Sunday, January 31, 2010

Economic Recovery, Job Creation, Taxation and Interest Rates
Carlos M Pelaez

The end of the recession in mid 2009 after four consecutive quarters of contraction was followed by two consecutive quarters of expansion in the second half of 2009. The Congressional Budget Office (CBO) estimates that GDP is about 6.5 percent below potential output, which is the output that could be produced with employment of all labor and capital (http://www.cbo.gov/ftpdocs/108xx/doc10871/Summary.shtml#1045449 ). The unemployment rate of about 10.0 percent in December 2009 is twice the rate of 5.0 percent in December 2007.
The recession in the US resulted in four consecutive quarters of decline of GDP at annual percentage rates of: -2.7 QIII08, -5.4 QIV08, -6.4 QI09 and -0.7 QII09. The economy expanded again at annual percentage rates of: 2.2 QIII09 and 5.7 QIV09 (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&FirstYear=2008&LastYear=2009&Freq=Qtr ). The breakdown of the contributions in percentage points at annual rates by segments of GDP of the 5.7 percent annual growth rate in QIV09 is: 1.44 of personal consumption expenditures, 3.82 of gross private domestic investment (consisting of 0.43 in fixed investment and 3.39 in change in private inventories), 0.5 percent of net exports of goods and services and 0.02 of government consumption and investment. Growth in the GDP data is driven by the slower pace of inventory reduction in the fourth quarter that contributed 3.39 percentage points to the GDP growth rate of 5.7 percent. Eventually, firms will replenish inventories as demand increases. In the recession of the 1980s the quarterly annual percentage rate of growth of GDP was: -7.9 QII80, -0.7 QIII80, 7.6 QIV80, 8.6 QI81, -3.2 QII81, 4.9 QIII81, -4.9 QIV81, -6.4 QI82, 2.2 QII82, -1.5 QIII82 and 0.3 QIV82. During the recovery phase GDP grew at the quarterly annual percentage rate of: 5.1 QI83, 9.3 QII83, 8.1 QIII83, 8.5 QIV83, 8.0 QI84, 7.1 QII84 and thereafter at rates in excess of 3 percent. Change in private inventories was a significant contributor to the rate of GDP growth in terms of percentage points only in a few quarters: 3.5 QII83, 3.1 QIV83 and 5.1 QI84. Growth was driven by personal consumption expenditures and fixed investment. The rate of unemployment increased from 6.3 percent in January 1980 to a peak of 10.8 percent in December 1982, declining at year end to: 8.3 percent in 1983, 7.3 percent in 1984 and 7.0 percent in 1985 (http://data.bls.gov/PDQ/servlet/SurveyOutputServlet ). The recovery of full employment depends on sustained high quarterly annual rates of growth of GDP originating in demand and fixed investment.
There is a critical difference in the current environment. Interest rates declined sharply in the 1980s from a high of 19.10 percent for the fed funds rate in June 1981 to 8.95 percent in December 1982, remaining between 8.95 and 11.06 percent during the quarters of high growth in the expansion phase. Average inflation measured by the consumer price index was: 13.5 percent in 1980 and 10.3 percent in 1981, declining to 3.6 percent in 1985 (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt ). There is significant pressure on future interest rates because of the unwinding of monetary and fiscal expenditures discussed in turn.
First, fiscal deficits and debt. The baseline budget outlook of the CBO for the next ten years projects the budget deficit as percent of GDP of: -9.9 percent in 2009, -9.2 percent in 2010, -6.5 percent in 2011 and then declining deficits around 3 percent per year. The CBO finds that the 2009 deficit as percent of GDP is the largest since the end of World War II and the deficit estimated for 2010 would be the second largest. Legislation in the next few months increasing expenditures or reducing revenues could increase the projected deficit for 2010. Total federal outlays as percent of GDP have jumped to 24.7 percent in 2009, 24.1 percent in 2010 and 24.3 percent in 2011, remaining above 22 percent thereafter. Debt held by the public at the end of the year rises from 53.0 percent of GDP in 2009 to 60.3 percent in 2010, remaining above 65 percent in the remaining years.
In an application published in the Financial Times of their monumental research on financial crises, This Time is Different (http://www.amazon.com/This-Time-Different-Centuries-Financial/dp/0691142165/ref=pd_sim_b_7 ), Carmen Reinhart and Kenneth Rogoff argue that financial crises are followed by government debt crises (http://www.ft.com/cms/s/0/8844ab5a-0baa-11df-9f03-00144feabdc0.html ). Bailouts, fiscal stimulus and the sharp decline in government revenue cause increases in public debt by an average of 80 percent in three years. Sharply rising debt burdens restrict economic growth. Economic forecasts err frequently. There is risk that actual future deficits and debt may be higher than projected. Issuance of debt to finance deficits and refinance maturing debt may result in a risk premium over interest rates of federal debt because of the already high weight in investment portfolios. The CBO defines an “unsustainable federal budget” as federal debt increasing at a much faster rate than the economy as a whole (http://www.cbo.gov/ftpdocs/102xx/doc10297/SummaryforWeb_LTBO.pdf ). At some point revenue will have to increase by taxation and expenditures reduced by budget cuts, causing an adverse shock on the economy. Combinations of increasing taxes and interest rates would restrict future economic growth and employment creation.
