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May 1, 2008

The Inappropriateness of Financial Regulation

I have had the misfortune or fortune of being up close and personal with seven major financial crises in my banking career, from the US Savings and Loans crisis of the late 1980s to today’s credit crunch. In each crisis I have observed a “cycle” in the response to the crisis. In the middle of a crisis, when circumstances look dire and chunks of the financial system are falling off, proposals get radical. I recall in December 1992, with the UK and Italy having already been ejected from the European Exchange Rate Mechanism and Spain and Portugal looking vulnerable, some European policy makers flirted with capital controls. But a few months after each crisis is over, these radical plans are tidied away and we are left with three things. And they are always the same three things: better disclosure, prudential controls and risk management.

These measures are the regulatory version of apple pie and ice cream. Who would say no? The thing is – we have been investing heavily in these areas for the past twenty years and do not have much to show for it in terms of financial stability. Over the past eleven years we have had the Asian Financial Crisis, LTCM, the “dotcom bezzle” and now the credit crunch. While more disclosure, controls, and risk management are generally good things and necessary fraud reducing measures, there are few crises I have known from the inside that would not have happened if only there was more disclosure. People knew that sub-prime was a poor risk – it is called sub-prime, after all.

Regulatory shortcomings

The problem is more fundamental, and, unless we address these fundamental issues, we will be condemned to repeat the cycle of boom and bust. Lying close to the heart of the problem in all of these recent crises, from today’s credit crunch to the Savings and Loans debacle and beyond, is the inappropriateness of financial regulation.

My own view of banking regulation would be considered quaint next to today’s practice. I consider the primary objective of intervening in the banking market to be mitigating the substantial systemic consequences of market failure in banking. It is therefore puzzling to me that market prices are now placed at the heart of modern financial regulation, whether in the form of mark-to-market accounting or the market price of risk in risk models. It is not clear to me how we can rely on market prices to protect us from a failure of market prices. I have discussed this before many times so I will focus on the secondary objective, which is to avoid the discouragement of good banking.

A good bank is one that lends to a borrower that other banks would not lend to because of their superior knowledge of the borrower or one that would not lend to a borrower to which everyone lends because of their superior knowledge of the borrower. Modern regulators believe this is too quaint, and, to be fair, many banks were not any good at it. But instead of removing banking licenses from these banks, regulators decided to do away with relationship banking altogether and promoted a switch away from bank finance to market finance where loans are securitised, given public ratings, sold to many investors including other banks, and assessed using approved risk tools that are sensitive to publicly available prices. Now, bankers lend to borrowers that everyone else is lending to, the outcome of a process where the public price of risk is compared with its historic average and a control is applied based on public ratings.

Market finance

This switch to market finance improved “search liquidity” in quiet times. Credit risk that was previously bundled with market and liquidity risk was separated, priced and traded. This has improved the transparency and tradability, but it comes at the expense of systemic liquidity in noisy times.

Almost every economic model will tell you that if all the players have the same tastes (reduce capital adequacy requirements) and have the same information (public ratings, approved risk-models using market prices) that the system will sooner or later send the herd off the cliff edge (Persaud 2000). And no degree of greater sophistication in the modelling of the price of risk will get around this fact. In this world, where falling prices generate more sell-orders from price-sensitive risk models, markets will not be self-stabilising but destabilising and the only way to short-circuit the systemic collapse is for a non-market actor, like some agent of the tax payer, to come in and buy up assets to put a floor under their prices. (I wrote about this liquidity trade-off with some colleagues; Laganá et al. 2006)

Now this is a legitimate model: the marketisation of finance and the resulting improvement in search liquidity in quiet times, coupled with direct state intervention in the crisis. It is the model we have today. But I venture that it is a highly dangerous model. It is expropriation of gains by bankers and socialization of costs by taxpayers. Paying for a decade of bank bonuses can be very expensive for the taxpayer and the opportunities for moral hazard are enormous.

An alternative approach

The alternative model rests on three pillars. The first recognises that the biggest source of market and systemic failure is the economic cycle and so regulation cannot be blind and deaf to the cycle – it must put it close to the centre. Charles Goodhart and I have proposed contra-cyclical charges – capital charges that rise as the market price of risk falls as measured by financial market prices – and a good starting point for implementation of such charges is the Spanish system of dynamic provisioning (Goodhart and Persaud 2008).

The second pillar focuses regulation on systemically important distinctions, such as maturity mismatches and leverage, and not on out-dated distinctions between banks and non-banks. Institutions without leverage or mismatch should be lightly regulated – if at all – and in particular would not be required to adhere to short term rules such as mark-to-market accounting or market-price risk sensitivity that contribute to market dislocation. Bankers will argue against this, saying that it creates an unlevel playing field, but financial markets are based on diversity, not homogeneity. Incentivising long-term investors to behave long-term will mean that there will be more buyers when banks are forced to sell.

The third pillar is requiring banks to pay an insurance premium to tax payers against the risk that the tax payer will be required to bail them out. If such a market could be created, it would not only incentivise good banking and push the focus of regulation away from process to outcomes, but it would provide an incentive for banks to be less systemic. Today, banks have an incentive to be more systemic as a bail out is then guaranteed. The right response to Citibank’s routine failure to anticipate its credit risks is not for it to keep on getting bigger so that it can remain too big to fail, but for it to whither away under rising insurance premiums paid to tax payers.

Avinash Persaud is Chairman of Intelligence Capital


Goodhart, Charles and Avinash Persaud (2008). “How to avoid the next crash.” Financial Times, January 30.

Laganá, Marco, Martin Peřina, Isabel von Köppen-Mertes and Avinash Persaud (2006). "Implications for liquidity from innovation and transparency in the European corporate bond market." ECB Occasional Paper No. 50, August.

Persaud, Avinash (2000). “Sending the Herd off the Cliff Edge.” World Economics 1(4): 15-26.

May 2, 2008

Greenspan and His Critics Misread Housing

Greenspan’s critics conclude to varying degrees that his decision to reduce the Fed funds target to 1 percent, in 2003, where it remained for a year, was the cause of the property boom and that the reversal of this policy was the cause of subsequent house price declines.

For his critics to be correct there would presumably have to exist historical evidence showing that low nominal rates of interest have correlated with vibrant housing markets. Very little evidence supporting such a claim can be found.

Take, for example, the aftermath of President Nixon’s decision to sever the dollar’s link to gold, when the cash rate targeted by the Fed began to rise. Sitting at 5.5 percent in August of 1971, it reached a high of 10 percent by the end of 1973. Despite this substantial increase in the rate target, according to economic historian Allen Matusow’s book Nixon’s Economy, “Housing emerged as the most dynamic sector” in the early 70s.

Moving to Jimmy Carter’s presidency, from a low of 5 percent in 1976, the Fed funds rate rose all the way to 13 percent by the end of the decade. Housing hardly faltered, and as William Greider noted in Secrets of the Temple, the economy of the Carter years “improved the financial status of large classes of ordinary Americans,” and “particularly benefited the broad middle class of families that owned their homes.”

George Gilder arguably chronicled the late 70s housing market best in his 1981 book, Wealth and Poverty. Describing the property boom that occurred amidst skyrocketing interest rates, Gilder wrote, “What happened was that citizens speculated on their homes…Not only did their houses tend to rise in value about 20 percent faster than the price index, but with their small equity exposure they could gain higher percentage returns than all but the most phenomenally lucky shareholders.” Shades of this decade?

To show how this seemingly contrarian rate phenomenon is not unique to the U.S., we can look to Great Britain in the 70s. Although the Bank of England moved the bank rate from 5 to 9 percent in 1972, David Smith noted in The Rise and Fall of Monetarism that the sector which investors “chose above all others was property development.” Reflecting on the pound crisis years later, the June 1978 Bank of England Quarterly Bulletin explained that “There was no other general area of economic activity which seemed to offer as good a prospective rate of return to an entrepreneur as property development.” That was the case owing to the belief “that property was the inflation hedge par excellence.”

That the level of interest rates is somewhat of a sideshow when it comes to home prices—or even a contrarian indicator—raises the obvious question of what drives the property market. The answer is a fairly simple one, and it involves the direction of the currency; in our case, the dollar. While economic vitality is a certain factor when it comes to the health of the housing sector, as my Wainwright colleague David Ranson wrote last August in the Wall Street Journal, “the relationship between housing prices and the prices of highly inflation-sensitive assets such as commodities is much more impressive than the relationship with the economy.”

Notably, empirical evidence produced by Wainwright supports the conclusion that rising rates of interest don’t drive down housing prices in the way that intuition perhaps suggests they might. Indeed, nominal home prices since 1976 have increased the most when T-bill rates have risen over 200 basis points, and they’ve declined the most when those same rates have fallen more than 200 basis points.

This reasoning contradicts the popular assumption today suggesting that low interest rates explain the weak dollar. Instead, as dollar history has shown, the greenback has more frequently exhibited the weakness that’s reflected in the rising price of gold and home prices when rates are rising. If anything, this speaks to non-interest rate and non-Fed factors that have driven the dollar’s direction in recent times including geopolitical events, domestic policy decisions such as taxes and tariffs, and most importantly, the stance taken by the U.S. Treasury when it comes to defining the dollar’s price.

Looking at this from the perspective of Treasury actions in this decade, Secretaries O’Neill and Snow mocked or questioned the importance of a strong dollar, while Secretary Paulson has frequently attempted to use his outsized reputation in China to force a revaluation of the yuan against the dollar. The actions of all three secretaries were an implicit communication to the markets that a weaker dollar was the Bush administration’s true policy, and those policies, combined with 9/11 and the imposition of tariffs on steel, lumber and shrimp in 2002 led to a falling dollar that powerfully drove up nominal home prices.

Much has also been made of the subprime debacle being directly related to low nominal rates along with laws such as the Community Reinvestment Act; the latter forcing lenders to make unwise loans in areas previously “redlined” by banks. While both arguably factored into the lending equation of recent vintage, they arguably whitewash over what really happened.

Put simply, when the unit of account weakens, there’s a flight to the real. Not only is housing an asset that is least vulnerable to a falling currency (compare the slight drop in home prices to the drop in equities over the last year), it’s an asset that in fact thrives in nominal terms in times of currency weakness. So while low rates and unfortunate legislation surely contributed to the property boom and subsequent moderation, the major factor has been dollar debasement that in Ranson’s words led capital “into assets that are invulnerable” to that same debasement.

In short, for Greenspan’s critics to be correct, there would have to be an historical correlation between low nominal rates of interest and currency weakness. That’s there’s very little speaks to criticism of the former Fed Chair that’s either misdirected, or unclear.

Mr. Greenspan’s recent responses to his critics have rightly failed when it came to repairing any reputation lost. More surprisingly, he’s embraced the very supposition about low rates and housing vitality used by his critics.

In Greenspan’s case, he’s pointed to falling rates as the driver of “remarkably similar housing bubbles that emerged in more than two dozen countries between 2001 and 2006.” To his way of thinking, a glut of savings worldwide pushed rates downward such that housing was the sure beneficiary.

The notion of a “glut” of savings is something that’s been similarly embraced by Greenspan’s successor at the Fed, but the assumption is a fallacious one. To believe in the concept of excessive saving is to assume a place in time where all human wants are satisfied such that capital would have to find another home; in the present case, property. But since we’ll never reach such a point due to the happy existence of entrepreneurs eager to serve infinite human wants, the idea that we hit nirvana in 2001 seems a bit farfetched.

Greenspan concluded that “the evidence that monetary policy added to the bubble is statistically very fragile.” By his lights, if there was such thing as a property bubble, it was a world event rather than something endemic to the United States.

In defending himself incorrectly, Greenspan missed the chance to prove his critics wrong. Contrary to his suggestions otherwise, monetary policy was at the heart of this decade’s real-estate boom, but not in the way Greenspan’s critics assume.

Mentioned earlier was the falling dollar since 2001, and the combination of geopolitical and policy factors that led to its weakness. Though the nominal level of rates (in particular, low rates) is a not very predictive indicator when it comes to the value of the dollar, exogenous and endogenous factors have historically affected the dollar negatively, and did so in this decade. So in talking about monetary policy, we should say the absence of policy, particularly any policy from Treasury meant to define the greenback’s price, made the dollar’s value vulnerable such that it weakened and fed the property boom.

And when we consider Greenspan’s argument that real estate rallied around the world, it has to be remembered that when the dollar weakens, foreign central banks frequently feel the need to devalue their currencies alongside ours. Indeed, lost in all the modern commentary about the dollar’s weakness versus all manner of foreign currencies is the certain truth that a falling dollar begets world inflation.

Simply put, comparing the dollar against other kinds of money in a floating currency world involves comparing one piece of paper lacking definition to another. When we bring an objective benchmark such as gold into the equation, an entirely different story emerges.

The story is a basic one, and it shows that the oft-chronicled foreign currency strength of recent vintage has been a mirage; one that has obscured the broad currency weakness that the dollar’s even greater weakness has hidden. Since 2001, the price of gold in terms of the British pound, euro and Aussie dollar respectively has increased 151, 101, and 94 percent, while our neighbors in Canada have seen the price of gold in terms of their own dollar rise 122 percent.

Seeking to maintain some level of parity with the dollar with trade in mind, foreign central banks in this decade have added to the U.S. mistake by allowing their own currencies to depreciate relative to gold. And with real estate most correlative with commodities, dollar policy stateside has led to a worldwide commodity boom in nominal terms that drove capital into appreciating real assets including housing. A lot has been said about the recent moderation of home prices, but the real correction will occur if and when U.S. monetary authorities seek to rein in dollar weakness.

There are varying views as to the Fed’s ability to control the dollar’s value with its interest-rate mechanism. But for one to tie this decade’s property boom to the level of rates is to defy history suggesting otherwise. The low nominal rates targeted by Greenspan were decidedly not the cause of the housing boom. Unfortunately, explanations by his critics about what happened proved just as wanting.

Contradictory Food-Price Signals

News reports leave little doubt that high prices are hitting subsistence level consumers around the world, and anger has lead to riots. Images of gaunt refugees swarming delivery trucks flash in our minds when we hear aid agencies speak of the plight induced by high prices. The economic logic makes the argument a reasonable one and having an American policy causing hunger is surely a gripping story.

Free market advocates have jumped on the news with gusto to pillory the distortions of non-market mechanism of mandates. Many have become quickly convinced that ethanol subsidies alone are guilty. The evidence has been enough to convince Texas Senator Kay Bailey Hutchison to propose legislation to freeze biofuel mandates at current levels. In her recent op-ed she authoritatively states, “The fact that America's energy policies are creating global instability should concern the leaders of both political parties. Restraining the dangerous effects of artificially inflated demand for ethanol should be an issue that unites both conservatives and progressives.” Some writers have been more calamitous, such as Deroy Murdock on National Review Online who exclaims, “’Stop!’ The emergency brake should be pulled — NOW — before ethanol wreaks further havoc.” The topic and implications have clearly yielded a lot of strong emotions.

Hyperbole aside, it would be compelling logic if only it did not directly contradict the logic against farm subsidies. Over the last few years, free market advocates portrayed the same higher prices as being good for the poorest countries. David T. Griswold of the Cato institute in his 2006 paper “Grain Drain: The Hidden Cost of Rice Subsidies” states, in reference to farm subsidies, that “U.S. policy drives down prices for rice by 4 to 6 percent. Those lower prices, in turn, perpetuate poverty and hardship for millions of rice farmers in developing countries” If farm subsidies cause lower prices and perpetuate poverty, how can ethanol mandates raise prices and perpetuate poverty? Higher prices can not be a virtue of farm subsidies, yet a vice of ethanol subsidies.

The reality is that higher food prices cause consumers to lose and producers to win, and the net effect may be positive for these poorer countries dealing with the current market disruption. The market is giving a price signal to third world producers to revive dormant production. Previously they were pushed out of production when developed-world farm subsidies undercut world prices. If Mr. Griswold is correct, then high prices may be a boon for the most desperately poor because farming is one of the few forms of production that requires virtually no capital at its most basic level. The short-term pain for consumers may be a long-term gain as the inflated prices have finally produced a profitable environment for farming in countries so desperately in need of stable food supplies and expanded enterprise.

Ethanol as the sole explanation is hard to swallow in light of other global economic issues as well. With a laundry list of other commodities experiencing price spikes in recent years it seems a stretch to think that grains are not also subject to the same forces. From the weak dollar effects of Fed policy to the rising consumer class in India and China, explanations for the broad rise in commodities are being ignored in the narrow interest of unwinding ethanol subsidies.

The economic reasoning is there to explain that ethanol mandates increase prices, but exaggerating its effects for political expediency is dishonest. It has also not been established that high food prices are unequivocally against the interest of poorer nations. If the oft-stated objection to farm subsidies is the negative effects of lower food prices on the third world, drumming this claim that high food prices are bad into the folk economic understanding of Americans harms efforts to eliminate both market distortions. Ethanol mandates may have failed in many ways, but this attack doesn’t hold much water.

May 6, 2008

Fed Funds, Inflation & Crime

Put simply, government can take from us in two ways: first by taxing our income, and second through the debasement of the money we earn. While marginal tax rates fell across the board for Americans in 2003, the federal government has more than erased those gains through its oversight of a collapsing dollar that began to decline in 2001. With money not buying nearly as much as it used to (a dollar bought 1/253rd of an ounce of gold in 2001 compared 1/870th of an ounce today) some citizens are apparently resorting to crime to retrieve some of what the federal government has taken.

Commodities are of course priced in dollars, and with the dollar’s fall, commodities have shined such that thievery has been on the rise. And even though commodities have been surging for nearly seven years, record highs reached since last fall have generated a not insignificant amount of editorials fingering the declining Fed funds rate as the cause. Going back to last September, the Fed has overseen reductions in its target rate of 325 basis points, and looked at in isolation, editorials suggesting a correlation between rate decreases and a falling greenback would seemingly make a lot of sense. Since the Fed began reducing rates last September the dollar price of gold has risen 29 percent, and oil has risen 59 percent.

But what frequently goes unmentioned is the direction of commodities from June of 2004 to September of 2007; a period in which the Fed funds rate was increased 425 basis points. During the time in question, the dollar price of gold rose 72 percent, and the price of oil rose 85 percent.

As Stanford economist Ronald McKinnon wrote in his 1996 book Rules of the Game, “the traditional ‘Keynesian’ precepts of monetary management, where ‘the’ absolute level of nominal rates of interest is accepted as a measure of ease or tightness, are highly suspect.” Notably, dollar history since 1971 shows a much greater correlation between a weak dollar and rising rates, as opposed to the consensus assumptions today suggesting the opposite. Faulty intuition or perhaps repetition of the statement that high nominal rates mean the Fed is “tight” has won out over empirical evidence revealing something quite different.

In August of 1971 (a worthwhile dateline considering August marked the end of the Bretton Woods system of fixed exchange rates) the Fed funds rate sat at 5.5%, but by year-end 1974 the rate had risen 300 basis points. Despite this alleged tightening gold rose 385 percent. From 1974 to 1977, the Fed’s cash rate fell roughly 300 basis points, and gold fell 20 percent.

From January of 1977 to January of 1980, the Fed funds rate was increased 925 basis points, but rather than a tightening whereby the dollar price of gold collapsed, the yellow metal instead rose 686 percent. As mentioned before, intuition perhaps suggests the Fed tightens or strengthens the dollar when it raises rates, but referencing McKinnon once again as to what happened in the 70s, “the higher American rate of interest reduced the demand for non-interest bearing dollar balances while, at the same time, the Federal Reserve failed to reduce the supply of base money commensurately (emphasis mine).”

More modernly, the Fed began raising rates in July of 1999, lifting the key interest rate from 5 percent to 6.5 percent in November 2000. Amidst this seeming austerity, gold actually rose from $258 to $265 an ounce. In December 2000 the Fed began lowering the bank rate once again, from 6.5 percent to 3.75 percent by July of 2001. But after 275 basis points of rate cuts, the gold price was largely unchanged.

All of the previous examples ignore the outsized impact Treasury policy has on the direction of the dollar, along with geopolitical and domestic factors such as terrorism and tax rates that surely impact trust in the currency, and general demand for same. So even if the negative impact on the dollar due to high rates of interest is wholly coincidental, there remains the question of whether the Fed funds rate itself is the driver of currency liquidity and valuations as so many assume.

In considering this, we can look to RealClearMarkets articles by Wayne Jett and Doug Johnson. Sure enough, Jett and Johnson have made the basic point that, “the funds rate is not the valve to liquidity flows that it has been represented to be.” Both have bolstered the latter view through presentation of a St. Louis Fed study explaining just that. Indeed, as Johnson noted in an article last week, even though the Fed funds rate see-sawed from 1% to 19% from the 50s to the 80s, “base money reserves grew at a steady 3.1% annual rate regardless of the Fed funds rate.”

Moving to rate comparisons, when not decrying allegedly low nominal cash rates, many editorials have mentioned low levels of U.S. rates relative to those in other countries as an explanation of the dollar’s woes. The logic underpinning the latter argument is that high nominal rates attract investment which allegedly bolsters the currency; an assumption that at first blush seems logical until we consider that U.S. rates in the 70s were higher and the dollar weak precisely because investment was lagging. If that’s not enough, since 1978 Japanese long-term rates have averaged 3 to 4 percentage points lower than those in the U.S., but rather than a yen negative, the latter has risen well over 100 percent against the dollar.

In defense of rate-hike advocates, the positions taken by those in that camp emanate from a pro-dollar perspective in the sense that a stronger dollar is desired. But it should at the very least be acknowledged that the overnight rate for money set by the Fed is artificial, and even at 2 percent it is roughly 30 basis points above 6 month T-Bill rates set by markets and over 60 basis points higher than 3 month T-Bills. With T-Bill rates in mind, can any rate hawk credibly suggest that the overnight rate for cash would be higher than 3 and 6-month rates in a free-floating rate environment?

In the end, it should be remembered that strong, stable currencies are low-rate currencies. Rather than engaging in rate machinations totally unsuited to achieving a strong and stable dollar, rate hawks might concede that as the issuer of the world’s reserve currency, we should have the lowest rates in the world. Rather than utilizing the highly questionable rate mechanism to fix the dollar, a better solution would be to jawbone the U.S. Treasury to simply define the dollar in terms of gold; an action that if credibly done would cause a positive collapse in rates across the curve. If so, tales of beehive thefts and recession would quickly disappear.

May 7, 2008

The Good News You Missed on Food Prices

• A story in Friday’s Chicago Tribune talked of “desperate” money-saving tactics grocery shoppers are resorting to in order to keep down their weekly food bill.

