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Thursday, December 9, 2010
In his April 2009 article for Vanity Fair (no longer fully available), Michael Lewis told the story about how Iceland's banking system basically imploded during the financial crisis. One of my favourite stories from the article is the one he tells about the fate of the country's many Land Rovers.
Presumably because they are a great tool for hauling fish across the Icelandic tundra, Land Rovers were a popular item for the small island nation. They were even more popular as the result of the availability of cheap financing during the pre-crisis boom in credit. The problem was, this cheap financing was provided in foreign currency; the interest rate for euros, pounds and dollars was far lower than that for the domestic currency, the krona. This is all fine and good if your salary is paid in euros, pounds and dollars, but in fact most people in Iceland are paid in krona.
When Iceland's economy went down the crapper, the value of the krona went with it. Since the value of their income had just plunged relative to the value of their debts, many civilized citizens of Iceland were forced to make one of two choices:
- Attempt to pay back their car loans in salted cod
- Do something crazy
"Icelandic Bank: Dear Mr. Ragnar Hjalrnarsson, the monthly payments on your Land Rover are 3 months overdue."
Mr. Hjalrnarsson: *panting furiously, having just run for cover*
"Iclelandic Bank: Mr. Hjalrnarsson?"
*KABOOOM*
"Mr. Hjalrnarsson: Land Rover? What is this Land Rover of which you speak?"
FIN
The fine folks in Iceland had resorted to blowing up their Land Rovers to avoid paying them back. Seriously. This is a country that, in 2008, still had a GDP-per-capita of over $52,000.
Why am I re-telling this story? Because the exploding Land Rover is a great metaphor for a currency mismatch: the situation wherein debts are denominated in a different currency than the income used to pay down those debts. Currency mismatches can exist not just for individuals, but for entire economies at the macro level. But since economies can't go around blowing up Land Rovers whenever it comes time to rollover their debts, the consequences can be quite severe.
The currency mismatch is not a problem specific to our most recent financial crisis, however; here is economist Morris Goldstein, speaking in 2007:
".... [S]erious currency mismatch has been a feature of every major emerging-market currency crisis of the past dozen years. It was there in Mexico in 1994–95, in the Asian crisis countries in 1997–98, in Russia in 1998, in Brazil in 1998–99 and 2001–02, in Turkey in 2001–02, and in Argentina in 2001–02.... [C]urrency mismatch provides the best explanation we have for why large exchange rate depreciations in emerging economies have had such costly growth effects. When financial liabilities are mostly denominated in dollars or in other reserve currencies while assets and revenues are mainly denominated in local currency, then a large depreciation of the local currency will result in balance sheet problems that ultimately cause economic growth to nosedive."
Here is Brad DeLong:
"The decade of the 1990s was marked by the sudden emergence of international financial crises. In a typical such crisis, a sudden loss of confidence in the value of a country’s currency by international currency speculators was followed by a rapid rise in the value of foreign currency—in the exchange rate—the threat of large-scale bankruptcies of banks and firms, financial panic, and a sharp severe recession. These crises hit in the Mexican peso crisis of 1994-1995. Then followed the far-reaching East Asian crisis of 1997-1998. The decade ended with crises in Brazil, Turkey, and Argentina."
The currency mismatch is not merely a modern creature - oh no. In the period of unfettered capitalism that characterized the late 19th and early 20th centuries, "hot money" was flowing into what we would now call emerging markets: Southeast Asia and South America. There were quite a few financial blow-ups involving currency and maturity mismatches - the Barings crisis of 1890 being the most famous.
In other words, we need to recognize that the risk of a currency mismatch contributing a major financial meltdown is present in just about every period in which we see capital flowing easily across borders. This leads me to ask one simple, juvenile, question:
Why why why why WHY?
With all this history, why hasn't anyone learned their bloody lesson? Why do we continue to see, to this very day, the potential for instability caused by currency mismatches present - and growing - in a variety of markets. I can think of several factors that play a role:
1) Access - pretty straightforward: you need easy access to international capital markets. This has been easier during certain periods of time (pre-1914, the Great Moderation of the 1990s-2000s, etc) and in certain regions (for instance, small EU members have direct access to foreign lending from other EU members due to the membership requirement for open capital accounts).
