Wednesday, March 26, 2008

Important commentary on the financial crisis

Martin Wolf is (I think) the best economic analyst writing from a pro-free market perspective working in the media today. Read his latest commentary in the Financial Times. If he concludes that the US "has passed the high water mark of financial deregulation," that is probably the case. The end of an era.

The rescue of Bear Stearns marks liberalisation’s limit
By Martin Wolf

Published: March 25 2008 19:06 Last updated: March 25 2008 19:06

Remember Friday March 14 2008: it was the day the dream of global free- market capitalism died. For three decades we have moved towards market-driven financial systems. By its decision to rescue Bear Stearns, the Federal Reserve, the institution responsible for monetary policy in the US, chief protagonist of free-market capitalism, declared this era over. It showed in deeds its agreement with the remark by Josef Ackermann, chief executive of Deutsche Bank, that “I no longer believe in the market’s self-healing power”. Deregulation has reached its limits.

Mine is not a judgment on whether the Fed was right to rescue Bear Stearns from bankruptcy. I do not know whether the risks justified the decisions not only to act as lender of last resort to an investment bank but to take credit risk on the Fed’s books. But the officials involved are serious people. They must have had reasons for their decisions. They can surely point to the dangers of the times – a crisis that Alan Greenspan, former chairman of the Federal Reserve, calls “the most wrenching since the end of the second world war” – and the role of Bear Stearns in these fragile markets.

Mine is more a judgment on the implications of the Fed’s decision. Put simply, Bear Stearns was deemed too systemically important to fail. This view was, it is true, reached in haste, at a time of crisis. But times of crisis are when new functions emerge, notably the practices associated with the lender-of-last-resort function of central banks, in the 19th century.

The implications of this decision are evident: there will have to be far greater regulation of such institutions. The Fed has provided a valuable form of insurance to the investment banks. Indeed, that is already evident from what has happened in the stock market since the rescue: the other big investment banks have enjoyed sizeable jumps in their share prices (see chart below). This is moral hazard made visible. The Fed decided that a money market “strike” against investment banks is the equivalent of a run on deposits in a commercial bank. It concluded that it must, for this reason, open the monetary spigots in favour of such institutions. Greater regulation must be on the way.

The lobbies of Wall Street will, it is true, resist onerous regulation of capital requirements or liquidity, after this crisis is over. They may succeed. But, intellectually, their position is now untenable. Systemically important institutions must pay for any official protection they receive. Their ability to enjoy the upside on the risks they run, while shifting parts of the downside on to society at large, must be restricted. This is not just a matter of simple justice (although it is that, too). It is also a matter of efficiency. An unregulated, but subsidised, casino will not allocate resources well. Moreover, that subsidisation does not now apply only to shareholders, but to all creditors. Its effect is to make the costs of funds unreasonably cheap. These grossly misaligned incentives must be tackled.

I greatly regret the fact that the Fed thought it necessary to take this step. Once upon a time, I had hoped that securitisation would shift a substantial part of the risk-bearing outside the regulated banking system, where governments would no longer need to intervene. That has proved a delusion. A vast amount of risky, if not downright fraudulent, lending, promoted by equally risky finance, has made securitised markets highly risky. This has damaged institutions, notably Bear Stearns, that operated intensively in these markets.

Yet the extension of the Fed’s safety net to investment banks is not the only reason this crisis must mark a turning-point in attitudes to financial liberalisation. So, too, is the mess in the US (and perhaps quite soon several other developed countries’) housing markets. Ben Bernanke, Fed chairman, famously understated, described much of the subprime mortgage lending of recent years as “neither responsible nor prudent” in a speech whose details make one’s hair stand on end.* This is Fed-speak for “criminal and crazy”. Again, this must not happen again, particularly since the losses imposed on the financial system by such lending could yet prove enormous. The collapse in house prices, rising defaults and foreclosures will affect millions of voters. Politicians will not ignore their plight, even if the result is a costly bail-out of the imprudent. But the aftermath will surely be much more regulation than today’s.

If the US itself has passed the high water mark of financial deregulation, this will have wide global implications. Until recently, it was possible to tell the Chinese, the Indians or those who suffered significant financial crises in the past two decades that there existed a financial system both free and robust. That is the case no longer. It will be hard, indeed, to persuade such countries that the market failures revealed in the US and other high-income countries are not a dire warning. If the US, with its vast experience and resources, was unable to avoid these traps, why, they will ask, should we expect to do better?
These longer-term implications for attitudes to deregulated financial markets are far from the only reason the present turmoil is so significant. We still have to get through the immediate crisis. A collapse in financial profits (so significant in the US economy), a house-price crash and a big rise in commodity prices are a combination likely to generate a long and deep recession. To tackle this danger the Fed has already slashed short-term rates to 2.25 per cent. Meanwhile, the Fed also clearly risks a global flight from dollar- denominated liabilities and a resurgence in inflation. It is hard to see a reason for yields on long-term Treasuries being so low, other than a desire to hold the liabilities of the US Treasury, safest issuer of dollar- denominated securities.

