Government-sponsored Enterprises: Fannie Mae and Freddie Mac
Carlos M. Pelaez
In a perfectly competitive economy maximum efficiency is attained when the economy produces output for all goods and services at which price equals marginal cost. The definition of marginal cost is the increase in cost resulting from the production of an extra unit of output of goods or services. Costs include normal profits or the remuneration required for entrepreneurs to organize production. Government intervenes directly by fixing maximum or minimum prices of goods and services.
First, the fixing of prices by the government below marginal cost, or maximum price, causes a shortage or less output of the good or service than optimal. The sale of an extra unit brings in a price that is lower than the cost of producing that extra unit, resulting in a loss, such that the extra unit is not produced. New York real estate prices are frozen for certain residences but not for new construction. The city has had a perennial housing “shortage” with the coexistence of frozen rents of a few hundred dollars with monthly rents of $6000 for a two-bedroom apartment. The elimination of frozen rents would increase construction to the point where the cost of housing in the city would move toward the optimum. There is a social welfare loss because output or construction is less than what is required by the preferences (needs) of society.
Second, the government can also fix a minimum price above marginal cost. The producer would increase output because an extra unit of production, or price, would bring in more revenue than what it costs, or marginal cost. In this case there is a surplus of unsold output. Agricultural support programs in the US by minimum prices caused perennial unsold surpluses purchased and stockpiled by the government. The situation is more complex when the supply of the good or service depends on past prices. For example, the coffee tree planted today only provides full output in three years. Brazil had a majority share of world coffee output and engaged in withdrawals by the government of coffee from the market after 1906 to maintain high prices that induced higher production in a few years as analyzed by Antonio Delfim Netto (Pelaez, ed., Essays on Coffee and Economic Development). The continuing support of coffee prices eroded Brazil’s advantage by encouraging other producers that gained market share. There is a welfare loss in that capital, labor and natural resources are used to produce more than what is desired (needed) at the expense of other goods that could have been produced. There is also a transfer of income from taxpayers to the subsidized producers benefitting from the minimum prices.
The current credit/dollar crisis and global recession originated in one of the largest subsidies in US history that caused overproduction of housing. The various forms of this housing subsidy or minimum housing price occurred as follows (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, and Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4):
●30-year Treasury Bond. On August 9, 2001, Treasury ceased the auction of the 30-year Treasury bond and did not auction this security again until August 2005. The objective was to reduce mortgage rates in an effort to lower monthly payments of mortgages that actually injected more money effectively in homeowners’ pockets than through tax rebates. The 30-year Treasury is used as an asset to match the liabilities of long-term contracts such as pensions. The sudden disappearance of new 30-year Treasury bonds caused an increase in demand for mortgage bonds that raised their prices, which is equivalent to a reduction of mortgage rates (Pelaez and Pelaez, Government Intervention in Globalization, 52-6).
●Zero Interest Rate. The fed funds rate is the rate at which banks sell to each other excess reserves deposited at the Federal Reserve Banks (FRB). The fed funds rate is an approximation of the marginal cost of funding of banks and influences the levels of most other rates charged by banks to their clients. The Fed lowered the fed funds rate by decrements in periodic meetings of the Federal Open Market Committee (FOMC) from 6 percent on January 3, 2001, to 1 percent on January 25, 2003, maintaining it at that level until June 30, 2004, and then raising it in increments to 5.25 percent by June 29, 2006. The lowering of the fed funds rate to 1 percent and the announced intention of lowering it to zero if required in avoiding deflation that never materialized distorted the calculations of risk and return in almost every activity in the world. Near zero interest rates encourage excessive debt with risk priced at very low levels; low liquidity and leverage are induced because of the hunt for high yields to remunerate capital. The flood of cheap liquidity encouraged unsound credit. The rapid increase in rates from 1 percent to 5.25 percent shows the current Fed trap of lowering rates close to zero because of the pain caused by their subsequent sharp increase.
●Housing Subsidy. Dwight Jafee and John Quigley published in the Brookings-Wharton Papers on Urban Affairs of 2007 an estimate of the US housing subsidy in 2006 of $221 billion composed of $37.9 billion in government expenditures for low-income housing, $156.5 billion in federal tax subsidies for housing and $26.7 billion in credit subsidies (cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 44, Regulation of Banks and Finance, 219).
●Fannie and Freddie. In 1990, the total portfolio of Fannie and Freddie amounted to $604 billion of which $135 billion in the retained portfolio and $604 billion in guarantees of mortgage-backed securities (MBS) equivalent to 25.4 percent of total mortgages in the US of $2911 billion. In the third quarter of 2008 the total portfolio stood at $5243 billion of which $1498 billion in the retained portfolio and $3744 billion in guarantees of MBS equivalent to 43.5 percent of total mortgages in the US of $12,057 billion (data from the OFHEO in Pelaez and Pelaez, Financial Regulation after the Global Recession, 45).
The Chief Economist of the National Association of Realtors (NAR) estimates that the loss of homeowner equity from the peak of house prices in 2006 to mid 2009 accumulated to $5.5 trillion (http://www.realtor.org/research/economists_outlook/commentaries/ehs0609ly ). The loss is equivalent to 38.9 percent of estimated GDP for 2009 of $14,140 billion. Total house value in the US stood in mid 2009 at $17 trillion about equal to the value in 2003. The gain in home equity between 2000 and 2005 was $4 trillion (calculation of the NAR cited in Pelaez and Pelaez, The Global Recession Risk, 224). This fluctuation in home values can be explained by the above factors. Mortgage rates declined significantly from 7.91 percent in 1999 to 6.68 percent in mid 2006 (Pelaez and Pelaez, The Global Recession Risk, 224, citing data of Freddie Mac). Part of the decline originated in the more benign inflation environment but it was reinforced by the discontinuance of the auctions of 30-year treasuries, the zero interest rate, the housing subsidy and the operations of Fannie and Freddie. Lower mortgage rates and accessibility to housing loans in the flood of cheap credit attracted homeowners and investors, causing significant increase in demand for houses and thus their prices. As in the case of agricultural commodities, construction of a house takes time from the initial decision as developers plan projects, buy land and begin building and marketing of houses for future delivery. The $4 trillion gain in homeowner equity calculated by the NAR reflects the increase in house prices that motivated more construction. More units kept on reaching the market after prices began declining.
