Wednesday, September 24, 2008

And, the Rebuttal

. Wednesday, September 24, 2008
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Americans don't like the idea of our tax dollars going to bailout a bunch of companies run by massively rich executives.  Chris Dodd's plan is a reflection of the American voters' affinity for fairness (and punitive measures).  While fairness is a laudable goal, it isn't always the best guide for policy creation, and here's why:

At the heart of Dodd's proposal is the belief that taxpayers will invest too much in this bailout to be satisfied with assuming all of the risky debt with none of the potential upside that equity ownership conveys.  I'd first like to remind readers that there is an entire (profitable) industry that buys bad debt at reduced rates and then finds ways to cajole debtors into paying back that debt - ever heard of a collection agency?  Now, I'm not suggesting that the government start making harassing calls to debtors, but I am pointing out that you can make lots of money by buying bad debt obligations.

More importantly is that critics of Paulson's plan fail to recognize all the positive externalities that this bailout will afford.  Those externalities (basically, the propping up of the economy which keeps jobs from being cut, keeps pensions and retirement savings accounts secure, keeps access to credit relatively cheap) will provide taxpayers much more economic gains then equity positions in the finance industry could ever afford. And we can access those external gains without all the headaches of legislating the terms of a government equity position (how much equity?, what type of voting rights?, when can the government sell its holdings?, potential for increased lobbying from companies in which the government is invested? etc.).

The reason why Wall Street needs bailing out is because the market cannot adequately and independently self-correct due to a preponderance of externalities.  That is why the government needs to step in - because the government doesn't have a free-rider incentive and the government has the clout and the capital to actually get something done.  It would be a mistake to limit the government to behavior of firms - because the government's ability to bolster the economy at this point comes directly from its ability to NOT act like a firm.

Of course, I am not without criticism of Paulson's plan (I'm a grad student for God's sake, it's my job to criticize everything as much as humanly possible), but I'll save those criticism for another post - I'm well beyond my 50 word limit.

Will - tell me why I'm wrong . . . .

Monday, September 22, 2008

In Favor of the Dodd Plan

. Monday, September 22, 2008
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(Sarah posted a great comment to my post earlier today. At the bottom of my post, I linked to Sebastian Mellaby's citation of several academic proposals which bear some similarities to Sen. Dodd's counter-proposal to the Paulson plan. In the next few posts, Sarah and I are going argue the merits and demerits of the Dodd and Paulson plans. All of this is off-the-cuff, but hey: it's a blog. Apologies for the length.)

Dodd's plan accepts the basic assumptions of Paulson's: that massive government intervention has become necessary in order to stabilize markets and prevent financial market contagion from sinking the real economy. But Dodd's plan differs from Paulson's in several key areas. In my view Dodd's plan improves Paulson's on balance, but I have caveats. The list:

1. Paulson wants unilateral authority, with no review from Congress or the courts. This is insane, undemocratic, illegal, etc. Dodd wants an oversight committee comprised of the Chairmen of the Fed, FDIC, and SEC, plus two representatives from the financial industry. Paulson would still essentially serve as the CEO of United States, Inc., but his board of trustees would be comprised of this committee, which would presumably report to Congress and be subject to the judicial process if necessary. Dodd's proposal alleviates concern along two fronts: first, that too much discretion would be given to Paulson with too little accountability; second, that potential for moral hazard will be lessened because Paulson's actions will be more transparent and authority will be more dispersed.

2. Paulson wants broad discretion to use the cash in any way he sees fit, and has intimated that this will mostly entail buying "bad debt" so that banks won't have to carry them on their balance sheets any longer. This basically means one thing:

Anyway, I wanted to let you know that, behind closed doors, Paulson describes the plan differently. He explicitly says that it will buy assets at above market prices (although he still claims that they are undervalued) because the holders won't sell at market prices. Anna Eshoo pressed him on how the government can compel the holders to sell, and he basically dodged the question. I think that's because he didn't want to admit that the government would just keep offering more and more.


Why? Well, most of the "toxic debt" is still in the form of CDOs, especially mortgage-backed securities (MBS). These things were never intended to be bought-and-sold like other securities. As such, they don't really have a "market price" in the same way that stocks and T-bonds have. Even if they did, that "market price" is effectively $0 at present; simply put, nobody will buy these MBS at any real price. If the problem for banks is that they are short on capital, selling MBS at a massive loss to the Treasury (or anybody else) isn't going to do any good. In order to balance their sheets, they'd still have to sell more equity or dump assets at fire-sale prices. As Krugman has noted, the Treasury will essentially have to over-pay in order to create the desired effect. But that means that the U.S. government and its shareholders (i.e. taxpayers) will be essentially guaranteeing a pretty major loss for itself in order to reduce losses for banks who made bad decisions. This is corporate welfare in the extreme. If Bush and Paulson want that sort of action, then they should have to properly sell it to the American people and her Congress. They don't want to do that, for obvious reasons, so they shouldn't be allowed to get away with it.

