A Crisis in Two Narratives

Raghuram Rajan


CHICAGO – With the world’s industrial democracies in crisis, two competing narratives of its sources – and appropriate remedies – are emerging. The first, better-known diagnosis is that demand has collapsed because of high debt accumulated prior to the crisis. Households (and countries) that were most prone to spend cannot borrow any more. To revive growth, others must be encouraged to spendgovernments that can still borrow should run larger deficits, and rock-bottom interest rates should discourage thrifty households from saving.

Under these circumstances, budgetary recklessness is a virtue, at least in the short term. In the medium term, once growth revives, debt can be paid down and the financial sector curbed so that it does not inflict another crisis on the world.

This narrative – the standard Keynesian line, modified for a debt crisis – is the one to which most government officials, central bankers, and Wall Street economists have subscribed, and needs little elaboration. Its virtue is that it gives policymakers something clear to do, with promised returns that match the political cycle.
Unfortunately, despite past stimulus, growth is still tepid, and it is increasingly difficult to find sensible new spending that can pay off in the short run.

Attention is therefore shifting to the second narrative, which suggests that the advanced economies’ fundamental capacity to grow by making useful things has been declining for decades, a trend that was masked by debt-fueled spending. More such spending will not return these countries to a sustainable growth path. Instead, they must improve the environment for growth.

The second narrative starts with the 1950’s and 1960’s, an era of rapid growth in the West and Japan. Several factors, including post-war reconstruction, the resurgence of trade after the protectionist 1930’s, the introduction of new technologies in power, transport, and communications across countries, and expansion of educational attainment, underpinned the long boom. But, as Tyler Cowen has argued in his book The Great Stagnation, once theselow-hanging fruit” were plucked, it became much harder to propel growth from the 1970’s onward.

Meanwhile, as Wolfgang Streeck writes persuasively in New Left Review, democratic governments, facing what seemed, in the 1960’s, like an endless vista of innovation and growth, were quick to expand the welfare state. But, when growth faltered, this meant that government spending expanded, even as its resources shrank. For a while, central banks accommodated that spending. The resulting high inflation created widespread discontent, especially because little growth resulted. Faith in Keynesian stimulus diminished, though high inflation did reduce public-debt levels.

Central banks then began to focus on low and stable inflation as their primary objective, and became more independent from their political masters. But deficit spending by governments continued apace, and public debt as a share of GDP in industrial countries climbed steadily from the late 1970’s, this time without inflation to reduce its real value.

Recognizing the need to find new sources of growth, towards the end of Jimmy Carter’s presidency, and then under Ronald Reagan, the United States deregulated industry and the financial sector, as did Margaret Thatcher in the United Kingdom. Productivity growth increased substantially in these countries over time, which persuaded Continental Europe to adopt reforms of its own, often pushed by the European Commission.Yet even this growth was not enough, given previous governments’ generous promises of health care and pensionspromises made even less tenable by rising life expectancy and falling birth rates.

Public debt continued to grow. And the incomes of the moderately educated middle class failed to benefit from deregulation-led growth (though it improved their lot as consumers).

The most recent phase of the advanced economies’ frenzied search for growth took different forms. In some countries, most notably the US, a private-sector credit boom created jobs in low-skilled industries like construction, and precipitated a consumption boom as people borrowed against overvalued houses. In other countries, like Greece, as well as under regional administrations in Italy and Spain, a government-led hiring spree created secure jobs for the moderately educated.

In this “fundamental narrative, the advanced countries’ pre-crisis GDP was unsustainable, bolstered by borrowing and unproductive make-work jobs. More borrowed growth – the Keynesian formula – may create the illusion of normalcy, and may be useful in the immediate aftermath of a deep crisis to calm a panic, but it is no solution to a fundamental growth problem.

If this diagnosis is correct, advanced countries need to focus on reviving innovation and productivity growth over the medium term, and on realigning welfare promises with revenue capacity, while alleviating the pain of the truly destitute in the short run. For example, Southern Europe’s growth potential may consist in deregulating service sectors and reducing employment protection to spur creation of more private-sector jobs for retrenched government workers and unemployed youth.

