The bubble that is Greece and the disaster to come

“Bubbles are back as a topic of serious discussion, as they were before the financial crisis. The questions are: (1) can you spot bubbles, (2) can policymakers do anything to deflate them gently, and (3) can anyone make money when bubbles get out of control?

Our answers are: Spotting pure equity bubbles may sometimes be hard, but we can always see unsustainable finances supported by cheap credit. But policymakers will not act because all great (and dangerous) bubbles build their own political support; bubbles are invincible, until they collapse. A few investors can do well by betting against such bubbles, but it’s harder than you might think because you have to get the timing right – and that’s much more about luck than skill.
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To think about this more specifically, consider the case of Greece today. It might seem odd to suggest there is a bubble in a country so evidently under financial pressure – and working hard to stave off collapse with the help of its neighbors – but the important thing about bubbles is: Don’t listen to the “market color” (otherwise known as ex post rationalization), just look at the numbers.

By the end of 2011 Greece’s debt will around 150% of GDP (the numbers here are based on the 2009 IMF Article IV assessment; we make some adjustments for the worsening economy and the restating of numbers since that time – for example, the fiscal deficit in 2009 will likely turn out to be about 8 percent, which is double what the IMF expected until recently). About 80 percent of this debt is foreign owned, and a large part of this is thought held by residents of France and Germany. Every 1 percentage point rise in interest rates means Greece needs to send an additional 1.2 percent of GDP abroad to those bondholders.

What if Greek interest rates rise to, say, 10% – a modest premium for a country which has the highest external public debt/GDP ratio in the world, which continues (under the so-called “austerity” program) to refinance even the interest on that debt without actually paying a centime out of its own pocket, and which is struggling to establish any sustained backing from the rest of Europe? Greece would need to send at total of 12% of GDP abroad per year, once they rollover the existing stock of debt to these new rates (nearly half of Greek debt will roll over within 3 years).

This is simply impossible and unheard of for any long period of history. German reparation payments were 2.4 percent of GNP during 1925-32, and in the years immediately after 1982, the net transfer of resources from Latin America was 3.5 percent of GDP (a fifth of its export earnings). Neither of these were good experiences.
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If such measures are not taken, we are clearly heading for a train wreck. The European politicians have been tested, and now we know the results: They are not careful, they are reckless.”

Peter Boone and Simon Johnson, "The Coming Greek Debt Bubble", The Baseline Scenario Blog (11 March 2010).

http://baselinescenario.com/2010/03/11/the-coming-greek-debt-bubble/

Peter Boone is chairman of the charity Effective Intervention at the London School of Economics' Center for Economic Performance. Simon Johnson is Ronald A. Kurtz Professor of Entrepreneurship at the Sloan School of Management at MIT. From March 2007 through the end of August 2008 Professor Johnson was Chief Economist of the International Monetary Fund.


Let us be clear on this: The Greek debt situation is unsustainable and sooner or later the entire mess will come crashing down. So the question is who will pay.

Why should the Greeks pay? Creditors in France and Germany have known for a decade that the Greeks were living well beyond their ability to repay any loans, and yet they loaned the money to Greece anyway. Even now, the French and German governments in an act of continuing stupidity are encouraging their financial institutions to buy Greek bonds. Any idiot can see where this is all heading. Granted, abandoning the Greeks in their hour of need would be a disaster. But any idiot can also see that if the Greeks are bailed out an even greater disaster is on the horizon, one that could engulf the entire European Community. Better to cut the losses now, not just in Greece but elsewhere in the EU, rather than risk the much greater disaster to come. Given the stupidity of the French and Germans, and the terribly high price -- a overwhelmingly crushing price -- the Greeks will have to pay if they try to pay back the debt, maybe the Greeks ought to just repudiate the debt and tell the French and Germans to eat the debt as the price they must pay for lying to their citizens about the creditworthiness of the Greek government. While this is not good for Greece, it is much better than many years as a slave to French and German financial interests, transferring a significant and growing percentage of its GDP to foreigners.

Why should the French and the Germans pay? Creditors in France and Germany made loans to the Greeks in good faith, with assurances that Greece would change its ways and guarantees they would be paid back. In this sense, these were not reckless loans but extended in the expectation that conditions for sustainability were being established and the rules of the Maastricht Treaty, mandating sensible macroeconomic policies, would be enforced. French and German banks, pension funds, and other investors were encouraged -- nay, virtually told by their governments – to buy these bonds, because their governments, in an act of delusion we call a Ponzi scheme, saw the continued financing of Greece as a way to pay the interest on the previously issued bonds. But surely Greek politicians were knowingly at the center of this scheme to defraud the French and the German financial sector; even now, they continue to promote this dishonest scheme for their own benefit, forcing the French and the Germans to become slaves to the Greek standard of living. It is the Greek politicians, manipulating and lying to their French and German counterparts and acting on behalf of the Greek government and a selfish Greek people, that caused this problem, so the Greeks must pay as their debt collapses under the weight of their deception and greed.

We do not know how this will play out. But play out it will, and however it does it will not be pretty. For the moment, the Ponzi scheme that is Greek debt builds before our eyes as governments, rather than bursting this bubble, encourage an ever-increasing flow of money into what in the end will be a black hole of financial ruin. But do not forget that because governments are orchestrating this disaster as they blindly try and run away from its consequences, many of those throwing even more money into this bottomless pit expect to be bailed out in the end. So it is likely to continue for a while.

And less us note that Greece is not the only country led by reckless and irresponsible politicians that base its national budget on a Ponzi scheme. That country, too, is on a course that cannot end happily.

Greece still awaits a bailout that may not come

“The EU, led by France and Germany, appears to have some sort of financing package in the works for Greece (probably still without a major role for the IMF). But the main goal seems to be to buy time – hoping for better global outcomes – rather than dealing with the issues at any more fundamental level.

Greece needs 30-35bn euros to cover its funding needs for the rest of this year. But under their current fiscal plan, we are looking at something like 60bn euros in refinancing per year over the next several years – taking their debt level to 150 percent of GDP; hardly a sustainable medium-term fiscal framework.

A fully credible package would need around 200bn euros, to cover three years. But the moral hazard involved in such a deal would be immense – there is no way the German government can sell that to voters (or find that much money through an off-government balance sheet operation).

