Tuesday, 30 September 2008

Expectations Bail-Out

What is a bail-out?

It’s just a promise.

A government bail-out of a private company is a promise to provide assistance such that some socially important function of the company can survive without discontinuity. The most often used form is short-term liquidity provision during bankruptcy. However, the ‘assistance’ could be provided in many other forms than mere cash (e.g., procurement orders). You, as the government, do this so that some vitally important products or services are not disrupted, or so that the reallocation of a large part of the labour force does not burden the social security system, etc. Typically, it is a systemic function provided by the private sector that you want to save.

The point here is that the bail-out is usually not immediate. It is a promise for future action. It is the promise itself that provides the stability. Frequently, the delivery is not needed or is not regarded as important when it actually takes place.

When a government offers a large pile of future cash, as in the case of the embattled Paulson Plan now, what is really promised is not the same as the number cited. It is only a “huge number”. It is managing expectations: it serves as a guarantee that the government will provide all the cash necessary to reduce the disruption to an acceptable level.

And this is the problem here.

The power to make such a promise can come from three sources.

First, the government may sit on enough cash to deliver. This is by far not the case now. None of the Western governments have much cash, especially compared to the size of their financial sectors (although there are small exceptions, like Norway). If they had, the power behind the bailout promise would come from their ability to cover the entire system. When the government offers cash on hand, it is essentially playing on expectations based on unrealistic assumptions about the ability of governments. Playing on omnipotence can get you only so far.

Second, the governments can promise future tax revenues, say by announcing that the money needed for the bailout would be borrowed first, and then the repayment needed would be raised from the tax base. However, the indebtedness of most western governments is substantial. That of the US is so large that it would not be able to get membership in the Eurozone. Thus raising the kind of money needed to fully back the financial sector would be impossible. Furthermore, what would be the source of new loans in a global financial crisis? From whom would you get that kind of money?

Finally, and most importantly, a future tax-revenue-based bail out in the magnitude of the annual GDP is unrealistic, to be euphemistic. (One year of US GDP could cover only around one-fourth of the US financial sector, and then the global linkages have not come in yet). You cannot promise to save the entire economy from collapse by promising money that you will collect in the future from the same entity. Thus the implicit promise of a full government guarantee, plays on the assumption that only a partial guarantee will really be needed.

Which leads to the third source of power:

The power of the bail-out promise could come from the government’s singular ability to change the rules. This reads something like this: “I do not have enough money to buy you out. And I cannot possibly promise to raise enough money from you in the future to buy you out now. But I could promise to change the rules under which you operate. Then I could claim that you will be in better condition in the future. If you do believe this then, arguably, you will be in a better condition. Then I can promise to raise taxes from the healthy-you in the future, and thus I can even promise to back you up with money now…”

This argument is entirely based on the assumption that there is a way to change the rules such that the current chaos is sorted out, and not repeated in the future. Hence all the sudden talk of socialism. That would change the rules, that is for sure. Some people might even believe in it. But you would need a mass change in the way western societies view themselves for such an expectations-bail out to work.


All of these expectations are based on a framework of thinking which is rapidly going out of date. Since 16 September we have been re-evaluating what is possible.

Which brings us to the ultimate question: can the US government, or any government, credibly promise to deliver systemic solutions now? Doesn’t this crisis, which is still in its early days, reveal that there is a need to replace the national level economy-management toolbox with global policy institutions? Could any local solution be a remedy even for the short term?

Monday, 29 September 2008

Europe’s New Golden Age? Fat Chance!

