Thursday, 29 January 2009

Bank Nationalisation Is Charlatan Medicine

It is now demonstrated beautifully that giganormous system level risks originate from the financial sector, which then banks accumulate in a very non-transparent way. As a consequence, an unexpected - and sizable - shock hit the global economy. The panic button was promptly jumped on, and governments around the world started to shoot emergency cash injections towards any bank standing up. (Ok, not quite anyone: sorry Lehman...)

Shockingly, even some decent economists started to advocate for state ownership of banks, arguing that nationalisation of the banking sector was the way forward. Ha!

Thread 1: Systemic Risk

Con, against the nationalisation of banks. Banking is not a strategic industry where direct security risks would arise.

Pro. However, it can create systemic risk that could (and did) result in a major disruption of the entire economic system.

Con. The level of systemic risk is contained by the set of (effective) rules that the banking system operates in. In other words, it is the regulatory-supervisory framework that sets the level of systemic risk. You could have fully private owned, and fully state owned banking system, and any of the two blowing up, or remaining in control.

Observation. Look at the relatively large number of banks in the mature world, which are in some form of community control, state, municipal, co-operative. Their exposure to the current crisis varies along their countries regulatory regimes, rather than their ownership background.

Thread conclusion. The presence of systemic risk in the financial sector is no valid argument for nationalisation.

Thread 2: Societal Needs 

Pro. If the banks were in direct state control, they would allocate their lending to areas where the society would really need it.

Con. There is no natural monopoly in finance. Instead: it works best when driven by private profit motives, as proven by not only the historical efficiency of most of the banking functions (market failure tends to originate from some external distortion), but also the innovation track record.

Observation. “Development banks” have, in general, been a disaster. You could perhaps argue that they can supplement outright government subsidies, but any of their efforts to compete with the ‘real’ banks has been a remarkable failure due to the inherent inefficiency coming with bureaucracy-determined allocation of credit.

Thread conclusion.
There is no valid efficiency argument for the nationalisation of banks.

Thread 3: Asymmetric Information

Pro. There is a major asymmetric information problem. Although mature supervisory agencies have strong mandate, and could, in theory, monitor every aspect of a supervised bank’s operations, in practice such full transparency is not possible. State ownership could increase the transparency.

Con. It is true that there is an asymmetric information problem. But. Changing ownership will not, in itself, alter the setup. There is no reason why an effectively run state owned bank would have different incentives not to allow full supervisory transparency than a private owned bank. In fact, what is needed here is a better regulatory coverage, which, I would argue, will not be achieved before a truly global regime is not implemented.

Observation. The banks that have rogue traders do not know of them. Obviously. So that will not be affected by state ownership. Whereas, the risks that are know, like large NPL stock in subsidiaries seated in other countries, are best controlled by a regulatory regimes that monitors all possible areas where subsidiaries may be. That is global.

Thread conclusion. There is a strong asymmetric information argument, but that calls for better, and, in particular, wider regulatory regime than nationalisation.

Thread 4: Crisis Action

Pro. The governments around world reacted to the financial crisis by de facto nationalisation of a host of banks. This has not stopped the crisis from deepening. Other, previously shielded banks are coming under threat from the ripples of the previous ones going down. Nationalising now, not as a long term policy, but as a short term crisis measure would reduce the societal cost of clearing out. Then once a new regulatory regime is implemented, the entire banking system can start with a clean slate.

Con. It is true that once the crisis has started, and mass bail-out was the chosen (accidentally emerged) technique of dealing with it, seeing it through might make a lot of sense. However, the bail-outs so far, essentially imply a full guarantee of the entire banking system. The first bail-outs might have made sense, as a short term policy, an attempt to stop the crisis unfolding. The implied full guarantee of the entire banking system was a gamble on not having to back the whole economy. It is over now, and very clear that none of the world’s governments is strong enough to bail out their respective national economies. (Even less so, if you take into account that the global linkages would mean that any of these governments would effectively have to back more than its national economy. Unless of course there was a fully global harmonisation of policy, and an enforcement of it. We end up with the global government function again.)

