Fannie, Freddie, and International Relations

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

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

I Walk the Line...

The Fed's job is to create moral hazard. Discuss.

Export Boom Helps Factories Too

The NYT recently ran a misleading story about US exports. The Washington Post today compounded the error by publishing an opinion piece that cites the misleading Times article to justify skepticism about trade. This seems to offer the opportunity to see if I remember how to do this.

The take away point from the NY Times' story is that good news about exports is actually troubling news. For [although] "exports are the bright spot this year in an otherwise bleak economy...the world is not suddenly snapping up made-in-America goods like aircraft, machinery and staplers. The great attraction is decidedly low-luster commodities like corn, wheat, ore and scrap metal."

It turns out, however, that the world is actually buying more planes, machinery, and staplers from the US this year than it did last year. (Okay, I don't know about staplers specifically (which I don't think have been produced in the US for ten years), but consumers goods more broadly) The graph below makes this point explicitly by comparing non-agricultural exports each month in 2007 and 2008. It clearly indicates that American exports of manufactured goods are unambiguously greater in each month of 2008 than in the same month of 2007.




If you were the curious sort, you could go to the BEA website and download the data required to conduct comparisons for civilian aircraft, capital goods (machinery), and consumer goods (and maybe even automobiles). Were you to do so, you would find that in each of these categories, the world has purchased more from the US in 2008 than it did in 2007. Thus, the export boom is helping American factories, too.

Running on Empty

Macroeconomic stability, reserve accumulation, and debt relief in emerging market economies is creating budget problems for the IMF. As The Economist reports, "Its $1 billion budget is traditionally funded by the small profit it makes on lending money to cash-strapped countries. But IMF lending has collapsed in recent years as developing countries have improved their economic management. As a result, the fund looks set to run a deficit of some $400m a year for the foreseeable future."

One might think, "Right then, job well done. Last one out please turn off the lights." After all, the current placid environment reflects in many respects the end of an era that began 35 years ago with the first oil shock. Developing countries developed balance of payments problems in part (though not solely) as a consequence of the negative shocks directly and indirectly generated by the first oil shock. Governments turned to the IMF for assistance and reform. In a very broad sense, one might conclude that although it did take a long time for these problems to work their way through the system, they have finally done so.

This final working out has had two consequences. On the one hand, governments in developing societies have reflected (if that is possible) on the lessons and concluded "never again." Their response has been to recognize the importance of a stable macroeconomic environment and to accumulate foreign exchange reserves as insurance against external shocks. This is especially the case in East Asia, but ever more so in other parts of the world too. Hence, less demand for IMF resources and macroeconomic stabilization. On the other hand, because of these changes, the IMF has a vastly reduced role to play in the global economy.

If ever there were a time at which one could restructure the IMF, this is it. Yet, organizations persist. So, rather than liquidating the fund, or finding ways to fundamentally reduce its scale to bring it in line with current demand for its services, the Fund and the G7 governments are searching for alternative sources of revenue. The most popular source is the sale of some of the IMF's gold holdings (of which it holds 103.4 million ounces, currently valued at around $92 billion). The proceeds would then form a fund that would generate an annual revenue capable of contributing to the budget.

It will be interesting to watch this unfold over the next couple of months. Gold sales require Board approvals, and last time the issue arose (1999) the US Congress was not so keen to see this development. Let's see if they are any more keen this time around.

We're Not So Special

Kenneth Rogoff: "As the United States’ epic financial crisis continues to unfold; one can only wish that US policymakers were half as good at listening to advice from developing countries as they are at giving it. Americans don’t seem to realize that their “sub-prime” mortgage meltdown has all too much in common with many previous post-1945 banking crises throughout the world.

Professor Carmen Reinhart of the University of Maryland and I systematically compared the run-up to the US sub-prime crisis with the run-up to the 19 worst financial crises in the industrialized world over the past 60 years. These include epic crises in the Scandinavian countries, Spain, and Japan, along with lesser events such as the US savings and loan crises of the 1980’s.

Across virtually all the major indicators – including equity and housing price runs-ups, trade balance deficits, surges in government and household indebtedness, and pre-crisis growth trajectories – red lights are blinking for the US. Simply put, surging capital flows into the US artificially held down interest rates and inflated asset prices, leading to laxity in banking and regulatory standards and, ultimately, to a meltdown.

The US economy is in trouble, and the problems it spins off are unlikely to stop at the US border. Experts from emerging markets and elsewhere have much to say about dealing with financial crises. America should start to listen before it is too late."

You can access the academic paper this op-ed draws upon here.

How Unequal Are We?

"The bottom fifth [of Americans} earned just $9,974 [in 2006], but spent nearly twice that — an average of $18,153 a year." How is that possible? " So begins a fascinating Op-Ed in today's New York Times written by two Federal Reserve Bank of Dallas economists. The editorial's broader purpose is to offer an alternative measure of economic inequality in contemporary America.