In testimony before the US House of Representatives on December 9, 2009, the former chief credit officer of Fannie Mae, Edward Pinto, stated that Fannie and Freddie purchased about half of the outstanding 25 million nonprime mortgage loans in the value of $4.5 trillion with leverage ratio of 75:1 (cited by Pelaez and Pelaez, Financial Regulation after the Global Recession, 46, Regulation of Banks and Finance, 80). Nonprime mortgages were purchased or guaranteed by what turned out to be the US federal government (taxpayers) as everybody anticipated. The zero interest rate of the Fed created the impression that housing prices would increase forever. Homeowners believed that the downside was to live in a better residence for a couple of years before reset of mortgage rates and principal and then sell the house for a capital gain after repaying the mortgage. Lenders believed that the downside was early repayment of the mortgage or sale at market value in foreclosure. Low interest rates caused high house and stock prices making everybody feel artificially wealthier (Pelaez and Pelaez, Financial Regulation after the Global Recession, 234-6, Regulation of Banks and Finance, 175-7, Globalization and the State Vol. II, 212, Government Intervention in Globalization, 183). Mortgagors began defaulting after the peak in prices in 2006. Many of the nonprime mortgages were in MBS and derivatives known as collateralized mortgage obligations (CDO) that were financed with commercial paper issued by structured investment vehicles (SIV) often related to banks (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). The origin of the credit/dollar crisis was the default of mortgages because of the minimum price to housing artificially created by zero interest rates, the housing subsidy, Fannie and Freddie and not the financial innovations in securitization and structured products or irresponsible bankers.
Over the last nine quarters Fannie lost $120.5 billion and Freddie lost $67.9 billion (reported by www.bloomberg.com on December 25, 2009). On December 24, 2009, Treasury announced the elimination of the limit of $200 billion each for Fannie and Freddie of Treasury equity infusions that can now exceed the combined $400 billion of which the two companies have used $111 billion. Ideal and critical regulatory change should consist of gradual sale of the portfolios of Fannie and Freddie, returning residuals if any to shareholders. Housing subsidies if any should be incorporated in the federal budget but there should not be government-sponsored enterprises taking major risks that cause shocks in housing and financial markets. Guarantees of mortgages if any could be considered by Congress in a federal agency with prudent management and supervision. The heavy regulatory agenda focuses on irresponsibility of bankers in pursuit of bonuses but has ignored the actual causes of the credit/dollar crisis and global recession. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
Sunday, December 27, 2009
Sunday, December 20, 2009
Securitization, Derivatives and the Wall Street Act of the House of Representatives
Carlos M. Pelaez
Clear thought on financial regulation and understanding lending by banks require analysis of the functions of banks. Providing transformation services is a critical function of banks. In the model of bank runs of Diamond and Dybvig, banks can be conceptualized as converting monitored, illiquid loans and investments into liquid fed funds. Banks deposit required regulatory reserves at the Federal Reserve Banks (FRB), lending their reserves above those required by the Fed to other banks in overnight loans of fed funds (Pelaez and Pelaez, Globalization and the State, Vol. I, 34-7, Government Intervention in Globalization, 33-5, Financial Regulation after the Global Recession, 74-7, Regulation of Banks and Finance, 102-8). Loans and investments only begin to provide cash flows in the future but require cash immediately to pay for construction, machinery, working capital, wages and the like. Banks accept deposits from the public and provide the funds to business and investors so that they can initiate their projects that provide employment in producing goods and services. Monitoring consists of evaluating the feasibility of projects, a function that banks acquire through their relations with customers and developing techniques of project evaluation. Monitoring also ensures that borrowing companies and investors do not use resources for activities riskier than those in the loans agreement, such as using a loan for buying equipment while investing instead in high-risk stocks. The banking model of Diamond and Rajan analyzes the fragility of banks by the threat of bank runs. A bank can become insolvent if the value of the assets such as loans and investments cannot honor the value of the liabilities or deposits.
Investment in production of goods and services occurs now but cash is first received months and even years in the future. Financial institutions provide the liquidity now so that production and employment can start immediately. The funds for most loans are obtained through risk transfer or securitization (Pelaez and Pelaez, Financial Regulation after the Global Recession, 48-52, Regulation of Banks and Finance, 59-60). A potential home owner requiring money to buy a house enters into a mortgage with a mortgage lender. The money does not originate in a bank or other financial institution. The mortgage originator obtains the money by bundling mortgages of similar credit, maturity and rate into a bond called mortgage-backed security (MBS) (Pelaez and Pelaez, Financial Regulation after the Global Recession, 42-48). This security is sold to multiple investors including mutual funds and pension funds where many people invest their savings for emergencies and retirement. The payment of interest and principal of the MBS is obtained from the underlying mortgages. If there were not the funds to finance the mortgage, there would not be the construction and employment generated by building houses. The same is true of nearly all loans for business or consumers such as auto loans, credit cards, student loans and so on. Banks generate funds for credit by bundling loans of similar credit rating, maturity and rates in bonds known as asset-backed securities (ABS). Some of the MBS and ABS may be held for investment. A significant part of MBS and ABS are converted into immediate liquidity by means of the repo market or sale and repurchase agreements. The financial institution buys the MBS or ABS with funds obtained by selling the security in exchange for cash with a promise to repurchase it overnight or in a short period paying the interest on the loan with the MBS or ABS serving as collateral. The counterparty financing the MBS or ABS imposes a haircut or reduction in the price in the sale and repurchase contract to protect against a decline in the price of the MBS or ABS in the event that the repurchase agreement is not honored.
The engine of growth of the economy is what Joseph Schumpeter identified as waves of innovation or the application of technology to production or business organization. The world has experienced a second industrial revolution since about the 1970s characterized by new technology. Innovation requires financing for business to invest in plants and equipment and also for credit to consumers to buy the products, students to finance education and so on. The technological revolution created huge new needs of financing that were met with innovations in financial services. The role of regulation is to provide rules for orderly conduct of financial business but without frustrating innovation.
There has been significant growth of credit, interest and foreign exchange derivatives over the counter, that is, in contracts among entities, and in formal exchanges. Consider an example of a derivative used by a German exporter of $10,000 to the US at the rate of $1.3374/euro (Pelaez and Pelaez, Government Intervention in Globalization, 71-2). The exporter would receive 7,477 euros (10,000 divided by 1.3374). But the revenue could decline in a year to 6,403 euros if the dollar devalued to $1.5618/euro (10,000 divided by 1.5618). One hedge would be for the exporter to buy the euro relative to the dollar for delivery in months ahead by means of a forward exchange contract from the exporter’s bank to ensure the exchange rate for conversion of the revenue in euros of selling in the US. In contrast with futures markets for foreign exchange, the bank can tailor the forward contract to the precise needs of the exporter in terms of total value, start date and maturity.
The official interpretation of the credit/dollar crisis and global recession is that banks and financial institutions engaged in an “era of irresponsibility” by taking excessive risks in pursuit of bonuses. According to this view, banks and financial institutions require the sober tutelage of government to prevent excessive risks and the repetition of another financial crisis. The Wall Street Act approved by the House requires that “all standardized swap transactions between dealers and major swap transactions would have to be cleared and traded on an exchange or electronic platform.” A major swap participant is defined as a holder of a substantial net position in swaps, excluding hedging for commercial objectives, or creating significant exposure to counterparties requiring monitoring.
