The GATT (aka the WTO) works

There has been a dispute in the academic literature about the impact of the GATT on trade liberalization. The first shot was a set of papers by Andrew Rose. [1]. His papers have since been savaged by follow-up literature. [2]

The ongoing financial crisis has rendered this literature, quite literally, academic. What I mean is that, basically, the real test is what has just (not) happened. As Doug Irwin noted in his review of the GATT and its transition to the WTO, the first part of the 20th Century -- World War I and the early years of the Great Depression -- were characterized by savagely competitive tariff wars. [3] The framers of the Bretton Woods system had this firmly in mind when they set up the post-War system. [4] We may wonder at times exactly what the IMF and World Bank are doing at the moment. We no longer have to wonder about the GATT (aka the WTO). It is a systemic safeguard, and it seems to be working. Notice the deafening sounds of silence along Smoot-Hawley lines. Indeed, we have calls for further trade liberalization in the WTO. Recent events may also shed a new light on regionalism. In the academic literature, regional agreements have been seen as potential stumbling blocks to the multilateral system. Yet, as safeguards against protectionism in a big global crisis, the EU and NAFTA appear to be complementary safeguards. We have been focused, in much of the literature on the GATT and on regional trade negotiations, on the process of marginal concessions and terms-of-trade manipulation. Aside from all this academic analysis, in the real world the multilateral trading system is doing what it was actually meant to. There will be rising protectionist responses as we sink further into recession. However, as long as the system holds, this will not be broad based.

[1] A.K. Rose (2003), "Do WTO members have more liberal trade policy?" Journal of International Economics Volume 63, Issue 2, July 2004, Pages 209-235.

[2] A. Subramaniana and S-J Wei, "The WTO promotes trade, strongly but unevenly," Journal of International Economics, Volume 72, Issue 1, May 2007, Pages 151-175.

[3] D. Irwin (1995), "The GATT in Historical Perspective," The American Economic Review, Vol. 85, No. 2, pp. 323-328.

[4] J. Toye and R. Toye (2005), "From Multilateralism to Modernisation," Forum for Development Studies, No. 1, pp. 127-150.

[5] K. Bagwell and R. Staiger (1999), "An Economic Theory of the GATT," The American Economic Review, Vol. 89, No. 1, pp. 215-248.

Watch the Dollar

The dollar has appreciated strongly on world markets since the October Crisis began -- around 15% on the Canadian dollar, the euro, and the British pound. The banter on the financial talking head shows is that this reflects a flight to quality. This is an interesting thought. Financial markets in the United States are on a roller-coaster, the mortgage-backed securities market has collapsed, the Federal Reserve is more or less printing money, and the pundits talk quality. There may be more at play. The current financial crisis has involved a collapse in the credit mechanisms that modern economies rely on. The machinery that creates credit has become frozen. As a result, while the central banks pour money into the fuel tank of the commercial credit engine, this has not led to actual creation of financial credit. Rather, the broken "credit multiplier" means the supply of dollars and related dollar credits at the market level has dropped. With an effective shortage, the price has gone up. Europe has been more aggressive in taking steps to restart its credit mechanisms in this regard. Hence, the rise of the dollar may signal the continued relative failure of dollar-denominated credit mechanisms. This might not be a flight to credit, but a collapse of supply.  As recent new proposals to insure inter-bank loans come on line (and if this is expanded further to cover commercial loans), a signal of a successful restart of the credit machine in the U.S. may ironically be a drop in the dollar as the flow of dollar-denominated credits expands again. Watch the dollar.

Time to Recapitalize Households

In the last few weeks we have seen dramatic shifts in the position of governments on the current financial crisis. In the UK, Gordon Brown has spearheaded direct government equity stakes in banks, and is pushing for long-run structural fixes.[1] Following similar moves elsewhere in Europe, the Bush administration has jumped on board as well. Markets have now factored in expected government support, in the form of debt forgiveness (i.e. tax payer bailouts) and equity injections. As such, we should not expect dramatic changes in market performance at the moment unless new information emerges.