• An Associate Press story the day before told of consumers who are now stockpiling food as a hedge against future inflation as well as potential shortages.

If you know anything about food prices in America, you know that what all of these stories lack is a serious dose of context. Over the last several decades groceries have been one of the real bargains in America, and the average rate of inflation on dozens of food items tracked by the U.S. Bureau of Labor Statistics has consistently been less than increases in the purchasing power of the average American family. As a result, the percentage of income that families devote to their food purchases has fallen sharply since the food inflation of the 1970s, even though more and more Americans (like Sen. Schumer’s family, judging by his testimony) have opted for buying more premium-priced items, like organic foods. Recent price spikes have done little to reverse years of moderation in the cost of food.

The good news started for most consumers in the 1980s and has continued since then. In the decade before, food prices rose at average annual clip of 8.4 percent, which was more than a full point above the overall inflation rate. But in the 1980s, the rate of inflation on food items declined to 4.6 percent annually, nearly a point below general inflation. That downward momentum continued in the 1990s, when food prices rose by a mere 2.8 percent annually, a trend that has pretty much continued in the new century until the last few months.

You probably missed the many media stories over the years about what a bargain food has become, or maybe there simply weren’t many such stories. But one result of these very moderate increases in food prices is that we are paying less, sometimes considerably less, relative to our purchasing power today for a whole range of products, including many staples.

A pound of ground beef, for instance, cost $1.86 in March of 1980, which is, according to the BLS’ own cost-of-living calculator, the equivalent of $4.82 in buying power today. But in March of this year (the most recent monthly data, on which most pricing stories are based), a pound of ground beef cost on average just $2.82 in the United States.

A pound of fresh chicken, one of a dozen food basics that the BLS includes in its most-requested data series, was 67 cents in 1980, the equivalent of $1.71 in buying power today, though the actual average cost of chicken in March 2008 was just $1.17 a pound. A pound of coffee was $3.25 in 1980, the equivalent of $8.42 today. While you might pay that much for a pound of Starbucks coffee, the average retail price of coffee in American stores in March 2008 was $3.48.

Even among those items where price hikes have been steepest in the last year, consumers are hardly very far behind. Price spikes on flour have received enormous media attention, with Sen. Schumer observing that the cost of flour is up a “whopping” 32 percent in a year. But the increase comes after years when the price of flour was relatively stable. As a result, in March, a pound of flour cost 49 cents, compared to 21 cents a pound in 1980, which is the equivalent of 55 cents in today’s dollars.

In some cases, prices are rising now after having fallen. Sen. Schumer complained that bananas are up in price about 13 percent in the last year. True, but the Senator forgot to mention that the inflation rate for bananas has been negligible for years, and that in fact the price of a pound of bananas dropped by nearly 6 percent in 2004. That’s why bananas, at 59 cents a pound in March, are still a bargain compared to bananas which on an inflation-adjusted basis cost consumers 91 cents in 1980.

These differences are significant enough once you add them all up that they have helped produce a sharp decline in the percent of household income that the average family is paying for food. Since 1984 the BLS has tracked the impact of spending on dozens of categories—from groceries and energy to apparel, health care and entertainment—on family budgets. In 1984 the average family spent 9.3 percent of its after-tax income on food at home, but by 2006 (the latest year statistics are available) that percentage had fallen to just 5.9 percent of after-tax income. Even with the recent price hikes, Americans are spending on average about a third less of their family income on food than they did in 1984, and since food is a staple that everyone purchases, the gains have benefited families across the income spectrum. Among families in the lowest income quintile, spending on food has shrunk from 38 percent of after-tax income to 21 percent since 1984. Those in the second lowest quintile are spending 10 percent of family income on food, compared to 17 percent in 1984.

None of this is surprising to anyone who has spent considerable time in supermarkets over the years, or has watched how food retailing has changed. Consumers have an array of new stores to pick from that offer bargains on food, like warehouse clubs. Technology has driven up productivity in the food distribution network, cutting the cost of deliveries and keeping stores in-stock but not overstocked. The most successful food retailers today operate with net margins that are less than one percent of sales.

America’s low food prices, in other words, have been earned, not gifted from on high. But perhaps after nearly 30 years, some consumers (and much of the media) assume that we’re simply entitled to such low prices every year. Sen. Schumer probably best exemplified that sense of entitlement when, during his testimony, he complained that his daughter is now paying $12 a pound for organic chicken. Given that there’s no scientific evidence that organic foods are any better for us or any safer than other foods on store shelves, it’s hard to work up outrage about someone spending $12 for something that on average costs $1.17 a pound.

This year, economists are predicting food inflation of about 4 percent, which is higher than recent history, but hardly represents hyperinflation. The bad news is we haven’t seen this level of inflation on food since 1990. But that’s the good news, too.

Avoiding a Disorderly Deleveraging

Prolonged financial distress, which has now lasted for almost a year, is debilitating the financial system and risking a full-fledged crisis. Central bank interventions have thus far prevented worst-case outcomes, but they have alleviated symptoms rather than the underlying causes. Financial intermediaries are still in the process of shrinking their balance sheets, thus activating a channel of transmission of financial distress to the real economy.

The recent turmoil is a product of deep flaws in banks’ new business model and recent financial innovations. Many proposed reforms may reduce the risk of these events repeating, but most cannot undo the effects of the present crisis and insure a smooth transition. The immediate problem is a spiral of forced deleveraging and illiquidity, as the link between market and funding illiquidity strains balance sheets. Proposed remedies are either insufficient or unsatisfactory, which means that more radical interventions may be required. In CEPR Policy Insight 22, I propose a bold alternative.

Structural problems and medium-term solutions

The current turmoil can be attributed to a business model in which banks would pool and securitise credits that they originated to distribute them and transfer their risks to a myriad of investors. Though the new model promised benefits in credit allocation, new risk-return investment opportunities, and financial stability, it is now known to have suffered from a catalogue of problems. These range from excessive credit due to permissive monetary policies to flaws in ratings agencies’ risk models, from perverse incentives guiding the agencies and bank managers to regulatory failures. While mending those fault lines is an important task that will require international cooperation, it will at best take care of the future, not the present.

Forced deleveraging and the liquidity spiral

The immediate problem is the disorderly reaction to the unprecedented growth of the financial system’s leverage and its exposure to risk. As demand for asset-backed securities has disappeared, prices have collapsed without finding a floor. Banks are reporting losses that strain their capital positions. The loss of market liquidity affecting all classes of debt securities directly or indirectly owned by intermediaries has translated into a sharp decline of funding liquidity, the more so because short-term debt issued on wholesale markets has become a major component of banks’ funding. The forced adjustment of banks' balance sheets could, in the worst case, result in a credit crunch with painful consequences on the real economy.

Can we break the link between the illiquidity of banks’ securitised assets, which prevents their orderly liquidation, and the shortage of funding liquidity, which is the driving force of the negative feedback originating from the process of deleveraging?

For funding liquidity, emergency liquidity support from central banks has helped lower the temperature in the worst moments, but it is not a long-term solution. Setting a collateral value of illiquid securities does not provide a market for them and hence does not set a floor to their market prices; the collateralized securities remain on the intermediaries’ books, affecting the quality of their balance sheets. Capital increases are also insufficient to break the spiral, as injections of capital may prove inadequate only a few weeks after their announcement.

For market liquidity, suggested remedies are equally inadequate. Mandated full disclosure of losses might reduce uncertainty, but unless market liquidity is instantly restored, full disclosure of the situation at time t offers no guarantee that it will be the same at time t+1. Similarly, retreating from marking financial products to market or model during this time of crisis would face a number of difficulties.

More radical solutions

The feedback between market and funding liquidity problems demands more radical pre-emptive solutions. As long as “there is no immediate prospect that markets in mortgage-backed securities will operate normally”, “the situation will improve only if the overhang of illiquid assets on the banks’ balance sheets is dealt with” (Bank of England 2008). In creating its Special Liquidity Scheme, the Bank of England has moved to serve as the “market maker of last resort.”

The scheme allows banks and building societies to swap some of their illiquid assets, including debt securities rated no less than triple A, for specially issued Treasury Bills for up to three years. Eligible securities will be valued at market prices, if available, or, if not, at a price calculated by the Bank, with haircuts for private debt securities. Changes in market prices or in valuations will require re-margining. The credit risk will remain with the banks, so that there will be a loss for the lender only if the borrower defaults and the value of the collateral falls below that of the bills originally acquired in the operation.

Is the initiative bold enough? The scheme does not set a floor for assets’ market prices and uses market prices to value collateral, despite the fact that during a negative bubble they do not reflect fundamentals. Downward instability may moreover occur if haircut discounted collateral values trigger a convergence process for market prices requiring repeated re-margining.

In CEPR Policy Insight 22, I recommend the creation of a publicly sponsored entity that could issue guaranteed bonds to banks in exchange for illiquid assets, drawing on US Treasury Secretary Nicholas Brady’s solution to the Latin American sovereign debt crisis in 1989. This new entity, preferably multilateral, would value assets based on discounted cash flows and default probabilities rather than crisis-condition market prices.

As a firm floor is set to valuation and illiquid assets otherwise running to waste are replaced by eminently liquid Brady-style bonds, funding difficulties and, at the same time, the market liquidity problems besetting the banks’ balance sheets would be removed. Shielding the banks’ assets from the vagaries of disorderly markets is a necessary condition to dispel the uncertainty that prevents a proper working of credit markets.

Luigi Spaventa is Professor of Economics at the University of Rome and Former Chairman of the Commissione Nazionale per le Società e la Borsa (CONSOB). CEPR Research Fellow.


Bank of England (2008), Special Liquidity Scheme, Information, Market Notice, April 21.

May 8, 2008

Silver Lining In High Food Prices

Here is another truth: the price mechanism is a much better way to allocate natural resources than fighting wars, as the Western powers did in the last century.

The United States’ ill-considered, biofuels, subsidy programme, demonstrates how not to react.

Rather than acknowledge that high fuel prices are the best way to inspire energy conservation and innovation, the Bush administration has instituted huge subsidies to American farmers to grow grains for biofuel production. Never mind that this is inefficient in terms of water and land use.

Moreover, even under the most optimistic scenario, the US and the world will still be relying mainly on conventional fossil fuels until the hydrocarbon era comes to an end (which few of us will live to see).

Last but not least, diverting vast tracts of agricultural land into fuel production has contributed to a doubling of prices for wheat and other grains. With food riots in dozens of countries, isn’t it time to admit that the whole idea was a giant, if well-intentioned, mistake?

Another wrong turn is the proposal recently embraced by presidential candidate Hillary Clinton to temporarily scrap taxes on gasoline.

As laudable as it may be to help low-income drivers deal with soaring fuel costs, this is not the way to do it. The gas tax should be raised, not lowered.

The sad fact is that by keeping oil prices high, Opec is doing far more for environmental conservation than Western politicians who seek to prolong the era of unsustainable Western consumerism.

Of course, it isn't just the cost of oil that is high, but all commodity prices, from metals to food to lumber. Prices for many commodities have doubled over the past couple of years. Oil prices have risen almost 400 per cent in the last five years.

The proximate cause is a global economic boom that has been stronger, longer, and more broad-based than any in modern history.

Asia has led the way, but the past five years have been the best Latin America and Africa have enjoyed in decades.

Some politicians also complain about speculators who are trading commodities on complex and growing markets that allow them to bet on whether, say, future demand from emerging markets is likely to outstrip future supply.

But why is this a bad thing? If “speculators” are bidding up today’s commodity prices because they realise that future generations are going to want commodities too, isn’t that healthy?

High prices for commodities today mean more supply for future generations, while at the same time creating an incentive to develop new ways to conserve on consumption. Again, high prices are helping in ways that Western politicians seem afraid to contemplate.

While surging commodity prices are helping poor farmers and poor resource-rich countries, they are a catastrophe for the urban poor, some of whom spend 50 per cent of their income on food.

One element of the solution is to compensate the very poor for the higher cost of survival. Over the longer term, more money for fertiliser, and other aid to promote self-sufficiency, is also essential.

Kenneth Rogoff is the Thomas D. Cabot Professor of Public Policy and Professor of Economics at Harvard University. He was also the former Chief Economist at the IMF.

The Urgent Need To Abandon Inflation Targeting

The answer came in the form of “inflation targeting”, which says that whenever price growth exceeds a target level, interest rates should be raised. This crude recipe is based on little economic theory or empirical evidence; there is no reason to expect that regardless of the source of inflation, the best response is to increase interest rates. One hopes that most countries will have the good sense not to implement inflation targeting; my sympathies go to the unfortunate citizens of those that do. (Among the list of those who have officially adopted inflation targeting are: Israel, the Czech Republic, Poland, Brazil, Chile, Colombia, SA, Thailand, Korea, Mexico, Hungary, Peru, the Philippines, Slovakia, Indonesia, Romania, New Zealand, Canada, the UK, Sweden, Australia, Iceland and Norway.)

Today, inflation targeting is being put to the test — and it will almost certainly fail. Developing countries currently face higher rates of inflation, not because of poorer macro-management, but because oil and food prices are soaring, and these items represent a much larger share of the average household budget than in rich countries. In China, for example, inflation is approaching 8% or more. In Vietnam, it is expected to approach 18,2% this year, and in India it is 5,8% . By contrast, US inflation stands at 3%. Does that mean that these developing countries should raise their interest rates far more than the US?

Inflation in these countries is, for the most part, imported. Raising interest rates won’t have much effect on the international price of grains or fuel. Indeed, given the size of the US economy, a slowdown there might conceivably have a far bigger effect on global prices than a slowdown in any developing country, which suggests that, from a global perspective, US interest rates, and not those in developing countries, should be raised.

So long as developing countries remain integrated into the global economy — and do not take measures to restrain the impact of international prices on domestic prices — domestic prices of rice and other grains are bound to rise markedly when international prices do.

Raising interest rates can reduce aggregate demand, which can slow the economy and tame increases in prices of some goods and services, especially
nontraded goods and services. But, unless taken to an intolerable level, these measures by themselves cannot bring inflation down to the targeted levels. For example, even if global energy and food prices increase at a more moderate rate than now — for example, 20% per year — and get reflected in domestic prices, bringing the overall inflation rate to, say, 3% would require markedly falling prices elsewhere. That would almost surely entail a marked economic slowdown and high unemployment. The cure would be worse than the disease.

So, what should be done? First, politicians, or central bankers, should not be blamed for imported inflation, just as we should not give them credit for low inflation when the global environment is benign.

Second, we must recognise that high prices can cause enormous stress, especially for poorer people . Riots and protests in some developing countries are just the worst manifestation of this.

Advocates of trade liberalisation touted its advantages; but they were never fully honest about its risks, against which markets typically fail to provide adequate insurance. When it comes to agriculture, developed countries, such as the US and European Union members, insulate both consumers and farmers from these risks. But most developing countries do not have the institutional structures, or the resources, to do likewise. Many are imposing emergency measures like export taxes or bans, which help their own citizens, but at the expense of those elsewhere.

If we are to avoid an even stronger backlash against globalisation, the west must respond quickly. Biofuel subsidies, which have encouraged the shift of land from producing food into energy, must be repealed. Some of the billions spent to subsidise western farmers should now be spent to help poorer developing countries meet their basic food and energy needs.

Most importantly, both developing and developed countries need to abandon inflation targeting. The struggle to meet rising food and energy prices is hard enough. The weaker economy and higher unemployment that inflation targeting brings won’t have much effect on inflation; it will only make the task of surviving in these conditions more difficult.

Joseph Stiglitz is Professor of Economics at Columbia University. He was the recipient of the 2001 Nobel Prize in economics.

Blame The Models

A well-known American economist, drafted during World War II to work in the US Army meteorological service in England, got a phone call from a general in May 1944 asking for the weather forecast for Normandy in early June. The economist replied that it was impossible to forecast weather that far into the future. The general wholeheartedly agreed but nevertheless needed the number now for planning purposes.

Similar logic lies at the heart of the current crisis

Statistical modelling increasingly drives decision-making in the financial system while at the same time significant questions remain about model reliability and whether market participants trust these models. If we ask practitioners, regulators, or academics what they think of the quality of the statistical models underpinning pricing and risk analysis, their response is frequently negative. At the same time, many of these same individuals have no qualms about an ever-increasing use of models, not only for internal risk control but especially for the assessment of systemic risk and therefore the regulation of financial institutions.1 To have numbers seems to be more important than whether the numbers are reliable. This is a paradox. How can we simultaneously mistrust models and advocate their use?

What’s in a rating?

Understanding this paradox helps in understanding both how the crisis came about and the frequently inappropriate responses to the crisis. At the heart of the crisis is the quality of ratings on structured investment vehicles (SIVs). These ratings are generated by highly sophisticated statistical models.

Subprime mortgages have generated most headlines. That is of course simplistic. A single asset class worth only $400 billion should not be able to cause such turmoil. And indeed, the problem lies elsewhere, with how financial institutions packaged subprime loans into SIVs and conduits and the low quality of their ratings.

The main problem with the ratings of SIVs was the incorrect risk assessment provided by rating agencies, who underestimated the default correlation in mortgages by assuming that mortgage defaults are fairly independent events. Of course, at the height of the business cycle that may be true, but even a cursory glance at history reveals that mortgage defaults become highly correlated in downturns. Unfortunately, the data samples used to rate SIVs often were not long enough to include a recession.

Ultimately this implies that the quality of SIV ratings left something to be desired. However, the rating agencies have an 80-year history of evaluating corporate obligations, which does give us a benchmark to assess the ratings quality. Unfortunately, the quality of SIV ratings differs from the quality of ratings of regular corporations. A AAA for a SIV is not the same as a AAA for Microsoft.

And the market was not fooled. After all, why would a AAA-rated SIV earn 200 basis points above a AAA-rated corporate bond? One cannot escape the feeling that many players understood what was going on but happily went along. The pension fund manager buying such SIVs may have been incompetent, but he or she was more likely simply bypassing restrictions on buying high-risk assets.

Foolish sophistication

Underpinning this whole process is a view that sophistication implies quality: a really complicated statistical model must be right. That might be true if the laws of physics were akin to the statistical laws of finance. However finance is not physics, it is more complex, see e.g. Danielsson (2002).

In physics the phenomena being measured does not generally change with measurement. In the finance that is not true. Financial modelling changes the statistical laws governing the financial system in real-time. The reason is that market participants react to measurements and therefore change the underlying statistical processes. The modellers are always playing catch-up with each other. This becomes especially pronounced when the financial system gets into a crisis.

This is a phenomena we call endogenous risk, which emphasises the importance of interactions between institutions in determining market outcomes. Day-to-day, when everything is calm, we can ignore endogenous risk. In crisis, we cannot. And that is when the models fail.

This does not mean that models are without merits. On the contrary, they have a valuable use in the internal risk management processes of financial institutions, where the focus is on relatively frequent small events. The reliability of models designed for such purposes is readily assessed by a technique called backtesting, which is fundamental to the risk management process and is a key component in the Basel Accords.

Most models used to assess the probability of small frequent events can also be used to forecast the probability of large infrequent events. However, such extrapolation is inappropriate. Not only are the models calibrated and tested with particular events in mind, but it is impossible to tailor model quality to large infrequent events nor to assess the quality of such forecasts.

Taken to the extreme, I have seen banks required to calculate the risk of annual losses once every thousand years, the so-called 99.9% annual losses. However, the fact that we can get such numbers does not mean the numbers mean anything. The problem is that we cannot backtest at such extreme frequencies. Similar arguments apply to many other calculations such as expected shortfall or tail value-at-risk. Fundamental to the scientific process is verification, in our case backtesting. Neither the 99.9% models, nor most tail value-at-risk models can be backtested and therefore cannot be considered scientific.

Demanding numbers

We do however see increasing demands from supervisors for exactly the calculation of such numbers as a response to the crisis. Of course the underlying motivation is the worthwhile goal of trying to quantify financial stability and systemic risk. However, exploiting the banks’ internal models for this purpose is not the right way to do it. The internal models were not designed with this in mind and to do this calculation is a drain on the banks’ risk management resources. It is the lazy way out. If we don't understand how the system works, generating numbers may give us comfort. But the numbers do not imply understanding.

Indeed, the current crisis took everybody by surprise in spite of all the sophisticated models, all the stress testing, and all the numbers. I think the primary lesson from the crisis is that the financial institutions that had a good handle on liquidity risk management came out best. It was management and internal processes that mattered – not model quality. Indeed, the problem created by the conduits cannot be solved by models, but the problem could have been prevented by better management and especially better regulations.
With these facts increasingly understood, it is incomprehensible to me why supervisors are increasingly advocating the use of models in assessing the risk of individual institutions and financial stability. If model-driven mispricing enabled the crisis to happen, what makes us believe that the future models will be any better?

Therefore one of the most important lessons from the crisis has been the exposure of the unreliability of models and the importance of management. The view frequently expressed by supervisors that the solution to a problem like the subprime crisis is Basel II is not really true. The reason is that Basel II is based on modelling. What is missing is for the supervisors and the central banks to understand the products being traded in the markets and have an idea of the magnitude, potential for systemic risk, and interactions between institutions and endogenous risk, coupled with a willingness to act when necessary. In this crisis the key problem lies with bank supervision and central banking, as well as the banks themselves.

Jon Danielsson
is a Reader in Finance at the London School of Economics.


Danielsson, Jon (2002), “The Emperor has no Clothes: Limits to Risk Modelling”, Journal of Banking and Finance, 26(7),1273—1296.


1 For example, see Nassim Taleb (2007). "Fooled by randomness: the hidden role of chance in life and the markets" Penguin Books.

May 12, 2008

Moving Beyond Putinomics

Russia’s economic success is partly attributable to high oil and commodities prices. But oil is not the whole story. The tax reform of 2001 improved incentives to work and decreased tax evasion by introducing a flat 13% income tax – one of the world’s lowest. Liberalizing the procedures for corporate registration and licensing, and limiting inspections, improved the climate for small businesses and entrepreneurs. Conservative macroeconomic policy and financial-sector reform lowered interest rates and fueled an investment and consumption boom. Real wages tripled, and poverty and unemployment fell by half.

Yet Medvedev’s most notable pre-election speech – unusually liberal even by Western standards – recognized several economic challenges. Medvedev seems to understand that sustaining growth will not be easy: oil prices cannot rise forever, and the “low hanging fruit” of basic economic reform and prudent macroeconomic policies have already been picked. According to Medvedev, the only solution is to empower private initiative and innovation.

