'If in fact you just simply want to make a lot of money,.. would you rather have a mind that is brilliant about the economy or would you rather have a mind that is brilliant about understanding human psychology'
Iceland’s current woes teach a useful lesson about the interconnectedness of global markets: trouble can come from anywhere. Homeowners default on mortgages in San Diego, and suddenly people in Reykjavík are paying more for gasoline and wondering if their bank deposits are safe. That doesn’t mean that Iceland is an innocent victim. The country went overboard with spending and borrowing—between 2000 and 2007, domestic credit in the Icelandic banking system more than quadrupled as a share of G.D.P. And relying on foreign money to fuel that kind of frenzy is foolish, since it puts you at the mercy of fickle foreign investors. But Icelanders can be forgiven for wondering if they’ve really been any more reckless than many other countries—most obviously the U.S., which relies heavily on foreign capital to fund home buying and profligate consumption, and whose banking system is rife with reckless lending.
And that’s the second lesson of Iceland’s plight: even in a flat world, there are different rules for different players. In order to prop up the króna, and keep foreign capital from fleeing, Iceland’s central bank has had to raise interest rates to an astounding fifteen per cent, a move that will slow the economy to a crawl. By contrast, the dollar, while weak, has evaded the króna’s precipitous fall; the Federal Reserve, far from raising interest rates, has slashed them; and Congress is borrowing a hundred and fifty-two billion dollars to hand out tax rebates. Iceland’s government has been forced to inflict pain; the U.S. is doing everything possible to avoid it. If Iceland were to attempt to emulate America’s approach, its currency would be demolished, and foreign investors would almost certainly head for the exits. The U.S., by contrast, remains the beneficiary of the world’s generosity—no matter how bad our financial situation looks, countries like China and Japan keep pouring hundreds of billions of dollars into U.S. securities. They’re doing this not out of kindness, of course, but because the U.S. is a colossal market and they need us to keep buying stuff. The world can’t afford to have the U.S. fail, and so we are able to get away with behavior that would wreck smaller countries. Great for us, but when we look at Iceland’s predicament we should say that there but for the grace of China go we.
Finally, in conclusion, I would like to say that my blog at IMF.org is again up and running. Please invite your readers and listeners to ask questions or post comments there. To make things a little more interesting, while I have been speaking, I have put up a post regarding what I regard as the key messages from this morning's discussions. Thank you very much.
Finally, let me comment briefly on some policy implications of this global assessment. A key message is that, with continuing tensions and uncertainties prevailing in global markets, policymakers in both advanced and emerging economies need to respond to a potentially quickly changing balance of risks. In addition, in our view, now is the time when prudent governments will draw up contingent plans to guard against deeper "tail risks."
Priority must be given to containing financial disruptions in a durable manner. As was discussed at yesterday's press conference on our Global Financial Stability Report, a key focus must continue to be recognizing losses quickly and rebuilding financial capital.
Macroeconomic policies can play a complementary role in supporting demand and limiting the negative interaction between financial markets and the real economy.
Monetary policy remains the first line of defense. Central banks in several advanced economies, notably the United states, have appropriately eased policy rates as their growth outlooks have worsened, and may need to continue easing until their economies find a firmer footing. In the Euro Area, current inflation remains uncomfortably high, but we expect that inflation will come down over the relevant roughly two-year policy horizon in the context of slower growth. This should provide some room for future policy easing on the part of the European Central Bank.
Fiscal policy is the second line of defense. The U.S. fiscal stimulus, for example, looks likely to provide timely support in the second half of this year. However, the use of fiscal space, where available, should be temporary and not jeopardize efforts aimed at consolidating public finances over the medium term.
Given the risk of negative interplay between housing and credit markets, the so-called third line of defense—namely, the use of public sector balance sheets—may be needed to support housing and financial markets.
In the United States, steps have already been taken to ensure the availability of mortgage financing and to stem systemic risk, but more may be needed before financial and housing markets find completely stable ground.
We also cannot ignore the international aspects of the current financial crisis. Given the cross-border dimensions of exposures and counterparty risks, solutions implemented in national silos may not be adequate to resolving an underlying global problem of capital adequacy in the financial system.
In many emerging and developing economies, the challenge remains to manage inflation and overheating risks, but it will be important to respond flexibly if global downside risks intensify.
Finally, as a way to reduce global pressure on food and energy prices, more open trade policies in those products would be a good start. Less insular biofuels policy in advanced economies would help relieve some pressure. At the same time, we encourage countries to avoid raising taxes or imposing quotas on their food exports. These reduce incentives for domestic producers and also increase international prices.
Credit deterioration, which was first evident in the U.S. subprime market, is now showing up in higher-quality residential mortgages, U.S. commercial real estate, and the corporate debt markets, according to the GFSR. These concerns are further exacerbated by a drop in valuations of structured credit products and a dramatic drying up of market liquidity.