Second, monetary stimulus. Traditional monetary stimulus during recessions consists of lowering the target of the fed funds rate, which is now at 0-0.25 percent. The Federal Open Market Committee (FOMC) will and should increase the policy rate together with the recovery of real economic activity. The zero interest rate creates significant distortions even during recessions. There is an incentive to short the dollar and go long in commodities or emerging market stocks in what is known as the carry trade (Pelaez and Pelaez, Globalization and the State Vol. II, 203-4, Government Intervention in Globalization, 70-4). Creating and unwinding carry trades cause wide fluctuations in financial variables such as exchange rates and prices of commodities and stocks. The carry trade depends on low interest rates in a major currency, such as the yen and the dollar, and high-yielding currencies or financial markets. Zero interest rates also encourage low liquidity because of the hunt for higher yields to remunerate financial assets. Higher yields are associated with significantly higher risks and unsound allocation of credit. The 1 percent fed funds target and corresponding forward guidance followed by an increase to 5.25 percent, the housing subsidy of $221 billion per year, purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie and Freddie and the interruption of auctions of 30-year Treasury securities to lower mortgage rates constituted causal factors of the credit/dollar crisis and global recession (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, 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).
There are three types of information in the press release of the FOMC on January 27: (1) there is continuing improvement in the economy, even in labor markets, with sufficient resource slack that could permit 0-0.25 percent interest rates in an unknown period in the future without threatening inflation; (2) several of the credit facilities created during the crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession, Table 6.3, 160-1, Regulation of Banks and Finance, 224-6) are phasing out on their own; and (3) the purchase of mortgage-backed securities will continue until reaching $1.25 trillion and of agency securities to about $175 billion but then cease in accordance with economic conditions (http://www.federalreserve.gov/newsevents/press/monetary/20100127a.htm ). The Fed is also considering the use of the rate paid on deposits by banks as the new policy rate, replacing the fed funds rate (http://www.bloomberg.com/apps/news?pid=20601087&sid=aHWsoTqQqTi0 ). Both rates reflect the marginal costs of banks.
An innovative policy used by the Fed during the credit crisis is the change in composition and size of its balance sheet (Pelaez and Pelaez, Regulation of Banks and Finance, 224, Financial Regulation after the Global Recession, 167-9, see The Global Recession Risk, 83-107). The Fed balance sheet for the week ending on January 27 shows total credit of $2234 billion of which $1912 billion is in “securities held outright,” consisting of $776 trillion in US Treasury securities, $973 billion in mortgage-backed securities and $162 billion in Federal agency securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). A major source of financing of the portfolio of securities of the Fed is $1104 billion of reserve balances with the Federal Reserve Banks. At some point the Fed will begin the process of unwinding the balance sheet. Interest rates paid on bank balances at the Federal Reserve Banks will have to increase to prevent withdrawals of those balances that banks could use in lending to numerous sound projects of clients. Increasing demand for bank loans would increase lending interest rates. The combined retained portfolio of Fannie and Freddie is around $1.6 trillion and that of the Fed another $1.6 trillion. Actual or expected sales of these portfolios could exert upward pressure on long-term interest rates. Increase in short-term fed funds rates and long-term rates of mortgage-backed securities could shift upward the entire yield curve with much sharper difference between the short and long-ends.
Policy should focus on avoiding tax and interest shocks that could slow the economic recovery, preventing full employment. It may be impossible to perfectly smooth the expansion path of the economy but the similar experience in the 1980s provides evidence that the economy can grow rapidly without interruption, reducing the rate of unemployment by several percentage points. Increases in federal budget revenue and increases in interest rates will be unavoidable. The only magic that may remain is not following policies of excessive spending by being more creative in attaining indispensable goals with parsimonious programs. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)

Sunday, January 24, 2010

The Mirage that Crises Are Opportunities for Tightening Financial Regulation
Carlos M. Pelaez
The administration announced on January 21, 2010, two more proposals of financial regulation. First, banks and financial institutions owning a bank will not be allowed to engage in proprietary trading unrelated to customer services for their own profit and “invest in or sponsor a hedge fund or a private equity fund” (http://www.whitehouse.gov/the-press-office/president-obama-calls-new-restrictions-size-and-scope-financial-institutions-rein-e) Second, there will be “broader limits on the excessive growth of the market share of liabilities at the largest financial firms” (Ibid). The economic rationale for the measures is the contention that the credit/dollar crisis and global recession was caused by banks and financial institutions taking “huge, reckless risks in pursuit of quick profits and massive bonuses” (http://www.whitehouse.gov/the-press-office/remarks-president-financial-reform). The crisis is portrayed as the result of a “binge of irresponsibility” by financial institutions. The cure is enforcing “responsibility” in financial institutions by means of official regulation.
This writing provides systematic analysis of the pure economic issues involved in the new proposal of financial regulation: (1) efficiency and stability of broad or universal versus specialized banking, (2) proprietary trading, (3) hedge funds and private equity, (4) banking sector consolidation and (5) recovery of the economy and job creation. These issues are discussed in turn.
First, broad versus specialized banking. The universal or broad bank engages in all financial services: taking funds from the public to lend, underwriting and brokerage of securities and insurance. The Glass-Steagall Act of 1933 separated investment and commercial banking; the Bank Holding Company Act and the National Banking Act prohibited US banks from engaging in insurance, real estate brokerage and other financial services. The Gramm-Leach-Bliley Financial Modernization Act sanctioned the de facto evolution of US banks into broad banks (Peláez and Peláez, Financial Regulation after the Global Recession, 91-5, Regulation of Banks and Finance, 117-21). There are issues of financial stability and efficiency in the proposed regulation. The financial stability or too-big-to fail argument behind the proposed regulation is that the failure of one or more large financial conglomerates engaging in complex relations with other financial and nonfinancial entities could have “systemic” effects, which could cause the failure of other financial institutions and collapse of the economy. The policy intends to prevent banks from becoming “too big and systemic.” George Benston finds that only 10 of 9440 banks that failed during the Great Depression were not specialized banks with one or few branches (cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 92). In 1983-90, 1150 commercial and savings banks, about 8 percent of the industry in 1980, failed, and 900 savings and loans, or about 25 percent of the industry, were closed, merged or placed in conservatorship by federal agencies. The cost to taxpayers of resolving insolvent savings and loans amounted to $150 billion or several times that amount in current dollars (George Benston and George Kaufman cited in Financial Regulation after the Global Recession, 56). There is no reason why well-capitalized broad banks are more prone to failure than a system consisting of a large number of specialized deposit/lending banks. The US system of specialized banks for directed lending to housing through savings and loans, Federal Home Loan Banks (FHLB) and Fannie Mae and Freddie Mac was a source of failure and bad loans in the credit crises of the 1980s and in 2008. The FDIC reports that over 170 smaller banks have failed in the US since 2008 (http://www.fdic.gov/bank/individual/failed/banklist.html ). The US has had more banking panics than other countries because of the large number of small banks with more fragile capital structure, which is a product of regulation.
