A graphical look at the post-Lehman world economic trends

Ananth, John Authers, and JP Morgan have nice summaries of the post-Lehman events and trends. 

The defining feature of the post-Lehman decade has been the zero-bound interest rates, which is still in the negative territory in a few cases.

The central banks embarked on an extraordinary expansion of their balance sheet, buying up more than $10 trillion in bonds. And it remains at historic highs

The ultra-low rates penalised savers, benefited borrowers and corporates, boosted asset prices, and increased the top 1 percent's share of global wealth by 10 percentage points.

One of the most important consequences of the extraordinary monetary accommodation has been a surge in global debt burden. Global debt has surged from $84 trillion at the turn of the century to $173 trillion at the time of the 2008 crisis, and $250 trillion today.

Non-financial corporations (77% of GDP in 2008 to 90% today), governments, and China have been the biggest offenders. Consider this,

China is now saddled with almost $40 trillion of debt, compared with less than $30 trillion for all other emerging markets combined. In 2008, the group had $16 trillion of debt, while China only carried $7 trillion. 

Excluding financial corporations, it was $169 trillion in H1 2017. 

Non-financial corporate bonds outstanding have increased 2.7 times over the past decade to $11.7 trillion.

Governments too have been the big offenders,

The US government has been leading from the front,

The $15.3 trillion U.S. Treasury market, the world’s biggest bond market... has tripled in size since August 2008. For context, in the prior 10-year period, it grew by “only” $1.5 trillion, even amid the beginning of the Iraq War. The totality of U.S. federal debt now makes up more than 100 percent of America’s gross domestic product. 

Student loans have exploded in the US,

The issuance of leveraged, covenant-lite loans and junk bonds by US non-financial corporates has doubled.

Even as wages have remained stagnant, corporate profits have surged,

Irrespective of Dodd-Frank legislation and creation of resolution mechanisms for systematic winding down of failed institutions, markets seem to still believe in the too-big-to-fail (TBTF) subsidy. As a reflection, the difference between the interest rate differential in the borrowings of the parent financial institution and its banking unit has remained stable. Clearly the markets believe that in case of a systemic crisis, the parent units will get bailed out along with the banking units.

The remarkable growth of Chinese banks to top the global banking table adds more to the ever growing concerns about the next crisis being made in China.

A rare encouraging feature has been the reversal of financial globalisation and step fall in global cross-border flows.

Global bonds held by non-bank investors as a percentage of their total holdings of equities/bonds/M2 has risen sharply post-Lehman, reflecting risk reduction, regulatory changes, and demographic shifts.

As to real GDP growth, the US economy may appear to have rebound the most.

But once controlled for working age population, Japan has been the undoubted best performer since the crisis in terms of real output per working age person...

... and in terms of employment creation.

The balance sheet of the global financial crisis

An excellent summary of the balance sheet of the global financial crisis from Nelson Schwartz in the Times,

The financial crisis didn’t just kill the dream of getting rich from your day job. It also put an end to a fundamental belief of the middle class: that owning a home was always a good idea because prices moved in only one direction — up... When the bubble burst, the bedrock investment for many families was wiped out by a combination of falling home values and too much debt. A decade after this debacle, the typical middle-class family’s net worth is still more than $40,000 below where it was in 2007, according to the Federal Reserve. The damage done to the middle-class psyche is impossible to price, of course, but no one doubts that it was vast.

Banks were hurt, too, but aside from the collapse of Lehman Brothers, the pain proved transitory. Bankers themselves were never punished for their sins. In one form or another — the Troubled Asset Relief Program, quantitative easing, the Fed’s discount window — the financial sector was supported in spectacular fashion.

Like the bankers, shareholders and investors were also bailed out. By cutting interest rates to near zero and pumping trillions — yes, you read that right — into the economy, the Federal Reserve essentially put a trampoline under the stock market. The subsequent bounce produced a windfall, but only for a limited group of beneficiaries. Only about half of American households have any exposure to the stock market, including 401(k)’s and retirement plans, and ownership of the shares of individual companies is clustered among upper-income families.

For homeowners, there wasn’t much of a rescue package from Washington, and eight million succumbed to foreclosure. Sometimes, eviction came in the form of marshals with court orders; in other cases, families quietly handed over the keys to the bank and just walked away. Although home prices in hot markets have fully recovered, many homeowners are still underwater in the worst-hit states like Florida, Arizona and Nevada. Meanwhile, more Americans are renting and have little prospect of ever owning a home.

Worsening the picture, the post-crisis era has been marked by an increased disparity in wealth between white, Hispanic and African-American members of the middle class. That’s according to an analysis of Fed data by the Pew Research Center, which found that families in the latter two groups were more dependent on housing as their principal form of investment. Not only were both minority groups harder hit by foreclosures, but Hispanics were also twice as likely as other Americans to be living in Sun Belt states where the housing crash was most severe.

In 2016, net worth among white middle-income families was 19 percent below 2007 levels, adjusted for inflation. But among blacks, it was down 40 percent, and Hispanics saw a drop of 46 percent. For many, old-fashioned hard work has simply not been a viable path out of this hole. After unemployment peaked in the fall of 2009, it took years for joblessness to return to pre-recession levels. Slack in the labor market left the employed and unemployed alike with little leverage to demand raises, even as corporate profits surged... A recent study by the Federal Reserve Bank of St. Louis found that while all birth cohorts lost wealth during the Great Recession, Americans born in the 1980s were at the “greatest risk for becoming a lost generation for wealth accumulation.”...

Maybe it was inevitable that when half the population watches its wages stagnate while the other half gets rich in the market, the result is President Donald Trump and Brexit.

By the way, as an assessment of the post-crisis response, there could not have been anything more stark than this by Neil Irwin, and this by Peter Doyle. The former was a close observer of the response whereas the latter was a participant in the response. In particular, their respective assessments of the recent Brookings conference that brought together the leading crisis policy makers. 

