Are we on the path to recovery?

According to the latest data from Bloomberg, as of March 31, 2009 The US Treasury and Fed had committed a total of $12.8 Trillion to the financial rescue efforts. Out of this committed limit, $ 4,169.71 billion was drawn down as of March 31, 2009.

How much should a Sovereign Borrow? - continued reasoning on the Treasury finances

Chapter 18 of 'Principles of Corporate Finance' authored by Brealey & Myers deals with the interesting topic 'How much should a firm borrow?'. I don't know of any slim volumes in the public domain that present a similar reasoning for Sovereign borrowers. However, King Financing is one of the biggest games in the world. I bet the King Financiers have batteries of private PhDs churning out reams of ring-binded reports to work out the considerations for them. So I'm left to deal with this important topic with my own wits.
First of all you need to reason with the different categories of expenses or 'outlays' that a Government has. A Government needs money to provide certain public goods, for which it will collect taxes. For instance, people pay taxes and the collected amounts may be utilized to pay salaries for cops who maintain the law and order. Then you have outlays that are intended to create a long term benefit. For instance, the US Government can provide an economic stimulus for Chinese laptop manufacturers by giving free computers to school kids. The Government hopes that the kid will utilize the computer to pick up various skills, in turn earning a better income when it grows. This will result in a higher income tax collection for the Government in future.
It's important to split the Government outlays into items that are like operating expenses they have to provide required public services, and items that are intended to provide a long term return in terms of future GDP expansion and increased future tax collections.
The next part of the reasoning is on the interest the Government pays on its outstanding debt. You have to remember that a Government Bond holder isn't a beneficiary in future higher tax realizations of the Treasury. The debt holder simply receives interest and hopefully, the principal back from the Government.
The Government financier's interest is to make sure that the interest being paid is out of the money the Government is levying on citizens on an ongoing basis, and not out of the money that is realized from the Government borrowings themselves. A Government debt holder will expect interest to be paid out of the annual earnings of the Treasury. The one year term is derived on the understanding that most levies are collected on an annual basis.
From this reasoning, it is clear that on a stand-alone basis a Sovereign can borrow to the extent that the excess of its annual levies over outlays for operating expenses to provide routine public services is sufficiently large to meet interest payment obligations on its outstanding debt.
In case of the US Treasury, foreign central banks have a compulsion to lend money to them due to the military-diplomatic hegemonic compulsions. This factor enables the US Treasury to create a 'safety bubble' if it so chooses. Also, the triangular debt trading in the Treasury securities amongst the Treasury, Fed and primary dealers constitutes a method of extracting contributions to Treasury debt through the secret concession embedded in the Treasury Supplementary Financing Account.
In this framework, you need to analyze whether the US Treasury interest outgo is coming out of an excess of Treasury Revenues over routine operating expenses or not. If not, the Treasury is completely dependent on foreign central banks for financing. The day China decides to stop buying Treasuries, all other foreign central banks will have no choice but to follow suit, and in this scenario the US Treasury will go bankrupt.
To be continued ...

Updated: Is it time to prepare Insolvency Accounts for the US Treasury?

