didn’t do it.

He says Fed has all the powers but the ideology of Mr G was just too strong:

KATHERINE LANPHER: You’re asking the question: “Where was the Fed?” What’s your answer to that?

ELIOT SPITZER: I think that they made an affirmative ideological choice not to intervene and we have now, and I remember when I read Alan Greenspan’s autobiography being amazed because here was somebody who was writing in these glowing terms about Ayn Rand and the notion that governments should never intervene in the marketplace, and yet the Fed is the fundamental most important regulator out there. It swamps the capacity of the SEC, and OCC, OTS, all the others. The Fed has the capacity to look at any entity on the street, and say to them, “You have too much debt, you have too much leverage, raise your capital ratios, or you won’t have access to the borrowing we authorize.”

His excellent suggestion for Obama:

I’m not there having crafted a specific alternative plan. I’m not going to pretend that I could, or I would, in 30 seconds on air. The one thing I would say would be put people at the Fed, put people at the SEC, who affirmatively want to regulate.

I think this is a very very important point (His anecdote on how OCC did not allow NY State to look at predatory lending and complex derivatives is quite interesting).

Seeing the vast literature on economics and finance, you hardly come across any papers strongly in favour of regulation. The regulators  are mostly trained with  the same kind of literature and even though they become regulators, favor for self-regulation is pretty strong.  There were hints in Enron crisis, dotcom crisis, LTCM bailout that self regulation does not work, but was ignored.  This crisis has ofcourse changed all this with mr G agreeing that he was mistaken and rest simply followed.

This is not just limited to US but common across economies and instiutions. As I pointed in this post, the key people believed something was happening but did nothing. Why? The main reason is their beliefs but I guess  financial oligarchy also had a chief role to play. After all, most regulators had prior experience in the big fin firms as well.

This crisis is not just ba plain case of economics going wrong. There are some interesting political nuances to it as well. It should lead to some great literature on political economy.

Understanding credit crunches and historical comparisons

June 22, 2009

Elizabeth Duke, Fed Governor has given a very useful speech covering all the  main policies and their impact on financial markets.

It has a pretty useful discussion on credit crunches:

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Libertarian Paternalism happening in India and US

June 19, 2009

SEBI has passed some major reforms y’day. It was in an overdrive mode last year and is interesting to see some action once again. The idea is to make equity investments  more friendly for investors

  • It has lowered transaction costs across the entire securities trading spectrum,
  • it has floated a concept of anchor investor to make markets more stable (cannot sell share till 30 days of allotment),
  • No shares to have superior voting rights

However, two developments weree really interesting as we see some form of libertarian paternalism (LP) happening:

Rationalisation of disclosure norms for rights issues: Since rights issues are made to existing shareholders, who are in possession of basic information about the company and have been receiving reports regarding major developments in the company on a continuous basis, it has been decided to rationalize disclosures in rights issue offer document by doing away with or modifying existing disclosure requirements.

So, it has done away with disclosures which are repeated in the rights issue prospectus making it easier for investors to read. This is a form of LP where the regulator has intervened making things easier for the investor. The standard regulation approach following classical economics would be let investors decide which info is useful and which is not. However, we know it does not really work that way and SEBI has intervened to make things easier. However, the choice to select whether to invest in the rights share or not remains with the investor (this is what LP is all about).

Another decision:

Transparency in payment of commission to Mutual Fund distributors : There shall be no entry load for the schemes, existing or new, of a Mutual Fund.  The upfront commission to distributors shall be paid by the investor to the distributor directly. The distributors shall disclose the commission, trail or otherwise, received by them for different schemes/ mutual funds which they are distributing or advising the investors.

 This is again a continued form of LP from SEBI. I have bragged in numerous posts how mutual funds in India(see this one, see US case) are actually a distributor’s fund with most benefits going to a distributor than an investor. SEBI has been trying to reform this. It first removed entry load from direct applications, then it asked MFs not to charge entry load in case of bonus units. And now this step which does away with direct loads completely.

However, again it leaves the discretion to investors on how much entry load they want to pay their distributors. This is what LP also suggests- just intervene to kae things better. This means distributors better provide valuable investment advice or he does not get any commissions.

Now in the US. As I mentioned in my last post Obams’ new plan proposes setting a Consumer Financial Protection Agency. This will look into all matters pertaining to regulation in financial products/payments that matter to consumers.