2) Import requirements - it is unlikely that many exporters or banks will accept the Papua New Guinea kina in an exchange for the sale of goods & services, for instance. Small economies with non-reserve currencies need to use foreign currencies to purchase the things they need, or borrow the funds they need. This can lead to debts in those same foreign currencies.
3) Lack of trust in the local currency - often domestic borrowers will seek outside financing if the local currency has a history of high inflation, political meddling, or exchange rate volatility.
4) weak domestic capital markets - sometimes domestic borrowers simply cannot raise money domestically. There are any number of elements to this, including: restrictive local banking regulations, lack of expertise, or lack of appetite (see #3).
5) Behavioural/psychological element - it is hard to resist cheap money. Look at the subprime real estate crisis in the United States and you can see how difficult it is for people to resist borrowing irresponsibly (often from irresponsible lenders). The people in Iceland basically did the same thing, and got burned when interest rate on the loans shot up. People tend to overestimate their ability to predict future events.
6) ...what have I missed?
One argument I'm not buying is lack of awareness. As illustrated above, the challenge of currency and maturity mismatches is not new. Policymakers know and appreciate the dangers associated with a country (or many of its citizens) borrowing in foreign currency, particularly for the short-term. But sometimes the problem is an inability to stop hot money inflows & outflows - see the point about access above - and the costs associated with markets who are perceived to have overly-restrictive measures in place for investments.
Why am I bothering with all of this? It is because, even though the crises I've mentioned above are mostly old news, the challenge posed by hot money inflows is as topical as ever. This is part due to the expansionary monetary policies adopted by the United States and other large developed economies to stimulate recovery. I discussed this back in April with this atrociously-titled post, but if anything the trend has become more pronounced in the period since then.
The recent IMF global markets monitor suggests that capital inflows to emerging markets continues to surge, led primarily by portfolio flows to liquid debt and equity markets. In many parts of the world (including parts of Latin America and Asia), the levels of inflows are reaching pre-Lehman levels. It is important to emphasize that this is not foreign direct investment (i.e. the money isn't there for the long-haul).
India is seeing heavy capital market inflows, again mostly in equities and mostly portfolio inflows. China is also trying to keep a lid on domestic credit growth and just recently capped the amount of lending by domestic banks.
In fact, many emerging markets are toying with capital controls as a way to limit volatility. Brazil has done so, and there is speculation (so far un-founded) that Malaysia will follow suit. Brazil was even somewhat successful in getting pro-capital control language in the G20 communique from Korea ("practical tools to overcome sudden reversals of flows," anyone?). The large exporters will also continue to keep large foreign exchange reserves as a buffer - a policy that turned out to be rather justified in recent years, despite the distorting effects it has on global imbalances and the huge opportunity cost.
All of this suggests that the dangers associated with currency mismatches and rapid capital inflows have not gone away. Quite the opposite. Large inflows may be justified in the current environment of strong emerging market performance, but our ability peer into the future is limited. We do not know what is coming next.
We do not know who will be blowing up their Land Rovers next.
Saturday, November 13, 2010
Tuesday, August 31, 2010
PIMCO's Mohamed El-Erian asks the same question, but does a much better job than I in providing a comprehensive look at the global economy. I really like this piece because it takes a step back from the to-and-fro of daily market reporting and punditry - what you have instead is a healthy dose of perspective:
"In sum, the current policy approaches here and abroad are unlikely to deliver a durable and robust U.S. recovery and, critically, create sufficient growth in jobs. Yet the main debate in Washington is whether to do more of the same -- namely, another fiscal stimulus and another round of quantitative easing by the Federal Reserve. This clearly conflicts with evidence that a broader and more holistic response is needed....Is there anything else?
What is critical to keep in mind is that this situation is part of a broad, multiyear process driven by national and global realignments. It's a secular phenomenon that needs to be better understood and navigated -- by recognizing its structural dimensions and by urgently broadening the excessively cyclical policy mindsets that abound. Unfortunately, the approach in too many industrial countries has been to kick the can down the road, seemingly hoping for a series of immaculate economic recoveries.