There is the efficiency issue of best practice in bank management and its consequences for financing prosperity. Banking is characterized by declining costs because of bulky fixed investments required for initiation of lines of business (Pelaez and Pelaez, Regulation of Banks and Finance, 82-9, Financial Regulation after the Global Recession, 63-9). There has been a new industrial/technological revolution in the past three decades centered on information technology (IT). Banking is highly intensive in the creation, processing, transmission and decision use of information. The first transaction of a $100 million IT facility costs $100 million but the hundred millionth costs only one dollar. Competitive banking requires large volumes of transactions to reach the minimum cost of operations. There are also economies of scope in that fees and rates for providing traditional banking to clients may be lower because of the savings of jointly using the same originating and distribution activities of traditional banking in underwriting, insurance and brokerage. Intervention by regulation would increase credit rates and diminish volume. Major research efforts show the information benefits of underwriting and syndication by commercial banks without conflicts of interest before the Great Depression and in recent periods (Regulation of Banks and Finance, 121-9, Financial Regulation after the Global Recession, 95-8). Limits on the size of banks imposed by regulators would prevent financial institutions from attaining optimal scale of operations that provide cheaper and higher volume of financial services. The proposed regulation would make US banks uncompetitive in international operations and in financing the large needs of US corporations with adverse effects on the economy and job creation.
Second, proprietary trading. There appears to be only one bank currently deriving significant earnings from proprietary trading, which did better during the crisis than most others. Proprietary trading with computer programs arbitraging small differences in spreads is not a source of risk but rather lowers financial costs, making markets more liquid. Not much can be made out of the proposed measure because of the need for the applicable regulatory definition of proprietary trading together with sound analysis of the risks involved and their past occurrence. As in most of the proposals, there is a transfer of risk and business away from banks to other financial institutions such as hedge funds that betrays the intended effort of controlling “systemic” risk that is also loosely defined. How can a council of regulators control systemic risk if they failed to anticipate it during the credit/dollar crisis and global recession?
Third, hedge funds and private equity. The spiral of financial innovation of the view of Functional Structural Finance (FSF) accompanied the rise of pools of capital in the form of hedge funds and private equity (Pelaez and Pelaez, Financial Regulation after the Global Recession, 101-9, Globalization and the State Vol. I, 59-71, Government Intervention in Globalization, 49-52). There were no systemic problems with hedge funds and private equity in the current crisis even as the pools of capital shrank significantly. The liquidation of Long Term Capital Management (LTCM) has been significantly exaggerated (Pelaez and Pelaez, Financial Regulation after the Global Recession, 103-4, Globalization and the State Vol. I, 60-2, International Financial Architecture, 87-9, 108-12). The initial high returns derived from aggressive strategies are likely to be followed by lower abnormal returns and convergence in strategies with mutual funds and under similar regulation (René Stulz cited in Financial Regulation after the Global Recession, 101). The technological revolution and the global recession will require restructuring of corporate control that can be accomplished without the need of traumatic bankruptcy court by taking a company private and then converting it again into a public company (Pelaez and Pelaez, Regulation of Banks and Finance, 157-66, Globalization and the State Vol. I, 49-59, Government Intervention in Globalization, 46-9). Fracturing private equity and hedge fund markets will prevent restructuring of the economy for faster growth and job creation. The forced sale of hedge fund and private equity operations of banks would cause a decline in their stock prices at the time when they need to replenish capital if the new Basel capital requirements are strengthened. Legislation mandating sale of hedge funds and private equity units in a period of several years would still cause immediate deterioration of equity prices of large banks, harming pension and savings funds held by millions of Americans that own 75 percent of large bank stocks with insiders owning less than 1 percent. The evident beneficiaries are independent hedge funds and private equity funds that would face less competition. Banks would be deprived of sources of diversifying credit losses such as those in real estate that caused the credit crisis. The proposals increase large bank vulnerabilities.
Fourth, banking sector consolidation. The limit on the size of liabilities of banks and the use of antitrust regulation to prevent consolidation would prevent optimum size financial institutions and force the ones in trouble into bankruptcy courts instead of exit via mergers and acquisitions. Consolidation is preferable to bankruptcy (Pelaez and Pelaez, Regulation of Banks and Finance, 157-66, Globalization and the State Vol. I, 49-59, Government Intervention in Globalization, 46-9) and will be required because of new technology and the effects of the global recession. Companies that need downsizing may not be able to sell subsidiaries and segments of business to companies in relatively stronger conditions.
Fifth, recovery of the economy and job creation. The model of economic growth of the US is based on innovation with a university, research and entrepreneurial system applying scientific knowledge to practical problems of production while there are significant efforts in the European Union to move forward in enhancing productivity (Pelaez and Pelaez, The Global Recession Risk, 135-44). The expansion phase of the economy requires dynamism similar to the 6 percent annual growth rates of GDP during eight consecutive quarters after the 1982 recession in order to attain full employment. Risk management of the economy by regulators will restrict entrepreneurship not only in finance but in all economic activities. Strong stable financial institutions are required to finance productive economic activities and investment. Tightening regulation after the credit/dollar crisis and global recession may prevent recovery of full employment by interrupting the flow of funds to production and investment.