3. One way around this problem is to force banks to stop paying dividends and/or to issue more equity (see the Mellaby piece linked in my first post). No banks will do this on their own, because that is a powerful market signal that that bank is failing, a sell-off will ensure, and the firm's value will fall. If the government forces all banks to do it, then credibility can be maintained. But not all banks are on the brink, so why punish those who managed their money well? You could put downward pressure on an already reeling market. And if you only mandate that "sick" banks act in this way, then that will be a strong signal as well, and firm value will still plummet.

So what to do? Dodd proposes that the Fed provide the needed liquidity for firms to roll over their paper. In exchange, those firms will provide equity equal to the size of the government's "investment". In other words, U.S. taxpayers will get equal value for their dollar by paying present market value for partial ownership. We will still be taking on some risk, but now we have a share of the upside and not just the downside. If the firms do well, we may make money. If the firms do poorly... well, the Paulson plan has us taking on that risk anyway.

This is not ideal, in my view. There are still a lot of questions to be asked and answered, and I expect Sarah to spell them out in more detail in her post. But we aren't dealing with "first-best" scenarios here. This may be the best we can do in a bad situation.

As an alternative, Arnold Kling proposes instead to drop the capital requirements for banks. He acknowledges that this will still mean more risk exposure for U.S. government since they insure banks. Not only that, but his proposal doesn't kick in for another year and the crisis is more immediate than that. Lastly, if one of the main problems in this financial trouble is too little risk-aversion by banks (or poor risk judgment, if you prefer), then it seems a bit presumptuous to give more casino credit to these banks and practically dare them to gamble with it. Which leads to...

4. CEO compensation. A loaded topic, to be sure. Dodd's plan, contra Paulson, has provisions for punitive damages for CEOs whose firms have done poorly. Executive compensation and severance packages could be arbitrarily reduced, presumably by Paulson's oversight committee (or Congress?) if it "is in the public interest". Well, what does that mean? What is the public interest? What levels of reduction? Matthew Yglesias wants "punitive measures". John McCain says that CEOs of bailed-out firms shouldn't be paid more than the U.S. President ($400k/year). I automatically recoil at vague language like that in the Dodd plan, but even ignoring that for the moment: what's the incentive facing executives if that clause remains? It's for CEOs and their boards to keep gambling and not seek help from the government if that action would mean that their personal compensation is going to fall from millions to mere thousands. It effectively creates moral hazard for these executives, and that's a really dumb thing to do right now. The government can only respond in four ways to executives who choose to take the gamble: do nothing and let the firms collapse, which defeats the point of this whole exercise; unilaterally violate compensation contracts, which would violate centuries of legal tradition; forcibly nationalize firms which don't want to be nationalized, which is a step (or twelve) further than anyone really wants to go; or appeal directly to shareholders. But shareholders are incentivized to gamble too since they will probably lose everything if the government bails out the firm (see AIG). In any case, such a move would likely take too long when firm survival is measured hour-to-hour.

In the grand scheme of things, CEO compensation is not a big deal. A few dozen million might sound like a lot, until you realize that we're really talking about hundreds of billions right now, at the least. Democrats and progressives would be wise to save that fight for another day; it just doesn't matter right now, and might actually be counter-productive. I'm guessing that these CEOs won't be getting salaries quite so big at their next job anyway.

Deal or No Deal (U.S. Congressman Edition)

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Hate to make this place all-bailout, all-the-time, but that's the biggest issue of the day.

If I'm a U.S. Congressman, and I'm being asked to give $700bn to the Treasury Department with no string attached, I say "no deal" whether I'm a Republican or a Democrat. If I'm a Republican, I'm ideologically opposed to massive government programs with essentially no oversight. I'm concerned about the fact that the current Treasury Secretary will likely be replaced in five months, and will presumably be seeking a job on Wall Street at that time. The term "moral hazard" has been tossed around a lot in recent weeks; this plan, if enacted, would immediately go in the Guinness book. If I'm a Republican, I'm also worried that I don't know who the new Treasury Secretary is going to be in five months, he's probably going to be appointed by President Obama (still the favorite according to the betting markets), and if the Congress gives up power to the Treasury Department now it may not get to change its mind later. I'm also wary of the provisions which will be added by Congressional Democrats in exchange for their votes. I note that right-leaning economists are very skeptical of this plan, and not just the far-right libertarians.