Government does not know better than banks and financial institutions how to control risks so as to prevent financial crises and recessions. Available theory is equivocal and empirical evidence mixed. The credit/dollar crisis and global recession originated in errors of economic policy. The reduction in 2003-2004 of the fed funds rate to 1 percent with the announced intention to keep it near zero as long as required eroded the discipline of calculating risk/rewards by business, households, government, banks and financial institutions (Pelaez and Pelaez, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4, Financial Regulation after the Global Recession, 157-66, and Regulation of Banks and Finance, 217-27). These low interest rates caused excessive risk taking and leverage, low liquidity and unsound credit in the expectation that central banks had mastered a technique of promoting sustained economic growth without inflation. The debacle in derivatives originated primarily in underlying nonprime mortgages that were given a seal of government approval by the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie Mae and Freddie Mac. The announcement in September 2008 of the need of $700 billion for the withdrawal of bank “toxic” assets or the world would face a catastrophe contracted counterparty financing of MBS and ABS, paralyzing financial markets. None of the programs of withdrawing toxic assets in September 2008 and February 2009 withdrew one dollar of toxic assets. Confidence eventually returned when counterparties had the time to evaluate the soundness of assets. It is possible to conclude that the crisis would not have occurred had it not been for the wide swings of interest rates caused by the Fed.
The Wall Street Act restricts the volume of financing, increases the cost of credit, weakens banks and financial markets, and frustrates innovation precisely when financing is critical for business and consumers in the effort to increase production and create employment. There is still time to consider more sober banking and financial regulation that recognizes the need for financing and innovation together with the cooperation of government and business in promoting growth and employment. Excessive intrusion on business by regulation can reduce the volume of financing required for future prosperity. Financial regulation that is stricter than in other countries can export the financial industry outside the US as it happened with Regulation Q created by the Banking Act of 1933 in a depression rush of regulation (Pelaez and Pelaez, Regulation of Banks and Finance, 74-5). (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
Carlos M. Pelaez
Clear thought on financial regulation and understanding lending by banks require analysis of the functions of banks. Providing transformation services is a critical function of banks. In the model of bank runs of Diamond and Dybvig, banks can be conceptualized as converting monitored, illiquid loans and investments into liquid fed funds. Banks deposit required regulatory reserves at the Federal Reserve Banks (FRB), lending their reserves above those required by the Fed to other banks in overnight loans of fed funds (Pelaez and Pelaez, Globalization and the State, Vol. I, 34-7, Government Intervention in Globalization, 33-5, Financial Regulation after the Global Recession, 74-7, Regulation of Banks and Finance, 102-8). Loans and investments only begin to provide cash flows in the future but require cash immediately to pay for construction, machinery, working capital, wages and the like. Banks accept deposits from the public and provide the funds to business and investors so that they can initiate their projects that provide employment in producing goods and services. Monitoring consists of evaluating the feasibility of projects, a function that banks acquire through their relations with customers and developing techniques of project evaluation. Monitoring also ensures that borrowing companies and investors do not use resources for activities riskier than those in the loans agreement, such as using a loan for buying equipment while investing instead in high-risk stocks. The banking model of Diamond and Rajan analyzes the fragility of banks by the threat of bank runs. A bank can become insolvent if the value of the assets such as loans and investments cannot honor the value of the liabilities or deposits.
Investment in production of goods and services occurs now but cash is first received months and even years in the future. Financial institutions provide the liquidity now so that production and employment can start immediately. The funds for most loans are obtained through risk transfer or securitization (Pelaez and Pelaez, Financial Regulation after the Global Recession, 48-52, Regulation of Banks and Finance, 59-60). A potential home owner requiring money to buy a house enters into a mortgage with a mortgage lender. The money does not originate in a bank or other financial institution. The mortgage originator obtains the money by bundling mortgages of similar credit, maturity and rate into a bond called mortgage-backed security (MBS) (Pelaez and Pelaez, Financial Regulation after the Global Recession, 42-48). This security is sold to multiple investors including mutual funds and pension funds where many people invest their savings for emergencies and retirement. The payment of interest and principal of the MBS is obtained from the underlying mortgages. If there were not the funds to finance the mortgage, there would not be the construction and employment generated by building houses. The same is true of nearly all loans for business or consumers such as auto loans, credit cards, student loans and so on. Banks generate funds for credit by bundling loans of similar credit rating, maturity and rates in bonds known as asset-backed securities (ABS). Some of the MBS and ABS may be held for investment. A significant part of MBS and ABS are converted into immediate liquidity by means of the repo market or sale and repurchase agreements. The financial institution buys the MBS or ABS with funds obtained by selling the security in exchange for cash with a promise to repurchase it overnight or in a short period paying the interest on the loan with the MBS or ABS serving as collateral. The counterparty financing the MBS or ABS imposes a haircut or reduction in the price in the sale and repurchase contract to protect against a decline in the price of the MBS or ABS in the event that the repurchase agreement is not honored.
The engine of growth of the economy is what Joseph Schumpeter identified as waves of innovation or the application of technology to production or business organization. The world has experienced a second industrial revolution since about the 1970s characterized by new technology. Innovation requires financing for business to invest in plants and equipment and also for credit to consumers to buy the products, students to finance education and so on. The technological revolution created huge new needs of financing that were met with innovations in financial services. The role of regulation is to provide rules for orderly conduct of financial business but without frustrating innovation.
There has been significant growth of credit, interest and foreign exchange derivatives over the counter, that is, in contracts among entities, and in formal exchanges. Consider an example of a derivative used by a German exporter of $10,000 to the US at the rate of $1.3374/euro (Pelaez and Pelaez, Government Intervention in Globalization, 71-2). The exporter would receive 7,477 euros (10,000 divided by 1.3374). But the revenue could decline in a year to 6,403 euros if the dollar devalued to $1.5618/euro (10,000 divided by 1.5618). One hedge would be for the exporter to buy the euro relative to the dollar for delivery in months ahead by means of a forward exchange contract from the exporter’s bank to ensure the exchange rate for conversion of the revenue in euros of selling in the US. In contrast with futures markets for foreign exchange, the bank can tailor the forward contract to the precise needs of the exporter in terms of total value, start date and maturity.
The official interpretation of the credit/dollar crisis and global recession is that banks and financial institutions engaged in an “era of irresponsibility” by taking excessive risks in pursuit of bonuses. According to this view, banks and financial institutions require the sober tutelage of government to prevent excessive risks and the repetition of another financial crisis. The Wall Street Act approved by the House requires that “all standardized swap transactions between dealers and major swap transactions would have to be cleared and traded on an exchange or electronic platform.” A major swap participant is defined as a holder of a substantial net position in swaps, excluding hedging for commercial objectives, or creating significant exposure to counterparties requiring monitoring.
