Monday, 27 October 2008

Sisyphus’s Next Job

Comedy in Three Acts

Dramatis Personae

Problem, son of Old Habits, in love with Global System

Solution, king of Cheap Talk, a.k.a Good Enough

Trouble, cute little Goodfellow, messing with the World

Governors, presidents, ministers, all kinds of further support. Running around the stage at high velocity, in random directions. Some without head attached.

Act I. Regulation

Scene 1. Financial sector rules
(Problem and Solution stand facing each other. Trouble enters, happy.)

Solution: Increase regulation.

Trouble: Increased regulation within the old regulatory framework would only work if an isolationist approach was adopted at the same time. This would cause major inefficiency in the global economy. It would mean the end of ‘global finance’.

Without isolation of the national financial sectors, systemic risk would ‘flow’ to the weakest regulatory regimes. Overall global risk would not be contained, nor would the impact on the national economies. 

Solution: Globally harmonised financial sector regulation. Agency: OECD (you get harmonised as you enter the rich-club), IMF(emphasis on extending the harmonisation umbrella to emerging markets, as well).

Trouble: Lack of enforcement creates incentive to cheat by national governments: free riding on the global stability while boosting financial sector at home.

Solution: More than harmonisation. Global regulatory body with enforcement capabilities.

Problem: There is no existing mechanism to either create such an authority, or to supervise it.

Scene 2. Dynamic regulation
(A large paper-maché puppet falls from the sky. As it lands, it breaks into three pieces and bursts into fire.)

Problem: The set of rules is only part of the effective regulation that creates the framework that channels financial sector activities. Not only the way the rules are enforced is part of any regulatory regime, but also the active and reactive supervision coming from the government and the central bank. 

Any regulatory rule is fully defined only by the framework of dynamic leverages.

Solution: Harmonise the dynamic regulation, as well.

Trouble: It is impossible to harmonise non-conventional intervention, which is the essence of successful central bank crisis management. Game-changing solutions, by definition, cannot come from the game itself. 

For instance, the Brazilian central bank beat the 1998 attack by using unconventional, previously taboo tactics, such as going against particular hedges of the attackers, and thus forcing them to take an unacceptable level of risk. In essence, they stopped the possibility of leveraging, through unexpected through-market tools.

The non-static, active part of any regulatory regime is directly geared towards monitoring and managing systemic risk. Thus the essence is the immediacy and out-of-the-box solutions.  

Solution: A global rapid-reaction central bank committee facilitating harmonised reaction.

Problem: This would never work unless all monetary policy is co-ordinated on a global level.

Act II. Monetary Policy

Scene 1. Interest rate
(A human sized musical note marches through the stage, singing in whispering voice.)

Problem: The market is unable to recover from a systemic shock.

Solution: Monetary policy intervention by individual central banks. If the markets fall due to capital flight, hike rates a lot. If the market falls due to recession fears, cut rates a lot.

Problem: The algorithm will not work. When everyone is having troubles in a full global contagion, both rapidly changing capital flows and recession are lurking. There is no clear equilibrium in the world-wide rate game. Monetary chaos is certain.

Trouble: Thus national level monetary policy action is ineffective both in managing the global economy directly, and in providing leadership through expectations.

Solution: One-off interest rate move harmonisation would provide ‘leadership’ in crisis.

Trouble: Expectations can only refer to future policy measures by existing institutions. Or, at least, institutions perceived to exist. Therefore, one-off interest rate move harmonisation makes sense only as a harmonised expectations management exercise within the national economy framework. One-off moves, thus, cannot move expectations, unless they contain an implicit promise of future harmonisation of policy.

Problem: Thus, one-off, ad hoc solutions as a rule cannot possibly fill the global policy vacuum.

Solution: Institutionalised interest rate harmonisation among at least the leading central banks. Move all rates at the same time, in a harmonised fashion.

Trouble: A half-point cut has very different effects in different monetary environments. Thus harmonisation of rate moves makes sense only if the interest rates are allowed to be different. Only the timing is harmonised, but the moves are independent (even if ‘discussed’). but in this case, not much has changed. There is still no effective global policy.