1. Transparency: CFPA will be authorized to require that all disclosures and other communications with consumers be reasonable: balanced in their presentation of benefits, and clear and conspicuous in their identification of costs, penalties, and risks.

2. Simplicity. We propose that the regulator be authorized to define standardsfor “plain vanilla” products that are simpler and have straightforward pricing. The CFPA should be authorized to require all providers and intermediaries to offer these products prominently, alongside whatever other lawful products they choose to offer.

3. Fairness. Where efforts to improve transparency and simplicity prove inadequate to prevent unfair treatment and abuse, we propose that the CFPA be authorized to place tailored restrictions on product terms and provider practices, if the benefits outweigh the costs. Moreover, we propose to authorize the Agency to impose appropriate duties of care on financial intermediaries.

4. Access. The Agency should enforce fair lending laws and the Community Reinvestment Act and otherwise seek to ensure that underserved consumers and communities have access to prudent financial services, lending, and investment.

Just like in SEBI’s case, this one is also a form of LP. As consumers cannot understand financial products, it is better to ask the agency to simplify things for them. US takes a step further and even advocates designing plain vanilla financial products ( I had also advocated the same in my paper) helping people make right choices.

All this would have been completely unthinkable if not this crisis. Though in India’s case the issues are completely different. Indian regulators seem to have taken a liking for findings of behevaioral economics (see this as well) (though am not sure whether SEBI has consciously nudged). I even pointed Fed could be nudging as well.

These are all quite remarkable development I must say. We may not be realising it, but LP is beginning to shape our decisions

Paul Samuelson advice for economists: study economic history

June 19, 2009

Conor Clarke Of Atlantic conducts superb interview of Paul Samuelson, one of the greatest economists of all time. It is two parts.  Part one is here and Part two is here. He discusses about great depression, economic policies then, the current crisis, his secret of being youthful (he is 94 and to remember and answer so many qs is quite remarkable)

The final question was another confirmation to the importance of eco history:

Very last thing. What would you say to someone starting graduate study in economics? Where do you think the big developments in modern macro are going to be, or in the micro foundations of modern macro? Where does it go from here and how does the current crisis change it?

Well, I’d say, and this is probably a change from what I would have said when I was younger: Have a very healthy respect for the study of economic history, because that’s the raw material out of which any of your conjectures or testings will come. And I think the recent period has illustrated that. The governor of the Bank of England seems to have forgotten or not known that there was no bank insurance in England, so when Northern Rock got a run, he was surprised. Well, he shouldn’t have been.

But history doesn’t tell its own story. You’ve got to bring to it all the statistical testings that are possible. And we have a lot more information now than we used to.

So, Samuelson says what host of others have been saying- learn eco history and remember it.  I hope our econ departments are listening and acting. Unfortunately, behavioral economics also tells you people have really short memories. Let’s hope things change.

Columbia B-School Students’ India tour

June 19, 2009

Early this year, a group of 30 students from Columbia Business School participated in a study tour to India, visiting media companies, conglomerates, politicians and government agencies.

They had a essay contest to write about their experiences (they have this every year across countries). The three winners’ essays  are a good quick read. It gives you an account of how students see India. Quite a lot of hope from India.

Don’t policies that lead to stabilization lead to higher growth?

June 19, 2009

Economics is getting so confused these days. So many economics pillars have gone down in this crisis

  • monetary stability implies financial stability
  • central banks independence is crucial to economic growth
  • if a crisis happens, central banks can mop up the mess by plain rate cutting
  • self regulation of firms is the best option etc etc

A bigger list of such issues is summarised here. Visitors are free to add more.

Now comes questioning another pillar – policies that lead to higher stabilization lead to higher growth. Kevin Warsh, Fed Governor in his recent speech says

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Rising Government debts are unsustainable but are desirable

June 18, 2009

Paul de Grauwe et al have an interesting article in eurointelligence which points to the dilemma facing fiscal policymakers.  

There is no doubt that government debts and deficits are unsustainable. The US, the UK and other industrialized countries now have budget deficits of more than 10% of GDP. With such deficits, government debts are exploding rapidly. Simple extrapolations into the future lead to the conclusion that these debt and deficit levels are unsustainable and that they will have to be reversed to avoid insolvency.

However, the problem is not as easy as it sounds:

The fact that government debts and deficits are unsustainable does not however imply that they are undesirable today. There is no contradiction in the statement that government debts are both unsustainable and desirable. Why is that?