The punch line is simple: measuring household income yields a 15:1 ratio between the highest and lowest fifths of the income distribution. This gap income lies at the base of most hand-wringing over globalization. Yet, if one measures household consumption expenditures instead of income, the ratio between the richest and poorest fifths falls to 4 to 1. Measured at the individual (rather than the household) level, the ratio falls further to only 2.1 to 1 (wealthier households have more people than poorer households). Thus, the extent of inequality we observe is sensitive to how we measure it.

I don't know if they are right when they assert that consumption expenditures provide a better measure of inequality than income. What I do know, however, is that different measures of the same concept can generate very different conclusions. As we often base policy on what we believe is happening, it might prove useful to examine multiple measures before deciding on a change in policy.

Update: Krugman posts on this article. He thinks it's inaccurate: "So my basic reaction to the piece was, there they go again. There’s some truth in what they say, but no news."

While the House Burns

Legend has it that shortly after FDR's inauguration in 1932, Congress engaged in a long floor debate on one of the components of the first New Deal. As the debate carried on into the night, a group of legislators began heckling, "the house is burning! the house is burning!" In that spirit, I give you the following.

The Group of Seven meet tomorrow in Tokyo to confirm their unwillingness to work collectively to stabilize the world economy. The list of items on which the world's advanced industrialized countries cannot agree is short but includes practically every policy that matters.
Exchange rates: EU governments are not particularly happy about the dollar's weakness, but the US is unwilling to discuss exchange rates.
Fiscal policy: Governments disagree about the need for a coordinated fiscal response. While the UK is contemplating fiscal expansion, the Japanese and Germans resist. The German attitude is particularly troubling: "Germany’s deputy finance minister has said the blame, and thus the responsibility, lies squarely with the US."
Monetary Policy: The Fed has slashed rates. The ECB remains committed to its current emphasis on holding the line against incipient inflation and shows no indication that it believes that it should shift away from that target (H/T Mankiw). (Brings the old adage to mind: "Generals always prepare to fight the previous war."

I'm not saying that 2007-08 is the same as 1929-1932, but in the face of a pretty serious financial crisis that has raged, with varying degrees of ferocity, since mid-2007, one can't help but be a little concerned (and puzzled) by the systematic unwillingness to consider any kind of cooperative response. Also, isn't it about time we started to invite China to these affairs?

True or False?

I find this video funny. Mario Cuomo asks to be asked a series of True-False questions about the economy and US policy. One might suspect that the answers to True-False questions would be, well, short. True or False. Watch and learn what it takes to be a politician.

Also, notice the importance he attaches to finding who is to blame...

H/T The Big Picture

Who is to Blame?

Who should we blame for our current economic difficulties? I have been thinking about this question for the past week. Not because I wonder who we should blame, but because I am puzzled by the quest to find the person or persons who are responsible. The consensus places primary responsibility on Alan Greenspan. A few, such as Fred Bergsten, blame the IMF as well (for what, exactly, remains unclear). There appears also to be a consensus that Bernanke is to blame for failing to respond correctly to financial weakness (whatever that means) in order to make things better.

I find the search for a culprit puzzling for two reasons. First, the blame game rests on faulty reasoning. Those who assign blame implicitly compare what did happen with a utopian counter-factual of what would have happened had a different policy been followed. Greenspan is to blame because he cut rates too much and fueled the housing bubble. Asserting that these rate cuts were mistaken (and thus G is to blame) requires one to believe that not cutting rates would have produced a much better outcome. Yet, what would have happened had G not cut rates? We might have had a severe rather than a mild recession in the early 2000s. Then we would blame him for not cutting rates (fully unaware, of course, that cutting rates would have produced a housing bubble). So, when we assign blame we assume that the path not taken was a better path without having any good reason to believe this.

Second, when we assign blame we assume that individuals can control highly complex systems. Yet, our understanding of the relationship between monetary policy instruments and economic activity has not yet reached the status of Newtonian mechanics. There is considerable uncertainty about how financial markets work, and how they respond to changes in monetary policy. Whatever imperfect understanding does exist is constantly in flux as financial markets innovate. Is it reasonable to expect the Fed to anticipate the emergence of the new and highly complex financial instruments that drove the sub-prime lending boom? How reasonable is it then to argue that the housing bubble was foreseeable (and foreseen) by Greenspan? This is, of course, the inverse of the first flaw in reasoning; we assume that the future consequences of our current decisions are knowable and we can therefore avoid bad futures.

So why do we insist on assigning blame? I don't know, maybe it reflects our discomfort with the uncertainty that pervades all of the decisions we make and our inability to accept how little direct control we have over the broader forces that shape our lives. Or, perhaps it reflects the exigencies of democratic politics. In a world in which we expect so much from our government, we have lost the capacity to distinguish between those things that a government can be reasonably expected to do and those things we think it should be able to do. As a consequence, we expect unreasonable things from our government, and these expectations create opportunities that those seeking office can exploit to their electoral advantage.