Thursday, September 18, 2008

Credible Credibility in Credit Markets

. Thursday, September 18, 2008

Alex's earlier post posed an interesting question:

If the United States is not going to follow its own advice of not intervening in its own financial market to bail out failing domestic firms when staring down one of the biggest financial crises in its history, why should/would any other nation follow the non-intervention policy when a similar financial panic occurs in their economy?

Has the United States lost all credibility to prescribe strict free-market, non-interventionist solutions to financial panic around the world?


It is certainly a question worth asking. But there's another way to look at it. First, consider that there is a difference between the IMF and the US government. They often act in tandem, but that doesn't mean that the actions of one can be conflated as an implicit act of the other. I know Alex didn't mean that, and was instead looking at broader philosophies, but it's still an important distinction.

Secondly, there is a major difference between one country using its own assets to bail out local companies and another country using borrowed money for domestic corporate welfare. Loans always come with strings attached, and the IMF has traditionally taken a pretty strong line: IMF loans are to be used for short-term balance of payments deficits, not for domestic welfare spending. In exchange, the IMF demands structural adjustments in the hopes of preventing a reoccurrence of whatever problem they are trying to fix. (I'm not defending the history of the IMF here; there's plenty to criticize. My point is simply to make distinctions.)

So the proper analogy isn't between IMF loans and domestic US policy, but rather between the terms of the IMF loans as compared to the terms of the Fed/Treasury loans. The Fed/Treasury loans have all come at a high price: Bear Sterns is dead; Fannie Mae and Freddie Mac cease to exist in their previous form, and appear likely to be broken up and liquidated in a fire sale; Lehman Brothers is dead; AIG is still alive, but their problem was liquidity and not insolvency. In all cases, the shareholders lost almost their entire investments. The Fed/Treasury loans, like the IMF loans, came at a heavy price: the way that these entities had previously done business has been completely eliminated, with major losses for the parties involved. In most cases, these business don't even exist anymore. In short, I can see more similarity than difference between the terms of IMF and Fed/Treasury loans.

As for credibility in the eyes of foreign governments and investors: if I were the manager of a sovereign wealth fund which was highly leveraged in US credit markets, recent actions by the Fed and the Treasury would increased their credibility in my eyes. By granting an implicit guarantee to practically the entire U.S. financial system, U.S. investments now look less risky than they would have if all these businesses were simply allowed to collapse without any further thought, with devastating repercussions for the domestic and global economies. If these moves by the Fed/Treasury work out, then future investors can look at U.S. credit markets with some reassurance, knowing that if their investments are on the verge of completely failing the U.S. government will likely step in provide some relief.

Does that create a moral hazard? Like the world has never seen before. These short-term fixes could prove to be incredibly costly down the line, and that's the worry, which is why Lehman was allowed to collapse, Merrill Lynch was forced into selling to Bank of America: the Fed had to draw the line somewhere. After all, a lot of the current troubles were aided by massive inflows of foreign capital into U.S. markets, which made loans so affordable in the first place. The U.S. credit markets were already perceived as being the safest in the world; with an explicit government guarantee, that safety might look even more appealing to foreign investors, and dramatic flows of foreign capital might keep coming. Right now, we need the liquidity, but in the future if money stays as cheap as its been in the past 5-7 years we might face another crisis similar to this one. Unless we get a lot better at assessing risk, of course.

UPDATE: Ken Rogoff is thinking along similar lines:

One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 54-year lows. It is almost as if the more the US messes up, the more the world loves it. ...

It is a very good thing that the rest of the world retains such confidence in America’s ability to manage its problems, otherwise the financial crisis would be far worse.

Let us hope the US political and regulatory response continues to inspire this optimism. Otherwise, sharply rising interest rates and a rapidly declining dollar could put the US in a bind that many emerging markets are all too familiar with.


Export-biased foreign countries know that their economic fortunes are tied to ours, so it's likely that they'll keep pumping money into our markets as long as they have no better alternative, keeping interest rates low and the dollar relatively high. If they ever stop, it'll hurt us badly, but it might hurt them worse. Another key: U.S. debt is dollar-denominated, so we don't have to worry about exchange-rate fluctuations when servicing this debt. Indeed, we can just inflate the debt away if it comes down to it. Foreign central banks and sovereign wealth funds know all this; they are incentivized to keep the U.S. markets afloat by providing capital to ease liquidity trouble, just as the U.S. government is.

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Credible Credibility in Credit Markets
 
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