Category Archives: Financial Crises

World Bank Says Have a Nice Day

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From Ian Talley of the WSJ.

A host of governments around the world don’t have enough income to buffer against growth risks and higher borrowing costs. “You might think that you have sustainable debt dynamics, but that can change dramatically,” said Ayhan Kose, a lead author of the bank’s latest Global Economic Prospects report. Part of the report was published late Wednesday.

Read the whole thing. It is hard to pick out the scariest sentence.

The way I think about institutions that rely heavily on debt is that there are two equilibria. In the good equilibrium, lenders are confident (rightly or wrongly) that the debt will be repaid, interest rates are low, and there is no crisis. In the bad equilibrium, lenders are doubtful (rightly or wrongly) that the debt will be repaid, interest rates are high, and there is a crisis. While you are in the good equilibrium, it looks like borrowing does not cause any problem. When you hit the bad equilibrium, people look back and ask how you could have been so stupid. A few years ago, I explained the challenge with predicting the trigger point for a crisis ahead of time.

The article suggests that emerging markets are more fragile because in those countries private companies often need to be propped up by government, and in a crisis credit dries up for both private and public borrowers. The implicit assumption is that developed countries are immune from such double whammies. I am not so sure.

Narrative is the New Baloney Sandwich

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Brad DeLong writes,

When it became clear in late 2008 that the orgy of deregulation coupled with global imbalances was confronting the global economy with a shock at least as dangerous as the Great Crash that had initiated the Great Depression. . .

Pointer from Mark Thoma.

Noting that on this year’s Washington Post list, “narrative” is in the “out” column, to be replaced this year by “facts,” I resolve in 2015 to use the phrase “I call Narrative” where I would have said “I call Baloney Sandwich.”

The phrase “orgy of deregulation” is a much-used narrative/baloney sandwich. Others have used it. Interestingly, in the version of the essay that appears on Project Syndicate, DeLong does not use it.

1. The facts are that one can just as easily blame the financial crash on an attempted tightening of regulation. That is, in the process of trying to rein in bank risk-taking by adopting risk-based capital regulations, regulators gave preference to highly-rated mortgage-backed securities, which in turn led to the manufacturing of such securities out of sub-prime loans.

2. The global imbalances that many of us thought were a bigger risk factor than the housing bubble did not in fact blow up the way that we thought that they would. The housing bubble blew up instead.

3. I call narrative whenever someone talks about the causes of the financial crisis without making any reference to looser mortgage lendings standards and/or without mentioning that government policies were hostile not to those institutions who dropped rigorous lending standards but to those who attempted to maintain them.

The Threat of Debt

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Luigi Buttiglione, Philip R. Lane, Lucrezia Reichlin and Vincent Reinhart write,

Contrary to widely held beliefs, the world has not yet begun to delever and the global debt-to-GDP is still growing, breaking new highs. At the same time, in a poisonous combination, world growth and inflation are also lower than previously expected, also – though not only – as a legacy of the past crisis. Deleveraging and slower nominal growth are in many cases interacting in a vicious loop, with the latter making the deleveraging process harder and the former exacerbating the economic slowdown. Moreover, the global capacity to take on debt has been reduced through the combination of slower expansion in real output and lower inflation.

Much of the debt increase has taken place in emerging markets, notably China. I remain suspicious of aggregate debt-to-GDP numbers as an indicator. Indeed, the paper speaks to many of the issues with this measure that trouble me). However, the authors make a reasonable case to worry about two risks. One is that any adverse economic development will be multiplied by the defaults that result from high leverage. The other is that a “confidence crisis,” in which creditors lose faith in some debt instruments, becomes self-fulfilling. As the authors put it,

we outline the nature of the leverage cycle, a pattern repeated across economies and over time in which a reasonable enthusiasm about economic growth becomes overblown, fostering the belief that there is a greater capacity to take on debt than is actually the case. A financial crisis represents the shock of recognition of this over-borrowing and over-lending, with implications for output very different from a ‘normal’ recession. Second, we explain the theoretical foundations of debt capacity limits. Debt capacity represents the resources available to fund current and future spending and to repay current outstanding debt. Estimates of debt capacity crucially depend on beliefs about future potential output and can be quite sensitive to revisions in these expectations.