As this drama unfolds, here has been a parallel debate in the context of the U.S. Presidential elections on what to do with bad mortgages. The McCain plan was a version of the Bush plan -- have taxpayers take over bad loans. This has been heavily criticized. Yet, they are correct that something needs to be done in the housing market. In the old days, with the FSLIC, if a Savings and Loan failed, the government would have been the one to ultimately step in and clear housing stocks. This did not end well last time, and it is not clear why the current analogue will be any better. Already we are seeing discussion of what to do about increasing foreclosure rates.[2]

Here is a crazy idea, instead of just buying up bad mortgages at face value -- Recapitalize Households. What I mean is the following.

1. in cases where households now owe more than their house is worth, but where they can make payments on a mortgage at the current value (i.e. a proper credit check), the government buys the mortgage from the current holder at the current value of the property -- NOT at the face value of the mortgage


2. The government takes an equity stake (up to perhaps 25%) in the property itself, shared with the homeowner and to be recovered at sale of the house.


3. Details can be worked out, but a logical set-up is that the government shares any future increase in property value with the homeowner. This provides an incentive to the homeowner to care for the value of the house, while providing relief from the drop in values. It also imposes part of the cost and responsibility on the owner.


4. The government uses its greater market power to borrow, and finances a new mortgage for actual equity at a better rate -- improving the cash-flow position of the household.


5. A provision is included to allow homeowners to trade more equity to the government, up to some limit, in exchange for cash now.
   
   

Such a program would have the following effects:

• banks would receive some relief as we reduce pressure from bad mortgages and they recover market value without all the risks of dumping a large stock of vacant housing


• homeowners can stay in their homes


• the government recapitalizes households (relieving cash-flow and solvency problems)


• households and banks both carry the costs of the bad loans


• government will recover costs as the housing market recovers

Given the stricter redrafting of bankruptcy laws in the U.S., something of the sort will be necessary to prevent a political firestorm if housing markets get much worse.

References

[1] "Gordon Brown's call for a new Bretton Woods gains traction ," 15 October 2008, The Telegraph.
http://www.telegraph.co.uk/finance/3201885/Gordon-Browns-call-for-a-new-Bretton-Woods-gains-traction.html

[2] Matthew Benjamin, McCain, Obama Promoting Populist Appeals on Rescue (Update2)," 14 October Bloomberg. http://www.bloomberg.com/apps/news?pid=20601070&sid=ahfMrINj__Mw&refer=home

The Orthogonality of Leadership and Crisis

or·tho·go·nal (ôr-thog-uh-nl)

Adj. 1. irrelevant - having no bearing on or connection with the subject at issue; "an irrelevant comment"; "irrelevant allegations."

misregulation (mis-reg-yuh-ley-shuhn)

Noun. 1. wrong or imperfect regulations. 2. a process of deliberately wrong or imperfect regulation for personal gain.

The U.S. does not have a monopoly on leadership failure. In a recent editorial in the New York Times and Herald Tribune, Paul Krugman states the obvious.

...the people who should be steering us away from that abyss are out to lunch.
A leadership vacuum, NYTimes, 3 Oct 2008

The economic crisis in the U.S. is deep and real, and requires leadership to match. The mismatch between leadership needs and the crew in charge is frightening. At the same time, a similar drama is unfolding on the other side of the Atlantic. In some ways, it offers more potential to go wrong in many more frightening ways than in the U.S., as it is exposing historical fractures linked to the most base tribal instincts of the European leadership class. This is one reason why the open letter from academic economists posted on VoxEU to European policy makers needs to be taken seriously.

This is a once-in-a-lifetime crisis. Trust among financial institutions is disappearing; fear may spread. Last week’s US experience showed that saving one bank at a time won’t work. A systemic response is needed and in Europe this means an EU-led initiative to recapitalize the banking sector. Unless European leaders immediately unite to address this crisis before it spirals out of control, they may find themselves fighting over how best to salvage the aftermath...
Open Letter to European leaders on Europe’s banking crisis: A call to action .