“Some say the world will end in fire, Some say in ice.” Harvard’s Kenneth Rogoff recently quoted Robert Frost’s words in describing the dangers of financial ruin (fire) and inflation (ice) confronting us.** These are perilous times. They are also historic times. The US is showing the limits of deregulation. Managing this unavoidable shift, without throwing away what has been gained in the past three decades, is a huge challenge. So is getting through the deleveraging ahead in anything like one piece. But we must start in the right place, by recognising that even the recent past is a foreign country.

*Fostering Sustainable Homeownership, March 14 2008,;
**Globalization and Monetary Policy, March 7 2008, conference on globalization, inflation and monetary Policy,

Copyright The Financial Times Limited 2008

When taxpayers end up holding the baby

Business Times - 21 Mar 2008

When taxpayers end up holding the baby

Greater oversight and transparency of financial industry needed to regain market trust


FOR a while, officials, lawmakers and pundits in Washington were debating whether the American economy was - or soon would be - in a recession. The key historical analogy applied in their discussions was the mild recession in late 1990, during the presidency of George Bush the elder that lasted for only six months.

The message then was that the economy was facing a cyclical downturn that could be managed through appropriate monetary and fiscal policies.

So it is intriguing - or scary, some would argue - when the same officials, lawmakers and pundits are now starting to refer more frequently in recent days to the Great Depression of the 1930s and to the various 'New Deal' programmes initiated by then president Franklin Delano Roosevelt.

Under his leadership, the US federal government succeeded in rescuing the American capitalist system by using the government's power and resources to refinance homes, bail out banks and create the American welfare state.

No one called any of that 'socialism', but it was certainly a form of huge intervention by the federal government in the economy - which runs very much contrary to the free market philosophy shared by President George Bush the younger and his economic advisers.

It's certainly too early to describe the current signs of economic downturn and financial meltdown as the beginning of a depression - great or small. But when one considers some of the recent moves taken by the US central bank, and in particular, the decision to negotiate a bailout for the insolvent investment bank, Bear Stearns, and to supply emergency credit to other financial firms, it becomes clear that the current administration - whose cheerleaders in the media and think-tanks have for years been celebrating the 'magic of the market' - has decided that there were no magicians on Wall Street. It's the much reviled government that is going to have to fix the economic problems now.

Say good-bye to Adam Smith, and say hello, once again, to John Maynard Keynes.

Optimists hope that the Fed's rescue of Bear Stearns and the opening of its lending window to investment banks would prove to be limited in nature, not unlike the move by the administration of President Bill Clinton and Alan Greenspan's Fed to negotiate a bailout of the troubled hedge fund, the Long-Term Capital Management (LTCM) firm in 1998.

But it's quite possible that what we saw last weekend revealed the shape of things to come in the form of more government-backed bailouts of other highly leveraged financial institutions whose possible collapse could devastate the entire economy by producing a financial meltdown.

Indeed, the federal government, through its central bank, has decided to put in a lot of taxpayers' money in order to save a firm whose top executives had made a lot of easy money in recent years - advancing their own private interests, as opposed to the public good. This has been justified - by the administration and Congress - on the basis of the potential risk that the collapse of Bear Stearns could pose to the public interest in the shape of a national and perhaps even global economic calamity.

In fact, even Democrats, including presidential candidates Hillary Clinton and Barack Obama, and the states they represent - New York and Illinois, which contain key centres for America's financial industry - have backed the latest moves by the Fed.

Washington is wishing and hoping that these dramatic steps - the term 'historic' has also been used by the media - coupled with Tuesday's decision by the policymaking arms of the Fed to cut the federal funds rate by a three-quarter percentage point will be a shot in the arm for the financial sector and will finally make credit available to help stimulate new business activity.

Whether all this will indeed bring about a long-term uptrend or whether Washington is just postponing the big day of reckoning on Wall Street remains to be seen.

Indeed, there are few signs that the financial institutions are regaining the sense of confidence that the crisis is over. In a way, no one seems to fully understand what exactly are the causes and the magnitude of this catastrophe that looks more and more like a huge black hole.

If anything, the frantic response by the Fed suggests to some investment bankers that Ben Bernanke and his colleagues are as confused as they are.

Moreover, while the Fed's announcement on Tuesday suggested that the central bank continues to be more concerned over a possible recession than about the risk of inflation, for most American consumers facing higher energy and food prices it certainly feels like inflationary times and it's doubtful they are about to spend extra hours and extra dollars - assuming these dollars will be available - in the shopping mall and help energise business activity.

It looks, therefore, that in order to create the conditions for ending the credit squeeze, the US federal government will need to intervene in a more systematic and direct way in the economy. In addition to more bailouts of financial institutions, plans could include providing more government-backed loans to homeowners facing foreclosures and guaranteeing failing mortgages in order to prevent such foreclosures.

And it is not inconceivable that, at some point, one or two of the failed financial institutions will have to go into receivership like Northern Rock did in England. That's the 'N' (for 'nationalisation') word.

Indeed, as the federal government becomes more directly involved in rescuing irresponsible investors and consumers, the public through Congress could end up demanding that Washington acquires more regulatory power over those sectors of the markets whose reckless decisions have brought about the current crisis.

Demanding more oversight and transparency when it comes to the financial industry will almost certainly be part of the necessary process of renewing a sense of trust among investors and consumers. After all, it was the lack of oversight and transparency that created the conditions for the current mess.

Copyright © 2007 Singapore Press Holdings Ltd. All rights reserved.