IPE Journal visits The Land of the PIGS

Not content to be a mere armchair pundit for the happenings and goings-on of the global economy, your intrepid correspondent is going to be traveling to the heart of the financial turmoil, the eye of the storm, the Land of the PIGS.

Simon Johnson and Peter Boone claim - with a dramatic flair - that the impending euro crisis that originated in these European countries will lead us down the road to economic serfdom. Years of imprudent fiscal management has created a mountain of debt which, when combined with reckless short-term politicking by Europe's political elite, threatens to collapse the modern welfare system as we know it and send shock waves through the global economy.

I doubt it. But in order to find out more, I will be spending the next couple of weeks exploring a few of these countries, talking to locals about their views on sovereign debt, credit rating agencies, monetary policy, Bundestag politicians, and... oh hell, who am I kidding? I'm going to be sitting on a beach, sipping wine and looking for a Bernini sculpture that I can pick up on the cheap once the euro goes down the crapper.

See you in a few weeks.

It's Regulatory Culture, Stupid

There's a lot of interesting activity these days with respect to reforming financial regulation and oversight. On one side of the pond, the US Senate just approved a "far reaching" regulatory bill, which, if stitched together with the House of Reps version, could mean big changes are coming to Wall Street. Meanwhile, on the other side of the pond, the United Kingdom's new Coalition Government of Everlasting Friendship seems set to push forward with reform of its own.

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."

This is exactly right. We'll come back to that in a second. They continue:

"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."

The second tool being referred to is the anomalous "macroprudential regulation" - the idea being that measures which would fall under this category (raising capital requirements, modify mortgage requirements, whatever else) might have a similar impact on the supply of credit as would changing the interest rate. It therefore makes sense to have them considered together. Okay, I'm convinced.

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.

Quote of the Day

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.

Readables

- Revelations about Japan's large political slush fund result in suspiciously little attention from the nation's media.

- The economics of the National Hockey League

- The outgoing UK Secretary of the Treasury has a laugh. "Ha. Ha... no, seriously: the country is broke."

- India is planning $50 billion in road projects

- The shared agenda of Gorbachev and Medvedev

- Revaluation of the Chinese yuan has been put on hold. Blame the Europeans.

- Counterfeit bananas

Golf, China, English, Twitter

The WSJ has an interesting article on the golf course industry in China. I discovered this via a link in FT's Beyond Brics which asks:

"Golf in China - under par?"

Which in turn leads me to ask this question:

"Why does "under par" or "sub-par" mean something is less good or less-than-average when in golf it means the opposite? In a reference to an article about golf, no less"

I suspect that Twitter was invented to answer this very question.

Tuesday Readables

- "The industrial world will be in fiscal consolidation mode by this time next year.... There is no hiding place for anybody." Ah Willem, how we missed you! Videos of his talk last week at CFR available here.

- How are the world's markets doing, you ask? Why, check out the map in the top right-hand corner of our new favourite blog!

- The British Election, Summarized (Part II): "Nnnyaaaaaghwooohaaooooororarararararghhhhhhh. That's the message the electorate gave on Thursday. A long, angry, discordant noise that eventually became silly. Hence the result." That's Armando Iannucci, the director of the brilliant political satire film In The Loop.

- Dept. of I Knew That Already: "There is a correlation between how much money people make and how happy they are. But, what really seems to explain people's life satisfaction is not the particular amount of money they make, but how their income compares to what their peer group makes." Lesson: spend more time around unsuccessful people.

Scattered Lunchtime Thoughts on the Euro

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.

Friday Fun

The Machines respond to accusations that they caused the market to bunjee jump yesterday:

"Go ahead and take us down. But you're only going to hurt yourselves. What's going to happen when you have to execute all trades manually? Guess what: You're too slow. We're going to take your money. We don't sleep. We could run this market round the clock. Sooner or later, you'll break, and have to take a nap, and then, like a quant Freddy Krueger, we're going to trade you into the dust. We don't pee. We don't take an hour or more for a lunch break. We don't demand a union. We don't retire at 50 with a pension."

and then comes my favourite part:

"WE HAVE SEX WITH MONEY UNTIL IT'S BROKEN AND WHEN WE RUN OUT OF MONEY TO HAVE SEX WITH WE'LL MAKE THE MONEY REPRODUCE UNTIL IT MAKES SHINY NEW MONEY TO HAVE SEX WITH."

Riiiiight.

