Archive for category: Commentary

May 28, 2007

If global warming is the ultimate inconvenient truth, the most important inconvenient truth about global warming policy, argued in last month’s column, is what happens in the developing world. These countries will deliver three-quarters of the increase in global greenhouse gas emissions over the next generation, on current forecasts. Beyond the developing world’s preponderant impact on emissions, there is the additional reality that because so much of economic activity is mobile, policies that restrict emissions in some places but not everywhere may just relocate emissions not reduce them.

Developing countries recognise that today’s greenhouse gas problem was made mostly by industrial countries, that their own energy usage per capita represents about 20 per cent of the corresponding industrial country usage and that their citizens have pressing material needs. They are also keenly aware of the uncertainty surrounding projections of economic growth, patterns of production and future energy technologies. It is easy to sympathise with their extreme reluctance to commit to levels of emissions decades from now that are lower than what industrial countries are emitting today.

For these and other reasons, I argued last time that the Kyoto approach to climate change – through the setting of targets – could prove to be like the League of Nations approach to preserving peace: idealistic and visionary yet impractical, ultimately ineffective and perhaps even counterproductive because of the valuable political capital it consumes. I hope I am wrong but I fear that commitments to vast reductions in emissions decades hence are no more real than commitments to end aggressions or war.

What then should be done either instead of or as a complement to the Kyoto approach? The place to start is with the recognition that it is much easier for governments to make and keep commitments to policies they can control than to outcomes they cannot assure. Whatever targets are negotiated or set, emphasis should also be placed on concrete measures that will have meaningful impact.

First, the US must engage in an energy efficiency programme that takes effect without delay and has meaningful bite. As long as developing countries can point to the US as a free rider there will not be serious dialogue about what they are willing to do. I prefer carbon and/or gasoline tax measures to permit systems or heavy regulatory approaches because the latter are more likely to be economically inefficient and to be regressive. The key point is that after Kyoto, where there was US vision in setting goals but no on-the-ground action, there must be real policy commitments.

Second, the major industrial countries should commit to a very large increase in funding for research in technologies that offer the prospect of reducing the concentration of greenhouse gases, such as renewable energy, carbon sequestration and energy efficient engines. They should also learn a lesson from the pharmaceutical experience and commit to making intellectual property relating to clean energy available to developing countries on preferential terms. It may be that ambitious emissions- reduction targets can be achieved with existing technology, yet new technologies could help.

Third, the World Bank, and probably the regional development banks, should be reconstituted by their shareholders as “Banks for Development and the Global Environment” and take on as a major mission the provision of subsidised capital for projects that have environmental benefits that go beyond national borders. There is much that can be done to encourage energy efficiency in almost every sector within developing countries, yet national governments have inadequate incentives to take account of global impacts. Moreover, the institutions need a new role with respect to countries other than the poorest ones at a time when the leading developing countries are actually exporting rather than importing capital.

Fourth, a goal should be set of eliminating by 2025 the more than $200bn the world spends each year on energy subsidies, and enforced through strategies such as those used for inappropriate subsidies in trade. This is a clear case where environmental and economic imperatives coincide and it is one where external political commitment is likely to be desirable in many countries, just as in the trade area. This will require considerable work on the definition of and measurement of total energy subsidies. Such work will lay a foundation for the more ambitious efforts that may be needed in harmonising world energy prices above market levels in the future.

There is a final critical process element in the policy response. Given that viable solutions depend on significant changes in developing country policies and that these countries are unlikely to make them unless they see their own interests as at stake, it is essential that they be full participants in setting the global direction. They are surely likely to do more if they can help shape policy than if it is simply the Group of Seven leading industrialised nations seeking to bring them along.

Is all of this a sufficiently ambitious agenda? Perhaps not; and perhaps political efforts to generate commitments to ambitious if remote targets can be worthwhile as powerful forces for change, as with human rights in eastern Europe. But they must be married to more immediate if less dramatic steps that have real and practical effect.

The writer is Charles W. Eliot university professor at Harvard

Copyright The Financial Times Limited 2012.

July 29, 2007

For some time now, the large flow of capital from the developing to the industrialised world has been the principal irony of the international financial system. In 2007 this flow will total well over half a trillion dollars, a figure that will be comfortably exceeded by the build-up in reserves and sovereign wealth funds (SWFs) in developing countries.

Indeed, Morgan Stanley has estimated on reasonable assumptions that there is now close to $2,500bn (£1,200bn, €1,800bn) in SWFs and that this figure will increase to $5,000bn by 2010 and $12,000bn by 2015.

Inevitably, and appropriately, countries possessed of publicly held foreign assets far in excess of anything needed to respond to financial contingencies feel pressure to deploy them strategically or at least to earn higher returns than those available in US Treasury bills or their foreign equivalents. Even without this pressure, SWFs are now growing at a faster pace than the global rate of new issuance of traditional reserve assets.

There is plenty of room for debate over how large these funds should become. (Does China really need a saving rate in excess of 50 per cent that all but forces hundreds of billions of dollars in reserve growth?) But on any plausible path over the next few years, a crucial question for the global financial system and indeed for the global economy is how these funds will be invested.

The question is profound and goes to the nature of global capitalism. A signal event of the past quarter-century has been the sharp decline in the extent of direct state ownership of business as the private sector has taken ownership of what were once government-owned companies. Yet governments are now accumulating various kinds of stakes in what were once purely private companies through their cross-border investment activities.

In the last month we have seen government-controlled Chinese entities take the largest external stake (albeit non-voting) in Blackstone, a big private equity group that, indirectly through its holdings, is one of the largest employers in the US. The government of Qatar is seeking to gain control of J. Sainsbury, one of Britain’s largest supermarket chains. Gazprom, a Russian conglomerate in effect controlled by the Kremlin, has strategic interests in the energy sectors of a number of countries and even a stake in Airbus. Entities controlled by the governments of China and Singapore are offering to take a substantial stake in Barclays, giving it more heft in its effort to pull off the world’s largest banking merger, with ABN Amro.

To date most of the official commentary on the issue of SWFs has been framed in terms of traditional arguments about cross-border capital flows. US and UK officials have raised ­concerns that focus only on the desirability of reciprocity and transparency and on how to treat sectors that trigger national security questions. Others, particularly in ­continental Europe, have been less positive and have emphasised nationalist considerations about the benefits of local ownership and control.