Government does not know better than banks and financial institutions how to control risks so as to prevent financial crises and recessions. Available theory is equivocal and empirical evidence mixed. The credit/dollar crisis and global recession originated in errors of economic policy. The reduction in 2003-2004 of the fed funds rate to 1 percent with the announced intention to keep it near zero as long as required eroded the discipline of calculating risk/rewards by business, households, government, banks and financial institutions (Pelaez and Pelaez, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4, Financial Regulation after the Global Recession, 157-66, and Regulation of Banks and Finance, 217-27). These low interest rates caused excessive risk taking and leverage, low liquidity and unsound credit in the expectation that central banks had mastered a technique of promoting sustained economic growth without inflation. The debacle in derivatives originated primarily in underlying nonprime mortgages that were given a seal of government approval by the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie Mae and Freddie Mac. The announcement in September 2008 of the need of $700 billion for the withdrawal of bank “toxic” assets or the world would face a catastrophe contracted counterparty financing of MBS and ABS, paralyzing financial markets. None of the programs of withdrawing toxic assets in September 2008 and February 2009 withdrew one dollar of toxic assets. Confidence eventually returned when counterparties had the time to evaluate the soundness of assets. It is possible to conclude that the crisis would not have occurred had it not been for the wide swings of interest rates caused by the Fed.
The Wall Street Act restricts the volume of financing, increases the cost of credit, weakens banks and financial markets, and frustrates innovation precisely when financing is critical for business and consumers in the effort to increase production and create employment. There is still time to consider more sober banking and financial regulation that recognizes the need for financing and innovation together with the cooperation of government and business in promoting growth and employment. Excessive intrusion on business by regulation can reduce the volume of financing required for future prosperity. Financial regulation that is stricter than in other countries can export the financial industry outside the US as it happened with Regulation Q created by the Banking Act of 1933 in a depression rush of regulation (Pelaez and Pelaez, Regulation of Banks and Finance, 74-5). (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
Sunday, December 13, 2009
The Wall Street Reform and Consumer Protection Act
Carlos M. Pelaez
The US House of Representatives passed by a vote of 223-202 on December 11, 2009, the H.R. 4173 Wall Street Reform and Consumer Protection Act (Wall Street Act). This writing analyzes the Wall Street Act by means of two main approaches to the causes, duration and depth of the credit/dollar crisis and global recession, which lead to different evaluations of banking and financial regulation.
First, the proposals emanating from government follow Official Prudential and Systemic Regulation (OPSR) (Pelaez and Pelaez, Financial Regulation after the Global Recession, 30-4, Regulation of Banks and Finance, 217-24, International Financial Architecture, 101-60, Government Intervention in Globalization, 31-7, Globalization and the State, Vol. I, 30-43, Globalization and the State, Vol. II, 102-8). The assumed goal of OPSR is protecting depositors, investors, output and employment from failures in banking and financial markets. Financial crises are considered as the most important market failure, which is processed through “systemic risk.” The credit crisis allegedly originated in excessive risk taking by banks that were motivated in generating short-term profits to appropriate “irresponsible” compensation in bonuses and stock options. The failure of Lehman Bros in September 2008 affected the ability of other financial companies such as American International Group (AIG) and Citigroup to finance themselves in the market. Systemic effects consisted of paralysis of credit in multiple segments of financial markets, causing illiquidity of large companies and the collapse of their stock prices that prevented the raising of new capital. The government was forced into bailing out failing companies by equity infusions through the Troubled Assets Relief Program (TARP), which eventually restored confidence in financial markets.
Second, the alternative Finance View (FV) claims that the credit/dollar crisis and global recession were caused by government policies (Pelaez and Pelaez, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4, Financial Regulation after the Global Recession, 157-66, and Regulation of Banks and Finance, 217-27). The reduction of the interest rates on interbank loans or fed funds to 1 percent in 2003-4 with the announced determination to keep them at that level indefinitely distorted decisions on risk and returns of households, banks, companies and government. The interest-rate subsidy caused overproduction of housing and rising real estate prices fueled by the gigantic housing subsidy of the US of $221 billion per year, the purchase or guarantee of $1.6 trillion of non prime mortgages by Fannie and Freddie and the reduction of mortgage rates by elimination of the 30-year Treasury bond. The result of low interest rates and the housing subsidy was excessive construction of houses, laxity in borrowing and lending because house prices were expected to increase forever as central banks kept low interest rates, excessive risk exposures and leverage, low liquidity and unsound credit. Mortgage decisions based on permanently low interest rates turned sour when the Fed increased interest rates from 1 percent to 5.25 percent in 2004-2006, disrupting securitization and derivatives markets. The alarmist proposal of TARP in the second half of September 2009 as if it were required in avoiding another Great Depression because of “toxic assets” in all banks, instead of the failure of Lehman Bros, caused a crisis of confidence that stopped financing in many segments. Markets recovered on their own without withdrawal of toxic assets as first proposed by TARP and in the new administration by the Financial Stability Plan (FSP). Policy prolonged and deepened the credit/dollar crisis and global recession. The regulation passed by the Wall Street Reform and Consumer Protection Act is analyzed below by means of these two approaches.
(1)Cram down. The high moment of the US House of Representatives was the rejection by 241-188 votes of the “cram down,” allowing bankruptcy judges to reduce principal and interest rates on mortgages, extending repayment periods. Securitization of mortgages dates at least to the charter of Freddie Mac in 1970 to guarantee securities backed by mortgages and worked well until the zero interest rate and housing subsidy caused the credit crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession, 42-52, Regulation of Banks and Finance, 58-60, 79-80). Securitization allows a critical function of finance by bundling many small loans in large securities purchased by investors such as mutual and pension funds where individuals deposit their savings and build their retirements. Generalized default of mortgage-backed securities by bankruptcy judges as proposed in the cram down process would fracture the source of finance required for reconstruction of housing finance, economic growth and creation of employment. Investors and savers would not invest again in mortgage-backed securities and there could be a repetition of the credit crunch. The objective of the cram down of scaring ultimate holders of claims to modify mortgages failed but it scared investors financing new mortgages required for economic growth and employment creation.
