Bloomberg interview of Dr. Doom, Nouri Roubini at NYU. (audio, about 20 minutes)
Archive for October 28th, 2008
David Gitlitz writes on the Journal that "We won't suffer a Japanese Deflation". A good review of history.
As U.S. credit markets continue to be roiled in chaos, some are bandying about the notion that America's problems resemble those of Japan in its deflationary "lost decade" of the 1990s. "Deflation looms. It certainly does loom," said one functionary for a major international bank. "The cycle in which debt destruction and asset price destruction reinforce each other clearly has a very, very, strong negative effect on the economy."
This analysis expresses a common fallacy that asset-price declines give rise to economic weakness, and the effect is therefore deflationary. But "deflation" is not a synonym for economic contraction. Deflation is rather a sustained decline in the overall price level, i.e., the opposite of inflation. Like inflation, deflation is a monetary phenomenon.
There is no evidence that deflationary influences are now at work in the U.S. economy. I was very familiar with the Japanese deflation, having been the first to recognize and name it in a 1995 op-ed on this page. I was exposed to considerable public criticism by the Bank of Japan at the time, but history has shown my diagnosis to be entirely correct.
Aside from some superficial similarities, the current U.S. financial market disturbance bears no resemblance to the economic misery that afflicted Japan for more than a decade, and in important ways continues to linger there. In fact, the comparison should provide some comfort to Americans. U.S. monetary conditions are nearly the exact opposite of the devastating deflation that characterized the Japanese experience.
The U.S. had its real-estate bubble through the first six years or so of the current decade, and on the surface, that might seem comparable to the real-estate bubble that preceded Japan's decade of deflation. Our bubble had its roots in the Fed's exceptionally accommodative monetary policy — a situation not unlike Japan through the late 1980s, when the Bank of Japan was also too easy for too long. But unlike the Fed, the BoJ turned toward tightness with a vengeance, apparently with the objective — at least initially — of pricking the bubble.
Japanese land prices began their long fall in 1991 on the heels of a sharp currency appreciation in 1990, with the yen soaring nearly 20% against both the dollar and gold. That was just the beginning. By 1995, the yen/dollar would see a nearly 50% appreciation, and the BoJ's deflationary bias remained in place for a number of years. The relentless rise in the currency's purchasing power magnified the real burden of yen debt, crushing borrowers and crippling the Japanese banking system.
Contrast that with the U.S. experience, in which the decline in real-estate values would coincide not with a deflationary appreciation of the dollar, but an inflationary depreciation. From the time home prices peaked in mid-2006 through the currency's lows last spring, the trade-weighted value of the dollar fell by some 18%. Over the same period, the price of gold rose by about 75%. While the dollar has rebounded moderately in the last several months, by any objective measure it remains in a weak position. On a trade-weighted basis, it has returned to its levels of about a year ago. But before doing so, it had never been weaker. At around $830 in gold terms, the dollar has recovered a modicum of the purchasing power lost when gold soared above $1,000 last March in the midst of the Bear Stearns calamity. But at current levels the price of gold is double what it was four years ago.
The relative damage to real-estate values between the U.S. and Japan is instructive. Thus far, U.S. home prices have fallen about 12.5% from their peak. But they remain about 40% above their 2000 levels. In Japan, by 2001 the destruction of values brought land prices down to about half their levels of the late 1980s.
The U.S. housing downturn and associated financial-market turbulence is attributable not to tight monetary conditions, but to an unsustainable speculative bubble triggered by loose monetary conditions. The current market turmoil might well put the economy into at least a shallow and short-lived recession. But unlike Japan, the U.S. economy will not have to dig its way out of a debilitating, long-lasting monetary deflation.
On the contrary, the current economic climate is marked by a considerable upswing in inflation, with the headline consumer price index now running at about 5.4%, up from less than 2% a year ago. The decline in crude oil prices will keep down the reported rate for a few months. But once oil stops falling, the underlying inflationary influences will reassert themselves, and no sizeable long-lasting decline in reported inflation is likely in the foreseeable future.
The "lost decade" of stagnation and monetary deflation, and its remaining legacy today, were the product of a persistently too-tight Bank of Japan. The Fed was not tight even before the present crisis, and as the crisis has unfolded has gotten progressively easier. Today, America's real concern is inflation.
Mr. Gitlitz is chief economist at Trend Macrolytics, LLC.