This report came out two months ago, and I do not recall it getting much play. I think it deserves your attention. Read the whole thing. For the pointer I thank Jon Mauldin’s email newsletter.

A “Tough” Capital Rule for Big Banks?

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So the headline says. But from the actual article,

The extra core-capital requirement could be as high as 4.5 percent of risk-weighted assets on top of the baseline 7 percent defined under rules known as Basel III, according to analysts including Citigroup’s Keith Horowitz.

The term “risk-weighted” gives the banks a loophole you can drive a truck through. My guess is that if you had this rule in place in 2005, its main impact would have been to steer banks into holding more AAA-rated mortgage securities.

eP*/P

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Those are the symbols for the “real exchange rate,” or the terms of trade, both measured inversely, or “competitiveness,” measured directly. That is, when this expression goes up, the real exchange rate depreciates, the terms of trade worsen, and competitiveness improves. e is the nominal exchange rate. Say that we are Japan, and e is yen/dollar. As e goes up, it means that our exchange rate is depreciating. (I am forever confused by that way of writing e, but that’s how it’s done.) P* is the domestic price index of our trading partners, and P is our domestic price index. Suppose that we (Japan) are relatively deflationary, which means that P*/P is going up. That has the same effect as a currency depreciation.

It appears to me that Japan is experiencing both a nominal currency depreciation (a rise in e) and an increase P*/P. That means that Japan is certainly experiencing a real exchange rate depreciation, or a real deterioration in its terms of trade. It has to give up more Toyotas to import the same amount of beef. In terms of purchasing power in world markets, the Japanese are becoming worse off.

At the same time, Japan has become more competitive. Japanese consumers will be inclined to import less beef. Toyota will find itself able to export more cars.

The question I have is this: when does Japan succeed in inflating away some of its debt? In terms of world purchasing power, it is already doing so. Japanese holders of government bonds are earning negative returns relative to the cost of a consumption basket. But that does not help the government. The government needs an increase in yen-denominated tax revenue.

Possibly related: Brad DeLong writes,

That process–the rise in domestic nominal prices and wages, and the larger fall in the nominal value of the currency–may derange the price system and so disrupt aggregate supply. The new equilibrium may be one in which the real depreciation of the currency is expansionary in the sense that it tends to push real aggregate demand above potential output. But the economy may nevertheless be in depression, if the process of getting to the new equilibrium has entailed nominal price swings large enough to have been sufficiently disruptive to the market-mediated division of labor. Weimar 1923.

Pointer from Mark Thoma.

I see that as the crux of the issue. If investors lose confidence in Japan’s bonds, the Japanese government loses its ability to borrow. When you lose the ability to borrow and you are running large deficits, watch out.

UPDATE: Read Tyler Cowen’s post on this topic.

My Review of Peter Wallison’s Forthcoming Book

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is here.

Wallison’s thesis is that policymakers in Washington underestimated the significance of the surge in nontraditional mortgages. What is perhaps even more deplorable is the way that these mortgages continue to be downplayed in the mainstream narratives of the crisis and in the policy responses that followed.

Meanwhile, CNN Money reports on programs that offer 3 percent down payments.

The new loans will only be doled out to those who buy private mortgage insurance, have a credit score of at least 620 and offer complete documentation of their income, assets and job status. And, to further mitigate risk, the agencies will require borrowers to receive home ownership counseling.

Once again, the government is pushing home borrowership, setting households up to fail and making the housing market more speculative. Of course, when the stuff hits the fan, the government officials involved will blame lenders, not themselves.

The European Debt Crisis–Not Quite Over

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Theodore Pelagidis writes,

The latest polls put Syriza ahead by 5-7 points, as angry voters from across the political spectrum get behind the party. It’s not surprising. This “supermarket” party promises almost everything to anyone, masking its policies with romantic pledges to stop humanitarian crises, to make the black market and bureaucracy disappear, to increase the minimum wage and minimum pension by around 40 percent (despite the fact that the social security system is in bad shape) and, last but not least, to negotiate a huge amount of debt forgiveness, mainly by having–sorry, ordering—the European Central Bank to buy most of it.