Uncertainty about the size and distribution of bank losses, reduced capital buffers, and the normal reduction in credit as the cycle turns are also likely to weigh heavily on household borrowing, business investment, and asset prices. This, in turn, would affect employment, output growth, and balance sheets—thereby creating worrying macroeconomic feedback effects.
This feedback dynamic is potentially more severe than in earlier credit cycles, as it was fueled by a proliferation of new credit products that allowed more people to obtain credit, the report said. "Thus, it is now clear that the current turmoil is more than simply a liquidity event, reflecting deep-seated balance sheet fragilities, which means its effects are likely to be broader, deeper, and more protracted," it added.
To simplify heroically, there are three main models of financial regulation in operation around the globe. The first is functional regulation, whereby separate regulators oversee different types of financial company. Most countries have moved away from that model, on the solid grounds that financial markets themselves have become more interlinked and companies more promiscuous. The US is a prominent exception. Americans have remained as committed to a highly complex form of functional regulation as they are to suit trousers that ride above the ankle.
The second model is unitary regulation, with a single institution covering most if not all of the financial sector. Although this model is often associated with London and the Financial Services Authority, the Scandinavians started the trend on the back of the banking crises there in the early 1990s. Following the UK switch a number of other countries, including Japan, South Korea and Germany, did the same. Now more than 50 countries operate something similar, although no two models are precisely the same. Time was - way back in August 2007 - when the unitary authority strategy was carrying all before it. In the ANR era (After Northern Rock) some of the gilt has gone off that brand, although the underlying logic remains strong.
The third scheme is known in the trade as Twin Peaks - a long-forgotten US television series not adorned by Kylie - whereby two regulators are established: one for prudence, focusing on capital soundness, and one to monitor the general conduct of business standards. So far only two countries have followed this prescription, originally devised by UK academics: Australia and the Netherlands. They have done so in subtly but importantly different ways. In Amsterdam the central bank is the prudential regulator. In Sydney there is a separate authority, leaving the Reserve Bank withscrutiny of the payments system and responsibility for financial stability.
After a brief global tour the US Treasury has come to rest near Sydney Harbour, a very agreeable location, one must admit. The Paulson plan would strip the Fed of its direct role in supervising bank holding companies and give it instead a broad remit to look for trouble across the financial system. In an important sentence in his speech Mr Paulson gave a hint of his reasoning, and a clear warning to the investment banks. "It would be premature to assume," he said, "these institutions should have permanent access to the discount window and permanent supervision by the Fed." The Treasury is clearly nervous about the growing assumption in the markets that brokers will continue to be able to deposit mortgage securities, food stamps and dead mice at the discount window in return for hard cash. I suspect this will be a hard proposition to sell to Congress, however logical it may be.
Interestingly, some of the best analysis is coming from economic journalists, who are unencumbered by either the fight for tenure or post-tenure lethargy.
If the government underwrites all the risks, call it socialism. If it underwrites only the failures, call it foolishness.
First, the mnemonics. On March 14, the Federal Reserve extended access to its discount window to a non-depository, Bear Stearns, for the first time since the 1930s. (The discount window is the Fed’s lending facility, where loans are made at a rate above the federal funds rates and can be secured with a wide variety of collateral.) According to the Federal Reserve Act, lending to such an individual, partnership, or corporation (an IPC) requires the affirmative vote of five of the governors of the Federal Reserve Board. Moreover, the Federal Reserve must attest that there are “unusual and exigent” circumstances and that failure to lend would impair the economy. On March 16, the Fed granted other investment banks access to its lending facility.
On the prior Tuesday, the Fed had introduced a new program called the Term Securities Lending Facility (TSLF), under which it will loan some of the Treasury securities currently on its balance sheet to key financial market participants in return for other securities as collateral. The term of these transactions is 28 days, and the fee paid for the loan of Treasury securities will be set in an auction.
For the past few months, the Fed has been holding regular auctions for depositories of its discount window credit, also for a term of 28 days. This is referred to as the Term Auction Facility (TAF), in which depositories bid for credit. Earlier this month, these auctions were bumped up to total $100 billion per month. To put that sum in perspective, the amount of discount window loans outstanding this month will likely be nine times the previous monthly record from 1919 to the inception of the TAF (see the nearby chart). And if the TAF continues at its recent pace through June of this year, the Federal Reserve will have extended a greater volume of loans over the first eight months of the program than it had cumulatively lent over the prior 90 years.
Last but not least, the Fed also announced that it will loan another $100 billion in the form of 28-day term repurchase (RP) agreements. RPs are the bread-and-butter of a central bank’s open market operations. In the typical RP, the Fed lends money to its dealer counterparties for a fixed term, taking collateral in the form of Treasury securities or the debt and mortgage-backed securities of the government-sponsored lenders, Freddie Mac and Fannie Mae.
If we tally up all these new programs, the Federal Reserve appears willing to commit almost one-half of its balance sheet, around $400 billion, to promote the renewed health of financial markets. Given its open-ended invitation for investment banks to follow the Bear Stearns route and tap the Fed’s discount window, it may wind up committing even more.