Neil Irwin describes the post-crisis response as "the high-water mark for a mold of centrist, technocratic policymaking that seeks to tweak and nudge existing institutions toward better outcomes". His enthusiastic paean to the "technocrats" like Tim Geithner, Hank Paulson, and Ben Bernanke, without any reference to counterfactual situations nor the issues raised by his own colleague, Nelson Schwartz in the above-referenced article, is representative of the hegemony and rot among opinion makers on the liberal side. Doyle raises several concerns, none of which merit even a cursory mention for Irwin. Nor any mention of the consequences of the post-crisis response, nor the fact that the so-called recovery is confined only to the top 10% and has barely touched the rest, nor even the toxic debt legacy fuelled by the extraordinarily long period of low interest rates. 

This and this present alternative perspectives just on the Lehman decision. 

It is not so much the specifics of the policies initiated in the immediate aftermath of the crisis that should be the matter for debate. It is about the manner in which those policies were formulated and the stakeholder consultations that went into it. It is about those who were heard and who were not, those whose interests were prioritised and those whose interests were marginalised. It is about those policies which were not pursued with same fervour or not initiated at all. It is about the continuation of those policies well beyond reasonable limits, both in scale and in time duration. It is about the consequences of those actions that has left the financial markets more concentrated and arguably at least as unstable as before the crisis. It is about the failure to entrench the learnings from the crisis and prevent a slip-back to the same ideologies and policies that led to the crisis. It is about how the post-crisis response policies have set the stage for the next financial crisis. It is about how the same "technocrats" contributed to each of the aforementioned failings. In the absence of a reference to any of these, Irwin's qualification of the post-crisis policy responses as a "success" is stunning!

Midweek reading links

1. Arguably the biggest suffering caused by the sub-prime mortgage meltdown involved the 7.8 m home foreclosures during the 2007-16 period. While the TBTF firms got bailed out, households got foreclosed out!

And who purchased them? Sample this

Since the crisis Blackstone has marched into markets that others have been forced to vacate. Its credit arm finances businesses that would once have borrowed from Wall Street banks. But nothing underscores Mr Schwarzman’s rise more clearly than the portfolio of more than 80,000 single-family homes that have made his firm one of America’s biggest private landlords. With so many people unable to get on the property ladder, Blackstone reckoned the rental market would be highly lucrative. Beginning in 2012, the firm dispatched representatives to buy houses in fast-growing metropolitan areas across the nation, including southern California, Chicago and Atlanta. About one-third of the properties were bought in foreclosure auctions, typically without anyone even inspecting them first. The result of that effort is a company called Invitation Homes that floated on the stock market last year. Today it is worth $21.6bn including debt, buoyed by a 35 per cent increase in US house prices since the start of 2013 and an unyielding approach that few private landlords can match.

People lose their houses and with it their hard-earned life-time savings. Hedge funds, benefiting from the extraordinary monetary accommodation, pocket these houses for fire-sale prices!

2 Interesting take on Trump by Peter Beinart who argues that Trump's supporters fear the corruption of American traditional identity, not American law. In the context of a murder in Iowa of a white woman by a Latino immigrant,

In a forthcoming book titled How Fascism Works, the Yale philosophy professor Jason Stanley makes an intriguing claim. “Corruption, to the fascist politician,” he suggests, “is really about the corruption of purity rather than of the law. Officially, the fascist politician’s denunciations of corruption sound like a denunciation of political corruption. But such talk is intended to evoke corruption in the sense of the usurpation of the traditional order.”... When Trump instructed Cohen to pay off women with whom he’d had affairs, he may have been violating the law. But he was upholding traditional gender and class hierarchies. Since time immemorial, powerful men have been cheating on their wives and using their power to evade the consequences. The Iowa murder, by contrast, signifies the inversion—the corruption—of that “traditional order.” Throughout American history, few notions have been as sacrosanct as the belief that white women must be protected from nonwhite men. By allegedly murdering Tibbetts, Rivera did not merely violate the law. He did something more subversive: He violated America’s traditional racial and sexual norms.

Once you grasp that for Trump and many of his supporters, corruption means less the violation of law than the violation of established hierarchies, their behavior makes more sense... Why were Trump’s supporters so convinced that Clinton was the more corrupt candidate even as reporters uncovered far more damning evidence about Trump’s foundation than they did about Clinton’s? Likely because Clinton’s candidacy threatened traditional gender roles. For many Americans, female ambition—especially in service of a feminist agenda—in and of itself represents a form of corruption... For many Republicans, Trump remains uncorrupt—indeed, anticorrupt—because what they fear most isn’t the corruption of American law; it’s the corruption of America’s traditional identity. And in the struggle against that form of corruption—the kind embodied by Cristhian Rivera—Trump isn’t the problem. He’s the solution.

3.Tirthankar Roy draws attention to the serious limitations of historical economic data.

Maddison’s work shows growing inequality in average incomes between countries. The data is – to put it mildly – bad data. Look closely, you will see that the average income of India was USD533 for 1820-1870. Year after year for 50 years Indians earned exactly USD533 on average (and exactly USD550 for 320 years before that). These numbers contain no worthwhile information about Indian history. Such is the quality of the statistics on which the divergence debate has so far been based.

4. Fascinating essay on the rise of India's Rs 23 trillion mutual funds industry which today attracts Rs 75 bn every month.

5. FT has a nice story on the emergence of a united US-Japan-US front in the trade war with China and how it is starting to bite in Beijing.

In recent months the EU and Japan have joined forces with the US in WTO complaints against “forced technology transfers” in China through mandatory joint venture structures with local partners... Tokyo has been pleasantly surprised by a Beijing-initiated rapprochement over the past year. According to one Japanese official, a recent spate of Chinese overtures are all “thanks to Trump”. The official adds: “Trump’s trade policies have been influencing China’s diplomatic stance.” ... “The Chinese should be worried about Trump,” says Steve Bannon, Mr Trump’s former political adviser. “They’ve never had to confront anything like this.”... Wang Chong at the Charhar Institute, a Beijing-based think-tank, says China’s current problem in the US is not just related to Mr Trump: “Both the Republican and Democratic parties have reached a consensus that they should try to curb China’s development.”