What has received less attention are the particular risks associated with ownership by government-controlled entities, particularly where the ownership stake is taken through direct investments. The logic of the capitalist system depends on shareholders causing companies to act so as to maximise the value of their shares. It is far from obvious that this will over time be the only motivation of governments as shareholders. They may want to see their national companies compete effectively, or to extract technology or to achieve influence.

We have seen the degree of concern over News Corp’s attempt to buy The Wall Street Journal. How differently should one feel about a direct investment stake of a foreign government in a media or publishing company?

Apart from the question of what foreign stakes would mean for companies, there is the additional question of what they might mean for host governments. What about the day when a country joins some “coalition of the willing” and asks the US president to support a tax break for a company in which it has invested? Or when a decision has to be made about whether to bail out a company, much of whose debt is held by an ally’s central bank?

All of these risks would be greatly mitigated if SWFs invested through intermediary asset managers, as is the case with most institutional pools of capital such as endowments and pension funds. The experience of many endowments and pension funds suggests that this approach is in most cases likely to produce the best risk-adjusted returns.

To the extent that SWFs pursue different approaches from other large pools of capital, the reasons have to be examined. The most plausible reasons – the pursuit of objectives other than maximising risk-adjusted returns and the ability to use government status to increase returns – are also most suspect from the viewpoint of the global system.

None of this is to propose policy. That can come only after the investment policies of SWFs have been much more extensively debated and many details have been clarified. But it is to register a cautionary note about the debates over SWFs so far.

Governments are very different from other economic actors. Their investments should be governed by rules designed with that reality very clearly in mind.

The writer is Charles W. Eliot university professor at Harvard

Copyright The Financial Times Limited 2012.

September 23, 2007

Central to every policy discussion in response to a financial crisis or the prospect of a crisis is the concept of moral hazard. Unfortunately, there is great confusion in many quarters about the circumstances when moral hazard is, and is not, a problem. The world has at least as much to fear from a moral hazard fundamentalism that precludes actions that would enhance confidence and stability as it does from moral hazard itself.

The term “moral hazard” originally comes from the area of insurance. It refers to the prospect that insurance will distort behaviour, for example when holders of fire insurance take less precaution with respect to avoiding fire or when holders of health insurance use more healthcare than they would if they were not insured.
In the financial arena the spectre of moral hazard is invoked to oppose policies that reduce the losses of financial institutions that have made bad decisions. In particular, it is used to caution against creating an expectation that there will be future “bail-outs”.

Moral hazard forms the basis for criticism of a wide range of measures including, among others; large International Monetary Fund loans to countries experiencing financial panics; public sector actions to facilitate co-ordination of creditors, as in the famous 1998 case of the New York Fed and Long Term Capital Management; lender of last resort activities by central banks through their discount window; aggressive cuts in interest rates following collapses in asset prices; and the extension of government guarantees or quasi-guarantees to liabilities of financial institutions, as in deposit insurance or the US government’s support for the credit of mortgage lenders Fannie Mae and Freddie Mac.

Moral hazard fundamentalists misunderstand the insurance analogy, fail to recognise the special features of public actions to maintain confidence in the financial sector and conflate what are in fact quite different policy issues. As a consequence, their proposed policies, if followed, would reduce the efficiency of the financial sector in normal times, exacerbate financial crises and increase economic instability. They are wrong in three crucial respects.

First, granting for the moment the relevance of the insurance analogy, as the economist Michael Mussa has pointed out, the prospect that people may smoke in bed is not usually taken as an argument against the existence of fire departments. Moreover, if there is “contagion” as fires can spread from one building to the next, the argument for not leaving things to the free market is greatly strengthened. In the presence of contagion there is every reason to expect that individual institutions will under-insure because they will not feel obliged to take account of the benefits their insurance will have for others.

Second, the insurance analogy fails to take account of what is a key aspect of the financial context – moral hazard and confidence are opposite sides of the same coin. Financial institutions can fail because they become insolvent, as misguided lending or borrowing causes their liabilities to exceed their assets. But solvent institutions can also fail because of illiquidity simply because creditors rush to withdraw their funds and assets cannot be liquidated fast enough. In this latter case the availability of external support averts needless panic and contagion.

More subtly, but no less important, the knowledge that efforts will be made to stand behind solvent institutions facing runs reduces the capital institutions have to hold, encourages investment in productive but illiquid projects and reduces the risk of contagion.

Third, in the insurance template used in thinking about moral hazard, the insurer pays more out because of the behavioural changes induced by insurance, such as when the failure to install fire extinguishers makes fires more costly. Something parallel happens when the government guarantees a financial institution’s liabilities.

But much of what financial authorities do in response to crises does not impose any costs on taxpayers and may actually make them better off. In the much criticised LTCM case no taxpayer money, except perhaps the cost of a lunch, was spent. A competent lender of last resort – in Bagehot’s sense of one who lends freely at a penalty rate against good collateral – actually turns a profit, as the IMF did in its response to the financial crises of the 1990s. Monetary policies that prevent deflation of the kind that cost Japan a decade of growth in the 1990s are another example of how a policy can respond to stress without imposing costs on taxpayers or the economy.

Where does all of this leave policy? It certainly suggests that moral hazard is not always a negative with respect to policy responses to financial stress. In particular, the idea put forward by some that a central bank should act only once it is clear that financial problems have become serious enough to threaten a breakdown of the financial system or a sharp downturn in economic activity cannot be right.

Instead, these considerations suggest that prudent central banks will make judgments during financial crises not on the basis of “avoiding moral hazard” but rather by asking themselves three questions.

First, are there substantial contagion effects? Second, is the problem a liquidity problem where a contribution to stability can be provided with high probability or does it involve problems of solvency? Third, is it reasonable to expect that the action in question will not impose costs on taxpayers? If the answers to all three questions are affirmative, there is a strong case for public action.

The writer is the Charles W. Eliot professor at Harvard University

Copyright The Financial Times Limited 2012.

November 25, 2007

Three months ago it was reasonable to expect that the subprime credit crisis would be a financially significant event but not one that would threaten the overall pattern of economic growth. This is still a possible outcome but no longer the preponderant probability.

