Comment 60: Two blocked comments to an opinion column on WSJ online and beyond. "Tracing the liquidity squeeze (10) and "The pulse of globalization (2). (October 2, 2008)
Professor EDMUND S. PHELPS, the recipient of the 2006 Nobel Prize in Economics and the director of the Center on Capitalism and Society at Columbia University, has posted an opinion column on The Wall Street Journal online on Cotober 1, 2008, titled We Need to Recapitalize the Banks. We tried to post two comments related to the opinion column, but both of them were rejected by the monitor of The Wall Street Journal online. We consider the two comments substantially illuminating for the readers interested in many aspects of the current financial crysis in the US that is affecting the global economy, so the two comments are reproduced here. Taking this opportunity we have also added three additional comments about the insurance plan, the suspension of the "mark to market" rule both of which are strongly pushed by the conservative Republican members of the House of Representatives, and the reason why Euro is falling rapidly against Dollar.
Many economists are blindsided about the modern economic developments because they have failed to incorporate the drastic event ushered in by the globalization, that is, the runaway trade deficit, into their model. Many are still clinching on the simplistic view provided by the GDP compilation that imports are bad and exports are good for the economy. They fail to notice that the way of GDP compilation is simply a bookkeeping issue necessitated by the way that GDP counts the domestic production. GDP counts final sales instead of production directly, and thus counts all the imports as domestic production, so at the end imports needs to be subtracted in a separate category to arrive in the true domestic production; the imports are produced in foreign countries and are parts of GDP of those foreign countries but not the domestic production of US. Also the production to generate exports are missed in the final-sales method so exports need to be added in the separate category, too. The true impact of the trade deficit cannot be gauged from the bookkeeping compilation of GDP. One way to see the impact of trade deficit is to look at the financial market. Before the start of the globalization era in early 1980's, trade balance is a small part of the US economy and can be ignored in the first order of approximation. In such a closed system personal savings are the sole source of the seed money for the financial system. The amount of personal savings and the rate of turnover of the personal savings for repeated lending determine how much liquidity or credit is generated within a fixed time span. The runaway trade deficit has changed the picture significantly. The dollars handed out due to trade deficit eventually flow into the hands of large foreign financial institutions and foreign governments. They have no choice but to return those trade-deficit generated dollars back to the US financial market to gain some returns. When those large blocks of dollars return, most of them are thrown directly into the financial market to be lent out to needy borrowers. This set up eliminates the need of personal savings as the seed money so that US consumers not only have reduced savings to near zero and spent all their earnings, but have borrowed heavily against this pot of gold called trade deficit. US Government also borrowed through its chronicle budget deficit from the same pot of gold without immediate economic punishment from such wanton behavior as in the preglobalization era. Participants in the financial market have all the incentive to push the turnover rate of the trade-deficit generated seed money to maximum so that they can profit from the maximum amount of fee-income. The frenzy of pushing the turnover rate to maximum inevitably makes the leverage of those entities sky high, and all those toxic debts are just the tip of the iceberg of this nice set up. Unfortunately the runaway trade deficit makes Dollar weak and in turn the runaway trade deficit is curbed. The stagnation in the growth of trade deficit means the stagnation of the growth of the seed money. The number of buyers of toxic debts dwindle first and the value of the toxic debts fall. This touches off a chain reaction of correction of over-leverage, the turnover rate of the seed money falls, the overall creation of liquidity wanes , and thus the grand liquidity squeeze starts.
