By Ricardo J. Caballero
Suppose it was possible to rewind the clock to the first time we had a strong urge to rewrite economic history. A favourite stopping date would be the days before theLehman-AIG debacle last year. Until then, we were dealing with localised inefficiencies and predatory behaviour among the main financial institutions. There was plenty to fix but it seemed manageable, mostly a matter of accelerating the medicine and aggressively dealing with problems on a case-by-case basis.
All of this changed for the worse after the Lehman-AIG event. The problem ceased to be firm-and market-localised, and turned into a severe systemic panic attack. This change in the nature of the problem has strong policy implications, since it requires a systemic, not a case-by-case, remedy. Of course the systemic problem first appears in relatively weaker institutions, but one should not confuse causes and consequences. Surely some financial institutions will appear insolvent in the strict accounting sense; this is what mark-to-market accounting will do to almost any leveraged institution in the midst of a severe systemic crisis.
However, simply destroying the intangible capital of a financial institution, or forcing a significant dilution of a stakeholder as a means of dealing with a systemic symptom of fear, is a highly inefficient and counterproductive policy response. It is the economic equivalent of putting out a fire with gasoline.
Fortunately, both the US Treasury and the Federal Reserve have the right diagnosis. They understand that the need is to restore systemic confidence with a limited amount of financial and political capital. They are on the right track, although not at the speed we all feel is required.
To remedy the latter, we should help, rather than obstruct them. We all have our favourite plans, but at this point we are of little help to anyone when we keep changing the entire policy paradigm. We should take what we know of their current plan as given, and restrict our recommendations to operate within their framework. This is important not only to accelerate the process, but also to eliminate the enormous policy uncertainty that is destroying the stock market, private wealth, and balance sheets.
In this spirit, I would propose that any new recommendation should satisfy three constraints:
- Only good (policy) news is allowed. Any amendment to their plan must do more, not less, for the financial institutions and their stakeholders. This principle should be advertised broadly right away
- It must have a reasonable cost. The amendment cannot be significantly more expensive for the US government than the current plan, and
- It must be wealth enhancing. It cannot go against, and it hopefully should reinforce, the fiscal stimulus package.
The following plan satisfies these constraints:
- Raising private capital. Announce today that banks in need of more capital if aggregate conditions worsen (the stress test), will be given an option between the previously announced programme and one in which new private capital raised receives a government guarantee for a price five years from now set at the February 2009 price used for the preferred shares. Alternatively, the government may invest in common shares but give the right to new investors to repurchase the government shares within five years at that price plus an interest rate charge. This guarantee holds regardless of whether the financial institution survives the crisis. Any difference between the expected costs of these two options is paid as a premium by shareholders (and possibly debt-holders).
- Insuring aggregate risk. The return on hard to value assets, whether they remain on the books of the financial institutions or are sold into the PPIF (public-private investment fund), should be guaranteed by the government at the insurance prices prevailing before the Lehman-AIG crisis. These assets can be subject to a “representations and warranties” clause where the financial institution pays a penalty if the performance of its insured assets is worse than the average of the corresponding category, five years hence.
The first item is clearly a positive development for shareholders since it adds an option which has no additional value over the current programme if the financial institution’s post-crisis future is poor, but is very valuable otherwise.
Interestingly, whenever the option has value, it also helps the government since now the private sector injects the capital in exchange for a guarantee that is not likely to be executed in such a scenario. Moreover, by bringing some sense of a floor, this policy also would trigger a stock market boom and hence reinforce the aggregate demand effects of the fiscal package. The second item has similar virtues, and it deals directly with one of the key adverse selection problems complicating asset valuations at this time (that banks will sell and insure their worst assets).
Will these policies be enough? Surely not, but if we are all rowing the same boat in the same direction, and keep a cool head, we will get out of this mess sooner rather than later...FT
Ricardo J. Caballero is head of the department of economics at Massachusetts Institute of Technology
Extract of Editorial
It’s the Regulations, Not the
- NYT, Published: March 18, 2009
It has become a truism of the financial crisis that
the system was prone to collapse because there
was no single regulator who had the legal tools and
authority to prevent a systemwide meltdown. That
belief has led to calls from some lawmakers and
major banks, among others, for a new “systemic
risk regulator” — one regulator to monitor the
entire financial landscape for problems that could
lead to cascading failures...
Rather, it is rooted in the refusal of regulators,
lawmakers and executive-branch officials to heed
warnings about risks in the system and to use their
powers to head them off. It is the result of
antiregulatory bias and deregulatory zeal —
ascendant over the last three decades, but
especially prevalent in the last 10 years — that
eclipsed not only rules and regulations, but the very
will to regulate...
In the late 1990s, a drive to fully regulate swaps
was squashed by Congress, with the support of
then-President Bill Clinton’s Treasury Department.
