Today, Im going to take a look at the issue of “moral hazard” and how it pertains to the current economic crisis. Of particular importance is the issue of whether or not government guarantees encourage private investors to take excessive risks which might inturn increase the chance of future crises. With profit privatized and risk socialized, is it any wonder that investors are willing to take on more and more risk in search of higher returns?
While resisting the temptation to look back to the origins of this crisis, I prefer to look forward to wonder if we are laying the foundation for future moral hazard (while at the very same time attempting to regulate away the risks of future crises).
Its interesting that the same week the IMF announces $1 trillion in new funding (loans, mostly) to help emerging markets through the crisis (with fewer conditions attached)…we also see a boom in new lending to emerging markets from private investors. On the surface this may appear to be a good thing, right? Dont we want new lending to emerging markets? Yes, but…
What is interesting is that private lenders increased lending because their perceived level of risk has decreased. Think about it like this… if you knew that the IMF was going to be there to back-stop default from the countries that were borrowing, wouldnt you be more willing to take risks to lend money to countries that might default? (especially if you thought emerging markets could borrow from the IMF in the future without all of the tough conditions normally attached to IMF money).
While the policy decision to allocate extra money to the IMF (with less conditions attached) may achieve the objective of increased global liquidity, and by encouraging private capital flows it might help reduce the impact and spread of the economic crisis of today, I wonder if this might just be another example of socializing risks and encouraging private investors into the assumption of government guarantees (as they did with Freddie / Fannie, etc).
This latest news article (shown in italics below) caught my attention: Emerging-Market Bond Sales Surge to Two-Year High
“Investor confidence has been buoyed by a pledge from theGroup of 20 nations yesterday to triple the resources of the International Monetary Fund to $750 billion. The Washington-based fund has allocated more than $70 billion to help developing countries avoid defaults as the economic crisis reduces demand for exports, cuts lending from Western banks and triggers a slide in currencies”
My comments: Increased IMF protection leads emerging markets to borrow more because the risk of default is being transferred from private lender to public institution.
“Risk appetite is returning and people are looking to invest in more established emerging markets with better liquidity,” said Beat Siegenthaler, chief emerging-markets strategist at TD Securities in London.
My thoughts: Sure, the “risk appetite” is returning…but that’s because private investors know that the IMF will be there to take some of that risk away. But, is the risk really being reduced, or just transferred? It appears as if moral hazard is leading to more risky behavior.
Consider this… most of the countries that are taking in new borrowing are doing so in foreign currencies (such as dollar-denominated, or euro-denominated bonds). This clearly adds riskto the system rather than reduces it… by borrowing in foreign funds, if the local currency were to depreciate, the repayment burden would skyrocket.
“Turkey’s Treasury may sell bonds in euros or dollars depending on the outcome of the G-20 summit in London, a spokesman for the Treasury said yesterday. And in other news…The Central Bank of Bahrain plans to issue bonds in U.S.dollars this year to help meet the country’s budget deficit…”
My thoughts: While markets around the globe rally to the news of IMF funding (and eased conditions attached to loans), Im left to wonder if it may just be a short term gain at the expense of long term pain?
I welcome your comments / thoughts…
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If I had one request for our leaders to consider during the G20 conference underway in London, it would be to concentrate on fixing the crisis of today, and spend less time talking about potential regulations intended to help us avoid doing the same crisis again in the future.
On one hand, its good to reflect back and try to assess what went wrong, and to figure out how we got into this mess. But, enacting regulation to avert the same disaster in the future runs the risk of erecting barriers to recovery today.
For example, I agree that it may be a good idea to increase capital reserve ratios at banks to avoid underfunded banks in the future, but by increasing reserve requirements today we risk reducing lending today (as we hope to avoid instability in the future). Also, it may be a good idea to regulate the “shadow banking” sector of hedge funds, private equity and so on…but what we need today is for secutitization markets to come back faster rather than later.
The problems facing the global economy are enormous. But our leaders need to be careful not to make todays crisis worse by attempting to restructure the system to correct yesterdays mistakes. Yes, I think reflection and remedy are required. But, now is not the time. Rather than trying to prevent tomorrows crisis, I think they should focus solely on fixing todays.
