Category — Finance & Banking

Saturday’s Kiva Dev Garage was a huge success with a great turnout and real progress on both some existing and entirely new projects. We had people working on iPhone and Facebook Apps, a Kiva loan browser, and lots of other cool things. My team worked on a Wordpress Widget that is both really easy to install and hopefully really compelling and will lead to more people lending to Kiva Entrepreneurs. Check out this great video from the event:

I recently wrote about alternate currencies as a solution to the financial crisis, specifically to the ineffectiveness of monetary policy at the zero interest rate bound. Well it looks like Greg Mankiw (independently) agrees with me which is quite exciting. When currencies loose value over time the Fed could lower its rate to less than zero (e.g. you give me $100 today, I’ll give you $98 in a year) and still find people who would be willing to lend at those terms:

Reduce the return to holding money below zero. Imagine that the Fed were to announce that, one year from today, it would pick a digit from 0 to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

It definitely is an unorthodox solution that would be difficult to implement in practice but it’s also novel and interesting and it helps us understand why certain solutions work and others don’t:

I understand that this plan is not entirely practical. But you have to give the student credit for thinking out of the box. And his plan does address a fundamental problem facing the economy right now: Given the fall in wealth, increases in risk premiums, and problems in the banking system, the interest rate consistent with full employment might well be negative.

One key challenge to coming up with good solutions to problems is understanding why things are the way they currently are and what an ideal solution would have to accomplish. Coming up with good ideas that don’t quite cut it is an excellent learning process for getting closer to the optimal solution.

Update: The Economist talks about Switzerland charging foreigners a fee to keep their money there in the 1970s – effectively imposing a negative interest rate (this would have to be a percentage of the assets kept there instead of a lump sum).

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.

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.

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.

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…

I just finished When Genius Failed – The Rise and Fall of Long Term Capital Management by Roger Lowenstein and as someone who was not following financial news back then it is very interesting to read it now given the events of recent months. The risks of excessive leverage, the increasing appetite for risk taking during prolonged economic upswings, and the lack of understanding of complex derivatives all played a major role in both the collapse of Long Term Capital Management and the current crisis:

The system of disclosure that worked so well with regard to traditional securities has not been able to do the job with respect to derivative contracts to put it plainly, investors have a pretty good idea about balance sheet risks, they are completely befuddled with regard to derivative risks.

Another common element has been Alan Greenspan’s refusal to step up regulation, even after witnessing several failures that could have destabilized the entire financial system:

Greenspan’s more serious and longer-running error has been to consistently shrug off the need for regulation and better disclosure with regard to derivative products. Deluded as to the banks’ ability to police themselves before the crisis, Greenspan called for a less burdensome regulatory regime barely six months after it.

His recent admission that he found a “flaw” in his system was widely talked about but even know Greenspan is unsure of how “significant or permanent” this flaw is. His argument that the investors financing LTCM were putting their own money at risk and would therefore implicitly regulate it by only lending to it if it were credible is patently absurd – thinking that a market will adequately price a particular asset is one thing, thinking that a relatively small number of investors will always be able to assess the risk of a complex (and in the case of LCTM secretive) counterparty is quite another. Furthermore, it should also be clear that tolerance of risk increases when investors have not suffered major losses for a number of years and that this has historically led to excessive risk taking. LTCM itself believed that the markets were not rational in the short term and nobody should believe that individual financial institutions will be rational in their lending. As Warren Buffet points out Meriweather, Haghani, Hilibrand, and the crew had all invested almost all of their own money and still made a colossal misjudgment.

I was just reading a little bit about the Greek Economy and wanted to highlight the following observation about the IMF that ends up giving it a bad name for government’s mistakes:

One key feature in all this woe has to be a political process that is extremely ineffective, and driven by the fact that no one likes to hear bad news, and that the last thing a politician is able to say is tighten-up your belts now lads and lasses, we are in for a rough ride. But isn’t this just how the IMF gets such a bad name for itself, since the IMF doctors get called in just where the domestic political process breaks down, and where local politicians haven’t the ability to stand up in front of their citizens and say, it’s going to have to be like this, I’m afraid. Isn’t this what just happened in Ukraine, Hungary and Latvia? And then people say, those “nasty folk” at the IMF, they cut pensions everywhere they go, and wages are down 8% in Hungary, and 15% in Latvia once the IMF get to run the show. That is the IMF make for a convenient scapegoat, but people seldom ask themselves why wages needed reducing, or why there is no money to pay the pensions.

Granted, there are other ways to reduce a deficit and the IMF might be biased on how it wants to cut deficits but the general point stands.

In a recent WSJ article Oliver Hart and Luigi Zingales suggest that since the main reason behind bailing out the likes of Bear Stearns and AIG because of worries about counter-party risk the government should have instead guaranteed those obligations:

[I]t suggests that the best way to proceed is to help third parties rather than the distressed company itself. In other words, instead of bailing out AIG and its creditors, it would have been better for the government to guarantee AIG’s obligations to J.P. Morgan and those who bought insurance from AIG. Such an action would have nipped the contagion in the bud, probably at much smaller cost to taxpayers than the cost of bailing out the whole of AIG. It would also have saved the government from having to take a position on AIG’s viability as a business, which could have been left to a bankruptcy court. Finally, it would have minimized concerns about moral hazard.

I’d be very curious to hear more about what others think about this proposal and how workable it would have been. How exactly would the government have guaranteed some of the complex obligations and what kind of risks would it have taken on by doing so? Would this have assuaged investors’ concerns?

I’ve been writing a lot about the Financial Crisis and relatively little about African development but I found a great short little paper by Shanta Devarajan, Chief Economist of the Africa Region at the World Bank, about the impact of the crisis on Africa that combines the too. If you’re curious about how the crisis has impacted other countries here’s a post about it’s impact in Eastern Europe and Iceland. It’s late and I want to keep this short but here’s the core idea followed by the five ways of how the crisis could have an impact, read the paper for more:

It is argued that the transmission mechanisms between the financial systems in Africa and the rest of the world are weak and will minimize the impact on the crisis. African financial institutions are not exposed to risks emanating from complex instruments in international financial markets because most banks in Sub-Saharan Africa rely on deposits to fund their loan portfolios (which they keep on their books to maturity); the interbank market is small; the market for securitized or derivative instruments is either small or nonexistent, and few rely on foreign borrowing to fund their lending operations. Exceptions to this position are then made for countries like Nigeria and South Africa which are seen as having meaningful transmission mechanisms with the larger financial systems in crisis.

This conventional position is now being challenged. As the immediate crisis faced in the last couple of months subsides, and policymakers begin to consider the longer term impact of the crisis in Africa, an emerging view is that the impact on the financial sector in Africa may actually be more significant and longer lasting than first assumed, and the impact on the non-financial sector in Africa will be more notable.

Impacts:

1. Weakened local investor confidence in equities and bonds on African Stock Exchanges
2. Return to ultraconservative lending practices 
3. Losses arising from central bank reserve management practices 
4. Renewed debate on the role of governments in the financial system 
5. Weakened balance sheets resulting from a downturn in the real economy

Finally, one obvious way the crisis will affect the real economy is through a drop in commodity prices:

Declining demand for commodities will impact African countries significantly. In Zambia for example, the economy is likely to take a hit from a share decline in copper prices (-24%ytd). As the financial crisis surges into all parts of the real economy in developed economies, African countries will experience a substantial decline in exports as the rapid pace of trade expansion in this decade decelerates sharply.