Instead of regulation, which could have prevented
the A.I.G. fiasco, a law was passed in 2000 that
deregulated swaps. By then, the Treasury secretary
was Lawrence Summers, who is now Mr. Obama’s
chief economic adviser.
There are many other examples where rules were
blocked, eliminated or ignored. They all make
painfully clear that what is needed is a
comprehensive response — to restore rules,
develop new ones as needed and enforce them
day to day; to reassert the government’s
regulatory mission; and to reaffirm the centrality of
solvency, safety and soundness of financial firms,
and of investor and consumer protection.
A new systemic-risk regulator could play a role in
that, coordinating the efforts and identifying
emerging risks. A systemic-risk regulator could also
assume the important function, currently lacking, of
a sort of F.D.I.C. for nonbank financial firms, with
authority to seize and restructure critically impaired
firms before they threaten the broader system...
Three Processes to Restore Sustainable U.S. Economic Growth
There are actually three processes that need to complete to a sufficient, if not ideal, degree to restore an attractive basis for long term U.S. economic growth. They are: righting the financial system, systemic de-leveraging and re-balancing the global trade and currency systems.
1. Righting the Financial System – This has clearly been the focus of Bernanke and Geithner, and evidence suggests that progress if not perfection has been made. However, a key element of correcting the banking industry that requires more effort on their part is getting the shadow banking system out into the light and neutralizing the derivative bomb. Because the amount of derivative exposure is so huge ($ hundreds of trillions notional and $ tens of trillions net) and because it is unclear who, besides AIG, is holding the old maids, extension of credit will remain restricted until the practical creditworthiness of institutions can be comfortably asssessed. It is not clear that Geithner's toxic asset plan includes derivatives. Part of this is a disclosure issue, which will be ongoing. Another part is a one time clean-up of the current situation.
There are other measures, besides dealing with toxic assets and liabilities that should be implemented as well. First, any institution too big to fail should be broken up or if it presents some other risk to the system, that risk should be regulated out of the firm. Second, leverage must be regulated in business lines that on a pooled basis present a systemic risk. Even if no one institution poses a problem, a large group of institutions that collectively over levers can also pose a problem. Three, incentive structures need to be changed to discourage looting behavior. It is perfectly rational for individual executives to originate or underwrite overly risky and poor investments when bonuses big enough to retire on are paid near the time of origination and long before the risks and hazards play out. 30 years ago, when most Wall Street firms were partnerships, a comfortable retirement depended on executives not putting their firms into jeopardy. Four, the captive relationship between Wall Street and Washington should be broken.
Politicians depend on well heeled bankers to fund increasingly expensive election campaigns and bureaucrats look to the street for well paying jobs when they have done their time working for peanuts at an agency. The inevitable quid pro quo from this dependency has resulted in de-regulatory favors, looking the other way (even at times for criminal behavior) and outright payments from taxpayers (call them bailouts or toxic asset purchases if you will). Government cannot serve the general interest of the populace when it is captive to the players of the securities industry. One tell-tale on this issue is a lack of indictments emerging from the present crisis. When the internet bubble broke a few years ago, several executives went to jail. The current mess, which has arguably been created by even more egregious behavior, has generated a rescue response rather than a draw-and-quarter response, complaints about bonuses notwithstanding.
2. Systemic De-Leveraging – Not only does the financial system need to be righted from over-leverage and other ills, but also the consumer sector, which is the major driver of the economy, needs to de-lever. Hedge fund manager Ray Dalio's notion of a D-process seems right on the mark here. Years of easy credit for mortgages, auto loans, credit cards (under the guise of financial innovation) fueled purchases beyond what was possible with household cash flow (i.e. take-home pay). False perceptions that increases in wealth due to rising home and equity prices were permanent lured people to spend more than they had earned, reducing the national savings rate to 0%. To a lesser extent, the industrial sector needs to de-lever as well. A surge of cheap credit fueled a buyout boom, and there are several good businesses bought by private equity firms that are carrying too much debt...
Asset values and the debts monetizing those assets have to return to a sustainable balance that is supportable with cash flow (ideally also recognizing requirements for future off balance sheet liabilities such as retirement). As Dalio has noted, this is a process not an event. Over the years, through the money multiplier effect, increasing leverage has been a significant driver of economic growth and thus systemic cash flow. With the tide going out, we are now in the difficult part of the cycle where the money multiplier works in reverse. That is falling asset values require reduced debt which reduces cash flow which further reduces credit which hurts asset values more and so on.
