Archive for October 19th, 2010

Crisis of US contract enforement system

October 19, 2010

Krugman highlights the ongoing mortgage forecloasure crisis in US.

American officials used to lecture other countries about their economic failings and tell them that they needed to emulate the U.S. model. The Asian financial crisis of the late 1990s, in particular, led to a lot of self-satisfied moralizing. Thus, in 2000, Lawrence Summers, then the Treasury secretary, declared that the keys to avoiding financial crisis were “well-capitalized and supervised banks, effective corporate governance and bankruptcy codes, and credible means of contract enforcement.” By implication, these were things the Asians lacked but we had.

Read the whole article in case missed. The crisis is not just about economics and finance. It has disturbed everything in US. What was once seen as epitome of property right system, contract enforecement system etc looks so wobbly now.

Lending to Small Business in this crisis

October 19, 2010

There are a couple of interesting papers on the topic.

First, this survey by NY Fed confirms what everyone would naturally think. In this crisis – small businesses are likely to be impacted more compared to large businesses:

The Federal Reserve Bank of New York today released Access to Credit: Poll Evidence from Small Businesses—results from a poll of small businesses in the region, as a part of the Bank’s Community Affairs Facts & Trends series. The results showed that during the first half of 2010:

  • 59% of poll respondents applied for credit, demonstrating existing demand;
  • Over two-thirds of poll respondents experienced sales/revenue declines, implying a broad weakening of small business finances; and
  • Only half of small business applicants received credit, and 75% reported receiving only ‘some’ or ‘none’ of the credit they wanted.

” Until now, we’ve only heard anecdotally about difficulties for regional small businesses in obtaining credit without any numbers to confirm this,” said Kausar Hamdani, senior vice president and Community Affairs officer at the Federal Reserve Bank of New York. “A main purpose of this poll was to hear directly from small businesses about their recent credit experiences and to analyze them systematically in order to learn more about where the largest obstacles exist.”

I came across two more papers.

First was this economic brief  by Marianna Kudlyak, David A. Price, and Juan M. Sánchez. They compare how small businesses have fared in previous recessions and monetary tightening episodes. They are about to come with a detailed paper later. So what are prelim findings?

They compare the recessions across three factors – sales, inventory and debt levels.

  Sales Inventory Short Term Debt
  Large Small Large Small Large Small
2007–2009 Recession  -14.94 -10.01 -6.23 -6.93 -18.62 -8.85
2001 Recession -15.33 -8.78 -13.36 -10.46 -36.95 -12.5
All Recessions pre–2001 -7.73 -7.97 -5.11 -5.82 -20.44 -7.86
Tight Money Dates -3.11 -6.44 -1.97 -6.05 -8.88 -11.12
  • In short term debt, we see smaller firms lowering debt by a smaller % compared to larger  firms in recessions. However, in tight money, large firms credit declines by a smaller %.
  • In Sales, we see sales of small firms contracting more than large firms for tight money and all pre-2001 recessions. However, in 2001 and 2007-09 recession, sales of large firms contract more
  • In inventory, we see small firms contract more in tight money, pre-2001 recessions and 2007-09 recession. Only in 2001 recession we see opposite case

The authors say:

These findings invite further research into the role of small firms in contractions, whether those con-tractions are the result of worsening credit condi-tions or other shocks. The findings as to periods of tight monetary policy—with firms behaving differently in 2007–2009 than in earlier periods of worsening credit—suggest that the economy of 2008 did not entirely fit the longstanding model in which small firms contract more than large firms in response to credit shocks, and that the contraction of small firms is responsible for the amplification of these shocks. This, together with the findings in Chari, Kehoe, and Christiano’s research, suggests that new or different forces may have been affecting the behavior of firms in those recessions.

One possibility that could be explored is whether large firms in the recent periods of tight money or recession faced greater credit constraints than has historically been the case—for example, because large firms were more highly leveraged, which in turn leads to the large firms being more heavily constrained by the availability of credit. Other explanations may emerge for the new patterns observed in Kudlyak and Sánchez’s study.

Hmm. Above survey says small business continue to face credit crunch, but large firms seem to have done worse in sales and short term debt. It could mean large firms face a more severe credit crunch this time as their sources of finance – Commercial papers, bank loans  etc have been bad. In case of small firms only bank loans come. But for large both non-bank and bank come as sources of finance. With both doing badly, large firms seem to be impacted more.

In another paper by Boston Fed econs say:

This paper exploits the differential financing needs across industrial sectors and provides strong empirical evidence that financing constraints of small businesses are important in explaining the unemployment dynamics around the Great Recession. In particular, we show that workers in small firms are more likely to become unemployed during the 2007-2009 financial crisis if they work in industries with high external financing needs. According to our estimates, eliminating financial constraints of small firms could add up to 850,000 jobs to the economy. We suggest that policies aimed at making credit available to small businesses would significantly help stabilize the labor markets and economic activity in the U.S

So this takes a step backwards and says  small firms that depend more on external finance must have faced more severe crunch. Hence, they would end up firing more people than both large firms depending on external finance and small firms not depending on external finance.

We find that during the Great Recession individuals are more likely to become unemployed if they work in sectors with high external financial dependence. In these sectors the impact of the recession on unemployment is stronger for smaller firms. By contrast, we do not find significant differences in unemployment propensity between small and large firms in sectors with low external financial dependence. These results indicate that the reduction in bank lending to financially constrained firms during the recent financial crisis is associated with increased layoffs of workers. The findings are robust to the different measures of external financial dependence.

Hmm. So it is not just enough to club all small firms as one as in above Richmond Fed paper. We also need to seperate firms depending on external finance. And then I think the evidence should fall through.Let me summarise the findings from the three papers. First, small firms vs large firms is an important area of study. It seems dynamics of small firms has changed in this crisis. THough, they have been impacted greatly from the crisis but in a few cases (like short term debt) large firms have taken a bigger hit. On looking at external finance of small vs large, one finds small firms that depend more on external finance fire more people than large firms. 

Institute for New Economic Thinking – Soros push to improve economic research –

October 19, 2010

I read about this Soros initiative a while back. But did not look up. After being frustrated with current state of economic research, Soros decided to fund economic research himself. The idea was to create a fresh perspective on economics using research.


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