The stark increase in government debts today is a natural consequence of the unsustainable debt explosion in the private sector during the last ten years….With the bursting of the bubble, consumers and financial institutions started a painful process of reducing their debt levels. This process of “deleveraging” is necessary to kick start the economy again. At the same time it is only possible if governments are willing to increase their debt levels.  

The fundamental insight that private debt levels can only decline if government debt is allowed to increase….

Then they use the approach developed by Grauwe as explained here:

This follows from two mechanisms, uncovered long ago by Irving Fisher and Keynes. Once the private sector has accumulated excessive debt and suddenly all want to reduce their debt levels at the same time, this will not work. The reason is that they all want to reduce their debt burdens through either asset sales or increased savings or both. But asset sales lower asset prices, thus increasing the solvency problems for the private sector.

In sum, we are facing both stock and flow deflations and govt has to step in. This is also what Paul Krugman has been saying (though in other words) but is being opposed by a number of economists.

Ok all this is given now. Whether econs like it or not, we are only going to see rise in deficits going ahead. The question is what next as crisis eases (whenever that happens)? How do we unwind/manage such huge deficit levels? The govts will simply keep issuing more and more bonds and hope all getsubscribed. The cost will be crowding out of savings and less capital available for private investments.

The other options for govts as Mankiw et al explains- either  inflate or default. The second is not really a option as it would lead to a disaster.  Central banks will not like first happening so it will be interesting to see the battle.

The govt is bailing out the private sector right now. Will private sector bail out the govt by agreeing to pay higher taxes? Even if they do, would it be enough? How will govts deleverage their debts?

Whatever country experiences I have read (see this, this) of managing govt debts, it is a big big battle. It has other linking problems of high inflation, crowding out, high int rates, etc etc. It does not look good at all.

Thinking about Ministry of Finance/Treasury

June 18, 2009

We have plenty of literature on central banks, their set-up, their institutional structure etc etc ( see this, this , this, this, this etc for some literature).

However, I was earlier thinking – what about similar literature on Ministries of Finance/Treasury (MOF/T)? Central Banks get much of the focus wrt economic institutions but I have always believed MoF/T is as important (perhaps more). This crisis has thrown them in limelight for all the wrong reasons but a sound MoF/T is as important to an economy as a central banker.

How are MoF/T organised? What are the differences in different MoF/T across countries ? What are the similarities? The differences between developed and developing? Are they converging towards some standard? How do MoF/T and Central Banks coordinate policies in their economies ( we focus too much attention on central banks)? What also interests me tremendously is what made MoF/T give up much of their power to central banks as stature of mentary policy grew? What were the causes? What were the processes? How do they keep a check on central banks?

 We usually get literature on MoF/T as an autobiography of some insider (Swagel points to some ideas) but not much like the research we get on central banks.

Actually what promoted me to write this post is this superb post from Tej Prakash of IMF.  he does provide some insights to above questions like:

While there is no standard model for the organizational structure of a MOF, it is generally agreed that there is a set of core tasks that any MOF should fulfill. This includes (1) budget formulation and implementation, (2) collection, custody, management, accounting, control and disbursement of public monies, (3) management of public assets and liabilities, (4) revenue and expenditure policy and management, and (5) design and implementation of macroeconomic and fiscal policies of  government. MOFs have also added many other tasks such as donor coordination, oversight of domestic financial markets (often by establishing regulatory bodies) [2], managing fiscal risks arising from various sources, financial oversight of public enterprises, and relations with international organizations such as the World Bank and the IMF.

The organizational structure of MOFs is also linked to the political-economy and to the governance structure of the country. Countries with presidential or parliamentary systems will likely have different organizational roles and structures of the MOF

The MOF as an institution also reflects the historical legacy of countries. Many formerly colonized countries inherited the institutional systems of their former rulers.

In many small, developing countries MOFs have been struggling with the increased requirements of their core role as well as of more complex processes and other innovations. MOFs in such economies also lack professional staff in many skill areas, such as treasury management and accounting.

It then looks at some suggestions for small developing economies. Excellent stuff. I need to do some literature survey on this. Anybody knows of such research do let me know.

Obama’s Financial System Fix plan – Version?

June 18, 2009

As pointed earlier, Obama has released the white paper (89 pages long) on what is being said as the most ambitious reform proposal for financial sector.

