Financial Regulation

Frank Rich, Simon Johnson, and many others, argues that the Obama plan for financial regulation is too tame. I think that the urge to regulate is occurring to quickly. The reason is that there is too much confusion out there on what caused the crisis. There is a great risk of putting a fence around the sheep that did not escape while the hogs run free.

For example, Rich blames Geithner and Summers for not resurrecting Glass-Steagall:

Suffice it to say that the Obama team has not resuscitated the Glass-Steagall Act, the New Deal reform that Summers helped dismantle in the Clinton years and that would have prevented the creation of banking behemoths that held the economy hostage.

Now one may think that eliminating Glass-Steagall was a bad idea, but it is hard to argue that it had any effect in causing this crisis. Bear Stearns and Lehman Brothers were not banks. Nor was AIG, of Fannie and Freddie for that matter. Had Glass-Steagall remained in force they still would have faced the same troubles. Moreover, hasn't anybody noticed that there are no investment banks left! One remedy that has been used in the crisis has been to turn investment banks into commercial banks.

Simon Johnson argues that the problem is that we have banks that are too large:

The issue was definitely not that banks and non-banks could fail in general. We're good at handling some kinds of financial failure. The problem was: a relatively small number of troubled banks were so large that their failure could imperil both our financial system and the world economy. And--at least in the view of Treasury--these banks were so large that they couldn't be taken over in a normal FDIC-type receivership.

Well, we may have banks that are too large, but Canada's banks are much bigger relative to GDP and they have been relatively immune to the crisis. More important, how big is too big. Think about Bear Stearns. They were not large. No conceivable regulation could prevent banks from being larger than they were. How were they saved? Folded into JP Morgan, a much bigger bank. Lehman was bigger than Bear, but not very big in context. How would regulation prevent that kind of problem cropping up again? Paul Krugman makes a similar point here.

The most egregious error, however, seems to be the notion that securitization was problematic because the banks had no "skin in the game." Here the administration seems out of whack. According to the Washington Post, the plan requires that:

Lenders would be required to retain at least 5 percent of the risk of losses on each package of loan pieces, known as an asset-backed security...

Sales of asset-backed securities provided the bulk of funding for mortgages and other consumer lending during the economic boom, as investors spent trillions of dollars buying what was often advertised as a safe, more lucrative alternative to ordinary bonds. The process was lucrative for banks, which could quickly sell loans and use the money for new lending. It was lucrative for Wall Street, which collected fees on each transaction. And it was lucrative for investors, who made outsized profits.

But as borrowers began to default on the underlying loans, the value of the securities collapsed, and everything came tumbling down.

The administration concluded that securitization encouraged looser lending standards, because companies that sold loans to investors had little reason to care whether borrowers could repay those loans. Furthermore, employees were paid to make loans, but they were not penalized for defaults. And investors could not easily check the excesses because they lacked basic information about the contents of each security.

Hello! Hasn't anybody noted that the big problem was that the banks carried too much of this debt on their books? Banks did not eliminate all of securitizations from their books. They kept the super-senior debt on their books. This is what created the hole in their balance sheets. It was not the losses of buyers of CDO's that caused the crisis. That was a mess, and caused losses, but did not make this crisis so huge. The big problem is that Citibank, Merrill, and others kept too much super-senior debt on their books, and when prices fell their balance sheets imploded.

Why did banks do this? There are many answers, but the big one is inadequate calculation of risks. Super-senior debt was considered so secure that the returns that could be obtained from selling it was not worth the effort. The biggest problem with securitization was the way the risks were calculated. Risks that were not independent were treated as if they were.

We need to figure out how to change the incentives for institutions to do risk management correctly. That means more skin in the game perhaps, but of the executives, not of the balance sheet. But mostly we need more thought.

Putin Makes Every Economists' Day

What unites economists in their frustration at politicians? No doubt, it is their fixation on domestic production over free trade. The Obama fiscal stimulus plan features "buy America" provisions. Nobody doubts the intelligence of Obama or the qualifications of his economic advisers, but these policies seem to be a fixture in so many countries.