How bad is the crisis in Europe? In a recent posting, I noted that the the European and Asian exposure to the toxic financial sludge floating around global financial markets is probably at least as bad as in the U.S. However, while the U.S. has set aside an initial $700 billion, and the pundits are admitting that more will be required, the only coordinated (meaning European) response so far has been the early renewal of existing European Central Bank credits for €32 billion, and the breaking up of an emerging cross-border banking system back into national sub-units. (In the Fortis bailout out, for example: the government intervention is breaking up the cross-border group along national lines, including the interest in ABN AMRO it bought in a consortium with Royal Bank of Scotland and Banco Santander.) The Irish step to guarantee deposits was also discriminatory (beggar-thy-neighbor) in implementation. The exposure of European banks to bad debt may be as bad as in the U.S. In my view, the relaxed approach to shielding investors from information they might not like (misleading them) is at the core of the problem. Indeed, the editorials and blogs pointing to the "failures of deregulation and market capitalism" miss the point. This crisis is the consequence of globally mixing bad math, misinformation, and good-old-boy politics with financial misregulation.

At one level, the issue is the global nature of the unfolding banking crisis. Recent news includes the nationalization of Fortis Bank by the Dutch government (including the retail banking business of ABN-AMRO), the collapse of the rescue package for Hypo Real Estate this weekend, and increased agitation in Europe as beggar-thy neighbor national solutions are emerging for what is really a Continental problem. In Ireland, for example, the decision of Ireland to provide a 100% guarantee to the deposits of Irish banks is causing a shift in deposits from non-Irish banks, obviously helping Irish banks but at the expense of other (e.g. British) banks operating in the same market but without guarantees.

At another level, this crisis is also a test for Europe. Following an announcement this weekend by European leaders that they would follow a more coordinated approach,

"Germany's Chancellor Angela Merkel insisted states would mainly act individually..."

This position has been backed by the head of the ECB, who has sided with Merkel. In response, like Ireland, Greece has also now guaranteed deposits.

Sigh.... Merkel's reactive undermining of a joint solution should be an alarm bell. Europe has been pushing deeper integration, including cross-border integration of its locally fragmented financial sectors. This is a good thing and a political necessity given history. It reflects hard work and real costs by the post-War generation. However, notwithstanding the pro-German reaction of the ECB, with the benefits of more integrated markets comes a responsibility for a more integrated approach to regulation and crisis management. A piecemeal approach to the current crisis will inevitably be beggar-thy-neighbor. There needs to be an integrated approach at a European level. Failure by European leaders to find a European solution risks setting back decades of European economic and political integration and efforts to exorcize Europe's tribal demons. Without a coordinated and aggressive attack on this crisis of confidence, it may get much much worse. Once European leadership is locked into national solutions, economic borders will grow wider and the slide back go tribal rivalry may begin yet again. The time to sort out responsibility (presumably the ECB is worried over wrong incentives and moral hazard) is after the crisis has been weathered.

Europeans deserve better from their leaders (and their Central Bankers) than a narrow local focus. They need to demand wider vision. A narrow, nationalist approach will not fix this problem, and will carry long term costs. It is important that national leaders in Europe act responsible and talk about positive, European approaches to the problem. Nationalist rhetoric may be appealing and easy. It is also irresponsible and reprehensible, especially given the shared burden of European history.

Quoting the letter again:

The problem is not a lack of understanding of how to stop financial crises. The problem is a lack of political will.

ADDENDUM:
There is a good discussion of the European exposure by Daniel Gross and Stefano Micossi on RGE Monitor: "Crisis Management Tools for the Euro Area." There is also some emerging realization that Europe's schadenfreude at the "American" crisis was premature. This crisis does not prove the "superiority of the general European banking model." Indeed a number of European state-owned banks have been caught in the same mess. As I have noted earlier, European banks have been staging mini-crisis for a while now (look up BAWAG scandal in google). Also see: "Europe Beginning to Realize Its Lenders Share in the Blame."