The President’s plan will:

Require that all financial firms that pose a significant risk to the financial system at large are subjected to strong consolidated supervision and regulation

Increase market discipline and transparency to make our markets strong enough to withstand system-wide stress and the potential failure of one or more large financial institutions

Rebuild trust in our markets by creating the Consumer Financial Protection Agency to focus exclusively on protecting consumers in credit, savings, and payment markets.

Provide the government with the tools needed to manage financial crises so it is not forced to choose between bailouts and financial collapse

Raise international regulatory standards and improve international coordination

We have heard all that so many times.  Hope there is more substance to it. WSJ BLog points out to economists’ views which are mixed really. I haven’t read the report so no comments.

Ezra Klein points to an excellent glossary to help you understand all the fancy terms :-)

I am happy to see third suggestion getting through- Consumer Financial Protection Agency. It is proposed by Liz Warren and ME  had pointedthis long back (in Dec 2007). Let me admit, at that time, I didn’t think the proposal would ever go through. The reason was not as the idea was impractical etc but I thought it would never be accepted within academia, regulators and above all financial players.

I also thought the idea is pretty useful for developing economies in particular.If people find finance difficult in developed econs and need an agency, developing economies need it more urgently. I am all for financial literacy but knowing ABC of finance is just not enough to keep up with the fin world.

Look at India, we have financial products with huge variety coming out left right and centre (and people want more). With no such independent agency in place, people mostly choose products which the distributors push at them without any understanding of so called risks and return. 

But yeah, next time developing economies have a report on their financial sector, we can hope to find this suggestion. Till now it must have sounded stupid but is going to become a reality in US of A. And financial players have little choice now but to accept it. Let’s see how this one is set up in US as it is not going to be easy.

Marcus Brunnermeier gets Bernacer 2008

June 17, 2009

Marcus Brunnermeier of Princeton gets the Bernacer award for 2009 (see previous winners’ list here). It is the European equivalent of Clark Medal awarded to promising European economists under age 40 (though most are now based in US Univs).

His papers have helped explain the recent crisis closely mimicing the practices of financial markets and its players.

 A useful summary of his research is provided by José Manuel González-Páramo of ECB here. He himself has a summary of his work here  (he calls it outdated though)

New Bretton Woods

June 17, 2009

Raghu Rajan in his new paper suggests new roles for World Bank and IMF. He says the ongoing crisis has pointed that these international institutions are still of importance but they need to redefine their roles. He calls this New Bretton Woods.

The Bretton Woods sisters—the International Bank for Reconstruction and Development (henceforth the World Bank) and the International Monetary Fund (IMF)—were set up in 1944. The original purpose of the former was to help post– World War II reconstruction; the purpose of the latter was to help revive global trade while averting the “beggar ‐thy‐neighbor” exchange rate policies that characterized the interwar years.

Over the years, the World Bank has refocused on helping poor countries grow while the IMF broadly attempts to foster country policies that ensure macroeconomic stability and limit adverse spillovers to the rest of the world. While these roles still remain, their nature has changed somewhat. In particular, given the development of financial markets around the world, the primary role of these institutions has moved to shaping, guiding, supplementing, and stabilizing the flow of private finance rather than substituting fully for it.

This paper focuses on the new ways multilateral institutions may have to perform old tasks, as well as the ways they could perform new tasks such as slowing climate change. Critical to their transformation will be the attitudes of the countries that play the largest role in their governance, as well as reform of the governance process itself. Hence the call for a new Bretton Woods.  

Interesting thoughts from Rajan. Actually what he says has been said on numerous forums by numeorus economists witha few additions and subtractions from Rajan’s viewpoint. It is important that we get the right suggestions but what is more important is willingness to pass on the reforms.

Comparing US recessions and Great Depression

June 17, 2009

There are numerous sources comparing previous US recessions with this one  (see UK here, India here).

CFR has an update on the same which is quite useful. It puts all recessions at time zero and compares across various economic parameters:

Financial markets have dramatically improved, but from an extremely low base. Rather than pricing in disaster, they anticipate tough times ahead. For example, the charts on the spread for AAA and BAA bonds show the credit market moving from unprecedented panic to a level of fear that is merely in keeping with the worst experiences since 1945.

Real economy indicators show signs of stabilization. See in particular the charts on manufacturing sentiment, nonfarm payrolls, oil prices, and car sales. Nonetheless, many of these indicators remain worse than anything hitherto experienced in the postwar period.