Even if necessary changes in policy are implemented, the odds now favour a US recession that slows growth significantly on a global basis. Without stronger policy responses than have been observed to date, moreover, there is the risk that the adverse impacts will be felt for the rest of this decade and beyond.

Several streams of data indicate how much more serious the situation is than was clear a few months ago. First, forward-looking indicators suggest that the housing sector may be in free-fall from what felt like the basement levels of a few months ago. Single family home construction may be down over the next year by as much as half from previous peak levels. There are forecasts implied by at least one property derivatives market indicating that nationwide house prices could fall from their previous peaks by as much as 25 per cent over the next several years.

We do not have comparable experiences on which to base predictions about what this will mean for the overall economy, but it is hard to believe declines of anything like this magnitude will not lead to a dramatic slowing in the consumer spending that has driven the economy in recent years.

Second, it is now clear that only a small part of the financial distress that must be worked through has yet been faced. On even the most optimistic estimates, the rate of foreclosure will more than double over the next year as rates reset on subprime mortgages and home values fall. Estimates vary, but there is nearly universal agreement that – if all assets were marked to market valuations – total losses in the American financial sector would be several times the $50bn or so in write-downs that have already been announced by big financial institutions. These figures take no account of the likelihood that losses will spread to the credit card, auto and commercial property sectors. Nor do they recognise the large volume of financial instruments that depend for their high ratings on guarantees provided by credit insurers whose own health is now very much in doubt.

Third, the capacity of the financial system to provide credit in support of new investment on the scale necessary to maintain economic expansion is in increasing doubt. The extent of the flight to quality and its expected persistence was powerfully demonstrated last week when the yield on the two-year Treasury bond dropped below 3 per cent for the first time in years. Banks and other financial intermediaries will inevitably curtail new lending as they are hit by a perfect storm of declining capital due to mark-to-market losses, involuntary balance sheet expansion as various backstop facilities are called, and greatly reduced confidence in the creditworthiness of traditional borrowers as the economy turns downwards and asset prices fall.

Then there are the potentially adverse effects on confidence of a sharply falling dollar, rising energy costs, geopolitical uncertainties especially in the Middle East, or lower global growth as economic slowdown and a falling dollar cause the US no longer to fulfil its traditional role of importer of last resort.

In such an environment, economic policy needs to be governed by the clear and public recognition that restoring the normal functioning of the financial system and containing any damage its breakdown may do the real economy is the central macro-economic and financial challenge facing the US. In the US today, as in many other countries in the past, confidence will return the first day an official statement about the economy proves to have been too pessimistic.

What concrete steps are necessary? First, maintaining demand must be the over-arching macro-economic priority. That means the Fed has to get ahead of the curve and recognise – as the market already has – that levels of the Fed Funds rate that were neutral when the financial system was working normally are quite contractionary today. As important as long-run deficit reduction is, fiscal policy needs to be on stand-by to provide immediate temporary stimulus through spending or tax benefits for low- and middle-income families if the situation worsens.

Second, policymakers need to articulate a clear strategy addressing the various pressures leading to contractions in credit. Very likely this will involve measures that are non-traditional, given how much of the problem lies outside bank balance sheets. The time for worrying about imprudent lending is past. The priority now has to be maintaining the flow of credit. The current main policy thrust – the so-called “super conduit”, in which banks co-operate to take on the assets of troubled investment vehicles – has never been publicly explained in any detail by the US Treasury. On the information available, the “super conduit” has worrying similarities with Japanese banking practices of the 1990s that aroused criticism from American authorities for their lack of transparency, suppression of genuine market pricing of bad credits, and inhibiting effect on new lending. Perhaps there is a strong case for it, but that case has yet to be made.

Third, there needs to be a comprehensive approach taken to maintaining demand in the housing market to the maximum extent possible. The government operating through the Federal Housing Administration, through Fannie Mae and Freddie Mac, or through some kind of direct lending, needs to assure that there is a continuing flow of reasonably priced loans to credit worthy home purchasers. At the same time there need to be templates established for the restructuring of mortgages to homeowners who cannot afford their resets, so every case does not have to be managed individually.

All of this may not be enough to avert a recession. But it is much more than is under way right now.

The writer is the Charles W. Eliot professor at Harvard University

Copyright The Financial Times Limited 2012.

February 24, 2008

The American economic outlook remains highly uncertain. But macro­economic policy is now properly aligned, as the economy will benefit over the next several quarters from fiscal and monetary stimulus. To the extent conditions warrant and inflation risks permit, monetary and fiscal policy are appropriately poised to provide further stimulus.

Policy towards America’s failing housing sector is in a far less satisfactory state. All honest analysts accept that policies adopted so far, such as the “teaser freezer” limits on resetting mortgage interest rates and increased federal support for mortgage lending, have had only a marginal impact on what may be the most serious crisis in housing finance since the Depression.

It appears house prices are down by 5-10 per cent from their peak, with derivatives markets predicting further declines of about 20 per cent. Price falls of this magnitude are likely to mean more than 10m would have negative equity in their homes and more than 2m foreclosures would take place over the next two years.

Foreclosures are extremely costly. Between transaction costs that typically run at one-third or more of a home’s value and the adverse impact on neighbouring properties, foreclosures can easily dissipate more than the total value of the home being repossessed. They also inflict collateral economic damage, as reduced wealth and diminished borrowing capacity in homes reduces consumer spending, increases credit market fragility and depresses local tax bases.

What can public policy do? It cannot and should not try to fix the fact that at current prices the supply of homes significantly exceeds demand or the reality that many own homes, often for speculation, that are no longer viable and should be back on the market.

But it can and should address a crucial issue: when the current owner is able and willing to pay more than the lender can get by foreclosing on a house, it makes no sense to go through with a foreclosure. Yet because of conflicts among lenders, legal uncertainties and concerns about encouraging defaults, there are grounds for fearing that wasteful and unnecessary foreclosures will take place on a large scale, hurting families, communities, the economy and the financial system.

How can this problem be addressed? The string has pretty much been played out on hortatory policy, to limited effect. Without finding ways of writing down mortgage liabilities, new finance will do nothing for the problem group that has negative equity. Direct government intervention in mortgage markets risks creating delays, burdening taxpayers and inhibiting necessary adjustments in house prices.

