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

Firewalls and Firestorms

This past Summer has seen the sub-prime lending crisis in the United States turn into a global liquidity crisis. Subsequent events illustrate two important things about financial globalziation. First, no financial crisis is really local. The U.S. crisis has sparked a bank run in the UK and has forced the German authorities to use tax payer money to support German banks in crisis. At the same time, because we are able to spread local shocks globally, the markets outside North America are absorbing some of the brunt of the U.S. crisis. In similar fashion, when we next have a crisis somewhere in Asia or Europe, the local impact will be less as global markets are better equipped to handle the shock than are local markets. This logic follows from the simple algebra of portfolio diversification and risk. And yet...

The current crisis also illustrates other, less sanguine, aspects of the emerging global financial architecture. One important aspect of modern banking is the blending of commercial banking services (managing the operating funds and transactions of businesses and households) with investment banking, speculation, and underwriting. For example, Germany's IKB Deutsche Industriebank AG had to receive financial support from the state-owned KfW development bank (along with other banks) because of its exposure to risks linked to the sub-prime crisis in the U.S. Its problems are linked to the bank's investment activities through Rhineland Funding. For those versed in the history of financial crises and regulation, this sounds uncomfortably like problems -- linked to investment activities of banks -- that preceded the crash of 1929. Indeed, in Europe it seems we are always facing banking scandals. It is clearly hard to bring perpetrators to task, and regulation is opaque and politically susceptible. This brings us to another aspect of the European side of the crisis -- an inherent instinct to distrust investors and hide information. Indeed, in a surreal twist on the logic of regulation, senior EU officials are calling for less transparency. To paraphrase Bank of England governor Mervyn King: "the European Market Abuse Directive was partly to blame for the crisis that hit Northern Rock by not allowing the Bank to act covertly." This follows similar statements by the European Commissioner Colin McCreevy (commissioner for the internal market). McCreevy is on record criticizing the UK for applying too much transparency. He said: “Unfortunately, in recent weeks, gold-plated transparency rules stood in the way of the quiet resolution of a problem before it became a crisis: The result was that transparency rules that were intended to underpin investor confidence, when put to the test, actually promoted investor panic." In other words, if we had been able to hide the problem from investors, we could have found a way to keep it quiet until the whole thing blew over. Elsewhere in the press it has been noted that "He said regulators would be wise to learn from the crisis and should adjust rules regarding transparency, saying it was often beneficial for issues affecting the stability of major financial institutions to be carried out behind closed doors." What?! Do recent scandals like Parmalat, Enron, and Bawag mean anything? Might it not be the case that we understood too little about the risks banks had taken on?

It may be time to revisit the logic and working of the old U.S. system that was underpinned by the Glass-Steagall Act. Following the Great Crash that opened the show for the Great Depression, the U.S. Congress introduced a system of financial firewalls. Some were geographic, with a deliberate segmentation of regional financial markets. Others related to areas of operation. Basic commercial banking had to be kept separate from investment banking. This was accompanied by Federal guarantees of commercial bank deposits. The cost of this guarantee was regulation. With financial innovation, and the ability of investment firms to offer bank-like services (like money market accounts), this system was eventually dismantled, ending with repeal of Glass-Steagall in 1999. This was accompanied by a wave of financial mergers in the U.S. that, many believe, did promote greater efficiency in the financial services sector. The geographic fragmentation of U.S. banks did lead to small and capital-weak institutions unable to weather the liquidity crisis set off in 1929. And there are benefits to bigger banks. Yet, in light of present events one might wonder about the merits of segmentation of commercial and investment services... We again find ourselves in a world where banks are blending investment and basic banking activities. The result is that institutions that are important to the working of the basic monetary system underpinning the economy are threatened by financial cross-obligations in their investment arms. At the same time, it is not clear that incentives and rules are structured properly for full transparency about risks undertaken.

There are arguments for letting banks collapse in the current crisis, to send the "right signal" to the market that management (and investors) are responsible for their decisions. In the absence of explicit government guarantees, it is the role of investors, management, and rating agencies to sort out risk and communicate information. However, it is clear that we live under a second-best set of political constraints. It is not possible to let major banks go under, along with corporate and private savings. Instead there will be bailouts. Witness Northern Rock , IKB Deutsche Industriebank AG, and BAWAG. Whether is is explicit (like the deposit insurance scheme in the US) or implicit (like repeated bailouts in the EU), we live in a world where political constraints mean risk-taking behavior by bank management is underwritten by the public purse. We may wish it was otherwise. We may be able to argue that theoretically the world would be better if this were not so. However, the reality of populist politics in the industrial world means it is not possible let such institutions fail. If we admit that a mix of implicit and explicit guarantees is unavoidable, then we need to rethink regulation. This includes capital requirements under Basel II, but it also means more. We need to revisit the concept of firewalls between the basic liquidity services of financial institutions, and their more adventurous investment activities. It is encouraging that the chairman of the Basel Committee on Banking Supervision Nout Wellink is skeptical of US bank plans to fix the current problem with conduits (junk bonds?) with an "uber-conduit" or superconduit. Wellink's comments are diplomatic. Comments on the blogosphere are less diplomatic. (For example "I'll be the first to admit I'm not a financial expert. But engaging in even more of the same behavior? Sounds like trying to solve a gambling problem by gambling your way out.") Also, notwithstanding the opinions of Messrs. McCreevy and King, we need more transparency, not less. We also need to at least consider modern versions of the 20th Century's financial firewalls. We can then let the investment industry be as innovative as it likes (within the law) while maintaining a more stable though admittedly less exciting sub-sector for basic transaction services.

Further reading:

[1] "Understanding How Glass-Steagall Act Impacts Investment Banking and the Role of Commercial Banks," Brain Bank.

[2] "Suspend Rock shares – it’s a false market," The Sunday Times online, October 28, 2007.

[3] "Credit Crisis Spreading New Jitters in Europe," The New York Times online, October 26, 2007.

[4] "European Commissioner McCreevy blames UK gold-plating for Northern Rock debacle," MoneyMarketing, Paul Mcmillan - 26-Oct-2007.

[5] "Boom and Bust in Early America," in Money, Greed, and Risk: Why Financial Crises and Crashes Happen By CHARLES R. MORRIS, Times Business online (Chapter 1). This provides a good read on earlier times. The present crisis is nothing new. To quote: "The secret of successful banking, reported a New York practitioner of the banker's dark arts in 1836, was to issue notes with 'a real furioso plate, one that will take with all creation—flaming with cupids, locomotives, rural scenery, and Hercules kicking the world over.'"

[6] "Super Conduit to the rescue!" Salon.com letters to the editor, 16 October 2007.