A more balanced view of the roles of the government and the private sector is required. The fact is that the credit/dollar crisis and global recession originated in four combined policies that stimulated excessive construction and high real estate prices, highly-leveraged risky financial exposures, unsound credit and low liquidity: (1) the interruption of auctions of the 30-year Treasury bond in 2001-2005 that caused purchases of mortgage-backed securities equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between June 2003 and June 2004 with the implicit intention in the “forward guidance” of maintaining low rates indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, 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). The combined stimuli mispriced risk, causing excessive risk and leverage as the public attempted to obtain higher returns on savings. The successful balancing of private and public roles is the most promising opportunity after the credit/dollar crisis and global recession. Constructive dialogue and cooperation of the public and private sectors will ensure future prosperity. The international forums in Basel provide global coordination toward an agenda that will improve regulation with implementation after the recovery of banking and employment perhaps in 2012. Anticipating stricter agendas in a rush to regulation may cause the exodus of banks and financial institutions and their high paying jobs to foreign jurisdictions that provide more constructive and participatory deliberation. Pursuit of the mirage of opportunity in tighter financial regulation may frustrate attaining the actual opportunity in entrepreneurial innovation of fast economic growth and job creation. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)

Sunday, January 17, 2010

Who Pays for the Big Bank Tax and How It Affects the Economy and Jobs
Carlos M. Pelaez
The administration announced on January 14, 2010, the creation of the Financial Crisis Responsibility Fee or the Tax on Big Banks (http://www.whitehouse.gov/the-press-office/president-obama-proposes-financial-crisis-responsibility-fee-recoup-every-last-penn ). The tax is fifteen basis points of covered liabilities per year or: (0.0015) x covered liabilities. These covered liabilities are defined as assets less Tier 1 capital less FDIC-assessed deposits (and/or insurance policy reserves, as appropriate). Tier 1 capital as defined in the Basel Capital Accord, also applied to Basel II, is being reformulated in the current consultative document of the Basel Committee on Banking Supervision (BCBS) (http://www.bis.org/publ/bcbs164.pdf?noframes=1, 4) as consisting mainly of retained earnings and common shares. The remaining portion of Tier 1 capital must consist of subordinated instruments with dividends or coupons that are non-cumulative without maturity date or incentive of redemption (for soft law and the Basel accords see Pelaez and Pelaez, International Financial Architecture, 239-300, Globalization and the State Vol. II, 114-48, Government Intervention in Globalization, 145-50, Financial Regulation after the Global Recession, 54-6, Regulation of Banks and Finance, 69-70). The BCBS is calibrating the overall minimum capital ratio and the composition of Tier 1 capital as part of the impact assessment process. Retained earnings and common shares will remain as the major portion of Tier 1 capital. The assessment of the Federal Deposit Insurance Corporation (FDIC) is a fee paid by insured depository institutions on their insured deposits (http://www.fdic.gov/regulations/laws/rules/2000-5000.html#fdic2000part327.3 See Pelaez and Pelaez, Regulation of Banks and Finance, 71-8, Financial Regulation after the Global Recession, 56-8). Consider the administration’s example of a bank with $1 trillion assets, $100 billion in Tier 1 capital and $500 billion in assessed deposits. The yearly tax would be: 0.0015 x ($1000 billion - $100 billion - $500 billion) = 0.0015 x $400 billion = $600 million. This tax will be assessed only on banks with more than $50 billion in assets and the administration expects that 60 percent of the tax will be collected from the largest ten banks. The objective of the tax is collecting over time the expected net cost of the Troubled Asset Relief Program (TARP) of $117 billion. The expected revenue from the tax in the first ten years would be $90 billion so that in about 12 years the government would recover the loss from TARP. The rationale of the tax is that the largest banks that received (and repaid with interest and repurchase of warrants) capital injection from TARP benefited directly or because of improved financial markets and should pay for the losses of other TARP recipients such as car manufacturers, Fannie Mae, Freddie Mac and AIG.
The objective of this post is to provide analysis of the purely economic issues of the Big Bank Tax: microeconomics of financial markets, capital regulation, efficiency in resource allocation in the economy, financial stability, growth and employment, budget deficit and the incidence or who pays for the tax. These issues are discussed in turn.
First, microeconomics of financial markets. This Big Bank Tax is at the wrong time for the wrong reasons. The administration claims that “many of the largest financial firms contributed to the financial crisis through the risks they took and all the largest firms benefitted enormously from the extraordinary actions taken to stabilize the financial system.” The fact is that the credit/dollar crisis and global recession originated in four combined policies that stimulated excessive construction and high real estate prices, highly-leveraged risky financial exposures, unsound credit and low liquidity (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, 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): (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between June 2003 and June 2004 with the implicit intention in the “forward guidance” of maintaining low rates indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac. The combined stimuli mispriced risk, causing excessive risk and leverage as the public attempted to obtain higher returns on savings. John Cochrane and Luigi Zingales provide evidence that the failure of Lehman Bros. was followed by an increase of 18 basis points in the LIBOR-OIS spread, a proxy for the risk of interbank short-term lending, but increased by 60 basis points after the testimony of TARP in Congress two weeks after Lehman’s failure (http://faculty.chicagobooth.edu/luigi.zingales/research/papers/lehman_and_the_financial_crisis.pdf ) The alarmist marketing of TARP as “provide funds or bankrupt banks” in Congress and the media created uncertainty in banks about the quality of their own assets and of those of possible counterparties, squeezing funds out of the sale and repurchase agreements that finance securitization of most credit. The ongoing tax and regulation effort is inopportune when the stocks of the four major investment and commercial banks of the US peaked at the end of October 2009 and have trended down to this writing. The earnings report of a major bank on Friday January 15 contained weakness in loan quality compensated by earnings in investment banking and trading. The crisis revealed how the stock price of banks can collapse to near zero, such as it occurred with Fannie, Freddie and Lehman, preventing the raising of new Tier 1 capital and dooming the institution to failure. The true lessons of TARP unveiled by Cochrane and Zingales should not be ignored. Sound large banks did not need TARP. Market confidence appears to have recovered primarily on its own not because of TARP or monetary policy.