Policymakers must break this active inertia by implementing a structural vision to accompany their current cyclical focus. Measures are needed to address key issues, which include the change in drivers of growth and employment creation; the high risk of skill erosion and lost labor productivity; financial deleveraging in the private sector; debt overhangs; the uncertain regulatory environment; and the unacceptably high risks facing the most vulnerable segments of society.
"An already polarized political environment is becoming even more fractured by real and far less substantive issues. There is virtually no political center that can anchor consensus and enable sustained implementation of policy. Meanwhile, as anti-Washington sentiments rise, interest in a national agenda is increasingly giving way to the election cycle. Internationally, the impressive degree of cross-border coordination seen during the global financial crisis has been reduced to inconsistent -- and at times contradictory -- national responses.
This worrisome trio of increasingly ineffective national and global policy stances, intense political polarization and growing social pressures speaks to the risk that the economy's recent soft patch will evolve into something even more troublesome and sinister."
Monday, May 24, 2010
Commentary abounds on both of these projects, but I would merely point to two articles: the first by Clive Crook on the US Senate bill; the second by Howard Davies and David Green (both formerly of the Financial Services Authority) on the situation in the UK.
To set the stage, Davies and Green make a truly important point:
"Any objective assessment of regulatory structures around the world during the crisis would find little or no relationship between structure and success."
"But we can draw three lessons from the crisis. First, the central bank needs good information about the financial system as a whole. Second, there is an argument for a second tool for the central bank to influence credit conditions. And third, the case for integrated regulation has been strengthened."
But under what structure? Davies and Green think that both should be under the roof of the central bank. Another possibility is the one proposed in the US Senate finance bill: create a financial stability oversight council. The council would consist of the most senior representatives from a whole range of government departments and agencies, including Treasury, the Fed, FDIC, the SEC, the new consumer protection agency, and the Federal Housing Finance Agency. In theory, interest rate decisions could be discussed alongside a whole range of financial policy considerations: fiscal policy, mortgage regulations, competition concerns, you name it. Get all the key players in the same room, the thinking goes, and problems can be identified and solved in a more coordinated manner.
Clive Crook dismisses this council idea as a weak solution. To be sure, it has not done anything to simplify the messy spiderweb that is financial regulation in the United States. On the other hand, a similar committee exists in Canada, a country widely praised of late for having weathered the financial storm quite nicely - maybe it could work in the US as well?
This is where we return to the opening statement from Davies and Green: there is no link between structure and success. Regulatory structure can be, at best, a facilitator; at worst, a barrier. I suspect that this council will only be as effective as its members allow it to be. An ineffective council would merely result in the status quo. Anything beyond the status quo is progress. Viewed that way, there is a lot of scope for this council to demonstrate its value in heading off future financial crises.
Nevertheless, I am increasingly of the view that who is sitting around the table matters more than the shape of the table*, so to speak. People matter. Regulatory culture matters. And that, unfortunately, is not something which can be legislated.
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*It could very well be that I'm being heavily influenced by the book I am currently reading, Liaquat Ahamed's excellent Lords of Finance, which tells the story of the world's four most influential central bankers in the run-up to the Great Depression.
Friday, May 21, 2010
While I continue to work on a (slightly) more detailed post about the recent US Senate bill on finance reform, I wanted to share this quote, via James Kwak. It's from Steve Waldman at Interfluidity and it gives some sense of the challenges faced by those who wish to prevent a repeat of our latest banking meltdown:"Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much ‘capital’ we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely ‘true’ model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank. There is a broad, multidimensional ‘space’ of defensible models by which capital might be computed. When we ‘measure’ capital, we select a model and then compute. If we were to randomly select among potential models (even weighted by regulatory acceptability, so that a compliant model is much more likely than an iffy one), we would generate a probability distribution of capital values. That distribution would be very broad, so that for large, complex banks negative values would be moderately probable, as would the highly positive values that actually get reported. . . . Given the heterogeneity of real-world arrangements, no ‘one-size-fits-all’ model can be legislated or regulated to ensure a consistent capital measure. We cannot have both free-form, ‘innovative’ banks and meaningful measures of regulatory capital."
Now, try explaining that to the general public. It's no wonder that people have attached themselves to a bank tax - it's simple. The reality, however, is not.