The ongoing grand liquidity squeeze first touched off the turmoil related to SIV in August of 2007, followed by the 2007-year-end panic and then the fall of Bear Stearns. However, the recent rapid fire developments, they are, the nationalization of Fannie Mae and Freddie Mac, the fall of Lehman Brothers, the defacto nationalization of AIG, the sale of Merrill Lynch, the sudden conversions of Morgan Stanley and Goldman Sachs to bank holding companies, and the sales of Washington Mutual and Wachovia arranged by FDIC, imply that the grand liquidity squeeze has become bad to worse and has entered into a new phase. Why? It can be understood rather easily by studying from the front of trade deficit. We consider the deficit of goods trade; US still have some surplus on the side of service trade. We need to consider both the overall deficit of the goods trade and the deficit of trades excluding industrials-materials and foods. The deficit of industrials-materials mainly come from crude oil imports, and the balance of trade of foods is a rather small part of the overall trade deficit. As Dollar falls the deficit excluding industrials-materials and foods is the first to be affected; it has stagnated and then fall gently since 2005. The overall deficit of goods trade was kept growing until 2006 by the help of higher crude oil price. However, the sharp fall of crude oil price in the latter part of 2006 pushed down the overall trade deficit and ushered in this grand liquidity squeeze by reducing the available amount of seed money to the financial system. The deficit excluding the trades of foods and industrials-materials is quickening its pace of decline since the late 2007. This phenomena was masked by the sharp rise of crude oil price in the first half of 2008 and the overall trade deficit was able to rise modestly through that period. The liquidity squeeze in the first half of 2008 is rather the result of the uneasiness in the financial market that has reduced the turnover rate of the seed money further. Though the actual trade deficit data of August and September are still not in, it is easy to expect that the deficit must have shrunk substantially considering the collapse of the crude oil price since the middle of July, and thus this sudden worsening of liquidity squeeze since August. Looking down the road the wane of US trade deficit will continue for quite a while and so will be the grand liquidity squeeze. Eventually the situation will stabilize, Dollar will rise against Euro and Yen, and China will be hesitant to push up Yuan further vs. Dollar. Thus US trade deficit will turn from fall to rise with some time lag like a few years and the grand liquidity squeeze will end. As time goes on a new phase of runaway trade deficit will appear, a new and even bigger bubble and than more pain associated with the burst of that bigger bubble. Common sense tells us that such cycle of bubbles cannot continue forever. Eventually the arrival of a big enough bubble and its burst will snap the global financial structure and push the global economy into a great depression. No matter how much nationalistic jingoism like, “Our ingenuity(?) and the flexibility(?) of our financial and free-market system will keep us world number one”, or “We are rapidly rising as the number one power of the world, the twenty-first century belongs to us, we are invincible so we don't need to care how the rest of the world fares”, is going to save the inevitable calamity created by the current ad hoc globalization system that makes the runaway trade imbalance inevitable.
In case of the buying of toxic debts like in the original bailout plan, what will the banks do after receiving the cash from the sale? Most likely they will apply the money to reduce their need to borrow from the credit market so that they will be stronger financially if the liquidity squeeze continues. In that case the hope that banks will increase lending and push up the turnover rate of money to lessen the liquidity squeeze will not be realized. If the purchase price is right, the majors will not suffer more than their write downs already taken. How about the case of recapitalization? What will the banks do with the new capital? Are they going to lend the new capital out or will they use the money to reduce their need to borrow in short-term from the credit market? There is no reason to believe that banks will behave differently from the case of buying of toxic debts from them; they will still not lend just as in the case of Japanese banks when they have received capital infusion from their government. The recapitalization plan will raise very thorny problems. Suppose 500 billion dollars out of 700 billion dollars earmarked are infused to the big five, (BAC, JPM, C, GS, MS), as capital infusion. US Government will be almost 50% share holder of those companies. They will be able to borrow at lower rate due to the implied support of US Government just like Fannie Mae and Freddie Mac. They will be able to beat well managed one that do not need the capital infusion from the government, like Wells Fargo and so on. Isn't it a scheme to reward the bad and extinguish the good ones in the name of emergency? Or the proponents of recapitalization plan advocate that US Government nationalize the whole financial sector and give up the principle of free market?
The insurance plan
The conservative members of the Republican party in the House of Representatives proposed a plan to insure the toxic debts in place of the 700 billion dollar bailout plan proposed by the administration, claiming that the insurance plan will not cost US government any money. Though no details are revealed about this plan, we can easily fill in the gap by ourselves and see why the insurance plan is not meaningful in dealing with the current crisis in the financial market.