Operating Cash Balance: The operating cash level of the US Treasury is mentioned in the daily Treasury statement to be $295,462 million as of 22-APR-2009. Out of this $199, 929 million is in the Treasury Supplementary Financing account.
Revenues and Outlays: The monthly Treasury statement contains the data on past revenues and outlays of the US Treasury. Last month, i.e. in March 2009, the US Treasury spent $192,273 million more than they earned. Since October 2009, their total excess of spending over revenue is $ 956,799 million - or nearly a trillion dollars.
Expected Deficits:
Here's a preliminary analysis of President Obama's budget proposals under the aegis of the Director of the Congressional Budget Office. Excerpt:
"CBO projects that if those proposals were enacted, the deficit would total $1.8 trillion (13 percent of GDP) in 2009 and $1.4 trillion (10 percent of GDP) in 2010. It would decline to about 4 percent of GDP by 2012 and remain between 4 percent and 6 percent of GDP through 2019.The cumulative deficit from 2010 to 2019 under the President’s proposals would total $9.3 trillion, compared with a cumulative deficit of $4.4 trillion projected under the current-law assumptions embodied in CBO’s baseline. Debt held by the public would rise, from 41 percent of GDP in 2008 to 57 percent in 2009 and then to 82 percent of GDP by 2019 (compared with 56 percent of GDP in that year under baseline assumptions). ”
The US Public Debt:
As of this writing, the US public debt totals $11.184 trillion.
Sources of financing:
One of the main sources of financing for the US Treasury is Chinese purchases of Treasury and other dollar denominated securities. Dr. Brad Setser at the Council on Foreign Relations is one of the world's foremost experts in the area of balance of payments and global capital flows; and he has taken a specialized interest in studying the size of holdings, currency composition and portfolio allocation of the world's central banks and sovereign wealth funds.
In this paper written along with Arpana Pandey for the CFR Center for Geoeconomic Studies, Dr. Setser has described estimation methodology and data to understand the activities of the People's Bank of China and its associated Sovereign entities.
Yesterday, China revealed its holdings of gold, and here's an article in the Financial Times on that topic.
Note on the United States Public Debt:
Here's a link to the Bureau of the Public Debt web site and on the site if you go to the link "see the U.S. Public Debt to the penny" - the total as of this writing is $11, 184, 922,662,862.85. Of this total, "Intragovernmental holdings" form $4.299 Trillion, and "Debt Held by the Public" forms $6.885 Trillion. In most media and official reports, only the $6.885 trillion is taken into account as US public debt. Typically, that calculation yields around 40+ % of GDP as the US Public Debt.
Understanding the correct nature of "intragovernmental holdings" provides you the accurate, and more practical picture. The contribution made by US citizens towards social security, and other sources of revenue of US government departments, was added to the Congressional Budget as an appropriation. The US Treasury then spent those amounts and issued debt securities to those other US Government entities. Mostly, the $ 4.3 trillion is US Treasury debt held by the Social Security Fund.
The common reasoning provided for not taking the Social Security appropriations into the Us public debt calculation is that that debt is simply not held by the public, and not settled in the market. The US Treasury has payables and liabilities towards Medicare and Social Security that are as yet unfunded.
My view is that what really matters is the cash flow situation. The $4.3 trillion owed to Social Security Fund can be seen as "flexible debt". As long as the Treasury is able to meet the outflows towards its unfunded liabilities, the intragovernmental debt holdings aren't that much of an issue.
Note: I've updated my comment on the US Public Debt after some further serious thinking.
To be continued ...

The Hollywood Economy

Here's an interesting article by Gloria Goodale in the Christian Science Monitor on America’s new-found obsession with summer blockbusters. Michael Cieply in the New York Times also wonders at Americans flocking to movies in the downturn.
And here’s a link to weekend by weekend box office numbers for late 2008 and early 2009.
And here's another article on the movie ticket boom from boston.com.

If Americans don't consume, will global trade crash and burn to the ground?

A couple of comments I made on another blog page:
One of the big lenses through which most Americans view the world’s trade is very approximately as follows: “If Americans don’t consume, global trade will crash and burn to the ground.” I expect that Fabius Maximus would have followed the reasoning in Brad Setser’s explanation for China’s February trade data. China’s exports are showing a decreasing year on year rate of decline in February versus January. The Chinese Lunar New year dates are used by Setser, Macroman, and other commentators to explain this trend. They’re unable to accept that China’s overall export volumes are not responding as expected to the fall in US aggregate demand.Another lens through which several people view the US status is that might be possible to reduce the import dependence through a “divide and rule” policy. For instance, one of the themes I’ve come across is that you can massively do away with imports from China through tariffs, etc, while the oil-exporters continue to hold dollar assets. Thus a currency crisis is prevented, and an imaginary “rapid and orderly rebalancing” can ensue, even as millions more are laid off abroad and political crises emerge there. The divide and rule advocates are unable to see the new alliance amongst the Eurasian powers, consisting mainly of Germany, Russia and China. Despite various differences amongst countries, the US dollar hegemony has become a rallying cry, and the US is now more widely seen in the world as the common enemy of all. (246 words)
What FM seems to be thinking about is a gradual import substitution, sector by sector, whatever. This is radically different from the “rapid and orderly” fantasies.The ruse here is very simple. Most people, unless they’re specialized in economics, or naturally very bright, have a belief that doing away with imports will result in higher local employment. For instance, people seem to imagine that, if you ban imports from China, local companies will come up rapidly, and local people will get jobs to manufacture things imported from China. The fact is that real wages of US workers are much higher than almost anywhere else. Consider a situation where all kinds of items, from textiles, nail clippers, electronics, etc are produced locally, and have to be priced accordingly. This provides two choices; either reduce the wages of US workers, or increase the prices of those goods. Neither of these choices results in a better economy or a better standard of living for people. Apart from reducing people to consuming only the barest essentials, the other effect is that aggregate employment will drop drastically. There’s no way to employ lots of high-paid Americans and hope to sell the same volumes at high prices. If you don’t pay the Americans well enough, despite lower prices, they won’t buy so much, so the factories will be unviable. As for hoping to increase exports, which country will buy US exports in the presence of a huge US Tariff? (245 words)

Fall of the Berlin Wall - Has the American Empire Collapsed?