Solution: Global universal interest rate set by a body with global statute.

Trouble: There are two issues with a single rate for the entire global economy. First, the global economy’s needs in terms of crisis management are very different from the monetary policy demands in the post-crisis world. Effective crisis management means, as argued above, a strong and credible common action, frozen in, that is a global monetary policy authority that can promise future action credibly. For normal times, however, the universal intervention, whose promise is the key to sorting out the crisis now, is too early for the world economy. The needs of the different parts of the world are wide ranging.

Solution: An institution that covers only part of the global economy. Merging the Fed, BoE, BoJ, and the ECB would not be unthinkable, and would cover around 65% of the world economy. Throw in a couple of others, like the Reserve Bank of Australia, or the Swedish Riskbank etc., and the ratio goes up to 75%. That could be a good start.

Problem: Talk about the institutionalisation of a programmed conflict with China.

Solution: Good point. However, if the crisis becomes deep enough to generate the political will for such harmonised global action, then the establishment of a strong and lasting institution in this fashion is not entirely impossible. Political constraints are agenda-defined. As the agenda changes, so does the strategy space.

Trouble: There is a second major issue with the single global interest rate, though. The currencies.

Scene 2. Exchange rate
(A group of currencies, of mixed age, start trembling in the background. The wind blows.)

Solution: Universal interest rate with flexible exchange rate regimes would work. A global authority, with some straightforward decision-making mechanism, decides about the interest rate level. Exchange rate regimes stay in the current, mostly flexible framework.

Trouble: If capital flows stay largely free, then the presence of a flexible exchange rate would substantially weaken the impact of the interest rate move. The consequence would be a world economy that still had the effective interest rates varying across currency regions. Thus each currency would end up with its own interest rate engineered from futures. This would substantially diminish the ability of any global monetary policy to control the global economy.

Solution: Quasi currency union with universal interest rate.

Trouble: Either the currency levels are regularly administered -- but then what’s the point? It would be the same, but less effective than the market set flexible rate - or currency exchange rates are set in stone, but then…

Solution: ...common global currency, universal interest rate.

Problem: There is no political will anywhere around the world to create either a common monetary authority or a global currency union. This direction is entirely unrealistic. It belongs to Fantasyland. You might as well waste your time writing a blog about it.

Act III. Fiscal Policy

Scene 1. National treasuries competition
(Tropical forest. A number of beautiful plants climb high rapidly, with colourful flowers. All in parasitic relationships with the trees)

Problem: You can’t have monetary policy without some fiscal policy constraints: competing national treasuries would destroy the policy of any global monetary policy authority. Under a common monetary policy umbrella the inflationary impact of any individual governments deficit would be reduced substantially. Consequently the real rates would need to be kept much higher than management of the private sector would require to stave off the overspending impetus of national governments.

Solution: Cover the bad end of the tail: have a shared insurance umbrella for governments in trouble -- this would make crisis management of monetary policy easier.

Trouble: Not exactly incentive-compatible, is it? Anyway, an insurance umbrella would only limit the global damage arising from singular overspending. The bigger trouble is that if the global central bank was to set a policy for growth in normal times, this would translate into an incentive to overspend by all governments. The aggregate effect would be too lax fiscal policy on the global level.

Solution: Limit fiscal policy excesses. Implement a set of straightforward rules to which all government budgets should adhere.

Trouble: There are major difficulties with this. To start with, this is a political impossibility, for budgetary constraints would need outside policing if to be effective. That would require a level of transparency that many national governments will not sign up for under any situation.

Solution: Have a similar limited global core fiscal policy as in the monetary policy case. The countries that are listed in that 75% of the global economy are all democratic, and thus have largely transparent government accounting. Policing the budget rules would not take that much new intrusion into state secrets.

Scene 2. Global treasury
(The forest opens to a beautiful equatorial lake. With slow, almost animated movement, a group of crocodiles slides into the water.)