Any insurance plan starts with a base price. For example, in the fire and causality insurance of a house, the base price is the cost to rebuild the house. If the house is destroyed, insurer will pay the base price to the owner of the house. What will be the base price for those toxic debts? Let us assume that those toxic debts have already lost 50% of their face value, according to the current market prices. The base price will naturally be set at 50% discount from the face value. A holder then pays premium to insure against the risk of further fall of the price. For such a private insurance program to be viable, the premium needs to be set at a rather high level since the housing woe is not abating at present. This program does not add liquidity to the banks but drain it further from them by requiring them to pay the expensive premium. The proponents may argue that by insuring the future downside risk, the banks are more likely to get financing from the credit market. However, the credit market worry about the falling price of those toxic debts is not the top issue anymore. The number one worry is now the high leverage. The proponents probably are not aware of the steadily advancing grand liquidity squeeze generated by the wane of the trade deficit as discussed in “comment 1” here and through out the series of “Tracing the liquidity squeeze” and in article 10. Anyone with the need to frequently rollover short-term debts in the credit market is in danger, no matter it holds toxic debts or not as has been pointed out in Comment 59. Quite a few commercial banks used to have large deposit base to cover all the loans they made, so they do not need to borrow in short-term from the credit market. This picture has changed since they absorbed highly leveraged investment banks. In that sense this insurance program is irrelevant to the effort to save the financial system from the wholesale collapse due to the freeze up of the credit market. The most crucial factor to save the banks is that they need additional liquidity so that they can reduce the needs to borrow in short-term from the credit market.
The suspension of "mark to market" rule
The mark-to-market rule requires publicly traded companies to mark the securities and assets they hold to the market price and then report the resulting financial situation to their stock holders and creditors. For example, a bank holds 10 billion dollars of toxic debts in face value, but the market value of those debts has fallen to 6 billion dollars. The mark-to-market rule forces the bank to book 4 billion dollar loss. Net losses need to be deducted from the capital of the bank. When the capital of the bank falls to near zero, FDIC needs to sale the bank to other healthier parties or declare the bank insolvent and liquidate the bank. The proponents of this proposal claim that if only this mark-to-market rule is suspended, the banks can pretend that there is no loss from holding those toxic debts and thus do not need to write down their capital. The proponents think that the credit market is so naive that it will be fooled easily by this kind of illusion. On Wall Street there is an old saying, “In crisis, it is not about the return on capital anymore, but is about the return of the capital.” If the mark-to-market rule is suspended, the credit market will take the worst and assume that all those abandoned the rule as near collapse. As the result the freeze of the credit market will intensify further. Probably it is better to have no bailout bill than a bill with the clause of suspension of mark-to-market rule embedded.
Why the sharp fall of Euro but not Yen against Dollar?
Euro is falling sharply in recent days against Dollar. In article 11 we have pointed out that the high flying Euro was the result of the rocketing-up crude oil price. Once the crude oil price collapses, Euro needs to fight by its own to hold its standing. So why the sharp fall of Euro? Quite a few European financial entities hold toxic debts originated from the US. Just like their US counter parts those European entities borrow in short-term from the credit market to finance the purchase of those toxic debts. The toxic debts are denominated in Dollar, so those unfortunate European entities have borrowed in the dollar-denominated credit market. There is only one global dollar-denominated credit market and that market has frozen. Neither those European entities nor their US counter parts are able to rollover their short-term dollar debts. The Federal Reserve Board is pushing out dollars to US based entities that needs to rollover those debts, and The European Central Bank is pushing out Euro to those trapped European entities. Those European entities then dump those Euro for Dollar and thus drive Euro sharply lower. In case of Yen, the exposure of Japanese entities to those toxic debts are far less than in Europe so the pressure for Yen to fall is very small. On the other hand the freeze up of the credit market and the danger of wholesale collapse of US financial system naturally cause Japanese banks reluctant to extend Yen loans to US based banks, and the US based banks must call back yen loans that finance yen-carry trades. Yen-carry trades are for speculative entities to borrow Yen at near zero interest rate, dump the Yen for Dollar and then use Dollar to buy commodities and US stocks. As yen-carry trades are forced to reverse, Yen rises against Dollar, whereas added downward pressures are exerted on commodities and US stocks alike.
Post a Comment