Have a nice day.

I Do Not Understand SPOE

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It stands for Single Point of Entry, and I wrote about it here. Peter Wallison and Paul Kupiec say that it won’t work.

Our analysis of the largest banks shows that most of these institutions could fail without causing their parent BHCs to be in default of danger of default. For the parent BHCs to be in danger of default, they would have to experience massive losses simultaneously in many or all of their bank and nonbank subsidiaries.

…For BHCs that will clearly become insolvent if their bank subsidiary fails, the SPOE can be invoked, but the mechanism it uses to prevent financial market disruptions is an extension of the government safety net…It will protect all large bank 39 creditors from losses by transferring bank losses to the parent BHC’s creditors and potentially to unaffiliated institutions that will be assessed to repay the OLF. Here, the SPOE strategy—because it promises to bail out failing large banks— reinforces the TBTF problem at the largestbanking institutions.

Think of two cases:

1. A bank subsidiary is in bad shape, but the overall holding company has positive value.
2. The holding company is insolvent.

I thought, perhaps naively, that the SPOE approach is not worth anything in case (2), but that it was supposed to apply to case (1).

However, Wallison and Kupiec say that the FDIC lacks the legal authority to implement SPOE in case (1). Their argument is that the FDIC was given a mandate to come up with a way to liquidate a failed bank, and SPOE is a way to recapitalize a failed bank, using the net worth of the holding company.

I think that the larger problem is the one I raised in my earlier post. I think that you tend to jump straight from an apparently solvent bank inside a solvent holding company to case (2) without stopping at case (1).

Perhaps I will gain more understanding of SPOE by watching the video of this event.

Central Planning, Capital Regulations, and the Risk Premium

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Per Kurowski writes,

current credit-risk-weighted capital (equity) requirements for banks, allow banks to hold government debt and loans to the AAAristocracy against much less equity than when financing “risky” small businesses and entrepreneurs, and so that is de facto what you get.

Risk-based capital regulations may or may not help regulators manage bank risk. (I argued here that the results were quite the opposite.) But they certainly affect the allocation of capital.

Many economists say that there is a huge demand for risk-free assets, as if this were a puzzle. Why is the “free market” so risk averse? Well, the government tells banks that they can earn a higher return on equity holding what the government defines as risk-free assets. AAA mortgage securities, Greek sovereign debt, whatever.

Kurowski’s post reminds me that financial regulation serves to allocate capital, and capital allocation by government can be thought of as central planning. There is a major socialist calculation problem involved. Moreover, there is a tarbaby problem. As the capital regulations produce perverse outcomes, policy makers look for policies to correct the outcomes, and these policies lead to other perverse outcomes, etc.

Is Demography (Economic) Destiny?

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The Economist blog writes,

An ageing population could hold down growth and interest rates through several channels. The most direct is through the supply of labour. An economy’s potential output depends on the number of workers and their productivity. In both Germany and Japan, the working-age population has been shrinking for more than a decade, and the rate of decline will accelerate in coming years (see chart). Britain’s potential workforce will stop growing in coming decades; America’s will grow at barely a third of the 0.9% rate that prevailed from 2000 to 2013.

Pointer from Tyler Cowen.

Along seemingly similar lines, Karl Smith writes,

It’s no accident that this phenomenon appeared in Japan first. As its population began to stagnate well before the rest of the industrialized world, investors found themselves with loads of capital, a dearth of workers, and repayment terms they could not meet.

First, think about this in the absence of inter-generational transfer schemes like Social Security.

1. If people live longer than they used to, then they either have to produce more (probably by retiring later) or consume less.

2. If birth rates decline, then you let capital depreciate faster than it would otherwise. Think of an economy where the only capital goods are houses that stay in good condition for fifty years. When birth rates are rising, you need to keep using some houses longer than fifty years, even though they no longer are in good condition. When birth rates are falling, you can take some houses out of service before fifty years, even though they still are in good condition.

This seems quite straightforward to me, and it is does not suggest that demographic changes should be highly disruptive. I am not persuaded by just-so stories about Japan. One can conjure many such stories. For example, maybe Japan slowed down because its corporatist approach to capital allocation was only effective for a decade or two.