The right focus is on measures that will prevent unnecessary foreclosures by facilitating more efficient settlements between homeowners and their creditors. Legal changes currently being debated, to bring practice with respect to family homes into conformity with general bankruptcy practice in two areas, could make an important contribution.

First, remarkably, bankruptcy laws currently provide that almost every form of property (including business property, vacation homes and those owned for rental) except an individual’s principal residence cannot be repossessed if an individual has a suitable court-approved bankruptcy plan. The rationale is the prevention of costly and inefficient liquidations. It is hard to see why similar protections should not be prudently extended to family homes.

Critics worry that such measures will dry up the supply of mortgage credit. This is a legitimate concern and the reason why legislation should be carefully and narrowly drafted, to be applicable only to past mortgages where there has been no fraud and where foreclosure is otherwise imminent. But it is worth noting that: some inhibition on lending to those who seem likely to go bankrupt might be a good thing; also, there has been an adequate supply of capital and ability to securitise in the market for vacation and rental housing, where debtors are protected; and moreover, chapter 12 of the bankruptcy code enacted in the mid-1980s, which applied these principles to family farms, helped to resolve great financial distress without long-term costs in terms of reduced farm lending – despite protestations much like those that are heard today.

Second, methods need to be found to enable creditors who accept a writedown in the value of their claims to retain an interest in the future appreciation of the homes on which they have mortgages. This is standard practice in situations of corporate distress, where debt claims are partially replaced by equity claims.

Obstacles to such mortgages include uncertainties about tax and accounting rules. But at a time when there are great advantages to inducing lenders to let families to remain in their homes – and when families facing foreclosure are prepared to do things they might not do in ordinary times – it would be desirable to pursue suggestions by the Office of Thrift Supervision for so-called negative equity certificates to support shared appreciation work-outs.

Bankruptcy reform alone could, on some estimates, avert 500,000 foreclosures and, by establishing templates for renegotiation, aid a wider restructuring of mortgage debts. Proper support for voluntary restructurings involving interests in future appreciation should realise still greater benefits. As with fiscal stimulus, rapid bipartisan co-operation between Congress and the administration would benefit the financial system, the real economy and millions of Americans.

The writer is Charles W. Eliot university professor at Harvard

Copyright The Financial Times Limited 2012.

April 27, 2008

While the financial crisis dominates current discussion on the US economy, questions regarding America’s future approach to globalisation are looming increasingly large.

Since the end of the second world war, American economic policy has supported an integrated global economy, stimulating development in poor countries, particularly in Asia, at unprecedented rates. Yet America’s commitment to internationalist economic policy is ever more in doubt. Even before the significant increases in unemployment likely in the months ahead, the indicators are all disturbing. Presidential candidates attack the North American Free Trade Agreement. The Colombian free trade agreement languishes. There are increasing attacks on foreign investment in the US, not to mention growing support for restrictive immigration policies.

To all of this the conventional wisdom has a well developed response, with four standard elements. First, the sceptic regarding trade deals or other internationalist policies is educated around the many benefits of trade, not just for exporters but also for consumers and the economy more generally.

Second, the sceptic is assured that the trade agreement in question is not just good classical economics that reaps the gains available from comparative advantage – it is also good mercantilism. This is because the US already has low trade barriers, which it will typically not need to reduce as much as its trading partner. Sometimes the argument is added that we are in competition with other major economic powers and will be at a disadvantage if a developing country has a free-trade agreement with them but not us.

Third, the sceptic is also told that most of the observed increases in income inequality in the American economy are due to new technology rather than increased trade – and that even to the extent that trade has a role, most increases in trade are not attributable to trade agreements.

Fourth, it is acknowledged that while trade agreements are good for the economy overall, not everyone wins. And so it is increasingly recognised that they must be complemented by more ambitious efforts to reduce income inequality and income insecurity. Sometimes the discussion focuses on adjustment assistance of various kinds. More recently, there has been a recognition of the need for much broader-gauged efforts to combat inequality and insecurity, such as universal healthcare.

All of these points have the very considerable virtue of being correct economic arguments. Taken together, they make a compelling case that the US is better off with than without trade agreements and that the world will be a richer, safer place with increasing economic integration. It is very possible that, if efforts to help those left behind are pursued with sufficient vigour, support for economic internationalism can be maintained.

But I suspect that the policy debate in the US, and probably in some other countries as well, will need to confront a deeper and broader issue: the gnawing suspicion of many that the very object of internationalist economic policy – the growing prosperity of the global economy – may not be in their interests. As Paul Samuelson pointed out several years ago, the valid proposition that trade barriers hurt an economy does not imply the corollary that it necessarily benefits from the economic success of its trading partners.

When other countries develop, American producers benefit from having larger markets to sell into but are challenged by more formidable competition. Which effect predominates cannot be judged a priori. But there are reasons to think that economic success abroad will be more problematic for American workers in the future.

First, developing countries increasingly export goods such as computers that the US produces on a significant scale, putting pressure on wages. At the same time, rising global prosperity increases the rewards accruing to the already highly paid producers of intellectual property goods such as films, where the US has a comparative advantage. Second, the growth of countries such as China raises competition for energy and environmental resources, raising the price for Americans.

Third and most fundamentally, growth in the global economy encourages the development of stateless elites whose allegiance is to global economic success and their own prosperity rather than the interests of the nation where they are headquartered. As one prominent chief executive put it in Davos this year: “We will be fine however America does but I hope for its sake that it will cut taxes and reduce regulation and put more pressure on young people to study in the ways that are necessary for it to be able to keep competing successfully.”

The chief executive was sincere and he captured an important truth. Even as globalisation increases inequality and insecurity, it is constantly and often legitimately invoked as an argument against the viability of progressive taxation, support for labour unions, strong regulation and substantial production of public goods that mitigate its adverse impacts.

In a world where Americans can legitimately doubt whether the success of the global economy is good for them, it will be increasingly difficult to mobilise support for economic internationalism. The focus must shift from supporting internationalism as traditionally defined to designing an internationalism that more successfully aligns the interests of working people and the middle class in rich countries with the success of the global economy. This will be the subject of my next column, which will appear on Monday May 5.