An interesting aspect of this process is the role of government. In order to reduce the pain of this process and perhaps to slow it down to a pace that can be managed (as an alternative to a collapse), the U.S. government has embarked on a process of transferring debt from the private sector (the banking system and consumers) to the public sector. Thus through bailouts, which allow financial institutions to settle debts, and outright purchases of mortgage backed securities by the Fed, Government has been assuming a portion (a sizeable one actually) of the declining leverage elsewhere in the economy. Furthermore, through transfer payments such as welfare to the unemployed, the government is braking the cashflow effect of the deleveraging process. It is clear though, that this is ballooning government debt (by some estimates currently on the order of $750,000 for a family of four) and that limits may be reached. If the federal government needs to go through a D-Process of its own, the implications will be significant. Rising treasury rates, a falling dollar either to other currencies and/or precious metals and surging tax rates may all be fallout from this in the future.
3. Rebalancing the global trade and currency systems – While the two processes above appear to be underway in varying degrees… and with varying competence… the process of reforming the trade and currency system appears yet to begin. While the globalization of trade over the last 20 years has clearly been beneficial to the parties involved (particularly those countries who have raised unprecedented numbers of citizens out of poverty), it has taken place in a less than perfect system. In the ideal of a free and fair trade system, markets and prices (including currency exchange rates) function so that economic forces (a la Adam Smith's invisible hand) allocate resources to their most productive uses in a fashion that leads to long run balances of trade between participating countries. While there are degrees of freedom in the current system, there are also a host of structural restrictions that inhibit free market processes in ways that provide certain significant favors to various parties. There is a reason World Trade Organization rules and other “free trade” agreements are tens of thousands of pages long. They are actually not “free trade” agreements but “negotiated trade” agreements. Consequently, economic laws that naturally regulate supply, demand, pricing and other variables to achieve balance are constrained and influenced by the arbitrary rules built into the system.
Underpinning the trade system is the world currency system, which also has some imperfections. In a more ideal world, currencies float in value relative to each other and in doing so, they help signal important adjustments to economic activity so as to maintain balance. The existing system, which reflects the Bretton Woods Agreement of over 60 years ago, inhibits this ideal. While currencies do float in value, the U.S. dollar is established as the world's reserve currency, which provides it some preferences that distort its value relative to other currencies. Furthermore, countries operating within the system, such as China , have been allowed to peg their currency values to the dollar, which has distorted those values not only against the already distorted value of the dollar but also against the various unpegged currencies.
The consequence of structural flaws in trade agreements and the currency system have led to extraordinary imbalances in trade, which has divided the world into surplus economies and deficit economies. The current state of affairs is unsustainable. The question is whether the requisite changes that must be made can be achieved cooperatively or if the systems will be allowed to break down in catastrophic fashion before a new order can emerge. If the rhetoric between China and the U.S. is any indication, tensions are rising to a point where the stage may be set to implement change.
Hopefully, talks and deals can be struck productively while avoiding trade wars or, worst of all, a military war. What is at stake here is difficult to underestimate, and the political will and craft required to achieve favorable outcomes will be extremely challenging. It is no wonder that this process is being saved for last. While the market's exuberance of the last two weeks should be enjoyed by all who have profited from it, eyes should be clear that more “interesting” times are in store.
By Thomas Auchincloss, Market Oracle UK
How Can We End America’s Losing
Streak? by Bob Chernow
Has America lost its confidence? Are we into a
losing streak? If so, can we turn it around?
I take my lead from Rosabeth Moss Kanter’s book,
Confidence. Kanter is a Harvard professor who has
studied long term winning and losing streaks in
business and sports. She is to the point and
practical. I have taken her observation to their
logical larger conclusion that America has a losing
Kanter says that “confidence is a sweet spot
between arrogance and despair. Overconfid
ence leads people to overshoot, to overbuild, to
become unnaturally exuberant or delusionally
optimistic and to assume they are invulnerable.
That is what induces people to become complacent
, leaders to neglect fundamental disciplines,
investors to turn into gamblers. But under-
confidence is just as bad, and perhaps worse. It
leads people to under-invest, to under innovate and
to assume that everything is stacked against them,
so there is no point in trying.”
Certainly this is where America stands now.
Retail spending stopped late in September, not just
for large purchases, but for modest ones. I have a
friend who owns three dry cleaner stores. He tells
me that October – usually his best month – is down
dramatically. My barber, Tom, said that his
business in mid-October was cut by 70%. Usually I
need to wait 35 minutes for a haircut. When I saw
him in mid-October at 11 a.m., I was his third
customer for the day.
My point is that Americans have pulled back. We
feel rudderless. Recently the Obama appointments
– all experienced and competent – have triggered a
Wall Street rally, in part because it fills a void of a
leaderless country and economy. But our
problems are deeper.