If I'm a Democrat, I'm thinking that I'm generally not happy with the way the Bush administration has used the unilateral authority it's had in the past. I'm thinking about Iraq (and not just the decision to invade), a host of civil liberties issues, lack of transparency in general, and corporatist tendencies. I'm thinking about the fact that while McCain is still an underdog he still has a 48% chance of winning (per Intrade), and his most notable executive decision so far has been to appoint Palin as his running-mate, which doesn't give me much confidence about his ability to pick capable technocrats in his administration. I'm very worried about the lack of oversight, since in this proposal Treasury decisions are non-reviewable by the Congress or the courts, essentially making Sec. Paulson the Supreme Monarch of Wall Street, and am even more cynical about moral hazards than my Republican counterpart. I'm concerned that President Obama will be constrained in his ability to enact social spending programs in January if all the money is spent today. I note that left-leaning economists are almost united in opposition to this plan, and not just the far-left anticapitalists.

If I'm a non-partisan wonk, I wonder what the point of this is. If the broader problem is still liquidity, then the Fed can fight that on its own. It's true that Treasuries were actually trading negative for a moment or two last week, but they were still trading, so it doesn't yet look like the Fed is "pushing on a string". In other words, it doesn't yet appear that the Fed has used up all its bullets. Additionally, there is still private and foreign capital out there to be had; if it's become difficult to get that capital, then the Fed and/or Treasury can do some regulatory tweaking on the margins to improve the situation without nationalizing all the risky assets in the world*.

If the problem is solvency, then I'm questioning the wisdom of putting the solvency of the U.S. government at risk. If that's too much Chicken Little for you, then I'm wondering why the government should, without oversight or even a structure of decision-rules, be nationalizing investment losses while keeping investment gains private. We've all heard of corporate welfare, but this may take the cake. And yes, some pension funds and retirement accounts will go down with the ship. That sucks, but that's what we've got a safety net for. Maybe the $700bn would be better spent shoring up those safety nets rather than bailing out Wall Street?

for more from the right, see Mankiw, Cowen, and Naked Capitalist.

for more from the left, see Krugman and DeLong.

Nadav Manham defends the plan here. Let's say that I think his view is best-case, and we have no reason to think that we're in best-case territory here.

*Sebastian Mellaby channels some academics proposing other solutions:

Raghuram Rajan and Luigi Zingales of the University of Chicago suggest ways to force the banks to raise capital without tapping the taxpayers. First, the government should tell banks to cancel all dividend payments. Banks don't do that on their own because it would signal weakness; if everyone knows the dividend has been canceled because of a government rule, the signaling issue would be removed. Second, the government should tell all healthy banks to issue new equity. Again, banks resist doing this because they don't want to signal weakness and they don't want to dilute existing shareholders. A government order could cut through these obstacles.

Meanwhile, Charles Calomiris of Columbia University and Douglas Elmendorf of the Brookings Institution have offered versions of another idea. The government should help not by buying banks' bad loans but by buying equity stakes in the banks themselves. Whereas it's horribly complicated to value bad loans, banks have share prices you can look up in seconds, so government could inject capital into banks quickly and at a fair level. The share prices of banks that recovered would rise, compensating taxpayers for losses on their stakes in the banks that eventually went under.

Thursday, September 18, 2008

Credible Credibility in Credit Markets

. Thursday, September 18, 2008
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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.

Live Together, Die Together....?

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Remember that factoid of money markets "breaking the buck" the other day?  Well, central banks around the world didn't take the news lightly, as the NY Times reports today.


Wow, look at all the tacit cooperation going on!  And the turn towards government regulation doesn't stop there.  The SEC has brought back rules against naked shorts, which are basically a strong bet on a stock going to zero.  Now there's talk of making all hedge funds publish their short positions - all in the hopes that those pesky speculators won't be able to destroy stock prices so fully and so quickly.  (Really, though, the most effective regulation might be to take a page from Russia's playbook and just shut down the whole exchange for a week.)

On last interesting tidbit - is anyone else struck by the news that Morgan Stanley (the investment bank that advised the government in the AIG deal) is now looking for buyers, possibly in China?