Second, capital regulation and replenishment. The consultative document of the BCBS provides for buffer stocks in the expansion phase of the cycle in order to manage capital requirements over the entire cycle, maximum ratios of debt to assets and sufficient liquidity to bridge banks through crises over at least 30-day periods. BCBS intends to conclude the new capital regulations by the end of this year but may suggest delay in implementation until after 2012 depending on recovery of banks. The same prudence should be exercised in financial tax and regulation legislation. Who would invest in common shares of banks, the key ingredient of Tier 1 capital, when banks are subject to taxes and regulation reducing remuneration of their equity capital?
Third, economic efficiency. Distortions such as taxes and quantitative controls prevent financial institutions from transferring excess savings to productive investments that increase efficiency and promote economic growth. The contemporary banking theory of Douglas Diamond, Philip Dybvig and Raghuram Rajan emphasizes the function of liquidity transformation and monitoring by which banks convert illiquid project with cash flows in the distant future into immediately available cash such as demand deposits (Pelaez and Pelaez, Regulation of Banks and Finance, 37-44, 51-60, Financial Regulation after the Global Recession, 22-6, 30-42, Globalization and the State Vol. II, 73-81, Government Intervention in Globalization, 128-31). The approach of functional structural finance (FSF) of Robert Merton and Zvi Bodie warns against frustrating financial innovation because of the adverse impact on the efficiency of the economy and growth (Pelaez and Pelaez, Regulation of Banks and Finance, 234-6, Financial Regulation after the Global Recession, 34-7). Prudence instead of rush to taxation and regulation would be advisable to permit the adequate provision of banking and financial functions required for optimum allocation of resources that can move the economy to full employment.
Fourth, financial stability and crisis prevention. The rationale of the Big Bank Tax is preventing leverage excesses that allegedly caused the credit/dollar crisis and global recession. A tax on debt increases interest rates. Thus, the tax is inopportune because it will add to the formidable pressure on interest rates originating in increasing fed funds rates and the entire structure of short-term rates from the current 0-0.25 percent target, unwinding the combined MBS portfolio of $2.5 trillion held by the Fed, Fannie and Freddie equivalent to about a fifth of total mortgages outstanding in the US, financing high projected fiscal deficits and refinancing rapidly growing debt. The tax contributes to financial instability by high increases and volatility of interest rates, affecting other financial variables and possibly the real economy.
Fifth, growth and employment. A key lesson of history is that the growth rate in this expansion phase must be similar to that in the 1980s. The economy expanded during five consecutive quarters at annual real rates ranging from 7.1 percent in the second quarter of 1984 (QII84) to 9.3 percent in the second quarter of 1983 (QII83), which were more than twice that of trend around 3.5 percent. Those high rates of growth are required in the next quarters to create again the jobs lost during the contraction. There is a critical difference in the current environment. Interest rates declined sharply in the 1980s from a high of 19.10 percent for the fed funds rate in June 1981 to 8.95 percent in December 1982, remaining between 8.95 and 11.06 percent after the expansion phase. The opposite trend will occur during the current expansion phase because the feds funds rate is fixed by the Fed at 0-0.25 percent and must and will increase sharply in the months and years ahead. Imprudence in financial taxation and regulation can frustrate rapid growth during the expansion phase of the economy, preventing recovery of full employment as it happened during the second half of the 1930s.
Sixth, fiscal budget. Dollars of revenue and expenditure are fungible, that is, identical dollars enter the government as revenue and exit as expenditure. It cannot be claimed that the dollars entering via the Big Bank Tax are the ones paying the deficit created by TARP. The Big Bank Tax revenue simply mixes with all other government revenue. What is required is restraint on the deficit and debt to avoid a more devastating future debt crisis such as that threatening the excessively indebted countries in Europe known as PIGS (Portugal, Ireland but sometimes Italy, Greece and Spain). The Big Bank Tax may remain forever.
Seventh, tax incidence. Consumers of bank credit will pay for the tax that will increase interest rates and reduce the total usage of credit. The analysis is similar to that of the social welfare loss of an excise tax by Harold Hotelling (cited in Pelaez and Pelaez, Globalization and the State Vol. I, 119-25, Government Intervention in Globalization, 87, Financial Regulation after the Global Recession, 22, Regulation of Banks and Finance, 27-32). Monopolistic conditions in banking markets suggest that demand is likely inelastic such that the total payment of interest by consumers will increase as a result of the tax with a part being appropriated by the government. Securitization is financed with debt such that of all consumer debt—credit cards, mortgages, auto loans, students loans and so on—will cost more to the borrowers. The Big Bank Tax will redistribute income from consumers of bank credit to the government instead of from big banks to the government. Institutional investors representing million of consumers own three quarters of the common equity of three of the largest four banks and 62.8 percent in the other bank subject to the tax and insiders about 0.6 percent with the exception of 9.7 percent in one bank. Banks are owned by millions of savers and retirees not by their managers.
The taxation and regulation syndrome could export the financial industry and its jobs to other jurisdictions. This is the time for prudence and protracted informed debate instead of rushing into harmful taxation and regulation. The emphasis should be on maintaining the volume of intermediation ensuring rapid growth of the economy and return to full employment. If taxation, regulation and government spending—ranking in similar longevity with the oldest professions—were a panacea, there would not be economic problems or need for this post. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)

Sunday, January 10, 2010

Did Fed Low Interest Rates Cause the Credit/Dollar Crisis and Global Recession?