For example, we are into the “blame game”. My
friend Congressmen Jim Sensenbrenner believes
that the sub-prime crisis was caused because the
poor were “given” mortgages. Support for the auto
industry is equated with helping the unions. Others
want to punish the “evil-doers” who were
responsible for the failure of our banking system.
The “blame game” turns winners into losers, in part
because the attitude is revenge, not problem
solving. Indeed when we let our ideology shape
the facts, like Mr. Sensenbrenner, we cannot
saveour problems. For my part, I want the
economy to recover. I seek financial health more
As Professor Kanter says, “if losses mount, pressure
goes up – or the perception of pressure”. “Stress
makes it easier to panic. Panic makes it easier to
lose. Losing increases neglect”.
“Signs of failure cause people to dislike or avoid one
another, hide information, and disclaim
responsibility – key elements in denial”.
As to the reason behind the sudden stopping of
shopping, it is fear and anxiety. “People can
become paralyzed by anxiety – the learned
Warren Buffett likes to say that “it’s only when the
tide goes out that you know who has been
swimming naked”. So we look at the Chrysler, GM
& Ford executives who flew down to Washington to
beg for money in their Lear jets and think silently
that “these guys are out of touch”. We see
Secretary Paulson and the now irrelevant Bernanke
fumble with their plans to shore up the system.
They are merely throwing mud against the wall to
see what sticks!
These folks are easy targets. But attacking them
does not help us solve our problems.
“Of all the pathologies that accumulate in a losing
streak, one of the most damaging to individuals,
and eventually to the places they work and live, is
passivity and learned helplessness. When people
become resigned to their fate, nothing ever
So, have we lost faith in our financial system, our
economy, our government and ourselves?
Perhaps! But we Americans are an optimistic
people. We see adversity as opportunity. We shine
when adversity hits us. We get up when we
Kanter suggests that we get “people to engage in
positive ways” and to “find reasons to identify with
everyone’s fate”. I’d second that suggestion.
Business and government needs to again “walk the
factory floors”. They need to understand their
customers and get useful feedback from their
employees. Some “winners” do that now. I made a
suggestion to Costco and received a call from their
CEO, who questioned me about one of their stores.
He picked up on a problem about check out lines
and corrected it. On the other hand, I wrote Fede
ral Reserve Chair Bernanke just after he was
appointed in 2006. I was predicting the sub-prime
crisis and made specific suggestions on reducing its
impact. I was answered by a PR flack who had not
read my comments. I responded to her, asking her
to pass on my letter to Bernanke. This was not
done. He and others remain isolated from the
problems we are having.
What can we as citizens do? First, be positive. Do
something positive, even if it is a small gesture. For
example, I bring up the newspapers for the office
and make the coffee when I come in early. This
starts me off positively for the day. Volunteer to
help those less fortunate.
Try to look at the glass half full, not half empty. Will
lowered gas prices stimulate the economy by
putting more money in people’s pockets? Some
conservative estimates say that most American
will“save” $1250 a year. Are there opportunities in
the bond and stock markets? Is government
helping to stabilize financial institutions and will that
lead to the freeing up of loans? Will layoffs mean
that businesses will be more efficient? Are the
Obama appointments men and women who are
competent and experienced? You get the idea.
Emblazon as your motto “Don’t address blame
solve the problem”.
Do what you can do yourself to have people look at
the world in a less defensive manner and remind
others that we have the power to change direction
, through our own efforts, through elections, and
with a plan. What was it that Horace said” Many
shall be restored that now are fallen and many shall
fall that are now in honor.”
Ten principles for a Black Swan-proof world
By Nassim Nicholas Taleb
Published: April 7 2009 FT
1. What is fragile should break early while it is still small. Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks – and hence the most fragile – become the biggest.
2. No socialisation of losses and privatisation of gains. Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism. In France in the 1980s, the socialists took over the banks. In the US in the 2000s, the banks took over the government. This is surreal.
3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus. The economics establishment (universities, regulators, central bankers, government officials, various organisations staffed with economists) lost its legitimacy with the failure of the system. It is irresponsible and foolish to put our trust in the ability of such experts to get us out of this mess. Instead, find the smart people whose hands are clean.
4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.
5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.
6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.
7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”. Cascading rumours are a product of complex systems. Governments cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.
8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is not homeopathy, it is denial. The debt crisis is not a temporary problem, it is a structural one. We need rehab.
9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement. Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require. Citizens should experience anxiety about their own businesses (which they control), not their investments (which they do not control).
10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.
Then we will see an economic life closer to our biological environment: smaller companies, richer ecology, no leverage. A world in which entrepreneurs, not bankers, take the risks and companies are born and die every day without making the news.
In other words, a place more resistant to black swans.
The writer is a veteran trader, a distinguished professor at New York University’s Polytechnic Institute and the author of The Black Swan: The Impact of the Highly Improbable