by Andreas Hoffmann and Nicolás Cachanosky
The Federal Reserve’s (Fed) and European Central Bank’s (ECB) policy responses to the recent financial disasters offer two tales of unintended consequences. Our previous post outlined undesired effects of the Fed’s policies. In this post, we suggest that the ECB’s stabilization policy did not only fail to achieve its goals. Monetary policy has also hampered the structural adjustment of the European economy and prolonged the crisis.
by Alexander Fink[1] and Andreas Hoffmann[2]
Since 2009, the role of government in banking has increased substantially in Europe. This is, first, a consequence of capital injections or bailouts of private banks (for instance Dexia in Belgium, Royal Bank of Scotland in the UK, Hypo Real Estate and Commerzbank in Germany, Fortis in the Benelux, ABN Amro in the Netherlands, or Allied Irish Bank in Ireland). Second, the ECB has taken on a more dominant role in financial markets. And third, low-interest rates and mounting EU regulation seem to discourage private bank lending. Whereas private banks de-leverage and roll back their portfolios in the absence of great opportunities, so-called development banks substantially gain market share. This is odd and worrisome at the same time.
by Roger Koppl
Income inequality matters. Let me say that again so you know I meant it: Income inequality matters. This statement may be surprising coming from a self-described “Austrian” economist and a “liberal” in the good old-fashioned pro-market sense. It shouldn’t be. It should be one of our issues. The surprise should be that we pro-market types have not spoken up more on this central issue, thereby letting it become associated almost exclusively with more or less “progressive” opinion.
This indifference to income distribution is all the more mysterious because pro-market thinkers generally support a theory of politics that tells us to watch out for ways the state can be used to create unjust privileges for some at the expense of others. We should expect the distribution of income to be skewed toward the politically powerful and away from the poor and politically weak. In a representative democracy “special interests” engage in “rent seeking” to get special favors. Those special favors enrich some at the expense of others. That’s what they are meant to do! Continue reading
by Andreas Hoffmann and Holger Zemanek*
Over the last two years Carmen Reinhart and Belen Sbrancia have published a series of papers on financial repression and its historical role in financing government debt. They show that throughout the Bretton Woods period governments in many advanced economies repressed financial markets to liquidate the high levels of debt that had been accumulated by the end of World War II.
During this period, low policy rates reduced debt servicing costs. Financial repression raised the attractiveness of government bonds relative to other investments. Inflation liquidated government debt. The authors report an annual debt liquidation effect for, e.g., the US and UK government debt of about 3 – 4 percent of GDP (Reinhart and Sbrancia 2011).
Today government debt levels in many countries are comparable to those after the Second World War II! After all, good politicians do not need a World War. There are plenty of other ways to spend. But in the light of the European debt crisis, governments are feeling the need to correct the spending-revenue misalignments in order to make debt-service sustainable. Continue reading
by Chidem Kurdas
Gore Vidal died a few days ago. He was a remarkably erudite author, as any reader of his marvelous historical novels – Burr and Lincoln are just a sample – notices. He never went to college. Continue reading
by Chidem Kurdas
After all that’s been said and written about financial crises, it is rare to come across useful insights. Financing Failure. A Century of Bailouts by Vern McKinley documents a major continuity with past policy making. He shows that policies intended to prop up failing companies are nothing new—the same basic pattern has recurred time and again.
But there is one notable change: the bailouts grew ever larger and the agencies concerned with them ever more numerous. Anyone thinking about recent crises and future prospects would do well to keep these points in mind. Continue reading
by Chidem Kurdas
Regulation advocates seem to regard the JP Morgan loss as the best thing since sliced bread. Thus Paul Krugman gleefully bawls out Mitt Romney for refusing to see it as a sign for greater government intervention.
Krugman repeats the by now well-known argument on banks, as a riff on “It’s a Wonderful Life.” The Jimmy Stewart character makes “a risky bet on some complex financial instrument,” loses the money and causes his bank to collapse. The moral: banks should not be allowed to take on much risk because “they put the whole economy in jeopardy” and “shouldn’t be allowed to run wild, since they are in effect gambling with taxpayers’ money.”
The fact is, banks make money by taking risk. That’s always been the business model. Even Bailey Building and Loan in “It’s a Wonderful Life” makes risky home loans—one might think of them as subprime. Continue reading
by Jerry O’Driscoll
J.P. Morgan Chase & Co., one of the nation’s leading banks, revealed that a London trader racked up trading losses reportedly amounting to $2.3 billion over a 15-day period. The losses averaged over $150 million per day, sometimes hitting $200 million daily. The bank states the trades were done to hedge existing risks.