Trouble: This transparency argument is based on a myth, that the democratic, western governments have transparent budgetary accounting. Just take the example of what happened to Belgium after submitting itself to ECB scrutiny. What we learned was that before the setup of the Eurozone, the numbers that we were shown were mostly cooked. Or take Italy. Or Greece. This would not be an isolated problem of only a few governments. 

By the way, Eurozone. The second trouble with the pre-set fiscal rules is that they might allow overall limitation of fiscal excesses, and thus more or less effective monetary policy, but still impede any dynamic setting of fiscal policy. The Maastricht rules serve as a quasi-minister of finance, but a very rigid one. Thus there is no system-level fiscal policy. National governments find themselves facing an incentive structure to push to the limit of the rules. The management of the economy then becomes ineffective.

Solution: Actively harmonised global fiscal policy. Limits regularly adjusted to global economic climate, some ongoing decision-making mechanism is needed, as opposed to one-off setup at the beginning.

Trouble: This is not global fiscal policy, this is globally constrained national fiscal policy, what happens to global costs and spending? At least the cost of global institutions has to be covered in some way where the organisation is not hostage to the year-to-year budgets of national political processes.

Solution: Global treasury: tax framework, global treasury revenues, global government services.

Problem: There will never be political will for this. Any legitimate setup would need some kind of minimum harmonisation of the political system and thus political values, at least among the leading global regions. No chance.

Epilogue: The Case For Global Economic Authority

Thus is the argument towards the creation of a set of institutions that would generate and implement global economic policy. At the heart is the observation that neither global regulation, nor global monetary policy can be set without efficient, institutionalised decision-making mechanism, and enforcement. Arguably, if this crisis is truly a global crisis, then there will not be a ‘solution’ until a credible global policy framework emerges.

However, there is no political will at the moment to support the rise of such global policy institutions, and anyway they could not be effective without at least some kind of fiscal policy harmonisation, which would require a politically impossible intrusion into each other’s budgetary processes.

Trouble: Wouldn’t this mean that there’d be a global government that would be tempted to intervene in a host of other issues?

Solution: Like global warming, the relationship with the Biosphere, cultural diversity, etc?

Trouble: Yes… And also global government policing… Do we want that? Seriously.

(Exit all. The World wanders in, talking to herself in low voice. After a short while, she exits looking confused)

Tuesday, 21 October 2008

The Birth Of The New Global Capital?

(Notes from Abu Dhabi and Dubai)
I didn’t plan for this. There I was, arguing for an overarching crisis. That a tsunami was coming. That the outer islands had already been hit, and that we could see that enormous wave coming towards the beach. No one was to be spared. Can’t you see, people, it will hit us all? There will be no dry land left. Run for your lives!

The past five weeks looked good for us, Armageddon-types. 

And then suddenly, there it is. A place that could convincingly be the Winner of The Crisis. Two new-born cities on the coast of the Arabian Peninsula. To my utter surprise, I have started to suspect not only that the Twin Cities of the Gulf could survive the meltdown relatively unharmed, but also that they might even gain spectacularly from it. 

First, the obvious: although Dubai has considerable debt, neither rescheduling, nor financing should be a problem, as long as it can find the right words for a difficult conversation with the Older Brother. The rivalry with Abu Dhabi will give way to co-operation, which will display the fact that the two centres are, in reality, on the way to becoming one.

This One City is sitting on an accumulated wealth in the magnitude of the US bail-out package, even if you correct the latter with a ‘reality-multiplier’ (a.k.a. ‘the second bailout package’...). This is coupled with an exceptionally strong development dynamic, cash-financed in large part, and thus unaffected, or at least not directly affected, by the financial meltdown. 

Financial centres that weather the current crisis without a systemic meltdown will see their reputation gain. There is nothing more confidence-building than the history of stability amidst the storm. Imagine ocean liners about to cross the Atlantic, after a gigantic storm. You probably wouldn’t want to take a small boat. Nor the enormous ship that almost sank, even if it has all the luxury in the world. How about that nice, medium sized vessel almost unmoved by the winds, waves, and storm?

Stability will pay off nicely in the post-crisis world.