It could be argued that “leveraging” got out of hand, and that the bubble popped because of “too much credit”. But, Ive long argued in this blog that “deleveraging” is the most harmful and most powerful trend that has been building since 2007,and that most of the pain we feel today (with lost jobs, lost production, lost income) is a direct result of the forceful deleveraging that was forced upon us. For our leaders at the G20….if we want to ease the pain of this recession, we shouldn’t expect solutions to be found in regulations to avoid future leveraging. That action might solve yesterdays problem, and might avoid tomorrows….but it does nothing to solve todays.
A general theme that I see arising from the G20 leaders is a desire to “restructure and regulate”. Great. But, first, please do what you can to stop the current crisis, even if those actions are not the best long-term solutions, and even if those solutions dont fit with the new “structure or regulation”.
Brad Setser recently commented that “the lessons the effort to reform the international financial architecture in the 1990s holds for today’s effort to reform the global financial system. Then, as now, there was a real desire to create a system that was less prone to major crises — though the financial crises of the late 1990s were concentrated in the emerging economies, not the US and Europe.”
mmmm…. I find it alarming when todays top analysts from our most independent think tanks are flat-out assuming that “restructuring and regulation” are what our leaders should be focused on today. While I agree with most of Mr. Setser’s analysis, I take objection with the undelying assumptions that now is the time to focus on preventing potential crises of tomorrow…
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A hotly debated topic these days is in regards to the proper role of government in stimulating the economy. The worry on one side is that without government spending, the economy would fall into a deep recession. The worry on the other side is that government would become overbearing and crowd-out private enterprise. In my opinion, both arguments are compelling, and probably each are ½ right.
To defend the position of increased government spending, I previously argued that if private investors only wanted to give their money to the government (by pouring money into Treasuries, and shunning all forms of risky investments), then the government had a responsibility to recycle those funds and reinvest them back in the private sector. I also argued (here) that if the credit markets were frozen and if the financial system was broken (as it was), then traditional monetary policy wouldn’t work, leaving only the only tools of fiscal policy to shock the economy out of a crisis.
But, to defend the second position (that fiscal stimulus was dangerous in the temptation to increase the size of government, and decrease the role of free enterprise), I also argued repeatedly that the stimulus plan (as passed) was (a) not going to work, (b) too small and misdirected, and (c) just a bandaid: a temporary measure to buy time to fix the root of the problem: the deleveraging of the financial system. See my suggestions of what to do here.
In addition, I also would like to add that I believe there is too much wasteful spending which is being attributed to “Keynes” without much true economic justification for that spending (other than to quote “Keynes”). Supporting this position, I welcome my readers o see an article here from Benn Steil. This point was recently driven home personally when I visited my wife’s aunt (who is a local artist in the NE of Brazil), and saw that she was reading an article on Keynes and his justification for spending to stimulate the economy. At that moment, I knew we were experiencing a Keynes-bubble in the popular press (globally), and my conclusion was that this fascination with Keynes must be unhealthy for true discussion on economic theory by serious professionals.
Another insightful analysis comes from Amity Shales here about FDR and the new Deal…questioning the rise of big government (and the resulting decrease of free enterprise). Read both carefully, and see if you don’t hesitate before signing up for the next spending plan based on either “Keynes”, or on “FDR/ new deal” economics.
The debate of big vs small government (fiscal vs monetary policy) is intense, real, and probably just heating up. I expect to see more philosophical debates along these lines over the coming months / years. At the moment, the momentum seems to be tipping (temporarily) away from free markets and toward big government stimulus. While this debate dates back generations (see Wikipedia articles on both Keynes and Friedman), the more recent trend seems to be one in which Keynes is back in fashion, and the monetarist’s influence has faded slightly… Time will tell, but Ill bet the pendulum will eventually swing back. This debate is old, ongoing, complex and not done yet…
Part 2 of this article is coming soon…
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An interesting trend recently has been the un-freezing of the credit markets.
As per Bloomberg, “Credit markets began to recover as the government started guaranteeing bonds sold by financial institutions, the Fed purchased commercial paper and the Obama administration introduced its fiscal stimulus package, said National Penn’s Barnes. The government has invested more than $250 billion in U.S. banks, insurers and credit-card companies.”
“Record Sales: An increase in corporate bond sales …. Borrowers sold $223 billion of corporate bonds this year, up 61 percent from the same period in 2008 and 43 percent ahead of the record pace set in 2007, Bloomberg data show.”