(2)Financial Stability Oversight Council (Council). The Wall Street Act establishes an “inter-agency oversight council that will identify financial companies that are so large, interconnected, or risky that their collapse would put the entire economy at risk.” Systemic risk is a concept in search of a definition for rigorous measurement. As Professor Hal C. Scott states, Congress should appoint “a new expert commission designed to fully investigate the extent and consequences of interconnectedness before any new regulation of systemically important institutions is actually adopted” http://www.capmktsreg.org/pdfs/09-Dec-11_Do_We_Really_Need_a_Systemic_Regulator_by_Hal_S_Scott(WSJ).pdf
(3)Large, Interconnected Financial Firms. The Council will apply stricter standards and regulation to financial companies posing threats to financial stability, imposing higher capital requirements and limits on leverage and concentration of risk exposures. The twelve members of the Council and limited staff will determine the size, structure and risk decisions of 11 banking organizations that in 2006 had $4.6 trillion of assets equivalent to 44 percent of total US banking assets of $10.5 trillion and 96 percent of US foreign banking assets of close to $1 trillion (Pelaez and Pelaez, Globalization and the State Vol. II, 147). The Council of the Wall Street Act will undermine the competitiveness of American banks to finance American companies of optimum size and technology in world markets. Decisions on reducing the size of financial companies may have similar consequences on financial instability as the alarmist announcement of TARP in September 2008: anticipation of problems in a company will drive the stock price toward zero, causing its disorganized illiquidity and bankruptcy as it happened with Bear Stearns, Lehman Bros, Fannie and Freddie. The Wall Street Act is predicated on the assumption that the Council of 12 agencies is superior in financial management to the entire financial market. The consequences of regulatory failures that may occur will be magnified by these exceptional powers without definition and rigorous measurement of the elusive concept of “interconnectedness. “
(4)Role of the Fed. The Council is a far more politicized agency than the Federal Reserve System (FRS), which is the evident loser in legislation perhaps because of its tradition of independence. The FRS will be the “agent of the Council” in regulating systemic risk consolidated across banks and wherever found individually. The Government Accountability Office (GAO) would examine the FRS to increase transparency of the FRS and its actions. There is significant risk of political decisions on economic events at the wrong time. Surveillance of the actions of the Federal Open Market Committee (FOMC) could frustrate monetary policy as financial markets and the public anticipate reversals because of political pressure of what could be correct policy that still has not had time to be processed. The relation of the Council and the Fed resembles several individuals simultaneously handling the steering wheel and stepping on accelerators and breaks of a vehicle. The best informed driver, the Fed, would not have control of the vehicle as it moves into frontal collision.
(5)Dissolution Authority. The Wall Street Act declares the end of the doctrine of “too big to fail.” Regulators will dissolve large, very complex financial institutions in an “orderly and controlled manner.” These are the same regulators that managed the resolution of Bear Stearns, Lehman Bros, AIG, CountryWide, Washington Mutual, Fannie, Freddie and over 100 banks now armed with the elusive definition and measurement of interconnectedness. The main objective of the new authority is that shareholders and unsecured creditors instead of taxpayers bear the burden of dissolution. The new process will be different from bankruptcy because it will prevent “contagion and disruption to the entire system and the overall economy.” There is no new knowledge on defining, measuring and preventing systemic risk. There is no such thing as orderly resolution of a financial crisis. The Wall Street Act creates a Systemic Dissolution Fund with assessments on financial companies for a total of $150 billion. This Fund would be insufficient to deal with Fannie and Freddie whose fate and pivotal role in the financial crisis are not even mentioned in the Wall Street Act.
(6) Consumer Financial Protection Agency (CFPA). The CFPA is designed to protect the public from unfair and deceptive financial products and services in avoiding another financial crisis. The actual deception of the public was in encouraging excessive risk and debt by the promise of nearly zero interest rates during an indefinite period and the housing subsidy that could make true the dream of owning a house bought at peak real estate prices with guaranteed mortgages and the interest rates near historical lows. The CFPA will restrict the volume of consumer loans and increase interest rates in consumer credit much the same as the credit card bill because of the lack of investors and lenders providing funds under regulation that prevents sound assessment of lending risk.
The major weakness of the Wall Street Act is its sole reliance on OPSR. Constructive regulation should be based on Functional Structural Finance (FSAF) by which the government would induce the spirals of innovation that have contributed to past prosperity with balanced regulation. The uses and limitations of regulations are not properly blended in the Wall Street Act, which can frustrate financial functions for growth of output and employment creation. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
Carlos M. Pelaez
The US House of Representatives passed by a vote of 223-202 on December 11, 2009, the H.R. 4173 Wall Street Reform and Consumer Protection Act (Wall Street Act). This writing analyzes the Wall Street Act by means of two main approaches to the causes, duration and depth of the credit/dollar crisis and global recession, which lead to different evaluations of banking and financial regulation.
First, the proposals emanating from government follow Official Prudential and Systemic Regulation (OPSR) (Pelaez and Pelaez, Financial Regulation after the Global Recession, 30-4, Regulation of Banks and Finance, 217-24, International Financial Architecture, 101-60, Government Intervention in Globalization, 31-7, Globalization and the State, Vol. I, 30-43, Globalization and the State, Vol. II, 102-8). The assumed goal of OPSR is protecting depositors, investors, output and employment from failures in banking and financial markets. Financial crises are considered as the most important market failure, which is processed through “systemic risk.” The credit crisis allegedly originated in excessive risk taking by banks that were motivated in generating short-term profits to appropriate “irresponsible” compensation in bonuses and stock options. The failure of Lehman Bros in September 2008 affected the ability of other financial companies such as American International Group (AIG) and Citigroup to finance themselves in the market. Systemic effects consisted of paralysis of credit in multiple segments of financial markets, causing illiquidity of large companies and the collapse of their stock prices that prevented the raising of new capital. The government was forced into bailing out failing companies by equity infusions through the Troubled Assets Relief Program (TARP), which eventually restored confidence in financial markets.
Second, the alternative Finance View (FV) claims that the credit/dollar crisis and global recession were caused by government policies (Pelaez and Pelaez, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4, Financial Regulation after the Global Recession, 157-66, and Regulation of Banks and Finance, 217-27). The reduction of the interest rates on interbank loans or fed funds to 1 percent in 2003-4 with the announced determination to keep them at that level indefinitely distorted decisions on risk and returns of households, banks, companies and government. The interest-rate subsidy caused overproduction of housing and rising real estate prices fueled by the gigantic housing subsidy of the US of $221 billion per year, the purchase or guarantee of $1.6 trillion of non prime mortgages by Fannie and Freddie and the reduction of mortgage rates by elimination of the 30-year Treasury bond. The result of low interest rates and the housing subsidy was excessive construction of houses, laxity in borrowing and lending because house prices were expected to increase forever as central banks kept low interest rates, excessive risk exposures and leverage, low liquidity and unsound credit. Mortgage decisions based on permanently low interest rates turned sour when the Fed increased interest rates from 1 percent to 5.25 percent in 2004-2006, disrupting securitization and derivatives markets. The alarmist proposal of TARP in the second half of September 2009 as if it were required in avoiding another Great Depression because of “toxic assets” in all banks, instead of the failure of Lehman Bros, caused a crisis of confidence that stopped financing in many segments. Markets recovered on their own without withdrawal of toxic assets as first proposed by TARP and in the new administration by the Financial Stability Plan (FSP). Policy prolonged and deepened the credit/dollar crisis and global recession. The regulation passed by the Wall Street Reform and Consumer Protection Act is analyzed below by means of these two approaches.