Second, the coming global regulatory overhaul is very likely to favour a financial centre with pre-existing buzz and relatively large size, but lack of high gearing. Agile and flexible regulatory response teams, could enable Abu Dhabi-Dubai to make the most of the inevitable global clampdown. Special Purpose Vehicles might be out, yet the need for ‘effective solutions’ will be all the same.

The point is that the regulator here does not need to worry about the global systemic effect. The supervisor needs to be seen to sign up for the to-be-emerging global regulatory protocols, make sure that the local system does not melt down, and then offer the maximum flexibility. The rising global New Rule Book will probably take a multi-tiered form, leaving ample room for local manoeuvring. Both the history and the attitude of the emerging ‘United Emirati Centre of Global Finance’ suggests that the appetite will be there to go in this direction. 

Third, the talent flow will be staggering. The meltdown of the other economic centres of the world will result in a lot of well educated and experienced professionals finding themselves on the street. They might as well find their way to this sunny oasis of opportunity. The human capital shortage in the Gulf may well be a thing of the past. 

As a partnership, then, Abu Dhabi-Dubai could emerge as a winner. If on the other hand the cities prefer to go it alone though, one has a far greater chance of success than the other. Despite the mass denial among Dubai entrepreneurs, the global crisis would be certain to hit them, big time. Credit crunch is already there. There are doubts that Dubai alone has enough to back its banking sector. Abu Dhabi does. The collapse of tourism will hit Dubai badly. Abu Dhabi, being at the early phase of the sector’s development will hardly feel a mosquito bite. The inevitable fall of global transportation will hit the Dubai port. Abu Dhabi, again, will stay mostly unaffected. The ill-conceived manufacturing projects will inexorably be weeded out. The Dubai audacity of unfeasible electronics production will be trumped by the sensible oil-industry support manufacturing projects of Abu Dhabi. It is very unlikely that this advantage will not be turned into hard positions. As the FT pointed out yesterday, it is going to be a tough conversation.

Yet, the potential is there. The Twin Cities of the Gulf might take a new role, this time as the capital of the post-16-September World. Or at least one of them.

Wednesday, 8 October 2008

Me And My Friend, Alex

“With knots, the best is to use a hatchet,” - he used to say. “Just as it is coming towards you, large and complicated. Dark, and sometimes frightening.” Yes, it happened even to him. Only occasionally, though. “Just cut it right through. That’s all you can do. But, that will take any of them down.”

He was good at knots.

What the world’s governments are doing is using Lilliputian scissors on the knot of the world’s new Gordium. And they can’t even decide which side to start. They may eventually get there, and cut through the systemic entanglement of global finance, but it will cost time and rivers of sweat.

Or in other words: capital markets and banking activities have come to a halt anyway. The bit that is left is mostly desperate attempts of finding cover. There is zero ‘normal’ activity left in the financial sector of the countries that the contagion has already reached. All the rest spend their entire time jittering.


Suspend all activities. Stop the knot knotting. [sorry]

Then comes the hatchet. Unwind all positions. Take your time. Clear positions. Clear multiple accounts. Clear entities. We should each have one figure at the end.

You will say that this will require a price for each position, which is impossible. Well, yes and no. It will be impossible to do it fairly, but it is too late for that anyway.

You will say that the ‘hatchet technique’ will not work for the derivatives. Yes, it will not be perfect. But is there a viable alternative?

And meanwhile in the other room…

Design the new, post-knot regulatory system. Try to be a bit more sensible than before. Maybe look at the tried-solutions of some other countries. To give you a hint, I would start with the places that are rich, and highly banked, that have sophisticated capital markets, and so on, but at the same time are NOT in trouble. If the intersection of their regulatory rules has elements, there you are, you have got a starting point. (You might even be surprised about how non-empty that set is going to be.)

Then everyone can take their post-hatcheting figures, and start the game again. With the proviso that the number is strictly positive. As for those with a red number next to their names, this is the time for government led social solidarity to provide that proverbial net.

We are going this way, anyway. The wave of bail-outs allow the financial sector to unwind itself, arguably making more mess, while the prices are as artificial as ever. The new rules will come in, but will be affected by the ad hoc, spur of the moment, immediate urgencies rather than the long term rationales behind the would-be perfect new regulation. At the same time, the non-transparent clearing will make any social protection very costly, and likely to be perceived as unjust.