John Gordon, author of “An Empire of Wealth: The Epic History of American Economic Power” offers us a good short history of American Banking:
How could the richest and most productive economy the world has ever known have a financial system so prone to periodic and catastrophic break down? One answer is the baleful influence of Thomas Jefferson.
Jefferson, to be sure, was a genius and fully deserves his place on Mt. Rushmore. But he was also a quintessential intellectual who was often insulated from the real world. He hated commerce, he hated speculators, he hated the grubby business of getting and spending (except his own spending, of course, which eventually bankrupted him). Most of all, he hated banks, the symbol for him of concentrated economic power. Because he was the founder of an enduring political movement, his influence has been strongly felt to the present day.
Consider central banking. A central bank’s most important jobs are to guard the money supply — regulating the economy thereby — and to act as a lender of last resort to regular banks in times of financial distress. Central banks are, by their nature, very large and powerful institutions. They need to be to be effective.
Jefferson’s chief political rival, Alexander Hamilton, had grown up almost literally in a counting house, in the West Indian island of St. Croix, managing the place by the time he was in his middle teens. He had a profound and practical understanding of markets and how they work, an understanding that Jefferson, born a landed aristocrat who lived off the labor of slaves, utterly lacked.
Hamilton wanted to establish a central bank modeled on the Bank of England. The government would own 20% of the stock, have two seats on the board, and the right to inspect the books at any time. But, like the Bank of England then, it would otherwise be owned by its stockholders.
To Jefferson, who may not have understood the concept of central banking, Hamilton’s idea was what today might be called “a giveaway to the rich.” He fought it tooth and nail, but Hamilton won the battle and the Bank of the United States was established in 1792. It was a big success and its stockholders did very well. It also provided the country with a regular money supply with its own banknotes, and a coherent, disciplined banking system.
But as the Federalists lost power and the Jeffersonians became the dominant party, the bank’s charter was not renewed in 1811. The near-disaster of the War of 1812 caused President James Madison to realize the virtues of a central bank and a second bank was established in 1816. But President Andrew Jackson, a Jeffersonian to his core, killed it and the country had no central bank for the next 73 years.
We paid a heavy price for the Jeffersonian aversion to central banking. Without a central bank there was no way to inject liquidity into the banking system to stem a panic. As a result, the panics of the 19th century were far worse here than in Europe and precipitated longer and deeper depressions. In 1907, J.P. Morgan, probably the most powerful private banker who ever lived, acted as the central bank to end the panic that year.
Even Jefferson’s political heirs realized after 1907 that what was now the largest economy in the world could not do without a central bank. The Federal Reserve was created in 1913. But, again, they fought to make it weaker rather than stronger. Instead of one central bank, they created 12 separate banks located across the country and only weakly coordinated.
No small part of the reason that an ordinary recession that began in the spring of 1929 turned into the calamity of the Great Depression was the inability of the Federal Reserve to do its job. It was completely reorganized in 1934 and the U.S. finally had a central bank with the powers it needed to function. That is a principal reason there was no panic for nearly 60 years after 1929 and the crash of 1987 had no lasting effect on the American economy.
While the Constitution gives the federal government control of the money supply, it is silent on the control of banks, which create money. In the early days they created money both through making loans and by issuing banknotes and today do so by extending credit. Had Hamilton’s Bank of the United States been allowed to survive, it might well have evolved the uniform regulatory regime a banking system needs to flourish.
Without it, banking regulation was left to the states. Some states provided firm regulation, others hardly any. Many states, influenced by Jeffersonian notions of the evils of powerful banks, made sure they remained small by forbidding branching. In banking, small means weak. There were about a thousand banks in the country by 1840, but that does not convey the whole story. Half the banks that opened between 1810 and 1820 had failed by 1825, as did half those founded in the 1830s by 1845.
Many “wildcat banks,” so called because they were headquartered “out among the wildcats,” were simple frauds, issuing as many banknotes as they could before disappearing. By the 1840s there were thousands of issues of banknotes in circulation and publishers did a brisk business in “banknote detectors” to help catch frauds.
The Civil War ended this monetary chaos when Congress passed the National Bank Act, offering federal charters to banks that had enough capital and would submit to strict regulation. Banknotes issued by national banks had to be uniform in design and backed by substantial reserves invested in federal bonds. Meanwhile Congress got the state banks out of the banknote business by putting a 10% tax on their issuance. But National banks could not branch if their state did not allow it and could not branch across state lines.