Have a look at this video , showing a historic moment - the bulldozer gores into the Iron Curtain on the Bornholmer Strasse. And here's the official video from BBC archives.

Dollar Funding of Foreign Banks - some notes

I looked at line item 5) in the TIC data on “Claims on Foreigners by Type and Counterparty”. The item is called “Foreign Banks, including own foreign offices”.The claims peaked at $2.170 Trillion in August 2008. The claims declined to $1.937 trillion by December 2008, the latest data available at the link below. The decrease of $233 billion in claims payable in dollars by foreign banks and foreign branches of US banks is better reflected in the TIC data.Also, the level of around $2 trillion tallies more closely with the BIS estimate of the dollar funding gap faced by foreign banks. The total liability of US banks to foreign banks by end 2008, $ 637.6 b is probably not reflective of the total amount of dollar funding circulating in foreign banking systems.
http://www.treas.gov/tic/bctype.txt
@Brad: The negative liability line probably represents transfers from branches of foreign banks located in the US to their branches outside the US.Liabilities of US Chartered banks to foreign banks grew from $293.8 b at the end of 2004 to $637.6 b at the end of 2008. This growth creates a picture of increasing borrowings of US banks from foreign banks. Also, the growth in US banks liabilities to foreign banks doesn’t explain the increase in liabilities of foreign bank branches to foreign banks. US Banks liabilities to foreign banks grew from $ 420.3 b at the end of 2006 to $478.2b at the end of 2007, an increase of only $ 57.9 b. The liabilities of foreign branches to foreign banks grew from -$255.3b to -$424.50b between 2006 and 2007, an increase of $ 169.20 billion in owings from foreign banks to their branches here.I remember seeing a line item in the TIC data reflecting something like claims on foreign banks payable in dollars.I think that might be a better indication of the amount of dollar loans not rolled over/withdrawn from foreign banks.

Brad: the combined assets of the broker-dealers and funding companies rose by around $325b (if I got the math and netting right)

Me: From L129 and L130 I got an increase of $326.60 b. I took the funding cos investments in broker dealers out of the total assets for 2008 and 2007. The difference could be rounding.

IMF quotas analysis with links

The link below has the voting power shares at the IMF.
http://www.imf.org/external/np/sec/memdir/eds.htm
In simpler terms, a voting/quota share determines the amount of forex that each country is eligible for out of a total increase in SDRs. SDRs are electronic credits from the IMF to countries, that can used for foreign exchange. This is like an equity stake that each member country gets in IMF combine.
The link below takes you to an FT Op-ed by Edwin M. Truman, after he took office as the US Treasury’s IMF person. (Title: ‘How the IMF can help save the world economy’)
http://www.ft.com/cms/s/0/ccafa8d4-09b8-11de-add8-0000779fd2ac.html
And here’s a link to another Op-ed by Ted Truman on IMF Reform:
http://www.petersoninstitute.org/publications/opeds/oped.cfm?ResearchID=1106

Ted Truman proposes overall, an increase of $250 billion in the world’s foreign exchange through SDR credits from the IMF. And, somewhere between 5 and 10 percent of voting rights will be re-distributed away from “traditional industrial countries” to others (as a best case).

Currently the United States has 16.77 % of IMF voting rights, and China has 3.66%. Australia has only 1.47%. Geithner was the US Treasury's representative to the IMF during the 1998 Asian crisis. He personally made sure with his program then, that all those countries would learna lifelong lesson not to depend too much on foreign loans, and to build a large enough forex reserve.

IMF Quotas

The IMF’s list of Directors and Voting Power provides data on the IMF Quotas.