Inequality and corruption are the main obstacles. Despite Russia’s recent economic achievements, both remain at alarmingly high levels. According to Forbes magazine, there were 87 Russian billionaires, with combined wealth of $471 billion, a figure second only to the United States. Yet their net worth accounts for roughly 30% of Russia’s GDP, whereas America’s 469 billionaires are worth only about 10% of US GDP.

More importantly, inequality of opportunity is very high as well. According to a recent survey, a majority of Russians believes that acquiring wealth requires criminal activity and political connections. Only 20% believe that talent matters. These beliefs are self-fulfilling prophecies.

Aside from the relatively small middle class and the even smaller business and intellectual elite, most Russians neither take risks to become entrepreneurs nor favor economic and political liberalization. According to a recent large survey by the European Bank of Reconstruction and Development, only 36% of Russians support democracy and a mere 28% support market reform, by far the lowest among all transition countries on both counts.

The other major barrier to growth is corruption. In another World Bank-EBRD survey, 40% of firms in Russia reported making frequent unofficial payments, and roughly the same percentage indicated that corruption is a serious problem in doing business. Unlike in other emerging markets, corruption has not declined with economic growth; it remains as high as in countries with one-quarter the per capita income of Russia.

One reason for sustained corruption is that Russia’s powerful bureaucracy stands to lose too much from economic liberalization. Perhaps more importantly, it is hard to fight corruption without political reform, media freedom, and a vibrant civil society.

Remarkably, Medvedev is not wary of speaking about political liberalization. Indeed, he quotes Catherine the Great: “Freedom is the soul of everything. I want obedience to the law but not to the law of slaves.” He knows that the rule of law is a pre-requisite for sustainable economic growth and promises to build an independent and effective court system. In other words, his program is similar to Putin’s in 2000. Unfortunately, as Putin himself recently acknowledged, much of that agenda never materialized.

Implementing Medvedev’s program would benefit both Russia and the West. This latter point should not be forgotten, because the West’s interests in Russia have grown since Putin was elected: foreign investment is booming, the middle class is hungry for all things Western, and even Russian companies are investing abroad.

Russia is already a large market, and if growth continues, it will be eligible to discuss OECD accession in a few years. One lever that the West has is to condition membership on political and economic liberalization. Medvedev appears to understand that such a new burst of liberalization is in Russia’s interest as well.

Sergei Guriev is Dean and Professor at the New Economic School in Moscow. Aleh Tsyvinski is an Economics Professor at Harvard University and the New Economic School.

May 13, 2008

Should the Fed Pay Interest on Reserves?

To be fair in airing the issue, why not pay interest on bank reserves? Banks deposit reserves into the care of the Federal Reserve. Shouldn’t they be entitled to interest on their money while the Fed has it?

Reserves are Reserved from Risk

Importantly the Fed really does not have “use” of the reserve funds. Reserves are kept at the Fed for safety and security, just as the same reserves would be kept in the vaults of individual banks if the Fed did not exist. Reserves are kept free of any investment risk so each bank will assuredly have funds to protect its depositors against loss due to risks taken in the bank’s lending and investment operations. The Federal Reserve does not invest those funds, putting them at risk in order to earn a return, so no interest is owed to the member banks on their reserves.

Indeed, holding, protecting and accounting for the reserves are services that cost the Fed operating expenses. These expenses reasonably should be paid by member banks through fees to the Fed because the banks receive business benefits of added security for banking customers.

Who Pays the Bill?

If permitted by Congress to do so, the Federal Reserve says it can afford to pay interest on the reserves from funds the Fed earns on its own portfolio of assets. Ordinarily those assets are Treasury securities, on which the U. S. Treasury pays interest. Recently the Fed has turned about half of those assets into various types of private debt instruments. The Fed receives interest earnings on those assets, spends what it chooses for its own operations, and is required by law to transfer any remaining balance to the federal Treasury. In 2007, for example, the Fed paid $34.4 billion to the Treasury from its earnings.

In a very real sense, therefore, funds to pay interest to banks on reserves held for safekeeping would come from the U. S. Treasury, and the expense would add to the federal budget deficit. In context, the Federal Reserve proposes to pay banks to hold funds in reserve as security while the balance of bank capital is invested in loans and other banking business. And the U. S. Treasury would bear the cost. That does not sound well considered.

The Federal Reserve acquires its portfolio by creating dollars for use in buying those assets. With this discretion, the Fed can always increase its portfolio and its earnings on assets, so long as it is willing to create more money and, perhaps, more inflation. The Fed could create more dollars to increase its portfolio and earnings enough to maintain its high level of yearly transfers of “free money” to Treasury and still pay interest on bank reserves. But Americans would wind up paying the bill anyway through the hidden tax called inflation. Bank reserves are not invested to earn return on the capital, so the only source of funds to pay interest on reserves is money creation, which inflates the value of all dollars.

Favoring Banks

Maybe the Federal Reserve proposes paying interest to banks because banks are strapped for capital. The Fed recently acted emergently to pump $25 billion into Bear Stearns and an additional $30 billion into J. P. Morgan Chase Bank as an inducement to step forward and acquire Bear Stearns. Paying interest on reserves might calm agitation towards the Fed felt by other banks left out of such a unique opportunity as was given to Morgan Chase.

Fed Needs “Better Control”

Having considered the range of motives likely to be influencing the Federal Reserve’s proposal, we finally come to the reason the Fed says it ought to pay interest on bank reserves. The Fed says doing so will enable the central bank “to gain better control over interest rates and more leverage to battle the credit crunch” since the funds rate would be “less likely to plunge below the Fed's official target -- now 2% -- on days when the banking system is awash in cash.” (Emphasis added.) These are the words of Greg Ip of the Wall Street Journal, who in most instances may be regarded as the Fed’s spokesman in financial media. In a word, this explanation is sophistry – pure and unadulterated.

The funds rate target is a charade insofar as monetary policy is concerned, employed by the Federal Reserve to assist member banks in setting their prime interest rates anti-competitively. The funds rate is not the valve of dollar liquidity. This is proved yet again by the Fed’s own argument, which shows the Fed is perfectly comfortable with a banking system “awash in cash” so long as member banks don’t charge less for overnight loans of reserves than the funds rate target.

Why does the Fed desire that the funds rate target be honored even when the system is awash in cash? Because, when the target rate is honored, one bank does not get a competitive advantage over other banks by negotiating a lower-than-target interest rate for borrowing overnight reserves. Again, the funds rate target is all about removing competition from banking. If the Fed were actually guiding liquidity by interest rate signals, it would view undercutting of the funds rate target as evidence liquidity should be drained, and would act accordingly.

Moreover, funds rate manipulation is entirely incapable of stabilizing the dollar’s value. Nonetheless, manipulating domestic interest rates, asset prices, unemployment and economic growth are things the Federal Reserve insists upon doing, and people the world over suffer for it.

Forget Interest – Stabilize the Dollar

In combination with the Federal Reserve’s less-than-transparent liquidity management, interest rate manipulation has produced severe dollar deflation (as during 1997-2002) and severe dollar devaluation (as during 2004-2008) during the past decade. To avoid continuing destructive cycles of this nature, the Federal Reserve should abandon interest rate manipulation and proceed by managing its asset portfolio to stabilize the dollar’s value relative to gold. This would satisfy every producer in the world that the dollar is trustworthy again, so long as the U. S. sticks by this essential reform.

Federal Reserve governors, do your duty to strengthen and stabilize the dollar. Forget paying interest to banks on reserves that sound banking practice demands be held away from investment risk. End your use of currency devaluation as a weapon of trade war. Impoverished Americans and inflamed nationalism around the globe are not legacies you should cherish.

Wall Street IS Main Street

Last this writer checked, investment of any kind is uncertain. If housing, equity or art purchases offered only rising returns, those seeking to enter any of those markets would frequently be shut out. It is because investment is uncertain that markets have traditionally been allowed to clear at lower prices such that the distant object of home, equity and yes, art ownership, has become a reality for Americans to varying degrees.

Efforts to insulate the property markets from what some deem their sharper edges will enervate the economy first for encouraging all manner of speculation on what would become a “protected” industry and sector. Secondly, protection works at cross purposes with Nanny Washington’s other stated goal: rising wages for the alleged “working class”. If housing is turned into a certain bet, a great deal of capital will be reoriented toward the ground rather than to entrepreneurs with less innovation and lower wages the certain result.

It should also be asked if the various economic commentators supporting a bailout have ever heard of margin loans. The latter, when applied to equities means that investors of all stripes are able to achieve greater exposure to a certain company or market index while not fronting the full amount of cash needed for same. Where margin is considered, investors have frequently gone “under water” in the form that certain homeowners have.

The above method of investing of course resembles home ownership in some ways, so imagine for a moment what our economy would look like if margin bets were protected too? If so, lots of capital would be locked up in former stock-market luminaries along the lines of GM, Enron and Digital Equipment Corporation such that capital for tomorrow’s innovators would be in lower supply.

Many might say that protecting Wall Street is different from protecting Main Street. And there lies a persistent myth. Indeed, lost in the absurd “Wall Street” versus “Main Street” discussion is the basic truth that Main Street’s interests fully intersect with those of Wall Street. For those who doubt this, they need only consider the microscopic percentage of Americans who actually lack exposure to the stock and capital markets. To the extent that any Americans don’t possess brokerage accounts, 401(k)s or pensions with stock-market investments, they frequently work for companies and/or individuals whose ability to pay them has a Wall Street origin. In the end, Wall Street is Main Street.

And there lies the folly of Wessel’s seemingly insouciant countenance toward Rep. Frank’s approach to the mortgage crisis. According to Wessel, “Mr. Frank would offer lenders and eligible borrowers a deal: If the lender agrees to cut the debt so the homeowner owes no more than 90% of the house’s current value, and the Federal Housing Administration determines the homeowner can afford a new loan, then the lender gets rid of the mortgage and the FHA insures a new mortgage for the remaining balance.” Life’s so easy when the taxpayer is on the hook.

Unfortunately, what Wessel ignores is that mortgage holder and taxpayer are one and the same. And to the extent that they’re not, his casual approach to reaching into the pockets of responsible Americans to fund the profligacy of those who are not reeks of shortsightedness. Implicit in Wessel’s point-of-view is that if Uncle Sam simply comes to the rescue one more time, all will be fine. Not very likely.

Thankfully, a White House and Treasury that have sadly sought to soften the blow of the housing downturn are not on board with Frank’s plan. To Wessel, it’s “a bit jarring to hear the Treasury vilifying people who are acting in their economic self-interest.” What Wessel misses is that owing to broad-based American exposure to the securities markets, efforts to bail out homeowners on the backs of lenders means that if lenders get a “haircut” on mortgage payments, so too will the very individuals struggling under the weight of mortgage debt. As Nobel Laureate Robert Mundell long ago noted, “the only closed economy is the world economy.” Amen.

Though he wisely suggested during his confirmation hearings that he would refrain from commenting on politics and policy, Fed Chairman Bernanke has said, “If a foreclosure is preventable, the economic case for trying to avoid foreclosure is strong.” Absolutely. Forgotten amidst all the housing hysteria is the certainty that both borrowers and lenders have strong incentives (credit ratings for borrowers, earnings for lenders) to avoid foreclosure. That being the case, our minders in Washington should step aside and let those two interested parties work out a deal; one that by definition will aid Wall Street and Main Street entities that are inextricably linked.

Central Banking Doctrine in Light of the Crisis

On April 8 of this year, Paul Volcker addressed the Economic Club of New York about the current crisis. The Federal Reserve, he noted, has gone to “the very edge” of its legal authority. “Out of necessity,” said Volcker, “sweeping powers have been exercised in a manner that is neither natural nor comfortable for a central bank”.1 He was referring to the $29 billion guarantee of Bear Stearns assets that had been extended to JP Morgan and the subsequent offer to swap $100 billion of Treasuries for illiquid bank assets. The Bear Stearns “rescue” was aimed at averting a dangerous situation in the default risk derivative market, and the swap operation sought to restore some liquidity to “frozen” markets. These were indeed unconventional measures, but ones without which more conventional interest rate policy could not be expected to have much effect in the current situation.

It is probably fortunate that the Fed had at its helm the most distinguished student in his generation of the Great Depression and someone, therefore, able to perceive the “necessity” more or less correctly. As in the Japanese case, the lesson of the Depression is that a collapse of credit cannot be reversed and that the consequences linger for a very long time. It is also true, however, that until only a year or two ago Chairman Ben Bernanke was a consistent and outspoken advocate of a monetary policy of strict inflation targeting, which is to say, of a central banking doctrine that required an exclusive concentration on keeping consumer prices within a narrow range with no attention to asset prices, exchange rates, credit quality or (of course) unemployment.

Bear Stearns, Northern Rock, and Landesbank Sachsen are the best known institutional victims of the current crisis – so far. But the damage is of course far more extensive and a great many CEOs have had to go into ignominious retirement with only a few million2 dollars as plaster on their wounded reputations. It is the rule of efficient capitalism that you must pay for your mistakes alas!

There are two aspects of the wreckage from the current crisis that have not attracted much attention so far. One is the wreck of what was until a year ago the widely accepted central banking doctrine. The other is the damage to the macroeconomic theory that underpinned that doctrine.3 In this column, I discuss two central tenets of modern central banking doctrine – inflation targeting and central bank independence.

Inflation targeting

Critical to the central banking doctrine was the proposition that monetary policy is fundamentally only about controlling the price level.4 Using the bank’s power over nominal values to try to manipulate real variables such as output and employment would have only transitory and on balance undesirable effects. The goal of monetary policy, therefore, could only be to stabilise the price level (or its rate of change). This would be most efficaciously accomplished by inflation targeting, an adaptive strategy that requires the bank to respond to any deviation of the price level from target by moving the interest rate in the opposite direction.

This strategy failed in the United States. The Federal Reserve lowered the federal funds rate drastically in an effort to counter the effects of the dot.com crash. In this, the Fed was successful. But it then maintained the rate at an extremely low level because inflation, measured by various variants of the CPI, stayed low and constant. In an inflation targeting regime this is taken to be feedback confirming that the interest rate is “right”. In the present instance, however, US consumer goods prices were being stabilised by competition from imports and the exchange rate policies of the countries of origin of those imports. American monetary policy was far too easy and led to the build-up of a serious asset price bubble, mainly in real estate, and an associated general deterioration in the quality of credit. The problems we now face are in large part due to this policy failure.


A second tenet of the doctrine was central bank independence. Since using the bank’s powers to effect temporary changes in real variables was deemed dysfunctional, the central bank needed to be insulated from political pressures. This tenet was predicated on the twin ideas that a policy of stabilising nominal values would be politically neutral and that this could be achieved by inflation targeting. Monetary policy would then be a purely technical matter and the technicians would best be able to perform their task free from the interference of politicians.

Transparency of central banking was a minor lemma of the doctrine. If monetary policy is a purely technical matter, it does not hurt to have the public listen in on what the technicians are talking about doing. On the contrary, it will be a benefit all around since it allows the private sector to form more accurate expectations and to plan ahead more efficiently. But if the decisions to be taken are inherently political in the sense of having inescapable redistributive consequences, having the public listen in on all deliberations may make it all but impossible to make decisions in a timely manner.

When monetary policy comes to involve choices of inflating or deflating, of favouring debtors or creditors, of selectively bailing out some and not others, of allowing or preventing banks to collude, no democratic country can leave these decisions to unelected technicians. The independence doctrine becomes impossible to uphold.

Consider as examples two columns that have appeared in the Wall Street Journal in recent weeks. One, by John Makin (April 14), argued that leaving house prices to find their own level in the present situation would lead to a disastrous depression. Policy, therefore, should be to inflate so as to stabilise them somewhere near present levels. If the Fed were to succeed in this, it might not find it easy to regain control of the inflation once it had gotten underway, particularly since some of the support of the dollar by other countries would surely be withdrawn. But in any case, the distributive consequences of Makin’s proposal are obvious to all who (like myself) are on more or less fixed pensions. The other column, by Martin Feldstein (April 15), argues that the Fed had already gone too far in lowering interest rates and is courting inflation. He was in favour of the Fed’s attempts to unfreeze the blocked markets and restore liquidity by the unorthodox means that Volcker had mentioned.

The likely prospect for the United States in any case is a period of stagflation. The issue is going to be how much inflation and how much unemployment and stagnation are we going to have. To the extent that this can be determined or at least influenced by policy, the choices that will have to be made are obviously not of the sort to be left to unelected technicians.

Axel Leijonhufvud is Professor Emeritus, Department of Economics at UCLA.


1 Quoted as delivered orally www.youtube.com/watch?v═ticXF2h3ypc. New York Times, April 9, has slightly different wording.

2 In one case apparently not all that few (reportedly 190 million!).

3 For discussion of this damage, see CEPR Policy Insight 23.

4 This focus is one of the legacies of Monetarism. Historically, central banks developed in order to secure the stability of credit.

Visit this article at VoxEU's website.

May 14, 2008

In Britain, the Economy, Stupid

But although Brits were only voting for local councils, the election bears some striking similarities to ours. In the U.K. as here, a party which has been in office through several national election cycles, Labour, faced an electorate at a time of growing economic worry. England’s long housing boom, which has been at times even frothier than ours, has ended, and foreclosures are rising. A major financial institution recently had to be bailed out by the government. Prices, including the already steep price of gas, are rising, eliciting grumbling among voters who have quickly forgotten their own income gains over the last several years.

Facing these circumstances, Labour took a drubbing, winning just 24 percent of the vote nationwide, because its leaders ignored James Carville’s oft-repeated advice that in tough times, it’s the economy that voters care about. Instead, Labour acted positively stupid about the economy, in the process appearing out of touch with voters by seeming almost indifferent to economic news. It’s a lesson that the Republican Party’s looming presidential nominee, John McCain, who occasionally appears as if the economy is the last thing on his mind, can learn from.

To understand the elections, one needs to appreciate the controversy generated by Labour’s missteps, especially the repeal of Britain’s lowest tax rate, the so-called “10p band”—a policy that went into effect right before the election and consequently raised taxes on some 5 million low-income earners. Labour enacted the change the previous year in the name of reforming the tax system, eliminating the 10 percent rate on annual income between £5,225 and £7,455 and taxing everyone at a 20 percent rate on the first £36,000 they earned above £5,435--which effectively raised taxes on many working class taxpayers.

Showing how little attention the party was paying to the details, Labour’s leader, Prime Minster Gordon Brown, claimed he didn’t realize how many people would pay higher taxes as a result (and still disputes estimates even by his own party members), nor did he seem to understand how ill-timed was the effective date of the tax increase—coming as it did right before the election. As the tax went into effect amidst a general economic slowdown, Brown was galloping off to the United States to meet with President Bush, only to return home to an uproar. In the month before the election, I counted more than 1,000 references by British newspapers to the 10p rate repeal and the coming elections. Needless to say, there were few supporters of the move once its impact became clear, even among Labour’s members of parliament, many of whom lobbied for repeal.

The tax hike only added to a perception that the government had grown fat at the public’s expense and out of touch with the average person. In a poll done before the election, 68 percent of the public said they were “not confident at all” in Labour’s ability to confront the U.K.’s economic problems. Another poll found that Brown’s approval rating had fallen farther than Neville Chamberlain’s did after Hitler invaded Norway in 1940.

Brown wasn’t helped by the fact that shortly before the election the British government released details of the personal spending of Members of Parliament under pressure from freedom-of-information campaigners in the U.K. The reports showed that Labour’s former deputy prime minister, John Prescott, “renowned for his prodigious appetite,” as one newspaper described him, charged the British public some £4,000 to stock his larder, while Brown claimed nearly £5,000 to have his private flat cleaned before he became Prime Minister. Voters also weren’t happy to learn that former Labour Prime Minister Tony Blair charged his annual £116 television license, one of England’s most irritating levies, to taxpayers. The exceptional spending habits of some Tory MPs, out of power for 11 years, didn’t cause quite the same stir.

The vote in London—not just in the mayor’s race, but in local districts—was especially symptomatic of what Brits are worried about these days. There, Labour lost to an unusual coalition that included those who were uneasy about the economy, mad at the tax hike, and apprehensive about increasing disorder and rising crime. The upheaval went beyond voters in the London suburbs—roughly the equivalent of New York City’s middle-class outer boroughs—who have been grousing about London’s growing social problems for some time. As one newspaper remarked, “when the suburban revolt met the fury of those hit by the 10p rate, meltdown ensued.”

Under these circumstances, the Conservative Party did not so much win the election as the extraordinarily unpopular Brown blew it. The Conservatives, for years on the outs and intellectually bankrupt under former leader Michael Howard, now have a dashing and charismatic new leader in David Cameron, but he’s still feeling his way towards an agenda. At times, on issues like taxes, he doesn’t distinguish himself much from Labour. New York Times columnist David Brooks’ notion that Americans should be learning from Cameron’s “softer” version of conservatism, with “more emphasis on environmental issues, civility, assimilation and the moral climate,’’ is belied by the fact that Cameron appears to be studying American conservatives, at least on social issues.

Writing about poverty in England shortly after the election, Cameron observed that it is “now widely accepted that it is the cycle of family breakdown, worklessness, crime, drug and alcohol abuse that traps people in deprivation,” though in reality such observations are not nearly as well accepted in the U.K. as they are here in the United States. Cameron added that Conservatives were “developing plans for radical welfare reform to help people move from long-term poverty to long-term employment.” He might have added that welfare reform is now a decade old in America. Later in the same piece, Cameron recalled Margaret Thatcher’s school choice innovations and the choice movement here in America when he promised reform of Britain’s schools by “opening up the state system to new providers.”

The Labour Party still has time to rebound before the next national elections which must be held no later than 2010, and already Brown is sounding a little like McCain—hinting, for instance, at repeal of a gas tax increase that’s set to go into effect in autumn. He’s also assigned bureaucrats to figure out how to undo the impact of the 10p repeal through tax credits and other mechanisms, though the potential solutions are probably half-again too complicated for most voters to stomach. Meanwhile, his advisers have told him to put temporarily on the backburner some of his favorite agenda items that have little to do with the economy, like trying to make Britain into a worldwide leader on environmental issues.

As the presidential candidate of the party that now holds the White House, McCain will face some of the same challenges as Brown. Although Americans do not judge Republicans as harshly on the economy as Brits judge Labour, polls show that most voters still trust the Democrats more than they do the GOP. If McCain doesn’t overcome that deficit in a year in which economic headlines dominate, it’s difficult to see how he can win, unless the Democratic Party does the job for him by making Labour-like mistakes—which is unlikely—or unless something spectacular happens to push the economy off the front page.

But betting on something like that to happen is a little like betting that voters won’t notice when you raise their taxes.