In the US, the imperative is to improve the match between potential jobs and worker skills. People understand better than the government what they need and are acting accordingly. Many women, for example, are leaving low-paying jobs to acquire skills that will open doors to higher-paying positions.

Too little government attention has been focused on such issues, partly because payoffs occur beyond electoral horizons, and partly because the effectiveness of government programs has been mixed. Tax reform, however, can provide spur retraining and maintain incentives to work, even while fixing gaping fiscal holes.

Three powerful forces, one hopes, will help to create more productive jobs in the future: better use of information and communications technology (and new ways to make it pay), lower-cost energy as alternative sources are harnessed, and sharply rising demand in emerging markets for higher-value-added goods.

The advanced countries have a choice. They can act as if all is well, except that their consumers are in a funk, and that “animal spiritsmust be revived through stimulus. Or they can treat the crisis as a wake-up call to fix what debt has papered over in the last few decades. For better or worse, the narrative that persuades these countries’ governments and publics will determine their future – and that of the global economy.

Raghuram Rajan is Professor of Finance at the Booth School of Business, University of Chicago, and the author of Fault Lines: How Hidden Fractures Still Threaten the World Economy.

January 26, 2012 7:17 pm

MF Global: Uncertain futures

Jon Corzine, former CEO of MF Global,

David Kasouf did not feel like celebrating over the festive season. The 32-year-old independent futures trader from Long Island is one of the 36,000 former customers of MF Global whose money is yet to be returned to them in full.

Almost three months after the spectacular collapse of the broker-dealer, former customers such as Mr Kasouf, as well as farmers, grain transporters and small manufacturers, are still waiting to find out the whereabouts of $1.2bn in missing funds. Until regulators and investigators discover what happened, more than a quarter of the money once held in MF Global customer accounts will remain frozen.


People such as Mr Kasouf increasingly feel they will never get their money back. As Christmas app­roached, with a wife and two children to support, he considered selling his house or declaring bankruptcy. Ultimately, the 72 per cent of his funds MF Global’s bankruptcy trustee has since returned prevented this, but his view of the markets has been shaken. “This has practically destroyed my trust in the whole system,” he says.

Since MF Global filed for bankruptcy on October 31 and revealed that customer money was missing, attention has been focused on Jon Corzine, the firm’s former chief executive. Once a Wall Streetmaster of the universe”, with a career including stints as head of Goldman Sachs, a US senator and governor of New Jersey, Mr Corzine is now one of the most reviled figures in finance.

There has also been intense scrutiny of CME Group, America’s biggest futures exchange operator and the in­dustry body responsible for regulating MF Global’s commodities business. Some customers are angry at what they say was a lapse in oversight; others say a for-profit entity should not be regulating its own customers. CME responds that no watchdog can guarantee against fraud.

But the MF Global scandal is more than just a question of tarnished reputations. It has had a profound effect on the entire financial industry. The realisation that customers could lose money kept in segregated accounts separate from the firm’s own moneythought by many to be as safe as a bank – has severely damaged confidence in the 163-year-old US futures market. Before the financial crisis, futures were among the fastest-growing of all exchange-traded products.

“This is unprecedented. It’s the single biggest blow the industry has ever had to its business and credibility,” says a former senior CME executive. “It has forced us to ask the question: is the model of the futures industry so flawed that it can never be the same again?”

Such soul-searching is rare for a business that in the past 30 years has transformed itself from an agricultural backwater. Futures markets – which enable producers such as manufacturers to fix for the longer term the prices at which they buy or sell rather than expose themselves to the risk of volatility on the daily spot markets – were once seen chiefly as a system of crop insurance for farmers. Today investors trade agreements to buy and sell in the future anything from oil to financial products.