Unfortunately state banks did not disappear, but proliferated as never before. By 1920, there were almost 30,000 banks in the U.S., more than the rest of the world put together. Overwhelmingly they were small, “unitary” banks with capital under $1 million. As each of these unitary banks was tied to a local economy, if that economy went south, the bank often failed. As depression began to spread through American agriculture in the 1920s, bank failures averaged over 550 a year. With the Great Depression, a tsunami of bank failures threatened the collapse of the system.
The reorganization of the Federal Reserve and the creation of the Federal Deposit Insurance Corporation hugely reduced the number of bank failures and mostly ended bank runs. But there remained thousands of banks, along with thousands of savings and loan associations, mutual savings banks, and trust companies. While these were all banks, taking deposits and making loans, they were regulated, often at cross purposes, by different authorities. The Comptroller of the Currency, the Federal Reserve, the FDIC, the FSLIC, the SEC, the banking regulators of the states, and numerous other agencies all had jurisdiction over aspects of the American banking system.
The system was stable in the prosperous postwar years, but when inflation took off in the late 1960s, it began to break down. S&Ls, small and local but with disproportionate political influence, should have been forced to merge or liquidate when they could not compete in the new financial environment. Instead Congress made a series of quick fixes that made disaster inevitable.
In the 1990s interstate banking was finally allowed, creating nationwide banks of unprecedented size. But Congress’s attempt to force banks to make home loans to people who had limited creditworthiness, while encouraging Fannie Mae and Freddie Mac to take these dubious loans off their hands so that the banks could make still more of them, created another crisis in the banking system that is now playing out.
While it will be painful, the present crisis will at least provide another opportunity to give this country, finally, a unified banking system of large, diversified, well-capitalized banking institutions that are under the control of a unified and coherent regulatory system free of undue political influence.
According to this BW article, titled "Forget Adam Smith, Whatever Works", Federal Reserve Bank of Dallas President Richard W. Fisher, in addressing the high and mighty of global finance in Washington during pivotal meetings of the Group of Seven and the International Monetary Fund, borrowed a Chinese proverb popularized by the late Chinese leader Deng Xiaoping: "No matter if it is a white cat or a black cat, as long as it can catch mice, it is a good cat."
Washington's partial nationalization of banks marks a fundamental shift in thinking about the relationship of the public and private sectors.
Read more about the future of capitalism.
Complex financial products can be useful if regulated properly (source: wsj)
Proposals for a makeover of the financial system include reform of the credit derivatives market, which offers over $50 trillion of default insurance coverage. Do investors need that much insurance, or is this mainly a dangerous casino operating under the radar of regulators — until a major financial institution like AIG needs a bailout? What sort of reform is needed?
The seller of protection in a credit derivatives contract receives premiums from the buyer of protection until maturity, or until default of the named borrower. Contracts are negotiated over the counter, not on an exchange, so it is difficult to know how much insurance exists on each borrower, or to know who has insured whom, and for how much.
That privacy is not unusual in the normal course of business contracts. What is unusual is the size of the potential claims. There is a public interest in knowing that systemically important sellers of protection have not overdone it. If a large bank or insurance company does not have enough capital to cover settlement claims, then its failure, or the threat of it, can cause mayhem, as we have just seen.
The largest credit derivatives positions are held by big-bank credit derivatives dealers. Because they intermediate between buyers and sellers, dealers often have nearly offsetting positions. For example, according to J.P. Morgan's latest quarterly report, it had bought protection coverage on $5.2 trillion of debt principal, and sold protection on $5 trillion. The vast quantity of outstanding derivatives in the global market is therefore not a good gauge of the effective amount of insurance offered.
Of the $532 trillion notional amount of financial instruments covered by over-the-counter derivatives in June of this year — including credit derivatives, interest-rate swaps and equity derivatives — the International Swaps and Derivatives Association estimates potential exposures to counterparties of $2.7 trillion. These exposures are further reduced by collateral held against the potential failure of counterparties.
Of roughly $350 billion in credit derivative settlement claims that arose in Lehman's default, about $6 billion in actual settlement payments were scheduled for payment yesterday, after canceling offsetting claims. For illustration, suppose that Goldman Sachs had sold protection to the point that it owed $7 billion in Lehman settlement claims, and had purchased protection on which it was owed $7.5 billion. In this situation, Goldman would collect a net of $0.5 billion, unless a counterparty fails to pay. Suppose that one of Goldman's counterparties, say a hedge fund, had failed to pay Goldman a $100 million settlement claim. If Goldman had received the industry-average 65% collateralization from its counterparty, it would keep the collateral and be out $35 million. Goldman could then pursue additional recoveries as a claimant in the hedge fund's bankruptcy. The Depository Trust & Clearing Corporation, which keeps records of the majority of credit derivatives trades and settlements, reported yesterday that there were no payment failures on scheduled Lehman credit derivative settlements.