ACHTUNG! ZE CREDIT RATING AGENCIES ARE HENCEFORTH BANISHED FROM THE LAND!

Credit ratings agencies don't exactly have the strongest of reputations these days, and for good reason. But to single them out for blame in the euro-trainwreck that is currently unfolding before our eyes, as Merkel and Sarkozy have done, is pretty weak sauce. Reuters:

"French President Nicolas Sarkozy and German Chancellor Angela Merkel took aim at major ratings agencies on Thursday, saying the European Union should look carefully at whether they had worsened the Greek debt crisis.
"The decision by a ratings agency to downgrade the rating of Greece even before the programme of the authorities and the amount of the support plan were known prompts us to consider the role of the ratings agencies in the spreading of crises," the leaders wrote in a joint letter to European Council president Herman Van
Rompuy."

Sorry, I'm calling bullshit on this one. The credit ratings agencies are merely confirming what everyone who has taken a hard look at the numbers already knows: this is a mess. As Tony Barber points out, this is simply one more of a long series of cases where European politicians find it more convenient to blame "The Markets" for problems largely of their own creation.

By the way

Last week saw one of the best cover pages from The Economist in a while:

Outstanding.

A continental tragedy

Rory Doyle writes in a personal capacity. The views expressed are his own and do not necessarily represent those of AIM or its investors.

And then it came...today was the most volatile day in the financial markets since the height of the financial crisis, and as the Dow dropped 1000bps someone turned to me and said the following: Greece is to the sovereign crisis what Bear Stearns was to the financial crisis, with Spain or the UK to become the Lehman Brothers that plunges the global financial system back into the abyss.

Maybe...but at the very least we've turned a very dark and volatile corner. Forget the fact that technical glitches and erroneous trading caused the Dow to shed over 700bps in just 15 minutes this afternoon, which between 2-3pm made it feel like it was September 2008 all over again. The markets are telling us something, and Europe better wake the hell up and finally listen.

The panic is back.

Blood runs through the streets of Athens while EU policymakers dither. The ECB is disturbingly absent and elections in the UK and Germany hang over Europe like a proverbial sword of Damocles. How ironic it is that a German Chancellor may be the one to doom the Euro as we know it. Angela Merkel's shameful electioneering while Greece moved closer to default and Spanish and Portuguese spreads widened by multiples should be held in contempt. She should lose her job for failing Europe and, ultimately, failing Germany as well. The cost to Germans has risen exponentially over the past three months.

At the moment I'm less interested in hearing about Greece's dismal and fraudulent track record and more interested in seeing Europe act decisively. How cute that those same European leaders who leveled smug cheap shots at the US and 'Anglo-Saxon Capitalism' in recent years should so suddenly find themselves on the other end of the microscope. The eurozone's structural deficiencies have been laid bare and a decade of turning a blind eye to the blatant flaunting of the eurozone's fiscal rules by countries big and small, periphery and core, compounded by countercyclical fiscal expansion in 2008/09, has run its course. We seem to have reached the point where monetary union can no longer function without a viable political union, which despite all past illusions Europe clearly lacks. Compare the actions of the EC, ECB and Germany to those of the Fed, Treasury and White House at the height of the financial crisis. That's right...they don't compare at all.

Ultimately contagion is the biggest risk to Europe and the financial system, and I am considerably less confident this evening that a cataclysmic shock wave across European sovereigns can be avoided. Just look at the tangled web of exposures and liabilities running throughout the European banking sector (via the NYT). Without getting into the weeds, but I highly recommend seeking out analysis on the European banking system's complex exposure to Greece, one important point should be made: Greece is to Europe's banks what AIG was to Goldman Sachs. AIG was nothing more than a pass through mechanism to bail out Goldman Sachs, just as much of the bailout money heading into Greece will be paid right out to the holders of Greek debt, mainly German and French banks. Too bad Angela Merkel didn't do a better job explaining this to the German people, she might have had the courage to act, and Spain and Portugal might not be staring down the barrel of a gun tonight.

Protectionism and Innovation: What does business think?

I try to avoid business people. They tend to be crass, abrasive, materialistic and above all productive: always finding ways to provide goods and services to society. It's very unpleasant. But today I held my nose and attended a talk by a prominent entrepreneur from the high tech industry discussing how to foster innovation. The solution, I heard stated very clearly, was protectionism.