This trend of easing of credit can be clearly seen in the latest TED-spread graph,which serves as a proxy for banks’ willingness to lend to each other. See our discussion on LIBOR from GloboTrends.
Back in September / October 2008, the graph clearly shows distress. Bank to bank lending nearly ground to a halt.
While it may have been the freezing up of the credit markets that most people blamed for the deep economic downturn, I would argue otherwise. I believe that the credit market freeze need not have translated into a global recession had it not been for the deep and protracted downturn in consumer confidence (especially in the USA).
I previously argued (see article here) that the American consumer was essentially oblivious to the troubles in the credit markets prior to September 2008. While the “credit crisis” actually started in 2007, it wasn’t until Congress got involved did we see consumers get shell shocked, stop buying, and send shock waves through the global supply chains.
Blame Congress (and the financial media)
Until Congress got involved…. consumers kept spending, companies kept selling, importers kept importing, China kept producing, and commodity exporters kept on exporting. Essentially, the “real” economy kept moving along as if the “TED spread” spike didn’t exist (or was too technical to worry about). As late as the summer of 2008, it seemed as if the world economy had “decoupled” from the US, and would keep growing, producing, exporting, and life was fine.
Many analysts blame the fall of Lehman (and hence the Treasury for allowing them to fail) for the freeze up of the credit markets. Perhaps they are right that this was a trigger point, but I believe that most US consumers were still oblivious to the trouble even after Lehman failed. Well, maybe not completely oblivious, but they generally thought the troubles were just on “Wall Street” and didn’t effect “Main Street”….or….at least that’s how they DID think until Congress sold them otherwise (about how this bailout was for Main street, and not just for Wall Street).
My complaint is the way in which the public was sold on the “crisis” in order to get the money to fix the trouble. Congress either (a) didn’t understand finance, or (b) used the opportunity to grandstand for the folks back home. When they rejected the first TARP bill, the stock market tanked. The shock on Wall Street of how “Washington didn’t get it”…led to a massive sales pitch to sell the crisis to the public (for this, I blame the financial media, especially CNBC). In my opinion, it was this selling of the crisis that was the pivot point upon which the “credit crisis” turned into an economy wide “economic crisis”.
If only…
Fast forward to today…and the credit markets are working again.
An average $17.1 billion of corporate bonds traded daily this month, compared with $17.7 billion in January, according to the Financial Industry Regulatory Authority. The business is up from last year’s low of $9.4 billion in August and reached the highest level since February 2007, Finra data show.
Imagine for a minute how much better off we would all be had the credit-fix been done in private, or at least without as much fear mongering. Had Congress not done their best to scare the public, the real economy would probably be still moving along. Imagine if the credit “freeze” had just lasted till now, but the real economy hadn’t been sacrificed by politicians for false “anger” at the bankers.
Taking shots at bankers has become a popular sport in Washington these days, but I lay the blame of scaring the public squarely on Congress’s shoulders (with the help of the financial media).
“But I cant get a loan (at a decent price)”
The reason that rates are so high currently has nothing to do with “freezing” of credit markets…not anymore. The rates are high now…not because of “frozen credit markets”, but instead because corporate defaults are expected to rise in the near future (because of a fall in the REAL economy, not in the credit markets). As consumers quit spending, businesses are expected to fail (which then explains why banks dont want to lend).
Moody’s Investors Service forecast will rise to 16.4 percent by November, the highest since the Great Depression and about three times the current rate
Thanks Congress!
Read More:
- LIBOR
- http://www.bloomberg.com/apps/news?pid=20601087&sid=aRan_qqkjrAo&refer=worldwide
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This morning, I watched congress grilling US banking exec’s about the need to get money flowing again. Watching this session run in circles, it reminded me of a simple song my mother used to sing about a “hole in a bucket”, and the cascading flow of suggested fixes, with each leading to another, but none of them fixing the original problem (see song here)
While it may seem important to pressure banks to lend more (and it may look good on camera to appear tough on bankers)… pressuring the “traditional” banks to lend more won’t fix the problem of “deleveraging” of global financial system.
The problem with contraction of credit lies outside of the traditional commercial banking realm, and instead can be found in the (forced) contraction of the “shadow banking market“ (comprising hedge funds, broker-dealers, private equity funds, structured investment vehicles and conduits and money market funds, etc..).