So far, the credit derivatives settlement process has worked smoothly through several large defaults, but the safety of the settlement process could be improved significantly. Because dealers lay off such large positions with each other, a large fraction of their exposures is unnecessary. For example, suppose that Bank A is exposed to Bank B for $1 billion, while B is exposed to C for $1 billion, and C is exposed to A for $1 billion, all on the same underlying named borrower. That circle of exposures is eliminated if all three banks clear their positions with the same central clearing counterparty. Because Bank A is long and short by the same amount, it would have no settlement payment to make or to receive from the clearing counterparty. Banks B and C would likewise have no potential loss. In practice, exposures would not be offset so neatly, but a large fraction of them would.
The Fed is pressing dealers to quickly establish clearing in credit derivatives. The dealers have expressed an interest in using their own clearing counterparty, the Chicago Clearing Corporation. Alternatively, they could clear credit derivatives with a new joint venture of the Chicago Mercantile Exchange and Citadel (a large hedge fund). Either way, regulators should ensure that a clearing counterparty is extremely well capitalized and has strong operational controls.
Unfortunately, the urgency to set up clearing for credit derivatives may lead us to miss the opportunity to reduce exposures even further by clearing credit derivatives along with other forms of over-the-counter derivatives, such as interest-rate swaps and equity derivatives, which represent similarly large amounts of risk transfer. Regulators should press dealers to clear more types of derivatives with the same clearing house.
That investors can benefit from a market for insurance against default risk does not seem controversial. The market premiums offered on credit derivatives also provide investors with "price discovery" of the financial health of corporations and sovereign states. (Although trading is private, samples of prices are disseminated by financial news services.)
There is a public interest in limiting the exposure of large, systemically important financial institutions, relative to their capital, whether from derivatives or from other forms of risk taking. We were supposed to have had such limits, but they were not effective, and will presumably be revisited by regulators soon.
Regulators should also have access to more detailed information on the potential exposures of large financial players to each other. But general public disclosure of specific derivatives trades seems unnecessary in most cases, can lower incentives to invest efficiently, and runs counter to our norms for privacy. We do nothing like this in other financial markets, such as those for common stocks, except when positions are large enough to suggest the potential control of public corporations. (Derivatives do not carry control rights.)
Public disclosure can nevertheless be a good disinfectant whenever sufficiently severe conflicts of interest lead to inefficient control of risk (moral hazard) or to unfair exploitation of counterparties. If a lender can largely insure itself against its borrower's default, it has lessened its interest in the financial health of the borrower, and may neglect to monitor the borrower. Default losses to the lender would be passed on to credit derivatives counterparties, who may not be aware of the conflict of interest.
When unconstrained by good regulations, derivatives can be financial weapons of mass destruction. Our new regulations should be smart and surgical.
Mr. Duffie is a professor of finance at Stanford University's Graduate School of Business.
Crisis Shakes the Foundations of the Ivory Tower
The financial and economic tsunami that has ripped through Wall Street and the housing market is beginning to wash across the college green.
Higher education hasn't yet seen anything to compare with foreclosures and bank nationalizations in the private sector. But seized-up credit markets, shrinking endowment funds and a reduction in state subsidies are punishing universities from California to Vermont.
A campus construction boom is slowing, administrations are cutting jobs and faculty may be forced to pay more into their pension funds. The demise of a $9.3 billion investment fund used by 900 colleges has some schools scrambling to pay their bills.
It all brings a gloomy pall to what has been, until recently, a booming industry. Higher education has grown rapidly in the last half-century into a formidable slice of the economy. U.S. colleges and universities spend $334 billion annually, employ 3.4 million people and and enroll 17.5 million students.
The boom was powered by a growing stream of donations, strong returns on endowments, rising enrollments and tuition prices that climbed well above the rate of inflation — paid, more and more, by families who borrowed heavily to meet the bills.
All of these wealth generators for the Ivory Tower are facing threats in the current economic turmoil. The cratering stock market has already hit endowments. Falling markets typically take a toll on gifts, many of which are made, for tax reasons, in the form of appreciated stocks and bonds. Analysts and schools are predicting even bigger tuition increases than those seen so far. But this time, families may be in no position to meet the higher bills. Falling house prices have sapped their ability to use home-equity loans for tuition payments, and the credit crunch has forced many lenders to stop making student loans.