Europe could become the centre of the world, simply by not screwing up. Europe is big and loves government. But it will miss its chance for want of revolution.
When in globalisation, huge and mature is the best. The size of the European economy relative to that of the world makes it the largest economy on Earth that is both mature and integrated. The consequence: Europe possesses internal demand that could bridge over a global recession. 
Some emerging market people talk about China or Brazil being able to do the same. But this is a dream. Neither of these countries has made sufficient progress in economic transition to achieve a structure that could produce the necessary demand dynamics. As we have seen in numerous emerging markets before, hopes for a long-lasting domestic dynamo vanish shortly after the export impetus dries up. When things looked good, it was not that external demand had truly diminished in importance, it merely looked that way. Furthermore, despite the impressive expansion so far, neither of these countries is big enough to withstand a crisis. China is the size of Germany.  Brazil is the size of Canada. In comparison: the EU is larger than the US, Canada and Mexico put together. 
Furthermore, Europe’s potential to integrate its neighbourhood is much stronger than is the case for other regions. The number of people on the labour market with at least secondary-level education in Europe and its neighbourhood is more than double that in North America, for instance. At the same time, regional integration on a level even remotely similar to that in Europe is out of the question for decades in East or South Asia for obvious political reasons. Witness the ASEAN’s hopeless efforts at policy harmonisation. 
So Europe could be the dominant global region. If only there was a policy-making body to ensure that...
You must love your government. The European approach to governance makes it well-placed to withstand a global economic storm. Now is the time when it should perform at its best. 
Although, there are quite a few versions of the ‘European model’, the main theme is always the same, based on the notion of collective responsibility among independent individuals. 
The pure version is the semi-socialism of Scandinavia. The four North-West European countries have the largest presence of the state in the private economy of any other country group north of the 10,000-dollar annual income per capita mark. (Their tax revenue share of GDP is a staggering 47% as opposed to the rest of Europe’s 36% and the non-European OECD countries’ 29%.) But, crucially, their large state works: in the ‘institutions’ bit of the World Competitiveness Index, the four Scandinavian countries occupy four of the top eight slots. Markets and socialism clearly can form a good team. 
The rest of Europe acts out a series of variations on the pure case: lingua-etatist France, inflexible but strong Germany, the would-be socialist Mediterranean, the dreaming-of-being-different Britain, and the large-state-rampant-corruption new kids in Central and Eastern Europe. Still, even the UK, which sees itself as closest to the US model, will at one point have to come to terms with the reality of having strong state involvement. (Just as a passing example: the nationalisation of Northern Rock was swallowed much more easily than the US’s Fannie Mae and Freddie Mac a couple of months later. The temporary outrage subsided in seconds on the etatist-side of the Atlantic.)
European economic history is evidence that strong government - if done badly - may translate into non-performing economies. But if done well, it can create a framework in which the private economy thrives. Moreover, and critically for the current crisis, it can provide buffers against external shocks. It is, you could argue, to the latter form that Europe’s economic management needs to converge. And - there it is, or would be - the world’s new economic leader born.
Or maybe not...
A sclerotic pensioner with the identity problems of a teenager. A couple of years ago I was invited to moderate a roundtable discussion on the ‘European social model’. I wouldn’t have subjected myself to the pains of discovering the meaning of this concept, had the conference not taken place in one of the most beautiful Mediterranean villages, in Turkey. (I would have brushed up on the Inquisition for that…)
So when my friends called to say they needed a last-minute replacement chair, I signed up right away, although I did not know anything about the topic. (Shameless, I know.) I spent the following two weeks learning about the origin of the concept of the ‘European social model’. What I found was complete intellectual chaos. There is no common element - zero overlap in the 15 or so different definitions that are in use. The term does little more than fill the vacuum left by the absence of real common identity. It is empty. 
The elites that created the EU, an otherwise sensible project, failed to design a way to react to a crisis like this. There is no EU-level institution that could deliver the kind of governance that would make the European economy live up to its global potential. The current EU is a decrepit, ineffective and largely illegitimate body, more like a labour-union committee than a source of global leadership or cutting-edge governance. 
As we learned in the Central European transition countries, it is much easier to build brand new institutions than reform the old ones. The temptation is to ‘mend’ the system rather than truly reform it. Re-form it. ‘Mending’ means more regulation on top of the overbearing current regime, it means larger state French-style rather than re-thinking the content of governance Scandinavian-style. 
The institutional scleroticism of the unfinished EU calls for complete overhaul. But, for that, we would need a way to decide what ‘Europe’ is. In a legitimate way, in the form of Demos Kratia.
Funny how the European society, arguably the origin of globalisation, manages to react to the global challenges with the worst combination of age and youth.  It is as sclerotic as an elderly pensioner, but with the identity problems of a teenager.  Wisdom and dynamism would be a much more promising combination.