Observation. The implied probability of government default is on the rise in a large number of mature economies. At the same time several sovereign bailouts are on the way. This cannot go ad infinitum.

Thread conclusion. The reaction to the financial crisis in the form of de facto nationalisation of banks made (at least some) sense at the early stage. However by now, it is blowing budget capabilities up. No government is strong enough, and a sovereign default would be carry much higher systemic risk.

Overall Conclusion

Nationalisation of either the banks, or any other sector in trouble is not the way forward. It is merely a pseudo action (apart from the populism) instead of the politically still difficult support for the inevitable rise of the global economic governance architecture.

At this stage of the crisis, bank nationalisation is the charlatan’s medicine. It’s the global regulation, stupid.

Tuesday, 27 January 2009

Britain, An Unlikely Default Story

When I moved to the UK a few years ago, I did not expect that I would ever take a break from my new discipline, global economics, and return to the old one, emerging markets macro. And especially not with my new home country being the subject matter. And yet, the day has come. The fiscal response to the credit crunch combined with the implied and not-so-implied spending promises by the government towards a host of different industries - among them practically the entire financial sector - translate into an essentially unlimited government guarantee of the British economy. This, as I pointed out earlier, is a gamble on time, a bet that the global crisis would not last very long and thus that the state’s guarantee about keeping the entire economy afloat would never be called in. Now, it seems, that bet is lost.

Let me tell you what a pair of macro eyes that were trained by watching emerging markets sees now in the UK.

First, a country needs to have really bad numbers to go into default. That is a necessary condition. There is no amount of bad policy that could force insolvency in itself, unless, of course, a madman was in charge. (For an example of the latter, see North Korea 1987). You need awful numbers. Otherwise, bar that madman case, any government can avoid bankruptcy by changing its policy course, probably in line with the demands of the creditors (usually coming in the form of IMF ‘advice’). Turkey 2001 for instance had really bad numbers: large twin deficits on current account and budget, coupled with a largely malfunctioning banking sector. (For a brilliant summary read Ozatay&Sak)

The UK is producing some spectacularly bad numbers. Yet, the current picture looks bleak only in the mature economy context. As far as emerging markets go, there would still be a long way before hyperventilation really started… (Try, for instance, comparing the current UK situation to that described by the above mentioned Turkey crisis paper.)

Second, the country needs to have ineffective government levers. The point in debt default is that you can’t find anyone else to give you any loans with which you would be able to cover your previously set payments. Nobody, at any price. Which means that your would-be creditors think that the level of your debt burden is larger than anything you could ever collect in taxes, at any probability. This does not really happen with well-managed economies. This is one of the main differences between countries that we call ‘mature’ as opposed to ones that we call ‘emerging’. In an emerging market you tend not to trust the government (usually alongside the entire population…) to have the means to get debt payments collected. In 1997 and the first half of 1998, for instance, Russia was hit by a string of external shocks, a combination of bad policies (e.g., exchange rate regime), budget blasts (the cost of a war), and a worsening international finance environment (1997 Asian crisis melting demand for bonds), and falling commodity prices. Even then, all of these would not have been enough to sink Australia for instance. Thus for a sovereign default, you needed to have an inefficient government, too.

The UK is clearly a very well-run economy, with extremely well-oiled levers. It would need to be far from the current situation for us to need to start worrying about it. (The spectre of net government debt rising from 36% to 60% might be unsettling, perhaps. However, if this was an emerging market you would not even blink, as long as you trust the government to be able to control the process. You would call it ‘timely correction’, and ‘rightful counter-cyclical fiscal measures’.)

This is especially the case given that UK government debt is in pounds. You need to have a particularly stupid government/unlucky country to run into default due to a run on domestic currency-denominated debt. (Argentina 2002 defaulted for instance as nobody was willing to refinance its external - mostly dollar-denominated - debt. Had the government debt been denominated in peso, they could have avoided insolvency. At least for a while, as they also managed to meet the other criterion...) You might think that some of the policies of the British government are debatable. But that is not enough. We are nowhere near.