May 15, 2008

NFL Draft Reveals Folly of Antitrust

To show how difficult it is to predict what’s ahead, the world of sports offers easy to understand examples. In particular, last month’s National Football League draft illustrated yet again how hard it is to project which players will eventually dominate.

To show why that’s the case, it’s essential to look at the origins of the NFL draftees taken in the first round. Thanks to college football’s rabid following, recruiting of the players that fill out college rosters has generated a great deal of fan interest. Rivals.com, generally considered the #1 recruiting website, revealed last year how eagerly this process is followed when it was bought by Yahoo for a reported $100 million.

Each year, Rivals ranks what it deems the top high-school players, and fans pour over the rankings on a daily basis leading up to National Signing Day each February. Top-ranked players are given four and five star rankings, and it’s the four and five star players whose college choices alternately excite or depress fans around the country.

But are those rankings realistic? To some degree, yes. Of the 31 players drafted in the first round, 15 arrived at college with the coveted four or five star label. On the other hand, 16 first round draftees were given three-star rankings or lower, and as such, were likely ignored when they made their college choices.

When the top recruiting schools are considered, the University of Southern California has more often than not been crowned by Rivals as the top recruiting school going back to 2002. What’s odd, however, is that USC’s two national championship teams in this decade were largely stocked with players that filled out less-than-stellar recruiting classes. The best player among them, if performance in the NFL is a worthy benchmark, is Seattle Seahawks linebacker Lofa Tatupu, who arrived at USC as an unheralded transfer from Division I-AA University of Maine. Though Reggie Bush was heavily recruited out of high school, Rivals ranked him behind fellow ‘SC recruit Whitney Lewis. Bush won the Heisman trophy, while the last word heard on Lewis was that he transferred from USC to Northern Iowa.

If antitrust rules applied to recruiting, Southern Cal might have found itself defending its recruiting practices in court in recent years, but absent those kinds of rules, the inexact nature of recruiting revealed itself on the football field. USC lost its bid for a third straight title in the dying moments of the 2006 Rose Bowl, and in the past two seasons has lost two games each; including one to Stanford. And when the loss to Stanford is considered, it should be said that in last month’s draft USC had 10 players taken (the most of any school), including seven in the first two rounds. Among draft-eligible Stanford players, none were picked at all.

Yahoo Sports analyst and former Auburn head coach Terry Bowden actually ranked college teams based on their latest draft performance, and while college success doesn’t always translate to NFL riches, he noted that among the most drafted schools last month, four (Cal, Arkansas, Louisville, and Notre Dame) finished the season unranked. The Georgia Bulldogs ended last season ranked #2, but according to Bowden had only four players selected in the draft; none of them taken in the first four rounds.

When the draft’s predictive nature is considered, NFL fans have had their hearts broken regularly with high draft picks that proved to be busts, and low-round players their teams passed on. Indeed, Hall of Fame quarterback Joe Montana lasted until the third round back in the late 70s, while in the weeks leading up to the 1998 draft, the majority of scouts in the Indianapolis Colts’ front office preferred Ryan Leaf over future Hall of Famer Peyton Manning. Tom Brady is likely teased by teammates to this day for being selected behind Giovanni Carmazzi, and even though Dan Marino reached the Super Bowl first among quarterbacks selected in the first round of 1983’s draft, he was the sixth qb taken in that same first round. Tony Mandarich was drafted #2 overall in 1988, and came into the NFL with hype suggesting he would be the greatest left tackle ever. It is said that on the first day of mini-camp Green Bay coaches sensed from his footwork alone that he would never pan out. And he didn’t.

To show that evaluation mistakes apply to all sports, budget issues forced Oakland A’s general manager Billy Beane to shed star pitchers Tim Hudson, Barry Zito and Mark Mulder in recent years. The three combined to lead a staff that boasted a 3.63 ERA. Rather than imploding due to those substantial losses, the A’s presently lead the American League West behind no-name pitchers Greg Smith, Dana Eveland and Chad Gaudin; the three leading the league with a 3.26 ERA. Zito? After signing a $126 million dollar contract with the San Francisco Giants he went 11-13 last year, and is winless this season.

In 1976, two American Motors executives said if GM’s growth weren’t halted, “they might find themselves selling the whole market,” and that if “they wanted to wipe out everybody by 1980, the only one who could stop them is the government.” Nearly thirty years later GM chief executive Rick Wagoner was reduced to explaining away his company’s failures in a Wall Street Journal editorial, all while making a veiled plea for a taxpayer bailout. Before the stock market imploded at the beginning of this decade, former Tyco CEO Dennis Kozlowski made the cover of Barron's owing to the broadly held view that his executive talents put him in the league of Jack Welch. Right or wrong (this writer says wrong), Kozlowski is now serving time in prison. What these examples tell us is that corporate success, much like that enjoyed on the playing field, is charitably uncertain.

If coaches, general managers and corporate rivals frequently can’t successfully predict what’s ahead despite jobs and billions of dollars at stake, how can civil servants at the Justice Department? The world of sports reveals that what the DOJ attempts is very difficult at best, so the best economic solution when it comes to antitrust would be to scrap the concept altogether.

May 16, 2008

Getting Governance Right Is Good for Economic Growth

Good governance is, of course, essential insofar as it provides households with greater clarity and investors with greater assurance that they can secure a return on their efforts. Placing emphasis on governance also has the apparent virtue of helping to shift the focus of reform toward inherently desirable objectives.

Traditional recommendations like free trade, competitive exchange rates, and sound fiscal policy are worthwhile only to the extent that they achieve other desirable objectives, such as faster economic growth, lower poverty, and improved equity.

By contrast, the intrinsic importance of the rule of law, transparency, voice, accountability, or effective government is obvious. We might even say that good governance is development itself.

Unfortunately, much of the discussion surrounding governance reforms fails to make a distinction between governance-as-an-end and governance-as-a means. The result is muddled thinking and inappropriate strategies for reform.

Economists and aid agencies would be more useful if they turned their attention to what one might call ``governance writ small.''

This requires moving away from the broad governance agenda and focusing on reforms of specific institutions in order to target binding constraints on growth.

Poor countries suffer from a multitude of growth constraints, and effective reforms address the most binding among them.

Poor governance may, in general, be the binding constraint in Zimbabwe and a few other countries, but it was not in China, Vietnam, or Cambodia - countries that are growing rapidly despite poor governance - and it most surely is not in Ethiopia, South Africa, El Salvador, Mexico, or Brazil.

As a rule, broad governance reform is neither necessary nor sufficient for growth. It is not necessary, because what really works in practice is removing successive binding constraints, whether they are supply incentives in agriculture, infrastructure bottlenecks, or high credit costs.

It is not sufficient, because sustaining the fruits of governance reform without accompanying growth is difficult. As desirable as the rule of law and similar reforms may be in the long run and for development in general, they rarely deserve priority as part of a growth strategy.

Governance writ small focuses instead on those institutional arrangements that can best relax the constraints on growth. Suppose, for example, that we identify macroeconomic instability as the binding constraint in a particular economy.

In a previous era, an economic adviser might have recommended specific fiscal and monetary policies - a reduction in fiscal expenditures or a ceiling on credit - geared at restoring macroeconomic balances.

Today, that adviser would supplement these recommendations with others that are much more institutional in nature and fundamentally about governance.

So he or she might advocate making the central bank independent in order to reduce political meddling, and changing the framework for managing fiscal policy - setting up fiscal rules, for example, or allowing only an up-or-down legislative vote on budget proposals.

Macroeconomic policy is an area in which economists have done a lot of thinking about institutional prerequisites. The same is true in a few other areas, such as education policy and telecom regulation.

But in other areas, such as trade, employment, or industrial policies, prevailing thinking is either naive or non-existent.

That is a pity, because economists' understanding of the substantive issues, professional obsession with incentives, and attention to unanticipated consequences give them a natural advantage in designing institutional arrangements to further the objectives in question while minimizing behavioral distortions.

Designing appropriate institutional arrangements also requires both local knowledge and creativity. What works in one setting is unlikely to work in another.

While import liberalization works fine for integrating with the world economy when import-competing interests are not powerful and the currency is unlikely to become overvalued, export subsidies or special economic zones will work far better in other circumstances.
Similarly, central bank independence may be a great idea when monetary instability is the binding constraint, but it will backfire where the real challenge is poor competitiveness.

Unfortunately, the type of institutional reform promoted by, among others, the World Bank, IMF, and the World Trade Organization is biased toward a best-practice model, which presumes that a set of universally appropriate institutional arrangements can be determined and views convergence towards them as being inherently desirable.

But best-practice institutions are, by definition, non-contextual and cannot take local complications into account. Insofar as they narrow rather than expand the menu of available institutional choices, they serve the cause of good governance badly.

Good governance is good in and of itself. It can also be good for growth when it is targeted at binding constraints.

Too much focus on broad issues, such as rule of law and accountability, runs the risk that policymakers will end up tilting at windmills while overlooking the particular governance challenges most closely linked to economic growth.

Dani Rodrik is a Professor of Political Economy at Harvard University’s John F. Kennedy School of Government.

May 17, 2008

The Fed at the Crossroads

But there was growth. Gasoline sales were up 16.3%. And food sales were up 6.1%. 77% of the increase in retail sales this year has been from increases in food and gas sales. If you take out food and gas, retail sales are down by about 2% in the last three months.

The consumer is getting squeezed. Reuters did a rather anecdotal, but revealing survey of Wal-Mart buyers at the beginning of the month. They found a significant increase in store traffic from the end of the month to the first of the month. Surveys showed that shoppers were stretched on their budgets due to rising gas and food costs and simply had to wait until their monthly checks came to go to the store for food. Many indicated they had changed their buying habits, now shopping at lower-cost stores like Wal-Mart.

At the Mauldin household I must admit to a kind of food shock upon my return. I eat a lot of smoked turkey from a local grocery deli. Arriving back from South Africa last night, I sent my oldest son to the store to put in a supply for the next few days. My "regular" turkey that was about $5.99 a pound a few months ago is now selling for $8.99. That is considerably higher than the 5.9% food-at-home inflation rate that the folks who give us the CPI tell us is the case. Next time I will find a less expensive brand, as the Reuters survey suggest shoppers all across the country are doing.

(I do recognize the inconsistency of saving a few dollars at home while I eat out at nice restaurants where the price increases are even greater. It is all about what is in your head. There are books and massive studies devoted to such behavior.)

"Leslie Dach, executive vice president of corporate affairs and government relations at Wal-Mart, said the cycle of shoppers running out of money in between paychecks and then flocking to its stores on payday is 'more pronounced, more visible.'

While many U.S. retailers are facing waning sales as shoppers cut back on purchases of clothes, jewelry or home furnishings, Wal-Mart's vast grocery business and its emphasis on low prices is spurring a resurgence at its U.S. stores and in its stock price." (Reuters)

But prices are actually up at Wal-Mart. And not just from food. Looking at the latest Commerce Department data, we find that US import prices are up 15% year over year. Even taking out gasoline, prices are up 6.2%. And it is somewhat surprising that it is only 6.2%. Why?

Because the dollar has fallen by more than 6%. The Chinese ambassador to the US, Mr. Zhou Wenzhong, recently pointed out that the Chinese renminbi has appreciated almost 19% since July of 2005. I have been writing for years that the Chinese would allow their currency to appreciate slowly and steadily for their own purposes and on their own schedule. They need to do so in order to contain their own rising inflation. Look for it to rise another 10% by the middle of next year.

Consider that because of the rise of the renminbi, the prices for oil and food imports in China have risen 20% less than for US consumers. And the prices they charge us for their goods are only about 4% higher. But that meager growth is up from only 1% last fall. Those (notably economics-challenged Senators Schumer and Graham) who have been pressing for China to allow its currency to rise are going to find that such a rise ultimately means higher prices for US consumers. Be careful what you wish for, Senators. You just might get it.

Lower consumer spending is not just due to gas and food. There is also a psychological component. Frederic Mishkin, one of Ben Bernanke's colleagues at the Fed, has done research that suggests the "typical American family will cut its spending by up to 7 cents for every dollar in housing wealth it loses. Given a 20% fall in prices, this adds up to a nationwide reduction in consumer spending of about $350 billion a year, or 2.5% of the U.S.'s gross domestic product. That's a big number - more than enough to tip the economy into recession." (Conde Nast)

And that's if the fall in prices is only 20%. I continue to put forth the proposition that we are going to see a slow Muddle Through Recovery, as the boost we got from Mortgage Equity Withdrawals during the last recession will not be available this time.

Accounting for Inflation

If beauty is in the eye of the beholder, inflation is in the eye of the statistician. Because the number you end up with is dependent on the models and assumptions you choose. As the chart below shows, there have been two major revisions to how inflation is figured, one in 1983 and another in 1998. (Thanks to Barry Ritholtz at The Big Picture for this source.)

Note that using the same methodology as was used in 1983, inflation would be around 11.6% today. Before 1983, the BLS used actual home prices to account for inflation. After that time, they used something called Owners Equivalent Rent or OER. This is the theoretical price a home would rent for. There are sound reasons to use OER and equally good reasons to use actual home prices (as is done in Europe). But both methods have flaws. You just have to pick a methodology and stick with it.

And there are reasons to think that OER may not rise as it would normally do in this part of the cycle, because so many homes which cannot sell are being rented out, and rent prices might not rise as much as in past cycles.

Using actual home prices is only useful in an average sense over long periods of time. If you own a home with a 30-year mortgage you bought ten years ago, then you have not experienced price inflation for ten years. You have seen the value of your home go up, but that is not (necessarily) inflation. Your mortgage is the same. And a first-time buyer today has the potential to see a 30-50% deflation in home prices from a year ago if he is in the right area, like Florida or California.

Further, the OER tries to measure what a house would rent for. If someone pays more than that rental price, then there is some other factor at work. The Bureau of Labor Statistics suggests that this other factor is investment. If someone pays more for a house than the equivalent rental price because it is perceived as a good investment, then you are measuring apples and oranges. The OER tries to take out the investment angle.

Because the government agencies use OER, inflation was understated in the recent housing bubble. As home prices drop, OER would normally overstate inflation somewhat. If we had used actual home prices then inflation would have been overstated in the last six years, and now the CPI would be turning negative, even as gas and food are rising dramatically.

As I said, neither method is perfect. Over very long periods of time, either will give you reasonably accurate data. But over a time period as short as a few years, let alone a few months, there can be considerable "noise."

Also, notice in the chart that in 1998 the Clinton administration adopted new methodologies, among them hedonic pricing. Hedonic pricing suggests that as a product or service improves, the price for the equivalent item in today's market will fall. As an example, if we buy a computer that is twice as powerful as it was a few years ago, the statisticians assume that prices have fallen even if we pay the same for the computer.

In the same way, if in one year you had to pay extra for features like power steering or power windows in a car, and a few years later they were considered standard, then once again the price would be deemed to have gone down, as you were getting more "value" for your dollar. This is considered to be the case even if in actual dollars you paid more for the car.

Again, you can make a rational and serious economic argument for hedonic pricing. And believe me, many economists do. But those changes, along with others, have lowered the official rate of inflation. And since many government benefits are also tied to the official rate of inflation, the current methodology has lowered government expenses as well, including inflation adjustments for Social Security and pensions.

At one time, you could make a good case that the inflation numbers overstated inflation. But I am not persuaded that is the case anymore, even though many economists still argue that point. The CPI is more or less accurate ON THE AVERAGE. But that may not be the case for you. Your actual rise (or fall) in the level of your expenses may be more or less than the average.

But we do notice the increases more. The Bank Credit Analyst has a very interesting chart in its recent May issue. It shows that the high-frequency spending items like gasoline, food, education, and medical care make up 50% of the Consumer Price Index. These are items which we buy on a regular basis. And they are going up at a weighted average rate of 6.8%, a lot higher than the 4% for the CPI as a whole.

The 20% of the CPI which are low-frequency items like furniture, appliances, vehicles, and so on are actually falling at a -0.7% rate. Since OER (equivalent rent) is roughly 30% of CPI and is rising at 2.8%, even as home prices fall the overall rate is about 4%.

Our tendency to notice the price increases in more frequently purchased items more than the drop in less frequent expenditures is known as salience. What we see every day is more visible to us and is on our minds. And because the reality is that those prices are rising much faster than headline inflation, we tend to think inflation is understated.

I can look at my credit card bills and know that my restaurant bill is rising at much more than 4% a year. I do not think I am eating all that much better, and am actually eating less food in an attempt to hold down my weight. My travel expenses are up by more than the 5-7% in the BLS numbers. Those prices, and the price of turkey, are in my face constantly.

The Fed at the Crossroads

Legendary blues singer Robert Johnson was said to have sold his soul to the devil at the crossroads outside Rosedale, Mississippi, to be the best blues singer ever.

The Fed is also at a crossroads. What's the price for low inflation and a booming economy? Can you have both in today's environment without a deal with the devil? And can even Old Slewfoot deliver on such a dream?

Inflation is uncomfortably high at 4%. Even core inflation is well above the 1-2% comfort zone. But the economy is soft and getting softer. Even with the stimulus package kicking in this quarter, consumer spending is likely to be weak. There are some at the Fed who would like to raise rates as soon as possible to deal with inflation, but the economy is not cooperating. The housing crisis just keeps getting worse, and the credit crisis is causing banks to tighten lending standards on every manner of credit, even with Fed fund rates low. LIBOR and other credit costs and spreads are not dropping as one might have thought they would in response to low Fed fund rates. Tax receipts are slowing well below projections, especially sales tax receipts.

Let's look at some of the pressures on the economy. According to the National Small Business Association, more than 5,000 firms filed for bankruptcy in April 2008, the most in any month since new bankruptcy laws took effect in 2005. The data also show that in the first quarter of 2008 13,155 businesses filed for bankruptcy, an increase of nearly 45% from the 9,103 business bankruptcy filings during the same period in 2007.

Economists suggest that the leap in bankruptcy filings is a result of the troubles that started with subprime mortgages and other financial instruments of Wall Street, which are now trickling down to Main Street. The ensuing credit crunch, skyrocketing commodity prices, and dormant consumer sales are likely culprits for pushing many more businesses to the brink of bankruptcy throughout 2008.

The debt of 174 large US companies is trading at distressed levels, at well over 10% above comparable treasuries. Diane Vazza, S&P's credit chief, says defaults are rising at almost twice the rate of past downturns.

"US and European banks and financial institutions have 'enormous losses' from bad loans they haven't yet recognized and may have a harder time wooing sovereign-fund rescuers, Carlyle Group Chairman David Rubenstein said.

"'Based on information I see,' it will take at least a year before all losses are realized, and some financial institutions may fail, Rubenstein said... He didn't name any companies." (Bloomberg)

JPMorgan Chase & Co.'s chief executive said Monday that while the crisis in the credit markets appears to be three-quarters over, he believes a US recession is just beginning.

"'Even if the capital markets crisis resolves, it does not mean that this country will not go into a bad recession,' said CEO James Dimon, whose bank saw its first-quarter profit fall by half due to the recent collapse of the US mortgage market. 'The recession just started."

Raising interest rates in this type of environment would be very difficult. Seemingly everyone now reveres Paul Volker. But many forget, as Charles Gave points out, that he put the country through two severe recessions, bankrupting many Latin
American countries because of the high interest rates on the loans they had made in US dollars at much lower initial rates (shades of 'teaser rates'), which resulted in the technical bankruptcy of every major US bank. Those were not pleasant times, especially in Latin America. Be careful what you wish for.

If Ben Bernanke and the Fed governors decided to pull a Volker and raise rates in order to combat 4% inflation, there would be lynch mobs forming.

And it is not clear that inflation would respond to rising rates without a severe slowdown and an even worse recession. Oil prices would not respond to interest rates. Inflation, as Friedman tells us, is always and everywhere a function of money supply, and the money supply is not growing at anywhere near the rates of the 1970s. Oil is a function of supply and demand, spurred on by speculation. You can deliberately slow demand by tanking the economy, but are lower gas prices worth an 8% unemployment rate?

Likewise with food. Food price increases are due more to government policy (as in ethanol and subsidies) and increased demand for higher-quality foods, especially protein, from developing nations. I have yet to see a persuasive argument that food prices would respond to higher interest rates by courteously going lower. Unless, of course, you put the world economy into a severe recession. That would reduce demand for higher-quality foods. Again, not a wise policy.

Given that, the markets seem to be telling us that inflation in the future will not be the problem that the headlines suggest it is today. Let's look at this note and chart from Charles Gave of GaveKal (www.gavekal.com):

"The next question is the behavior of prices in the future. And to gage this, I will review two tools: one is the ECRI future inflation gauge of the University of Columbia,

and the other is the expected inflation for the next ten years as derived from the differences between a classical bond and an inflation indexed bond.

[Note: the red line is the ECRI gauge (left scale) and the grey is the expected inflation measure (right scale).]

"The least that can be said is that neither the forecasting tool of the Columbia University (which peaked at the beginning of 2006), nor the expected inflation are showing any signs of panic. We certainly do not see any significant rise in any of these two tools similar to the ones we saw from 1998 to 2000 or from 2002 to 2006. So maybe, just maybe, what we are seeing today is a change in relative prices (food and energy higher, housing lower) and not a general rise in the inflation rate."

I would not be surprised at all to find that inflation is not the problem it is today, by this time next year. In fact, given that we are seeing two bubbles burst and a recession and slow recovery, all of which are by definition deflationary, it would be odd if inflation got worse from here. Stranger things have happened, but the odds favor a view that inflation pressures will ease.

Bottom line? I think the Fed will be on hold for a rather long time. We are in a Muddle Through Economy. Even if the economy gets worse, as Jamie Dimon predicts, the problems in the economy would not be helped by lower rates. And until the economy starts growing at a rate above 2%, it will be difficult to justify raising rates in the face of such slow growth. And given the pressure on consumer spending and housing prices, I think the recovery that should begin later this year is going to be a rather tepid one.

Sell In May and Go Away

Numerous studies show that since World War II, as much as 99% of stock market returns have been generated between November 1 and May 1. Good friend and fishing buddy David Kotok of Cumberland Advisors sums it up nicely:

"According to the Ned Davis (NDR) database, starting in 1950, $10,000 invested in the S&P 500 Index every May 1st and then liquidated every October 31st would only be worth $10,026 today. That's right: had you stayed out of the stock market from November through April and only been in the market from May through October, you would have had no change during the last 57 years. 21 of those years would have been negative; 36 were positive. This happened during the same period that stock prices were rising about 75% of the time and markets made extended upward moves.

"Consider the results of the reverse strategy. Buy the S&P 500 Index on November 1st and sell all your stocks on May 1st. The outcome is dramatically different. Your original $10,000 would now be worth $372,890 as of April 30th closing prices in 2008. Out of the 58 periods you would have had positive results in 45 of them and negative results in only 13 years."