The writer is the Charles W. Eliot university professor at Harvard

Copyright The Financial Times Limited 2012.

June 1, 2008

After a modest interval with no big financial shocks, policy attention is turning to the task of preventing future crises and managing those that occur. While the deliberations will take quite a while to play out, there is some time pressure – because of the moral hazards created by the Federal Reserve’s extension of credit to investment banks and authorities’ desire to act before the sense of alarm created by recent events abates and complacency returns.

Proposals for changes in regulation and crisis response have come from many quarters, including the US Treasury and private sector groups. They offer important ideas on rearranging regulatory responsibilities – such as the Treasury’s suggestion of an enhanced role for the Federal Reserve with respect to investment banks and its call for a consumer financial regulator – and raise critical issues, such as that of procyclicality induced by regulation. They also contain a certain amount of essentially content-free calls for worthiness. So far missing from the debate has been a set of principles describing the properties of any desirable regulatory regime, against which proposals can be evaluated. Different observers will assign priority to different issues – here would be my list of six principles.

First, there should be a strong presumption against having regulators competing to supervise particular institutions or activities. Experience suggests that even when firms do not have the option of switching, there are substantial risks that regulators will be co-opted. Adding “forum shopping” exacerbates the problem.

Second, it should be recognised that to a substantial extent self-regulation is deregulation. Allowing institutions to determine capital levels based on risk models of their own design is tantamount to letting them set their own capital levels. We have seen institutions hurt again and again by events to which their models implied probabilities of less than one in a million. Where it is desired to impose capital requirements, this should be done in a way that can be monitored by supervisors on the basis of balance sheet data.

Third, regulation must be premised on the inability of institutions or their regulators to predict future market conditions with much confidence. As obvious as the subprime crisis may look in retrospect, it was not widely foreseen 18 months ago even by those worried about complacency in credit markets. As the fact that the Dow Jones index was below 6,500 when Alan Greenspan famously spoke of irrational exuberance illustrates, it is also easy to see bubbles even when assets are undervalued or properly valued, as US stocks were in 1996. Rather than judging where and when the next crisis will occur, regulators need to try to assure the resilience of the system with respect to economic shocks or problems in any one sector or institution.

Fourth, the focus of regulation must shift from the prudential practices of individual institutions to the health of the financial system. The proper focus of government regulation is not on how good a job managements do of looking out for their shareholders and bondholders. It is on the potential external consequences of their actions. This will require efforts to limit excesses when times are good and institutions appear robust – and efforts to avoid deleveraging in difficult times if that increases pressures on others. Prudence at the level of any one institution does involve more leverage at times when volatility is low than when it is high. The problem is that when any institution seeks to do what is prudent for it and sell off assets, it impairs the environment in which all others are operating and creates the kind of vicious cycle, in which liquidations beget declining prices and further liquidations, that we have just been through.

Fifth, any regulatory regime must address the risks arising from “parallel banking activities” in a realistic way. We have been reminded by recent events of the old truth that borrowing short and lending long with limited capital is always at the root of financial crisis. This type of activity is not confined to banks and their offshoots. It is practised by bond guarantors, hedge funds, mortgage institutions and some insurance companies among others. If capital requirements are raised only on one set of institutions, problems may be exacerbated as activity migrates to those that are not regulated. On the other hand, regulating all potentially highly leveraged entities is a formidable task. There is no ideal answer. But the fear is that regulation that ensures the regulated can compete fairly with the unregulated is regulation that either promises government subsidy or does not raise capital requirements much above market levels.

Sixth, regulatory policy must to the maximum extent possible create a situation in which the failure of an individual institution is not itself a source of systemic risk. Only in this way is it possible to contain the moral hazards associated with government support. The authorities had no realistic choice but to provide support as Bear Stearns faced bankruptcy. They do have a choice as to whether to put in place a regime where such problems can be managed with no government financial support provided directly or indirectly to shareholders or unsecured creditors. A resolution regime that could apply to any financial institution that became a source of systemic risk should be an urgent priority.

These principles are more easily asserted than they are reflected in an actual regulatory system. I hope to return in future columns to the question of regulatory system design.

The writer is the Charles W. Eliot university professor at Harvard University and a managing director of the D.E. Shaw group. The opinions here are his own

Copyright The Financial Times Limited 2012.

August 7, 2008

Macroeconomists, like medical scientists, use case studies to teach their students about the maladies to which the system is susceptible. For supply shocks and stagflation, the example is the 1970s. The financial dislocations that occur when bubbles burst are illustrated by the Great Depression and Japan’s problems in the 1990s. The importance of central bank credibility in resisting inflation emerges from discussion of the experience of the late 1960s and the 1970s.

What is most remarkable and troubling about our current difficulties is that all these elements – supply shocks, financial dislocations and concern about rising underlying inflation – are present at once. Moreover, the crisis is global in scope. Concerns about recession are spreading from the US to much of the industrialised world. Significant slowdowns appear more likely in a number of emerging markets, with inflation concerns worldwide at their highest level in more than a decade. There is a growing consensus that the west is facing the most serious financial crisis since the second world war.

Perhaps unsurprisingly in the face of so many adverse surprises, the policy debate has become cacophonous. Some emphasise the necessity of the painful adjustments under way, while others urge their mitigation. Some focus on product price inflation, some on asset price deflation as the principal problem. Some focus on assuring that imprudent lending by financial institutions is discouraged, others on assuring that financing for investment by households and businesses remains available. Some focus on slowing market adjustments to prevent panic, others on the need for rapid adjustment of prices to true fundamental levels, even if this is painful in the short run.

Equally unsurprisingly given the chaotic debate, policymaking has become increasingly reactive and erratic, with a growing tendency to repeat traditional errors. While US policymakers have long cited Japan’s indecisiveness with respect to troubled financial institutions, its resort to gimmickry and market manipulation, and its lack of transparency in the management of financial crisis in the 1990s as a negative example, they are increasingly repeating Japan’s errors.

Within the past month, the Treasury has made explicit the implicit guarantee on the $5,000bn (£2,500bn, €3,250bn) balance sheet of Fannie Mae and Freddie Mac in order to prevent a run on the government-sponsored enterprises while imposing no penalties on shareholders or forcing any changes on management – not even the cessation of dividends.