Carlos M. Pelaez
A counterfactual is an argument of what would have happened if events or policies would have been different than what actually happened in reality (Pelaez and Pelaez, Globalization and the State, Vol. I, 125). Most significant empirical economics consists of counterfactual analysis. One of the most important and hotly debated counterfactuals in history is that proposed by Milton Friedman and Anna Schwartz that the Great Depression could have been avoided if the Fed had engaged in lender of last resort policy (LOLR) in response to the contraction of money originating in the banking panic of the 1930s (Pelaez and Pelaez, Regulation of Banks and Finance, 198-200). Empirical analysis requires measuring the performance of the American economy with a rule of constant increase of the money supply proposed by Friedman that could have prevented the contraction of the 1930s. The major hurdle is that available data are what happened but there are no data of what would have happened or the counterfactual. Another counterfactual by Harold Cole and Lee Ohanion is if the economy of the United States would have returned to full employment in the 1930s, as many other large economies, if New Deal policies had not caused high prices by encouraging industrial monopolies and high wage rates by increasing unionization through the National Industrial Recovery Act of 1933 (NIRA) (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 214-217).The credit/dollar crisis and global recession poses a similar counterfactual: what would have happened if the Fed had not lowered interest rates on fed funds to 1 percent from June 2003 to June 2004. The Fed issued “forward guidance” in post-meeting statements of the Federal Open Market Committee (FOMC) that policy “was likely to remain accommodative for a ‘considerable period’” (http://www.federalreserve.gov/newsevents/speech/bernanke20100103a.htm ). This guidance could have been interpreted that the Fed could maintain the 1 percent interest rate as long as required to dispel the fear of “destructive” deflation in the US and that other tools of quantitative easing could have been used to shift downwardly the yield curve (http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm cited in Pelaez and Pelaez, The Global Recession Risk, 93). Quantitative easing has been used in the current crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-62, Regulation of Banks and Finance, 224-7).
There are two major competing counterfactuals on the causes of the credit/dollar crisis. First, the regulatory view of Official Prudential and Systemic Regulation (OPSR) explains the crisis in terms of failures of financial markets (Pelaez and Pelaez, Financial Regulation after the Global Recession, 32-4, 155-6). The counterfactual with regulatory recommendations is that stricter OPSR would have prevented the crisis and recession. The Financial Services Authority (FSA) provides an interpretation of the origin, severity and duration of the credit/dollar crisis in the Turner Review (cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 155-6). The low interest rates resulted from high savings rates in countries such as China and Japan, inducing investment in government securities in countries such as the United States that lowered real interest rates (adjusted for inflation) from levels around 3 percent in the 1990s to 1.5 percent in the beginning of the new millennium. These low rates encouraged investors to seek higher yielding alternative assets. Voracious risk appetite of investors induced financial innovations such as structured credit products that used high leverage and careless assessment of credit risk. The growth of securitization after 1995 was in the form of a system of “originate to distribute” in which financial institutions originated credit to all sectors but primarily to households and the financial system. Original credit obligations generated in the form of exotic securities such as adjustable rate mortgages (ARM) were pooled in securities sold to investors and other financial institutions but with part kept by the originating banks. These securities imploded after the default of the initial credit affecting not only the investors in the securities but also the originating banks keeping part of the risk. OPSR would have prevented the lax credit standards such as NINJA mortgages (no income, no jobs and no assets) and exotic products such as ARMs.
Second, an alternative view posits that regulatory failure caused, deepened and prolonged the credit/dollar crisis and global recession. The FOMC lowered the Fed funds rate to 1 percent from June 2003 to June 2004 because of the fear of “destructive deflation” similar to that in Japan in the “lost decade” (Pelaez and Pelaez, International Financial Architecture, 15-18, The Global Recession Risk, 83-95, 208-9, 221-5). Deflation is much more of a rare event than recognized in the fear of deflation: Andrew Atkeson and Patrick Kehoe analyze panel data for 17 countries over more than 100 years finding 65 cases of deflation without depression and 21 of depression without deflation, concluding there is no empirical evidence for association of depression and deflation (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 201). In retrospect, “destructive deflation” was not a threat justifying near zero interest rates for long periods and the deliberate expectation-creating “forward guidance” of maintaining those levels indefinitely. Income is a flow obtained by applying a rate of return to wealth (Milton Friedman, A Theory of the Consumption Function, cited by Pelaez and Pelaez, Regulation of Banks and Finance, 219, Globalization and the State, Vol. II, 200). In simplified form, consider the stock of wealth to be worth $1000 with rate of return of 10 percent, then the flow of income is 0.10 x $1000 equal to $100. Another form of viewing this simple equation is that wealth, $1000, is equal to income divided by the interest rate, or $100/0.10. Assume that the rate of interest declines to 1 percent. Wealth would be perceived as $100/0.01, which is equal to $10,000 or ten times more than before the lower interest rate. The Fed target of fed funds at 1 percent and guidance of low interest rates indefinitely created the perception of permanently increasing wealth in real estate and financial assets, eroding the discipline in calculating risks and returns in decisions by individuals, business, government and financial institutions. Imprudent decisions were made on the false impression created by monetary policy that housing prices and financial assets such as commodity futures and emerging market stocks would increase forever. The world engaged in carry trades of shorting the dollar to buy commodity futures and emerging market stocks that eventually caused an all-time nominal high of oil prices at about $145/barrel and the current rise of futures prices of gold, copper and oil.