Third, although the default does not necessarily come as a surprise, it tends to. Especially, if the financial sector is not well developed. Any emerging market government presiding over an economy with a mature financial system would, in practice, see many first signs, such as the premium on its previous debt obligations going sky high, before creditors, en masse, would turn away from it.

Have you seen the UK Treasury spread lately? You would need a different number of digits!

In conclusion: fears about the UK running into insolvency any time soon are far (far, far)- fetched. End of the Earth.


Having said that...

I would worry about the long-term implied guarantee though… At one point either the downturn ends naturally (if there is such a thing), or the global fiscal/monetary policy institutions are stepped up, or this country - and many others - will have to take back its word re what it would do to save its people. Still, defaulting on your promises is not the same as on your debt, is it?

Monday, 26 January 2009

A Post-Crisis Prediction For Global Emerging Markets

(This is an unpublished note that I wrote March 2008. Strictly for the buffs.)

What to expect when the recovery comes

Maybe it is time to talk about the coming upswing, whenever that is going to be. Since the previous downturn, emerging economies have come to play a far greater role in the global economy. This will change the way that the global financial system adjusts to the current crisis, and mean that the structure of the global economy will change for good.

A comparison with the recovery after the dotcom bubble burst is instructive. The ancient adage about every general fighting the previous war has been a valid criticism for forecasting the next crisis. But only the most arrogant military strategist would not try to learn from the mistakes of past campaigns.

During the dotcom crisis, the downturn in the business cycle caused the real economy to hold off on investment spending, and as a result production technologies gradually became outdated. The underlying drive to innovate, however, was not much affected by the slowdown: new ideas and solutions kept coming. So when companies could afford to invest again, and indeed were compelled to do so to keep up with the also-recovering competition, they invested in the latest technologies – and saw their productivity increase rapidly.

What we macroeconomists saw was a sudden increase in productivity, while employment was much slower to pick up; it did, eventually, once the catch-up in technology adjustment was complete.

Much of the same logic is present again now. Firms might have stopped investing, but technological innovation has its own momentum, from which they will be able to gain when they can afford to spend again. Right now, we see investment falling in response to reduced demand. We might expect, on the post-dotcom pattern, that this will be followed by a catch-up in technology investment, increased productivity growth, and finally, after some delay, a pick-up in employment.

Yet there is one major difference between this trough and the last: that is, the role of emerging markets in the global economy. The way in which emerging markets adopt, and increasingly generate, new technologies will alter the upswing after this trough significantly.

Producers in emerging markets are not suffering as much as their counterparts in mature economies in the current slowdown. Sure, their exports have been hit, but many of them have found that domestic demand is relatively buoyant. That is because their own economies are on an upwards growth path that is not so cyclical, but reflects real structural change. As a result, they do not have to simply sit out the global slowdown, but instead can turn to the domestic market and exploit pent-up domestic demand. When global demand for their products recovers too, they should find that they are better off than before the crisis. Quite likely they have access to extensive cheap labour, meaning that they can easily expand production to respond to increased demand.

Producers in emerging markets have also shown of late that they can adopt new technologies extremely rapidly. Spillover from mature markets happens much faster than it used to, and sometimes these countries are themselves the source of innovation. This too means that they have especially good potential to increase productivity quickly once the recovery comes and they can invest in new technology.

The technology catch-up effect, with companies preferring to update to the latest technologies before expanding their workforce, is likely to be repeated. However, emerging market countries are set to benefit all the more from this process, since it is in these countries that the cheapest skilled labour is to be found and the greatest productivity gains to be realised. Furthermore, for companies in developed countries, once they are in a position to start investing again, they are likely to weigh up the options and find that starting a new production unit in an emerging economy makes more financial sense than expanding existing capacities at home.