How did this happen and what are the lessons? The two questions are related.
It appears the individual traded on the basis of observed relationships among various derivative indices. The relationships broke down. Such a breakdown has been at the heart of a number of spectacular financial collapses, notably that of Long-Term Capital Management in 1998 and a number during the financial meltdown of 2007-08.
In short, there is nothing new in what happened. Yet financial institutions permit their traders to make the same kind of dangerous bets. In a Cato Policy Analysis, Kevin Dowd and three co-authors examined some of the technical problems with standard risk models utilized by banks. It is an exhaustive analysis and I commend it to those interested. The analysis goes to the question of how these losses happened.
Now to the lessons. Continue reading
by Chidem Kurdas
We’ve been going back and forth on the economics of too-big-to-fail banks but paying less attention to the politics. The most recent ThinkMarkets broadside on banks is Jerry O’Driscoll’s post on the Federal Reserve Bank of Dallas annual report.
In part of the report, the Dallas Fed’s director of research Harvey Rosenblum argues that the new Dodd-Frank regulations are insufficient to deal with the threat posed by too-big-to-fail banks and therefore these need to be broken into smaller entities. He and the bank’s president, Richard Fisher, made a similar point in a Wall Street Journal column. Some other Fed officials have espoused the position as well. Continue reading
by Jerry O’Driscoll
The issue of banks viewed as too big to fail has been taken up several times on this site. In its Annual Report, the Federal Reserve Bank of Dallas has weighed in on the topic with an essay on “Choosing the Road to Prosperity: Why We Must End Too Big to Fail – Now.”
It is authored by Harvey Rosenblum, the bank’s Director of Research. Since Richard Fisher, the bank’s president, signed off on the annual report, one presumes he endorses the substance of the essay.
It is a very hard-hitting piece, arguing that “the vitality of our capitalist system and the long-run prosperity it produces hang in the balance.” It explains why TBTF is “a perversion of capitalism,” which undermines faith in markets. Rosenblum quotes Allan Meltzer on point: “Capitalism without failure is like religion without sin.”
The essay spares no sacred cows and, among other things, charges that the “the Fed kept interest rates too low for too long” in the 2000s. That directly contradicts the stated position of Fed Chairman Ben Bernanke. I assume there is much grinding of teeth over the essay in Washington, D.C. The essay details how government support is the source of the gigantism in banking today, and debunks the idea that efficiencies and financial innovation are the reason why, since the early 1970s, the share of banking assets belonging to the five largest banks has grown from 17 percent to 52 percent of the total. These financial institutions expand in size to capture the government support available only to the largest banks.
The essay notes that “commercial banks holding roughly one-third of the assets in the banking system did essentially fail, surviving only with extraordinary government assistance.” As noted elsewhere, “a bailout is a failure, just with a different label.” Amazingly, the report even identifies two of the failed institutions – Citigroup and Bank of America (albeit in a footnote).
It’s a lengthy essay and I recommend it to everyone interested in the issue.
by Chidem Kurdas
Is the Federal Reserve a hotbed of trustbusters? Fed officials (as well as some academics) have been calling for forcible downsizing of big banks . “I am of the belief personally that the power of the five largest banks is too concentrated,” Dallas Federal Reserve Bank president Richard Fisher said a few days ago during a visit to Mexico, according to news reports. He’s expressed similar views before, as has Thomas Hoenig, former president of the Kansas City Fed.
Here on ThinkMarkets Jerry O’Driscoll, a Federal Reserve veteran, wrote: “There is no conceivable efficiency gain that justifies the risk these gigantic, risky institutions impose on all of us,” Continue reading
by Mario Rizzo
For those who enjoy trying to figure out what important thinkers might have thought about specific issues they never faced (and I am one of them!), the following letter I discovered will prove interesting and perhaps disconcerting to some.
Below is a brief excerpt from a letter that F.A. Hayek wrote to the journalist and political theorist Walter Lippmann in 1937.* The subject was the large modern corporation which Lippmann thought was prone to developing various degrees of monopoly power. This was a view shared by Frank H. Knight at this time, and Hayek may have agreed, at least to some extent.
The issues were: (1) Why was this the case? and (2) Was it consistent with (classical) liberalism for the government to do something about it? Continue reading
by Mario Rizzo
This will be a short post. Nearby is a Venn diagram showing the intersection between Goldman Sachs and the federal government: people who before or after were attached to both.