Reasoning out how the crisis spread around the world

The BIS paper on the dollar funding shortage doesn’t clearly explain how the crisis was transmitted from the United States to Europe.It’s easier to begin with understanding as to how the American problem was transmitted to different emerging markets. For several years emerging markets around the world had high interest rate regimes and had good growth due to secular strucutural changes in their domestic economies. Banks headquartered in New York,London made out loans denominated in USD to say, banks headquartered in BRIC countries. Rolling over the shorter term lower interest rate USD loans was the source of funding for a number of banks in the BRIC countries, who were able to profit from the interest rate spread across the currencies. Secondly a number of foreign institutional investors held equities in these markets, sometimes more than 20% of the total local market cap. These investments were made by using the integration of i-banking and commercial banking; and used the same source of funding - the New York/London interbank/FX Swap/Central bank dollar funding sources.Once the credit crisis broke loose in the US, the disruptions led to a vary large correction in these exchanges, and a local liquidity crisis due to inability to roll over the USD loans.The BIS paper classifies banks by their headquarters in different European countries. It totals up the “dollar denominated claims” of those banks, and totals up their “local currency assets”. Then it shows that the excess of the dollar denominated claims over the local currency assets was funded through the above three sources of USD funding.There are two important aspects here. A “dollar denominated claim” might perhaps be held in any geography, and not only in the US. This is because banks might lend to say I-Banks that might then go and invest in EUR denominated equities. Or a bank HQ’ed in Germany might make out a dollar-denominated loan to a bank HQ’ed in Eastern Europe; and the Eastern European bank might then lend to the local emerging market in its own currency. And so on.This requires a lot of further analysis and thinking. To be continued…

The Lehman collapse and its connection with the European banking collapse

The Lehman collapse and its connection with the European banking collapse is examined in this Baba/Ramaswamy paper at the BIS.

More on the US Dollar Shortage in global banking

As part of its latest quarterly review, the BIS has examined the shortage of US dollars in the international banking system.
Excerpts:
"
Global banking activity had grown remarkably between 2000 and mid- 2007. As banks’ balance sheets expanded, so did their appetite for foreign currency assets, notably US dollar-denominated claims on non-bank entities, reflecting in part the rapid pace of financial innovation during this period.
European banks, in particular, experienced the most pronounced growth in foreign claims relative to underlying measures of economic activity.
We explore the consequences of this expansion for banks’ financing needs. In a first step, we break down banks’ assets and liabilities by currency to examine cross-currency funding, or the extent to which banks fund in one currency and invest in another (via FX swaps). After 2000, some banking systems took on increasingly large net on-balance sheet positions in foreign currencies, particularly in US dollars. While the associated currency exposures were presumably hedged off-balance sheet, the build-up of large net US dollar positions exposed these banks to funding risk, or the risk that their funding positions could not be rolled over.
To gauge the magnitude of this risk, we next analyse banks’ US dollar funding gap. Breaking down banks’ US dollar assets and liabilities further, by counterparty sector, allows us to separate positions vis-à-vis non-bank end users of funds from interbank and other sources of short-term funding. A lowerbound estimate of banks’ funding gap, measured as the net amount of US dollars channelled to non-banks, shows that the major European banks’ funding needs were substantial ($1.1–1.3 trillion by mid-2007). Securing this funding became more difficult after the onset of the crisis, when credit risk concerns led to severe disruptions in the interbank and FX swap markets and in money market funds. We conclude with a discussion of how European banks, supported by central banks, reacted to these disruptions up to end- September 2008. "
...
On the European Banks' reactions to the crisis:
"
Banks reacted to this shortage in various ways, supported by actions taken by central banks to alleviate the funding pressures. Since the onset of the crisis, European banks’ net US dollar claims on non-banks have declined by more than 30% . This was primarily driven by greater US dollar liabilities booked by European banks’ US offices, which include their borrowing from the Federal Reserve lending facilities. Their local liabilities grew by $329 billion (13%) between Q2 2007 and Q3 2008, while their local assets remained largely unchanged.
This allowed European banks to channel funds out of the United States via inter-office transfers (right-hand panel), presumably to allow their head offices to replace US dollar funding previously obtained from other sources.
"

Ted Truman and new IMF Dreams - watch this carefully!

At this post on Dr. Paul Krugman's blog, Ted Truman is reported to have joined the US Treasury to reform the IMF. An article on Ted Truman's joining the Treasury has links to his writings. Hmm...let's see what Ted Truman has been advocating for the IMF.

Thomas Hoenig, President of Kansas Fed - mulls pre-privatized "bridge bank" resolution of insolvent US banks

Calculated Risk reports on the Koenig speech with characteristic alacrity.