Thursday, 25 September 2008

The quiet contagion

The World’s complacency is deafening.

The ‘explanations’ coming in from around the Globe take a surprising range of forms. All kinds of factors, all kinds of reasons, why that one country, that one region, or even that one city will be spared by this crisis. The denial is the only common element.

For instance...

No, China is fiiiinnnne. More of a problem is the domestic slow-down, if anything, really. But you know what, we’ve been worried about overheating so long. A bit of slow-down is great.

Or: Australia has an excellent banking regulatory system, unlike the US. This is not going to hit us here. We are not worried.

Or: Ah, Japan is a different case. The Americans’ crisis is more of a buying opportunity.

Or: Hey, the Brazilian economy is taking off. The momentum is domestic. Maybe the export markets will get rattled a bit, but there won’t be much lasting effect.

The first thing you learn in the emerging markets business is to suspect arguments about exceptionalism. If everyone is making such arguments amidst a global crisis, that should sound alarms.

My forecast is that there will be a slow, quiet contagion. For a while the (primarily US) policy alternatives will dominate the agenda. A lull of complacency will come in. We will hear a lot about the situation-being-not-so-bad.


Can you assume that this crisis is not going to impact consumer confidence in every place on Earth with a TV? If you are to decide to buy a new car now or delay, what would you do? How about real investment? Would you jump into a new venture at this moment? Or, would you finance one? If you were a retailer, what inventory strategy would you go for? Would you pile up as much as possible, leaving orders for more, or rather risk running out of the current stock first and see how people react to the new realities?

At one point, the hit to the real economy will become undeniable, and the global macroeconomic elite’s hope-bubble will burst.

This might be a good point to recall that the first life-boats to leave the Titanic were two-thirds empty, for lack of interest…

Tuesday, 23 September 2008

A week-old blog

What do you think?

It was the second day of the crisis when I started this blog. A week ago. It now has six postings, somewhat varying in style and depth. It would be rather useful for me if you gave me feed-back. Its direction, the topics, everything. Please.

Monday, 22 September 2008

Newtonian gamble

It is 1947. The Cold War is starting. A group of defence strategists get together to figure out how to best tackle it. They start with the analysis of the world war finished only two years earlier. They focus on details, where, of course, the devil lives. Weapons, or in general ‘military technology’ is all based on Newtonian mechanics. That is, the weapons that count. Or rather, the weapons that have counted so far. The world war was fought and won with arms from the pre-Einstein age. The two nuclear bombs, used at the very end, did not have much military effect. 

How large a mistake that would have been. To form the defence strategy of the 1950’s ignoring the reality of weapons based on quantum mechanics.

This is the recurring thought I have had reading the end-of-week press digesting last week’s ‘turbulent events’. Certainly, some regulatory armoury proposed in-line with the old thinking might still be appropriate. (Just as Newtonian mechanics does not contradict relativity theory, but is merely a sub-case -- and anyway you can use it to efficiently calculate the trajectory of the defence rockets that are to take down the incoming nuclear warhead-carrying missiles.) Most other ‘Newtonian ideas’ miss the point. For instance, it makes no sense to call for the regulation of executive pay. Do the politicians and their economic advisors (surprisingly from both ends of the political spectrum) really think that the current global meltdown is due to the contract structures of CEO’s? Even if they did encourage a risk-taking attitude?

At the start of last week, it looked as if the coming days were to bring the worst that could come, but would also lead to an entirely new world: the rise and definition of a global-economy-management institutional framework. It has happened to some extent. The US treasury secretary (who overnight has become the fiscal policy opinion leader of the world) is calling for semi-harmonised global treasury action, but with operations staying strictly on the national level. However, the big opportunity to change the intellectual framework and to look ahead has been largely missed. 

Apart from some calls for new thinking in the tsunami of analyses, there is not much that is filtering through. The particular actions, although they look brave (or brash), are products of the old framework. And, mostly, they are attacked or supported with the narrative of the past. 