Looks Like America's Got A Credibility Problem

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The United States, the champion of the free market, "the beacon of unfettered, free market capitalism", has implemented a policy "that the most liberal Democratic administration would [have never implemented] in its wildest dreams," says Ron Chernow, a leading American financial historian in today's NY Times. Interesting observation. But even more interesting is the effect that this bailout policy may have on global perceptions of American free market capitalism and America's ability to dictate a global economic response to a future international financial crisis. 

I was in the process of putting together a post on the American paradox of nationalization and its effect on the global economy, when the NY Times stole the idea from my head and beat me to it by posting an article highlighting this effect on their website. I sat thinking earlier this evening about the financial policies that the United States has currently implemented in its financial market when facing a crisis, while at the same time prescribing to developing nations facing financial panic/crisis, a radically different approach. Essentially, the United States has instructed the developing world to deregulate, privatize their financial markets and not intervene during financial crises, even in the face of financial disaster. For example:

In parts of Asia, the bailouts [yesterday of AIG] stirred bitter memories of the different approach the United States and the International Monetary Fund adopted during the economic crises there a decade ago.

When the I.M.F. pledged $20 billion to help South Korea survive the Asian financial crisis of the late 1990s, one of the conditions it imposed was that the Korean government allow ailing banks and other companies to collapse rather than bail them out, recalled Yung Chul Park, a professor of economics at Korea University in Seoul, who was deeply involved in the negotiations with the I.M.F.
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? Has it lost its ability to place conditions, including massive privatization and deregulation, on its development loans even though it seemingly nationalizes and regulates when it deems it necessary? It sure looks like it. 


Wednesday, September 17, 2008

Finally the Truth is Out....

. Wednesday, September 17, 2008
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"Congress is unlikely to pass new legislation to overhaul financial regulations this year because ``no one knows what to do,'' Senate Majority Leader Harry Reid said today. ``We are in new territory, this is a different game,'' Reid said at a briefing in Washington. Neither Federal Reserve Chairman Ben Bernanke nor Treasury Secretary Henry Paulson ``know what to do but they are trying to come up with ideas,'' Reid said."

Reid's remark prompted a masterfully understated response from Senator Mel Martinez (R-FL), who noted that Reid's comment is unlikely "to inspire confidence or begin to turn the tide on some of this.''

Unwilling to do nothing, however, Reid instead proposes a second fiscal stimulus package and a $25 billion loan to the US auto industry.

Gallows Humor

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Does this mean that the central bank of the United States is now the main sponsor of Manchester United? As a Liverpool supporter, I'd certainly hope not. But if so, can the Fed be considered independent any longer?

If the Fed's next action is to lend money at low rates to the Chicago Cubs so they can re-finance their exorbitant free agent acquisitions, then I'm joining the Ron Paul rEVOLution in calling for the abolishment of the Fed. That would be the last straw for this St. Louis Cardinals fan.

Risky Business

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Continuing the incredulous unraveling of the financial markets, AIG has become the latest recipient of US Fed and Treasury orchestrated and US tax-payer funded bailout (see here - NY Times free account needed - and here).  Adding to mass hysteria is knowledge that a prominent money market fund dipped below a $1 NAV yesterday (it sounds mundane, but basically realizes risk in the traditionally most riskless and liquid asset class available).


It's hard for most to conceptualize just how recent events on Wall Street will effect the global financial environment, mostly because the financial instruments that got us into this mess by failing to accurately assess risk are so hard to understand (see here for a basis primer on derivatives).  The proliferation of esoteric credit derivatives on the global financial market has made a lot of people a lot of money, but it's also contributed to increased opacity of information and a decrease in the ability of governments to regulate.  And now, the chickens are coming home to roost.

As Alex mentioned in his previous post, the events of the past few weeks (and really the past six months) beg the question of what appropriate regulation looks like and how to get there.  In an interconnected financial world, how much space are we willing to give to free market machinations?  When do you think the government, governments, or institutions should step in, if at all?  How will the effects of a systemic under-estimation of risk change investor behavior going forward (especially large investors like oil-rich countries and sovereign wealth funds)?


Monday, September 15, 2008

Cooperation in the International Financial System

. Monday, September 15, 2008
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As you may already know, Lehman Brothers, one of the largest investment banks in the world, filed for bankruptcy today after a very long weekend of negotiations that included the main power players of American (world) finance, could not save the investment bank from failing. The Federal Reserve Bank and the US Treasury drew the line this time around and firmly held that they would not provide tax payer money to rescue the investment bank or facilitate a takeover of the troubled firm by another institution (as they did in the Bear Stearns collapse in March) and that the market itself would have to find a solution to the problem or allow the bank to fail.