John Taylor finds support with econometric analysis that the low interest rates of the Fed caused a real estate boom in the US replicated in countries such as Spain and Charles Calomiris finds that the entry of Fannie Mae and Freddie Mac in subprime and Alt-A (or liar mortgages) coincided with the acceleration of that market from $395 billion in 2003 to $715 billion in 2004, reaching $1005 billion in 2005, with Fannie and Freddie remaining in that market after the decline of house prices in 2006 (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 219). The former chief credit officer of Fannie, Edward Pinto, provided testimony to Congress that Fannie and Freddie purchased or guaranteed $1.6 trillion of nonprime mortgages (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 219-20, Financial Regulation after the Global Recession, 156). To be sure, the process of increasing house prices began in the 1990s (http://www.federalreserve.gov/newsevents/speech/bernanke20100103a.htm ). Dwight Jaffee and John Quigley measure the prolonged and substantial subsidy of housing in the United States of $221 billion per year. Part of the subsidy was hidden from the budget in the hybrid public/private form of Fannie and Freddie. The regulatory error counterfactual posits that the credit crisis originated in four excessive types of stimuli in 2001-2004 (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, 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): (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between June 2003 and June 2004 with the implicit intention in the “forward guidance” of maintaining that rate indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac. The combined stimuli mispriced risk, causing excessive risk and leverage as the public attempted to obtain higher returns on savings.
The alternative counterfactual is that the credit/dollar crisis and global recession would have been avoided had there not been these four government regulatory policy errors stimulating excessive housing construction and speculative carry trades. The low interest rate target of the FOMC of fed funds at 1 percent from June 2003 to June 2004 was followed by sharp increase reaching 5.25 percent by June 2006. Construction lags house purchasing decisions as developers plan projects, open new land, begin construction, market the projects and eventually deliver the houses. Decisions by prospective new homeowners are lagged while they obtain credit at conditions that are affordable relative to expected income, shop for the new home, make a final decision and close the deal. The low interest rate of 1 percent for fed funds in 2003-2004 processed through the housing subsidy probably causing the increase in housing prices of 15 percent in 2004 and 17 percent in 2005 (http://www.federalreserve.gov/newsevents/speech/bernanke20100103a.htm ) that brought the world economy to the precipice of the credit/dollar crisis and global recession. The increase of the target fed funds rate from 1 percent in 2004 to 5.25 percent in 2006 processed devastatingly through the financial and real estate markets probably constituting the tipping point to the global recession. The defense of the rollercoaster behavior of fed funds target interest rates requires proving the more dubious counterfactual that the world economy would have performed better than without wide swings in interest rates.
There are elements of the Nirvana fallacy of Harold Demsetz in current regulatory proposals. This fallacy consists of identifying imperfections in actual markets while attributing to the government omniscience in observing imperfections in markets and omnipotence in always correcting them with textbook precision for an improvement in social welfare (cited in Pelaez and Pelaez, Globalization and the State, Vol. I, 133-7, 201, Government Intervention in Globalization, 81, Regulation of Banks and Finance, 18, Financial Regulation after the Global Recession, 11). OPSR finds alleged imperfections in behavior of consumers, investors and financial markets and institutions that can be cured in all cases by errorless regulation. The New Institutional Economics (NIE) argues that both markets and regulation can fail (Oliver Williamson cited in Pelaez and Pelaez, Globalization and the State, Vol. I, 137-43). Regulation oriented by the belief in an errorless government while in reality it created Fannie Mae and Freddie Mac could contribute to the frustration of economic growth and employment creation already endangered by the pressure on interest rates of (1) raising the fed funds rate again from zero; (2) selling the portfolios of MBS of $2.5 trillion held by the Fed, Fannie and Freddie equivalent to more than 20 percent of all outstanding mortgages; and (3) issuing new debt for financing trillion dollar deficits and refinancing debt rising to more than 60 percent of GDP. Credit crises are typically more benign than devastating debt crises. Policy and regulation should induce instead of frustrating innovation, growth and employment creation by the private sector.
(Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)

Sunday, January 3, 2010

The Interest Rate Threat of Unwinding the Stimulus
Carlos M. Pelaez
The comparison of the current credit/crisis and global recession with the Great Depression of the 1930s is misleading. 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 proper comparison for fruitful policy analysis is with the contraction of the early 1980s. Table 1 shows the annual rate of growth and fed funds rate in contraction quarters during the current recession and during the early 1980s. The objective of policy is not repeating the depression regulation of the 1930s but rather finding lessons in the 1980s. Cole and Ohanion have shown that the US economy did not recover to full employment in the 1930s because of government policy (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 215-7). The key lesson is that the growth rate in the expansion must be similar to that in the 1980s shown in the third column of Table 1. The economy expanded during five consecutive quarters at annual real rates ranging from 7.1 percent in the second quarter of 1984 (QII84) to 9.3 percent in the second quarter of 1983 (QII83), which were more than twice that of trend around 3.5 percent. Those high rates of growth are required in the next quarters to create again the jobs lost during the contraction.

Table 1 Annual Rate of Real GDP and Fed Funds Rate Percent per Year
Current Fed Funds 1980s Fed Funds 1980s Fed Funds
Recession Rate Recession Rate Expansion Rate
QIII08 -2.7 1.81 QII81 -3.2 19.10 QIV82 0.3 8.95
QIV08 -5.4 0.16 QIII81 4.9 15.87 QI83 5.1 8.77
QI09 -6.4 0.18 QIV81 -4.9 12.37 QII83 9.3 8.98
QII09 -0.7 0.21 QI82 -6.4 14.68 QIII83 8.1 9.45
QII82 2.2 14.15 QIV83 8.5 9.47
QIII82-1.5 10.31 QI84 8.0 9.91
QII84 7.1 11.06
Source: BEA, Department of Commerce, Board of Governors Federal Reserve System.