David goes on to show research at www.cumber.com as to why he thinks you should hold off on selling. I disagree, but then the stock market has been confirming David's position. My thought is that the Continuing Crisis will put pressure on corporate earnings throughout the summer, with more earnings disappointments at the end of this quarter.

Earnings disappointments are the stuff of bear markets. Richard Russell, one of the more astute market observers and in the past a serious bear, thinks we are now in a bull market. Dennis Gartman is now a bull. How do you argue with such astute traders?

I am sure Larry Kudlow will argue that the markets are telling us a recovery is imminent because the markets are rising. Nevertheless, I think this could be a very rocky summer for the markets in general. I look back to 2001-02 and find three bear market rallies of 20%. The market evidently did not know as much as it thought. But then, what do I know? If you have specific stocks you like, or are a trader, then that is fine. But for those whose only real equity choice in the retirement plan of investment in a long-only index, I would find one of the other options in bonds.

May 21, 2008

The Discordant State of Unions

In one corner of this no-holds-barred match is Barack Obama’s most important labor supporter, the Service Employees International Union, which helped spur a contentious split in the labor movement in 2005 when it bolted the AFL-CIO along with four other unions and formed the Change to Win coalition. Formed in the 1920s as a Chicago union representing janitors, SEIU has morphed into one of America’s biggest unions, representing some 1.9 million workers, by pursuing organizing efforts in sectors that are growing with taxpayer money.

Not surprisingly, SEIU’s biggest successes have come in healthcare, whose workers now constitute about 50 percent of its membership. Although only 8 percent of America’s private sector workforce is unionized, some 17 percent of hospital workers belong to unions and 21 percent of all registered nurses are unionized. While union membership shrinks elsewhere, in the last 20 years the number of nurses covered by union contracts in the United States has increased by 80 percent, a gain of some 240,000 union members.

This lucrative business for SEIU has turned traditional notions of union organizing on its head. Since government pays nearly half of all medical bills in this country, SEIU has scored many of its biggest victories working as a powerful lobbyist, often in collusion with employers rather than in confrontation with them. In New York State, for instance, the union’s local, 1199SEIU, struck up an unprecedented partnership with an employer group, the Greater New York Healthcare Association, and together campaigned relentlessly (and mostly successfully) to protect and expand the state’s Medicaid program—the most expensive such program in the country. Hyperbolic ads produced by the alliance condemned former Gov. George Pataki in 1999 when he tried to reform and trim the state’s Medicaid program, and again in 2007 when newly elected Gov. Eliot Spitzer targeted the bloated program for cost savings. In both cases politicians backed off as their popularity ratings sank from the advertising onslaught.

Even more astoundingly, when the contract between workers and hospitals represented by 1199 and Greater New York was about to expire in 2002, the alliance persuaded Pataki and the state legislature to ante up $1.8 billion in taxpayer money to give raises to 210,000 union members--an unprecedented gift by a state government to private employers and their workers in a state election year.

SEIU has been expert at using its legislative muscle to thwart efforts at health care cost savings. As California tried using more home health care workers to visit the sick, in hopes of reducing hospitalizations and nursing home admissions in its Medicaid program, SEIU persuaded state legislators to pass a bill making the workers, who were considered independent contractors, government employees, and then additional legislation to finance the cost of union contracts. Although Gov. Pete Wilson vetoed the financing bill, his successor, Gray Davis, whose 1998 election bid was heavily supported by SEIU, signed it, and from there it was a snap to organize the workers in a series of local drives, including one in and around Los Angeles in which SEIU signed up some 74,000 workers, the largest successful labor drive since the United Auto Workers organized General Motors in 1937. In this case, however, it was not car buyers, but taxpayers on the hook for the added costs of the contract. In the first five years after Davis signed the legislation, the state’s cost of the home health care program soared some $740 million.

Given SEIU’s size and clout, only a competitor with lots of moxie could successfully challenge it. That’s certainly a way to describe the California Nurses Association, which has been transformed by a former Teamsters’ organizer from a traditional professional association into a militant labor union. The CNA has gone on an ambitious organizing crusade outside of California and now boasts some 80,000 members, though its methods have been controversial. It has been called “a wildcat group” by the head of an Illinois nursing association and “California interlopers” by the chief executive of the Georgia Nurses Association. When California Gov. Arnold Schwarzenegger delayed implanting new hospital staffing regulations supported by the union, it picketed him at dozens of appearances around the country, sent a blimp to fly over a Super Bowl party he was hosting, and spent $100,000 on ads attacking him.

Like SEIU, the CNA has counted legislative victories as crucial to its growth. Its biggest victory so far has been to get Davis to sign legislation in 1999 mandating lower ratios of nurses-to-patients in hospitals, a move which state hospitals estimate when fully implemented will require an additional 4,000 nurses. Although a study published earlier this year by the peer-reviewed journal Policy, Politics & Nursing Practice concluded that so far the law, which has been phased in since 2003 in California, has had little effect on patient care in the state, CNA has heavily publicized its California legislative victory in its organizing efforts in other states.

In their present war over recruiting new members, both sides have accused the other of underhanded methods. CNA organizers are said to have posed as pizza delivery workers to gain access to a nurse’s unit in a Cincinnati hospital where CNA was trying to undermine an SEIU effort to organize some 8,000 workers at Catholic hospitals. SEIU responded by sending protestors to a speech by the head of CNA, where a small riot broke out between members of both unions. The two unions have been trading charges in ads run on left-wing Internet sites like Daily Kos.

Although labor leaders are worried that the spat will be a major distraction during a year in which labor is hoping to come together to influence the November elections, efforts to resolve the conflict haven’t gone very far, mostly because fundamental to this battle is animosity generated by the 2005 union split.

For taxpayers, however, the real import of this battle lies not in the ultimate winner, but in the road to victory that both unions have been employing. Although Democratic Presidential contenders Barack Obama and Hillary Clinton have tried to woo the union vote by promising to support legislation to make it easier for unions to sign up new members, in an American economy where most workers don’t want to be organized (only 35 percent of American workers said they might consider joining a union in a Zogby poll taken at the time of the Change to Win split) such legislation is only somewhat important.

The real payoffs for unions like SEIU and CNA is in supporting candidates that pledge to expand government-financed programs whose pay scales and contracts can then be influenced politically. For SEIU and CNA, promises by Obama and Clinton to pour more money into Medicaid and the federally financed State Children's Health Insurance Program represent the real future. Even more promising is the pledge both candidates have made to lift restrictions on states’ abilities to expand their own government-financed health programs, since unions wield more power in many state capitals—as their successes in Sacramento and Albany demonstrate--than they do in Washington, D.C.

Regardless of who wins the increasingly bitter battle between CNA and SEIU, both unions have their eye on one target—taxpayer-financed health care programs.

May 22, 2008

Taxes Matter, but the Dollar Matters More

As for the Democrats, both Barack Obama and Hillary Clinton have made plain their desire to sunset the 2003 legislation. In revealing their preference for a 2010 repeal of the 2003 reductions, both make the explicit point that they would like to see rates settle back to levels seen in the 1990s.

Sadly, the dollar's fall this decade has not generated any kind of campaign comment from either side. Oddly enough, both John McCain and Hillary Clinton support a federal gas-tax holiday for the summer, but it should be said that this gimmick is perhaps the primary campaign’s ultimate non-sequitur. To endorse an 18 cent per gallon tax cut on gasoline is to miss the point almost completely. Pump prices aren’t high due to federal taxes, but instead are reaching nosebleed levels thanks to a collapsing dollar.

If it’s agreed that stock-market returns at the very least indicate long-term economic optimism, the dollar’s fall should be issue #1 for candidates on both sides. While rates of taxation should never be ignored, it’s forgotten that inflation is but another form of taxation, albeit a somewhat hidden one. Just as high tax rates erode the value of paychecks and investments, so does inflation. And when stock-market returns over the last sixty years are considered, it becomes apparent that all three presidential candidates have taken their eyes off the ball. In short, it’s the dollar, stupid.

In his 1984 book, Losing Ground, Charles Murray wrote that the “average annual growth rate from 1953 to 1959 was 2.7 percent, noticeably lower than the average annual growth of 3.2 percent from 1970 to 1979.” Allowing for the certainty that government measures of economic activity are frequently misleading, Murray’s numbers would surely surprise economic historians who’ve characterized the ’50s as a period of economic revival in contrast with the stagnant, malaise-ridden ’70s. It should also be recalled that while it was nominally high in both decades, the top marginal tax rate was 91 percent in the ’50s against 71 percent in the ’70s.

The major difference between the two decades was not, however, in levels of taxation. Instead, the larger factor involved the dollar, whereby the U.S. economy in the ’50s benefited from a stable greenback measured as 1/35th of an ounce of gold. Conversely, thanks to President Nixon’s decision to sever the dollar/gold link in 1971, the dollar lacked definition afterward and proceeded to collapse. Despite the higher rates of growth that were achieved in the ’70s relative to the ’50s, the S&P 500 rose a mere 17 percent in that decade against a 255 percent return in the 1950s. High capital-gains rates were surely a factor in the ’70s underperformance, but with inflation a certain tax itself, the falling dollar (as evidenced by market returns in the present decade) to some degree made the tax penalty on investment irrelevant.

To show that levels of taxation surely matter, the reduction of the top rate from 91 percent to 71 percent in 1964 ignited impressive economic growth that was partially responsible for stocks reaching all-time highs in 1966. Still, many a commentator has noted that U.S. shares did not permanently pass those highs again until 1982. Sure enough, while the ’64 reduction in the tax wedge kept the economy buoyant, markets started to price in the likelihood that U.S. monetary authorities were growing increasingly impatient with the Bretton Woods system of fixed exchange rates.

This first showed up in private markets where gold traded far above the Bretton Woods $35/ounce fix, and later in government measures of inflation. By the end of 1968, consumer price inflation rose to 4.7 percent. So despite the pro-growth tax cuts passed after John F. Kennedy’s assassination, stock market returns greatly lagged those achieved in the ’50s. The S&P 500 ultimately rose a mere 54 percent in the ’60s due to inflationary monetary policy that stopped the mid-60s rally in its tracks.

A stronger dollar, 1980-2001. When we look at the ’80s, gold’s free fall from a high of $850 in January of 1980 was doubtless rooted in the approaching election of a president who preferred lower marginal rates and a return to the gold standard. And despite a needless recession caused by Fed policy that joined monetarism with Phillips Curve austerity, the ’80s economic revival occurred in concert with a strong dollar and S&P 500 returns of 121 percent during the Reagan years.

Moving to Bill Clinton’s election in 1992, the dollar sagged early on in the face of marginal rate increases combined with a renewed protectionist sentiment. In her 1995 book American Trade Policy: A Tragedy in the Making, Anne Krueger noted that by 1994, “bilateral trading relations with Japan had deteriorated under the Clinton Administration’s pressure for ‘quantitative targets.’” The latter policy helped drive the dollar to an all-time low versus the yen of 80/1.

Importantly, dollar policy changed not long after. Robert Rubin took over from Lloyd Bentsen at Treasury, and as economists Ronald McKinnon and Kenichi Ohno wrote in their 1997 book, Dollar and Yen, amidst the dollar’s rise from 80 to 113 yen by 1996, not once “did a responsible official in the American government complain that the dollar was too high.” With dollar policy sound, the 1993 tax increases were less biting given the tax “cut” achieved by a rising dollar. And while many credibly argue that the dollar rose into deflationary territory by the late ’90s, stocks soared with Rubin at Treasury; the S&P 500 rising 208 percent during Clinton’s presidency. The 1997 capital gains cuts surely helped the ’90s equity boom, though the rally’s origins predate any market knowledge of a capital gains reduction.

Bush, the dollar and the 2008 campaign. Many commentators with GOP leanings point to a “Bush Boom” that began with the 2003 income and capital gains reductions. Commentators with Democratic Party leanings point to a period of even greater economic growth that occurred amidst higher rates of taxation during the ’90s. Both sides perhaps downplay the greater story.

For GOP partisans to laud the economy’s performance under George W. Bush, they would have to ignore the basic truth that inflation is a taxing enemy of prosperity. S&P 500 returns during the Bush presidency of 3.6 percent compare poorly with the 30 percent return achieved during the charitably abysmal Carter years. And if they’re sanguine about 5 percent unemployment and recent GDP growth of .6 percent, they would also have to acknowledge that in GDP terms the economy grew every year of Carter’s presidency alongside the highest percentage job growth of any post-WWII president.

Democratic partisans would first have to admit that levels of taxation do matter. No credible candidate has suggested bringing tax rates back up to those experienced during the ’70s. They would also have to shed a rising protectionist instinct that has harmed the dollar, and if continued, would quickly discredit any tax plan brought forth under a Democratic administration. And for those who still believe that the Clinton tax increases helped the economy by bringing down interest rates, they should be reminded that the 30-year Treasury was yielding 5.8% when the Clinton tax increases passed in ’93 versus an 8% yield by 1994.

So while the broad policy goal should be one of bringing down tax rates across the board, the simpler reality is that with equities serving as a measure of long-term economic optimism, the U.S. economy has done well under all manner of tax regimes since World War II. What historical equity returns show is that dollar debasement is the one policy the stock market can’t withstand.

Today's Republicans talk up tax cuts, while Democrats talk up tax increases. Judging by equity returns, both sides ignore the dollar at their peril.

Friday's Home Sales Report & The Sorry State of Banking

In March, the annual pace of sales was 4.93 million, down 2 percent from
the previous month and 19.3 percent from a year earlier. The median price
in March was $200,700, a bit higher than in February, but 7.7 percent
lower than a year earlier.

The NAR?s index of pending home sales measures new contracts and provides
a forward looking indicator of final sales one or two months in advance.
Over the last year, this indicator has slid fitfully, and for February and
March combined it was down about 21 percent from a year earlier.

Based on this information and other soundings from the credit markets and
broader economy, my proprietary forecasting model indicates existing April
existing home sales will come in at about 4.84 million. The median prices
should fall to about $198,000.

Housing sales will remain well below the 7.1 million posted in 2005 and
prices will continue to slide. During the recent bubble, home and land
prices got out well in front of fundamentals, such as household personal
income and housing density. But for creative mortgages, which created huge
profits for New York banks and have since proven poisonous, many sales
would have never been completed at the lofty prices recorded in 2006 and
early 2007.

The U.S. consumer faces a constant drumbeat of bad news. Housing prices
are falling, gas prices are rising, good new jobs are getting scarcer than
hen's teeth, and credit card terms are getting tougher, even as the
Federal Reserve makes credit to banks cheaper.

Federal Reserve efforts to increase liquidity and bank lending have not
made mortgages adequately more available, especially in the Alt-A and
subprime categories. Alt-A loans are for homeowners offering good
repayment prospects but either less-than-perfect credit or recent income

Fannie Mae, generally, only takes a limited number of nonprime lenders,
and cannot finance many upper-end, more expensive homes. It certainly
does not finance the kind of liars loans, based on fictitious assertions
about home values and buyer incomes, that Citigroup, Merrill Lynch and
others bundled in bonds for sale to unknowing fixed income investors to
create transactions fees, profits and huge bonuses for executives.

Federal Reserve Chairman Ben Bernanke's strategy has two components. The
Fed has lowered short-term interest rates by slashing the Federal Funds
rate 3.25 percentage points since September 2007, and the Fed has
permitted banks to use subprime-backed mortgage securities to borrow from
the Federal Reserve. The latter is the so-called term auction facility.

These policies do not solve the basic problem, because these policies do
not provide banks with opportunities to write many new non-Fannie Mae
conforming mortgages.
Banks cannot provide the housing market with adequate amounts of mortgage
financing by taking deposits, writing mortgages and keeping those
mortgages on their portfolios. Bank deposits are not nearly enough to
carry the U.S. housing market. Much the same applies for loans to

In normal times, regional banks bundle mortgages into bonds, so-called
collateralized debt obligations, and sell these in the bond market through
the large Wall Street banks.
The recent subprime crisis revealed the large banks were not creating
legitimate bonds. Instead, they sliced and diced loans into
incomprehensibly complex derivatives, and then sold, bought, resold, and
insured those contraptions to generate fat fees and million dollar bonuses
for bank executives.

This alchemy discovered, insurance companies, mutual funds and other
private investors will no longer buy mortgage-backed bonds. Banks can no
longer repackage mortgages and other loans into bonds and are pulling back
lending. Home prices tank, consumers spend less, businesses fail and jobs

Private investors have taken massive losses, and the large banks have
taken more than $150 billion in losses on their books. This has left the
banks short of capital and in liquidity crises. The banks turned to
foreign governments, through sovereign investment funds, to sell new
shares and raise fresh capital, and to the Fed to boost liquidity.

Neither the sovereign investment funds nor Bernanke have required the
banks to change their business models, which essentially pays bankers for
creating arcane investment vehicles that generate transactions fees,
rather than writing sound mortgages and selling simple, understandable
mortgage-backed securities to investors.

Rather than reform their business practices to reenter the fixed income
market, Citigroup and other large financial houses are scaling back or
abandoning mortgage finance, and trolling financial markets for other
lucrative opportunities to write derivatives that pay outsized profits and
huge bonuses.

Most recently we have learned Citigroup?s hedge fund engineers have been
practicing slight of hand to sell derivatives based on bank-owned life
insurance policies, bilking investors and other banks for fees.

Until Citigroup and other major New York banks abandon such tainted
business practices, the bond market virtually remains closed to mortgage
finance, other than CDOs offered by Fannie Mae, and cannot supply the
volume and array of mortgage products necessary to support a full housing

The legislation to update regulation for Fannie Mae and other federally
sponsored banks and provide additional federal funds to assist these
institutions in working out troubled mortgages will help but the private
banks must be reformed and revitalized to fully finance a vibrant housing

The economic stimulus package tax rebates, interest rate cuts and
administration help for distressed homeowners are useful. The stimulus
package is less than the losses taken by private investors and the banks
on CDOs.

Getting the housing market going and the economy growing will require
Bernanke to aggressively pursue banking reform. Without genuine changes in
the way Wall Street handles mortgages and other loans, the economy can't
get back on track.

Peter Morici
is a professor at the University of Maryland School of
Business and former chief economist at the U.S. International Trade

May 23, 2008

A Tale of Two (Housing) States

Not understanding that the economics of home construction will not match a predetermined plan, new myopic regulations ran amok. The supply of new homes in these Smart Growth markets began to slow. By rationally responding to this new artificial restriction on supply, home prices rose rapidly. For a while, Smart Growth was making many people very rich on paper.

Other cities, however, imbibed much less of the Smart Growth kool-aid and prices stayed low. According to the S&P Case-Shiller Index, home prices in the Los Angeles and San Diego metros soared by 18% and 15% annually between 2001 and mid-2006. At the same time in the Atlanta and Dallas metros prices grew a mere 4.4% and 3% annually. Index data prior to 2001 is unavailable for Dallas, but home prices in Atlanta grew at the same 4.4% between 1991 and 2001. Adding to this price paradox is that Atlanta and Dallas were consistently among the fastest growing metropolitan areas in the United States.

It was then in mid-2006 that home prices in many of the highflying cities hit their all-time highs. Afterwards, home prices began to ease in L.A., San Diego, and San Francisco all before the foreclosures began to rise. The stock price of Countrywide hit an all-time high on Feb 2, 2007, showing that mortgage-lending investors had little idea of what was coming.

Home prices when rising at double-digit rates in a liquid market allow many to avoid foreclosure. Equity was growing too quickly to catch many people underwater on their mortgage. When home prices rose to more than ten times median income in California, demand simply could not continue to rise. Flat and then falling prices revealed how many people really could not afford to own a home.

For California, RealtyTrac data shows that foreclosures did not appreciably rise until August of 2006, but home prices were already flat in L.A. and falling in San Diego and San Francisco. Within six months, foreclosures in California grew by 30% and then a whopping 256% more within a year. The massive wave of foreclosures did not occur until nearly a year after prices had already started to drop.

The credit crisis began in part by the way that mortgage-backed securities are priced and by the highly leveraged nature of the mortgage lending industry. This home price boom wreaked havoc on a financial system unaccustomed to such volatility. Ratings are given to mortgage-backed securities based on backward looking analysis of defaults. In an environment where rapidly rising home prices mask foreclosures, risk premiums were too low and values too high on these securities. This practice had been a reliable model due to decades of steady trends. The mortgage lending business model was based on borrowing at low interest rates, lending to consumers at higher rates, and reselling the overpriced mortgage bundles to institutional investors. This system was unprepared for the fundamental changes brought by Smart Growth.

Defaults began to climb as prices fell, causing both the rate and severity of foreclosures to increase. At the same time interest rates were rising. The margins for mortgage lenders disappeared, and some companies collapsed. Any company or hedge fund that leveraged itself assuming faulty valuations of mortgage-backed assets was suddenly in trouble as well.

With less demand for their mortgage bundles, fewer loans were arranged. A vicious cycle set in where falling prices left more people underwater on their loans leading to more foreclosures. More foreclosures increased the supply of homes on the market leading to falling prices.

Painting Smart Growth as the culprit becomes inevitable because other theories on the housing crisis offer no explanation for geography. The Dallas metro was not experiencing the same surging prices as Los Angeles, but the differences do not stop there. Foreclosure rates in Texas have remained flat in the last two and a half years. Even with all the alleged and rampant fraud, resetting of ARMs, and irresponsible borrowers, Texas saw no surge in foreclosures. The only effect seen is slower sales after tightened credit requirements late in 2007. In Texas, there never was a bubble nor would there ever have been a credit crisis.

The only rational explanation for the differences between cities experiencing the housing crisis, and those that are not, is the prevalence of “Smart Growth” legislation. Sinister mortgage lenders and reckless borrowers are not the culprits. This housing crisis is an unprecedented disaster because of unprecedented meddling in the economics of housing development by the peddlers of “Smart Growth”. This scenario will happen again and again if its distortions are not removed.

May 24, 2008

Whither the Price of Oil?

I have talked for the past few months about why I feel we may be in for a tough investment environment and a Muddle Through Economy. I think in this type of market cycle it is important to increase your portfolio allocation weighting to noncorrelating investment strategies. I work with Steve Blumenthal and his team at CMG to help investors find managers who can take smaller minimums and who have such alternative strategies. We are creating a platform of managers that you can access for your personal portfolio. I recently completed a special write-up on Eric Leake of Anchor Capital, an investment advisor I am particularly impressed with. For the last 12-1/2 months, he is up 16.77%, in comparison to the S&P 500 index that is down -2.08% (net of fees from April 30, 2007 through May 15, 2008). Equally impressive is that he has generated this return while being uncorrelated to the S&P, and with lower volatility than the market.