Furthermore, the actions focus solely on the problems that have surfaced so far. The benevolent observer could argue that by saving the US financial system, global financial contagion can be stopped. Even if it comes at an exorbitant cost to be paid in the future in terms of cash, as well as the mess the uncertainty about ‘rules’ will make. If the world financial system is saved, the argument may go, the real economy impact will be small, while global contagion will be halted. 

People with a more diabolical approach to life would suggest that the wished-for buffering of sectoral and global contagion relies even more on containing the collapse in appetite for risk than on a direct cash injection. The sigh released by the markets at the end of last week is based on the axiom that the government, in particular the US government, is a risk-free institution. But isn’t what happened that the systemic risk coming from the potential collapse of several large actors in the economy has been reduced by shifting the risk onto the level of the entire system? Making the assumption that the system - the framework in which the individual actors operate - is unquestionably stable is an intellectual cheat.

Just as the Cold War turned out to be about perceptions of the two sides’ nuclear abilities, it seems that the perceptions of the global economic framework might turn out to be as important as the national-level regulatory weaponry. It is time to move beyond the era of Newtonian regulations if we are ever to reach the global economics theory of relativity.

Saturday, 20 September 2008

Hugging China

Here is a question to you. If you were a geopolitical strategist working for the Chinese government, what would you be thinking about the global banking crisis?

First, your country’s exposure in US capital markets has just been dealt a substantial blow. Clearly, pulling out now is not an option, the drag on the market would be insufferable. (However, the US government bailout implies a free ride for you, as well.) 

Second, your speech writing tasks just got easier. Just as the rules have gone, so has any possibility of credible American lectures. Pretence international selflessness gives way to blatant national selfishness. At least one aspect of economic diplomacy just got easier.

Third, your global strategy space has widened considerably. There is a ripple across the meagre international policy architecture. The depth of this ripple as well as the lightning speed with which it has opened up, creates an appetite for designing global institutions. The previous status quo that so many newly emerged economies, first of all China, had outgrown is now in question across the board. It is the perfect time to push through your own reform agenda. 

Furthermore, the relative positions could not be more favourable for you. Your domestic economy has little direct exposure now, even though the long term Chinese buffers are probably substantially overestimated. (We will learn a lot about the internal dynamics of the Chinese economy the next months.) What might be more important is that your new allies, developing countries with inefficient economies but a lot of natural resources, will be hard hit, and would welcome a ‘global insurance pool’, otherwise known as a short term umbrella in exchange for access to assets. 

A combination of these would create a formidable Chinese negotiating position. If China were in alliance with many developing former Western-affiliated countries (Indonesia, and many states in Sub-Saharan Africa come to mind), it will have the flow of raw materials insured. The financial blow to the Chinese state assets will not have a direct impact in all, but the full-meltdown scenarios. The domestic real economy will be on a dynamo for a while, even if a slowing one. And any basis for western arguments against China’s ‘influence’ on its currency has just been blown up.

In short, China will feel little impetus towards playing a constructive role in building up the new global institutions the West will suddenly be so enthusiastic about. Maybe this is the moment to throw open arms, and give China a big, warm hug.

Thursday, 18 September 2008

The Cacophony

The closer you are the more worried you are.

The analysing is almost as frantic as the markets, but there is clearly no agreement even about the basics. Neither on causes, nor on consequences.

The regulation-optimists. A.k.a. the ‘ultimate-denial-people’. The more political function you have, the more likely you are to be here.

The regulation-optimists see the current crisis as primarily caused by lack of adequate regulation. Thus, the solution is to have more of it. As if ‘regulation’ was a type of custard of which you pour more if you want. There is little consensus in the substantive discussion about the details of what is being proposed. The only recurring theme is that it should have been less easy to lend. Really? So all the financial innovations that would allow structuring risk should be out of the window? Is the argument really against sophistication? Oh, no, comes the answer, it should have been less easy to lend to risky people. I see, so your argument is like reacting to a mass highway accident by turning rusty old cars into horse-drawn carriages, while keeping all the Ferraris.

The ‘this will pass’ semi-optimists. The more academic your are, the more likely your argument goes in this direction.