The collapse in the federal government’s finances is unprecedented, raising questions about how the government deficit will be brought under control.

By most measures, the current recession is far milder than the Great Depression. But the appendix shows that house prices have recently fallen much more sharply than in the 1930s. 

Good stuff.

Inflation targeting framework completes 20 years

June 16, 2009

Inflation targeting framework (ITF) has completed its 20 years. It looks like a very new framework but has already completed 20 years.

It started in NZ in 1989 (New Zealand passed the legislation for inflation targeting in late 1989, with implementation from the beginning of 1990) At present 28 economies have adopted ITF last being Ghana in 2007.

Now, there are numerous  research papers weighing the +ves and -ves of ITF. This crisis has led to particularly sharp criticism of  ITF (Joe Stiglitz in particular. see in particular Yellen. She says ITs need to be revised upwards). The ITF Central Bankers though are united in their commitment to ITF. More is to come for sure.

Norges Bank (started best practice monetary policy) hosted a conferenceto review ITF’s 20 years. It has some great papers which tell you about evolution of ITF, experiences so far and challenges. A useful set of papers for Mon pol students.

If it was not this crisis, one would get to see more central banks hosting conferences,seminars to discuss the same.

Economics of Healthcare: new buzzword

June 16, 2009

I am suddenly seeing a big rush for research work and policy work on economics of healthcare.

Growth Commission has issued a full report on whether healthcare focus leads to better growth:

This book has been prepared for the Commission on Growth and Development to evaluate the state of knowledge on the relationship between health and economic growth. It does not pretend to provide all the answers, but does review the evidence as well as identify insights and policy levers to help countries pinpoint critical health investments that can enhance and strenghen national growth strategies.  It examines a variety of topics, including policy imperatives in assessing the benefits of health investments, the methodological challenges in measuring the link between health and economic growth at the macroeconomic leve, and the nature of the evidence on the types and timing of interventions that promote health, productivity, and earnings.

Council of Economic Advisers has prepared a reporton US healthcare with a surprise element. Unlike most reports which argue for an increase in investments in healthcare, this one suggests to reduce expenditure in this sector and make it more efficient:

The Council of Economic Advisers (CEA) has undertaken a comprehensive analysis of the economic impacts of health care reform. The report provides an overview of current economic impacts of health care in the United States and a forecast of where we are headed in the absence of reform; an analysis of inefficiencies and market failures in the current health care system; a discussion of the key components of health care reform; and an analysis of the economic effects of slowing health care cost growth and expanding coverage.

The findings in the report point to large economic impacts of genuine health care reform:

  • We estimate that slowing the annual growth rate of health care costs by 1.5 percentage points would increase real gross domestic product (GDP), relative to the no-reform baseline, by over 2 percent in 2020 and nearly 8 percent in 2030.
     
  • For a typical family of four, this implies that income in 2020 would be approximately $2,600 higher than it would have been without reform (in 2009 dollars), and that in 2030 it would be almost $10,000 higher. Under more conservative estimates of the reduction in the growth rate of health care costs, the income gains are smaller, but still substantial.
     
  • Slowing the growth rate of health care costs will prevent disastrous increases in the Federal budget deficit.
     
  • Slowing cost growth would lower the unemployment rate consistent with steady inflation by approximately one-quarter of a percentage point for a number of years. The beneficial impact on employment in the short and medium run (relative to the no-reform baseline) is estimated to be approximately 500,000 each year that the effect is felt.
  • Expanding health insurance coverage to the uninsured would increase net economic well-being by roughly $100 billion a year, which is roughly two-thirds of a percent of GDP.

This is quite interesting really. I have never read any govt proposing to lower the total costs of healthcare. Though reading on making it more efficient is pretty common. So what Obama wants to do is curtail total expenditure on healthcare and make whatever remaining more efficient and reachable to American public. Tyler Cowen has an article saying Obama should do something to control the rising expenditure under healthcare

Christy Romer is busy discussing this ambitious plan by Obama. Here is her speech where she says:

A former chair of the Council of Economic Advisers once described the job as playing economic pinball. Issues come flying at you from every direction. The Chair’s job is to respond quickly with good economic analysis. For the first several months that I was on the job, most of the balls flying at me were at least squarely in my comfort zone. Recession, fiscal stimulus, financial crises, and banking were all topics I had studied and felt I understood well.