You can get this report and others I have written by going to https://cmgfunds.net/public/mauldin_questionnaire.asp and filling out the form. If you are a manager and would like to be considered for the platform, drop a note to PJ Grzywacz at pjg@cmgfunds.net. And if you are an investment advisor and would like to see the managers that are on our platform and determine whether they might fit into your client portfolios, we do have a program to work directly with you.

And as always, if you have a net worth of over $2 million, I strongly suggest you go to www.accreditedinvestor.ws and register there. My partners in the US (Altegris Investments), London (Absolute Return Partners) and South Africa (Plexus) are experts in alternative investment strategies, including hedge funds and commodity funds. We have a very strong selection of funds in a wide variety of styles to help you diversify your portfolio. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.) And now, let's jump into the oil patch.

Those Nasty Index Speculators

Are institutional investors in the form of large commodity index funds the reason behind the current rise not just in oil prices but in the prices of seemingly all commodities? Michael Masters, a long-short hedge fund manager, in testimony before the Congressional Committee on Homeland Security and Governmental Affairs, said:

"You have asked the question 'Are Institutional Investors contributing to food and energy price inflation?' And my unequivocal answer is 'YES.' In this testimony I will explain that Institutional Investors are one of, if not the primary, factors affecting commodities prices today. Clearly, there are many factors that contribute to price determination in the commodities markets; I am here to expose a fast-growing yet virtually unnoticed factor, and one that presents a problem that can be expediently corrected through legislative policy action."

You can read the entire testimony at http://www.mcadforums.com/forums/files/michael_masters_written_testimony.pdf, but let's hear the basics of his argument:

"What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets: Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.

"These parties, who I call Index Speculators, allocate a portion of their portfolios to "investments" in the commodities futures market, and behave very differently from the traditional speculators that have always existed in this marketplace. I refer to them as "Index" Speculators because of their investing strategy: they distribute their allocation of dollars across the 25 key commodities futures according to the popular indices - the Standard & Poors - Goldman Sachs Commodity Index and the Dow Jones - AIG Commodity Index."

These index funds are composed of a number of commodities. While oil is the biggest component of the various funds, they also have exposure to grains, base metals, precious metals, and livestock. When you buy one of these funds you are buying a basket of commodities.

Why would an investor want exposure to a long-only index of commodities? Perhaps for portfolio diversification, as commodities are uncorrelated with the rest of the portfolio, or as a way to play the growing demand for commodities of all sorts from emerging markets, as a hedge against inflation, and so on. Mainline investment consultants began to suggest a few years ago to their clients that they get into the commodity market on a buy and hold basis, just like they do with stocks and bonds.

And they have done so in a very large way. As the chart below shows, at the end of 2003 there was $13 billion in commodity index funds. By March of this year, that amount had grown 20 times, to $260 billion. Masters also shows that this corresponds with the stratospheric rise in commodity prices. In many commodity futures markets, index speculators are now the single largest participant.

Is Correlation Causation?

There is no doubt that the rise in the investment in commodity indexes and the rise in prices correlate significantly. But does correlation necessarily mean that there is a direct cause and effect? Masters says it does. (Later we will look at arguments against this view.)

As an illustration, he shows that the rise in demand for oil from China in the past five years has been 920 million barrels of oil per year. But index demand (the word Masters uses) for oil has risen by 848 million barrels, almost as much as another China.

And Masters gives us facts that are interesting. There is enough wheat in the index speculator "stockpiles" in the US to feed every many, woman, and child all the bread, pasta, and baked goods they can eat for the next two years - about 1.3 billion bushels. Yet wheat has soared in price.

As the prices of the indexes have risen, the demand for the indexes has grown. And these indexes are not price sensitive. If a billion dollars is invested in a given week, the index funds simply buy whatever allocation of futures contracts is needed to make up their index, at whatever price is offered.

For the first 52 trading days of the year, demand for commodity index funds grew by more than $55 billion, or more than $1 billion a day. And as Masters points out, "There is a crucial distinction between Traditional Speculators and Index Speculators: Traditional Speculators provide liquidity by both buying and selling futures. Index Speculators buy futures and then roll their positions by buying calendar spreads. They never sell. Therefore, they consume liquidity and provide zero benefit to the futures markets.

"Index Speculators' trading strategies amount to virtual hoarding via the commodities futures markets. Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits."

And now we get inflammatory:

"Think about it this way: If Wall Street concocted a scheme whereby investors bought large amounts of pharmaceutical drugs and medical devices in order to profit from the resulting increase in prices, making these essential items unaffordable to sick and dying people, society would be justly outraged."

What about position limits? Aren't there real limits to the amount of a physical commodity that a fund or speculator can accumulate? Masters points out that there is, but the CFTC has given investment banks a loophole, in that they can sell unlimited size positions in the OTC swap markets if they hedge the positions.

So, a hedge fund could buy $500 million worth of wheat, which would be way beyond the actual market position limit, through a swap with a Wall Street bank, without having to worry about position limits. And there is no doubt that large purchases of any commodity will drive up prices, at least in the short term.

What does Masters think Congress should do? Prohibit pension funds from commodity index buying, close the swaps loophole on speculative positions, and make the CFTC (Commodity Futures Trading Commission) provide more transparency as to who is buying commodities. That would stop those nasty index speculators from driving up food and energy prices. Prices would come back down and we could all go back to driving our SUVs without having to worry about the cost.

Well, then, maybe not. It is not that simple. While there is no doubt that excess demand in the form of index buying can have a very real effect -on prices, it is not the whole story.

What an index funds does is buy a futures contract for a given commodity when money is first invested. Say that contract is six months out. When the contract is one month from expiration or delivery, the index fund sells that contract and buys another contract six months out. They sell before the contract could have an effect on the cash price of the physical commodity. The cash price is determined by supply and demand.

Let's look at supply. Masters mentioned wheat. Yes, the index speculators have built up a large futures position. But that is not the same as a large physical position. With demand soaring abroad and droughts crimping supply, the world's wheat stockpiles have fallen to their lowest level in 30 years, and stocks in the United States have dropped to levels unseen since 1948. That could go a long way to explaining rising wheat prices.

Corn? The USDA is expected to report corn stocks for the year ending Aug. 31, 2009, to fall to 685 million bushels, according to analysts surveyed by Thomson Reuters, down 47% from 1.283 billion bushels in 2008. The corn crop season ends on Aug. 31. (They expect wheat and soybean stocks to rise, for which we can be thankful.)

Bob Greer, executive vice president at PIMCO, rebuts Masters arguments in a very cogent paper recently sent to me. He argues that index funds do not affect the price but may contribute to volatility.

"Some market observers have tried to tie the level of inventories to index investment, most notably in crude oil. Their arguments take one of two forms:

"1) The indexer's act of selling the nearby and buying the distant contract forces the futures curve to be upward sloping (future price is higher than nearby price). This creates an incentive to own inventories and earn the "return to storage" represented by the slope of the futures curve. The act of increasing inventory keeps the commodity off the market, thus decreasing supply.

"2) A variation of the above argument is that the short seller, who takes the other side of the indexer's purchase, needs to protect their position by buying and holding the physical commodity.

"It would be nice if either of these arguments were true, in which case, the developed world would not be hostage to the Organization of the Petroleum Exporting Countries (OPEC). Any time we needed to increase crude inventories, we need merely to bring in more indexers, and the inventory would appear. In fact, the explanation for inventory levels of any commodity is much simpler. If, in the cash markets, production exceeds demand, inventories will rise. Otherwise they will fall. That is why, in six of the last eight years, global wheat inventories fell, regardless of index investment (USDA). That is why from 2006 to 2008, crude oil inventories declined and the crude oil curve went from upward sloping to downward sloping, in spite of increasing index investment (EIA). Furthermore, the second argument above breaks down when applied to non-storable commodities such as live cattle."

Further, Greer shows a chart from Deutsche Bank which highlights the fact that many commodities which are not in the index fund portfolios have risen higher than exchange-traded commodities (rice, for instance). Look at the chart below:

Greer concludes with these important paragraphs:

"Regarding intrinsic value, commodity futures prices converge to cash prices, and cash prices are set by the level of demand to consume physical goods such as steak, gasoline, and Wheaties. The price setting mechanism is not based on possibly erroneous assessment of a financial statement, nor on irrational exuberance. In commodities there is an outside measure of intrinsic value--the cash market--that is not dominant in equity, real estate, or tulip bulb markets. As actual commodity prices go higher or lower, they reflect consumption requirements for actual products, many of which are not very storable.

"This is a sharp contrast from internet stocks or vacation condos, which are subject to speculative bubbles. Unfortunately, our conventional wisdom regarding factors that create bubbles is rooted in asset classes like stocks and real estate, asset classes that have fundamentally different characteristics than physical and futures markets.

"Coincidence is not the same thing as causality. It is a coincidence that commodity index investment has increased in the last few years just as commodity prices have increased. If there is any causality, it is the other way around. Rising commodity prices have caused an increased interest in commodity investment. And it is certainly causality that fundamental supply, demand and inventory factors have driven commodity prices in many markets higher, whether or not those are markets in which index investors participate. This is the same causality that has driven commodity prices both higher and lower for many decades."

Where Will Oil Prices Go?

So, let's look at the fundamentals for oil. While a large part of this week's rise in oil was short covering (you can tell that from open positions), the supply of oil was down 7% from last year, even with demand beginning to fall. But there is an interesting footnote to that statistic, which we will visit later. Look at the chart below from www.economy.com:

Notice that supplies turned down sharply this last month, while the momentum of falling supply had been dropping since January. That is to say, the change in crude oil stocks was a negative 10% in January and was a little over -4% a month ago, falling to -7% today. But this is in the face of demand slowing. Today we learned that gasoline usage was down 4.2%, as prices are finally changing American driving behavior.

Jakab Spencer noted in his always interesting Dow Jones column that there is a disconnect between the New York Stock Exchange and the New York Mercantile Exchange, just one mile apart. The NYSE is pricing in $75 oil in oil stocks, while the futures market is surging over $135, and there are calls for near-term $150-a-barrel oil. The stock market is telling us that oil, at least in futures terms, is in a bubble.

And frankly, if you listened to their testimony, and more importantly pay attention to their actions, oil company executives simply do not believe that the price of oil is going to be $135 a barrel for the next few years. If they did, they would be punching more holes in the ground in places where it might be expensive to get the oil to market - but at $135 a barrel it would be profitable.

And then there is an odd circumstance in the oil picture that I think may suggest that we could see a break, and perhaps a violent one, in the near term for the price of oil.

Where Are All the Tankers?

For a few weeks now, observers have noticed that Iran is leasing tankers and storing oil in them. At about $140,000 a week or so, that is expensive storage. At first, conspiracy theorists were wondering if they were preparing for some kind of war or attack. But more conventionally, it may be they are having problems selling their oil. Their oil is not very high-quality, and there are only a few places that can take it and refine it. India, China, and the US are among the countries with refineries that can take Iranian oil. (And yes, George Friedman of Stratfor tells me some of it does end up in the US from time to time.)

India's refiners are telling Iran they no longer want their oil, preferring the higher-quality oil that is readily available in the area. So Iran has to decide whether to send it to China or "repackage" it so that it can end up in the US, while they try to get refiners in India to change their minds. Thus, they are leasing tankers to store the oil they are pumping.

I called George about six this evening and asked him about the Iranian situation, as that is a lot of oil that could come on the market at some point, as well as a possible reason that oil supplies are down. George has analysts on top of this situation.

He told me, "John, it's more interesting than that. It is not just Iran. Today we started checking on how many tankers Iran had, and soon discovered that there is a serious tanker shortage. Lease prices have soared in the past few weeks. It is clear there are a lot of speculators betting that oil is going to rise to $150 or so and are willing to pay very high prices for keeping the oil on the seas waiting for higher prices. It is a speculative boom."

He then told me about flying into New York in the early '80s. Outside the harbor were 30 or so tankers just sitting, waiting for prices to continue to increase as they had been doing for some time. When they did not, they all tried to get into the harbor at the same time, and of course they couldn't. It was the top of the market. Prices dropped, and the owners of the oil had to go to the futures market to hedge what they could. I had heard that story, but George saw it with his own eyes.

Almost everyone (except the stock market) is convinced oil is going higher in the near term. As I noted above, this week's rally was partially due to short covering by large institutions and companies which had sold production far into the future at much lower prices. They finally threw in the towel and took off their hedges.

Is it 1980 All Over Again?

We may be getting ready to stage a very interesting economic experiment. Is Masters right that prices are driven by speculation, or is it supply and demand? Follow me on this one. I am not saying that this will happen, but it is an interesting scenario.

Many developing countries subsidize the price of oil to their citizens, so they do not feel the pain of higher oil prices. But the headline of today's Financial Times is that Asia is finally getting ready to cut their subsidies as oil rises to $135. The awareness that they need to allow market conditions to prevail is finally being acknowledged, as they cannot afford the subsidies. This is going to help drive down demand for oil over time.

As demand starts to fall, let's remember that the storage facilities for oil waiting to be refined are a finite item. If all those tankers end up needing to find a home at the same time, even as demand for oil is going down, you could see the price of oil go down rather quickly in the short term.

If you are leasing tankers to deliver oil that is already hedged in price, you want to get it to port as soon as possible so that your lease payments stop as soon as possible. You only hold it on the high seas if you think the price is going up by more than your carrying costs (the cost of money and leasing the tanker). If you start to lose money, you sell your oil on the futures market and get it to port as fast as you can.

Now, here is where it could get interesting. Oil is the biggest component of the commodity index funds. If oil drops and looks likely to go lower, then the massive buying of these funds we have seen in the past few months could dry up. As Dennis Gartman says, it takes a lot of buying to make the price of something to go up, but it only takes a lack of buying to make it go down. And if there is net selling?

If we see money start to flow out of the index funds (and ETFs) because of momentum selling, that means the funds are not only selling their oil components, but also the grain and metal and meat. If the index funds are the key component in the rise of prices, we should see the price of all commodities go down in tandem and in sympathy. If oil is the only thing going down as index funds go down, then it is a supply-related issue.

But what if index funds continue to grow? If there is an abundance of oil, it will eventually show up in the spot price, as storage will be lacking, no matter what the longer-term futures prices do. The market will soon tell us whether index funds are a major factor. I tend to think that even while index fund buying is bullish, it is not the major factor that is the driver of commodity prices. And even if it is significant in the short term, in the long term fundamentals will drive the true price.

If it is simply index speculation, it will end in tears when the fundamentals catch up.

Let me say that I believe the long-term price of oil is going much higher. I was writing about $100 oil two years ago. $150 and $200 oil is in the cards at some point in the future. If you have not read the Outside the Box from last Monday, you should. My friend David Galland points out that Mexico, which supplies 14% of US oil, is likely to be a net importer of oil by the middle of the next decade, as their internal demand increases and production decreases. Iran will be a net importer within six years for the same reasons. Russia's oil exports are down this year, as are Mexico's. Energy costs are going to rise in the next decade, and maybe much sooner.

You can click on the following link to read the Outside the Box on where oil exports are headed in our future. And Casey Research does some top-notch analysis of energy investments (not just oil) in a very reasonably priced letter, if you are inclined to invest in individual stocks.

As for today, if I was in a long-only commodity index fund, unless my time horizon was very long I would be watching it closely and have some close stops. And I might wait until I saw what the price of oil was going to do. If you have some profits, then you might want to think about taking some off the table. Just a thought.

May 27, 2008

Can Central Banks Talk Too Much?

While practitioners in central banks and international institutions agree on the desirability of informative announcements and promote greater transparency on the ground that any information is valuable to markets, recent academic literature argues that public announcements may destabilise markets by generating some overreaction.

Financial markets and macroeconomic environments are often characterised by positive externalities – for example, during speculative episodes, it is rewarding for a trader to attack a currency or run a bank if others decide to do so.

In these environments, public announcements serve as focal points for traders in predicting others’ beliefs and, therefore, affect agents’ behaviour more than justified by their informational contents. If public announcements are inaccurate – because of inevitable forecast errors – private actions are drawn away from fundamental values.

Public information is a double-edged sword: it conveys valuable information, but it leads agents pursuing coordination to condition their actions on public announcements more than optimal. In this respect, Morris and Shin (2002) have shown that noisy public announcements may be detrimental to welfare. They conclude that central banks should commit to withholding relevant information or deliberately reduce its precision. This result has received a great deal of attention in the academic literature, in the financial press (see for example the Economist (2004)), and among central banks.

Degree of publicity and limited over-reaction

In a recent paper (Cornand and Heinemann, 2008), we challenge this conclusion by distinguishing two components of transparency: precision of information and degree of publicity. Precision is the inverse variance between a signal about some variable and that variable’s actual realisation. The degree of publicity is the proportion of market participants who receive a signal (message) from the central bank. We show that a message of limited publicity is always superior to withholding information or reducing the precision of announcements. Indeed, a public announcement serves as a focal point for traders predicting others’ actions so that traders’ actions are heavily influenced by public information. If this information is inaccurate, agents may coordinate on a state that differs substantially from fundamentals, generating welfare-detrimental overreactions.

However, all information is valuable to the extent that it helps predict the state of the world. A limited degree of publicity reduces incentives to exaggerate the weight on such a semi-public signal, because rational traders know that other traders do not share this information. On the other hand, a semi-public announcement improves the quality of decisions by those market participants who receive this signal. Therefore, limiting publicity combines the positive effects of valuable information for those who get it with confinement of its threats by limiting the number of receivers.

The higher the precision of public signals, the lower is the probability that an exaggerated weight reduces welfare. Hence, full publicity is optimal if public signals are sufficiently more precise than private information. However, even if authorities can only provide rather imprecise signals, they are better off providing this information to some market participants than withholding their knowledge from the market.

Any means of information dissemination that reduce the degree of common knowledge have the same effect as a limited degree of publicity. Thus, it may be more efficient to disseminate imprecise messages in communities or through media that reach only a part of all traders or limit higher-order beliefs by other means. Partial publicity can also be achieved when central bankers deliver speeches or invite a small group of journalists. Announcements in such environments are less widely reported than formal announcements or require more time to penetrate the whole community. Beliefs about the beliefs of other agents are less affected by these means than by formal publications at predetermined dates. Slow penetration prevents that these announcements become common knowledge at any point in time although the propagation of information may raise the degree of publicity above the primary proportion of informed traders. Optimal information policy must account for this multiplier effect.

These results give a rationale for the common practice of central banks releasing partially public information in addition to official publications: information with low precision should be partially withheld from the public; information of high precision should always be released with full publicity.

The optimal degree of publicity is rising in the precision of signals. If public signals can be released with a precision that is at least twice the precision of private information, public signals should be released to all traders. However, no information should be entirely withheld from markets.

Discussion and (practical) policy implications

There are several means by which central banks release information. Most important are a central bank’s own publications (hardcopies and Internet), press releases, press conferences, speeches and interviews. The general practice is that publications and press releases are distributed as widely as possible to get through to all market participants. In addition, publication time is announced beforehand, so as to make sure that everybody has the chance for receiving new information at the same time. Speeches and interviews, instead, are directed first of all to those who are physically present plus eventual listeners, if a speech is broadcasted. To reach a wider audience and avoid misinterpretation, the texts of important speeches are also disclosed and sometimes released via the Internet. For interviews, central banks invite journalists of leading financial newspapers to allow for the widest possible impact. None of these channels guarantees common knowledge, but there are clear attempts to achieve the highest possible degree of publicity. While this is desirable for rather precise announcements, central banks should avoid that messages of low precision become common knowledge.

In practice, common knowledge is more difficult to achieve than to avoid. However, if a central bank deliberately aims at avoiding common knowledge, there are various channels by which it can attempt to limit the degree of publicity, provided that is not legally obliged to publish its information:

1. Launching information in selected media may be a very efficient way of controlling the degree of publicity. Circulation of newspapers is well documented and may serve as a measure for the number of recipients. However, as circulation is endogenous, the central bank must select different media at different times.
2. Speeches may also be a very effective tool for achieving partial publicity, because attention to speeches is limited in comparison to written information (Walsh, 2006).
3. Central banks may communicate some information to small numbers of private banks, in particular when communication is related to banking supervision. Financial stability is directly connected to market overreactions in situations of strategic complementarity. In this respect, supervision is an example where central banks actually target limited publicity. For the purpose of limiting publicity, it may help not to announce such meetings or the identity of receivers of information to the public either.
4. The timing of announcements can be chosen deliberately to limit the geographic area in which it is acknowledged.
5. Releasing information at irregular times may not prevent everyone from eventually receiving the information. But, if publication time is not common knowledge, the information cannot become common knowledge at any point in time either.
6. Information that is provided via the Internet is, in principle, publicly available. Depending on the transparency of a website, information can be attained more or less easily. The more difficult it is to find certain data or speeches, the higher the uncertainty of traders about the state of other traders’ information. The more fragmented information is, the less likely that the whole picture becomes common knowledge, because not all fragments are recognised by all agents (Morris and Shin, 2007).
7. Under certain conditions, signals can only be interpreted in combination with ex ante information under the disposal of a limited fraction of market participants. This might be data that are informative only in combination with certain balance sheets or other private or “semi-public” information. For example, some moves in the foreign exchange market are pretty unintelligible unless one has information on positions and large trades. For this complementary information, a public release amounts to limited publicity. Ambiguous statements of general interest do not yield this effect. With different ex-ante information, an ambiguous statement amounts to an imprecise signal for traders with low ex ante information. Our results show, however, that imprecise signals should not be released to a general audience.
8. Selling data at prices that not all agents are willing to pay may also be a way to exclude some fraction of the public from getting information. For statistical offices, it is quite common to provide data to markets at high prices. Some central banks, like the Bank of France, charge local actors for sector-specific or regional data that are accompanied by an analysis of the central bank.


Far from being perfect, all these means of communication allow the central bank to provide partially public information and avoid market overreactions to information of poor quality. To some extent, these means play a role in the actual policy of central banks already. Therefore, our results give a rationale for central banks releasing partially public information in addition to official publications. Our main result shows that these means of partial publicity should only be employed for announcements of low precision.

Finally, there are some obvious implementation problems for our policy advice. In democratic societies, central bank independence needs to be underpinned by accountability and transparency. Hence, most important information cannot be withheld from segments of the public. Media coverage and private dissemination of signals generate multiplier effects for which the central bank must account. Simulations of our theoretical model show, however, that no agent has an incentive to fully publish semi-public announcements, because the competition advantage associated with information asymmetry is larger than the private gains from coordination that are induced by full publicity.