References:

[1] Open Letter to European leaders on Europe’s banking crisis: A call to action, VoxEU, October 2008.
http://www.voxeu.org/index.php?q=node/1729

[2] Paul Krugman,"A leadership vacuum," NYTimes 3 October 2008.
http://www.iht.com/articles/2008/10/03/opinion/edkrugman.php

[3] Joseph Francois, "Three Card Monty on the streets of New York, or "If this crisis is so different, why is it so familiar?" The Random Economist, 2 October 2008.
http://www.intereconomics.com/blogs/jff/2008/10/three-card-monty-on-streets-of-new-york.html

[4] Reuters, "Dutch media split over Fortis nationalization," 4 October 2008.
http://www.reuters.com/article/gc06/idUSTRE49314H20081004

[5] RTE News, "German bank on verge of collapse," 5 October 2008.
http://www.rte.ie/news/2008/1005/economy.html

[6] AFP, "Europe fights financial storm as bank deal collapses," 5 October 2008.
http://afp.google.com/article/ALeqM5hcWdSreh2tNafF5YVZbb2Te-Eivg

[7] Reuters, "EU rescue fund rejected as U.S. bailout advances," 3 October 2008.
http://www.reuters.com/article/bankingFinancial/idUSL252209520081003

[8] Daniel Gross and Stefano Micossi, Crisis Management Tools for the Euro Area, RGE Monitor, 2 Ocrtober 2008. http://www.rgemonitor.com/globalmacro-monitor/253833/crisis_management_tools_for_the_euro_area

[9] Craig Whitlock and Edward Cody, "Europe Beginning to Realize Its Lenders Share in the Blame," Washington Post, 1 October 2008. http://www.washingtonpost.com/wp-dyn/content/article/2008/10/01/AR2008100103406.html

Three Card Monty on the streets of New York, or "If this crisis is so different, why is it so familiar?"

In a recent New York Times editorial/blog, Paul Krugman argues that for the U.S. as a whole, there may be little net cost from the sub-prime bailout. [1] In the end, the cost to the U.S. taxpayer will depend on the people in charge acting responsibly and competently. We will witness massive transfers from the middle class taxpayer to Wall Street, but might not see comparable net costs to the U.S. There is a wide range of opinions and worries floating on the web about how competent and trustworthy the actors involved will really be. [2] At the same time, there is another player in the room, and he will lose massive sums of money. Indeed, in one way, we are looking at big losses for this other player no matter what happens in Washington. To explain what I mean, it helps to review history.

In the late 1970s and early 1980s, the Members of the OECD embarked on largescale deregulation of international investment flows. In Japan, the combination of high savings and foreign investment restrictions had led to an accumulated stock of domestic savings earning low returns. When the floodgates were opened, Japanese institutional investors poured into the United States. In a paper written at the time, a Japanese academic offered the following contemporary perspective:

"Since the basic change in Japan's law on foreign exchange controls in December 1980 toward deregulation Japanese banks, securities companies and institutional investors especially life insurance companies were gradually freed form rigid regulations on their overseas activities, and their management horizons and business activities were expanded on a world-wide scale. One of the new developments in Japan's foreign direct investment in the last few years is a sharp increase in investment in real estate business abroad, especially in the United States... Since around 1984 they are increasingly investing in real estate properties in the United States."[3]

Indeed, Japanese investment in real estate in the 1980s in the U.S. skyrocketed. An estimated $300 billion was poured into "high-profile properties like Rockefeller Center in New York and the Pebble Beach Golf Club in California."[4] Yet more was poured into U.S.-based financial institutions and instruments. As the subsequent Savings and Loan crisis rolled across the U.S. economic landscape, their holdings in commercial real estate alone lost roughly half their value. This coincided with a steep fall in the value of the dollar. The Japanese liquidated their positions at a fraction of original costs. Making a crude guesstimate, and assuming a 50% loss on their commercial property investments, they lost $150 billion by 1990 or roughly $230 billion in 2008 dollars. In other words, Japanese investors may have carried more than half the cost of the S&L crisis. The U.S. tax payer also paid a bit less than half, while on net for the U.S. much of this was just a net domestic transfer. From that point, of course, the Japanese went through a further real estate collapse of their own (Business Week estimated in 1998 that households may have suffered $250 billion in losses in Japan as real estate prices fell 70% from 1992 levels [5]).

