Eight Failures

Stiglitz listed the following Crisis' Triggers:

1) Too-big-to-fail banks have perverse incentives; if they gamble and win, they walk off with the proceeds; if they fail, taxpayers pick up the tab.

2) Financial institutions are too intertwined to fail; the part of AIG that cost America's taxpayers $180 billion was relatively small.

3) Even if individual banks are small, if they engage in correlated behavior – using the same models – their behavior can fuel systemic risk;

4) Incentive structures within banks are designed to encourage short-sighted behavior and excessive risk taking.

5) In assessing their own risk, banks do not look at the externalities that they (or their failure) would impose on others, which is one reason why we need regulation in the first place.

6) Banks have done a bad job in risk assessment – the models they were using were deeply flawed.

7) Investors, seemingly even less informed about the risk of excessive leverage than banks, put enormous pressure on banks to undertake excessive risk.

8) Regulators, who are supposed to understand all of this and prevent actions that spur systemic risk, failed. They, too, used flawed models and had flawed incentives; too many didn't understand the role of regulation; and too many became "captured" by those they were supposed to be regulating.

[...] These are not matters of black and white: the more we limit the size, the more relaxed we can be about these and other details of regulation. That is why King, Paul Volcker, the United Nations Commission of Experts on Reforms of the International Monetary and Financial System, and a host of others are right about the need to curb the big banks. What is required is a multi-prong approach, including special taxes, increased capital requirements, tighter supervision, and limits on size and risk-taking activities.

Such an approach won't prevent another crisis, but it would make one less likely – and less costly if it did occur.

Economic Cycles

Harold James commented:

"In the nineteenth-century world, people rapidly picked themselves up after downturns and went back to business as usual. In that sense, the phenomenon of the business cycle looked relatively permanent and unchanging. Nowadays, however, a cyclical collapse comes as a great surprise. In its aftermath, we start to reinvent our view of economics. Every ten years or so, we think that a particular model of growth is so broken that it cannot be resurrected. The world needed to be rethought in 1979, 1989, 1998, and 2008."

"[…] But each wave of collapse breeds a greater degree of disillusion about particular institutions, which are blamed for the outcome. It may be the welfare state in the 1970’s, the Communist Party apparatus in the 1980’s, the Asian industry and trade ministries in the 1990’s, or the nexus of the US Treasury and Wall Street in the 2000’s."

"As each institution is eroded, there is less and less left in the way of alternatives. That is also true of currencies."

"The dollar has been knocked off its pedestal by the crisis, but any conceivable substitute is obviously even more flawed and more problematical. The euro is the composite currency of an area with a poor growth record and an inadequate response to the economic crisis. The renminbi is still non-convertible. So there is no master currency at all any more."

WSJ survey

Findings of the last (Nov09) WSJ survey:

"On average [analysts] expect the Federal Reserve to raise interest rates around September 2010, a politically sensitive time considering midterm elections will be right around the corner and unemployment is forecast to still be over 9.5%."

"Emerging markets and commodities are the most likely places for another bubble to develop, according to economists, but they only put slightly better than 1-in-3 odds of such an unsustainable run-up in asset prices occurring in the next two years."

"More than half of the respondents see a U-shaped recovery with some slowness followed by solid growth, and 31% forecast a stronger, V-shaped recovery. Just 11% of economists expect an L-shaped rebound where economic activity stabilizes at a low level, and only 7% see a double-dip recession—another drop in gross domestic product after a short rebound—as the most likely scenario."

Charts & Data

Source: WSJ

Are potential "asset-price bubbles" always dangerous?

En un artículo publicado en Financial Times Frederic Mishkin identifica dos tipos de asset-bubbles: "pure irrational exuberance bubble" (Mild) y "a credit boom bubble" (Severe). Las burbujas del segundo tipo (feedback loop) presentan las siguientes características:

"[…] exuberant expectations about economic prospects or structural changes in financial markets lead to a credit boom. The resulting increased demand for some assets raises their price and, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more, creating a positive feedback loop. This feedback loop involves increasing leverage, further easing of credit standards, then even higher leverage, and the cycle continues. [...] Eventually, the bubble bursts and asset prices collapse, leading to a reversal of the feedback loop."

A diferencia de la perspectiva de Dr. Doom, Mishkin señala que:

"But if bubbles are a possibility now, does it look like they are of the dangerous, credit boom variety? At least in the US and Europe, the answer is clearly no. Our problem is not a credit boom, but that the deleveraging process has not fully ended. Credit markets are still tight and are presenting a serious drag on the economy."
Source: FT.com

Risky asset prices have risen too much, too soon

De acuerdo con Nouriel Roubini:

"Since March there has been a massive rally in all sorts of risky assets – equities, oil, energy and commodity prices – a narrowing of high-yield and high-grade credit spreads, and an even bigger rally in emerging market asset classes (their stocks, bonds and currencies). At the same time, the dollar has weakened sharply, while government bond yields have gently increased but stayed low and stable."

"Easy money, quantitative easing, credit easing and massive inflows of capital into the US via an accumulation of forex reserves by foreign central banks makes US fiscal deficits easier to fund and feeds the US equity and credit bubble."

Agrega:

"But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments."

Source: FT.com

A period of higher short-run price volatility

Robert Shiller writing for the New York Times:

Could the more extreme recent shift mean that home prices will just keep rising this time?