The Securities and Exchange Commission has sought to make short-selling harder, with the stated objective of raising (many would say manipulating) the stock prices of financial institutions, while some in the Congress have proposed to prevent certain investors from going long on commodity futures. Without much sign of official resistance, the global banking industry is pushing for less reliance on market prices and more on managerial judgment in valuing the assets where bad credit and investment decisions have led to hundreds of billions of dollars of losses over the past year.

Setting policy in a more proactive and principled way requires reaching a number of judgments regarding where things currently stand and the likely effects of potential actions or failures to act. In an effort to advance the debate, the remainder of this article poses and provides my answer to what seem to me to be the crucial questions for American economic policy.

How long will the economy stay weak on the current policy path?

The best available estimates suggest that the American economy is operating between 2 and 2.5 per cent below its sustainable potential level. This translates into more than $300bn, or $4,000 for the average family of four, in lost output. Even if, as I think unlikely, recession is avoided, growth is almost certain to be so slow that the gap between actual and potential output comes close to doubling over the next year or so. Given that unemployment peaked nearly two years after the end of the last recession, output and employment are likely to remain below their potential levels for several years in the best of circumstances.

Given the combined impact of rising commodity prices, falling house prices, reduced availability of credit and rising uncertainty, it is surprising that the economy has shown as much strength as it has in recent months. While it is possible that this speaks in some way to its enormous resilience, the preponderant probability is that, as the effects of tax rebates wear off and those of tighter credit conditions feed through, the economy will take another downwards turn.

Just as the bottom was called early a number of times in Japan in the early 1990s and in the US in the early 1930s, we have seen and no doubt will see moments of sunlight that create hope that the worst is past. Yet it bears emphasis that in the current context there can be no confident reliance on the equilibrating powers of the market.

Alan Greenspan has been fond of explaining that the resilience of the American financial system and economy results from reliance on two pillars: banks and capital markets. When the banks were in trouble, as in 1991, capital markets took up the slack; when the capital markets were in trouble, as in 1998, the banks took up the slack. Unfortunately, today both the banks and the capital markets show signs of crisis.

The point can be put in another way. Four vicious cycles are simultaneously under way: falling asset prices are forcing levered holders to sell, driving prices further down; losses at financial institutions are reducing their ability to finance investment, which in turn reduces asset values, causing further losses; the weakness of the financial system is reducing growth, which in turn weakens the financial system; and falling output is hitting employment, which in turn leads to reduced demand for output.

Without active efforts to interfere with these mechanisms, there can be no basis for confidence that the American economy will recover even in the medium term.

Are substantial output losses necessary or desirable? or desirable?

It is often argued that the current economic downturn is an inevitability that cannot be prevented, or that is necessary and desirable. Some observers almost seem to suggest that a recession is a kind of just desert for a country that has lived beyond its means. The more serious concerns are that an economic downturn is a necessary concomitant of increasing US national saving and reducing current account deficits, or of preserving the credibility of the Federal Reserve’s commitment to price stability.

Granting that US consumer spending grew more rapidly than gross domestic product over most of the past decade and that ultimately the consumption share of GDP will have to fall back to more normal levels, it is hard to see why necessary increases in saving require a protracted recession. Instead, declines in consumer spending and improvements in the government’s fiscal position should be sequenced to coincide with improvements in net exports and investment. Allowing consumer spending to spiral downwards without offsetting policy actions risks reducing investment and incomes in the US and transmitting the US slowdown to the rest of the world. More-over, even if the argument for supporting consumption at present were rejected, there would still be a strong argument for supporting investment in areas such as infrastructure, where there is no evidence of a glut and considerable evidence of shortfalls.

As for the inflation question, constant vigilance is necessary. It is certainly true that product price inflation has ticked upwards, though this seems to be heavily commodity-related. Even if commodity prices do not fall but only stop rising, the result will be an improvement in standard inflation measures. Moreover, if the principal problem is commodity price inflation, there are surely better ways to address it than increasing unemployment and reducing capital utilisation.

Crucially for the inflation process, there is not yet evidence of rising wage pressures or increases in the growth rate of unit labour costs. Nor do indexed bond markets reveal a significant change in longer-term inflationary expectations. In an environment of rising unemployment, greater worker insecurity and constantly increasing global competition, there are likely to be substantial pressures militating against any rapid increase in wages in the big industrial economies. Without rapid increases in labour costs, which are by far the largest component of production costs, it is hard to see how higher rates of inflation can be entrenched.

On balance, in the US at least, the risk that output will be too low over the next several years seems considerably greater than the risk that it will be too great and cause the economy to overheat or overborrow.

Can policy stimulate demand without adverse side-effects?

With the Federal Funds rate at 2 per cent, the remaining scope for monetary policy to stimulate the US economy is surely very limited. Even here, those who see a case for raising rates should remember that in the current environment the Fed funds rate is a very misleading indicator, as widening credit spreads and increased term premiums have caused borrowing costs to fall much less than the policy interest rate.

There remains considerable scope, however, for fiscal policy to stimulate demand on both the tax and spending sides over the next several years. The limited available evidence suggests that the propensity to consume out of the recent round of rebates was larger than many suspected. More important, given the pressures on state and local budgets and the dramatic increase in some inputs (the cost of building highways has risen 70 per cent since 2004), there is now a substantial backlog of infrastructure construction projects that have been interrupted or put on hold. Allowing these projects to go forward on a significant scale would stimulate the economy and would channel demand towards the construction workers – mostly men with relatively little education – who have borne the brunt of the economic downturn and whose medium-term prospects are bleakest.

In thinking about fiscal policy, it is essential to consider both near and long term. For the near term, larger deficits are likely to be potent in stimulating demand, especially in the context of an economy where there are constraints on the ability to lend and borrow. This is especially the case when new spending is directed at addressing the “repressed deficit” associated with the failure to maintain an adequate infrastructure.

Success in using fiscal policy will depend on also taking concrete steps that reduce projected deficits in the medium to long term. The enactment of new permanent measures, such as the extension of the 2001 tax cuts, without means to pay for them would be counterproductive. Conversely, measures that pointed to long-term fiscal savings would reinforce fiscal stimulus.