... the only trade deal he would accept from China is one Mr Xi could not possibly offer, because it would include concessions on how the party manages everything from industrial policy to state-owned enterprises and the renminbi. Others argue that Mr Trump’s ideal outcome is in fact no deal at all, so he can implement long-term tariffs on all Chinese exports to the US in a bid to bring about a radical overhaul of global supply chains. “People in the administration now understand that Trump may be flexible on so much stuff, but the hill he’s willing to die on is China,” says Mr Bannon. “Trump’s focus is shifting the supply chains out of China.”

Donald Trump gets eviscerated in the mainstream media for pretty much everything he does. And rightly too in many cases. But he deserves some applause here.

Not too many people will disagree that China resorts to extremely unfair trade practices, those which hurts manufacturers in other developing countries as much as in the US. In a fair world the Chinese actions should have long since been called to account. No American President who would have represented the mainstream establishment would have had the resolve and courage to do so. Trump has called the bluff and, in his own bluster-filled way, shaken up the entrenched equilibrium. 

6. The popular reaction to Serena Williams' abhorrent antics at the just concluded US Open Women's Final is a great illustration of the duplicity associated with the liberals. Serena has made a mockery of the existing rules of the game, behaved disgracefully (and has a track record of doing so),  and like the classic opportunist taken shelter behind race and sex to justify her actions. The referee has done what he was supposed to do as per the rule book and has a track record of doing so. And what do we get from the liberal establishment? Serena is portrayed as the victim and Carlos Ramos as the aggressor, in fact as a straw man who represents the racist and sexist establishment.

Evidently gender and race are very politically sensitive subjects. It is a mark of a liberal to be always on the right side of any gender and race debate. Serena Williams, also due to the politics surrounding her, ticks both boxes. So, it is almost suicidal to be seen to be taking on Serena, whatever the provocations. Liberals, therefore, rallied to her support. 

Add to the sex and race dimension, Serena is also a powerful persona in the tennis world. Besides being the GOAT, she also wields enormous influence among tennis administrators, sponsors, media, and players associations. Add everything in and the strong reactions in her favour is unsurprising. 

Martina Navratilova is among the very few sane voices trying to put matters in perspective.

This also highlights the contrast between the on-field governance of tennis and cricket. A tantrum like this is just impossible. Just remember the flak Steve Smith got with his "brain fade" moment when he apparently turned back to get dressing room reaction for an on-field review.

7. As emerging economies face turmoil, Times has a graphic that captures the external vulnerability, in terms of external debt to GDP ratio for the major emerging market economies.

8. As its new CEO, David Solomon, prepares to take charge, Times carries the story of sensational leak alleging unethical practices by a Goldman Sachs Partner, James C Katzman. Katzman, while leading Goldman's US West Coast M&A practice, complained to the bank's whistle-blower hotline about repeated attempts to obtain and then share confidential client information and hire a customer's child. Senior Goldman bankers apparently tried to "extract confidential client information from him that they intended to share with other Goldman customers or otherwise use for the bank’s benefit".

But the law firm managing the hotline, instead of independently investigating and presenting it before the Company Board, referred it to the Company's General Counsel and quietly buried it. Worse still, insiders, including the incoming CEO, tried to dissuade Katzman, who resigned from the firm, from pressing forward his complaints.

9. Finally, the Eritrea-Ethiopia border is open for trade after 20 years following the bitter separation of the two countries. Sample this,

Eritrea gained its independence from Ethiopia in the early 1990s, and war broke out later that decade, locking the two nations in unyielding hostilities that left more than 80,000 people dead. The turning point came in June, when Mr. Abiy announced that Ethiopia would “fully accept and implement” a peace agreement that was signed in 2000 but never honored. The formal deal was signed weeks later. Few people expected such a quick turn of events. Embassies have reopened, telephone lines have been restored and commercial flights between the capitals have resumed. An Ethiopian commercial ship docked in an Eritrean port last Wednesday — the first to do so in more than two decades.

Is this the most dramatic reversal of cross-border relations between countries in recent times?

Weekend reading links

1. Very good Livemint oped by V Praveen, an economics student, on the disconnect between economists and the markets.

2. Sweden is perhaps the epitome of generous and compassionate social democracy, a society where everyone lives a dignified life, gender inequality non-existent, sustainable development a cornerstone, and so on. Its economy is among the most competitive and it does more in terms of helping poor countries than almost anyone else. But next Sunday Sweden faces an election which threatens to disrupt the status quo. The center-left Social Democrats, who have come first in every election since 1917 and ruled the country, faces the prospect of losing power after more than a century. 

After receiving 163,000 asylum seekers in 2015, the highest proportion of any country, Sweden has been facing a growing populist backlash, led by the right-wing Sweden Democrats party. A spate of shootings, grenade attacks, and burned-out cars have gripped the country and fuelled the rise of populists. This has been coupled with the strains on the famed Swedish welfare state, Folkhemmet, which is financed by a 60.1% marginal tax rate. Rising waiting times in hospitals and deteriorating school results have become the lightning rods for this discontent. The consequence, as outlined, in a nice article in FT,

Scarcely a day has gone by in the past few years without a shooting, burned-out car, or even a grenade attack being reported in one of the cities. That has upended the usual political calculus in Sweden. Conventional issues around the state of the economy and jobs have seemed less important than normal, to the detriment of the ruling Social Democrat government and prime minister Stefan Lofven. Into the breach has stepped... the Sweden Democrats. Rooted in Sweden’s neo-Nazi movement, the party has tried to shed its racist image, entering parliament in 2010 and becoming the third-largest group four years later with 13 per cent of the vote. A stronger performance than that awaits this time as the party challenges for second — or perhaps first — place... The Sweden Democrats’ long-term core message is that Sweden needs to make a choice between immigration and guaranteeing the Folkhemmet.