(1)Cram down. The high moment of the US House of Representatives was the rejection by 241-188 votes of the “cram down,” allowing bankruptcy judges to reduce principal and interest rates on mortgages, extending repayment periods. Securitization of mortgages dates at least to the charter of Freddie Mac in 1970 to guarantee securities backed by mortgages and worked well until the zero interest rate and housing subsidy caused the credit crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession, 42-52, Regulation of Banks and Finance, 58-60, 79-80). Securitization allows a critical function of finance by bundling many small loans in large securities purchased by investors such as mutual and pension funds where individuals deposit their savings and build their retirements. Generalized default of mortgage-backed securities by bankruptcy judges as proposed in the cram down process would fracture the source of finance required for reconstruction of housing finance, economic growth and creation of employment. Investors and savers would not invest again in mortgage-backed securities and there could be a repetition of the credit crunch. The objective of the cram down of scaring ultimate holders of claims to modify mortgages failed but it scared investors financing new mortgages required for economic growth and employment creation.
(2)Financial Stability Oversight Council (Council). The Wall Street Act establishes an “inter-agency oversight council that will identify financial companies that are so large, interconnected, or risky that their collapse would put the entire economy at risk.” Systemic risk is a concept in search of a definition for rigorous measurement. As Professor Hal C. Scott states, Congress should appoint “a new expert commission designed to fully investigate the extent and consequences of interconnectedness before any new regulation of systemically important institutions is actually adopted” http://www.capmktsreg.org/pdfs/09-Dec-11_Do_We_Really_Need_a_Systemic_Regulator_by_Hal_S_Scott(WSJ).pdf
(3)Large, Interconnected Financial Firms. The Council will apply stricter standards and regulation to financial companies posing threats to financial stability, imposing higher capital requirements and limits on leverage and concentration of risk exposures. The twelve members of the Council and limited staff will determine the size, structure and risk decisions of 11 banking organizations that in 2006 had $4.6 trillion of assets equivalent to 44 percent of total US banking assets of $10.5 trillion and 96 percent of US foreign banking assets of close to $1 trillion (Pelaez and Pelaez, Globalization and the State Vol. II, 147). The Council of the Wall Street Act will undermine the competitiveness of American banks to finance American companies of optimum size and technology in world markets. Decisions on reducing the size of financial companies may have similar consequences on financial instability as the alarmist announcement of TARP in September 2008: anticipation of problems in a company will drive the stock price toward zero, causing its disorganized illiquidity and bankruptcy as it happened with Bear Stearns, Lehman Bros, Fannie and Freddie. The Wall Street Act is predicated on the assumption that the Council of 12 agencies is superior in financial management to the entire financial market. The consequences of regulatory failures that may occur will be magnified by these exceptional powers without definition and rigorous measurement of the elusive concept of “interconnectedness. “
(4)Role of the Fed. The Council is a far more politicized agency than the Federal Reserve System (FRS), which is the evident loser in legislation perhaps because of its tradition of independence. The FRS will be the “agent of the Council” in regulating systemic risk consolidated across banks and wherever found individually. The Government Accountability Office (GAO) would examine the FRS to increase transparency of the FRS and its actions. There is significant risk of political decisions on economic events at the wrong time. Surveillance of the actions of the Federal Open Market Committee (FOMC) could frustrate monetary policy as financial markets and the public anticipate reversals because of political pressure of what could be correct policy that still has not had time to be processed. The relation of the Council and the Fed resembles several individuals simultaneously handling the steering wheel and stepping on accelerators and breaks of a vehicle. The best informed driver, the Fed, would not have control of the vehicle as it moves into frontal collision.
(5)Dissolution Authority. The Wall Street Act declares the end of the doctrine of “too big to fail.” Regulators will dissolve large, very complex financial institutions in an “orderly and controlled manner.” These are the same regulators that managed the resolution of Bear Stearns, Lehman Bros, AIG, CountryWide, Washington Mutual, Fannie, Freddie and over 100 banks now armed with the elusive definition and measurement of interconnectedness. The main objective of the new authority is that shareholders and unsecured creditors instead of taxpayers bear the burden of dissolution. The new process will be different from bankruptcy because it will prevent “contagion and disruption to the entire system and the overall economy.” There is no new knowledge on defining, measuring and preventing systemic risk. There is no such thing as orderly resolution of a financial crisis. The Wall Street Act creates a Systemic Dissolution Fund with assessments on financial companies for a total of $150 billion. This Fund would be insufficient to deal with Fannie and Freddie whose fate and pivotal role in the financial crisis are not even mentioned in the Wall Street Act.
(6) Consumer Financial Protection Agency (CFPA). The CFPA is designed to protect the public from unfair and deceptive financial products and services in avoiding another financial crisis. The actual deception of the public was in encouraging excessive risk and debt by the promise of nearly zero interest rates during an indefinite period and the housing subsidy that could make true the dream of owning a house bought at peak real estate prices with guaranteed mortgages and the interest rates near historical lows. The CFPA will restrict the volume of consumer loans and increase interest rates in consumer credit much the same as the credit card bill because of the lack of investors and lenders providing funds under regulation that prevents sound assessment of lending risk.