Shadow Market troubles…
The traditional banks may be lending, but even if the traditional commercial banks were to open up the gates, and let their capital flow, they can’t make up for the massive-gaping-hole that is missing from the “shadow banking” market that has gone “missing in action” (or, off the cliff)…
Securitization has for several years exceeded bank loans as a percentage of private credit market debt.
In contrast to recent headlines, however, banks have been picking up their lending, but it has been the “shadow banks” that have faltered.
Banks have been recapitalized – yes – and banks have cautiously started to lend. But shadow banks are still delevering due to disappearing and unavailable fresh capital and, as they do, they continue to drag asset prices with them…
…while new loans can be and are being advanced via the banking system, it’s a much more difficult task to force shadow banks to lend. That lending depends on securitization which in turn depends on stable and eventually higher asset prices than currently exist
source: PIMCO
How big could the “hole” be?
Estimates are all over the board, so rather than try to make my own guess as to the size of the liability, Im going to share with you some of the more educated guesses Ive seen recently, and let you draw your own conclusions:
in January 2008 the International Monetary Fund published its $1tn estimate for the losses (that number has been revised upwards). Newer estimates look much worse…..according to Martin Wolf: “The International Monetary Fund argues that potential losses on US-originated credit assets alone are now $2,200bn (€1,700bn, £1,500bn), up from $1,400bn just last October. This is almost identical to the latest estimates from Goldman Sachs. In recent comments to the Financial Times, Nouriel Roubini of RGE Monitor and the Stern School of New York University estimates peak losses on US-generated assets at $3,600bn. Fortunately for the US, half of these losses will fall abroad. But, the rest of the world will strike back: as the world economy implodes, huge losses abroad – on sovereign, housing and corporate debt – will surely fall on US institutions, with dire effects.
Derivatives Market size…
If you look at global derivatives markets, according to the BIS, you see that there was
- Notional amounts outstanding: June’08 = $683,725 billion
- Gross market values = $20,353 billion (approx $20 Trillion USD!!)
- “Notional” value is the “maximum losses in case of a meltdown” ….and gives an idicator of the market’s size
- “gross market values” tells you the scale of financial risk transfer taking place in derivatives markets.”
Lets use the smaller number in this discussion. If you round down to $20 trillion, thats an incredible amount of money. The size of this mountain of “side-bets” (or “weapons of mass distruction, as Warren Buffet called them) is difficult to really put in personal terms. I found a great description of the magnitude of the mountain here:
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U.S. annual gross domestic product is about $15 trillion
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U.S. money supply is also about $15 trillion
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Current proposed U.S. federal budget is $3 trillion
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U.S. government’s maximum legal debt is $9 trillion
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U.S. mutual fund companies manage about $12 trillion
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World’s GDPs for all nations is approximately $50 trillion
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Unfunded Social Security and Medicare benefits $50 trillion to $65 trillion
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Total value of the world’s real estate is estimated at about $75 trillion
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Total value of world’s stock and bond markets is more than $100 trillion
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BIS valuation of world’s derivatives back in 2002 was about $100 trillion
- BIS 2007 valuation of the world’s derivatives was a whopping $516 trillion
- June ‘08…it grew to $683,000,000,000,000 (yes, thats Trillion, with a “T”)
- source: PIMCO
A massive “hole in the bucket”
You see, there’s a “hole in the bucket, deal Liza” (see video below here, if you dont know this one). And, no quantity of extra lending from traditional banks will fill that hole.
Links for more (from GloboTrends):
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The “savings glut” theory is one of the two main competing theories to explain some of the bigger mysteries of global finance in recent years (including the credit crisis of 2007 ). The basis of this theory is that there are underlying fundamental “global imbalances” which are causing all of the trouble (and which need to be fixed in order for the crises to stop). In this blog post, Im going to quickly outline “savings glut” theory…
The other theory (money glut)
The more popular (and easier to understand) theory (which Im not going to cover in this blog) is called the “money glut” theory…which basically says that American Central Bank kept interest rates too low for too long, which led to too much money, too much credit and encouraged too much risk taking by banks and greedy people on wall street. This is the popular version of the story that most people hear every night from their local news commentator. This is NOT the theory that Im going to review in this blog posting.