Alternatively, of course, the Greeks could make much more dramatic cuts to their primary deficit – the government budget balance if you take out interest payments – in order to stabilize their debt-GDP ratio.

But with no significant resurgence of growth in the eurozone coming for a long time, that would really mean moving from last year’s 7.7% GDP primary deficit to around a 6% GDP primary surplus (assuming they face a real interest rate of 5%, i.e., below what they are paying today).

The government won’t (or can’t?) do that. In 2009 Greek wages and pensions rose by 10.5% – an amazing spending spree. In the 2010 budget they are forecast to rise by 0.3%. Where is the austerity? No wonder the prime minister is popular – they aren’t really cutting much.

The bailout package is really just an opportunity for European banks to get out of Greek debt. The Greeks can’t really collapse until they lose access to funding, so the hope is that this prevents the problems from spreading – and the prospects of such a “rescue” will keep bond yields down for Portugal, Spain, and others.

Our baseline view is that Greece enters into quite a bad recession this year, their banks and corporates continue to have trouble raising financing – thus causing broader liquidity issues, and it all comes to a head again as we near the time the government needs to take ever harsher measures next year, when there is again no bilateral funding in place.

This is the new Greek cycle.”

Peter Boone and Simon Johnson, “An Underfunded Program For Greece”, The Baseline Scenario (1 March 2010).

http://baselinescenario.com/2010/03/01/an-underfunded-program-for-greece/#more-6619


Despite all the talk, I for one do not believe in the end the Germans will bail out the Greeks. Could be wrong, but I think the EU is stringing along the Greeks in hopes that somehow something will happen that will avert disaster. Perhaps the EU (that is, the Germans) might offer something should things get out of control with very bad and prolonged riots, but it will be peanuts compared to the problem and given only to calm the moment. In my view, the only hope the Greeks really have is the IMF, and I don’t think the IMF will help them any time soon. My prediction is drift in policy and drips of aid this year, with the real reckoning coming next year when Greece is forced out off the euro.

The reason I hold this view is that whatever Germany does for Greece it must do for Spain, Portugal and the other weak countries of Europe. It cannot afford to go down this road. So Greece will have to undertake the adjustment more or less on its own or with minimal support from the outside. Because immediately implementing a full-scale austerity program in Greece to establish competitiveness with the outside world would be extremely painful, it will have to be introduced over time. Hence, some program of minimal support allowing a difficult 2010 to become an even more difficult 2011 may be in the cards. If an EU program actually emerges I would expect it to be financed through the IMF, with just enough financing to survive 2010.

The root problem before Greece and the rest of Europe is demographic, not economic. Greece’s entitlement state with its huge public sector is not close to sustainable when the fertility rate is 1.3 children per woman and declining. Workers in Greece can retire at 58 and these workers, like those in the U.S. and elsewhere, have no intention of giving up their benefits, even if it bankrupts the state, which of course it already has. Greece has now run out of Greeks, and the remaining Greeks are looking to the EU (read the Germans) to support their welfare state in the style to which they have become accustom.

Germans, who have their own demographic problems and must work until 67, will never agree to supporting current income levels of countries with the level and increases in benefits available to Greeks. So reality is coming to Greece, sooner than they expected. The question is whether the contractionary policies that are on their way, not only in Greece but in Spain and Portugal and the other overextended states completely upset the economic and political stability of Europe. Expect large-scale emigration out of Greece and these other countries as the economic deteriorates with little prospect of recovery.

Similar imbalances describe the fiscal accounts of the U.S. and the U.K. and other large countries. Nothing is being done to address these problems, indeed, current policy efforts only aggravate them. Greece, in a sense, is a prelude to what is to come here if present policy continues and the Administration refuses to focus on jobs and the deficit.

While Greeks can run to the U.S. to escape a collapsing economy, where will the Americans run to?

Advice to the Republicans at the Blair House Meeting on Health Care

President Obama has convened a half-day bipartisan health care session, tentatively set for 25 February at the Blair House, to be televised live to the nation. Here is some advice offered by Keith Hennessey to the Republican side:

“I think that good policy is also good politics for Republicans. Even if they take the most cynical view of the Blair House meeting, I recommend they take the invitation at face value and attempt to participate constructively.

• Show up as invited.

• Focus your public comments on substance more than process. Republican leaders are spending too much time on a “start over” message. I would instead talk about why you oppose the House-passed and Senate-passed bills, and how you are open to any legislative process and solution that addresses those problems. Since the policy problems are core to the bill, you achieve the same effect, but you will be getting your substantive message out rather than looking like you’re bickering over process.

◦ The bills create a nearly trillion dollar entitlement program when we know that entitlement spending drives our long-term budget problem.

◦ The bills slow the growth of Medicare spending (a good thing) but then turn around and respend that money on a new spending program (bad).

◦ Health insurance would essentially become a governmental function, even without a public option.

◦ More decisions about the costs and benefits of various medical procedures and treatments would be pushed away from individuals and toward government officials.

◦ National health spending would increase. Health premiums would increase for most who have employer-based health insurance today. The cost control measures, weak as they were, have been further watered down to the point of irrelevance.

◦ The bills are filled with targeted benefits and carve-outs: especially the Nebraska and Louisiana Medicaid deals, exempting unions from the Cadillac tax, and carve-outs for certain Blue Cross / Blue Shield plans.

• Offer a wide range of substantive health policy changes (to current law, not to the bill), but do not feel obliged to have a single unified Republican proposal. It’s critical that Republicans step up and offer policy solutions, but they don’t have to be afraid of admitting that they are not unified as a party on those solutions.

Different Members can push for different reforms: talk about medical liability reform, buying insurance across state lines, replacing the current law tax exclusion with a deduction or a credit, high risk pools, association health plans, health savings accounts and high deductible health plans. Republicans need to be aggressive in pushing positive policy ideas for health policy reform, even if they disagree amongst themselves. Embrace the differing views within the big tent, and use those differences to make your argument for an open amendment process.”

Keith Hennessey, “The Blair House debate”, KeithHennessey.com (15 February 2010).

http://keithhennessey.com/2010/02/15/blair-house/


Keith Hennessey was Assistant to the President for Economic Policy and Director of the National Economic Council under President George W. Bush. It is the position now held by Lawrence Summers under President Barack Obama. His blog was recently named by the Wall Street Journal as one of its “Top 25 Economics Blogs”.