When dealing with knots, the Greek pros cannot be beaten.

Tuesday, 7 October 2008

The Song of the Earth

Mahler 1908. The triumph of the individual becoming one with the Earth. Death is merely part of the cycle of Life. One’s Life. Any particular one’s life, and the lives of all of us, individual ones. The highest point reached by human civilisation. The world was becoming interconnected and global, savouring the fruits of rapid economic growth after decades of innovation. New technologies created exciting new ways of life, while art and music thrived on the waves of ideas and thought coming from the other side of the Globe. The “World drunk with eternal love and life” was in sight.

Mahler did not turn out to be an accurate oracle: the highest point happened to be a peak. The Short Century was to be about something other than the love affair between the individual and the Earth. And in it “the earth breathing full of peace and sleep” was a mere dream amidst the terror.

The Century passed. The history of listening to The Song of the Earth through the era of upheaval, the social oppression of the individual, and World’s unhappiness create a backdrop in which the height can now be envisaged as a peak, and we know that the future is not necessarily a straight path from the past.

The horrors of the wars and dictators of the 20th century could, perhaps, have been avoided with foresight. Probably not. Wisdom and leadership need a history of failures. They had no Globe to look back on, the History of the World had been merely a collection of national narratives. For us, it is very different.

Unlike our peers 100 years ago, we can conceive the precipice. And we have the association base that the abstract ‘hope’ needs to manifest in action.

We have the Earth now. Our dreams are still the same. The Song of the Earth may turn out to be prophetic. This time.

“Everywhere and forever the distance shines in bright and blue.”

(Notes from 1 October, Budapest Festival Orchestra playing Mahler’s Das Lied von der Erde, SBC, London, with the super-human voice of Christianne Stotijn, conducted by the genius, Ivan Fischer. )

Friday, 3 October 2008

The Tiger

My Dear Friends, People of Denial. You amaze me.

Don’t you ever wonder why your Explanations and Explications, your Wisdom of Experience, your Expert Authority are so cheap, useless, and empty? These days.

Do you ever suspect that the world financial meltdown might reflect something more than ‘greedy CEO’ contracts encouraging “risk-taking culture”? (Wasn’t ‘greed’ meant to go with being a corporate leader, anyway? Isn’t risk-taking culture the essence of a sophisticated financial sector? Isn’t every word about CEO compensations pure populism?)

Do you really think that the financial engineering of super-highly leveraged derivatives could bring down the entire global economy even if it were under-regulated? Wouldn’t existing policy tools be able to deal with the intermingled mess if something else was not looming in there? (Something large, dark, and unknown...) Wouldn’t you need something more to explain why the over-packaged non-transparent risk bundles have not been sorted out in the last 18 months, since we have known for sure that they are around?

Isn’t it that our assessment of ‘risk’ comes from a particular framework? Notably the same one where Your Infinite Wisdom originates? Isn’t it that pricing risk essentially relies on a particular understanding of the entire system? Isn’t the problem really with our current definition of ‘the entire system’?

Aren’t all of these excuses really denials about the need to go and discover that large, dark, unknown Something?.

Could it be that our perception of what the ‘system’ is, and what we imagine about the ‘way-it-works’ are wrong. In other words. That we have been modelling a different ‘economy’ to the one that is really out there, and we have been mistaken about how it moves, reacts, behaves? If so, we would be screwed, wouldn’t we? We would have incorrect ideas about what the risks really were, and we would price them incorrectly. And when the inevitable troubles came, it would be impossible to pick an effective instrument to sort them out.

Huge piles of incorrectly priced risk bundles and inadequate policy tools? That’s what that would mean.

We are screwed.

It is as if we were vets, and an animal was brought in, in urgency. We rush it to the operating theatre, and get down to saving it. Only gradually occurs to us that we have got the species wrong. “Professor, shall we opt for the sedatives after all? I am not sure if bunnies should have teeth of this size.”