But recently, the balls have been coming predominantly from less familiar territory. In particular, having made it through a macroeconomic-centered first one hundred days, the President declared health care reform his number one domestic priority. For me, as I would tell my children, this was a chance to grow. I was encouraged along by the head of the White House effort on health care, Nancy-Ann DeParle, who asked me to write a report explaining the economic effects of successful reform.

What followed was surely the most intense six weeks of my life. My staff and I threw ourselves into serious analysis and economic modeling. Our findings are summarized in a report that the CEA just issued last week. The results can perhaps be best summarized by describing how my own views have evolved. As a result of the study, I have gone from being a positive, but somewhat passive, supporter of health care reform to a passionate advocate. What I would like to do this afternoon is describe some of what we found.

Then Romer discusses the findings at Brookings with other experts (Like David Cutler, noted healthcare economist from Harvard). I have not read the testimony but should be very interesting.

Health care is such an important part of our economy and it’s such an important part of our fiscal outlook. I think I’ve heard from both Christina Romer who will be speaking shortly, and David Cutler one of our panelists, that if you’re an economist working on public policy, sooner or later you’re going to become a health economist and I think this event reinforces that. I think that’s true for Doug as well.

Then we have CBO which keep taking out reportson US healthcare, medicaid etc. The latest discusses the cost and benefit analysis of health insurance coverage which also makes a interesting reading. WP explainsthe crucial role CBO plays in the new Obama healthcare plan. Its report would suggest whether the CEA report is worth the salt or not.

And this is just US. Rising Healthcare and medical costs are always an issue for European economies. Healthcare economics looks a hot topic for research.

PS.

Via CBO Director blog I got to know of CBO and its work. It is pretty impressive and a high pressure job. It will be great if India also has its version of CBO office which reviews the various govt policies. There is CGA which does some evaluation but is too limited in scope. We need an allrounder providing easy to read reports for the general public. A place where you can evaluate govt policies from an independent and different lens.

Obama to announce Financial sector reforms yet again

June 16, 2009

Despite Larry Summer’s wish I don’t think this crisis will be remembered for the change Obama and his team is trying to make. It will mainly be remembered for how this crisis wiped out a sector (and its ivy league firms) which looked so promising otherwise, how it then became a huge economic crisis and how policymakers struggled to make proper policies. After a while off course all recessions end and so some policies will obviously take the credit.

Today, blogs  are discussing this new Washigton Post piece by Summers and Geithner (SG). The duo say:

This current financial crisis had many causes. It had its roots in the global imbalance in saving and consumption, in the widespread use of poorly understood financial instruments, in shortsightedness and excessive leverage at financial institutions. But it was also the product of basic failures in financial supervision and regulation.

Our framework for financial regulation is riddled with gaps, weaknesses and jurisdictional overlaps, and suffers from an outdated conception of financial risk. In recent years, the pace of innovation in the financial sector has outstripped the pace of regulatory modernization, leaving entire markets and market participants largely unregulated.

That is why, this week — at the president’s direction, and after months of consultation with Congress, regulators, business and consumer groups, academics and experts — the administration will put forward a plan to modernize financial regulation and supervision. The goal is to create a more stable regulatory regime that is flexible and effective; that is able to secure the benefits of financial innovation while guarding the system against its own excess.

On reading this, I was like again – Oh no not again? How many times do they want to come up with similar reform packages? We had Paulson’s Blueprint, followed by Geithner’s Financial Stability plan, then we keep having proposals linked to financial stability off and on and now this new plan. And it is not just about financial stability but things like executive compensations keep making a comeback. By keeping basic issues open-ended endlessly we are just getting nowhere.

Simon Johnson has already called the new Obama finance planas a plan which will help build the next crisis. He looks at the 5 proposals highlighted by S-G and says how each are just plain-talk. Unless , the proposed reform check the financial oligarchy, the system will only produce crisis more severe than this one.

Now let’s see what comes up on Wednesday.

How would Summers like this crisis to be remembered?

June 15, 2009

Larry Summers in his recent speech at CFR (testimony here) says:

I’m often asked what our — how I would define our objectives in the economic areas.  Here’s the answer that I’ve learned to give.  My daughter’s last year in high school, she studied U.S. history.    

Interesting for somebody my age to observe what they do and do not learn: 1982 recession, not mentioned; 1975 recession, not mentioned.    

Any economic fluctuation in my lifetime, not mentioned; the Great Depression, six weeks of study.    