It is thus refreshing, and certainly surprising, to hear Prime Minister Vladimir Putin arguing recently:

But if we speaking in general about the economy then there is no reason to engage in import substitution if we can buy things more cheaply abroad. Because if we always just try to play catch up, we will always be behind.

Why the difference? Is Putin smarter? Or are western politicians subject to more political pressures?

More on CAFE standards and GM

Now that the taxpayer owns GM it is important to recall the impact of CAFE standards on the auto industry. Mark Jacobsen wrote an important paper on this. He divides the auto industry into three groups: those constrained by CAFE who obey; those constrained who disobey and pay the fines; and those for whom the constraints don't apply because their fleets are already fuel-efficient. Naturally, the "Big Three" are the first group, Mercedes and BMW are in the second group, and Toyota and Honda lead the third group. Jacobsen then analyzes how CAFE standards impact the three groups.

There are many important results. Jim Hamilton discussed them in this post a while back. Perhaps, most important, is the simple inefficiency of CAFE standards. They reduce carbon but at perhaps 6 times the cost of a gasoline tax. But most important for now is the differential impact. Because producers like Toyota and Honda are not constrained they pick up the residual demand for larger cars not served by the Big Three who must shrink their fleets in response to higher standards. Think more Accuras and less Buicks. Since larger cars are more profitable, Toyota and Honda gain and the Big Three lose.

Thinking about these results in the wake of the increase in CAFE standards combined with the bankruptcy of GM and Chrysler one cannot help but think about the dissonance of these policies. By raising CAFE the government is making our new government-owned auto companies less profitable. Doublethink s the act of simultaneously accepting as correct two mutually contradictory beliefs, as defined by George Orwell in 1984. One might speculate about that in this case, though I think that politics is the more likely explanation. CAFE standards give off the impression of doing something, even though it is costly. And support for the auto industry is politically beneficial to the constituents of those in power. The fact that the former policy makes the latter even more costly is, perhaps, recognized, but it is ignored because this policy package is politically palatable.

The Yuan as Reserve Currency?

Reform of the architecture of the international financial system will be crucial in the near future. The economic shifts that have been taking place, most notably regarding emerging economies have not yet been recognized in terms of financial architecture. China sits on the worlds' largest stock of reserves and Russia is now third. Capital flows now not from the rich to the poor countries but from the emerging market economies to the industrialized ones. The financial system has to accommodate these flows and reforms are needed to facilitate the process. This is one important research item for our new center, CRIFES.

There has been some talk of the yuan replacing the dollar as a reserve currency. This is partly motivated by politics, and partly by the desire for the Chinese to diversify their dollar holdings. As Sebastian Mallaby describes it:

China's other approach is to promote the global use of its own currency. Its central bank has offered yuan to Indonesia and Argentina in return for rupiah and pesos. It hopes more trade will be denominated in yuan. Its contribution to the new IMF-like East Asian reserve fund may one day mean that a crisis-prone country in the region borrows partly in yuan.

All this is intended to buy China's currency some respectability. But as an escape from China's dollar trap, it is laughable. The idea is that once the yuan goes international, foreigners may be willing to borrow in it. That way, China can keep running a trade surplus and exporting capital, but instead of accumulating bonds denominated in dollars it would be able to accumulate bonds denominated in yuan.

Mallaby notes that for this to work all the currency risk would be shifted to China's debtors. Why would they be willing to accept the currency risk? This is not negligible given that most consider China's currency to be undervalued. So a debtor would be faced with a non-negligible risk of their debts appreciating with the yuan.

This suggests a more fundamental problem. How can the yuan become a reserve currency when investors believe that its value is determined by domestic political concerns? The cost of being a reserve currency is that, at least to some extent, domestic concerns are subordinated to international ones. When the US failed on this score in the late 1960's it brought the Bretton Woods system down, though not the dollar's status. While the US is not perfect, the value of the dollar primarily depends on fundamentals, not central bank policy.

As long as China manipulates it currency, or is perceived to do so, it will be impossible for it to become widely held as an international store of value. Nor do China's capital controls help.