The major weakness of the Wall Street Act is its sole reliance on OPSR. Constructive regulation should be based on Functional Structural Finance (FSAF) by which the government would induce the spirals of innovation that have contributed to past prosperity with balanced regulation. The uses and limitations of regulations are not properly blended in the Wall Street Act, which can frustrate financial functions for growth of output and employment creation. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
Sunday, December 6, 2009
Regulation, Trade and Devaluation Wars
Carlos M. Pelaez
The influential economist Joan Robinson analyzed “beggar-my-neighbor remedies for unemployment” as the use of protectionism or impediments to foreign trade in promoting domestic employment, causing unemployment in other countries, which characterized the Great Depression (Robinson, Essays in the Theory of Employment, Macmillan, 1937). The credit/dollar crisis and global recession after 2007 is typically exaggerated as the “worst” financial and economic crisis since the Great Depression of the 1930s. Comprehensive review of the vast literature on the Great Depression reveals a contraction of output and employment that was immeasurably stronger than the world contraction in 2008-2009 (Pelaez and Pelaez, Regulation of Banks and Finance, 197-217). The decline in real or price adjusted GDP in 1930-1933 accumulated to 26.7 percent and 45.5 percent in current dollars or without adjusting by price changes (Pelaez and Pelaez, Financial Regulation after the Global Recession, 151). The cumulative decline of inflation adjusted GDP of the United States during the current recession in the last two quarters of 2008 and first two quarters of 2009 was 4.7 percent. GDP increased in the third quarter of 2009. The hyperbole has been used in proposing massive fiscal/monetary stimulus as required in “avoiding another Great Depression” and, subsequently, in the argument that in the absence of such stimulus there would have been another Great Depression and that the stimulus should be maintained indefinitely. There is no convincing method to disprove the assertion because it is a “counterfactual” or what would have been economic conditions in the absence of the stimulus, which cannot be fully resolved because there are no data without the stimulus and even if available no decisive method to isolate multiple effects in a comparison with the available data with stimulus. The current credit/dollar crisis and global recession bears more resemblance in dimensions to the world debt crisis that required interest rates of fed funds of 19.08 percent in January 1981 because of the inflation shock resulting from the fine tuning of the late 1970s exacerbated by the oil price increases following the Iranian revolution. The current worldwide regulation, trade and devaluation wars are reminiscent of the analysis by Joan Robinson of beggar-my-neighbor remedies for unemployment (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars, 174-84, Globalization and the State, Vol. I, 157-206, and Globalization and the State, Vol. II. 205-13). The troubled world economic environment of regulation, trade and devaluation is analyzed below in turn.
First, Regulation. There is a heavy agenda of regulation of finance worldwide. The Banking Act of 1933 prohibited payment of interest on demand deposits and imposed limits on interest rates paid on time deposits issued by commercial banks. Interest rate controls imposed by Regulation Q and the rise of banking by buying money through certificates of deposit (CD) to lend in large volumes encouraged the permanent exodus of banking from New York to London (Pelaez and Pelaez, Regulation of Banks and Finance, 74-5). Regulation Q was a costly government failure. The objective of regulation is to correct “market failures” or the use of collective action by the government to attain improvements over freer markets. The approach of the new institutional economics (NIE) is that both markets and governments may fail (Pelaez and Pelaez, Government Intervention in Globalization, 83-4, Globalization and the State Vol. I, 139-43, and Globalization and the State Vol. II, 211-3). That is, there is no assurance that the intervention by the government could improve over the state of no intervention and the similar counterfactual difficulty in analyzing government intervention after it occurs. It is quite difficult or nearly impossible with the available knowledge and institutional structure for the government to control systemic risk without exacerbating it such as in downsizing large banks. Banking panics were more common and pernicious in the United States than in other countries because of the large number of small banks, so-called unit banks, restricted by regulation to operate with only one office or within the boundaries of states. Research by Calomiris and Gorton concludes that unit banking systems are more prone to banking panics (Pelaez and Pelaez, Regulation of Banks and Finance, 202-3). Smaller banks may not be able to provide the volume of loans and financial services required by large business. American banks and companies would lose in world markets competing with international companies and banks that attain optimum scale, that is, produce at minimum costs. The replacement of the Federal Reserve System (FRS) with less independent regulators may lead to more politicized decisions on monetary policy and regulation, similar to the debacle of Fannie and Freddie, which could increase financial instability causing a worst future crisis. Rushed recession regulation has seldom improved regulatory structure and its effectiveness.
Second, Devaluation. The regulatory agenda in parliaments departs from the analysis of the credit/dollar crisis and global recession as caused by “an era of irresponsibility” in the form of excessive leverage and risk motivated by compensation of bankers without relation to performance. An alternative interpretation is that the credit/dollar crisis and global recession was caused by the zero interest rate on fed funds in 2003-2004 that eroded the discipline of risk/return calculations, encouraging high leverage and risk, low liquidity and unsound credit. Overproduction of housing was induced by lowering mortgage interest rates by eliminating the 30-year Treasury bond, the yearly housing subsidy in the United States of over $200 billion and the purchase or guarantee by Fannie Mae and Freddie Mac of $1.5 trillion of nonprime mortgages (Pelaez and Pelaez, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4, Financial Regulation after the Global Recession, 157-66, and Regulation of Banks and Finance, 217-27). The erosion of bank discipline in risk management was caused by policy impulses. The zero interest rate in 2008 caused the carry trade of shorting the dollar and going long in commodities and emerging market stocks (Pelaez and Pelaez, Government Intervention in Globalization, 70-4). The dollar firmed as haven for risk aversion in world markets after the alarmist proposal of the Troubled Assets Relief Program (TARP) in September 2008 and then devalued after March 2009 with the return of risk appetite. World trade imbalances are primarily the trade deficit of the United States and the trade surplus of China. The Chinese renminbi needs to revalue, that is, fewer renminbi to buy a dollar, which cheapens imports into China and makes its exports more expensive. China moved in the path of adjustment by revaluing the renminbi from 8.28/dollar in 2005 to 6.83/dollar, or 17.5 percent reverse devaluation, but it fixed the renminbi against the dollar again in July 2008 to prevent an erosion of its competitiveness in exports during the global recession. The devaluation of the dollar caused significant loss of competitiveness especially in Asian exporting countries that intervened in their foreign exchange markets to arrest the appreciation of their currencies relative to the dollar. The employment report on November 4 showing loss of only 11,000 jobs and decline in the rate of unemployment raises the possibility that the Fed may increase interest rates in 2010, which are now at 0-0.25 percent per year on fed funds. The dollar would appreciate against most currencies making American exports more expensive and imports cheaper, contributing to the deterioration of the trade deficit. The zero interest rate could be considered a regulatory failure, causing financial instability. The world competitive devaluation would resemble those in earlier episodes such as the Asian crisis of 1997-1998. The countries that abandoned the gold standard in 1931 performed better than those that remained in gold as shown in vast literature on the Great Depression (Pelaez and Pelaez, Regulation of Banks and Finance, 198-217).