Monday, May 10, 2010
1. Last Thursday, when the crisis of confidence in European sovereign debt led to a sharp dip in the markets, many emerging market economies suffered as investors fled to safety (USD, YEN). This was particularly the case in Central and Eastern Europe and East Asian economies (ex-Japan). Today, the announcement of a super-massive Euro-bailout led markets in emerging economies to rebound strongly, particularly in risky asset classes. None of this is suprising. But it does drive home the point that Greece's problems are not merely a danger to Europe, but to much of the world economy. This is particularly the case for emerging markets that are heavily-reliant on foreign financing to sustain their growth.
2. It will be interesting to see if they will act upon this realization and use Greece as leverage to push for reforms at the IMF and World Bank that would give them more say in future bail-out decisions.
3. Nassim Taleb must be giddy with glee.
4. I agree with Tyler Cowen's assessment that "[t]he major European powers would not have come up with a nearly $1 trillion bailout, also involving de facto loss of ECB independence, unless they were scared ****less."
5. In the 1920s, the expert opinion of central bankers, Treasury officials, leading newspapers and many in the financial sector was that the world must return to the gold standard. Yes, there would be painful austerity and increased unemployment, but it was inconceivable that the global economy could function without the link to gold. They were wrong: clinging to gold did more harm than good.
Now we hear from many euro-politicians and eurocrats that "It is inconceivable that Greece leaves the euro." The consequences would indeed be dire. But I fear the option is dismissed out of hand because of some mental block that prevents people from even considering the possibility. This phenomenon could be termed "euro-fetters" or the "euro-mentalité" (with apologies to Barry Eichengreen). Let's be clear: a country leaving the euro is still an option, and for Greece it may even be a desirable one.
Monday, April 26, 2010
- Buttonwood: The debate over financial reform in the US is taking place in an ideological fog: "Anyway, it wouild [sic] be nice if the tenor of the discussion dealt with [the] difficult issues. Instead, of course, the Democrats will accuse the Republicans of being in the banks' pockets and the Republicans will accuse the Democrats of being socialists." As opposed to the debate over health care, which was civilized.
- Hot money into China is being sterilized, but at the expense of the very imbalances that set the stage for the financial crisis.
- Can greater domestic consumption in China save the world? Nope.
- The backroom soap opera that is life among the German wikipedians (via The Browser)
- Do people work less in the US when the World Cup is going on?
Monday, April 19, 2010
This post was meant to have been written a couple of months ago, as a follow-up to this piece, but as I am easily distracted – especially by shiny objects – the draft was set aside and ultimately forgotten. Forgotten, that is, until the IMF went ahead and published their take on the matter. Since the IMF report is an Official Publication and contains things called “Granger causality tests,” and other such statistical chicanery, I will leverage from it quite heavily:
The issue at hand is the increase in capital flows from rich countries to “receiving” economies, and how that will affect the latter. Starting in 2003, but really expanding from 2007-present, the Liquidity-Time Explosion (that’s my term, not the IMF’s) resulted in large outflows of capital from the G4 (US, UK, then later Japan and the Euro-area). This was the result of interest rates in those economies hitting rock bottom, or close to it. Cheap money in the G4 (if one can get any) is logically channelled from the low-interest rate environment to economies that have higher rates of return.
The receiving economies are mainly emerging markets in Asia, emerging Europe, Latin America, the Middle East and Africa. To be clear, capital inflows can be a very good thing for these countries as it helps fund domestic investment and long-term growth. It especially makes sense for capital to be flowing to countries that have rosy growth prospects, which is the case for many emerging markets.
However, the IMF looks at the rapid rate of asset price growth in some emerging markets recently and asks the following, crucial question: “Are capital flows into receiving economies primarily driven by the countries’ strong economic fundamentals and, therefore, likely to remain stable over the medium to long term, or are they primarily driven by the abundant global liquidity?”
Looking at the data, the IMF concludes that, yes, global liquidity is playing a significant role. But the effect is not uniform: the type of exchange rate regime in the receiving economy plays an important role in determining how it is affected: “… the higher the flexibility of the exchange rate, the lower the spillover of global liquidity and the more the cushioning impact of domestic asset returns.”