Our objective:  Make sure that when people study history in 2040, they don’t learn about the — how the economy was performing in 2008 and 2009.  (Laughter.)  

But you know — and this really is my final point.  (Laughter.) What they did learn about, they did learn about a whole set of laws that were passed in the 1930s that saved the market from its own excesses.  They learned about a whole set of laws that were passed, actually, by both Roosevelts, that responded to the excesses of the market system and enabled the market system to evolve and function better going forward.  

That is what I hope students will be studying a generation from now, when they study this period, as we manage this crisis and we set the stage for a healthier, even better-functioning market system in the future.

:-) I don’t really think this crisis will be known as per Larry Summers desires. The policy responses were far off the mark as crisis enfolded. Though things have improved now, policy criticisms continue and we have other concerns emerging (high deficits, exit strategies etc). The Crisis of 2007 might not get 6 weeks of study but might get 4 weeks study in US history.

Anyways a must read speech from Summers. He tells you how Obama is weighing the various economic principles before intervening. It is a very very tough call with no easy answers.

Understanding China’s reforms through the years

June 15, 2009

Bert Hofman and Jingliang Wu have written a fantastic paper on China’s economic development and how various reforms were initiated. It is written for the Growth Commisison  and makes a superb read.

What is particularly interesting is how China managed to pass market reforms (its gradual approach) and also continue with its heavy state planning. Where as the other socialist economies could manage neither of the two approaches.

Starting with a heavily distorted and extremely poor economy, China gradually reformed by improving incentives in agriculture, phasing out the planned economy and allowing nonstate enterprise entry, opening up to the outside world, reforming state enterprises and the financial sector, and ultimately by starting to establish the modern tools of macroeconomic management.

The way China went about its reforms was marked by gradualism, experimentation, and decentralization, which allowed the most appropriate institutions to emerge that delivered high growth that by and large benefited all. Strong incentives for local governments to deliver growth, competition among jurisdictions, and strong control of corruption limited rent seeking in the semi‐reformed system, whereas investment in human capital and the organizations that were to design reforms continued to provide impetus for the reform process. Learning from other countries’ experience was important, but more important was China’s adaptation of that experience to its own particular circumstances and needs. 

How Merril Lynched Bank of America?

June 13, 2009

Committee on Govt Oversight and Reform held a hearing to discuss precisely the title of the post. Ken Lewis, CEO of BoA was asked to testify and one should really read his testimony and opening statements of the members.

The opening statement says:

On September 15, 2008, when the financial crisis was at its height, Bank of America announced that it was purchasing Merrill Lynch, creating one of the nation’s largest financial institutions. At the time, Bank of America’s CEO, Ken Lewis, called the merger “a great opportunity for [Bank of America] shareholders.”

When it was announced on September 15 th, this merger was a marriage negotiated between two willing parties. It was designed for the exclusive benefit of private shareholders, and it was to be paid for exclusively with private money.

Four months later, on January 16, 2009, after the merger was consummated and the quarterly earnings were announced, the world woke up to a different kind of marriage.

The American people discovered that Merrill Lynch had experienced a $15 billion fourth quarter loss. Most importantly, we found out that the merger had taken place only after the Federal government had committed to give Bank of America billions in taxpayer money.

What happened in the interim?

Lewis begins by defending the deal as an immense value creator and making BoAML a supermarket of financial services. He then shows how the alliance has led to them becoming a leader in so many financial services. He also adds how ML is now contributing bulk of the revenues as commercial banking has declined because of the recession.

Towards the end he reflects on the actual issue being discussed and says he had  expressed concern over ML losses and wanted to delay the deal. But was asked by US Treasury and Fed to continue it as it would pose huge concenrs to the system as a whole!

The closing statement of Chairman of the hearing sums up the entire thing best:

As we come to the conclusion of this hearing it’s important to remember that we have heard only one side of the story today. The Committee needs to hear from Mr. Paulson and Mr. Bernanke before we draw any hard and fast conclusions.

However, I do think it is fair to observe that a flawed financial regulatory process was at work in this case. We see closed door meetings, coded messages, motives questioned and private e-mails. Basically the regulators and the financial institutions seemed to be making up the rules as they went along.

As Congress considers financial regulatory reform, one of the lessons from this case is that we need much more transparency and accountability in our financial regulatory and oversight process. The American taxpayers and corporate shareholders deserve no less.

All you can do is  :-) and shudder at state of affairs.