Third, Trade. Jobless recoveries encourage the use of collective action by the government to restrict the entry of foreign-produced goods and services or the protectionism for promoting domestic employment at the expense of foreign employment deplored by Joan Robinson. A recent Gallup Poll shows that keeping jobs in the United States by not importing goods and services is the most favored employment-creation measure of Americans even beating tax reduction. This is likely the view of populations across the world. The competitive devaluation and ongoing measures to create trade barriers may complement each other. There may well be a return of the image of throwing rocks in ports to prevent trade perhaps also frustrating the international transmission of ideas, raising frictions in international relations. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
Carlos M. Pelaez
The influential economist Joan Robinson analyzed “beggar-my-neighbor remedies for unemployment” as the use of protectionism or impediments to foreign trade in promoting domestic employment, causing unemployment in other countries, which characterized the Great Depression (Robinson, Essays in the Theory of Employment, Macmillan, 1937). The credit/dollar crisis and global recession after 2007 is typically exaggerated as the “worst” financial and economic crisis since the Great Depression of the 1930s. Comprehensive review of the vast literature on the Great Depression reveals a contraction of output and employment that was immeasurably stronger than the world contraction in 2008-2009 (Pelaez and Pelaez, Regulation of Banks and Finance, 197-217). The decline in real or price adjusted GDP in 1930-1933 accumulated to 26.7 percent and 45.5 percent in current dollars or without adjusting by price changes (Pelaez and Pelaez, Financial Regulation after the Global Recession, 151). The cumulative decline of inflation adjusted GDP of the United States during the current recession in the last two quarters of 2008 and first two quarters of 2009 was 4.7 percent. GDP increased in the third quarter of 2009. The hyperbole has been used in proposing massive fiscal/monetary stimulus as required in “avoiding another Great Depression” and, subsequently, in the argument that in the absence of such stimulus there would have been another Great Depression and that the stimulus should be maintained indefinitely. There is no convincing method to disprove the assertion because it is a “counterfactual” or what would have been economic conditions in the absence of the stimulus, which cannot be fully resolved because there are no data without the stimulus and even if available no decisive method to isolate multiple effects in a comparison with the available data with stimulus. The current credit/dollar crisis and global recession bears more resemblance in dimensions to the world debt crisis that required interest rates of fed funds of 19.08 percent in January 1981 because of the inflation shock resulting from the fine tuning of the late 1970s exacerbated by the oil price increases following the Iranian revolution. The current worldwide regulation, trade and devaluation wars are reminiscent of the analysis by Joan Robinson of beggar-my-neighbor remedies for unemployment (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars, 174-84, Globalization and the State, Vol. I, 157-206, and Globalization and the State, Vol. II. 205-13). The troubled world economic environment of regulation, trade and devaluation is analyzed below in turn.
First, Regulation. There is a heavy agenda of regulation of finance worldwide. The Banking Act of 1933 prohibited payment of interest on demand deposits and imposed limits on interest rates paid on time deposits issued by commercial banks. Interest rate controls imposed by Regulation Q and the rise of banking by buying money through certificates of deposit (CD) to lend in large volumes encouraged the permanent exodus of banking from New York to London (Pelaez and Pelaez, Regulation of Banks and Finance, 74-5). Regulation Q was a costly government failure. The objective of regulation is to correct “market failures” or the use of collective action by the government to attain improvements over freer markets. The approach of the new institutional economics (NIE) is that both markets and governments may fail (Pelaez and Pelaez, Government Intervention in Globalization, 83-4, Globalization and the State Vol. I, 139-43, and Globalization and the State Vol. II, 211-3). That is, there is no assurance that the intervention by the government could improve over the state of no intervention and the similar counterfactual difficulty in analyzing government intervention after it occurs. It is quite difficult or nearly impossible with the available knowledge and institutional structure for the government to control systemic risk without exacerbating it such as in downsizing large banks. Banking panics were more common and pernicious in the United States than in other countries because of the large number of small banks, so-called unit banks, restricted by regulation to operate with only one office or within the boundaries of states. Research by Calomiris and Gorton concludes that unit banking systems are more prone to banking panics (Pelaez and Pelaez, Regulation of Banks and Finance, 202-3). Smaller banks may not be able to provide the volume of loans and financial services required by large business. American banks and companies would lose in world markets competing with international companies and banks that attain optimum scale, that is, produce at minimum costs. The replacement of the Federal Reserve System (FRS) with less independent regulators may lead to more politicized decisions on monetary policy and regulation, similar to the debacle of Fannie and Freddie, which could increase financial instability causing a worst future crisis. Rushed recession regulation has seldom improved regulatory structure and its effectiveness.
Second, Devaluation. The regulatory agenda in parliaments departs from the analysis of the credit/dollar crisis and global recession as caused by “an era of irresponsibility” in the form of excessive leverage and risk motivated by compensation of bankers without relation to performance. An alternative interpretation is that the credit/dollar crisis and global recession was caused by the zero interest rate on fed funds in 2003-2004 that eroded the discipline of risk/return calculations, encouraging high leverage and risk, low liquidity and unsound credit. Overproduction of housing was induced by lowering mortgage interest rates by eliminating the 30-year Treasury bond, the yearly housing subsidy in the United States of over $200 billion and the purchase or guarantee by Fannie Mae and Freddie Mac of $1.5 trillion of nonprime mortgages (Pelaez and Pelaez, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4, Financial Regulation after the Global Recession, 157-66, and Regulation of Banks and Finance, 217-27). The erosion of bank discipline in risk management was caused by policy impulses. The zero interest rate in 2008 caused the carry trade of shorting the dollar and going long in commodities and emerging market stocks (Pelaez and Pelaez, Government Intervention in Globalization, 70-4). The dollar firmed as haven for risk aversion in world markets after the alarmist proposal of the Troubled Assets Relief Program (TARP) in September 2008 and then devalued after March 2009 with the return of risk appetite. World trade imbalances are primarily the trade deficit of the United States and the trade surplus of China. The Chinese renminbi needs to revalue, that is, fewer renminbi to buy a dollar, which cheapens imports into China and makes its exports more expensive. China moved in the path of adjustment by revaluing the renminbi from 8.28/dollar in 2005 to 6.83/dollar, or 17.5 percent reverse devaluation, but it fixed the renminbi against the dollar again in July 2008 to prevent an erosion of its competitiveness in exports during the global recession. The devaluation of the dollar caused significant loss of competitiveness especially in Asian exporting countries that intervened in their foreign exchange markets to arrest the appreciation of their currencies relative to the dollar. The employment report on November 4 showing loss of only 11,000 jobs and decline in the rate of unemployment raises the possibility that the Fed may increase interest rates in 2010, which are now at 0-0.25 percent per year on fed funds. The dollar would appreciate against most currencies making American exports more expensive and imports cheaper, contributing to the deterioration of the trade deficit. The zero interest rate could be considered a regulatory failure, causing financial instability. The world competitive devaluation would resemble those in earlier episodes such as the Asian crisis of 1997-1998. The countries that abandoned the gold standard in 1931 performed better than those that remained in gold as shown in vast literature on the Great Depression (Pelaez and Pelaez, Regulation of Banks and Finance, 198-217).
Third, Trade. Jobless recoveries encourage the use of collective action by the government to restrict the entry of foreign-produced goods and services or the protectionism for promoting domestic employment at the expense of foreign employment deplored by Joan Robinson. A recent Gallup Poll shows that keeping jobs in the United States by not importing goods and services is the most favored employment-creation measure of Americans even beating tax reduction. This is likely the view of populations across the world. The competitive devaluation and ongoing measures to create trade barriers may complement each other. There may well be a return of the image of throwing rocks in ports to prevent trade perhaps also frustrating the international transmission of ideas, raising frictions in international relations. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
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