3. Chris Balding argues that the new US trade pact with Mexico, with its 75% local content requirements and 40-45% content come from factories paying more than $16 per hour, and strict intellectual property rights regime, is also aimed against China and likely to curtail the use of Mexico as a trans-shipment or assembly location using Chinese inputs. He writes,

The Mexico accord tightens rules of origin on automobiles, so that 40 percent to 45 percent of their content must be made by domestic companies whose workers earn at least $16 an hour. This limits the scope for assembly in Mexico with Chinese components, favoring higher-value parts from manufacturers covered by the agreement... In digital services, the draft limits a government’s ability “to require disclosure of proprietary computer source code and algorithms,” something China has mandated for most IT providers. This section also targets prohibitions being applied to “digital products distributed electronically,” such as Facebook and Twitter. The data and financial-services obligations even prohibit local data-storage requirements: Beijing has declared the audit records of Chinese firms listed in New York off-limits to U.S. regulators, for example. If doubts remained, consider the environment section: Mexico and the U.S. agreed to prohibit “shark-finning,” the practice of cutting the fins from sharks and leaving them to die. China is a major consumer of shark fins. The two sides also agreed to prohibit illegal or unregulated fishing. The labor section of the accord requires “worker representation in collective bargaining.” While independent unions in Mexico and the U.S. have varied challenges, they don’t face the level of official intimidation of labor activists in China.

As Balding writes, Trump can now achieve his objective of reining in China as no other US President if he can now use this opportunity to strike similar pacts with Canada and Europe.

Even if the real impact of the local content requirement is less than the hype, taken together the deal turns the tables on China's remorseless unilateral trade policy actions.

4. Nice article on the transformation of Seattle. The rapid growth of Amazon in particular has transformed the City for the good and the bad - traffic congestion, unaffordable housing, homelessness, and gentrification. The strong resistance to change zoning laws to allow greater density exacerbates these problems.

The role of Microsoft co-founder Paul Allen's construction company, Vulcan, which alone has developed properties worth over $6 bn in Seattle and occupies a fifth of the city's prime office space, bears resemblance with the role of DLF in Gurgaon.

It is one more reminder about the dangers of rapid urbanisation. To quote Greg Nickels, Seattle Mayor from 2002-10, “One of the big challenges with growth is to not allow it to overwhelm you.”

5. Gillian Tett looks back at the Global Financial Crisis and asks whether lessons have been learnt. I am inclined to answer mostly in the negative.

6. The Economist captures the delicious irony of the academic economist shoving aside his own theory when faced with the real world challenge of running a central bank.

Imagine if Milton Friedman had been put in charge of a central bank, only to lose his job for expanding the money supply too quickly. Or if Robert Shiller, the Nobel-prizewinning author of “Irrational Exuberance”, were given a similar post, only to depart having allowed a stockmarket bubble to inflate. That is the kind of irony that attended the resignation under pressure of Federico Sturzenegger as governor of Argentina’s central bank on June 14th, a casualty of deepening turmoil in emerging markets. Mr Sturzenegger's most-cited paper showed that stated currency policy was often a poor guide to actual policy. Many countries claim to let their currencies float freely but in fact “intervene recurrently to stabilise their exchange rates”. Their deeds often belie their words. Mr Sturzenegger lost his job for much the same thing... After Argentina agreed on a $50bn loan from the IMF, he said he would intervene in the foreign-exchange market only in “disruptive situations”. But when the peso soon came under renewed pressure, he resumed selling foreign-exchange reserves, which fell by $665m on June 12th-13th. He gave up the fight on June 14th, allowing the currency to drop by 5.3% against the dollar on a day that ended with his departure.

7. Another article captures this decline in use of public transport in the US,

The American Public Transportation Association’s figures show that the number of journeys in the country as a whole has fallen in each of the past three years. In 2016-17 every kind of mass public transport became less busy: buses, subways, commuter trains and trams. New Yorkers took 2.8% fewer weekday trips on public transport and 4.2% fewer weekend trips in the 12 months to April 2018, compared with the previous year. In Chicago and Washington, DC, the decline in public-transport trips has been even steeper.

This broad trend is mirrored, even if with less strong decline, in European cities. In the 2007-13 period, Madrid metro, for example, lost 19% of its commuters. One reason for the decline is the rise of ride-hailing services,

In San Francisco public transport accounts for 16% of all weekday trips, ride-hailing for 9%. People mostly seem to use Uber and Lyft to get to places well-served by mass transport (see map). One study of the city by five Californian academics asked ride-hailing customers how they would have made their most recent trip if the service did not exist. One-third replied that they would have taken public transport. In a study of Boston, 42% said the same thing. Self-driving taxis are likely to steal even more riders in future, because they will be so cheap.

The article also points to other potential sources - economic weakness and e-commerce make less people venture out, changing work habits as more people work remotely as well as in co-working spaces near their homes, increased use of bicycles, the boom in office development around transit stations reduces last mile commutes, and cheaper driving costs due to fuel efficiency and cheaper fuels.

8. Finally, a good story in Indian Express narrating the challenges faced by India's cleanest railway station. Two things stand out. First, cleanliness comes with a significant fiscal cost. The station awarded its cleanliness contract in 2016 to a new contractor for a three year cost of Rs 8.7 Cr, a near doubling from the earlier Rs 4.8 Cr. This cost is fiscally unsustainable when replicated across the country.

Second, the increased cleaning and enforcement of fines appears not to have had much impact on the generation of waste itself or the habits of rail passengers. The real success will be to reduce the generation of waste and ensure more responsible disposal by those generating waste.

The Great Recession and World Economy in a graphic

Times has this graphic that captures the performance of the major world economies and their equity markets over the past five years.

The financial sector distortions in three graphics

In the aftermath of the sub-prime mortgage meltdown, there has been a fierce debate on the spectacular growth of the financial sector in recent decades and its attendant resource mis-allocation problems. Here are three excellent graphics that captures the essence of what has gone wrong.

Buoyed by a wave of financial market deregulation policies, the sector's share of the GDP of western economies have exploded since the mid-nineties.

This excessive returns are reflected in the steep increase in financial sector compensation since then. In particular, the ratio of executives compensation to the average worker's salary has rocketed.


















Financial sector wages have grown exponentially. As compensation returns rose, risk appetites too ballooned, thereby leaving a trail of incentive distortions everywhere.

The long post-war era of the Great Moderation suddenly gave way to the Great Excess!

The recovery from Great Recession

Most of the major developed economies are yet to recover from the depths of the Great Recession. In fact, as the graphic highlights, except Canada, Belgium, US and Germany, none of the rest have regained their pre-crisis GDP level.  