For a home buyer who borrows 90 percent of the money to acquire a house, an appreciation rate of 11.2 percent offers an investment bonanza. By putting a small amount of money down, investors stand to make a large gain if home prices climb. That is the power of leveraging. Recently, however, home buyers have also experienced the unpleasant consequences of leverage when home prices fall. Investing in a home during the wild past few years has been like gambling in a casino: You can leave with riches or empty pockets.

At the moment, it appears that the extreme ups and downs of the housing market have turned many Americans into housing speculators. Many people are still playing a leverage game, watching various economic indicators as well as the state of federal bailout programs […] in an effort to time their home-buying decisions.

Markets have gone up too much, too soon, too fast

Accordingly with Bloomberg Nouriel Roubini said:

I see the risk of a correction, especially when the markets now realize that the recovery is not rapid and V-shaped, but more like U- shaped. That might be in the fourth quarter or the first quarter of next year.

In the short run we need monetary and fiscal stimulus to avoid another tipping point and to avoid deflation, but now this easy money has already started to create asset bubbles in equities, commodities, credit and emerging markets

S&P 5000 (from Oct08 to date)

Dow Jones (from Oct08 to date)

We are facing many crises

The 64th opening of the General Assembly asks us to rise to an exceptional moment. We are facing many crises – food, energy, recession, and pandemic flu – occurring all at once. If ever there were a time to act in a spirit of renewed multilateralism, a time to put the “united” back into the United Nations, it is now.

[…] And that is what we are doing, as action on three issues of historic consequence demonstrates. […] the threat of catastrophic climate change, […] nuclear disarmament, [and] turning the corner to recovery (from financial Recession).

Project-Syndicate, Ban Ki-moon

Confidence, Confidence and Trust

On a fundamental level, all crises share causes and cures but they also have many differences. The cure is made up of two ingredients: 1) regain confidence to resolve a crisis; and 2) preserve confidence to prevent a crisis from repeating itself. Given the international dimension of this crisis and the proliferation of cross-border banking, the cure for this crisis also involves a third component – trust between authorities to enhance cross-border crisis management.

Stefan Ingves at the Eurofi Forum

At the Mortgage Broker's...

Una síntesis del inicio de la crisis actual (Selección Adversa y Daño Moral)

RSG Investment Bank, "Trust the 'Really Smart Guys' for all your investment needs"

Home Prices Increase

"U.S. home prices rose in July from a month earlier, according to the S&P Case-Shiller home-price indexes, with just two of the metropolitan areas showing declines. Meanwhile, the rate of annual declines continues to accelerate"

WSJ.com

The full S&P / Case-Schiller report

Emerging Markets and Global Financial Reform

The home country must put a cap on leverage, limit acceptable liquidity and funding practices, and have a resolution regime for winding up complex financial institutions. Otherwise, emerging markets should be able to say that banks from that country will not be allowed to enter.

[E]merging markets need to redouble their efforts to build bond markets, but on a local basis. Countries with more developed bond markets experienced less negative fallout from the crisis, since their large firms retained access to non-bank sources of finance.

Encouraging participation by foreign investors is a quick way to jump-start local bond market activity. But recent experience suggests that quickest is not best. Regulations limiting foreign participation to prudent levels should be part of the new international regime.

Project Syndicate, Eichengreen

Los Desafíos de la Competitividad

Inauguración: Dr. Cabrero, Sen. Navarrete, Mtro. Romero Hicks, Dr. Rodrick (El Futuro del Capitalismo, A partir del minuto 33), Dr. Esquivel

Reinventing Economics

As George Akerlof and I argue in our recent book Animal Spirits , the current financial crisis was driven by speculative bubbles in the housing market, the stock market, and energy and other commodities markets. Bubbles are caused by feedback loops: rising speculative prices encourage optimism, which encourages more buying, and hence further speculative price increases – until the crash comes.

[…] Yet events like the Great Depression, as well as the recent crisis, will never be fully understood without understanding bubbles. The fact that monetary-policy mistakes were an important cause of the Great Depression does not mean that we completely understand that crisis, or that other crises (including the current one) fit that mold.

Robert Schiller

Finding the Policy Exit

The problem is that most economies are now barely bottoming out, so reversing the fiscal and monetary stimulus too soon – before private demand has recovered more robustly – could tip these economies back into deflation and recession. Japan made that mistake in 1998-2000, just as the US did in 1937-1939.

But, if governments maintain large budget deficits and continue to monetize them as they have been doing, at some point – after the current deflationary forces become more subdued – bond markets will revolt. When that happens, inflationary expectations will mount, long-term government bond yields will rise, mortgage rates and private market rates will increase, and one would end up with stagflation (inflation and recession).

Nouiel Roubini

"Macroeconomists, Economist and the Crisis"

"The current global financial crisis and recession, whose depth is unprecedented in recent decades, has cast doubts about the work of macroeconomists, the usefulness of their theories, and their capacity to anticipate and deal with crises. These are the issues I will discuss today."

José De Gregorio

"Schumpeter’s Time"

"One of Schumpeter’s most important contributions was the emphasis he placed on the tremendous power of innovation and entrepreneurial initiative to drive growth through a process he famously characterized as "creative destruction." His work captured not only an economic truth, but also the particular source of America’s strength and dynamism."
Lawrence Summers
Director of the National Economic Council

One Year Ago

Cochrane & Zingales

Why no one saw it coming

"Everyone from the Queen of England to laid-off Detroit autoworkers wants to know why more experts did not see the financial crisis coming. It is an awkward question. How can policymakers be so certain that financial catastrophe won’t soon recur when they seemed to have no idea that such a crisis would happen in the first place?"
Rogoff