At a time when many political candidates — notably Democratic presidential nominee Barack Obama — are stressing the importance of access to college to the country's economic future, financial exigencies threaten to offset or overcome anything the government can do to promote more college attendance.
"This is the worst environment for colleges I can remember," says Mark Ruloff, a consultant at Watson Wyatt in Arlington, Va., who advises college endowments. With their ability to raise capital curtailed by the crisis, schools may be forced to sell their most liquid endowment assets at a time when the markets are not offering much, he predicts.
Molly Corbett Broad, president of the American Council on Education, which represents 1,600 colleges and universities, says public schools face the greatest challenge in a slumping economy because they get as much as three-quarters of their revenue from state taxpayers.
She says students could face double-digit tuition increases next year, up from the typical 4% to 6% level in recent years. Some university presidents privately confided to her that their institutions, which she declined to name, are even considering midyear tuition hikes. Ms. Broad adds that small private colleges without hefty endowments may have to consider merging with bigger rivals.
Some colleges are already feeling squeezed. As part of steep statewide budget cuts, the University of Massachusetts system this week said it would have to cut its budget by about $25 million, or 5%. The flagship Amherst campus froze hiring in all but the most critical positions. To avoid reductions in financial aid or increases in fees, the University of Massachusetts president, Jack M. Wilson, promised work force cuts and consolidations.
Boston University's president sent faculty a letter late last month announcing that the school is imposing a freeze on new hires and new construction projects. The crisis, Robert A. Brown wrote, has "created unprecedented volatility for our students, their parents and the University."
The debt markets' breakdown comes at an inopportune time for colleges, which have been building gyms and dorms to attract top students. College construction soared to $15 billion in 2006 from $10 billion in 2001, according to College Planning and Management magazine. The figure slipped slightly to $14.5 billion in 2007 amid concerns about a weakening economy.
The state of Colorado has frozen hiring and state construction projects, including about $50 million worth at public universities, such as the renovation of an arts and science center at the University of Colorado at Boulder.
The Tennessee Board of Regents, which oversees the University of Memphis, five other universities and 13 community colleges, has been forced to cut $58 million since July.
Bob Adams, vice chancellor for business and finance, says the system, with 190,000 students, may have to increase tuition "fairly significantly" next year. Including tuition, room and board and other fees, students typically pay $12,500 annually.
The University of Memphis recently announced a voluntary employee buyout program. Mr. Adams says schools are also delaying equipment purchases, such as laboratory equipment, and library acquisitions, including books and subscriptions. He says he suspects that classes will get larger because of rising enrollments and shrinking staffs. "It may get to the point where we don't have the facilities to meet the demand," Mr. Adams says.
The University of California, Berkeley, faces $28 million in cuts or unavoidable cost increases for the academic year that began in July, according to Nathan Brostrom, vice-chancellor of administration. He says that rising health care costs will result in an 11% increase in the cost of providing medical and dental benefits to staff starting in 2009. Starting in July, Berkeley faculty and staff have been told to expect to make contributions to their pension funds for the first time since 1990 because slumping stock markets have eaten away the pension surplus.
Before the meltdown, richer colleges such as Harvard and Yale had responded to pressure from Washington and started to spend more of their endowments to lessen the tuition burden. Endowments have swelled in recent years, with 785 of the wealthiest holding more than $400 billion in assets as of 2007.
Now, Moody's Investors Service, the bond rater, is projecting endowment returns to be negative for the first time since 2002. In a report Thursday, the ratings agency estimates that college endowment losses averaged 5% to 7% in the year ended June 30. Since then, including spending and stock market losses, Moody's figures colleges experienced another 30% decline in cash and investments.
The crisis has even made colleges wary about where they keep their ready cash. Earlier this month, a fund that invests cash for about 900 colleges suddenly froze withdrawals. Schools, which can now withdraw about 40% of their money, may not be able to get all of it back until 2011.
Before Wachovia Corp., the fund's trustee, said it was terminating the fund, it held $9.3 billion in assets. The Commonfund Short-Term Fund, used like a checking account at many schools, invested in some mortgage-backed securities that now can't be sold for their full value.
At the University of Vermont, the finance chief secured a $50 million outside line of credit from a local bank to ensure he meets payroll and other monthly obligations — a move he made after learning the school cannot withdraw a chunk of the $79 million it held from a short-term cash fund until next year at the earliest.