Looks Like America's Got A Credibility Problem

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. 

Finally the Truth is Out....

"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

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

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)?

Cooperation in the International Financial System

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!

Good Discussion of the U.S. Economy

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.

(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.

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.