Savings glut (summarized)
The less well known (and more difficult to understand) theory of what-went-wrong…is the “savings glut theory”….which basically says that the root of the problem lies not within the US, but with the fundamental imbalance of international finance.
While finance is risky (borrow short, lend long), it is even more risky when it crosses borders. Countries in Asia and Latin America learned the lesson not to accept deficits after punishing recessions in the 1990’s and early 2000’s. Since then, nearly all emerging nations (and most developed ones, minus USA) have fought hard to keep current account surpluses. In an effort to keep away from risky deficits, many central banks (especially in emerging Asia) have purposefully chosen to (a) keep their currencies undervalued, and (b) to accumulate foreign exchange reserves to buffer against potential shocks. Note that the countries with large reserves in 2009 are the ones most likely to survive this latest crisis with their economies in tact. After seeing the prescriptions given by the IMF after the last round of crises, most emerging countries said “no thanks” to foreign capital, and instead have chosen to run massive surpluses.
The key to understanding the “savings glut” theory is to first understand that the nations “balance of payments“, by definition, must BALANCE. That means that if a country chooses not to accept foreign capital, and therefore if they choose to run a capital account deficit…then they must by definition also run a current account surplus (the current account is physical goods exports). That means that in order to export capital, they must also export products (I know, it gets a bit confusing, sorry). The net result = they must keep the currency undervalued for this to work. And the currency of choice = the US dollar (as a target peg).
“Ok, so what is the problem?” you might ask…
Well, due to the rules of global accounting…if one country runs a current account surplus, then others must run a current account deficit. That part is easy to understand….if one country exports, another must import. Ok, but what is less obvious is that if one country runs a capital account surplus (think China), then another MUST run a capital account surplus (think USA). This is the root of the “savings glut” theory…
The savings glut theory states that sometime in the late 1990’s to early 2000’s…there was a massive amount of countries that all decided “thats enough”…no more foreign capital can come in. It was too risky, and led to too many crises. As Martin Wolf says, they chose to “smoke, but not inhale” from international finance…and so began a massive financial recycling program, whereby money that came in quickly was sent back to sender. Money no longer flowed from rich countries to poor ones…instead money was borrowed on a massive scale from poor ones to rich ones.
Why did this happen? The theory is that international finance proved to be too risky, and so developing countries almost unanimously chose to reject international finance and send it back. (the only emerging markets that did not follow this prescription seems to have been the emerging Eastern European nations, many of which are now facing crisis…on a much deeper scale than emerging Asia).
Enter the “borrower of last resort”
But, with all of these emerging countries sending money back, unfortunately, there was only ONE country on the planet that was willing and able to accept it: the USA. (note that economists that subscribe to this theory are extremely critical of Germany / Japan and other developed nations that did not take some of this capital that was flooding the USA).
The US, as the theory goes, was uniquely capable to absorb this flood of “savings” because the US dollar was the global reserve currency, and the US could borrow in its own currency on a massive scale (with no chance of foreign exchange crisis).
Who Believes this theory?
Surprisingly, the “savings glut” theory has some pretty impressive followers…
- Ben Bernanke is the most famous. He outlined this exact position in a famous speech in 2005: http://www.federalreserve.gov/boarddocs/speeches/2005/200503102/default.htm
- Another is Martin Wolf (FT.com chief columnist). Take a chance and read his book on “Fixing Global Finance” see link below… it is a very well documented, and well thought out summary of the global “savings glut” theory (with his recommendations for the future)… a summary (brief) can be found here: http://www.ft.com/cms/s/0/f7d97f0c-1901-11dc-a961-000b5df10621.html
- Another is Greenspan…who in 2005, called the mixture of low long-term interest rates and high productivity growth a “conundrum”, which could only be explained by a flood a cheap credit from abroad… see http://www.federalreserve.gov/Boarddocs/hh/2005/february/testimony.htm
- Even the Economist magazine seems to have jumped on board with this theory as of late. (see the special report on fixing global finance here and here)
- the list goes on and on….
Who is to right? Who is to blame?
The reality is that both “savings glut” theorists and “money glut” practitioners are probably each 1/2 right. I read somewhere…”the Chinese may have supplied the noose, but it was the US that strangled themselves”…Thats probably the most accurate way of reconciling the “savings glut” vs “money glut” theories…