This means that the pick-up in employment in mature economies will be delayed further. Much of the job creation will be in emerging markets, with the latter seeing another big expansion boom.

Of course not all emerging markets are the same, and the recent troubles have confirmed that a separation is occurring between the more and less robust emerging economies. Those with weak fundamentals will have neither the cushion of buoyant domestic demand now nor the capacity to attract FDI when things begin to look rosier globally. However, the many emerging markets with stronger fundamentals, that have really done their homework in terms of changing the structure of their economies (or are lucky enough to sit on abundant natural resources), are about to see the benefit of all their hard work (fortune). They could be catapulted into a very strong position in the world economy within a very short time. Then we will really see what they are made of.

Thursday, 22 January 2009

Regulating Knowledge Creation Of Global Finance

Our crisis is a crisis of knowledge. We witness a remarkable market failure in creating high quality financial research for the global economy.

There is plenty of evidence. The lack of adequate modelling framework for the global economy results in the absence of effective asset valuation; the lack of price anchors lead to major bubbles in boost times, and a downward asset-price-spiral in bad times. The standard answer has been to blame rating agencies and the lack of 'deep-thought' on the part of investors. Calls for more or different regulation are ample. 

The cause for the problem: 

1. Investors were looking at a new horizon with the old set of tools. Their coverage grew from local to global in a very short time, and thus there was, and is, a complete lack of adequate in-house research capacity in most investment houses, especially outside the main financial centres.

2. There is a significant incentive compatibility problem with the bulk of the external investment advisory services. The investment banks do offer global and universal research coverage, but the advice provided is often superficial, and despite the Chinese wall regulations, is still broadly in line of the interest of the banks; at the same time the business model of rating agencies further amplifies the incentive compatibility originated distortions. 

Alternative source of modelling innovation has so far failed to deliver:

The upgrade of the in-house research capacities of global investors has so far lagged due to the very large cost of building up global modelling centres, coupled by the uncertainty of the pay-offs due to the lack of adequate modelling framework. Furthermore, the induction of such build-up might lead to major concentration of investors on the global scale, creating a new set of problems.

State-provided research has been entirely inadequate in providing the necessary innovation, while academic research has been lagging, probably due to data availability reasons. 

The small set of independent research houses are struggling for being driven out of the market by the large amount of low quality free research published by investment banks: as a consequence, most of the major independent global research houses are politics centred.

The consequence is a market failure without an obvious regulatory solution. 

There are three main non-regulatory solutions:

Solution: reputation. Deal with the problem from a reputation angle. The argument goes like this: the market learns from its mistakes, this is ultimately a reputation game. This argument suggests that investment banking research is a product with asymmetric information problem, where credibility collapses in one-off games, and a reputation based equilibrium emerges in the repeated game. 

Solution: refined regulation. Recognise that the core of the problem is a regulatory failure, and seek a solution through the refinement of the regulatory system. The burst of the dot-com bubble resulted in a wave of regulation that tried to tackle the incentive problem inherent in the investment banking research. The refinement of this regulation may result in increased efficiency, especially if accompanied by a global regulatory umbrella ensuring coordination and some universal standards.

Solution: global economics. The core of the problem is that the emergence of the global economy has not been accompanied by the rise of a new, global level socio-economic modelling framework, and thus the solution is ‘global knowledge leadership’. The basis of this argument is the assumption that the knowledge and theoretical underpinning about the socio-economic universe around us is essentially a public good. Thus, although arguably the monitoring of the movement of the system given the availability of the data and the framework is delivered most effectively in a competitive framework, we cannot expect the same institutions to provide an innovation in the framework itself. As the new organisation level, the global economy, emerges, the existing toolbox becomes obsolete, the data inadequate. Consequently, the creation of the new framework is a global quasi public good, with manifest policy implications.

It is not going to be a surprise that I’d go with the third version...

Wednesday, 21 January 2009

A Policy Speech, But No Global Leadership

Most commentators are underwhelmed by Obama’s inaugural speech. However, an analysis of the text reveals the reason for the disappointment. Going against the expectations, this was a mostly policy speech, although you have to work a bit to uncover the content.