Dr. Brad Setser on Sovereign Wealth, Sovereign Power and Foreign Official Agency Purchases

Here's an extract from Dr. Brad Setser's paper titled Sovereign Wealth and Sovereign Power. (the emphasis is mine)
"
For U.S. policymakers today, complacency is tempting because of comforting arguments that it is not in creditors’ interests to precipitate a crisis. One comforting argument is that it would take a decision by a major creditor to dump all dollar reserves to cause a run on the dollar — and that this sort of decision is so drastic as to be unlikely.
But history contradicts this argument. During the Suez crisis, both British chancellor Harold Macmillan and Prime Minister Anthony Eden were convinced that the U.S. government was behind the run on the pound. But the U.S. government actually reduced its sterling holdings by only four million pounds—or around $11 million dollars—between the end of September 1956 and the end of December, a fraction of the $450 million drain from September through November with which HM Treasury had to contend.43 The United States did not need to sell pounds to put pressure on Britain, just as Russia, China, or Saudi Arabia might not need to sell dollars to put pressure on the United States today. As W. Scott Lucas writes: "The Americans did not have to sabotage the pound to influence Britain ... they merely had to refuse to support it."
Contrary to what the comforting narrative might suggest, a country seeking to use its holdings of dollars to influence U.S. policy has options that fall short of the "nuclear option" of dumping large quantities of dollar reserves.
– A creditor government could sell holdings of "risk" assets and purchase "safe" U.S. assets, creating instability in certain segments of the market. This could be done without triggering the appreciation of its own currency against the dollar or directly jeopardizing its exports.
- A creditor government could change how it intervenes in the currency market. A country, for example, could halt its accumulation of dollars without ending all intervention in the currency market if it sells all the dollars it buys in the market for other currencies.
– A creditor government could stop intervening in the currency market, halting its accumulation of foreign assets, whether in dollars or other currencies.
– A creditor government could halt its intervention and sell its existing stocks of dollars and dollar-denominated financial assets, the "nuclear option." If it held a large equity portfolio, this could include large stock sales.
"
In this essay at his blog Brad Setser says "And now even government-backed Agencies are too risky. " (He's discussing the Russian Federation's 2008 action to offload all holdings of Agencies, while accumulating increased volumes of Treasuries.)
There have also been other essays from Dr. Brad Setser, comparing the Fed's willingness to take a higher level of risk, to provide stability during the crisis; against the de-stabilizing influence exercized by foreign central banks, such as the People's Bank of China when they dumped Agencies during the crisis. (I'll try to provide more links to Brad's blog essays and excerpts as time permits)
While he doesn't explicitly state this in his latest essay, Dr. Brad Setser has been advocating increased Agency purchases from foreign central banks for some time now.
If foreign official creditors were excessively concerned about exercising influence on US policies; they could have done that by making conditions in return for continued lending to the US Agencies in 2008. Setser's data clearly shows they massively exited their Agency holdings, and exchanged them for Treasuries. Since there is no information about any conditions made by them that the US Government did not meet, the foreign official Agency debt sell off is an indication that foreign official creditors, in 2008, did not pursue the agenda postulated in Dr. Brad Setser's paper on Sovereign Wealth and Sovereign Power.
In September 2008, the Henry Paulson announcement of a conservatorship for the Agencies made it abundantly clear that though they are known, till date as "Government Sponsored Enterprises" or alternatively as "Agencies" of the US Government; in fact, they are private entities enjoying only a limited guarantee from the US Treasury. Clarification of the non-Governmental status of the Agencies, clearly, was the main cause of the foreign official sell-off in Agencies.
If foreign central banks were to buy Agencies now, that would in fact signal some nefarious intentions on their part, as long as you still accept the risk of foreign official creditors wanting to use their creditor status to influence US policies. So I see a discrepancy here between the recognition of that risk in Brad Setser's paper linked above; and his on going advocacy of a stabilizing influence from foreign official Agency purchases.

Will the Us dollar get weaker or stronger now?

Here's my view:
Yen and USD-funded carry trades will be put on massively once the credit crunch eases. I’m not sure what level the yen and USD exchange rates will settle down at.As the RMB gets acceptance as a reserve currency, Russia, Germany, France, Iran, Venezuela all continue to shift their forex reserves composition to a combination of RMB, JPY, Russian roubles, EUR, etc. The USD will draw strength mainly from its RMB peg.The US still has a perhaps 4-5 years available to deal with an emerging balance of payments crisis. That period, according to Obama’s plan, is to be used to reduce dependence on imported oil, and build a more skilled workforce that can provide better export performance in a weaker dollar world. These two factors can actually be expected to mitigate the effects of an emerging external finance solvency crisis for the US.In between, there are old-style trade protectionists in the guise of current account imbalance theorists; calling for an immediate disruption to the external financing flow to the US. If this goes through, the US will definitely face a sovereign default before the end of this year or the middle of next year.

PS: I posted this as a comment on Brad Setser's blog. As anybody can see, it is quite relevant to the topic of his blog post today;but you should wonder if he will be able to tolerate such a radical difference with his views.

My comment below has been approved on Dr. Krugman's blog!

Showing, therefore, that I'm allowed there ...