The sector is proud to have made itself a central element of global financial institutions’ risk-management strategies. CME, once a member-owned trading club, is now one of the world’s most powerful exchange groups. The MF Global debacle threatens to undermine those achievements. The most obvious indication of the loss of trust in the industry is a fall in futures trading volumes since the collapse of MF Global, which was a dominant force in Chicago’s agricultural trading markets and the largest broker on the New York Mercantile Exchange, an energy-trading venue also owned by Chicago-based CME. Most ob­servers say the effect of MF Global’s collapse is the primary explanation.

The impact has reverberated across the industry. “Even brokers who didn’t necessarily have their accounts at MF Global are seeing incredible trepidation, especially from international market participants,” says Christine Cochran of the Commodity Markets Council, a Washington industry group whose members include big agricultural traders such as Archer Daniels Midland, food companies such as Kraft, hedge funds and futures brokers. “They will pull their money out every night ... It remains to be seen if that trust can be repaired.”

At groups such as Scoular, which handles grain at 58 silo complexes in North America, risk managers are rethinking how to insure against price fluctuations. “The industry felt using the commodity exchanges was a way to transfer risk without having to worry about counterparty risk [that trading partners would go bankrupt],” says Bob Ludington, Scoular’s chief operating officer. “When the MF Global situation happened, that really woke everybody up. They said: ‘Wait a minute, there is counterparty risk.’ Then the question is, who do you do business with?”

Regulators have viewed futures as a model for reforming the vast markets in swapsderivatives that are privately negotiated rather than traded on exchanges – such as the credit default swaps made infamous by the financial crisis. But the collapse of MF Global has prompted some grain merchants to move in the opposite direction. Scoular, for example, is buying from big banks more agricultural swaps, where physical delivery of the underlying commodity is not required. Unlike futures, these derivatives are notcleared”, or protected against the risk of default by an exchange clearing house.

“It’s basically taking bank counterparty risk as opposed to [futures broker] counterparty risk,” says Mr Ludington.

. . .

Before MF Global fell, CME often touted the fact that no customer had lost money as a result of a clearing member default. Futures brokers reiterated that claim, leading customers to leave plentiful money in their accounts to cover margin callsincreases in the deposit traders must leave at the exchange clearing house to indicate good faith in fulfilling their contracts. Indeed, futures brokers depend on this, making their profits by reinvesting excess capital and receiving interest on the investments.

As it turns out, unlike bank deposits, futures trading accounts are uninsured by the federal government. And there is no industry body akin to the Securities Investor Protection Corporation, which has a reserve covering securities customers for up to $500,000, to help clients of failed futures brokers.

In the wake of MF Global’s collapse, traders are scrutinising brokers more closely. However, the Commodity Futures Trading Commission, the Washington futures watchdog, this week said 70 firms subject to an emergency spot check were compliant.

People are really evaluating, who am I doing business with?” says Scott Cordes, president of Country Hedging, a Minneapolis-based futures broker. The lack of trust, he adds, could prompt clients to take their chances in spot markets. “If we can’t restore the integrity back in the marketplace, long term I think you’ll have people taking on more risk than they should be. They might not be hedging.”

Since the missing money was held in MF Global’s own accounts, CME is not legally obliged to make up the shortfall in customers’ funds. Had this happened before CME became a public company a decade ago, its members might well have clubbed together to bail out its traders. Now, its shareholders would be loath to do so.

CME did offer a guarantee of $550m to encourage the bankruptcy trustee to release more frozen funds. That has not, however, stopped calls for CME to come up with all the money itself.

Yet even if the money is found or replaced, it is far from clear confidence can be rebuilt without a change in oversight. “The damage has been done,” says John Lothian, who runs MarketsWiki, an industry website. “There are some structural issues that need to be addressedbankruptcy, self-regulation – and they will be.”

. . .

The affair has already spurred changes. Last month the CFTC revived a rule limiting brokers’ investment options for customer cash. On January 11, as it passed new rules imposing stricter protection for big traders that use cleared swaps, it said it might consider similar safeguards for futures.