The fact that it is almost four-and-half years since the Great Recession struck makes this one of the longest periods of sustained economic weakness since the Great Depression. The labour market conditions mirror the GDP levels, thereby causing untold human suffering. With private sector in no position to lead growth, creditors still wary of lending, and household and business balance sheets debt-laden, government remains the only agent capable of kick-starting growth. But the fervour with which austerity is being promoted means that the only engine of growth is yet to be turned on full throttle.

Jaime Dimon and "regulatory capture"

Amidst all the discussion surrounding JP Morgan Chase's bet on corporate debt derivatives going terribly wrong, this from Eliot Spitzer, highlights the severe structural problems in Wall Street. The presence of JP Morgan Chairman Jamie Dimon - who lobbied aggressively to redefine the meaning of hedging under the Volcker Rule that was proposed to curb proprietary trading by deposit taking commercial institutions (banks) - on the board of the New York Federal Reserve should constitute as one of the most egregious and shameful examples of "regulatory capture",

Jamie Dimon sits on the board of the New York Federal Reserve Bank - the very organization that is supposed to oversee his bank’s financial practices, the organization that is supposed to issue all sorts of regulations that control what his bank can do, the very organization he has been lobbying to relax the rules about the bets he wants to make...

The Fed conflict is so obvious that it defies any possible rationalization or explanation. For a decade, the New York Fed has failed to pick up on any of the significant Wall Street threats:  excess leverage, subprime fraud, dangerous concentration in “too big to fail” entities.  Maybe the reason is that the board is controlled by the very voices that have been at the root of the failure. There has been not the slightest voice of protest from the board—yet it is a public organization!

By any yardstick of propriety, leave alone decency, Jamie Dimon and all others similarly placed should recuse themselves from the NY FRB Board. See this, this, this, this, this, and this about how JP Morgan's corporate debt derivatives bet went wrong. See also this on why the New York Fed is rife with conflicts of interest and incentive distortions.

Update 1 (7/7/2012)

The scandal that erupted in the aftermath of revealations that Barclays rigged its interest rate estimates used to calculate LIBOR once again spotlights attention at the rotten core of global banking. 

The London Interbank Offer Rate (LIBOR), which is a measure of the rate at which banks borrow money in the money markets, is released each day by the British Bankers’ Association (BBA), covering 10 currencies and 15 different maturities. The Libor rate is used to set rates for some $800 trillion in global financial transactions from derivatives to consumer lending. More than $10 trillion in loans to businesses and consumers have interest rates based on Libor, with the borrowers paying more or less depending on where Libor is on a particular day. Many derivative contracts are also based on it. The BBA collects the rates at which each bank says it could have borrowed money that day without putting up any security for the loan. The highest and lowest responses are thrown out, and the rest are averaged to produce a number. There is no need for any bank to show that it actually borrowed at the rate it claims.

Barclays rigged the LIBOR by manipulating its estimates to suit its interests. During the financial crisis, it low balled its estimate of borrowing rates so as to reassure everyone of its creditworthiness. At other times, when its trading positions called for lower rates, it lowballed its estimates even if it reduced the interest income received by the bank. The FT was scathing in its verdict,

The bankers involved have betrayed an important public trust – that of keeping an accurate public record of the key market rates that are used to value contracts worth trillions of dollars. They did this to make money and to conceal from the wider world their true cost of borrowing. This was market-rigging on a grand scale. It is hard to think of anything more damning – or more corrosive of the reputation of capitalism.

The always incisive Simon Johnson points to Dennis Kelleher of Better Markets, who has a devastating critique of the major banks that have been colluding to rig the LIBOR,

The Libor interest rate is based on a survey of banks like Barclays.  Those banks know what that the information they provide in that survey sets the Libor rate, which is then used to set the rate for those $800 trillion-plus transactions. What Barclays settled - and what the other banks are being investigated and sued for - is knowingly and intentionally providing false information that they knew would result in a false Libor rate being set. This is not some isolated sales practice or trading strategy. The allegations are of a massive conspiracy involving 20 or so of the biggest banks in the world manipulating one of the most important rates in the world. So this isn't about Libor - this is about Lie-More.

That seems to be the business model for the big global finance houses.  They like to call themselves "banks," but they aren't banks in any traditional sense. They are global behemoths that are not just too-big-to-fail, but also too-big-to-regulate and too-big-to-manage. Take JP Morgan Chase for example. It has a $2.35 trillion balance sheet, more than 270,000 employees worldwide, thousands of legal entities, 554 subsidiaries and, as proved by the recent trading losses in London, a CEO, CFO and management team that has no idea what is going on in their own bank.

Some lessons from the sub-prime crisis responses

There are very few counterfactuals in social sciences. The closest to such a counterfactual are the contrasting responses of US and Europe to resolving their respective financial market crises. Though in recent months, Europe has taken steps to emulate the US, the initial responses across both sides of the Atlantic bear a striking contrast.

In the US, at the first signs of the sub-prime crisis bursting, the Treasury and the Federal Reserve aggressively intervened to contain the damage. The Treasury came forward with its Troubled Assets Relief Program (TARP) to directly assist the beleaguered banks and other financial institutions with equity injections. The Federal Reserve expanded its balance sheet many times and initiated quantitative easing programs to emerge as the lender, insurer, and buyer of last resort for the financial markets.

However, across the Atlantic, driven both by lack of similar political resolve and strong ideological predilections, the Eurozone governments and the European Central Bank refrained from aggressive intervention. They let events take their own course in the hope that markets would soon resolve the issue. Credit markets froze, driving up sovereign debt yields and nearly shutting off the peripheral economies. Banks, saddled with massive sovereign debt exposures, stumbled to the brink. The ECB refused to lend either to the banks or the battered sovereigns. It stepped in finally only when the situation had worsened considerably.

The contrasting fortunes of both economies, atleast their respective financial sectors, is a clear verdict on the policy courses followed on both sides of the Atlantic. Europe stares at a potential Japan like financial dystopia, whereas American financial institutions have recovered smartly and are back to doing all those things that caused the sub-prime crisis! However, there are a few quick learnings from the situations across both sides,

1. The loudest message from the two different courses of action is that markets do not repair themselves and when faced with such deep financial market crises, governments and central banks have to step in with aggressive policies.This becomes all the more important as the complexity of our banking systems increase and the too-big-to-fail syndrome become entrenched.