At a time when the economy is stagnate and the financial system remains in disarray, the Administration insists on continuing a fruitless debate about its version of health care reform even though it is clear nothing substantive will come of it. I suppose if I were a policy wonk like Hennessey, I would suggest to the Republicans something along the lines he has proposed above.

Fortunately (for the Republicans) I am not a policy wonk and have no interest in providing them with ideas for a health care debate with the President that I believe will go nowhere. So, instead, let me make some suggestions about what the Republicans should recommend in the area of health care. It can be summarized as follows: Scrape the President’s comprehensive approach to health care reform and instead make modest and steady changes over several Congresses along the following lines.

1. Move to a government-supported system that provides catastrophic health care insurance for all citizens that would cover very high cost, relatively long-term and narrowly-defined medical needs. Limit this coverage to medical conditions that are truly life-threatening or family-destroying.

2. Focus on strengthening private major medical health insurance and slowly and steadily discourage the use of the comprehensive health insurance packages the government has mandated to cover relatively minor medical expenses. Encourage people to pay for the normal and regular health expenses from their own pocket or through high deductable major medical plans.

3. Do not use government regulations and mandates on health insurance companies in an attempt to widen insurance coverage to the poor. This only results in cost-shifting and greater administrative expenses. Rather, any new subsidies intended to cover the poor should be in the form of health care vouchers which should be paid out of general revenues, not linked only to wages. Eliminate Medicaid by substituting health care vouchers.

4. Encourage charity care in the area of health care.

5. All savings garnered from efficiency gains in Medicare should be used to shore up Medicare. No savings in Medicare should be used to fund new health care insurance subsidies or an expansion of current entitlements. Raise the age of eligibility and deductibles to benefit from Medicare.

6. Step-by-step introduce the following kinds of health insurance reforms:

a. Allow interstate competition in health insurance.
b. Remove the preferential tax treatment of employer-provided health insurance.
c. Remove restrictions on the portability of health care insurance.
d. Allow individuals to waive extraordinary litigation claims in return for lower premiums, perhaps capping them at $1,000,000.
e. Move to widen the kinds of procedures that nurses and other medical staff can undertake to weaken the doctor’s monopoly on the provision of skilled medical care.

7. Increase the supply of medical care providers by:

a. Increasing the number of medical schools, nursing schools and technical schools providing training in medical specialties.
b. Allow medical professionals with licenses in one state to practice in another state.

Many of these reforms would not cost a dime and others would reduce the present cost of health care insurance significantly.

The sovereign debt crisis of Greece is only the beginning

“It began in Athens. It is spreading to Lisbon and Madrid. But it would be a grave mistake to assume that the sovereign debt crisis that is unfolding will remain confined to the weaker eurozone economies. For this is more than just a Mediterranean problem with a farmyard acronym [DOW: a reference to the PIIGS, Portugal, Ireland, Iceland, Greece and Spain]. It is a fiscal crisis of the western world. Its ramifications are far more profound than most investors currently appreciate.
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… [T]he idiosyncrasies of the eurozone should not distract us from the general nature of the fiscal crisis that is now afflicting most western economies. Call it the fractal geometry of debt: the problem is essentially the same from Iceland to Ireland to Britain to the US. It just comes in widely differing sizes.

What we in the western world are about to learn is that there is no such thing as a Keynesian free lunch. Deficits did not “save” us half so much as monetary policy – zero interest rates plus quantitative easing – did. First, the impact of government spending (the hallowed “multiplier”) has been much less than the proponents of stimulus hoped. Second, there is a good deal of “leakage” from open economies in a globalised world. Last, crucially, explosions of public debt incur bills that fall due much sooner than we expect

For the world’s biggest economy, the US, the day of reckoning still seems reassuringly remote. The worse things get in the eurozone, the more the US dollar rallies as nervous investors park their cash in the “safe haven” of American government debt. This effect may persist for some months, just as the dollar and Treasuries rallied in the depths of the banking panic in late 2008.

Yet even a casual look at the fiscal position of the federal government (not to mention the states) makes a nonsense of the phrase “safe haven”. US government debt is a safe haven the way Pearl Harbor was a safe haven in 1941.

Even according to the White House’s new budget projections, the gross federal debt in public hands will exceed 100 per cent of GDP in just two years’ time. This year, like last year, the federal deficit will be around 10 per cent of GDP. The long-run projections of the Congressional Budget Office suggest that the US will never again run a balanced budget. That’s right, never.

The International Monetary Fund recently published estimates of the fiscal adjustments developed economies would need to make to restore fiscal stability over the decade ahead. Worst were Japan and the UK (a fiscal tightening of 13 per cent of GDP). Then came Ireland, Spain and Greece (9 per cent). And in sixth place? Step forward America, which would need to tighten fiscal policy by 8.8 per cent of GDP to satisfy the IMF.
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The Obama administration’s new budget blithely assumes real GDP growth of 3.6 per cent over the next five years, with inflation averaging 1.4 per cent. But with rising real rates, growth might well be lower. Under those circumstances, interest payments could soar as a share of federal revenue – from a tenth to a fifth to a quarter.
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On reflection, it is appropriate that the fiscal crisis of the west has begun in Greece, the birthplace of western civilization. Soon it will cross the channel to Britain. But the key question is when that crisis will reach the last bastion of western power, on the other side of the Atlantic.”

Niall Ferguson, “A Greek crisis is coming to America”, Financial Times (10 February 2010).

http://www.ft.com/cms/s/0/f90bca10-1679-11df-bf44-00144feab49a.html

Niall Ferguson, one of the world’s top financial historians, is the Laurence A. Tisch Professor of History at Harvard University and the William Ziegler Professor of Business Administration at Harvard Business School. He has also accepted the Philippe Roman Chair in History and International Affairs at the London School of Economics beginning later this year. He was educated at the private Glasgow Academy in Scotland, and at Magdalen College, Oxford.


The major sovereign debt crisis that has been gathering steam over the past few years is now close to exploding. Although the pressure is now on the weaker countries in the eurozone everyone knows the fiscal problems facing the world economy go far beyond Greece and the Club Med countries. As Professor Ferguson points out, it is only a matter of time before Europe’s sorrows and travails are transmitted to the United States and its already difficult economic situation becomes worse.