This Comment at Paul Krugman's New York Times Blog

I just uploaded this comment to Dr. Krugman's post titled hey-who-you-callin-neo-wicksellian?
I read an interesting paper on quantitative easing written by a couple of economists at the Fed. Apart from citing the Japanese case, they also go into something called a “floor price system”, that was an innovation of the New Zealand Central Bank. It would be nice to get some further explanation of the use of the short term interest rate and other factors that can be used to influence money supply. Here, I notice the argument that if the money supply increases in the presence of a ZIRP, you’re just substituting cash for short term debt. This is something I’ve never come across and it would really be useful if this can be expanded on further, either by Dr. Krugman or other knowledgeable commentators.— Indian Investor

This comment has nothing controversial in it; it just asks for further explanation that would be useful to understand better. There's a surprising change today. Previously for several days, as I noted before, my comments there wouldn't appear in the status "awaiting moderation" after I uploaded but today this comment does appear in that status!

Can Paul Volcker get away with talking nonsense at Canadian bankers?

The short answer seems to be, yes.
Here's an excerpt from a Paul Volcker speech:
"This phenomenon can be traced back at least five or six years. We had, at that time, a major underlying imbalance in the world economy. The American proclivity to consume was in full force. Our consumption rate was about 5% higher, relative to our GNP or what our production normally is. Our spending – consumption, investment, government — was running about 5% or more above our production, even though we were more or less at full employment.
You had the opposite in China and Asia, generally, where the Chinese were consuming maybe 40% of their GNP – we consumed 70% of our GNP. They had a lot of surplus dollars because they had a lot of exports. Their exports were feeding our consumption and they were financing it very nicely with very cheap money. That was a very convenient but unsustainable situation. The money was so easy, funds were so easily available that there was, in effect, a kind of incentive to finding ways to spend it."
Is Paul Volcker reasoning accurately here? Suppose, for instance, that Indians acquire an increased penchant for importing more and more electronic gadgets from China. And China decides to buy a lot of Government of India securities to artificially strengthen the Indian Rupee. How would this turn out? The FRBM target is to reduce the fiscal deficit to around 3% by next year. As long as the Government maintains a strong fiscal path, and spends in tune with its income; it wouldn't matter whether the G-Secs are held by locals or foreigners; or the People's Bank of China.
PBoC INR denominated forex reserves would in this example strengthen the INR artificially, and that will make life easy for Indian consumers of China's electronics. But as long as the Government finances are strong, we would never go bust as a result of consuming those electronics at those cheap prices. In fact, the more the PBoC buys INR securities, the happier we would have been at this free Chinese giveaway of their electronics.
Paul Volcker is diverting attention from the simple fact that it was the US Treasury that borrowed huge amounts, far in excess of its income, and spent it on various items. The US Treasury is directly responsible for this whole mess. And by having these kinds of speeches, they're proceeding in the direction of more and more Government debt, rather than less, creating a dangerous situation where the Sovereign itself can be forced into default.
Here's the full speech: (I got it from a comment posted at Brad Setser's blog)
I really feel a sense of profound disappointment coming up here. We are having a great financial problem around the world. And finance doesn’t work without some sense of trust and confidence and people meaning what they say. You take their oral word and their written word as a sign that their intentions will be carried out.
The letter of invitation I had to this affair indicated that there would be about 40 people here, people with whom I could have an intimate conversation. So I feel a bit betrayed this evening. Forty has swelled to I don’t know how many, and I don’t know how intimate our conversation can be. But I will, at the very least, be informal.
There is a certain interest in what’s going on in the financial world. And I will disappoint you by saying I don’t know all the answers. But I know something about the problem. Let me just sketch it out a little bit and suggest where we may be going. There is a lot of talk about how we get out of this, but I think it’s worth remembering, or analyzing, how this all started.
This is not an ordinary recession. I have never, in my lifetime, seen a financial problem of this sort. It has the makings of something much more serious than an ordinary recession where you go down for a while and then you bounce up and it’s partly a monetary – but a self-correcting – phenomenon. The ordinary recession does not bring into question the stability and the solidity of the whole financial system. Why is it that this is so much more profound a crisis? I’m not saying it’s going to get anywhere as serious as the Great Depression, but that was not an ordinary business cycle either.
This phenomenon can be traced back at least five or six years. We had, at that time, a major underlying imbalance in the world economy. The American proclivity to consume was in full force. Our consumption rate was about 5% higher, relative to our GNP or what our production normally is. Our spending – consumption, investment, government — was running about 5% or more above our production, even though we were more or less at full employment.