2. Related to this is the central and disproportionate importance that financial markets have come to assume in determing the economic fortunes of a country. Despite the fact that the financial sector occupies a far less share of both the economy and the working population, its good health is critical to the fortunes of any modern economy.

3. Similar to the stark contrast between the US and European responses is the difference between the responses by the US Government and the Fed to the condition of over-leveraged financial institutions and debt-ridden individual households. The latter received nothing like the unlimited and cheap liquidity injections, debt rescheduling at very favorable terms, and sweeping credit guarantees offered to the financial institutions. Household foreclosures, even when it happened in a massive scale, became a source of concern only when it threatened to affect an exposed financial institution.

In other words, the disciplining elements of the free-markets are reserved for individual households and small business firms, while the financial sector behemoths, the much trumpeted success stories of deregulated free-market capitalism, face no such constraints. The negative externalities created by financial institutions do not get internalized.

4. All this highlights the increasingly sharp cleavage between the real economy and the financial markets. Are the gains of the financial markets, especially their outsized wins, coming at the expense of the real economy? Is there a recession or even a depression lurking at the end of a sustained period of financial market boom? The financial markets, especially in their current avatar, appear to have become too big a systemic risk to be left as it is.

The "mother of all bailouts" unmasked!

A Bloomberg investigation has revealed the stunning magnitude of the post-Lehman financial market bailout. Hitherto information about only the $700 bn Troubled Assets Relief Program (TARP) was made public and the details of the liquidity injection facilities were withheld on grounds that it would stigmatize borrowers and thereby destabilize market confidence. However, it now emerges that the Fed's liquidity infusion support dwarfs the TARP and should rightly assume the moniker of the "mother of all bailouts"!

As the crisis deepened, the Fed had to expand its traditional discount window to provide liquidity support to the frozen credit markets. By the end of 2008, the central bank had established or expanded 11 lending facilities catering to banks, securities firms and corporations that couldn’t get short-term loans from their usual sources. Such credit support involved reduced credit standards and collateral requirements.

The report finds,

Add up guarantees and lending limits (to direct lending), and the Fed had committed $7.77 trillion as of March 2009 to rescuing the financial system, more than half the value of everything produced in the US that year... The Fed didn’t tell anyone which banks were in trouble so deep they required a combined $1.2 trillion on Dec. 5, 2008, their single neediest day. Bankers didn’t mention that they took tens of billions of dollars in emergency loans at the same time they were assuring investors their firms were healthy.

While TARP credit had some strings attached, the liquidity injections came without any conditions attached and was a virtual doleout. And these banks, including foreign ones, profited by atleast $13 bn from the Fed's below market lending rates. It is no wonder that the Fed and the big banks fought for more than two years to keep details of the largest bailout in U.S. history a secret. The report writes that the witholding of this information helped the banks ward off pressures for greater regulatory oversight,

Saved by the bailout, bankers lobbied against government regulations, a job made easier by the Fed, which never disclosed the details of the rescue to lawmakers even as Congress doled out more money and debated new rules aimed at preventing the next collapse... While Fed officials say that almost all of the loans were repaid and there have been no losses, details suggest taxpayers paid a price beyond dollars as the secret funding helped preserve a broken status quo and enabled the biggest banks to grow even bigger.

The hypocrisy of concealing the fact of being under life-support while at the same time publicly claiming stability and strength is captured in the report,

"On Nov. 26, 2008, then-Bank of America (BAC) Corp. Chief Executive Officer Kenneth D. Lewis wrote to shareholders that he headed 'one of the strongest and most stable major banks in the world'. He didn’t say that his Charlotte, North Carolina-based firm owed the central bank $86 billion that day."

On Sept. 21, 2008, a week after Lehman went bankrupt, Goldman Sachs converted to a bank holding company, gaining access to the Federal Reserve's last-resort lending program for banks, the discount window. While it took only $50 million from the window, New York-based Goldman Sachs had been borrowing from the central bank for six months from two temporary programs for broker-dealers: the Term Securities Lending Facility and the single-tranche open market operations, or ST OMO. On Dec. 31, 2008, Goldman Sachs had $34.5 billion of loans from ST OMO, some of it at an interest rate of 0.01 percent. "We weren't relying on those mechanisms", Goldman CEO Lloyd Blankfein told the Financial Crisis Inquiry Commission in January 2010.



The exposures of the six biggest financial institutions were staggering. The six biggest US banks, received $160 billion of TARP funds and borrowed as much as $460 billion from the Fed (measured by peak daily debt), and accounted for 63% of the average daily debt to the Fed by all publicly traded US banks, money managers and investment-services firms.



See the interactive graphic here.

Is monetary accommodation becoming a dogma?

When history of the tumultous period of the Great Recession will be written, central bankers will be among its dominant characters. All along the crisis, across the world, monetary policy has been the predominant and preferred choice to fight both financial market instability and boost aggregate demand.

In a recent blog post, Brad DeLong echoed this view when he advocated further massive expansion of the Fed's balance sheet and committing to a target nominal GDP growth. He writes,

"The Federal Reserve might be able to spark a real economic recovery by... announcing that it is going to keep short-term Treasury interest rates low not just as long as the economy is depressed but even afterwards when the economy has recovered and when it would normally be raising interest rates: that it is going to keep short-term Treasury interest rates low until it generates an inflationary boom, and that you had better start building capacity now to serve your customers during that inflationary boom or your competitors will do so and take your profits...

If I were in the hot seat, I would follow the Jan Hatzius plan: (a) take the Fed's balance sheet up to $5T over the next two months, and (b) say that if that turned out not to be enough to get nominal GDP growth to a path that will return it to its pre-2007 trend within three years, that I would then keep interest rates low and take the Fed's balance sheet even higher until it did."

