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Sunday, August 14, 2011

Transcript 453: Simon Johnson and the Hysterical Matrons of the Market

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Downside risks in our baseline forecast, which we repeated in January, included a new and messier financial sector meltdown. Hard to imagine even today, you say, with the huge cash balances at the banks, now $1.4 trillion. That is ten percent of GDP. You forget that many of the assets on their balance sheets are valued at mark-to-make-believe. Combine this with the new leg down now unfolding. It’s not pretty. And add to this the fact that the trading houses are exposed to the stock market more than anybody else, having abandoned investment in favor of speculation, including in commodities. I can hear Ben Bernanke saying it now, “Nobody saw this coming.”

Where is Baffled Ben? That comes next week.

Beginning next week, Demand Side will concentrate exclusively on forecasting and forecasts. We believe we have the record and awareness of who has been right and who has been wrong. In spite of its being free, it will be the best look forward, short-, medium- and long-term.

Today we bring in Simon Johnson and Nouriel Roubini to take a look at monetary policy and leadership in the current financial mess.

We begin with Simon Johnson, former chief economist at the IMF, and the voice that is most clear and most accurate about what needs to be done and what doesn’t

Johnson writes in a recent post.
In the wake of recent equity market declines, the clamor for bailouts of various kinds grows ever louder around the world. Influential voices call for “leadership” from the US and Western Europe, and for policymakers in those countries to “get ahead of the curve”. This is all code for a simple and familiar plea: Do something that will protect investors, particularly creditors who have lent a lot of money to banks and countries that now appear to be in serious difficulty.

But providing another round of unconditional creditor bailouts in this situation would be a mistake. What we need is a combination of transparent losses where bad loans were made, combined with a ring fencing approach that protects sound governments and firms. There is no sign yet that policymakers are willing to make that distinction clear.

The situation around the world is undeniably bad. … Europe is most definitely “On the Brink” of a serious economic crisis that could involve widespread defaults or significant inflation or both. At the same time, Bank of America shares this week fell to their lowest in 2 years; with other large banks under pressure, there is a legitimate fear of rerunning the parts of the financial crisis of 2008-09.

The Financial Stability Oversight Council’s recently released first annual report does not provide particularly up-to-date numbers, but most of the global warning lights that they discuss in Chapter 7 must now be flashing red. As recently as 2008-09, there were three kinds of government support available to the US and European economies when such systemic financial trouble hit. But all three traditional forms of bailout are now much harder to pull off.

First, over the past 30 years interest rate cuts and other forms of expansionary monetary policy became standard practice in the face of potential financial market disruption – this is the original meaning of the “Greenspan put”. But short-term interest rates are already very low in the United States. The European Central Bank (ECB) has room to cut rates – but both the ECB and the Federal Reserve fear that inflation may soon return. Unlike fall 2008, they are reluctant to respond to the latest round of stock market declines with a dramatic easing of monetary policy.

Second, after the initial monetary policy response in fall 2008, it was fiscal policy that took the lead in preventing global economic freefall – with significant attempts to provide countercyclical stimulus in the US, much of Western Europe, and China.

Now the eurozone faces a series of fiscal crises … Further stimulus is out of the question – the issue in Europe is who will do what kind of austerity and how fast.

The fiscal crisis in the US is more imagined than real. The S&P downgrade of long-term US government debt sparked a massive sell-off – but not in government debt. Investors around the world vote with their feet; they see US government assets as one of the safest available assets. Still, further fiscal stimulus is most definitely not on the political table in Washington.

And even Chinese fiscal policy shows signs of tightening – as the authorities try to prevent any overheating that could accelerate inflation.

Third, in 2008-09, monetary and fiscal policies were complemented by government capital injections directly into US and European banks. But these became harder to do under the Dodd-Frank financial reform legislation – unless there is a large-scale systemic approach, which would be very hard to get through this Congress.

The worst financial sector problems are in Europe. But the recent banking stress tests there were completely unrealistic as they did not include default events that now appear inevitable. To run one set of misleading stress tests (in 2010) might be considered excusable, to do this twice during the same crisis is unconscionable. There is no coherent financial sector policy within the eurozone.

What are the policy options now? The people in charge of European and US policy would clearly prefer to do nothing or postpone dealing with the underlying issues. This is a bad idea as it puts markets in charge – and these markets are panicked.