The study of economic history provides a comfortable backdrop against which what is happening now is not necessarily that unique. You are probably using the phrase “yes, that is correct, but history would suggest that…”. And, of course, you can also point to the - historical - fact that market people and politicians always overreact in times of crisis, always ignoring the lessons of the past. It is very difficult to argue against you, for (a) the facts of the past are on your side, and (b) people did try to claim at every crisis in history that their one was special.

The return-to-decoupling semi-pessimists. If you have a strong exposure in China or the Gulf, the idea probably has already crossed you mind. (Russia, with perfect timing, ruled itself out of the oh-no-we-are-immune club.)

The concept of decoupling, very badly defined most of the way, was rather fashionable up until around a year ago. It started with the revival of the ‘global regions’ notion, and ended up using macroeconomic variable clustering. After the fifteen-weeks of fame, however, the idea-bubble had burst, being pointed out that intra-regional trade patterns in East Asia were just catching up to the global level of integration, and macroeconomic convergence is actually the opposite of decoupling. Now, the idea is coming back again. Although the arguments tend to be mostly emotional (“please, please, let something stay safe, I will be good, I promise”), at least we will have the ultimate test of the hypothesis.

The armageddon type. The closer you are to action, on the markets, or in media, or in policy, the more likely you are to be in this category. Disturbingly, that is true within the armageddon group itself: the most worried people are the ones who really see what is happening.

Soldiers tell you that people who get hit by a bullet will most often go into a state of disbelief. Although you have seen this happen to others, you just do not believe that it is happening to YOU. This denial seems to be the only general characteristic of the reactions now. People seem to ‘get’ what happened so far, but the improbable nature of these events make forecasting the consequences emotionally difficult. However, those who are closely involved with sorting out the crisis, and in that are making up new rules, and trying to invent new policy tools, have no choice but to come to terms with the depth and width of the trouble. They are talking about actual banks that will come next, rather than the generalities of financial contagion. They are discussing the collapse of actual countries rather than pondering if the ‘world economy could turn into recession’. Very worrying.

To sum up, imagine that you are rushed to the hospital, you don’t feel well, and a bunch of doctors come up to you. The first one says, oh, no problem, a bit too much running around with wet hair, perhaps; we will sort you out now, and then you just have to make sure you put a hat on from now on. The second one ponders that, well, you do have a nasty flu, but in the past you survived all of them, no? Nothing to be worried about. The third one announces that although, for some odd sounding reason, they will have to chop a leg and and arm off, the good news is that you will have two limbs left. And then comes the fourth, who turns out to be a specialist on your rare virus, examines you thoroughly, and then she comments on how interesting tomorrow’s dissection will be.

Wednesday, 17 September 2008

Rules versus discretion…

This is the end of market capitalism as we know it. 
Imagine this, someone asks you a week ago, to assign a probability to the Fed taking 80% share of AIG and thus the most important central bank of the world effectively nationalising the largest insurance company. Would you have just laughed? Or would you have bothered to actually say less than 1%? Or would you have got bogged down in giving a lecture on the main principles of economics, and explained - probably slowly - the idea behind rules versus discretion? 
Clearly, somebody got very scared yesterday. They did halt the immediate meltdown with one bold move. But they also considerably upped the stakes.
Short term worry one. Large. This move implies the promise of nationalisation of the entire US economy in a meltdown scenario. Not only participation in the risk pool is not voluntary any more, but the state now chops off the end of the distribution. Although a systemic collapse has been averted, at least for the time being, uncertainty about the framework in which the risks are being priced has increased considerably. Not only are we on a sailing boat out at sea in the middle of a big storm, but at the same time, someone is shaking the entire Earth. A whole new meaning to ‘choppy waters’. 
Short term worry two. Very large. This week we have seen the unthinkable. So, here is an ‘unaskable’ question: is the Fed large enough to deliver the implicit guarantee it made? What happens if the gamble of nationalising AIG does not pay off? There are a lot of signs, and even more rumours, about a host of other ‘immediate’ collapses. How much can the Fed and the US government pretend to be merely a clearing house and bankruptcy manager before the markets start discussing the limit to which the Fed can, rather than wants, to go? What would that do to risk perceptions? 
Long term worry. Gigantic. Rules are out of the window. In fact the concept of ‘rules’ is out of the window. Ad hoc solutions may be necessary in an emergency, but they nevertheless form expectations and change the perceived rulebook. How high can a pyramid of impulse actions be built before it collapses? This may seem a secondary worry now, given that the world has not yet sunk into abyss by mid-week, an achievement in itself, but will form very hard constraints in building up the post-crisis institutions. 
Global worry. Unknown magnitude. How much implicit global risk has the Fed taken on? Where is the legitimacy and mandate for that? What will the ultimate backers, the US taxpayers say about it? How adequate will the Fed’s implicit global economic management be for the rest of the world, either country by country, or - more importantly, for the entire global economy? There are strong arguments that what is unfolding now is the first truly global crisis. It’s not very likely that the unilateral approach from the US would be more successful in dealing with, say, global security issues. 
The last few days have changed the way we think about market economies. Systemic mispricing of risks, and thus collapsing financial institutions, could themselves be attributed to the globalisation of the effective economic systems in which these risks occur. We thought that new, global models would solve the problem. Now, the very foundations of the discipline of economics are being altered. Up until the rise of ‘unified macroeconomics’ the debate was between the proponents of a large state and those of a small one. In the past two decades this has given way to a new narrative, about what the state does irrespective of its actual size. Governance, institutional competition, and quality of government services are what mattered. This was, in a way, a downgrading of the state. You are not sovereign any more. You have to be smart. You have to compete for people and capital. What the Fed has done, the most unlikely institution to do so, has put the role of the state at centre-stage again. 