So countries with fixed exchange rates should expect to have seen a significant impact on domestic asset valuations. And wouldn’t you know it! Just last week, fixed-exchange-rate China announced almost 12% growth in their economy last year and almost 12% growth in their housing market last month alone. That’s not to say that China doesn’t have huge growth potential, but you’ve really got to wonder.
So what are the implications of this Liquidity-Time Explosion, anyway? As the IMF paper explains, benefits aside, surges in capital flows can lead to large swings in the exchange rate (which can be de-stabilizing), or it can lead to a boom in domestic credit creation, possibly resulting in inflation, asset bubbles, and a general overheating of the economy.
Indeed, historically speaking, financial crises in emerging markets are usually preceded by a surge in capital inflows from abroad - often linked to factors identified in the previous paragraph. The recent work by Reinhart and Rogoff provided further evidence for that trend. The capital inflows are particularly de-stabilizing if they are short-term debt and denominated in a foreign currency.
Aware of all of this, the IMF paper explores the various policy options available for receiving countries, including an in-depth look at capital controls. Explore that if you wish. In macro-terms, I think it’s important to recognize that this situation exists and that it is a source of vulnerability. Remember that the capital is flowing out of the G4 due to low interest rates – if those rates go up, the capital inflows to emerging markets could slow down or even reverse. It is here that policy coordination in bodies like the G20 will prove to be crucial.
But even policy coordination cannot insure against the fact that Shit Happens – there are outlying events, black swans, fat tails of all kinds that can rapidly change the situation in any given economy. We have seen two examples of that recently with Iceland’s volcano and the tragic plane crash in Poland. This uncertainty about the future means that economies on the receiving end need to insulate themselves from potential shocks, while sending countries need to be aware of the knock-on effects of their policies. What seems clear, however, is that the status quo has potential for disaster.
Monday, August 17, 2009
The idea of creating a Gleco (global economic council) is presented by Timothy Adams and Arrigo Sadun in this morning's FT. That's right: a Gleco.
Adding layers to an already convoluted system seems like a strange approach to addressing global financial stability. I get that their aim is to provide an overall direction to things, to guide the various international organizations towards a coherent objective. But that's not likely going to play out in practice. Every organization that this Gleco oversees would have to have a seat at the table, in addition to the reps from nation-states.
And even if this Gleco is chaired by the G20, in ten or fifteen years a series of Unforeseen Events will likely result in membership that no longer represents the true balance of power - precisely the same argument they level against the IMF.
The fact is, for this financial crisis at least, it was the policies and not the institutions which caused the problems. And its hard enough to get the key players to agree on what exactly were the problematic policies in the first place, never mind what to do about them. A Gleco will not fix this.
Take the FSB (no, not that FSB, the Financial Stability Board - the closest thing to an existing global economic council). With two dozen member states and another dozen reps from international bodies, I suspect that the participants of the FSB find that it's plenty difficult to reach agreement as is, thank you, and you can take your Gleco idea and stuff it away somewhere for later.
I think that's probably the way to go. Proposals of this sort make for interesting op-ed material, but in practical terms its more helpful to focus on improving our existing institutions. A Gleco is at best a colourful distraction.
Monday, May 11, 2009
Awesome blogs by "really smart people" (pointer from Free Exchange)
The Buy-American mentality in action: a Belgian-owned, Canadian-made pipe is ripped out of the ground and replaced by an identical one that was made in the U.S. of A. Serves 'em right for making bilingual pipes, anyway.
The podcast of a CFR round-table entitled "The Financial Crisis and Global Financial and Monetary Cooperation"
Boeing's arial drones are now available for rent.
Taking stock at Arsenal
Tuesday, March 31, 2009
Determined to avoid yet another G20 yawn-fest, the French are now threatening a walkout. Their finance minister has indicated that she will not sign the final communiqué should their demands for "deliverables" not be met (re: a global financial regulator, conceived and implemented by the end of the week).
Spicy stuff. I'm not familiar enough with international diplomacy to answer this with confidence, but is France operating on such a different plane that it can threaten not to sign the G20 document, sign the document four days later, and suffer no significant reprecussions? Because if not, it's not clear to me what this publicity stunt will achieve. If the leaders summit was going to agree to set up a global regulator, the G20 finance deputies and their sherpas would have already have laid the groundwork for one. The leaked draft communiqué shows no signs of any truly "global" regulator, only a more integrated collection of national ones.