Developing Country’s Strategies post-crisis

June 13, 2009

Dani Rodrik has written a thoughtful paperproviding growth strategies for developing econs after this crisis.

First a bit of growth econ history. His basic presumption is that countries that have grown in the past 50 years have done so from specialising in industrial tradable products:

What is common about Japan, South Korea, and China is that they based their growth strategies on developing industrial capabilities, rather than on specializing according to their (static) comparative advantages. They each became manufacturing superpowers in short order— and much more rapidly than one would have expected based on their resource endowments. China’s export bundle was built up using strategic industrial policies that forced foreign companies to transfer technology, and as a result resembles one for a country that is three or four times as rich (Rodrik 2006). South Korea started out with very little manufacturing capability and quickly moved from simple manufactures (in the 1960s) to more complex products (in the 1970s). Japan, unlike the other two countries, had developed an industrial base (prior to the Second World War), but this base was totally destroyed in the war and was restored thanks to trade and industrial policies that protected domestic producers.

The general lesson to be drawn from the experience of these post-war growth champions is this: High-growth countries are those that are able to undertake rapid structural transformation from low-productivity (“traditional”) to high-productivity (“modern”) activities. These modern activities are largely tradable products, and within tradables, they are mostly industrial ones (although tradable services are clearly becoming important as well). In other words, poor countries become rich by producing what rich countries produce.

Hmm. And what were the policies?

First, it is clear that sound “fundamentals” have played a role, as long as we interpret the term quite broadly and not associate it with any specific laundry list of policies 

Second, all successful countries have followed what one might call “productivist” policies. These are activist policies aimed at enhancing the profitability of modern industrial activities and accelerating the movement of resources towards modern industrial activities. They go considerably beyond the conventional recommendation to reduce red tape, corruption, and the cost of doing business. They entail in addition (or sometimes instead): 

  • explicit industrial policies in support of new economic activities (trade protection, subsidies, tax and credit incentives, special government attention);
  • undervalued currencies to promote tradables; and 
  • a certain degree of repression of finance , to enable subsidized credit, development  banking, and currency undervaluation.

This is pretty much the advice Rodrik (along with others at KSG School) has given across the years. He then looks at the criticism of each of the above three growth strategies.

He then says this crisis has led to 3 things which are of concern to developing econs:

The indirect effects operate through the channels of international trade and finance. Three likely developments here are of potential concern: (i) reduced appetite for cross-border lending; (ii) slower growth in world trade; and (iii) less tolerance for large external trade imbalances.

As per Rodrik, each of the three are not a concern for developing economies. Instead by focusing on industrial policies to produce tradables and focusing on domestic demand, the developing econs can still grow.

Read the rest of the paper for more details. As usual Rodrik does not disappoint and has some great insights for developing economies and its policymakers.

Credit rating agencies underestimate risks of big financial firms

June 12, 2009

Andrew Kuritzkes, a partner at Oliver Wyman in an interview with Wharton Knowledge Centre says:

Knowledge@Wharton: You’ve been quoted as saying that large financial institutions have failed at a much higher frequency than generally perceived. Can you put that in perspective? That’s a pretty strong statement.

Kuritzkes: Yes. What I’ve looked at is the empirical record of large financial institutions, which I define as global top 100 financial firms — what their actual failure rate was over the last 20 years. There’s a notion we had before the crisis that large financial firms — the Lehman Brothers, the Bear Stearns, the AIGs — were actually very safe firms, that they had very high credit ratings — typically a single A or better — and that these firms should fail at a very, very low rate. But when you actually look at the empirical record, it turns out if you go back over 20 years there were 26 failures of firms that would have been in the list of global top 100 financial firms.

Knowledge@Wharton: What were some of the big ones? I think I can remember Continental Illinois was probably one. Was that before [the particular time period you mentioned]?

Kuritzkes: That was before that time, yes. My analysis shows that over the 20-year period, the default rate or the failure rate for the global top 100 works out to be 1.3%, which is at least an order of magnitude higher than the default rate implied by credit ratings of the global top 100. The median credit rating of the top 100 firms in 2007 was single-A-plus. That’s consistent with the default rate of about four basis points. So … the historical record seems to show that these firms actually fail by… more than 20 times the implied failure rate of the credit ratings.

Phew. 20 times!!! Though there is no research paper attached with the interview so one has to just go by his findings.

Read the entire interview for some excellent insights and criticism of ongoing policies.


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