Adhoc Rescues, Global Coordination, and the Superclass

I just finished Superclass and while it initially sounded like exactly the kind of book I don’t like to read, after hearing Rothkopf in person and seeing Chris Blattman recommend it (in a hilarious post titled ‘Midway Down the Intellectual Food Chain) I decided to get the audio book. It was definitely entertaining and pretty interesting at times but definitely not a must-read. I was, however, struck by a conversation Rothkopf  had with Timothy Geithner (remember him?) on how he helped resolve a crisis in the derivatives market (the book doesn’t give any further information) that I think really captures the way many complicated (and extremely urgent) problems are addressed in our increasingly complex world:

What we did is, we got the fourteen major firms in a room down the hall here with their primary supervisors [..] and we said to them “You guys have got to fix this problem, tell us how you are going to fix it and we will work out some basic regime to work out there are no free riders to give you comfort so you know that if you move individually, everybody else will move with you” and there is nothing written, no guidance, no regulation, no formal process, [...]

These fourteen firms he continued, accounted for something like 90% of the all the activity in this market. The Fed, the SEC, the FSA, the Swiss and the Germans were there, and hose were the principals, each firm brought three people, they had an executive committee of four firms that had almost weekly a conference call among the four firms. And the best thing about the process was that it was efficient, there was nothing written except letters from the firm laying out their commitments, there’s no formal mechanism we could have used to force this on anybody so we had to invent it.

You have to have a borderless collaborative process, it does not mean it has to be universal every jurisdiction or every institution it just needs a critical mass of the right players it is a much more concentrated world, if you focus on the limited number of the ten to twenty large institutions that have some global reach, then you can do a lot.

Geithner is right, the world is becoming increasingly international but there are very few effective (and quick acting) international governing bodies and these adhoc meetings work very well. You don’t need to be a believer in World Government to realize that closer international coordination on finance and the economy (if nothing else) will be important in the future. The problem with doing things on an adhoc basis by getting the most powerful people and organizations in one room is that the concerns of the wider populace will be underrepresented (or not represented at all). The hurried actions of the US Treasury and Federal Reserve during the failure/bailout of Bear Stearns, AIG, and Lehman Brothers showed that personal contacts and informal meetings can help ensure quick action in an unforeseen crisis but they also show the dangers and resulting unfairness of the outcomes reached in such meetings. In the years ahead we will have to figure out how to build more effective coordinating (and potentially regulating) bodies on both the national and international scale. That should be a fun challenge.

The Extent of the Crisis

From the Economist:

In Germany December’s machine-tool orders were 40% lower than a year earlier. Half of China’s 9,000 or so toy exporters have gone bust. Taiwan’s shipments of notebook computers fell by a third in the month of January. The number of cars being assembled in America was 60% below January 2008.

Yes these numbers are among the extremes and other industries aren’t faring quite as badly but the core point is that this is an international crisis and it will have serious impact everywhere – goodbye to fantasies of decoupling. A Fistful of Euros has had excellent coverage of how the crisis is affecting European and other countries, things are looking bad in Russia, Ukraine, Japan, Ireland, Latvia, and pretty much everywhere else.

The Point of Financial Systems

While I personally find the complexities of the financial system fascinating it is important to remember (especially with lots of people currently questioning it’s usefulness) what the purpose of the financial system is. Brad DeLong (who uses Apture on his blog) sums up an old Robert Shiller paper on the purpose of financial systems and the problems, distortions, and inefficiencies they face:

Financial markets are supposed to tell the real economy the value of providing for the future–of taking resources today and using them nor just for consumption or current enjoyment but in building up technologies, factories, buildings, and companies that will produce value for the future. And Shiller has more than anyone else argued economists into admitting that financial markets do a really lousy job. The prices that financial markets feed the real economy value safety too much, are also much too frightened of risk, on average are too low–that is, greatly undervalue the worth of providing for the future, and are also grossly excessively volatile. Depending on the date, the same flow of rationally-expected future profits and values can vary in its price by a factor of three depending on what Akerlof and Shiller call “animal spirits”

Both group think and excess volatility are topics that everyone is very aware of right now but I few people would cite excessive risk aversion as a problem after the subprime mortage debacle. I do, however, agree that when it comes to investing in the future investors are very risk averse, at least when it comes to industries that they don’t fully understand. The problem was not that people knew that subprime mortgages were extremely risky but took the risk anyway, they understood subprime loans quite well but made the (fatal) assumption that house prices would continue to rise forever.