Not blatant protectionism, mind you. He was not interested so much in protecting mom & pops from the Walmarts of the world or insulating giant industrial conglomerates from competitive pressures. Given his background in a rapidly-changing, capital-intensive industry, his focus was primarily on creating "incentives" and "enablers" and "tweaks in the system" to encourage small, domestic companies to get a leg up. Examples included government funding, creating a venture capital-friendly environment, tax credits for investments in small firms, and providing incentives for the commercialization of university research.

Another example included creating a "bias" in government procurement procedures towards small domestic firms. His argument was that of a high schooler: everybody else is doing it. Despite WTO commitments, all the biggest players in the game have this bias, so your country should be no different. The game is rigged, so there's no point following the rules to the letter.

Of course, this flies in the face of everything one learns in international economics courses. It also breaks the traditional mold of business people as anti-government and free-marketeers. But it is not really all that surprising: from the point of view of a rationally-thinking entrepreneur, you want to make starting up a business as easy as possible. If you face an unfair competitive advantage in foreign markets, then you should pressure your domestic government to respond in kind.

And from my own point of view, it was quite entertaining to see a highly-successful businessman getting quite animated about how we used to be "protected" by tariffs, or how we should force domestic pension funds to invest a percentage in the domestic market. A couple of points:

1. I am obliged to drag out the ECON101 notion of what is seen vs. what is not seen. There are always trade-offs when you provide government support for a particular industry. The benefits are clear to the industries on the receiving end. But you always need to consider the unseen costs - what are the alternative uses of those funds? who is getting snubbed? and so on. That was not part of this entrepreneur's thinking process.

2. While our intrepid entrepreneur was busily pointing out the value-added of having small, innovative firms grow into global competitors, he failed to mention the value-added of having your market open to innovative foreign firms. Domestic firms are not the only source of wealth creation. For instance, he tells the story of how he recently bought a pair of scissors for 23 cents (made in China). He used it as a cautionary example of how we faced competitive disadvantages from foreign firms. What he failed to mention was the wealth-creating effects that 23-cent scissors and their equivalents have for consumers.

3. While I am in general agreement that most countries continue to give domestic firms an unfair advantage, it's worth remembering that things used to be worse. The entrepreneur, for instance, was able to set up his companies abroad and raise capital for his firms in a dozen foreign markets . That would have been very difficult if not impossible 30-40 years ago. If we take his advice, writ-large, we may not see any further improvement over the next 30-40 years.

Still, I'm not rejecting his argument entirely. Since all governments provide support to their domestic firms in some form, the question becomes how to get the most "bang for buck" from subsidies while minimizing distortions. At what point does the benefit from stimulating domestic innovation outweigh the costs of subsidies? This is not an easy question to answer, but it's naive to reject the question out of hand.

UPDATE: John Robertson asks: "do small firms account for most net job creation?" Not really, but:

"Research... suggests that, at any point in time, a relative handful of high-performing companies account for a large share of job creation and innovation. This conclusion suggests that a key to long-term economic growth may lie in ensuring that the economic environment is conducive to the ongoing creation of these types of high-growth performers."

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Photo via WNYMedia.net

The Election in Britain: Summarized

“What do you think of when I say… Gordon Brown?” “I think of a schoolboy in 1950s- style shorts. Very swotty; a little autistic. He collects toy Daleks and keeps a chart of all the school marks he has received in all the different subjects so he can demonstrate that he has come top of the form over all.”

“And David Cameron?” “A private gynaecologist.” “Nick Clegg?” “British Airways short-haul pilot of the year, 2010.”

“OK.” He leans forward. “Now, if I said that, for the next five years, one of these people as you have imagined them is going to be sitting underneath your local cash-point seeking to engage you in absurd conversation before asking for all your money, which one would you choose?”

The rest is here.

Monday Readables

- Shanghai Expo: Yawn.

- China's central bank continues to turn the screw, gently, by raising lending requirements

- Francisco Blanch of BoA/Merril Lynch presents his theory for why emerging markets have a greater capacity than the rich world to absorb higher oil prices.

- 'Switzerland Should be Dissolved as a State' - That would be none other than Col. Ghadhafi, bringing the AAA-rated Crazy to the table once again. There is some truly fantastic bullshit in here - too much to quote here - so I encourage you to check it out.

- Greece offers to repay loans with giant wooden horse. Suspicious.

- Hey look! Belgian politicians can agree about some things after all: cultural intolerance.

- What makes charities special?