Self-regulatory bodies including CME and the National Futures Association are working on possible rule changes for customer funds. The Futures Industry Association, which represents brokers, has set up a task force to suggest reforms.

CME’s role as a designated self-regulatory body is under intensifying scrutiny. Barney Frank, the congressman who spearheaded the overhaul of financial regulation, has suggested stripping it of this function. “How did the government allow a for-profit company to have such major regulatory authority?” asks the head of one Chicago futures broker. “It would certainly appear that there’s a conflict of interest there.”

CME demurs. “The self-regulatory model is really a misnomer for a complex system of organisations that work together to ensure effective regulation,” says Anita Liskey, a CME spokeswoman. “It is a proven system that has withstood the test of time. For over 75 years, customers have lost money due to a shortfall in their segregated accounts only once, and that was due to a firm’s actions in violations of law. That record compares very favourably to alternative approaches.”

CME argues that because it guarantees trades, it has a vested interest in ensuring firms are fully compliant. It also says it has the expertise to do so and notes that self-regulation does not cost taxpayers. It employs 200 auditors and regulators, at an annual cost of $40m, to carry out its duties.

Brokers, too, face further scrutiny. CME, along with the industry, is ex­ploring additional protections for customer collateral held at the firm-level,” says Ms Liskey. “That is where the failure occurred, not at the clearing house, and that is where we and others in the industry believe we need to focus.”

The debate has gone further, however, with some questioning the very structure that allows brokers to make profits. “The model has always been that you hold the customers’ cash, you invest it and keep the interest,” the former CME executive notes. “It’s the customers’ moneywhy shouldn’t they keep the interest?”

Already, changes made by the CFTC threaten brokers’ business model. Limiting their investment options will cut a crucial source of revenue. Fees might be increased as a result, which could put off retail investors.

Ultimately, a quick fix looks un­likely. Trust has been completely shaken and it’ll be a long, slow, hard climb back,” says the futures broker’s head. “When farmers and small-town banks don’t trust us, we need to take a long look in the mirror.”

Scandals and losses of speculators past

MF Global’s fall is a fresh embarrassment for an industry that has worked hard to disown a history of scandal, writes Gregory Meyer.

Since the US futures markets were founded in the 19th century, many scandals have involvedcorners” – buying up large quantities of a commodity to drive up the price. In 1888 Benjamin Hutchinson, known as Old Hutch, amassed wheat supplies and shipped them out of town in order to corner the Chicago futures market, according to a book on futures by Robert Kolb and James Overdahl. The resulting scarcity meant traders who had agreed to deliver the grain to him and other buyers at a lower price found it extremely costly if not impossible to honour their contracts. Some reportedly killed themselves in the face of financial ruin.

In the 20th century’s most notorious corner, the Hunt brothers tried to gain control of the silver futures market in 1979-80, more than quintupling the price. This unleashed a flood of scrap silverware into the market – which, combined with the intervention of regulators, deflated the bubble.

With the advent of financial futures in markets from interest rates to currencies, the industry has attracted a broader clientele, from Wall Street banks to pension funds. “It had much more of a Wild West feel, with many larger-than-life characters, prior to the 1980s,” says Professor Craig Pirrong of the University of Houston.

Still, in 1985 the fall of the Volume Investors brokerage over a gold trade cost customers money. In 1998 the bankruptcy of Griffin Trading, a Chicago-based futures firm, caused big losses to traders in London, driving several out of business.

“The futures industry has worked very hard for decades to overcome that stigma and image of itself,” says Emily Lambert, author of The Futures, a market history.

Copyright The Financial Times Limited 2012.

January 29, 2012, 7:56 pm

U.S. Banks Tally Their Exposure to Europe’s Debt Maelstrom


John Kolesidis/Reuters
Demonstrators in Athens. Banks are disclosing more of their exposure to Greece, Italy, Ireland, Portugal and Spain.

After a hurricane, homeowners check nervously to see if their insurance will cover all of their damages. With the European financial crisis still threatening a trail of defaults, United States banks are betting that their insurance is going to pay out.