A similar debate is being played out across the Atlantic in Europe. With the Eurozone economies grappling an existential crisis, there have been calls for the ECB to emulate the Federal Reserve and indulge in aggressive monetary policy to stabilize financial markets. A leading advocate of such measures, Wolfgang Munchau wrote,

"The European Central Bank must agree a backstop of some kind, either an unlimited guarantee of a maximum bond spread, a backstop to the EFSF, in addition to dramatic measures to increase short-term liquidity for the banking sector. That would take care of the immediate bankruptcy threat."

More specifically, in addition to advocating a fiscal union, he favors unconventional quantitative easing and issuance of large enough joint-and-several liability eurozone bonds. On same lines, James Surowiecki has called for the ECB becoming the lender of last resort for the embattled European economies,

"If the European Central Bank were to commit publicly to backstopping Italian and Spanish debt, by buying as many of their bonds as needed, the worries about default would recede and interest rates would fall. This wouldn’t cure the weakness of the Italian economy or eliminate the hangover from the housing bubble in Spain, but it would avert a Lehman-style meltdown, buy time for economic reforms to work, and let these countries avoid the kind of over-the-top austerity measures that will worsen the debt crisis by killing any prospect of economic growth."

The suggestions of DeLong, Munchau, and Surowiecki are representative of policy prescriptions on both sides of the Atlantic calling for aggressive measures to restore economies to their pre-crisis normal. The monetary policy bias is very distinct.

As I have blogged earlier, advocates of such policies suggest them more out of desperation than from any strong conviction. There is a strong urge to throw everything and the kitchen sink at the intractable problem and hope that something will click. Brad DeLong himself writes,

"How well would it work? We don't know. Are they worth trying? I certainly think so..."

While all such accommodatory policies will surely contribute towards backstopping losses and stabilizing the markets, there are two important questions. One, given the circumstances, how effective will be such policies? Two, what are the costs - direct and secondary market distortions - associated with this?

A honest assessment of both these questions will raise disconcerting answers. The severity of the crisis, on both sides of the Atlantic, means that the magnitude of monetary accommodation - liquidity injections and indirect debt guarantees - required to meaningfully and sustainably stabilize the financial markets is beyond the abilities of most central banks and governments.

Further, the secondary market distortions that are certain to be set off by such sustained and extra-ordinarily large monetary accommodation will certainly challenge global financial market stability. It will perpetuate many of the bad practices that contributed towards the sub-prime era financial market excesses - regulatory arbitrage, TBTF, mis-pricing of risk etc. This monetary accommodation and flood of liquidity has the strong likelihood of generating another round of resource misallocation in the financial markets. It will also expose the emerging economies to the vagaries of massive cross-border capital flows, with all its attendant adverse consequences.

Much of the academic debate that feeds into policy making has been on exploring alternatives to get the economy back to its pre-crisis normality at any cost. This line of thinking glosses over questions about whether the old normal is itself desirable. There is a strong case that the quarter century of Great Moderation, with its low unemployment rate and inflation coupled with high growth rates, was the result of a fortunate confluence of favorable factors. The dynamics generated by China and the emerging economies, a big wave of trade and financial market liberalization, and dramatic productivity improvements generated by advances in information technology contributed to the Great Moderation.

The past 15 years, atleast since the late nineties, has been an era of unprecedented complementarities. The emerging economies saved to cheaply finance consumption and deficits in many parts of the developed world. Cheap exports of consumer durables and non-durables served to keep inflation low across the world. The consumption boom in developed economies also kept up the demand for commodities from many developing countries. It was over-optimistic to imagine that these forces would maintain their momentum forever.

In the process of this era of extraordinary stability and growth, several distortions and imbalances had become institutionalized into the world economy. The monetary-pump-prime-your-way-out of recession fails to acknowledge that the efforts to restore normalcy would serve to perpetuate many of the same distortionary trends and policies that fuelled the crisis. For example, there is enough evidence that the ultra-low rates have benefitted the remaining big financial institutions, who have used the opportunity to grow even bigger and pose even greater systemic risks.

Apart from resolving the extant problem, every crisis is also an important opportunity to wring out the excesses of the bygone era that was in the first place responsible for the crisis. In this case, the later can be done both by letting those responsible pay for their recklessness and greed (after all this is the primary incentive formation and disciplining mechanism of capitalism) and by refining regulatory policies to pre-empt such future failures. Unfortunately, influential opinion makers across the world have been focussed more on exploring options to get the economy back to its pre-crisis normal instead of doing the hard problem solving to get things back to a more efficient and desirable "new normal".

Update 1 (3/12/2011)

In a move to ease Eurozone's debt squeeze, the Federal Reserve, ECB, BoE, BoJ, SNB, and Bank of Canada announced that they would reduce by about half the cost of a program under which banks in foreign countries could borrow dollars from their own central banks, which in turn get those dollars from the Fed. The banks also said that loans would be available until February 2013, extending a previous deadline of August 2012. This move effectively makes the Fed emerge as the global lender of last resort, lending dollars to foreign central banks so as to ease credit markets there. The move is intended to free up liquidity and ensure that European banks have funds during the sovereign debt crisis and keep borrowing costs down for consumers and firms.

These are loans between central banks rather than loans to individual foreign banks, there is very little risk to US taxpayers. However, in the face of ECB's reluctance to buy debt of the most beleaguered Eurozone economies and work as the risk absorber of last resort, this is the closest that the Fed can get to effectively doing ECB's job and purchasing foreign government debt itself.

The Great Macroeconomic Policy Debate - How to restore growth?

The biggest macroeconomic challenge now is to manage a recovery from the stubbornly persistent economic slowdown. But a fierce ideological battle is on about what strategy is required to achieve economic recovery.

Everyone agrees that across both US and large parts of Europe, household, bank, and government balance sheets are suffering from huge debt over-hang. As households cut back on consumption and banks refuse to lend, businesses are postponing investments. The high unemployment rates show no signs of coming down and the economies remain stuck at the trough, far longer than the aftermath of previous recessions. Governments, the only other agency capable of engineering a turn-around, are faced with huge sovereign debts and battered fiscal positions. With interest rates at zero bound and even extraordinary quantitative easing measures already having been tried out, monetary policy appears to have limited traction. So what is the way out?