So if the French aren't likely to get what they want by Friday, what do they stand to gain?
Thursday, March 12, 2009
The FT has a terrific interactive graphic outlining the priorities of each country at the April 2 G20 meeting in London. Build your own issue-linkages boys and girls!
Tuesday, January 20, 2009
There's nothing like a crisis to concentrate the mind. On January 15th, a collection of influential academics and financiers - known as the G30 - released a set of eighteen recommendations for reforming the international financial system. You can browse the summary or read about them here and here.
There a couple of things that need to be said. First, unlike the other G-units you hear about in the news, the G30 is a private group that does not represent official policy. Yet. (There are a large number of members, including Geitner and Volcker, that will be directly involved in shaping policy over the next several years).
Second, the group is, with one exception, entirely male.
Third, this old boys club may very well forshadow what's to come when the other old boys clubs, the G7 and G20, meet over the next year or two. Since the early 1990s the financial architecture exercise has lurched from one crisis to the next, with each set of proposals attempting to address the causes of the previous financial meltdown. (One of the emeritus members of the G30, Peter Kenen, likened the participants to generals preparing to fight the last war). In any event, the last big set of changes occurred in the wake of the Asian financial crisis in 1997/8 and left us with the G20, the Financial Stability Forum and a collection of "best practices" standards for insurance, accounting and securities, among other things.
Since then, however, the whole movement has largely been on hold. This is difficult to avoid given that, once the last crisis fades from memory, our political leaders get distracted by other issues. Besides, the economy recovered nicely from the mild recession in 2001 and things were looking up! Well, no more. The report from the G30 signals to me that the financial architecture exercise has received a new jolt of life. I'll have more on the actual content of the recommendations a little later. For now, it's enough to note that the renewed debate over the health of the financial architecture is long overdue and, in my view at least, a very welcome prospect.
Sunday, November 16, 2008
As most well-informed observers were stressing all week, yesterday's G20 meeting in Washington was not going to lead to new financial architecture for the glo
bal economic system. "Bretton Woods, the Sequel," this ain't. For one, it was not taking place in the New Hampshire hotel after which the original conference was named (see photo). For two, this meeting was not complemented by several years of preparatory groundwork or by unilateral American leadership coming on the heels of a paradigm-shifting depression and world war. So maybe Mr. Brown and Mr. Sarkozy were getting ahead of themselves with all of their blustery rhetoric.
Now, as is expected for these types of events, the G20 meeting produced a declaration (available here) that contained a fair bit of vague language on what the world leaders are going to do to a) address the current crisis and b) fortify the financial architecture to prevent a repeat performance. But the meeting did produce one, large, significant shift in the way our global economy will be governed in the near future: the G20 appears to have taken over from the outdated G7/G8. On this point, the punditry appears to be unanimous. This is important because the G20 includes powerful emerging economies like Brazil, China, India, Indonesia and Turkey.
This shift is long overdue, but will necessarily make international negotiations that much more difficult. As I alluded to above, the successful completion of the original B.Woods in 1944 was in large part due to the ability of the United States to push its agenda forward unilaterally. Had the Brits not been so crippled by the war, they surely would not have ratified the agreement. It should be clear that, 60 years on, there remain important philosophical differences between the Americans and Europeans on financial governance. Insert China and India into the mix and things become more complicated. But global financial governance is complicated and excluding these countries is a non-starter.
The agenda for the G20 membership from now until the next meeting in April 2009 is to make progress on a number of fronts. Highlights:
- Reform of the World Bank and International Monetary Fund to be more representative of the distribution of economic power (not new).
- Expand the membership of the Financial Stability Forum to include G20 members (relatively new). The FSF is a body that combines governments and international regulatory agencies to establish "best practices" in everything from accounting to insurance.
- Members have agreed to undergo a financial checkup by the IMF and increase funding for IMF lending programs to crisis-stricken countries (that's right, the IMF is relevant again).
- Various other sensible, but hardly revolutionary, promises to beef up financial supervision.
- And finally, a promise to deal with the fact that the Doha round of trade negotiations is dead. It has ceased to be. Bereft of life, it rests in peace. It's bleeding demised. It has rung down the curtain and joined the choir invisible...