The New York Times had some interesting analysis on the around the clock negotiations that occurred over the weekend. They paralleled the weekend negotiations with a similar round of talks that occurred during a bank run in the early 20th century:

Over the weekend, the Federal Reserve Bank of New York called together the leaders of most major financial firms in an effort to get them to act collectively to stem any possible panic, but could not force a deal.

In a way, that was similar to what happened a little more than a century ago, when the financier J.P. Morgan called the heads of all the trust companies in New York to a meeting in his library, and demanded that they agree to put up money to stop the bank run at another trust company.

The bankers did not want to do so, in part because they would need that money if the panic spread. Morgan locked the door, and kept the presidents in the library until morning, when they finally gave in. No such coercion exists this year.

This very interesting narrative got me to thinking. How does cooperation come about in the international (or domestic) financial system? Does a coercive mechanism have to be in place to in a sense force the hands of other firms to produce the liquidity necessary to save another financial institution? Do these institutions have to be coerced by the government, a central bank or another mechanism to take over a failing entity? Is it in the best interest of competing financial firms to bail out a competitor in order to ensure confidence in the financial market? Does the government have any responsibility to bail out a failing firm? How do we deem when a firm is too big to fail? Who deems it to big to fail and who saves it from failing? Fascinating questions that would make for an interesting research program (ahh dissertation!)

What do you think? Discuss!

Friday, September 12, 2008

Good Discussion of the U.S. Economy

. Friday, September 12, 2008
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Robert Rubin and Lawrence Summers were on Charlie Rose a couple of nights ago. The conversation was very good, although Rubin and Summers are both more pessimistic than some other economists. They spent most of their time discussing ways to improve the U.S. economy in the future, and the dangers of playing political games while the nation's economy burns. The entire episode may be watched here, but a snippet is below.

Big Win for Russia? Nyet.

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(red line: U.S. stock index S&P 500; blue line: Russian stock index RTSI)

The Russia/Georgia conflict has gotten a lot of attention from IR scholars and public commentators. Some have noted that Friedman's "Golden Arches Theory of Conflict Prevention" has now been definitively disproved, others have questioned whether or not "democratic peace" theories should also be cast aside. Still others see a return to the Cold War on the horizon, and think that the redux may be a bit hotter than the original.

But not very many people are talking about the economic consequences of the conflict for Russia and Georgia. They are... not good. The Financial Times has been doing a lot of good reporting on the Russian side, and things are not going well:

An exodus of foreign capital is forcing Russian banks to slash lending as the international reaction to the country’s military standoff with Georgia starts to affect the real economy.

Bankers say Russia is facing its worst crisis since the August 1998 default. The Russian stock market has plummeted more than 40 per cent since May. A flight of capital estimated by analysts at up to $20bn (€14bn, £11bn) since the start of the conflict is drying up liquidity. The Russian Trading System index fell another 7.5 per cent on Tuesday to its lowest level since June 2006.


The rouble fell to its lowest point since the Russian financial crisis of 1998. Putin and Medvedev are in a public squabble over whether this trouble is related to the Russia-Georgia conflict, but I know of no neutral observer which doesn't think that some, not all, of the recent financial and economic trouble in Russia can be blamed on a lack of investor confidence caused in part by the Caucasian Conflict.

What's striking is that this is going on while the price of oil is still fairly high and while there are major concerns about the safety of U.S. bonds and securities. Russia, along with other commodity-rich countries, should be benefitting from the U.S.'s troubles. Indeed, some of them are, but Russia isn't. Georgia isn't doing very well, either.

What does it all mean? Daniel Drezner thinks that a more globalized world makes war more costly, and therefore less likely. Russia and Georgia both acted belligerently, and both are paying a big price, despite the fact that there have been no economic sanctions placed on either. It is true that wars are more costly if the opportunity costs (i.e. lost trade and investment) are greater, but is that enough to prevent wars that might otherwise occur? A wiser man that I will have to answer that question.

Monday, September 8, 2008

Fannie, Freddie, and International Relations

. Monday, September 8, 2008
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Fannie Mae and Freddie Mac, the quasi-private investment groups that own or guarantee roughly half of the U.S. mortgage market, have now effectively been nationalized. The purpose of this blog isn’t to run-down all of the domestic effects of this (for that, see Brad DeLong and Calculated Risk, and keep in mind that Fannie & Freddie own or guarantee about $6 trillion in American mortgages), but there are implications for IPE study as well.