Conservatives are unambiguous in their advocacy of fiscal austerity and placing deficit reduction at the center of the macroeconomic agenda. They fear about the dangers of inflation taking hold and bond-market yields rising. They claim that the fiscal and monetary expansion of the last decade or so has produced several excesses that need to be wrung out before any meaningful economic recovery can begin. To this extent they advocate immediate re-balancing of public finances with policies to cut government expenditures, raise revenues (albeit without raising taxes), and carry out structural reforms.

They admit that while this will generate some short-term pain, it will be for the long-term good. They argue that this will generate "contractionary expansion", restoring market (business, investor, and consumer) confidence and shaping expectations and thereby encouraging business investments. See Robert Barro (academician), Stephen King (Business), and Wolfgang Schauble (politicians) advocating austerity and fiscal consolidation over expansion.

Liberals differ and propose further fiscal and monetary expansion as the only way out of this mess. The argue that the high persistent unemployment rates should be the central focus of policy makers. They point to historical evidence from US in 1930s and recently from Japan, to argue that unless governments undertake aggressive Keynesian stimulus spending and unconventional monetary expansion, the economy risks being stuck at the bottom for a long time.

They also point to the evident inability and reluctance of businesses to invest in such uncertain and weak environments, especially that of the job-creating but credit constrained small businesses. They see government spending as the only source of generating additional aggregate demand. They also argue that the ultra-low interest rates provide an excellent opportunity for governments to invest in infrastructure and other long-term spending so that the platform for longer-term growth is laid at the cheapest cost. They see little evidence of government spending crowding out private borrowing, inflation emerging as a concern anytime soon, or bond-markets catching cold. See Martin Wolf (Journalist), Mark Zandi (Business), Adam Posen (policy maker) and Dani Rodrik (academician) advocating expansionary policies.

There are also some others who have refrained from taking an explicit position, preferring to suggest specific measures. Some like Ken Rogoff have rightly argued in favor of policies that directly address the issue of cleaning up household and bank balance sheets. To this extent they advocate inflating away debts with a slightly higher inflation target, something which Olivier Blanchard, the IMF Chief Economist too had advocated earlier. However, the efficacy of higher inflation targeting has been questioned on credible enough grounds by Raghuram Rajan.

Interestingly, both sides invoke the magisterial historical examination of sovereign debt crisis, induced by various factors including banking collapses, by Carmen Reinhart and Kenneth Rogoff. Conservatives point to their finding that high-levels of growth dampen growth. Liberals point to their findings about the deep nature of recessions that follow banking collapses and argue that government support therefore is essential for expediting recovery.

All these views carry considerable ideological baggage and are evidently constrained by the need to accommodate their respective ideological predilections. Warts and all, the main issue is about which mixture of policies would be most effective in enabling a sustained recovery. An objective assessment reveals inconsistencies or practical difficulties with both sides.

The problem with the conservatives' position is that if all the actors - governments, businesses, financial institutions, and households - are badly constrained, then where would the thrust for recovery come from? Their argument is that debt restructuring and the dynamics that get generated could restore market confidence and thereby pull the economy up the recovery path. But, given the depth of the problems, will it carry the momentum required to pull the economy out? Even traditionally conservative institutions like the IMF have raised serious doubts about fiscal austerity arguing that it could hurt incomes and job prospects. Further, the experience in the current recession with such policies is hardly encouraging.

As several estimates of growth required to bring unemployment in the US to normal levels and also bridge the yawning output gap show, the scale - magnitude and time - of growth required to restore normalcy in the medium term is substantial. In the absence of a strong engine or anchor, what will be the source of this growth? The justifiable fear then is that the recovery process could go on for years.

The fundamental premise of the liberals' argument is that it is necessary to do everything possible to pull the economy out of recession. They fear, based on historical precedent, that in the absence of aggressive expansion, the unemployment problem will assume structural nature and become a socio-economic problem, and a lost decade will be inevitable. I am inclined to believe that this fear too has strong justifications. However, some of the liberals policy measures are not fully supported by fact and appear to based more on hope than objective considerations.

Their hope is that aggressive fiscal and monetary actions will buy enough time for the markets to repair battered balance sheets of all parties and set the stage for a sustainable recovery. But what if it does not? The trillions of dollars so far spent on fiscal and monetary stimulus in the US had not had the expected impact (there could be a counterfactual problem here). What is the certainty that more rounds of stimulus will work? More critically, it is possible that the amount of stimulus required to make any meaningful dent is so large as to make it fiscally and politically impossible. In the circumstances, expansionary policies would be merely throwing money down the drain.

So, if the fears of inaction appear well-justified, and the possible policy alternatives are fraught with deep uncertainty, then are the developed economies set to suffer a long and tortuous period of restructuring, high unemployment and low growth? Is this the inevitable cost of the excesses that got built-up over the past decade or so? Is it desirable to have a medium-term period of de-leveraging that is necessary to wring out the excesses and distortions, rebalance balance sheets, and achieve normalcy? In the meantime, is it appropriate if public policy refrains from anything proactive (either expansionary stimulus or austerity) and confines itself to the provision of a basic minimum social safety to those worst affected by the economic weakness?

Unfortunately this approach too appears untenable. It presupposes a longer period of high unemployment rates and economic weakness. However, there are widespread concerns about its long-term impact on the labour force itself. Longer the people stay unemployed, greater the difficulty to rejoin the workforce. Skills will atrophy and productivity will decline. The socio-economic impact of this will be pernicious. The long-term impact on America's labour force and the economy in general will be damaging. See also this excellent study by Alan Krueger and Andreas Mueller.

Then there is also the danger of Japan. That country ahs been stuck in the trough for nearly two decades now and no end appears in sight. Though there are considerable dis-similarities, there are exists striking similarities - similar asset crashes, huge public debts, aging work-force, and possibly a nominal zero-interest liquidity trap. The magnitude of the downside associated with these risks are so huge that not doing anything proactive appears unwise.

In view of all the aforementioned, and given the extremity risks, inactivity may not be desirable. But there is no clarity on which strategy is most effective in stimulating a recovery. In the circumstances, the only alternative may be to throw everything at the problem and hope that some mixture of policies does enough to put the economy in the recovery path.