When it comes to the kind of risks that innovative startups face (“is this technically possible?”, “will people really find it valuable?”, “can we figure out how to monetize it?”) I do believe that most investors, even most (not all!) venture capitalists tend to be too risk averse. Paul Graham recently wrote an excellent essay on the topic and I believe that creating the next generation of successful companies will require investment in big and bold ideas – even if some of them (especially in biotech) will take significant time until they make money. The eventual payoffs will be worth it.

A quick note on monetary policy

In yesterday’s post on why I am seriously starting to worry about the US economy and our plans for fixing it I said that monetary policy had with some exceptions run out of power. I want to elaborate a little bit on what I meant by this after stumbling upon two succinct paragraphs that give an overview of the problem in this post by Edward Hugh. First,  the problem:

Keynes argued that monetary policy ran the risk of becoming impotent in stimulating demand and raising spending since interest rates were already at their lowest possible level. Essentially he argued that increasing the monetary base by buying short-term government bonds is irrelevant at zero interest rates since money and short-term government bonds become effectively perfect substitutes.

As I said in my last post, however, there are still some things that can be done and while the Fed cannot lower short term interest rates any further it can still influence long term interest rates:

This (monetary policy impotence) argument has been challenged to some extent of late, most notably by Ben Bernanke, who argues that while the central bank may lose policy leverage over short term interest rates, by buying longer term instruments (10 or 30 year bonds) the bank may influence rates further up the yield curve.

This basically means that while short term interest rates have effectively reached zero the Federal Reserve can buy longer term bonds and thereby lower the interest rates on those, and incentivizing banks to shift their money to loan on which they can earn higher yields. This is extremely similar to what is generally known as Quantitive Easing (and unneccessarily complicated sounding term for a relatively simple concept).

Unfortunately even this won’t help too much in the situation that we are currently faced with since it does not address the underlying problem but it is something that other central banks such as the ECB should keep in mind. Some other possible actions a central bank could take are explained in this paper by Gauti Eggertson of the IMF that I have just started reading.

Why I am worried

I believe that fiscal stimulus is both fundamentally sound and very important in the current economic situation that we are in. Monetary policy has largely run out of power, yes, there are certain things that the Federal Reserve can still do but they would most likely be too little too late. I understand why some people are skeptical about borrowing more money when that is a big part of what got us  into this mess in the first place but over the long run a prolonged recession or absence of growth would lead to greater losses in tax revenue then a large and effective stimulus.

Without getting into the details and starting to argue about different multipliers I also believe that the current stimulus is far from perfect (my perfect stimulus would pretty much look like the one described by Alice Rivlin) and that we have significant work to do on how to improve our chances for long term economic success. As I said recently the centerpiece of such a long term stimulus should be things that make America and all Americans smarter, something I will write more about in the future.

What really has me worried right now though is that Tim Geithner’s proposal for saving and restructuring the banking system is too timid and too unclear at a time when everyone is looking for the government to come up with a clear plan. The reason I am so worried about this is that the rest of the economy will be severely hampered until the banks recover as well. I’ve been worried about this for a while but a recent New York Times article on Japan’s crisis focused this worry even more:

A further lesson from Japan is that the bank rescue will determine the fate of the wider economy. While President Obama has prioritized his stimulus plan, no stimulus is likely to succeed unless the banking sector is repaired.

We have to come up with an effective solution for the banking problem before we can hope to get the rest of the economy going again, and we should think hard about what we need to do and what it will take, even if the solutions might sound politically difficult.

So far, the Obama administration’s plan avoids the hardest decisions, like nationalizing banks, wiping out shareholders or allowing banks to collapse under the weight of their own bad debts. In the end, Japan had to do all those things.

More to come…