Last week, the Obama administration released its fiscal year 2011 budget, which forecasts fiscal deficits of 10.6 per cent and 8.3 per cent of GDP for 2010 and 2011, respectively. In this budget, future fiscal deficits are seen as likely to remain near $1 trillion over the course of the next decade. By historical standards they are unprecedented in the post-war era but the budget assumes they can somehow be financed.

Moreover, they are based on very optimistic assumptions about the performance of the economy in the years ahead. For example, the Administration’s budget assumes an average pace of economic growth of over 3½ per cent a year in the next five years and just under 3½ per cent a year over the next decade. Yet, real economic growth in the U.S. has averaged only 3 per cent a year in the post-war era, and there is little reason to believe future growth will match past growth, much less exceed it. Similarly, the Administration’s inflation forecast assumes an increase in prices of 2 per cent a year over the budget horizon while the long-term historic average is 3¼ a year. Most importantly, the budget assumes the President’s fiscal strategy of stimulus measures and tax increases will promote growth rather than depress it by crowding out private investment and generating higher interest rates. The budget reflects no aggressive fiscal reforms to deal with entitlements at the root of the deficit or substantive measures they might create incentives to invest and hire more workers and boost growth. In my view, the President’s policies are far more likely to produce a subpar economic recovery than the vigorous one the he foresees and, even more disconcerting, it continues down the road to unsustainable deficits and another financial crisis.

This country faces a fiscal time bomb caused by ever widening deficits and ever greater debt. As we continue down the present policy road our economic and financial problems can only deepen and the likelihood of a crisis can only increase. Given our fiscal position, the sovereign debt problems of Greece and other European countries are signs of deep troubles moving toward the United States. In fairness to the President, the Congress is as blind to the impending crash as he is, unyielding on both tax hikes (which I would not recommend) and spending cuts (which are very much needed). But whatever the problems created by unsustainable public finances abroad and a stubborn Congress at home, the President is President, and Presidents are expected to show the necessary leadership to identify problems, suggest remedies for them, and lead the country toward their resolution.

One wonders when this leadership will be forthcoming.

Non-performing loans in China

“Non-performing loans in China have risen into the “trillions of renminbi” because of poor lending practices, an insolvency lawyer said.

“We work really closely with SASAC, the state-owned enterprise regulator in China, and there are literally trillions and trillions of renminbi of, frankly, defaulting loans already in China that no one is doing anything about,” Neil McDonald, a Hong Kong-based business restructuring and insolvency partner with Lovells LLP, said at an Asia-Pacific Loan Market Association conference yesterday. “At some point there’s going to be a reckoning for that.”

China’s government is tightening controls, including banks’ reserve ratios, to prevent record lending from fueling inflation. The Shanghai office of the China Banking Regulatory Commission warned yesterday that a 10 percent fall in property values would treble the number of delinquent loans in the city. ...
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Over the past decade China’s government has spent more than $650 billion bailing out state banks after years of government- directed lending caused bad loans to balloon. The average non- performing loan ratio at Industrial & Commercial Bank of China Ltd., China Construction Bank Corp. and Bank of China Ltd. dropped to about 1.6 percent as of Sept. 30 from more than 20 percent before each bank was bailed out, according to earnings reports.

New loans last year helped ignite a Chinese real-estate boom, with prices in 70 cities rising at the fastest pace in 18 months in December.

Should property prices fall 10 percent in Shanghai, China’s second-most-expensive property market, the ratio of delinquent mortgages would almost triple for the city’s banks to 1.18 percent, according to the Shanghai branch of the CBRC yesterday, citing a stress test based on Sept. 30 figures. A 30 percent decline would cause the ratio to jump almost fivefold, the agency said.

Fitch Ratings said Dec. 17 that Chinese banks’ capital strength is probably more “strained” than it appears as lenders use more off-balance sheet transactions to make room for loans.”

Shelley Smith, “China Defaulting Loans Soar, Insolvency Lawyer Says”, Bloomberg News 5 (February 2010).

http://www.bloomberg.com/apps/news?pid=20601080&sid=aJhBD4AeX8WA

Shelley Smith is a Corporate Finance Reporter for Bloomberg News stationed in Hong Kong.


Current assessments of China’s economic growth this year point to an increase on the order of a 10 per cent increase in its GDP. This is a rebound from the approximately 9 per cent rise it recorded last year and more in line with its past performance. For the most part, China’s economic growth is based on the manufacturing of goods for export to foreign markets. The World Bank expects the demand for China’s exports to strengthen in coming months and domestic consumption and investment growth to be underpinned by continued stimulus from past policies, implying continued growth. While the Bank and other international agencies have mentioned recent moves to tighten credit in China, they do not point to a buildup of a economic troubles or a financial bubble, although of course these can occur out of the blue.

Nevertheless, concerns about Chinese banks seem to be growing. There is also an undercurrent of fear that environmental problems, social strife linked to unemployment, and fixed but irrational prices represent major problems to China of unknown and unknowable implications, all bad. Adding to these fears are reports that China has overbuilt capacity in such areas as steel, cement, and building material, far more than they can use domestically or could export, and this could set the stage for problems. The existence of newly built “empty cities” has also been widely reported, many newly constructed buildings stand empty or incomplete, and many factories have been shut. Unemployment is seen as a major and growing problem. There have also been many, many reports of shoddy products that represent a challenge to the economy. Given many reports of great gains matched by many reports of great problems, it is difficult to assess the true state of the Chinese economy.

On the financial side, the government prints trillions and trillions of renminbi and when the government says lend it, the banks lend it. The tide of lending, it is feared, is building to a “bubble” that could bring the Chinese economy down from the financial side. The Japanese Finance Minister, among others, has said his country is monitoring the situation and are concerned about signs of a bubble in the mainland’s economy. China’s past capital spending boom may be unsustainable and, indeed, may have resulted in many poor investment decisions. However, academics studying the Chinese economy seem less concerned, citing the strong control of the government over enterprises and a willingness to “hide” problems long enough to deal with them slowly and effectively. Note that if this is true academics have little idea of what is going on in the economy as the information stream available to them is corrupted.

If what is happening in the Chinese economy is confusing and contradictory so, too, it would seem are the people who monitor that economy.