Tuesday, 16 September 2008


It is very interesting to see how the narrative about the current crisis, which in my view is clearly a global one, stays on the national level. This is true for the policy makers, the media, as well as the investment banking chatter. Part of the reason is that the institutions that could do something about it are on the national level, such as central banks, treasuries, as well as regulatory bodies. However, that is perhaps the problem: current regulation, monetary and most of the fiscal policies operate on the national level. And not only the legitimacy and the mandate come from local rather than global entities, but the intellectual focus, the data, and the models stay there too.

As a consequence, we tend to overemphasize the national at the expense of learning about the global. While things were looking bright, prices tended to go up, and risk aversion was at historical lows, this did not matter. It was only a few scarecrows scratching their heads. Now, amidst the crisis, this limitation might impede effective intervention.

It seems that although there is a general recognition about ‘new economy’ and ‘globalisation’, the economics profession, as one, comes to terms with the new reality with a considerable lag. Thus, we keep discussing localised effects, either in geographic or in sectoral sense, rather than getting down to dealing with it on the global level. In the old times, when, say, a national economy recession took place, the economics profession did not have separate solutions for only part of the country, or a few sectors. The entire economic system was modeled, with the sub-national regional or sectoral dynamics making the analysis more refined, but only as part of the overall model or policy.

Now, it's as if we only focused on parts of the global economy, trying to figure out the dynamics of only that part, while ignoring the rest. If the global economy really is a system, this is not very likely to work.

The perfect day to start a global economy blog

Today is the perfect day to start a global economy blog. This could be the very first truly global crisis. So far all previous economic and financial crises were limited geographically or in sectoral width. Most emerging markets had been closed, and the relationship network among mature economies was too loose for a crisis to really impact all. Even the 1929-1933 meltdown or the two oil shocks of the 1970’s were reaching only part of the globe. This is not the case any more.

Will the entire banking sector get affected? Just look at the list of the banks that are dead worried now. They are not only ALL the large international banks, but also - of course - ALL the medium sized regional banks, as well. There is no large region or country with a financial sector of any sophistication in the world that would have been left insulated by today’s shock.

Will it spread to the rest of the economy? It already has. Liquidity is the staple for the entire economy (well, at least the monetised bit). But, maybe more importantly the risk appetite is gone. Funny how we have been laughing at the ridiculous levels of love of risk in the past years, and now there is NONE left.

I bet the biggest problem now is that the information systems of the ‘investment banking community’ (if there ever was anything community like about investment banks…) are not good enough and fast enough to reveal the extent of the damage that the folding of Lehman brings, as well as the danger lying in WaMu, AIG, and the host of others everyone is talking about. A lot of running around this week.