Camille Cornand is a Research Fellow at the Centre National de la Recherche Scientifique (CNRS). Frank Heinemann is Chair of Macroeconomics, Technische Universität Berlin.


Cornand C., and Heinemann F. (2008). ‘Optimal Degree of Public Information Dissemination’, The Economic Journal, vol. 118 (April), pp. 718-742.

Morris, S., and Shin, H. S. (2002). ‘Social value of public information’, American Economic Review, vol. 52(5), pp. 1522–34.

Morris, S. and Shin, H. S. (2007). ‘Optimal communication’, Journal of the European Economic Association, 5, pp. 594-602, conference proceedings.

The Economist (2004). ‘It’s not always good to talk’. July 22nd:71.

Walsh, C. E. (2006). ‘Transparency, flexibility, and inflation targeting’, in (F. Mishkin and K. Schmidt-Hebbel, eds.), Monetary Policy under Inflation Targeting, Central Bank of Chile, Santiago, Chile.

The U.S. Dollar Hits an Oil Slick

And how did the rise in the price of oil affect the dollar’s movement?

Because the oil market is global, with its price in different places virtually identical, the price reflects both total world demand for oil and total supply by all of the oil-producing countries. The primary demand for oil is as a transport fuel, with lesser amounts used for heating, energy, and as inputs for petrochemical industries like plastics. The increasing demand for oil from all countries, but particularly from rapidly growing emerging-market countries like China and India, has therefore been, and will continue to be, an important force pushing up the global price.

The thinking behind the question of whether oil would cost less today if it were priced in euros seems to be that, since the dollar has fallen relative to the euro, this would have contained the rise in the price of oil.

In reality, the currency in which oil is priced would have no significant or sustained effect on the price of oil when translated into dollars, euros, yen, or any other currency.

Here is why. The market is now in equilibrium with the price of oil at US$120. That translates into 75 euros at the current exchange rate of around US$1.60 per euro. If it were agreed that oil would instead be priced in euros, the quoted market-equilibrating price would still be 75 euros and therefore US$120.

Any lower price in euros would cause an excess of global demand for oil, while a price above 75 euros would not create enough demand to absorb all of the oil that producers wanted to sell at that price.

Of course, the rate of increase of the price of oil in euros during the past year was lower than the rate of increase in dollars. The euro price of oil last May was 48 euros, or 56 percent below its current price.

But that would be true even if oil had been priced in euros.

The coincidence of the dollar decline and the rise in the oil price suggests to many observers that the dollar’s decline caused the rise in the price of oil. That is only true to the extent that we think about the price of oil in dollars, since the dollar has fallen relative to other major currencies. But if the dollar-euro exchange rate had remained at the same level that it was last May, the dollar price of oil would have increased less.

The key point here is that the euro price of oil would be the same as it is today. And the dollar price of oil would have gone up 56 percent. The only effect of the dollar’s decline is to change the price in dollars relative to the price in euros and other currencies.

The high and rising price of oil does, however, contribute to the decline of the dollar, because the increasing cost of oil imports widens the US’ trade deficit. Last year, the US spent US$331 billion on oil imports, which was 47 percent of the US trade deficit of US$708 billion.

If the price of oil had remained at US$65 a barrel, the cost of the same volume of imports would have been only US$179 billion, and the trade deficit would have been one-fifth lower.

The dollar is declining because only a more competitive dollar can shrink the US trade deficit to a sustainable level.

Thus, as rising global demand pushes oil prices higher in the years ahead, it will become more difficult to shrink the US trade deficit, inducing more rapid dollar depreciation.

Martin Feldstein is Professor of Economics at Harvard and President of the National Bureau for Economic Research.

May 28, 2008

Income Inequality in the NFL

Hearing the back and forth between both sides, I wondered, is there really, as both sides seem to claim, income inequality in the NFL? And if there is, does it say anything about the gap between the rich and the rest of us in society in general? I took a look at the salary structure of the team with the biggest payroll in 2007, the Washington Redskins, who paid $123 million in salaries to 59 players, including those on the practice squad, over the course of the year. That’s a rich pot, but what I found was that the top quintile, or 20 percent, of the roster took home 63 percent of the money, and the top two quintiles earned 85 percent. The Skins’ aren’t an anomaly, even though they are one of the richest teams. The other teams at the top of the salary scale—the Pats and the Saints—devoted 62 percent and 60 percent of salaries, respectively, to a fifth of their players.

It was only slightly different at the bottom. The team with the lowest payroll in 2007, the Super Bowl-winning New York Giants (talk about value for your dollar), paid 59 percent of wages to the top 20 percent, and 78 percent to the richest 40 percent of players.

Is this fair? I suppose that depends on your definition of fairness. But by way of comparison, I took a look at how this income structure compares with household incomes in the United States. According to U.S. Census data, the top quintile, or 20 percent of households, captured about 51 percent of total family income, while the second quintile earned about 23 percent off all family income. Together, that amounts to about 74 percent of all household income. In other words, income is actually slightly more concentrated in the NFL than it is within our larger society, and there is a bigger gap between the richest and everyone else in football.

What makes this so astonishing is that the NFL has all sorts of mechanisms in place that we lack in our general labor market which are supposed to smooth out income inequality. For one thing, the NFL is entirely unionized, and we keep hearing (most recently from Barack Obama) that income inequality in America is in part a function of the decline in unions. The NFL also distributes talent to teams through a draft, which minimizes competition among employers for entry-level workers. No such check on bidding wars for the most talented exists within our general economy. The NFL has a cap on the amount of salaries it allows teams to pay, which presumably acts as a curb on salaries at the top of the wage scale. And players cannot jump to other teams until they have been in the league for four years, meaning that their employment mobility is far more limited than within our labor markets in general.

What is perhaps even more interesting is that what holds true in the NFL apparently is true within other major sports leagues, even though they all have very different collective bargaining agreements and salary structures. Mark Perry, a professor of finance and economics at the University of Michigan, has calculated the income distribution of teams in Major League Baseball, where there is no salary cap. What he found is that in 2007, the top teams were paying between 66 percent and 77 percent of their salaries to only 25 percent of their rosters. Moreover, Perry found that over 20 years, as baseball has grown richer and more successful as a sport, recording record attendance and revenues, the share of salaries going to the top 25 percent has increased for those same teams. The Mets, contenders in both 1988 and 2007, paid 61 percent in 1988 and 70 percent in 2007 to the top quarter of their rosters.

In the NBA, where rosters are much smaller, the divide is just as stark. In the season that ended in spring 2007, the Phoenix Suns, with the leagues’ richest payroll, that is, with the most money to disburse among its players, paid 68 percent of total salaries to just four of 14 players.

What accounts for this madness among professional sports owners? Perry, writing about Major League Baseball salaries, opines that “above-average competence commands higher monetary rewards in an increasingly competitive” environment. Why? Because professional sports are quintessential human-capital industries, valuing the talents of individuals far more than anything else. The old saw about the new economy, that your assets walk out the door every night, is especially true in sports.

Still, it’s not as if the top players are capturing all of the rewards of the growth in professional sports, to the exclusion of everyone else. As MLB and especially the NFL have cashed in over the years, everyone’s share has grown. The total payroll of the Washington Redskins has doubled in the past five years. While the top players (who’ve changed over time) got a chunk of that gain, the median salary on the team also increased 85 percent to $855,000.

Something similar is going on in the rest of society, where the premium paid for talent has been rising, pushing up salaries fastest among those at the top even as everyone gains. In a highly influential paper published last year, Harvard economists Claudia Goldin and Lawrence Katz attributed rising income inequality not to the standard culprits we hear about in presidential campaigns—like globalization or the decline of unions—but rather to the growing premium that a knowledge-based economy places on education, especially on a college degree. The authors estimate that the returns on a college education actually fell from 1915 to 1950 as our universities supplied more grads than the economy could absorb, narrowing the income gap in the process between college grads and everyone else. That began to change, however, when rapid technological innovation created a demand, which has outstripped supply, for highly educated workers, something that began in earnest in the 1980s and has continued since then.

Facing such a dynamic in the labor market, there are a few things a society may be able to do to narrow the income gap for some people, like ensuring that public schools do the best job possible preparing kids for college, so that those with the potential for college don’t get their aspirations quashed because they’re stuck in a bad system.

But in a world in which not everyone is cut out to earn college or post-graduate degrees, as long as the economy keeps valuing the sheepskin so much it may be difficult to restrain income inequality. The goal in that case is to continue to ensure that the overall economy keeps growing so that everyone’s pie gets bigger, even if it’s impossible to micromanage how the pie is cut up.

After all, the NFL has fewer than 1,700 players, compared to a U.S. workforce of some 138 million, and the league employs a variety of rigorous mechanisms to redistribute income, yet it hasn’t done a very good job of smoothing out the rough edges of income inequality. They’re all getting richer in the NFL, just not at exactly same rate.

What Gold Tells Us About Housing

First, a digression as to why Gold is important. Gold is the most important market signal of all because it defines the price of a currency, including the dollar, and the value of currencies relative to others. Gold is the best measure of currencies because of the intrinsic qualities within it.

For one, we know where gold is, even in the ground. It is also virtually indestructible. New gold is generally consumed, leaving the existing stock static. Furthermore, as Paul Hoffmeister of Bretton Woods Research points out, gold is the one commodity that has never backwardized, i.e. the spot price never exceeds the long price. What this tells us is that gold is not susceptible to short term supply/demand pressures, thereby maintaining stability relative to currencies. What is critical to remember is that movements in the gold price indicate either dollar strength or dollar weakness. A stable gold price is ideal because it means that monetary policy is neither deflationary or inflationary.

The uniqueness of gold as a market indicator can be useful in analyzing the housing market, other fundamentals aside. The two most watched housing market indicators are new housing starts and existing home sales. The evidence suggests that the price of gold can shed light on the prospects for both.

Homebuilders and Housing Starts

With the current housing crisis in mind, we can look to single family home starts since 1970. When tracked against the spot price of gold, a rather startling trend emerges. Housing starts tend to rise or fall based on divergences in the gold price. When the dollar/gold price changes dramatically, i.e. monetary policy becomes inflationary or deflationary, housing starts fall in tandem.

What the data evidences is that the Fed’s monetary policy has engineered seven slowdowns in housing starts since 1971. Five slowdowns were the result of inflationary pressures indicated in the gold price. Two were the result of deflationary pressures, particularly the 1980-1982 episode that liquidated many home builders. Housing tends to do well once monetary policy is oriented correctly, i.e. monetary policy becomes disinflationary or reflationary.


Particularly apparent is the long sustained bull market in housing starts from 1991-2005. This period coincided with the Fed’s best monetary policy management, which generally stabilized the dollar against gold and wrung residual inflation from the 1970s out of the system. Of course, an added benefit to dollar stability was lower long term rates, increasing affordability for newer and better housing.

The current housing problems began in late 2005 when the gold price really started to rise, reflecting accelerating inflationary pressures. While gold has been increasing steadily since 2001 (and the dollar weakening) it is apparent that the market gave up on the Fed’s lack of dollar management in 2005. Thus the subsequent rapid decline in housing starts was a logical response to the lack of direction from the Fed regarding the dollar. This is the trend that is further evidenced in inflationary periods in 1972-1975, 1978-1979, 1986-1988, and 1990-1991.

This is not to say that other factors such as sudden changes in fiscal and regulatory policy can’t have ill effects on housing starts. But the evidence suggests that new housing starts thrive when gold, and thus the dollar, are stable.

Existing Homes and Falling Prices

Next, we look to the Census Bureau’s reported national median home price. Although nominal prices have risen over time, real prices - as defined in ounces of gold - declined rather sharply beginning in 1971 and rose very slowly subsequently to the dollar devaluation of the 1970s.


Keeping the recent housing boom in perspective, housing values in real terms peaked in 2001, albeit slightly lower than where they were in the 1960s. The trend in increasing real values as measured in gold from 1980 onward had simply reversed what the inflation of the 1970s did to real values that peaked in the late 1960s. So the perception that housing keeps pace with inflation is misleading. Instead, nominal prices serve to minimize losses in real terms at best.

While aggressive underwriting fueling unprecedented home buying generally gets the blame for the fall in existing home prices, blame truly lies at the feet of the government’s inflationary monetary policy. The current decline in nominal prices is the market’s way of bringing nominal prices in line with housing’s real value in gold. Home prices are adjusting to the Fed and Treasury’s wanton neglect of the dollar.

Where Does Housing Go From Here?

In short, no one really knows for sure when existing housing prices will recover or when housing starts will resume at a healthy clip, but an eye on the gold price should help us monitor the situation. Nationally, nominal housing is 13% off its March 2007 high, and is currently worth in real terms 231 gold ounces. This of course will vary by individual market, with the coastal areas more likely to have steeper fall-off in prices. But what is really scary is that the housing to gold ratio could still fall further judging by historical evidence.

Current nominal housing prices in gold ounces have yet to reach the February 1980 bottom price of 101 gold ounces, implying a nominal housing price of $90,000. Will housing fall that far? Highly unlikely, due to a more ‘moderate’ devaluation of the dollar in gold terms, lower taxes on capital in general, and a tax code biased in favor of home ownership. But this is nonetheless illustrative of how far nominal housing prices can decline to equate to the historical precedent in gold terms. The bottom in real values in 1980 was against an implied 460% devaluation in the dollar gold price from 1977-1980, as compared with a 250% devaluation in the dollar gold price from 2005-2008. Of course, this presumption assumes that the Fed and Treasury correct wayward monetary policy.

In the current crisis, it is impossible that housing will recover without a correction of the slide in the dollar, of which said weakness is demonstrated by the rise in gold to over $900/oz. This is because participants in the housing market, home buyers, builders, and lenders, will not make investments until they can be assured the Fed won’t devalue the dollar again.

In spite of policymakers likely to make the situation worse in the coming weeks trying to fix the problem, the solution is really quite simple. Fix the dollar to gold. It is not even necessary to fix the dollar to a lower five-year average gold price. What is important is to fix to a price and stick to it. Roosevelt devalued the dollar against gold in 1935, but the price was fixed nonetheless.

Maintaining a dollar/gold price would allow homebuilders to commence building, homeowners would no longer be inclined to walk away from their homes due to falling prices, and lenders would not be awash in red ink from mark-to-market losses and foreclosures. We would also hear a lot less about Home Depot closing flagship stores, depressed homebuilder stocks, and those ever-increasing foreclosure rates.

Insuring Against Insurance

Yet we have seen major changes recently in homeowners’ insurance rates. For example, the average homeowner premium in Florida soared from $723 at the start of 2002 to $1,465 in the first quarter of 2007. Such rapid increases represent a risk that is on the same order of magnitude as many of the damage risks that the policies are supposed to address.

In a study presented in early May at America’s National Bureau of Economic Research, the economists Dwight Jaffee, Howard Kunreuther, and Erwann Michel-Kerjan called for a fundamental change in policy aimed at developing true long-term insurance (LTI) that set insurance premiums for many years. Unless we do that, homeowners are unsure from year to year whether their insurance policies will be canceled or that their premiums will skyrocket unexpectedly as they have in coastal regions of Florida where there is hurricane and flood risk. As the authors point out, for insurers to even consider a long term policy they must have the freedom to charge premiums that reflects risk.

Urbanization itself is also a source of risk, as evidenced by the recent earthquake in China, which has cost at least tens of thousands of lives. Moreover, global warming appears to be increasing the intensity of storms. Some scientists attribute the intensity of Cyclone Nargis, which struck Myanmar, killing more than 30,000, to global warming.

Of course, we do not know for sure that these risks will mean higher insured losses in the future. Population growth in coastal areas may not continue to imply more risk exposure, since choice lots may already be getting somewhat more scarce, and further development may favor more central areas. And urbanization, if done right, leads to better catastrophe planning and stricter construction standards, which might actually reduce risks. In fact, long term insurance may encourage homeowners to invest in risk reducing measures because the premium discounts they will obtain for taking this action will justify incurring the cost of investment.

The course of global warming, and its impact on future storms, is also the subject of considerable uncertainty. Meteorology is not an exact science, and we cannot predict the precise extent and impact of environmental initiatives, though progress in weather forecasting might also reduce the damage caused by hurricanes.

Data presented by Roger Pielke in the Natural Hazards Review in February shows that actual insured losses caused by the most important hurricanes since 1900 followed a U-shaped curve. The most damaging hurricanes (scaled for the size of the economy) to hit the United States occurred both in the early twentieth century and most recently – the worst being the 1926 hurricane that struck Miami, Florida.

Just as no one anticipated this U-shaped pattern of losses, so future losses must remain essentially unknown. This means that the problem is not a certain increase in homeowners’ insurance losses, but rather a risk of increase. Paradoxically, that is a good thing, because it means that risk-management technology can be used to mitigate the problem.

To see why, consider health or life insurance. If genetic information ever enables an exact prediction of each individual’s ultimate date of illness and death, that information, if commonly available, would make such insurance impossible to get (no one would insure someone about whom it is known that he will suffer from the harm to be insured against). It is just the same with homeowners’ insurance: because the risk of losses is uncertain, it can be sold by those who feel most concerned about it to others who can better bear it.

Insurance regulators are certainly well aware of the risk of future increases in homeowners’ insurance premiums. But trying to address these risks by limiting such increases doesn’t work well, because if insurance companies are not making any money, they will withdraw from the market. Nor can this problem be solved by imposing fees on insurance companies that withdraw from the market in response to premium caps, because the companies will eventually learn to consider the possibility of such fees even before entering an insurance market.

Sometimes, governments have become directly involved in providing insurance. In the US, for example, Florida’s state legislature created the Citizens’ Property Insurance Corporation in 2002. But replacing private insurance with government insurance plans is far from optimal. Like other forms of saving and investment, it is better that insurance be allocated by a market, rather than in a political arena.

The beauty of the LTI plan proposed by Jaffee, Kunreuther, and Michel-Kerjan is that it would allow market forces to determine long-term (20 years or more) insurance premiums. The premiums would be set so that there would be no reason for insurance companies to withdraw from the market in response to greater risk. Homeowners can rest assured that they can continue to insure their property at known rates.

Moreover, the premiums would provide price signals that would guide new construction. In areas where scientists think that there is a likelihood that greater risks will prevail in coming years, high insurance premiums would provide a market incentive to curtail development. Everyone would end up better off.

Robert Shiller is Professor of Economics at Yale University, Chief Economist at MacroMarkets LLC and author of Irrational Exuberance and The New Financial Order: Risk in the 21st Century.

The Effects of Trade Liberalization on Schooling in India

India has experienced a substantial economic boom over the last twenty years. Associated with this economic expansion has been a dramatic increase in schooling attendance. Less than half of rural children age ten to fourteen attended school in 1983. By 2000, nearly three out of four were in school. Many factors have influenced India's economic growth and the concurrent increase in schooling. India's radical restructuring of its trade policy, including the August 1991 tariff reductions, have likely played a role in this boom.

Prior to the 1991 reforms, average tariff rates in India exceeded 80 percent. The August 1991 tariff reforms were agreed to by the Indian government as a part of an IMF stabilisation package, following decades of tariff policy stagnation. The reforms reduced the average tariff to 30 percent by 1997 and reduced the large dispersion of tariff rates across industries. Non-tariff barriers to trade, such as import licenses, were also largely eliminated, albeit with some delay. Declining tariffs and increased international competition likely benefited Indian households through lower prices, improved quality and variety of goods and inputs, and increased specialisation of production.

However, the benefits of trade reform were not equally distributed across India. A recent study by Petia Topalova (2005) of the International Monetary Fund documents that Indian communities with a concentration of industries that lost protection have experienced smaller declines in poverty than the national trend.

Why would communities with a concentration of industries losing tariff protection not experience poverty declines as large as experienced elsewhere? There is an adjustment process that occurs with the loss of tariff protection, and adjustment may take time. Topalova's study documents that workers in industries that experienced larger declines in tariffs observed declines in their relative wages, and it appears that adults in affected communities do not experience the same increases in income as experienced in communities better positioned to take advantage of the tariff declines. Patterns of trade adjustment similar to India have documented in countries as diverse as Mexico and Morocco.

Trade liberalisation, poverty, and schooling

The trade adjustment process appears to have affected the education of children who were school-age during the adjustment period. In India, the schooling and literacy of school-age children appears to have been attenuated in areas with a greater concentration of industries that lost protection relative to other parts of India.

Nilgiri district in the Indian state of Tamil Nadu is an interesting example. Prior to the passage of the 1991 tariff reforms, employment in rural Nilgiri was heavily concentrated in tea. In 1991, forty-seven percent of the employed population in rural Nilgiri was directly involved in tea cultivation and another eleven percent of the employed population was in closely related industries. The 1991 reforms reduced tariffs on imported tea from eighty to twenty-four percent in 1997. While poverty declined across almost all of rural India in the 1990s, the fraction of the population living in poverty in Nilgiri actually increased eleven percent and schooling attendance declined by fifteen percent.

Many other changes may have occurred in Nilgiri during this period besides the decline in tariff protection on tea. However, across Indian districts, we see a pattern similar to what the Nilgiri example suggests. Places where employment was more concentrated in heavily protected industries have not experienced the same declines in poverty as elsewhere in India. They also have not experienced the same increases in schooling. Importantly, this association between tariff changes, schooling, and poverty does not seem to be explained by changes in other aspects of economic or education policy. It does not appear to be due to pre-existing time trends in schooling or poverty nor the out-migration of more educated and wealthier individuals from areas where heavily protected industries were concentrated.

In communities with concentrations of industries losing protection, schooling increases lagging behind the national average seem due to the relationship between poverty and tariff reductions. Schooling improvements might be attenuated if the returns to schooling decline in affected communities or if more lucrative employment opportunities become available to children. Neither appears to be case in the present context. If anything, returns to education may be rising in communities losing protection more than in other communities. Some children work more, but this work is largely by girls in household domestic chores. Illiterate adult males and women, two groups who are often substitutes for child labour, do not appear to be working substantially more. Interestingly, far more often than working in the formal labour market, children who do not attend school appear to combine that lack of schooling with a lack of work.

Schooling costs

Why would children not work if poverty is an important reason that they are not attending school? Many writers document the low wages paid to children. While some assert this reflects discrimination against children it may also owe to the fact that children are not very productive workers. The economic returns to working might be minimal, but schooling is expensive. One recent study put direct schooling costs for one child as seven percent of annual income for the poorest decile of the Indian population. Importantly, these schooling costs are concentrated in certain times of the year. Hence, poor households who have difficulty borrowing and saving may see the child's most important economic contribution as the avoidance of schooling costs.