China’s economy is either an economic miracle or an economic mirage. I don’t know which.

Paul Volcker on 'too big to fail'

LW: Central banks and governments have extended the "safety net" of deposit insurance and lender of last resort facilities "to support investment banks, mortgage providers and the world's largest insurance company". These non-banks receive massive taxpayer support, but most escape the tight regulation and supervision to which commercial banks are subject.

“Adam Smith more than 200 years ago advocated keeping banks small. Then an individual failure would not be so destructive for the economy. That approach does not really seem feasible in today's world, not given the size of businesses, the substantial investment required in technology and the national and international reach required.

Instead, governments have long provided commercial banks with the public "safety net." The implied moral hazard has been balanced by close regulation and supervision. Improved capital requirements and leverage restrictions are now also under consideration in international forums as a key element of reform. ...

[As for other capital market institutions, few are] "too big" or "too interconnected" to fail. In fact, sizable numbers ... fail or voluntarily cease business in troubled times with no adverse consequences for the viability of markets.

What we do need is protection against the outliers. There are a limited number of investment banks (or perhaps insurance companies or other firms) the failure of which would be so disturbing as to raise concern about a broader market disruption. In such cases, authority by a relevant supervisory agency to limit their capital and leverage would be important, as the president has proposed.”

Paul Volcker, "How to Reform Our Financial System", New York Times (31 January 2010).

http://www.nytimes.com/2010/01/31/opinion/31volcker.html


LW: Paul Volcker (1927-) chaired the Federal Reserve under Presidents Jimmy Carter and Ronald Reagan and is now chairman of President Obama's Economic Recovery Advisory Board. He is providing sensible advice, with international relevance. Government leaders and central bankers everywhere should take note.

DOW: I agree with Larry this is an important article by a very experienced central banker noted for his aversion to inflation and love of fly-fishing.

In this article, Volcker advances several ideas he has advocated for some time and which reflect elements in the proposed bank regulations announced by the Obama Administration last week.

Essentially, and in broad outline, Volcker distinguishes between the banking activities of deposit-taking institutions such as commercial banks on the one hand and those of investment banks, private equity funds, and hedge funds on the other. Under his proposal, commercial banks would be limited to traditional banking services such as accepting deposits, making loans to businesses and consumers, investing in corporate and government bonds, and generating fee-based income by renting safe-deposit boxes. They would be prohibited from engaging in risky activities such as trading stocks, bonds, currencies, commodities and derivatives. Only commercial banks would receive “lender of last resort” support from the Federal Reserve to protect depositors.

Investment banks have traditionally raised capital from investors and engaged in capital market activities such as issuing and selling securities, insuring bonds and providing advice and financial support for mergers and acquisitions. They also engage in the trading of derivatives, foreign currency, commodities and equities. At times, they “make a market” by buying and selling a financial product to earn income on each trade or deal in derivatives by creating complex financial products intended to generate a high return. Other activities include investment management for wealthy individuals and merchant banking were it invests its own capital in a client company. Investment banks frequently have global scope.

Until 1999, commercial banks were not allowed to engage in investment banking activities and investment banks were not allowed to accept demand deposits. In my view, removing the separation between these two kinds of banking activities has proven to be unwise and we should reinstitute it. If we do, commercial banking should be narrowly limited to those kinds of loans and investments which involve minimal risk.

Volcker and others say they want to limit the size of big finance and impose more and better regulation on the financial sector, including greater regulation at the international level. Yet he admits “keeping banks small … does not really seem feasible in today’s world, not given the size of businesses, the substantial investment required in technology and the national and international reach required.” In this situation, investment banks clearly have to be tightly regulated but I for one am doubtful that more regulation by the public sector will make much of a difference. I simply do not believe better regulation by the public sector is possible. We always say we want better performance from government and we never get it. So why should I believe regulation of the banking system by government can really improve?

I would rather put very strong incentives in place to discourage bankers from growing too big in the first place and then, as they inevitably do, start making bad investments as a regular part of their everyday business. To be sure, let bankers make a good living and the banks be very profitable and let them be subject to government regulation. But let us change “the rules of the game” to encourage banks and their owners and investors to be prudent, very, very prudent. As a first step, as Volcker suggests, no bailouts for owners and investors in investment banks and similar kinds of financial institutions such as insurance companies. They are on their own. As a second step, remove limited liability protection from the owners of these banks and, more importantly, from the management of these banks. Let them pay personally when they make major mistakes. Both owners and management should be held liable in their personal capacity to creditors of these financial institutions. If we did this, the banks would not become too big because then the owners and managers would fear loss of control, with its risks to their wallets and their livelihoods.

It would also cause them to think hard about every investment decisions they made. They would carefully evaluate each investment they made and spread the risks they took far and wide and in doing so add stability to the entire system.

I know I would sleep better if the owners and management of these banks were fully accountable for the performance of their banks, even if they wouldn’t rest as well as they do now.

A tip of the hat to Larry for the Tdj.

Saving and the sex ratio in China

“Much attention has been directed toward China’s high savings rate. Not only is the savings rate disproportionately high compared to virtually any other country, but it directly impacts China’s current account surplus and the U.S. consumer deficit. When national savings exceeds investment, the excess savings shows up in China’s current account surplus.
...
Given its far-reaching effects, both private sector analysts and policy makers have attempted to trace the causes of China’s high savings rate and to predict how long it will last. Some have attributed the savings primarily to Chinese corporations rather than households. Others point to a precautionary savings motive: because Chinese people are worried about costs of healthcare, education and old-age pensions and are unsure about how much these costs might change over time, they respond by saving more. Other explanations point to habit formation or financial development.

“But these explanations do not tell the whole story, and possibly are not the most important part of the story,” says Wei. Instead, Wei hypothesized that an important social phenomenon is the primary driver of the high savings rate: for the last few decades China has experienced a significant imbalance between the number of male and female children born to its citizens.

There are approximately 122 boys born for every 100 girls today, a ratio that translates into cutting about one in five Chinese men out of the marriage market when this generation of children grows up. Three factors conspire to produce the imbalance. First, Chinese parents often prefer sons. Second, it has become increasingly inexpensive for even a relatively poor farmer to afford the $12 Ultrasound B, the most common technology used for learning the gender of a fetus.