For example, central banks, sovereign wealth funds, and other international investors bought heavily into Fannie Mae and Freddie Mac, because they were under the impression that the investments were as close to riskless as one could get*. As Treasury Secretary Paulson noted, nearly $5 trillion in Fannie/Freddie debt and securities are owned by investors all over the world. To put that into perspective, the combined GDP of the U.K. and Italy in 2007 was less than $5 trillion. There is simply no way that the U.S. Treasury could let the companies fail and allow those nations (and other investors) to take a hit that big. If they did, says Tyler Cowen, the effects would be catastrophic:

The flow of capital from them and from other central banks, sovereign wealth funds, and plain old ordinary investors would shut down very quickly. The dollar would fall say 30-40 percent in a week, there would be payments system gridlock, margin calls at the clearinghouses would go unmet, and only a trading shutdown would stop the Dow from shedding half its value. Most of the U.S. banking system would be insolvent. Emergency Fed/Treasury action would recapitalize the FDIC but we would lose an independent central bank and setting the money supply would be a crapshoot. The rate of unemployment would climb into double digits and stay there. Many Americans would not have access to their savings. The future supply of foreign investment would be noticeably lower. The Federal government would lose its AAA rating and we would pay much more in borrowing costs. The deficit would skyrocket.


Tyler Cowen isn't known as a pessimist, but considering that “when the U.S. sneezes, the world gets a cold,” the prospects for international financial markets as a whole could have been catastrophic if the U.S. had not acted. In short, it’s likely that international political concerns, such as maintaining the credibility of the U.S. government in the eyes of other foreign nations, have essentially forced the Treasury Department to step in, even if they didn’t want to.

The news of nationalization was greeted warmly by nearly everyone. The announcement was made yesterday for the benefit of foreign financial markets trading overnight, and those markets responded by posting large gains. The heads of the European and Japanese central banks spoke positively of the take-over. There is still some pain ahead, especially for domestic banks, but by nationalizing Fannie and Freddie the U.S. Treasury may have dodged a bullet. At least temporarily.

*As it turns out, they were right: these investments were largely riskless since the implicit guarantee of the debt by the U.S. government has now turned into an explicit guarantee. Are there moral hazard concerns? You betcha. But, as the saying goes, "in the long run, we're all dead."

[UPDATE: U.S. markets posted huge gains today in response to the bail-out news. The dollar gained against the Euro, Pound, Swiss Franc, and Yen.]

The Ford ECOnetic is on sale, but not in America

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Business Week has a very interesting article this week detailing an often overlooked consequence of the relatively weak US dollar. The Ford ECOnetic, a 65 mpg vehicle that goes on sale in Europe this November, is part of a new line of clean diesel engine vehicles that are roughly 30% more fuel efficient and as clean or cleaner than traditional gasoline engine vehicles. However, don’t expect to see this more efficient, clean diesel car at your local Ford dealership anytime soon.

The reason? The Ford ECOnetic’s diesel engine is manufactured in England, where labor costs are significantly higher than other vehicle manufacturing countries such as Mexico and Brazil. The higher labor costs coupled with the weakness of the dollar relative to the British pound, has led Ford to conclude that the vehicle would not be price competitive with cars already available on the US market. The relative strength of the British pound (the exchange rate is currently 1.7687 USD to 1 GBP) has significantly increased the cost of importing the vehicle into the United States, thus increasing the price tag that consumers would have to pay.

When analyzing the impact of currency levels on trade, most analysts simply point to the fact that the weakness in the dollar has led to a decrease in total imports and an increase in total exports. However, the most interesting consequence of this phenomenon is not that the weak dollar has increased net exports, but that there is evidence to suggest that the dollar’s weakness has constrained the variety and quality of goods available in US consumer markets. International economic theory is in line with what we are currently seeing with the Ford ECOnetic. Economic theory would imply that a relatively weak currency will constrain the variety of goods available in the domestic market as goods that normally would be imported would be priced out of the domestic market because of the weakening domestic currency. This is a consequence that is often overlooked by American consumers who typically tend to believe that the same goods will be available in their grocery stores or their automobile dealerships regardless of the level of exchange rates. 

Check out the article here: Ford ECOnetic

Tuesday, September 2, 2008

I Walk the Line...

. Tuesday, September 2, 2008
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The Fed's job is to create moral hazard. Discuss.

International Political Economy at the University of North Carolina: September 2008
 

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