There is a critical difference in the current environment. Interest rates declined sharply in the 1980s from a high of 19.10 percent for the fed funds rate in June 1981 to 8.95 percent in December 1982, remaining between 8.95 and 11.06 percent after the expansion phase (see Table 1). The opposite trend will occur during the current expansion phase because the feds funds rate is fixed by the Fed at 0-0.25 percent and must and will increase sharply in the months and years ahead. The zero interest rate may be considered a government regulatory failure. The problem with fiscal and monetary stimulus is the pain of the unwinding. If the stimulus is not unwound or increased the economy may contract in the future again during a tough debt crisis.
There are two issues relevant to the analysis of the stimulus: its size and the simultaneous unwinding of fiscal and monetary policy. First, the size of the stimulus can be explained by the origin of the credit/dollar crisis and global recession. The credit crisis originated in four excessive types of stimuli in 2001-4 (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): (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between June 2003 and June 2004 with the announced intention of even lowering the rate if required; (3) the housing subsidy of $221 billion per year; and (3) the purchase or guarantee of $1.6 trillion of nonprime MBS by Fannie Mae and Freddie Mac. The combined stimuli mispriced risk, causing excessive risk and leverage as the public attempted to obtain higher returns on savings. Investors reduced liquidity in the hunt for higher returns and lenders relaxed credit standards acquiring bad loans. Consumers borrowed excessively at the artificially low interest rates relative to their capacity to repay. The rise in prices of stocks and real estate created a false feeling of permanent increases in wealth, mispricing risk for lenders, borrowers, government and nearly all economic agents. Country risk is beginning to feel stress in the growing number of excessively indebted countries in the group known as PIGS (Portugal, Italy, Greece and Spain). The Fed increased interest rates from 1 percent in June 2004 to 5.25 percent by June 2006. The reset of mortgage interest rates and principal caused default of mortgage loans and declining real estate prices. The default of underlying mortgages caused losses in structured products such as MBS, collateralized debt obligations (CDO) and credit default swaps (CDS) (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). Some financial institutions and investors began to suffer losses, causing reductions of capital that triggered increases in perception of risk of counterparty financing. Initial monetary policy consisted of reductions in fed funds rates by open market operations touching the “zero bound” of 0-0.25 percent in December 2008 and revival of the rediscount window. Research by Bloomberg finds that the US government and the Fed “spent, lent or committed $12.8 trillion” by March 2009 which was about the entire economic activity or GDP in 2008 (www.bloomberg.com cited in Pelaez and Pelaez, Regulation of Banks and Finance, 224). The amount disbursed or lent by March 2009 was about $4.2 trillion.
Second, the volume of unwinding includes major positions in securities by the Fed, Fannie and Freddie. The Fed used about 11 facilities of monetary policy during the crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession, Table 6.3, 160-1). The Fed engaged in the policy of “quantitative easing” (Pelaez and Pelaez, Regulation of Banks and Finance, 224, The Global Recession Risk, 83-107). When the policy rate or fed funds rate is near the “zero bound” the Fed could expand its balance sheet by acquiring government securities, ignoring the interest rate and focusing on the volume of bank reserves. The purchase of long-term securities by the Fed could lower long-term interest rates, stimulating recovery of the economy by increasing investment. The Fed borrowed by paying interest rates on reserves deposited by banks and by Treasury depositing the proceeds from the issue of short-term Treasury bills at the supplementary account of the Fed; these deposits were invested by the Fed in long-term Treasury securities and MBS. The Fed balance sheet increased by 115.7 percent from $855.1 billion in February 2008 to $1844.9 billion in February 2009 (Pelaez and Pelaez, Regulation of Banks and Finance, 225-6, Financial Regulation after the Global Recession, 158-9). The Fed balance sheet for the week ending December 30, 2009, lists holdings of $909.6 billion of MBS, $707.6 billion of Treasury notes and bonds and $159.9 billion of Federal agency securities. At some point the Fed would sell that portfolio of about $1.6 trillion of long-term securities, causing a decrease in their prices that is equivalent to an increase in their yields. The total retained portfolio of mortgages of Fannie and Freddie stood at $1.6 trillion in the second quarter of 2009 according to their supervisor the Federal Housing Finance Agency (FHFA). The combined portfolio of Fannie and Freddie is 45.5 percent of the value of total residential mortgages and 31.8 percent of total MBS while the retained portfolio is 13.7 percent. The total residential mortgage value outstanding in the US in the second quarter of 2009 was $11.8 trillion of which the Fed, Fannie and Freddie held about 21 percent. The Congressional Budget Office forecasts the federal deficit as percent of GDP at 11.2 percent in 2009, 9.6 percent in 2010 and 6.1 percent in 2011. The debt to GDP ratio would increase from 40.8 percent in 2008 to 65.2 percent in 2011.
The combined pressure on interest rates is formidable consisting of raising the fed funds rate from 0-0.25 percent to a new higher level, unwinding the portfolios of the Fed, Fannie and Freddie and issuing debt to finance deficits of the federal government and refinance maturing debt. The increase in interest rates together with an ambitious regulatory agenda in most of the economy may frustrate the high rates of growth of GDP required to absorb the unemployed. Unwinding past aggressive policy impulses may take many years of lower growth and employment creation. Exuberance in easy monetary policy results in interest rate increases while similar exuberance in easy fiscal policy ends with tax increases. The combination of high interest rates and taxation will restrain the capacity of the private sector to drive growth and job creation. The risk is increases of interest rates for all maturities, or parallel shift of the yield curve, but with sharper increases in long-term interest rates, or steepening of the yield curve. Stress tests of balance sheets should include aberrant behavior of interest rates that may increase in capricious paths by the mere anticipation of changing policy. The unwinding strategy should balance the need of regulation by allowing sufficient dynamism for the private sector to create, finance and implement innovation. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)