More Overnight/Early Morning Developments

The Federal Reserve, along with the European Central Bank, the Bank of England and the Swiss, Canadian and Swedish central banks enacted, a coordinated, emergency cut in their benchmark interest rates early this morning. This comes in response to massive stock market declines in Japan, Russia, Indonesia and many other global indexes overnight along with further market interventions by European governments and central banks to prop up failing institutions, as Tom observed. The cut's timing also shows the urgency of central bank officials attempting to stem the fear of the aforementioned developments from further battering European and American markets during today's trading.

This is purely and clearly a psychological move by the world's central banks. Something needed to be done, in a coordinated way, to show the markets that the central banks were ready and able to intervene to stem any remote possibility of global financial collapse and the central banks believed further liquidity was the answer. But the problem is not liquidity, its confidence. How lowering a target rate that does not actually really matter (check out the data on the effective FFR over the past 3 weeks), will fix the problem, I can not see. Lowering the target as a purely psychological tool to attempt to impact investor confidence, may have an impact. How much of an impact and will the impact be enough? I have no idea but, I guess we'll see.

Overnight Developments

Britain announced a three-part multibillion-dollar bailout for its beleaguered banks, and Spain moved to mount a separate rescue of its own banking sector.

And the Fed is now in the commercial paper business.

Meanwhile...

In Moscow, the Micex index plunged 15.5 percent at the opening and exchange officials suspended trading until Friday.

Japanese stocks plunged 9.4 percent Wednesday, leading the Nikkei 225 to at 9,203.32, the lowest since 2003. It was the biggest single-day loss in the index since October 1987. The selloff followed Tuesday’s drop of more than 3 percent. The index is now down 40 percent in 2008.

Indonesia’s stock exchange halted trading after a morning plunge of 10.4 percent.

Looks like another bumpy day. Anybody have any idea about what to do? If so, post them in the comments section. I will offer some further thoughts later. Gotta go teach now.

Now What?

European governments appear "dazed and confused," said Jim Reid, a strategist at Deutsche Bank. "And this isn't helping confidence and will probably end up costing them more in the long run." Not surprising that they are dazed and confused, given the sharp about face that has occurred in most EU members in the last two days. Seems that guaranteeing bank deposits is not such a bad idea after all.

Press reports hint that Sarkozy is seeking an emergency G8 meeting this week. Not obvious that this is a good idea. Market reactions to the non-agreement EU-4 summit and post-non-agreement scramble to bailout Hypo Real Estate and other European financial institutions suggest that market participants do not believe that EU governments fully appreciate the stakes. "Until now the solutions have appeared to be uncoordinated, so perhaps it's time for a more coordinated approach globally," said Torsten Slok, an economist at Deutsche Bank AG in New York. Indeed. Yet, calling an emergency G8 summit merely adds fuel to the fire unless EU governments have a meaningful coordinated response to announce at its conclusion. (H/T to Calculated Risk).

Krugman posted a short paper elaborating his thoughts on contagion. He makes a concise argument about why the EU can't hide.

Update: Just noticed that Tuesday's NY Times has a piece that (finally) criticizes EU governments for their head-in-the-sand attitudes and failure to embrace a coordinated response. “It’s mind-boggling that the Europeans have coordinated so little up until this point” (Simon Johnson, former Chief economist at the IMF).

Sauve Qui Peut

French President Nikolas Sarkozy, in his capacity as EU President, called an emergency summit this weekend among the four largest EU members to discuss EU cooperation in face of the financial crisis.

The gathering failed to produce a constructive response. They agreed on the need to work together, but proved unable to agree on how this cooperation might be best pursued.

EU leaders seem torn between two unproductive orientations.

Along one path, EU governments seem determined to see this as an American crisis that they can somehow avoid, rather than a global financial crisis that they cannot. Gordon Brown said pointedly that the crisis “has come from America.” Mr. Berlusconi claimed that “Europe is not facing and never faced the risks in the American system.” Europeans, he said, “set aside money in savings.”

Along the other path, EU leaders have pursued uncoordinated national responses and then criticized each other for the half measures each takes (see how EU governments have reacted to Ireland's decision to guarantee 100 percent of deposits). Such behavior has prompted Peter Mandelson to warn of the dangers of a “new wave of economic nationalism”, which would create “distortions” and lead to an approach of “every man for himself”.

I fear that this approach reflects a failure to comprehend how the world has changed, and is more likely to aggravate than mitigate the crisis in which we find ourselves.

The End of an Era?

We've been mostly focusing on the domestic aspects of the financial crisis, but it's important to remember that this is a global crisis. In Europe, the major leaders are coming together to coordinate their responses:

French President Nicolas Sarkozy along with Germany's Chancellor Angela Merkel said Saturday that the "global financial crisis needs a global response."

Ms. Merkel and Mr. Sarkozy were speaking to the press ahead of a summit in Paris of leaders of the European members of the Group of eight leading countries, along with Eurogroup Chairman Jean-Claude Juncker and European Commission President Jose-Manuel Barroso, to discuss the financial turmoil.

"It's a global crisis that requires a global response. In today's world, Europe must show the will for a solution. That will reassure everyone, including savers," Mr. Sarkozy said.

Ms. Merkel said that all countries must take responsibility in sorting out the financial crisis and added that "those who caused the damage will have to contribute to the global effort.

In the past, this sort of coordinated European action would have been undermined by the U.S., and without U.S. support such a proposal would wither on the vine. As Drezner notes, both Japan and Europe tried something similar following the Asian financial crisis a decade ago, but the U.S. scuttled the efforts. If Europe is successful this time around, it may signal the decline of America as the hegemon of the global financial system.

And, the Rebuttal

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 . . . .

In Favor of the Dodd Plan

(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)

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.

Credible Credibility in Credit Markets

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....?

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?