So today, in 2008, we are looking at $700 billion set aside in reserves (so far) to clean up the U.S. exposure to sub-prime backed securities. More may be needed up front, but much will also be recovered over time as markets recover. Also, as Paul Krugman has stressed [1], much of these costs are essentially a domestic transfer. We are looking at a big debt for equity swap, where the shortfall is picked up by the U.S. taxpayer but a number of U.S. investors are saved in the process. To the extent we are saving U.S. shareholders and investors, these are "just" massive internal transfers. Unless this gets messier, and more expensive.

However..... rewind back to the 1980s, when Japanese institutional investors were badly burned by the U.S. real estate meltdown, and may have lost $250 billion or more in today's terms (with a worse hit adjusting for the ongoing exchange rate hit at the time). Today, we are looking at a sub-prime mess where half of the "stinky mortgages" (a phrase I steal from the sub-prime primer [6]) are held in the U.S., and the other half are overseas. Indeed, while the Chinese and Japanese may be holding massive amounts of U.S. Federal debt obligations, Europeans may own $250 billion in sub-prime junk, Japan may hold $200 billion, and China may hold $260 billion. Taiwan and Korea may hold another $50 billion. I say "may" because one problem here is continued lack of transperency, which has obviously contributed to the ongoign financial market jitters. ("Might it not be the case that we understood too little about the risks banks had taken on?"[7]) It is not clear what the foreign exposure actually is, and the estimates quoted here from 2007 may be low.[8]

So, the U.S. is apparently ready to bail out U.S. holders of sub-prime securities. This is only half the problem. To a large extent, the U.S. bailout involves internal transfers. At the same time however, we may want to use U.S. taxpayer costs as a money metric of the cost imposed on foreign investors, who will not be bailed out by the U.S. Congress and face very very real losses. Basically, much and perhaps most of the net financial cost of this crisis will fall on foreign investors. We are looking at the unwinding of an unintended real estate scam, where foreign investors lose several hundred billion dollars inside the U.S. financial system. In New York, Three Card Monty [9] is illegal. The city does, however, offer much more elaborate ways to see your money disappear.

References


[1] Paul Krugman, "Where Will the Money Come From?," NYTimes, September 30, 2008, 9:04 am.

http://krugman.blogs.nytimes.com/2008/09/30/where-will-the-money-come-from/

[2] Matt Stoler, "As the Senate Votes," Wed Oct 01, 2008 at 19:57

http://www.openleft.com/showDiary.do?diaryId=8743

[3] Ryutaro Komiya, "Japan's Foreign Direct Investment: Facts and Theoretical Considerations," University of Tokyo, October 1987.

http://www.e.u-tokyo.ac.jp/cirje/research/dp/87/f13/dp.pdf

[4] Terry Pristin, "COMMERCIAL REAL ESTATE; Echoes of the 80's: Japanese Return to U.S. Market," NYTimes January 26, 2005.

http://query.nytimes.com/gst/fullpage.html?res=950DE4D61F38F935A15752C0A9639C8B63&n=Top/Reference/Times%20Topics/Subjects/F/Foreign%20Investments

[5] Business Week, "JAPAN'S REAL CRISIS: Until its hidden debt mess is cleared up, no recovery is possible," 1998.

http://www.businessweek.com/1998/20/topstory.htm

[6] "Subprime Primer:How SubPrime Really Works," BigPicture, Friday, February 15, 2008 | 11:15 AM

http://bigpicture.typepad.com/comments/2008/02/how-subprime-re.html

[7] J.F. Francois, "Firewalls and Firestorms," The Random Economist blog, Sunday, October 28, 2007.

http://www.intereconomics.com/blogs/jff/2007/10/firewalls-and-firestorms.html

[8] Martin Hutchinson, "Where are the subprime bodies buried?" Money Morning, Tuesday, August 21st, 2007.

http://www.moneymorning.com/2007/08/21/subprime_bodies/

[9] Glenn Hester, "Three Card Monte from a Police Officer’s Perspective," threecardmonty.com.

http://www.threecardmonte.com/police_three_card_monte.html