This is one reason that the current political-economic system will continue to fail. Those who exercise positions of political influence are not about the let particular so-called private institutions go under (there have been exceptions, of course). The idea is that they will use the ill-defined systemic-risk notions to preserve the status-quo. This is why I floated, two years ago, the idea that perhaps the government must break up the large financial institutions so that they can fail without dragging us all (particularly me) down with them. My positive program for laissez-faire, so to speak.
A picture is worth a thousand words!
by Andreas Hoffmann
In today’s publication Thomas Mayer writes that he is “an Austrian in economics.” Mayer is the chief economist of Deutsche Bank Group and head of Deutsche Bank Research. Mayer argues that Austrian theory fits recent events well. He suggests that
“Failure of the liquidationists to overcome the Great Depression of the early 1930s prepared the ground for an era of interventionist economic policies. Modern macroeconomics and finance nourished the belief that we can successfully plan for the future. But the present crisis teaches us that we live in a world of Knightian uncertainty, where the ―unknown unknowns dominate and our plans for the future are regularly thwarted by unforeseen and unforeseeable events. Continue reading
by Chidem Kurdas
The current financial crisis is a reverse of the 2008 disaster in key respects. Then, investment banks were seen as the main culprits while governments appeared in the guise of cavalry riding to the rescue. The trouble originated in the United States and spread to Europe. This time, the culprits are certain governments, the problem is European and how badly it will affect the American financial system is a question. How did the crisis go from US-based mortgage securities and Lehman Brothers to Italian sovereign debt and French banks? Continue reading
by Andreas Hoffmann and Gunther Schnabl
It came as a surprise to many: the Swiss National Bank announced an exchange rate target. Accordingly, the Swiss franc will be held above the level of 1.20 francs per euro. Switzerland gives up a part of its sovereignty, when the ECB makes bad press in buying trash-rated euro area government bonds to support unsustainable national budgets.
But, particularly in an environment of global excess liquidity originating in too-easy monetary policies in major advanced economies, small open economies have incentives to stabilize exchange rates. Continue reading
by Andreas Hoffmann
The euro benefited Germany more than others in the zone. Germany exported and won, the others had to import German goods and lost (link). This seems to be a consensus in the world of politics. The second consensus is that a bail-out package for the euro problem children or even euro bonds are necessary to safe this euro. And obviously without this euro, there would be no EU.
The combination of the two arguments is used to convince the German parliament and public of that the bail-out packages are necessary. Continue reading
By Chidem Kurdas
In the first inning of what looks to be an intricate political game, the Obama administration and its financial industry allies suggested that the economy needs the federal government full force in the mortgage market.
The case was pithily made by bond honcho Bill Gross, who oversees more than $1 trillion of investments as head of giant bond shop PIMCO and was a speaker at the Treasury Department’s conference on the future of Fannie Mae and Freddie Mac.
“Having grown accustomed to a housing market aided and abetted by Uncle Sam, the habit cannot be broken by going cold turkey into the camp of private lending,” he wrote in a recap of his talk.
It’s an argument that is at once practical and yet nightmarish. Heroin dealer has his customers hooked. They can’t do without him. Therefore they will have to make sure he stays in business and continues ministering to their needs. Continue reading
by Mario Rizzo
What has been disappointing about the recent stimulus vs. austerity debate is the recycling of arguments that have been gone over many times before in many newspapers and blogs. The debate has become tiresome and unenlightening.
The major feature of the debate that is responsible for the lack of enlightenment is, well, its unrelenting macro-aggregate character. The main variables are excess demand for goods, excess supply of financial assets, total government spending, deficit to GDP ratios, government debt to GDP ratios, the confidence of economic agents in government bonds (as measured by yields), and so forth.
Is there anything important going on beneath the surface – factors that have a more direct causal relationship to the decisions of real economic agents?
Now a breath of fresh air! Continue reading
By Chidem Kurdas
Media coverage compounds the confusion about financial problems. Take a recent piece by Floyd Norris, probably the best informed of the New York Times finance columnists.
“Credit-default swaps are, in reality, insurance,” he writes in “Naked Truth on Default Swaps”. The seller of a credit default swap pays the buyer of the contract if there is a default on the specified bond. Mr. Norris asks: shouldn’t CDS be subject to the principle that “you cannot buy insurance on my life, or on my house, unless you have an insurable interest”?