You had the opposite in China and Asia, generally, where the Chinese were consuming maybe 40% of their GNP – we consumed 70% of our GNP. They had a lot of surplus dollars because they had a lot of exports. Their exports were feeding our consumption and they were financing it very nicely with very cheap money. That was a very convenient but unsustainable situation. The money was so easy, funds were so easily available that there was, in effect, a kind of incentive to finding ways to spend it.
When we finished with the ordinary ways of spending it – with the help of our new profession of financial engineering – we developed ways of making weaker and weaker mortgages. The biggest investment in the economy was residential housing. And we developed a technique of manufacturing class D mortgages but putting them in packages which the financial engineers said were class A.
So there was an enormous incentive to take advantage of this bit of arbitrage – cheap money, poor mortgages but saleable mortgages. A lot of people made money through this process. I won’t go over all the details, but you had then a normal business cycle on top of it. It was a period of enthusiasm. Everybody was feeling exuberant. They wanted to invest and spend.
You had a bubble first in the stock market and then in the housing market. You had a big increase in housing prices in the United States, held up by these new mortgages. It was true in other countries as well, but particularly in the United States. It was all fine for a while, but of course, eventually, the house prices levelled off and began going down. At some point people began getting nervous and the whole process stopped because they realized these mortgages were no good.
You might ask how it went on as long as it did. The grading agencies didn’t do their job and the banks didn’t do their job and the accountants went haywire. I have my own take on this. There were two things that were particularly contributory and very simple. Compensation practices had gotten totally out of hand and spurred financial people to aim for a lot of short-term money without worrying about the eventual consequences. And then there was this obscure financial engineering that none of them understood, but all their mathematical experts were telling them to trust. These two things carried us over the brink.
One of the saddest days of my life was when my grandson – and he’s a particularly brilliant grandson – went to college. He was good at mathematics. And after he had been at college for a year or two I asked him what he wanted to do when he grew up. He said, “I want to be a financial engineer.” My heart sank. Why was he going to waste his life on this profession?
A year or so ago, my daughter had seen something in the paper, some disparaging remarks I had made about financial engineering. She sent it to my grandson, who normally didn’t communicate with me very much. He sent me an email, “Grandpa, don’t blame it on us! We were just following the orders we were getting from our bosses.” The only thing I could do was send him back an email, “I will not accept the Nuremberg excuse.”
There was so much opaqueness, so many complications and misunderstandings involved in very complex financial engineering by people who, in my opinion, did not know financial markets. They knew mathematics. They thought financial markets obeyed mathematical laws. They have found out differently now. You know, they all said these events only happen once every hundred years. But we have “once every hundred years” events happening every year or two, which tells me something is the matter with the analysis.
So I think we have a problem which is not an ordinary business cycle problem. It is much more difficult to get out of and it has shaken the foundations of our financial institutions. The system is broken. I’m not going to linger over what to do about it. It is very difficult. It is going to take a lot of money and a lot of losses in the banking system. It is not unique to the United States. It is probably worse in the UK and it is just about as bad in Europe and it has infected other economies as well. Canada is relatively less infected, for reasons that are consistent with the direction in which I think the financial markets and financial institutions should go.
So I’ll jump over the short-term process, which is how we get out of the mess, and consider what we should be aiming for when we get out of the mess. That, in turn, might help instruct the kind of action we should be taking in the interim to get out of it.
In the United States, in the UK, as well – and potentially elsewhere – things are partly being held together by totally extraordinary actions by a central bank. In the United States, it’s the Federal Reserve, in London, the Bank of England. They are providing direct credit to markets in massive volume, in a way that contradicts all the traditions and laws that have governed central banking behaviour for a hundred years.
So what are we aiming for? I mention this because I recently chaired a report on this. It was part of the so-called Group of 30, which has got some attention. It’s a long and rather turgid report but let me simplify what the conclusion is, which I will state more boldly than the report itself does.
In the future, we are going to need a financial system which is not going to be so prone to crisis and certainly will not be prone to the severity of a crisis of this sort. Financial systems always fluctuate and go up and down and have crises, but let’s not have a big crisis that undermines the whole economy. And if that’s the kind of financial system we want and should have, it’s going to be different from the financial system that has developed in the last 20 years.
What do I mean by different? I think a primary characteristic of the system ought to be a strong, traditional, commercial banking-type system. Probably we ought to have some very large institutions – or at least that’s the way the market is going – whose primary purpose is a kind of fiduciary responsibility to service consumers, individuals, businesses and governments by providing outlets for their money and by providing credit. They ought to be the core of the credit and financial system.