The Dollar

The NYTimes reports that the dollar is weakening:

The dollar skidded to its lowest point in five months this week, battered by creeping fears that Washington’s costly efforts to stimulate the economy are growing harder to finance and may set off an unwelcome bout of inflation. Analysts are increasingly concerned that a rise in prices could hurt consumer spending, deepening the recession.

While the facts are undisputed, some of the analysis is weird as is the title:

As Dollars Pile Up, Uneasy Traders Lower the Currency’s Value

This makes the movements sound almost like some conspiracy, or a mystery. One analyst is quoted to the effect that this is all psychology. But this cannot be right. The dollar has been on a slide for almost a decade due to our excessive borrowing from the rest of the world. The financial crisis caused a temporary reversal in the process -- that was psychological -- fear caused people to hold dollars. But fundamental factors mean the dollar has to decline. While the article presents a graphic for the dollar for the last three months, look instead at the last 6 years.


When you look at the dollar against the euro since 2002 you can see that the economic crisis caused a temporary halt to a longer term problem. And nothing we have done to deal with the recession -- big deficits, lots of central bank credit -- is going to make the dollar stronger in the future.

Chrysler Dealers

In most communities auto dealers are among the local power elite. I wonder how many auto dealers vote Democratic. I ask this question after reading this article about how Chrysler dealers are being treated in the auto bailout. The disaffected have formed

the Committee of Chrysler Affected Dealers, who are contesting the company’s action. Next week and on June 3, the bankruptcy judge handling Chrysler’s case will consider their objections.

Many of those fighting the hardest are dealers who recently spent huge amounts of money to stay in the company’s good graces, who sacrificed their own profits to help keep the company intact or who otherwise thought they had bent over backward to ensure that Chrysler could survive, only to learn that they were the ones who would not.

Now I am certainly not contesting the view that Chrysler and GM have too many dealers. It is just that Chrysler and GM had too much of everything, but given electoral politics it seems that the President's auto task force is listening to the electoral polls as it distributes the burden among workers, bondholders, and dealers.

This has led to complaints from a group of Congressmen who argue (according to this article in the Post) that

the auto task force is waging a "war on capital" by favoring the United Auto Workers, who are being offered a 39 percent equity stake in the new GM, over bondholders, many of them small investors and retirees, who are being offered 10 percent.

The irony here, of course, is that most of the same Congressmen voted against any bailout when this issue was before the Congress. Given that they punted the ball to the President is it cool now to complain and demand that the ball be returned?

More bailouts

The Federal Government is set to offer more TARP money to GMAC. According to this article in the WSJ:

The GMAC injection is designed to firm up the auto-financing company's battered balance sheet and allow it to continue making loans for car purchases at GM and Chrysler LLC. The Treasury already put $5 billion into GMAC in December.

The GMAC funding is an illustration of how rapidly the government effort to rescue the U.S. auto industry is escalating in cost and scope. What began as an emergency batch of loans to GM, Chrysler and GMAC in December -- totaling just over $20 billion -- now looks likely to balloon well beyond $50 billion and could approach $100 billion by the end of the year.

So we are increasing subsidies to the automakers at the same time that higher CAFE standards make them less competitive. At the same time, the head of the UAW believes that the equity of GM and Chrysler is worthless, and he should know since he has the discretion to make it so. See this article (hat tip to Falkenblog):

UAW president Ron Gettelfinger said the union hopes to sell its stake in both companies quickly because he is more interested in raising cash to cover retiree health care costs than having an ownership stake in GM (GM, Fortune 500) and Chrysler.

"Let somebody else take the stock. Give us the money," Gettelfinger said at a recent press conference. "We are trading debt for equity, and what is the value of the equity? Let's be honest, it's zero today."

What scares me the most is that while rationality says ignore sunk costs, politically sunk costs matter. I doubt we are close to the end of these subsidies.

Meanwhile, the big banks want to give back their TARP money. Of course, one reason for this is just to avoid government interference in their operations. A second reason is to signal their strength. The fear is that they may need the money again in the future. Essentially, the government would like them to keep the TARP money so the likelihood of a future bailout is reduced, but the government cannot refrain from using its leverage to make them miserable, so they don't want to keep the funds.