In fact, it appears that the effects of Indian tariff reforms on schooling are smallest in districts where schooling is less costly. Imagine two communities with identical concentrations of the same industries that lost protection. In the community located in a state with school feeding programs, girl scholarships, and overall lower schooling costs, the adjustment process appears to have no impact on schooling. That is, schooling costs appear to be the reason why there is a link between poverty, schooling, and Indian tariff reform.


Because the Indian tariff reforms appear to affect schooling principally through their effect on local poverty rates, it is possible to extrapolate from the Indian tariff reductions to gauge how important poverty reduction has been in driving India's rise in schooling. It appears that falling poverty can account for half of the increase in schooling that has occurred in India over the 1990s. The remaining growth in schooling may owe to changes in schooling costs, increases in perceived returns to education, or changes elsewhere in the economy in the economic opportunities to children.

There are two lessons from this study of Indian tariff reforms that are important for policy. First, in the context of trade liberalisations and opening to international competition, it is not just labour directly employed in protected industries that is affected. The family as a whole should be considered and helped to cope with trade adjustment. The children studied herein, whose schooling is attenuated because they were at critical schooling ages while their communities underwent adjustment, will be affected throughout their lives. Ten years after the tariff reforms started, children of school-age at the time of reforms and living in affected communities have reduced primary school completion rates and diminished literacy relative to children living in communities that were only exposed to the positive effects of trade reform. The effects of a lack of education and illiteracy add up over a lifetime. One reasonable guess is those children of school-age in communities negatively affected by the reforms will experience forty-three percent less lifetime consumption than children in communities that only benefitted from the reforms.

A second lesson from the Indian example is that it might be relatively inexpensive to break the link between a lack of schooling and poverty. Schooling costs might make schooling expensive relative to other things that the household consumes, but in the Indian example, the foregone consumption attributable to those costs seems far more important. Policies that make schooling more affordable or truly free can help break the link between poverty and schooling, perhaps giving poor families a new capacity to help break out of poverty itself.

Eric Edmonds is Associate Professor of Economics at Dartmouth College and Director of the Child Labor Network at IZA.

Nina Pavcnik is Associate Professor at Dartmouth College and CEPR Research Affiliate.

For further reading:

This essay is based on the study: Edmonds, E., N. Pavcnik, and P. Topalova, 2008, "Trade adjustment and human capital investments: Evidence from Indian tariff reform", CEPR Discussion Paper 6772.
Mark Rosenzweig and Kaivan Munshi discuss why geographic mobility in India is so low: Munshi, K. and M. Rosenzweig (2005). “Why is Mobility in India so Low? Social Insurance, Inequality, and Growth.” BREAD Working Paper No. 97, July 2005.
For a discussion of other recent experiences with trade adjustment, see: Goldberg, P. and N. Pavcnik (2007). “Distributional Effects of Globalization in Developing Countries," Journal of Economic Literature.

May 31, 2008

The Problem with the Euro

But then the EIA report gave the rest of the story. It seems the shortfall "was due to temporary delays in crude oil tanker off-loadings on the Gulf Coast." And as Dennis Gartman noted this morning, "officials at the Louisiana Offshore Oil Port (LOOP) said

that some crude oil tankers cancelled scheduled deliveries last week." The owners of the oil in those tankers are now down about 6-7%, whether it is speculators in the pits or the actual trading companies.

I talked with George Friedman of Stratfor this morning, and he says that the supply of tankers is even tighter, which suggests there is even more oil on the seas looking for a home. Crude oil prices could be under pressure in the next few weeks and months as whoever holds that oil is going to want to get it onshore somewhere and out of very expensive tankers.

Swapping out Commodities

The Commodity Futures Trading Commission announced yesterday that they are looking very hard at possibly closing a regulatory loophole that allowed some extremely large commodity index funds to get around position limits. For those not familiar with the concept of limits, it basically works like this. No trader or fund is allowed to own more than a specific amount of a commodity traded on the futures exchange. This limit varies from commodity to commodity and exchange to exchange. The point is to keep one group from manipulating the price of a commodity, as the Hunts did with silver in the early 80s.

The loophole is one where large investment banks can sell a "swap" for a specific commodity like corn and then hedge their position in the futures markets. There is no limit on the amount of the commodity that can be hedged. So, a fund can accumulate sizeable positions far in excess of what they could do directly by working with an investment bank. In essence, the swap is a derivative issued by a bank which acts just like a futures trade, but it is with the bank as guarantor and not an exchange. Swaps are not regulated as such. And up until now, the banks were seen as legitimate hedgers so there were no limits on what they could buy in the futures markets.

This works for very large commodity index funds which try to mirror a particular commodity index and need to be able to buy very large positions in excess of the normal limits (and there are scores of them), and for the banks that make the commissions and profits on the swaps. Remember, the fund gets a management fee, so growing the size of the fund grows their fees.

These indexes typically have about 26 commodities, with the largest allocation to oil, but almost anything that is traded has some small portion of the allocation. As I noted last week, there are some who believe this is working to drive up the price of commodities beyond the simply supply and demand principles. Whether or not you believe this to be the case, the CFTC is looking at the loophole.

The key word in the announcement yesterday was the word "classification." Right now the banks are classified as hedgers and as such have no limits. But they are not really hedging the actual physical commodity as a farmer or General Mills might do, but the hedge is their financial position.

If the CFTC decides to look through them to the funds, and they did use the word transparency in their announcement, they could decide to change the classification of the banks from hedgers to speculators. While I do no think that might make a difference in the long run, in the short run it could make commodities volatile in the extreme, and exert downward pressure up and down the price curve, depending on how they would decide to unwind the commodity index funds.

For what its worth, I advised my daughter to get out of the commodity fund she was in for the time being. When the regulators are in the room, anything could happen. And they are getting intense pressure from Congress to change the rules. My bet is that the train has left the station and it is but a matter of time until position limits are put in place for commodity funds, including commodity ETFs. Is that a good thing? I think not, but that matters not one whit. The hand writing is on he wall.

Does this mean I am not a long term commodity bull? No, I remain bullish on a host of commodities over the long term from a supply and demand perspective. It is just that you might want to consider whether to stand aside for a time while the congressional elephant is stampeding around the room. Maybe it is a non-event and someone figures out a way to unwind the positions slowly and over time. Maybe the grandfather the current funds at the size they are today. Who knows? As I said, when the regulators are under pressure to do something, I want to know what the new rules will be before I play in the game.

The Euro at Par with the Dollar

About five years ago, I said that the euro, which was trading at about $.88 at the time would rise to $1.50 and then fall back to $1 over the course of a decade or more. It would be one huge round trip. By the way, giving credit where credit is due, that opinion was crystallized over a long dinner with bond expert Lord Alex Bridport and several companions in Geneva. The logic was compelling then and it still is now. We are halfway through that decade long trip and it remains to be seen if we get back to parity. I think we will.

Why would the euro fall? Because the currency is still an experiment in cooperation. At some point, one or more of the weaker European countries is going to need more monetary stimulation than the majority of the countries in the union, for a variety of reasons. Will they pull out to be able to issue their own fiat currency? Will the EU as a whole slow down as the US recovers?

About 4 times a year, I give myself permission to not write a letter, taking a little mental vacation. This week, Louis Gave is graciously allowing me to use a chapter from his latest book, "A Roadmap for Troubled Times" which highlights some of the problems the euro is going to face, as well as analysis on a host of topics.

Gentle reader, this is an important topic and Louis says it better than I can. I highly recommend you get the book and read it. It is only about 200 pages and is a very easy read. The chapters on China are worth the price of admission, as well as his suggested investment themes. You can order the book at Amazon.com.

So, without further ado, let's jump into the problem with the Euro.

The Change In Policy

The Divergence in European Spreads - Why Now?

Back in May 2007, we wrote a piece entitled "Part 2-So What Should We Worry About". In that ad hoc comment, we wrote: "The crux of the thesis of our latest book, The End is Not Nigh, is simple and goes something like this: a) Asian central banks continue to manipulate their currencies and prevent them from finding a fair value against either the US$ or the Euro b) this manipulation triggers an accumulation in central bank reserves which, in turn, leads to low real rates around the world c) the combination of low global real rates and low Asian exchange rates amounts to a subsidy for Asian production and Western consumption d) in the US, the subsidy has by and large been captured by individual consumers e) meanwhile, in Europe, the subsidy has been cashed in by governments whose debt has skyrocketed f) we see little reason why, in the near future, the subsidy should be removed but g) if it were removed, the US would most likely encounter a consumer recession (not the end of the world) while h) Europe could go through a debt crisis (far more problematic)."

We went on and wrote: "Last week, and against most observers' expectations, the Indian central bank did not raise rates at its meeting. Instead, it seems that the authorities are allowing the currency to rise and hopefully thereby absorb some of the country's inflationary pressures (linked to energy and higher food prices). In recent weeks, the rupee has shot higher and now stands at a post-Asian crisis high. And interestingly, the local market is loving it. While Indian stocks had been sucking wind year to date, the central bank's apparent policy shift (from higher interest rates to higher exchange rates) has triggered a very sharp rally.

This of course is an interesting turn of events and we would not be surprised if Asian central banks were to study developments in India carefully over the coming quarters. After all, India is blazing a path that a number of Asian countries may yet decide to follow.

One could argue that a change in monetary policy in Asia could end up being a "triple whammy" for Western economies. It would mean that:

  • Asian central banks would export less capital into our bond markets and this would likely lead to a drift higher in real rates around the world.
  • Asian exchange rates would move sharply higher, which in turn would likely mean higher import prices in the US and Europe.
  • As Asian exchange rates start to move higher, Asia's private savers would likely start repatriating capital, further amplifying exchange rate and interest rate movements. This would also likely lead to collapses in monetary aggregates in the Europe and the US.

Finally, we concluded the paper by saying: As we highlighted in Part 1: Why We Remain Bullish, we are not worried about valuations. And we are also not worried about "excess leverage" in the system, or the threat of a "private equity bubble". We also do not fear an "economic meltdown" or a brutal end to the "Yen carry-trade" (which we did fear in the Spring of 2006). Instead, if we had to have one concern, it would have to be a possible change of monetary policy across Asia and the impact that this would have on real rates around the world. As we view things, the only reason Asian central banks would change their policies is if food prices continued to increase (in that respect, owning some soft commodities -- a hedge against rising real rates -- makes sense to us - as does owning Asian currencies). Interestingly, such a turn of events seems to be unfolding in India, yet no one seems to care. Monitoring changes in Asian inflation, monetary policies and exchange rates could prove more important than ever.

Nine months after that paper, we have indeed just gone through a period of a) rapidly rising food prices which have led to b) faster inflation rates across Asia, which have triggered c) a change in Asian monetary policy, notably a willingness to let the currencies appreciate faster than they have in the past. And if Asian central banks are now finally allowing their currencies to rise, then one thing is sure: Asian central banks will no longer need to print large amounts of their own currencies and accumulate US$ and Euros. They will thus also no longer need to buy US Treasuries and European bonds to the extent that they have.

Is it a co-incidence that, as Asia starts to allow its currencies to rise, US mortgages have been hitting the wall and spreads amongst European sovereigns have started to widen? The subsidy that Asian central banks have been giving to consumption in the US and governments in Europe (see The End is Not Nigh) is now disappearing.

Indeed, for the past five years, spreads of Italian ten-year government bonds to German bonds have hovered between 15bp and 25bp. But recently, spreads have started to break out on the upside.

And, of course, Italy is not alone. All across Europe, we have seen a widening of spreads between the "stronger" signatures (Germany, Holland, Austria, Finland, Ireland) and the "weaker" signatures (Portugal, Italy, Greece, Spain, Belgium, France) including those of Eastern Europe (Latvia, Romania, Hungary, Poland...).

Now as our more seasoned GaveKal reader will undeniably remember (see Divorce, Italian Style, or The End is Not Nigh), we have argued that spreads between Europe's sovereigns were set to widen for the past few years. And yet, nothing happened. Until, that is, we started to see Asian central banks allowing their currencies to start appreciating faster.

But what happens if Asian central banks now stop buying up European government debt to the tune of recent years? For a start, European money supply growth should decelerate rapidly and with it, economic activity. A bigger problem will then be the ability of European governments to raise further financing. Indeed, as economic activity tanks in Europe, and the Euro starts to fall, it is likely that investors will all of a sudden realize that governments only go bust when they issue debt in a currency that they cannot print.

In the past fifteen years, France government debt to GDP has moved from 35% in French Franc (i.e.: a currency the government could print at will) to 70% in Euros (i.e.: a currency that only the ECB can print). No wonder that Francois Fillon, the current French Prime Minister recently declared: "I run a state which now stands in a situation of financial bankruptcy, which has known deteriorating deficits for fifteen straight years and which has not voted a balanced budget for twenty-five years. This cannot last."

More importantly, the tightening-up of Europe's financial situation, and the widening of spreads between the "good borrowers" such as Austria, Finland or Germany and the "poorer borrowers" such as Italy, Greece, or Portugal, could have a devastating impact on Europe's commercial banks. Consider this piece of news from January 2008: "Landesbank Baden-Wuerttemberg, Germany's biggest state-owned bank, said 2007 profit will be about 300 million euros ($438.9 million) because of a drop in prices of banking and government securities. LBBW said it doesn't expect any defaults since the securities concerned have good ratings."

Less profits because of a drop in government securities? The careful reader may be somewhat surprised by this statement; after all, everywhere one cares to look across the OECD, government bond yields are close to their 2003 lows. So how did Germany's biggest state-owned bank manage to lose money on government securities? The answer, we believe finds its source in the funky regulations of Basel II. According to Basel II, an OECD country bank can sell a credit default swap on an OECD sovereign and this CDS:

  • Does not have to be marked to market (since it is assumed that an OECD country will not default on its debt).
  • Does not require the selling bank to put aside any capital on its balance sheet (since, once again, it is assumed that the country on which the CDS is written will not default).

In other words, for the past few years, clerks all over Europe's banks and insurance companies have boosted the bottom line with the "free money" that the sale of CDS provided. Every now and then, a clerk at the Treasury department of ABC Landesbanken would call up Goldman Sachs or Deutsche Bank and say: "I want to sell US$ 1bn of protection on Italy at 15bp for five years". And for five years, ABC Landesbanken would receive US$1.5 million without having to set aside capital on its balance sheet or take a "mark to market" risk on its income statement. Or so it thought...

Indeed, as the spreads between Italy and Germany start to widen something unexpected happens (a CDS will tend to reflect the spread between the issuer's debt and risk free debt of the same maturity. Otherwise an arbitrage could be made. If Italy's debt traded at 100bp over Germany and a CDS on Italy only cost 20bp, one could buy the Italian bond and buy the CDS and capture a "free" 80bp): ABC Landesbanken receives a margin call from Goldman Sachs and Deutsche Bank and, all of a sudden, what was a "risk and capital free" trade turns out to impact liquidity. Needless to say, this is the situation we are now in and this probably contributes further to the widening of spreads. All of a sudden, Europe's commercial banks are no longer keen to sell the spread as they have been for the past decade...  in fact, they are most likely trying to buy back some of the contracts they wrote before they move too far against them.

In other words, a widening of spreads represents the worst of both worlds for European banks. For a start, it puts their balance sheets under pressure. For seconds, it cuts down their income as the writing of CDS on Europe's weaker sovereigns slows to a crawl.

For Europe's policy-makers, the widening of spreads poses a serious challenge which, if left unchecked, could cut to the very credibility of the Euro and the European construction exercise. It could also trigger a negative spiral such as the one we saw in the US whereby as the cost of borrowing increases on the weakest signatures, rolling over debt becomes more problematic, hereby inviting higher spreads etc...  So how will Europe's politicians respond to this new challenge?

The widening of credit spreads across Europe reflects an economic reality. It makes no sense that say, Belgium and Ireland should borrow at the same rate.

The Euro 100bn question for investors should thus now be whether a) the recent widening is a one-off event and spreads are set to soon tighten again or b) the recent widening is the beginning of a more fundamentally-based re-pricing of risk across Euroland. The quandary now is whether politics can get us out!

In the mid 1990s, Europe's leaders got together and, in essence, said: "wouldn't it be great if we all got to borrow at the same rate as Germany?" And everyone around the table agreed that this would be a good thing. The decision was thus taken to a) create a currency which would resemble the DM, b) that this currency would be managed by a central bank with a mandate very similar to the Bundesbank's and c) that countries around the Euroland would strive to harmonize their fiscal policies (Maastricht Treaty rules and Stability and Growth Pact) to ensure the long term survival of the Euro. At the time it was also envisaged that the collapse in interest rates in certain countries (Italy, Belgium, Spain...) would give a tailwind to growth which would allow governments around the more indebted EMU countries to tighten their belts and clean up their fiscal houses.

The collapse in interest rates happened, as yields converged to the German rate... but unfortunately, the clean-up in fiscal houses did not. In fact some countries like France cashed in the "growth dividend" and voted themselves greater benefits such as the 35-hour work week.

Which brings us to today and the recent widening of spreads across Europe. This widening is a sign that the market is starting to acknowledge that the promises have not been kept. . But of course, the main problem with that solution is that it implies that Europe's governments will have to tighten their belts over the coming quarters, i.e.: at the worst possible time in the cycle. After all, it is always hard for a government to pull back and shrink its size of the GDP cake... but in an economic slowdown, it is close to impossible.

It is all the harder to do when there is little political will for far-reaching reforms. As a former German central banker once told us: "I use to think that France needed a Margaret Thatcher, I now realize she needs an Arthur Scargill" (Scargill was the Trotskyite leader of the Miner's Strike). In other words, to get a government to shrink its size, you first need a serious crisis (or a scarecrow a la Scargill); only then do people accept real sacrifices.

And we should make no mistake about it: reforming Europe's welfare states will take real sacrifices. Take pensions as an example: for years, most European countries have run a pay-as-you-go system whereby people of my generation will pay directly for the retirement benefits of my dad's generation (actually, this sounds like what I do at GaveKal every day). In other words, Europe's pension systems are usually massive pyramid schemes; they work as long as the base grows and ever more people contribute to the bottom of the pyramid. The problem, of course, is that in a growing number of European countries, the base is no longer growing.

As such, the off-balance sheet liabilities assumed by the government in matters of pensions which, until recently, had always been self-funding, are now set to come back on the governments' balance sheets. Now the last time Europe ran a comprehensive survey of pension liabilities was in 2003... and the data back then was scary. We guess the situation does not look any better today.

Europe's deteriorating demographic and pension situation alone means that Europe's governments do need to contemplate serious pension reform. Or, failing that, to open their borders to workers from all horizons in order to keep expanding the tax-paying, pension- contributing workforce. Needless to say, neither of these options is very enticing politically. As such, rather than convince millions of pensioners to cut their benefits, or work longer, Europe's politicians may be tempted to try and convince a small minority of central bankers sitting in Frankfurt to massively ease monetary policy and print a bunch of money to help the governments meet their liabilities.

In essence, the scenario we are painting is a simple one: the credit crunch which has thus far mostly only engulfed the US is starting to make its way into Europe. And soon enough, Europe's banks will likely be reporting losses and write-downs, and investors will flee to the safety of the highest government bond paper. Unfortunately for Italy, Greece, Belgium or Portugal, their paper does not qualify as "high quality".

Now as we highlighted earlier in this book, a credit crunch typically invites a "three-step" plan policy response. First, one collapses the currency (to make one's assets and goods more attractive to foreign capital and invite inward capital flows). Secondly, one needs to see the banks recapitalized (if the market can not do it, then the banks need to be nationalized). Thirdly, one puts in place a very steep yield curve in order to force the banks to start lending again and the private sector to take risk.

It is obvious today that this course of action is very much the preferred path of, for example, President Sarkozy. Hardly a day goes by without the French President taking the ECB to task for doing so little to help Europe's liquidity crunch. But each time he does, his comments are increasingly met by responses from Angela Merkel, the German Chancellor, for whom the independence of the ECB is sacrosanct.

The possibility of a massive easing from the ECB is nonetheless an interesting one and raises the question of how the market will respond to a more activist ECB. Would an ECB that did the bidding of politicians be seen as less of a Bundesbank and more of a Bank of Italy/Banque de France? And if so, would long bond yields across Europe be below 4% and the Euro at 1.55/US$? Would the foreign central banks that have been piling into European government paper remain keen to finance Europe's welfare states?

Another question, of course, is what would happen in the event of a bank bankruptcy in Europe? Would the ECB bail out the failing bank? Would the government of a failing bank be allowed to bend the EU's competition rules and nationalize the troubled financial institution? These are all questions with answers that remain unclear.

Of course, there is another way to go about dealing with a credit crunch: bitter infighting. This is what Japan did throughout the 1990s when the MoF would tell the BoJ that massive monetary easing was needed, only for the BoJ to turn around and say that the MoF needed to stop financing the construction of bridges that went from nowhere to nowhere. And as the infighting ensued, the Japanese banking system wrote off its entire capital base not once, but twice, over the course of the decade. Meanwhile investors shied away from all asset classes save the highest quality government bonds.

Could the same thing unfold in Europe? In Japan, there were only three sets of players (the BoJ, the MoF and the LDP) and over fifteen years, they could not seem to get the three-step plan (currency devaluation, bank recap, steep yield curve) right. In that regards, when considering the numbers of players involved in Europe, one may fear that the same policy paralysis could easily grip Europe. And, in this case, the recent break-out in the spreads that has now started will prove to have marked the start of a revolutionary trend for our financial markets: the end of the convergence trades and the start of the divergence trades.

A few years before his death, Professor Milton Friedman declared: "It seems to me that Europe, especially with the addition of more countries, is becoming ever-more susceptible to any asymmetric shock. Sooner or later, when the global economy hits a real bump, Europe's internal contradictions will tear it apart." Today, one should question whether the "real bump" is being hit and whether Milton Friedman will end up being proven right. But regardless of where one falls on the answers to these questions, one thing is sure: selling the bonds of Europe's weakest signatures and buying protection on Europe's weaker banks continues to make sense. It is some of the cheapest protection available against what remains a massive "fat- tail" risk to our financial systems. That's why we love this trade so much: the potential rewards are huge and the upfront costs still marginal. More importantly, it is a very good hedge against what would be a nightmare scenario for many financial institutions.

A Final Thought

In the next chapter of A Roadmap for Troubled Times, Louis goes into detail into how Italy might be the country to push the European Central Bank to take steps it might not otherwise want to take. Again, I strongly suggest you get the book. It is very thought-provoking and one of the better reads that I have had this year.

About May 2008

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