Third, and perhaps most importantly, China’s stringent family planning policy limits the number of children a couple can have. The policy allows most couples to have only one child. But in some regions, if a couple’s first child is a daughter, the state permits the couple to have another child. Families with one daughter that become pregnant with another daughter are more likely to terminate the second pregnancy in hopes of producing a son later on. (India, Korea, Vietnam and Singapore also have sex ratio imbalances that favor male children despite the absence of these stringent family planning policies. It might be that in these countries people voluntarily want to restrict the number of children they have, and still prefer sons and have access to inexpensive selective abortions. The sex ratio imbalance is high in these countries but not as extreme as in China.)

“The increased pressure on the marriage market in China might induce men and parents with sons to do things to make themselves more competitive,” Wei says. “Increasing savings is one logical way to do that, to the extent that wealth helps to increase a man’s competitive edge. Parents increase household savings mostly by cutting down their own consumption.”

Wei worked with Xiaobo Zhang of the International Food Policy Research Institute in Washington, D.C., to see if his hypothesis held up, comparing savings data across regions and in households with sons versus those with daughters. “We find not only that households with sons save more than households with daughters in all regions,” Wei says, “but that households with sons tend to raise their savings rate if they also happen to live in a region with a more skewed sex ratio.””

“Why Do the Chinese Save So Much?”, post on Ideas that Work Blog, Columbia Business School (22 January 2010).

www4.gsb.columbia.edu/ideasatwork/feature/729422/Why+Do+the+Chinese+Save+So+Much%3F


Shang-Jin Wei is the N.T. Wang Professor of Chinese Business and Economy in the Finance and Economics Division at Columbia Business School and director of its Jerome A. Chazen Institute of International Business.


The most powerful forces now shaping the world are those related to demography and among the most significant of the changes taking place relate to fertility. Between 1970 and today, the world population experienced a major and unprecedented reduction in fertility levels, driven mostly by a reduction in fertility in developing countries. During this period, total fertility per woman fell from 4.5 children to 2.6 for the world as a whole, with 2.1 children as the replacement rate.

A number of factors are contributing to the decline in human fertility. Greater contraceptive use, abortion, and changing life styles have certainly affected the average fertility level. But in some countries, such as China, population controls and sex selection are also a important factor driving fertility down. China may be an extreme example of fertility decline, as its fertility has dropped sharply from an average of 5.7 children per woman in 1970 to an average of only 1.7 in 2007, far below the replacement level.

Another demographic change underway in an increasing number of countries is a changing sex ratio at birth. Historically, about 103 to 105 boys were born per 100 girls in almost all countries. Because the mortality of boys is higher than that of girls, the sex ratio moved toward 100 boys per 100 girls over time, reaching parity in many countries in cohorts corresponding to marriageable ages of the 20s and 30s. However, sex selection has moved the world average from 105 boys born per 100 girls in 1970 to 107 in 2010. In the case of China, the change has been much greater, from 107 in the 1970s to 122 today. It is also high in other Asian countries, the Pacific and in South-East Europe.

All this has implications for the United States. The demographic imbalance between men and women is seen by Professor Wei as the primary driver of the high saving rate of China and other Asian countries and the cause of their huge export surpluses. These export surpluses, in turn, correspond to and finance the budget and trade deficits the United States and other countries have recorded in recent years. If the problem of global imbalances is to be addressed, China must import more and the U.S. import less and, what is effectively the same thing, China must save less and the U.S. must save more. But if the high Chinese saving rate is rooted in demographic factors rather than economic factors, the usual economic policy instruments such as changes to exchange rates, relative interest rates, and income and price levels are not going to be effective in bringing about the necessary balance of payments adjustments to restore a balanced world economy.

If Professor Wei is correct, it may very well be much more difficult to eliminate the U.S. balance of payments deficits than we now believe.

Thanks to Tyler Cowen of Marginal Revolution to the point to this article.

How a Mozart string quintet helps explain high health care costs

“Nearly everyone agrees that there is something sick about the American health care system, especially when it comes to the seemingly out-of-control rise in costs.

While Democrats and Republicans continue to fight over the remedy, there is one man who can claim to have rendered a specific diagnosis and — more than 40 years later — he wants lawmakers and President Obama to know that there probably is no cure.

What afflicts the American health care system (and those of other industrialized nations) is called Baumol’s cost disease. It is named for William J. Baumol, an economist at New York University, who turns 88 next month. And it explains why health care costs will almost certainly continue to rise faster than general inflation, and why Democrats might not want to set expectations too high when it comes to their health care bill.
…
Dr. Baumol and a colleague, William G. Bowen, described the cost disease in a 1966 book on the economics of the performing arts. Their point was that some sectors of the economy are burdened by an inexorable rise in labor costs because they tend not to benefit from increased efficiency. As an example, they used a Mozart string quintet composed in 1787: 223 years later, it still requires five musicians and the same amount of time to play.

Despite all sorts of technological advances, health care, like the performing arts, suffers from the cost disease. So do other public services like education, police work and garbage collection. While some industries enjoy sharp increases in productivity (cars can be built faster than ever, retail inventory can be managed better), endeavors like health care are as labor-intensive as ever.

And yet, wages in health care grow to match wage increases in the broader economy. (Imagine trying to pay today’s violinist the same as a counterpart in 1787.)

All of this happens invisibly, but the proof is in the budget ledgers of local, state and federal governments. Cost disease helps explain why low-income Americans can now afford flat-screen televisions that were out of reach a decade ago, but health insurance that was unaffordable in January 2000 remains unaffordable in January 2010.

At the same time, demand for health care never lets up. …

“We do now have robots performing surgery, but the robot is under constant supervision of the surgeon during the process,” Dr. Baumol said. “You haven’t saved labor. You have done other good things, but it isn’t a way of cheapening the process.”

Recent research, including a December 2008 study for Centraal Planbureau, the Netherlands Bureau for Economic Policy Analysis, has found that Baumol’s cost disease continues to be a major factor in rising health costs around the world.”

David M. Herszenhorn, “For Ailing Health System, a Diagnosis but No Cure”, The New York Times (17 January 2010).

http://prescriptions.blogs.nytimes.com/2010/01/17/an-economist-who-sees-no-way-to-slow-rising-costs/

David M. Herszenhorn is a reporter for the New York Times.