That would mean that you should not be able to buy a default swap on a bond unless you own the bond. But this is a false deduction, because in practice even life insurance does not work on the insurable interest principle. Continue reading
by Andreas Hoffmann*
The European Central Bank (ECB) and the Fed differ in many aspects. First, the ECB is considered to be more hawkish on fighting inflationary tendencies. Its primary goal is price stability and it has continued to watch money growth. Output gaps below full-employment are only considered secondary as instrument to forecast inflation.
Secondly the ECB was constructed to be more independent than the Fed. Thus there has been less interaction with fiscal authorities. Less mobility from governments to the ECB (and vice versa) documents this independence. While in the US it is common to see central bank officials and the secretary of treasury plan the future of the economy, in Europe this is not the case. Central bank independence is considered an important aspect of credibility and stability of the currency (the German central bank model). However, the current crisis has made the ECB more “Anglo-Saxon.” Continue reading
by Chidem Kurdas
Before the near-trillion-dollar bailout package for financially shaky euro-zone governments was announced, French president Nicolas Sarkozy hauled out the financial whipping boys yet again. He promised to “confront speculators mercilessly.” They would soon “know once and for all what lies in store for them,” he said.
Presumably he meant that those betting on the decline of the euro will be squeezed and made to understand that he and his fellow office holders will protect the currency. Thus Mr. Sarkozy framed the issue—we’re not bailing out profligate governments, we’re defending our common currency against demonic speculators.
This message appears to play well politically But beneficial as it may be in the short term for those in office, it compounds the real problem. Continue reading
by Jerry O’Driscoll
No, I’m not offering up a delayed report on the Olympics. But I am following up on earlier post on why Canada avoided a banking crisis.
In today’s (March 19) Wall Street Journal, AEIs Alex Pollock provides an important piece of the puzzle. Canada avoided a housing crisis, the progenitor of the U.S. banking crisis. It did so by having sounder banking and housing policies. Above all, it had no Fannie Mae & Freddie Mac.
Canada isn’t a free-market paradise. But it beats the U.S. in banking and housing policies. I commend Alex’s article to you.
by Chidem Kurdas
There is one new regulation that is truly needed—a way to wind down, without major disruption to markets, failing broker-dealers and other financial companies. The new financial industry bill introduced by Senator Christopher Dodd claims to do this and solve the “too-big-to-fail” problem.
Reading the particulars of the bill, however, makes one queasy. To use a metaphor, what’s needed is a commitment to defensive war when necessary. What this and a related bill sneak under the radar is authority for pre-emptive war—with all the wide-open discretion that implies.
Lehman Brothers’ bankruptcy in September 2008 had a big impact on markets largely because the assets of its clients got tied up in courts, not just in the US but in the UK. With their capital frozen in years-long litigation, the clients – in particular hedge funds – sold securities to raise money. This selling put downward pressure on markets.
So, instituting a process by which large financial companies can be shut down without a lengthy bankruptcy case would reduce the impact of failures and get rid of the notion that investment banks need to be bailed out—expeditious and orderly winding down of a failed firm is the obvious solution.
While this process may be similar to established procedure for dealing with insolvent commercial banks, broker-dealers don’t have Federal Deposit Insurance Corp.-insured deposits. Their customers get only limited aid from the Securities Investor Protection Corp.—as the Bernard Madoff investors discovered.
The bill would establish a liquidation fund financed by the industry and authorize the appointment of FDIC as receiver for insolvent companies, with SIPC acting as trustee for broker-dealers. All that sounds reasonable. You don’t notice the danger until you’re deep into the 1,336 page bill. Continue reading
by Jerry O’Driscoll
That is the title of yesterday’s “Wonderland” column by Daniel Henninger in the Wall Street Journal.
Henninger distinguishes between market entrepreneurs and political entrepreneurs. Market entrepreneurs innovate and create new products. Political entrepreneurs make money by gaming the political system. “We need vision, vitality and commercial moxie. The government is draining it away.”
Bravo!
The real cost of TARP and stimulus is the diversion of resources and talent from creating value into transferring money from one pocket to another. The stimulus bill was a cover for a massive income transfer from the productive to the unproductive classes in society. TARP transferred money from profitable firms and hardworking Americans to profligate bankers.
Market entrepreneurs create products that generate the revenue needed to reproduce themselves and then grow. The political variety creates dependency and the need for new tax revenues to sustain unproductive activities. Markets create wealth and governments transfer it for a fee.
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