This kind of system was in place in the United States thirty years ago and is still in place in Canada, and may have provided support for the Canadian system during this particularly difficult time. I’m not arguing that you need an oligopoly to the extent you have one in Canada, but you do know by experience that these big commercial banking institutions will be protected by the government, de facto. No government has been willing to permit these institutions, or the creditors and depositors to these institutions, to be damaged. They recognize that the damage to the economy would be too great.
What has happened recently just underscores that. And I think we’re at the point where we can no longer fool ourselves by saying that is not the case. The government will support these institutions, which in turn implies a closer supervision and regulation of those institutions, a more effective regulation than we’ve had, at least in the United States, in the recent past. And that may involve a lot of different agencies and so forth. I won’t get into that.
But I think it does say that those institutions should not engage in highly risky entrepreneurial activity. That’s not their job because it brings into question the stability of the institution. They may make a lot of money and they may have a lot of fun, in the short run. It may encourage pursuit of a profit in the short run. But it is not consistent with the stability that those institutions should be about. It’s not consistent at all with avoiding conflict of interest.
These institutions that have arisen in the United States and the UK that combine hedge funds, equity funds, large proprietary trading with commercial banks, have enormous conflicts of interest. And I think the conflicts of interest contribute to their instability. So I would say let’s get rid of that. Let’s have big and small commercial banks and protect them – it’s the service part of the financial system.
And then we have the other part, which I’ll call the capital market system, which by and large isn’t directly dealing with customers. They’re dealing with each other. They’re trading. They’re about hedge funds and equity funds. And they have a function in providing fluid markets and innovating and providing some flexibility, and I don’t think they need to be so highly regulated. They’re not at the core of the system, unless they get really big. If they get really big then you have to regulate them, too. But I don’t think we need to have close regulation of every peewee hedge fund in the world.
So you have this bifurcated – in a sense – financial system that implies a lot about regulation and national governments. If you’re going to have an open system, you have got to get much more cooperation and coordination from different countries. I think that’s possible, given what we’re going through. You’ve got to do something about the infrastructure of the system and you have to worry about the credit rating agencies.
These banks were relying on credit rating agencies while putting these big packages of securities together and selling them. They had practically – they would never admit this – given up credit departments in their own institutions that were sophisticated and well-developed. That was a cost centre – why do we need it, they thought. Obviously that hasn’t worked out very well.
We have to look at the accounting system. We have to look at the system for dealing with derivatives and how they’re settled. So there are a lot of systemic issues. The main point I’m making is that we want to emerge from this with a more stable system. It will be less exciting for many people, but it will not warrant – I don’t think the present system does, either — $50 million dollar paydays in that central part of the system. Or even $25 or $100 million dollar paydays. If somebody can go out and gamble and make that money, okay. But don’t gamble with the public’s money. And that’s an important distinction.
It’s interesting that what I’m arguing for looks more like the Canadian system than the American system. When we delivered this report in a press conference, people said, “Oh you mean, banks won’t be able to have hedge funds? What are you talking about?” That same day, Citigroup announced, “We want to get rid of all that stuff. We now realize it was a mistake. We want to go back to our roots and be a real commercial bank.” I don’t know whether they’ll do that or not. But the fact that one of the leading proponents of the other system basically said, “We give up. It’s not the right system,” is interesting.
So let me just leave it at that. We’ve got more than 40 people here but they’re permitted to ask questions, is that the deal?

A few (seemingly forgotten) basic characteristics of the US economy

1) The US economy is more of a services economy than a products economy.In 2008, services totaled $ 6139.8 b out of the GDP of $14264.4 b, which is 43.04% of GDP.Durable goods were $ 944.40 b and non durable goods were $ 2846 b, giving a total of only 26.57% of GDP for goods altogether.
2) Services exports from the US are more than services imports, and the US has a trade surplus in the services category.Services exports were $551 b and imports were 407 b, giving a surplus of $144 b or so, which tho isn;t a major percentage of GDP.
3) Trade deficit is a small percentage of GDP for the US: The overall trade deficit including goods and services was $ 529 b in 2008 (according to above NIPA tables). (I noticed another table in which the non seasonally adjusted balance for 2008 overall is -$677 b). Overall, the US trade deficit is only 3.71% of GDP.
4) The goods deficit is insignficant in comarison to the total size of the US economy. For 2008, the goods deficit is around $ 821 b, which is around 5.76% of the US economy.
5) In 2008, Government consumption expenditures and gross investment (including Federal, State, local, defense, etc) totaled $ 2914.9 b. The US Government is therefore ~20.43% of the US economy.
Link to BIPA tables