William Baumol (1922-) was for many years a professor at Princeton and New York universities. He made contributions in many areas but is best known for the theory of contestable markets, the Baumol-Tobin model of transactions demand for money, and Baumol’s cost disease. A major influence on Professor Baumol was Joseph Schumpeter, and he claims that the object of his lifetime work was to develop a place in economic theory for Schumpeter’s entrepreneur.

In his 1967 article, Professor Baumol used the Mozart String Quintet note that the productivity of Classical music performers has not increased in 200 years since it takes the same number of musicians today and the same amount of time to play the quintet as it did in 1787. The article Baumol published was entitled “Macroeconomics of Unbalanced Growth”, and it looked at the effects of automation on the U.S. economy.

At the time (and continuing today), the U.S. was undergoing a revolution of factory automation where the introduction of new technologies and processes was raising productivity in many lines of manufacturing production. Other sectors, however, such as education, health services, and government services, among many others, were more labor-intensive, and there was less scope to substitute new technology-embodying capital for labor. Consequently, these sectors did not experience much productivity growth. As a result, costs and prices (and total income and employment) tended to fall in those activities conducive to technological progress and generating productivity advance (such as manufacturing) while costs and prices remained relatively high in non-manufacturing sectors (especially services).

While many people who work in high-productivity growth sectors such as manufacturing lose their jobs to automation, those that remain are paid more and average incomes rise. The huge and growing output of manufactured goods resulting from the growth in productivity tends to saturate the market for these products and the income elasticity of manufactures falls with time.

In contrast, in the more service-oriented sectors productivity gains are difficult to realize. Workers in these sectors nonetheless experience rising wages because they have the option of working in other occupations, and will leave if they are not adequately compensated. Many of these workers are also highly educated and would be difficult to replace should they resign. This also tends to keep their wages high. Finally, the service sector also benefits from a high income elasticity of demand as people choose to spend their rising incomes on health care, education and other labor-intensive services where productivity gains are difficult to generate.

Health care costs are high and rising because they involve high labor skills and personal attention and cannot be easily reduced by spreading the costs over more people. Like a Mozart string quintet, a certain number of workers are involved and the time taken to treat a patient, like the time it takes to play the music, is fixed. (But, let me note, that while it costs the same to produce the music, with recorded music it is much cheaper to consume it than in 1787, as it can now be replayed at almost zero marginal cost. Unfortunately, this is not the case with health care.)

It is a mistake for Congress and the Administration to imply that public policy can do much to reduce health care costs or the general efficiency of the health care sector. It can’t.

Thanks to Greg Mankiw for the pointer to this article.

Simon Johnson on the financial crisis and Obama’s advisors

LW: MIT economist Simon Johnson explains that the policies embraced by key members of Obama's economic team are opposite those they supported during the Asian financial crisis of the 1990s. This charge applies in particular to Lawrence Summers, in charge of the White House National Economic Council, Treasury Secretary Timothy F. Geithner, and David A. Lipton, who is now at the National Economic Council and the National Security Council. All three were heavily involved in preparing a US response to the Asian financial crisis.

“In the 1990s, they were opposed to unconditional bailouts — providing money to troubled financial institutions with no strings attached. .... The Treasury philosophy was clear and tough: "a healthy financial system cannot be built on the expectation of bailouts," Mr. Summers said in his American Economic Association speech in 2000. ...

“In the 1990s, the United States — working closely with the I.M.F. — insisted that crisis countries fundamentally restructure their financial systems, which involved forcing out top bank executives. In the United States during 2009, we not only kept our largest and most troubled banks intact (while on life support) but allowed the biggest six financial conglomerates to become larger, both in absolute terms and relative to the economy. ....”

If true, this has a terrible implication. The structure of our financial system has not changed in any way that will reduce reckless risk-taking by banks that are large enough to cause significant damage when they threaten to fail.”
Simon Johnson, "Lessons Learned but Not Applied", Economix (31 December 2009).
http://economix.blogs.nytimes.com/2009/12/31/by-simon-johnson-lessons-lea/


DOW: Simon Johnson is currently the Ronald A. Kurtz Professor of Entrepreneurship at the Sloan School of Management at MIT. From March 2007 through the end of August 2008 he was Chief Economist of the International Monetary Fund. Recently Prospect Magazine named Simon Johnson as the "clear winner" out of 25 economists who have made notable contributions to "public conversation" during the current financial crisis. Also on the list were Martin Wolf of the Financial Times, Paul Krugman of the New York Times, and Columbia University economist Joseph Stiglitz.

The issue Professor Johnson has focused on in this post is the one of “Moral Hazard”. Moral hazard is the tendency of a person or institution that is imperfectly monitored to engage in dishonest or risky behavior. (“Moral hazard” is another one of those lousy economic terms that makes no sense but is used by everyone anyway.) In the case of financial institutions, moral hazard is the tendency for financial bailouts by governments and central banks to encourage risky lending in the future, if the bankers come to believe they will be bailed out and not suffer personal loss if things go wrong.

Moral hazard has been a concern expressed about the Administration policy since it first took office. The objection is both that Wall Street has not simply been “saved” from its own stupidities but that the very people that made disastrous decisions have benefited from the very mistakes they made. This, it is argued, will only encourage them to be even more reckless in the future and, anyway, they should be fired and not benefit from their mistakes.

Nor has the issue of moral hazard been limited to the banks, as the Administration also bailed out auto companies, investors in housing, states and localities, and pension funds, among others. The fear on the part of the critics is both the unfairness of shifting the costs of all these bailouts to the taxpayer and the precedent it sets for the future.

As Simon Johnson notes, the problem of moral hazard is well understood by President Obama’s economic advisors. When addressing the question of bailouts at the international level in 2000 Larry Summers had this to say about the problem of moral hazard in his speech to the AEA:

“… as in the case of an efficient and incentive-compatible deposit-insurance and safety-net scheme, possible moral-hazard distortions induced by automatic guarantees need to be avoided to ensure that the scheme does not lead to systemic losses and distortions. Thus, it is certain that a healthy financial system cannot be built on the expectation of bailouts.”

American Economic Review, Vol. 90, No. 2 (May 2000).