The core to any feasible strategy must be bank capital. … without sufficient capital large banks and other financial institutions are prone to failure – this is what spreads failure and panic far and wide . The Basel III framework, negotiated just last year, is crumbling before our eyes; the failure to ensure sufficient capital is at the heart of the European meltdown – and why the pressure on US banks is mounting.

The Europeans have to decide, once and for all, which sovereigns will restructure their debts and which will be protected – to an unlimited degree – by the European Central Bank. A full-scale bank recapitalization program is required, along with management changes at almost all major European financial institutions.

If the Europeans fail to get a grip on their economic situation, the FDIC will be pressed to use its Dodd-Frank resolution powers to take over and manage the unwinding of a major financial institution. In that scenario, creditors are supposed to face losses that are transparent and clearly understood; the theory is that this will stabilize market expectations.


The Dodd-Frank reform process decided not to break up global megabanks, but rather to handle them under the FDIC’s resolution framework. We’re about to find out if this was a good idea – or if we are just on the brink of more unconditional bailouts.”

That from Simon Johnson

Next week we’ll begin focusing on the forecast. With help from Nouriel Roubini and a post entitled, Mission Impossible: Stop Another Recession. Our baseline is and has been, bouncing along the bottom with significant downside risks from European debt and fallout in the U.S. banking sector from commercial real estate. We predicted and still predict negative growth in the second half of this year. In the absence of policy options, we’re looking at 1932.

The hysterical matrons of the market are about to start shrieking. Hold onto your hats.


  1. I have always felt that the Basel III accord was deeply flawed. It relied on banks knowing the risk of their assets. They clearly missed that with the MBS fiasco. The rules should be very simple very conservative and unbreakable. Tier 1 capital should be shareholders funds, cash on deposit, and liquid government bonds. Anything that can vary in value should be considered tier one capital.

    Secondly the banks have captured their national regulators in terms of their banking model. So another crash is certain. Last year I thought within this decade. Now I think a lot sooner. Governments need to ignore banks as National champions in a race to see who is the worlds biggest banks. In fact banks above a certain size should have to pay substantial systemic risk premiums. Smaller banks and more competition will eliminate banks as a growth segment of the economy and accept life as a regulated utility.

    The economies of Europe and US have been bouncing along the bottom for the last three years. Even Germany have only benefited from the weakness of the euro from its weaker partners affecting the euro value. All the central banks have managed to achieve is a little froth in the markets. The inevitable decline of the markets is coming though will they create inflation to hide their complicity in the crimes of incompetence.

    Longer term until the US undergoes significant political and structural reforms it will basically slide into decline.

  2. I am reading Barry Eichengreen's "Exorbitant Privilege," and I am at the point where the ECB is created and the Bundesbank is requiring the single mandate of price stability and the ruling out of mechanisms for transfer and stability, as well as complete independence of the ECB from political influence.

    Now the monetary union depends on this institution (ECB) which sees inflation behind every bush and views support to demand as always and everywhere inflationary. I wonder if it is not time for tariffs. Quite the jump? But countries like Germany, Japan, China -- the hypercompetitive nations everyone is supposed to emulate -- could not exist if everyone emulated them. The very existence of their trade surpluses means there must be capital flowing to their trading partners, i.e., debts being incurred by them. So now when the insistence is that they must be repaid, the only means out -- growth -- is cut off by debt service requirements. It is the IMF strategy of insisting on stagnation.

    Tariffs could obtain capital from those who benefit from trade, provide a fund to compensate the losers from trade, who are often mentioned in the phrase "In theory trade provides gains enough so that everyone is made better off," and at the same time the price wall protects wages and businesses from the helter-skelter rush of corporations from one low-wage country to the next.

    If everyone erected the wall at the same height, it would not be unfair, it would promote local production and reduce transportation costs, environmental and monetary (which must also be a reduction of the incomes to the producers).

    Just a thought.

    Back at the beginning of this crisis, Joe Stiglitz opined that the way to save the euro was to have Germany leave the EU, since it would take the biggest problem with it. Many Germans like that idea themselves, likely because they don't understand its implications for their export or their banks. The fatal problem with the idea is that the political stability of the continent is improved by union.

    Your thoughts?