In the current global context, there is no reason why fiscal stimulus should be confined to the US. Measures that increased spending in countries where high saving has led to large current account surpluses are necessary if the global economy is to be rebalanced without a big downturn as US saving eventually increases. China, where household consumption has fallen below 40 per cent of GDP – a record peacetime low for any big economy – stands out in this regard.

How serious are remaining financial problems?

This is unknowable given uncertainties about market fluctuations and the real economy. While there surely will come a time when things hit bottom, it is not yet clear that it is at hand.

Several sources of evidence suggest that house prices will fall for some time to come, perhaps by 10 per cent or more. Big further declines would be necessary to restore their traditional level relative to rents, incomes or the price of other goods. There are growing signs that rates of default and foreclosure will rise considerably even well outside the subprime sector.

Beyond housing, there are also grounds for considerable concern about consumer and automobile credit, particularly if the economy turns down. Big and as yet not reported losses on commercial construction lending lie ahead. While the rate of default on corporate debt has not yet reached high levels, this is likely to change in the near future. For example, the pricing of the debt of the big American automobile companies now suggests a probability well over 90 per cent that one or more of them will go into default in the next five years – and the probability would no doubt be greater if markets did not recognise the possibility of extraordinary Federal support.

Then there is the problematic situation of the banking system. Where traditional non-mark to market accounting is in use, banks have not yet revised estimates of their capital to reflect likely future losses. In many cases, they have instead assumed that the market’s valuation of their assets reflects transient liquidity factors rather than underlying problems, and so are planning with assumptions considerably more optimistic than those embodied in market prices. Perhaps they will prove correct – but nothing in the experience of the past year gives confidence in the judgment of those who believe that market prices substantially undervalue their assets.

In all likelihood, the financial system will require very substantial capital infusions over the next year or two if it is to remain healthy. It is not clear where the capital will come from. Most of those who have provided financial institutions with capital over the past year have been badly burned. As valuations fall, it becomes increasingly difficult for financial institutions to raise capital necessary for them to retain market confidence, leading to further declines in valuation and yet another vicious cycle.

How can the authorities best support the financial system?

To date the focus of public policy has been on the extension of credit to banks and other financial institutions by the Federal Reserve so as to ensure their liquidity. This strategy is appropriate but may be reaching its limits. Where the problems a financial institution faces are of confidence or liquidity, lending can be highly efficacious. When the problems are of underlying solvency and the constraint on lending is a lack of capital, lending is not an availing strategy. It is necessary, at least on a contingency basis, to plan policy responses to such problems.

First, as the ad-hoc nature of the policy response to Bear Stearns and the GSEs illustrates, we do not have a framework in place in which the authorities can do what is necessary to counter systemic risk when a systemically important institution gets in trouble and at the same time protect the interests of taxpayers and the broader financial system.

Second, there is as yet no framework in place for handling the large quantity of bad assets sitting on financial institution balance sheets. During the last US banking crisis in the early 1990s, the Resolution Trust Corporation was established to manage impaired assets of banks and savings and loan institutions that the government had taken over. But it acquired assets only after the government took over banks. Consideration should be given to whether the government should establish a mechanism for purchasing assets from stressed banks in return for warrants or other consideration.

Third, there is the question of whether the government will need to find a way to recapitalise institutions through taking some kind of preferred interest, as ultimately proved necessary in the US in the 1930s and Japan in the 1990s. This is obviously a big step that one wants to avoid if possible. But in the absence of any framework for the government infusing capital, there is the danger that liabilities will simply be guaranteed de facto or de jure with no other change made, creating serious problems down the road. Government involvement in recapitalising financial institutions is like devaluation. It is a very unattractive last resort. Delay is very tempting, but it can be enormously costly.

* * *

Today, the end of the current financial crisis looks further away than it did in August 2007. Policy has not yet gotten ahead of the curve. I used to remark in the context of the emerging market crises of the 1990s that I would date the moment of recovery from the first time an official pronouncement proved to be too pessimistic. By this standard, recovery is not at hand.

The best prospects for managing a very difficult situation involve a comprehensive effort both to support the real economy through temporary fiscal stimulus and the financial system through a programme of measures directed at capital rather than liquidity problems. These steps offer no assurance of success but reactive drift raises the risks of costly failure.

Copyright The Financial Times Limited 2012.

September 28, 2008

Congressional negotiators have now completed action on a $700bn authorisation for the bail-out of the financial sector. This step was as necessary as the need for it was regrettable. There are hugely important tactical issues regarding the deployment of these funds that the authorities will need to consider in the weeks and months ahead if the chance of containing the damage is to be maximised. I expect to return to these issues once the legislation is passed.

In the meantime, it is necessary to consider the impact of the bail-out and the conditions necessitating it on federal budget policy. The idea seems to have taken hold in recent days that because of the unfortunate need to bail out the financial sector, the nation will have to scale back its aspirations in other areas such as healthcare, energy, education and tax relief. This is more wrong than right. We have here the unusual case where economic analysis actually suggests that dismal conclusions are unwarranted and the events of the last weeks suggest that for the near term, government should do more, not less.

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First, note that there is a major difference between a $700bn (€479bn, £380bn) programme to support the financial sector and $700bn in new outlays. No one is contemplating that the $700bn will simply be given away. All of its proposed uses involve either purchasing assets, buying equity in financial institutions or making loans that earn interest. Just as a family that goes on a $500,000 vacation is $500,000 poorer but a family that buys a $500,000 home is only poorer if it overpays, the impact of the $700bn programme on the fiscal position depends on how it is deployed and how the economy performs.

The American experience with financial support programmes is somewhat encouraging. The Chrysler bail-out, President Bill Clinton’s emergency loans to Mexico, and the Depression-era support programmes for housing and financial sectors all ultimately made profits for taxpayers. While the savings and loan bail-out through the Resolution Trust Corporation was costly, this reflected enormous losses in excess of the capacity of federal deposit insurance programmes. The head of the FDIC has offered assurances that nothing similar will be necessary this time. It is impossible to predict the ultimate cost to the Treasury of the bail-out programme and of the other guarantee commitments that financial authorities have – this will depend primarily on the economy as well as the quality of execution and oversight. But it is very unlikely to approach $700bn and will be spread over a number of years.