But bailouts are exactly what the Obama Administration’s policy has been. Wall Street is back in business earning huge profits and its executives are back in their offices receiving the huge bonuses. Car companies are living off the public dole and their executives are still receiving high salaries. Fannie and Freddie are still in business, still paying exorbitant salaries to their management, and still near financial collapse. Yet the rest of the economy remains in the doldrums and employment is still sinking.

It’s hard to understand why bailouts were bad policy during the Asian financial crisis in the 1990s and yet bailouts are wise economic policy for the U.S today.

Thanks to Larry Willmore for the Tdj.Presumably this time, the Summers-Geithner-Lipton group will argue that the only way to restore confidence was through the kind of unconditional and implicit bailout guarantees they opposed in the 1990s.

The downside of fixed exchange rates

LW: Martin Wolf has drafted another superb Wednesday column. He begins with these words:

“What would have happened during the financial crisis if the euro had not existed? The short answer is that there would have been currency crises among its members. The currencies of Greece, Ireland, Italy, Portugal and Spain would surely have fallen sharply against the old D-Mark. That is the outcome the creators of the eurozone wished to avoid. They have been successful. But, if the exchange rate cannot adjust, something else must instead. That "something else" is the economies of peripheral eurozone member countries. They are locked into competitive disinflation against Germany, the world's foremost exporter of very high-quality manufactures. I wish them luck.”

Martin Wolf, "The eurozone's next decade will be tough", Financial Times (6 January 2010).

http://www.ft.com/cms/s/0/19da1d26-fa2f-11de-beed-00144feab49a.html

The remainder of the column is just as informative, just as well-written, and should be read in its entirety. Martin ends on a sober note:

“When the eurozone was created, a huge literature emerged on whether it was an optimal currency union. We know now it was not. We are about to find out whether this matters.”

I've said this before, and will say it again: Martin Wolf's column alone is worth the price of an online subscription to the Financial Times. Non-subscribers, I understand, are allowed to download three articles each week. If you are a non-subscriber, do reserve one of your free weekly downloads for Martin Wolf. Martin rarely disappoints.


DOW: Let me begin by saying I endorse what Larry says above about the wisdom of Martin Wolf and double endorse his recommendation to download Martin’s weekly column.

Let me add that many economists -- I was one of them -- were never a supporter of the euro precisely because we did not think Europe as a whole was sufficiently integrated to allow a single currency to operate across such a varied economic landscape with such diverse policy objectives and different institutional structures. But I was sympathetic to the need to reduce the transactions costs associated with currency conversions and fluctuating exchange values, and I hoped that the introduction of a single currency would sufficiently discipline economic policy and improve economic performance so as to limit any problems caused by the introduction of a rigid and unchangeable unit to effect transactions and carry out investments over such a wide area. Opening up Europe as a whole to flows of people and capital was also a good idea that could help a continent overcome a terrible history of nationalistic turmoil.

Our fear was the euro would shift the internal balance of payments adjustment process among these countries entirely to changes in the level of income (and hence employment), as fixed exchange rates inevitably do, rather than allowing changes in relative prices to absorb some of the adjustment effects, as more flexible exchange rates tend to do. Wider swings in growth and more persistent external imbalances would result if a fixed exchange rate were imposed and the unemployment rate would be higher. If this happened, the economic situation in some of these countries would worsen over the long-run, not improve, at least relative to the other countries. This is what appears to have happened some of the peripheral countries.

The peripheral countries now have a difficult decision to make. By accepting the euro they have turned the conduct of their monetary policy over to the European Central Bank. It is no longer available to them as a domestic policy instrument. Moreover, now their fiscal policy must be directed at their external concerns rather than their internal problems. For these countries, fiscal policy is no longer a domestic policy instrument. The fixed exchange rate of the euro has become the sole concern and focus of economic policy in these countries. They will either have to discipline their internal policies to the demands of their external monetary relationships or they will have to abandon the euro.

As Martin Wolf mentions in his article, the late Charles Kindleberger of MIT argued that an open economy required a hegemon to bring stability to the external environment within which countries conduct their external economic relations. In the case of the eurozone it is Germany. But because of the nature of its own structural relationships Germany is not capable (or even willing) of carrying out this role. Consequently, the peripheral countries of the eurozone are left to fend on their own not only without support from other countries but with the constraints imposed by others tightening on them. Their immediate outlook is bleak and their adjustment process to deal with their problems is becoming increasing difficult.

In the same way for the same reasons as Kindleberger set forth the world economy requires a hegemon to provide it the stability and lend it the time required to adjust domestic productive structures and trading patterns to the incessant changes brought about by technological change and rising incomes. This hegemon is the United States, whose currency is the main international currency and whose economy is the main absorber and provider of goods and services at the international level. The U.S. attempted to avoid the role as hegemon at the end of the Second World War, or at least minimize it, through the establishment of a set of international monetary institutions -- the Bretton Woods System -- to which it transferred many of the operations necessary for the efficient functioning of the world economy. By doing so, it hoped to release itself from the constraints entailed in managing the world economy.

But the United States quickly learned that, in the end, there must be a spender and borrower of last resort in a crisis, and the IMF and other international agencies it created were not up to the task. Moreover, it quickly learned, to its sad regret, that that a fixed exchange rate system at the world level required domestic policy discipline on the part on the global hegemon and its failure to live within its means and conduct its domestic policy with the goal of international stability in mind would bring down the entire system. The world (and, equally, the Americans) has lived with the consequences of the inability of the United States to conduct its economic policies in a manner worthy of its responsibilities since the late 1960s and early 1970s. Nowhere is this clearer than in the sharp deterioration in long-term world and U.S. economic performance since that time and an increasingly chaotic international economy.

The upside of fixed exchange rate systems is that they provide the stability required for rapid economic advance and spreading global prosperity. The downside of fixed exchange rate systems is that they require discipline on the part of governments in the conduct of their monetary and fiscal policies, especially on the part of the hegemon, and a willingness to adjust to changes taking place outside their domestic economies.
As Martin points out, we are about to find out whether the peripheral members of the eurozone can summon the discipline necessary to deal with their deteriorating economic circumstances. One wonders whether the United States, which is far more important to the world economy and encompasses far more people than the smaller countries of the eurozone, can do the same.

Thanks to Larry Willmore for the Tdj.