In my count (and categorisation) 43% of the speech was directly policy related. Of that, around half (21% of the entire text) was dealing with the US economy. Here is my translation of the contents of economic policy bit: The US economy is in crisis. The endowments are still the same, but effective government action is needed. The coming government measures should be judged by their quality and not by their size. His government’s investments will be in: infrastructure, science and technology, alternative energy, all three tiers of the educational system.

There was zero mention, or even a hint towards the global economy, and the fact that the US economy is part of it.

Yet, there were three different mentions of the global socio-economic system.

One. Global society -- the most circumvent way of putting it:
We are shaped by every language and culture, drawn from every end of this earth; and because we have tasted the bitter swill of civil war and segregation, and emerged from that dark chapter stronger and more united, we cannot help but believe that the old hatreds shall someday pass; that the lines of tribe shall soon dissolve; that as the world grows smaller, our common humanity shall reveal itself; and that America must play its role in ushering in a new era of peace.
A translation of the above would be something like this: The US is a culturally diverse place that managed to form an identity out of a series of shocks. The global society is also a culturally diverse thing that will see a common identity rise, and the US should be instrumental in that.

Two. Cooperation with others on two global problems:
[We] can meet those new threats that demand even greater effort - even greater cooperation and understanding between nations. [...] With old friends and former foes, we will work tirelessly to lessen the nuclear threat, and roll back the spectre of a warming planet.
Thus he supports a global-level policy on nuclear non-proliferation and climate change, as far as ‘cooperation and understanding among nations’ and ‘working with all others’ counts as such). In any case, there are existing global institutions for both, which the Bush government largely ignored, so this may only be a promise towards the US takings its share, rather than any new global leadership.

Three. There is no mention of global economic policy architecture, but there is an indirect, implied presence of some kind of global policy institution in this quote:

To the people of poor nations, we pledge to work alongside you to make your farms flourish and let clean waters flow; to nourish starved bodies and feed hungry minds. And to those nations like ours that enjoy relative plenty, we say we can no longer afford indifference to suffering outside our borders; nor can we consume the world's resources without regard to effect. For the world has changed, and we must change with it.

Despite a relevant point (economic development aid in poor countries works better if it comes especially to healthcare and education, and in the form of assistance rather than aid money), the global policy promise is there only if you want to imagine it: effective delivery of economic development aid, as well as an enforced global constraint on resource extraction would imply some form of policy forming, implementing, monitoring, and rule enforcing global body.

Overall, this speech has not done much towards outlining a global economic policy architecture, which would be, and probably will be, necessary to contain the current global crisis. That’s a pity.

Tuesday, 20 January 2009

Obama Writer’s Block

I never thought this would ever happen to me. I have an Obama Writer's
Block. (Check the time stamp of the previous post.) I have been
waiting to chew on something, and there is nothing given. His 825bn
package, I could tear apart (at least part of it) with harsh words on
'more of the same', with 'hey, don't you get it, you cannot achieve
much without global action' etc. But, my mature and and well placed
friends keep calming me down. Not so fast. He can hardly emerge as the President he is elected before the inauguration, and cannot possibly
act as the leader of the world, I have been betting on.

And thus, there was the long wait (and my pause). Until yesterday, I
heard the first global reference. Not much, but at least global
something: 'mankind'.

Today evening (well, our time at least) he will be sworn in, he will
give that speech. He'd better tell us that he will want to build a new
global economic policy architecture. A truly global regulatory
framework, an institution delivering global harmonisation of monetary
policy (and, yes, including currencies), some sort of global fiscal
policy co-ordination (with enforceable rules), and maybe, some form of
universal development agency (going way beyond the World Bank's
mandate). He'd better tell us that he will be all of mankind's
president, not just the American president. He'd better recognise the
political capital that he piled about around the world. And he'd
better promise to use it.


Talk about the impossibility of meeting inflated expectations...