Second, the usual concern about government budget deficits is that the need for government bonds to be held by investors will crowd out other, more productive, investments or force greater dependence on foreign suppliers of capital. To the extent that the government purchases assets such as mortgage-backed securities with increased issuance of government debt, there is no such effect.

Third, since Keynes we have recognised that it is appropriate to allow government deficits to rise as the economy turns down if there is also a commitment to reduce deficits in good times. After using the economic expansion of the 1990s to bring down government indebtedness, the US made a serious error in allowing deficits to rise over the last eight years. But it would be compounding this error to override what economists call “automatic stabilisers” by seeking to reduce deficits in the near term.

Indeed, in the current circumstances the case for fiscal stimulus – policy actions that increase short-term deficits – is stronger than at any time in my professional lifetime. Unemployment is now almost certain to increase – probably to the highest levels observed in a generation. Monetary policy has very little scope to stimulate the economy given how low policy rates already are and the problems in the financial system. And experience around the world with economic downturns caused by financial distress suggests that while they are of uncertain depth, they are almost always of long duration.

The economic point here can be made more straightforwardly. The more people who are unemployed the more desirable it is that government takes steps to put them back to work by investing in infrastructure, energy or simply through tax cuts that allow families to avoid cutting back on their spending.

Fourth, it must be emphasised that nothing in the short-run case for fiscal stimulus vitiates the argument that action is necessary to ensure the US is financially viable in the long run. We still must address issues of entitlements and fiscal sustainability.

From this perspective the worst possible actions in the current context would be steps that have relatively modest budget impacts in the short run but that cut taxes or increase spending by growing amounts over time. Examples would include new entitlement programmes or exploding tax measures. The best measures would be those that represent short-run investments that will pay back to the government over time or those that are packaged with longer-term actions to improve the budget. Examples would include investments in healthcare restructuring or steps to enable states and localities to accelerate, or at least not slow down, their investments.

A time when confidence is lagging in the household, financial and business sectors is not a time for government to step back. Well-designed policies are essential to support the economy and given the seriousness of healthcare, energy, education and inequality issues, can make a longer-term contribution as well.

The writer is the Charles W. Eliot professor at Harvard University and managing director of D.E. Shaw & Co

Copyright The Financial Times Limited 2012.

October 27, 2008

Events as well as ideas shape policy choices in democracies. Who would have predicted a year ago that a Republican ad-ministration would demand that Congress make the largest set of investments in public companies in US peacetime history? Would anyone have supposed that President George W. Bush would convene a global effort to renew Bretton Woods through strengthened international financial regulation? It reminds us that in the economic sphere, as in the national security sphere, dramatic events can make the inconceivable become inevitable.

Discussions of the policy implications of the crisis have primarily focused on the immediate economic demands. The need to ensure the capital adequacy of financial institutions, maintain important credit flows, support the housing sector and the real economy, contain international spill-overs and reform regulation to prevent any recurrence of the crisis have rightly been the priority. In all these areas there will be many crucial policy choices to make in the months ahead.

However, policies that contain the crisis, support the economy and generate recovery are not sufficient to meet the historic challenge of this moment. Even with the best conceivable fiscal, monetary, financial and regulatory policies, economic performance depends on deeper and more structural policy choices. Nations cannot fine tune their way to delivering a prosperity that is more broadly based. In important ways, then, the crisis creates space to address longer standing problems. Just as patients hear advice regarding diet and exercise differently after a heart attack, so recent events should make it possible for the next US administration to accomplish more than might previously have been thought possible.

These broader goals depend on achieving the rapid and sustained growth that restores business confidence and generates the resources for investment. Economists do not understand what drives productivity growth very well. However, we know these facts: productivity grew rapidly after the second world war and then sometime between the late 1960s and mid-1970s it slowed dramatically only to re-accelerate to record levels in the mid-1990s. Unfortunately, even before the downturn, underlying productivity growth appeared to be slowing.

The most plausible explanation is that an array of transforming investments and technologies -the interstate highway system, widespread air travel and the expansion of electronics – were spurs to growth during the postwar period. Eventually their impact dissipated and, as energy costs rose, growth slowed until the information technology revolution kicked in during the 1990s. Unfortunately, the IT supply shock that powered the economy in the 1990s and early part of this decade appears to be diminishing.

So there is a need to ensure that the pressure to increase spending is directed at areas where it will have the most transformational impact. We need to identify those investments that stimulate demand in the short run and have a positive impact on productivity. These include renewable energy technologies and the infrastructure to support them, the broader application of biotechnologies and expanding broadband connectivity, an area where the US has fallen behind.

The crisis has also reminded us of the lessons of the technology bubble, Japan’s experience in the 1990s and of the US Great Depression – that finance-led growth is problematic. The wealth and income gains from the easy availability of credit were highly concentrated in the hands of a fortunate few. The benefits also proved temporary. In retrospect, the fact that 40 per cent of American corporate profits in 2006 went to the financial sector, and the closely related outcome – a doubling of the share of income going to the top 1 per cent of the population – should have been signs something was amiss.

Therefore we need to reform tax incentives that encourage financial risk taking, regulate leverage and prevent government policies that give rise to a toxic combination of privatised gains and socialised losses. This offers the prospect of a prosperity that is more firmly grounded and more inclusive. More fundamentally, short and longer-term imperatives come together with respect to policies that seek to ensure that any future prosperity is inclusive. The policies that are most effective in helping to support demand are those that help households struggling either because of low incomes or because they have recently lost part of their income. Recent events also remind us that individuals can become impoverished or lose health insurance through no fault of their own. This reinforces the need for people to have basic health and retirement security protection regardless of what happens to their employers.

All of these considerations suggest that the pendulum will swing – and should swing – towards an enhanced role for government in saving the market system from its excesses and inadequacies. Policymakers need to be attentive to potential government flaws as well. For example, they need to recognise that, even as events compel larger deficits in the short run, they reinforce the need for longer-term measures to keep government finances on a sound footing. They must also be wary of measures that have a short-term superficial appeal, yet have adverse long-term consequences.

It is said in all presidential election years that the choices made by the next president are uniquely important. This time the cliché is true. The gravity of our situation is matched only by the opportunity it presents.

The writer is the Charles W. Eliot university professor at Harvard and managing director of D.E. Shaw & Co

Copyright The Financial Times Limited 2012.