Five large American banks, including JPMorgan Chase and Goldman Sachs, have more than $80 billion of exposure to Italy, Spain, Portugal, Ireland and Greece, the most economically stressed nations in the euro currency zone, according to a New York Times analysis of the banks’ financial disclosures.

But these banks have made extensive use of a type of financial insurance, called credit-default swaps, to help them offset any losses that might occur if defaults swamped the five troubled nations. Using these swaps, along with other measures, the five banks have cut their theoretical exposure to the troubled countries by $30 billion, to $50 billion. The analysis also shows that Citigroup has the greatest percentage of its exposure potentially protected at 47 percent, while Bank of America has bought the least protection at 12 percent.

Graphic Margins of Uncertainty
Big banks have reduced their sovereign debt exposure, but they still have tens of billions of dollars of it.

On Sunday, the Greek government appeared close to a deal with the majority of its creditors that would lead to big write-down in the value of its debt. But even a deal could spawn a series of events that could lead to payouts on Greek credit-default swaps. While the Greek swaps would probably be paid, they represent only part of the $602 billion of swaps that have been written on the five troubled countries.

Credit-default swaps have functioned well for big bankruptcies, but they were also a big source of systemic weakness in 2008, when the American International Group nearly collapsed because it could not make payments on its side of its swaps contracts. Some market participants now doubt they would work properly during periods of great financial instability.

“The likelihood of actually getting paid out from owning a credit-default swap would be troubling to me if this were my hedge against a systemic shock — especially in a political environment unfriendly to more Wall Street bailouts,” Mark Spitznagel, chief investment officer at Universa Investments, a hedge fund, said through a spokesman.

Since the A.I.G. debacle, regulators have been working to make sure financial firms will actually be able to make, or collect, payments on their swaps when markets are failing. While regulators have the power to get a detailed look at banks’ swaps positions, investors have struggled to get a solid grasp of their exposures from the banks’ financial filings.

Analyzing banks’ Europe-related swaps can be like a walk through a fun house, where appearances are distorted and you don’t know what’s around the corner. The degree of disclosure among the five banks differs greatly and not all of them give a complete snapshot of their exposures and offsetting bets.

But that could change in February, when the banks release 2011 annual reports. The Securities and Exchange Commission this month requested that banks now provide fuller and more consistent presentations of their European positions, saying disclosures have lacked transparency, and might therefore be inadequate for investors. Bank representatives last week said they would comply with the guidance.

One upshot of the new disclosure might be that certain banks’ European numbers suddenly look substantially bigger, since the S.E.C. is effectively asking banks to unbundle key exposures in their financial statements so outsiders can see how big they are before offsetting items.If you do see a jump in gross exposures, there will be new questions for management,” said Mike Mayo, a bank analyst with brokerage CLSA.

Citigroup said it had $20.2 billion of exposure to the five stressed peripheral countries at the end of last year. The bank said it had $9.6 billion of “credit protection” on those countries, and had set aside $4.2 billion of collateral that would also offset its total exposure.

Collecting on the credit-protection swaps would mean Citigroup’s counterparties having the money in stressed times to make a full payment. John Gerspach, Citigroup’s chief financial officer, said this month that the bank was highly confident that it could collect, adding that the entities it bought protection from were “very high quality.”

Citigroup’s disclosed gross exposure to the five countries, including $7.4 billion in loans that have not actually been drawn, was $28.9 billion at the end of last year. Its net number, after credit-default swaps and collateral, was $15.1 billion. Put another way, Citigroup has “hedged47 percent of its disclosed exposure to the five countries.

Bank of America appears to have hedged the least, with only 12 percent of its stated $14.4 billion exposure offset with credit-default protection, according to the analysis. “We carefully manage our risk while still supporting our clients in Greece, Italy, Ireland, Portugal and Spain,” said Bank of America spokesman, Jerome F. Dubrowski.

Like other firms, Bank of America has cut its Europe exposure by aggressively selling assets and cutting back on lending since 2009, when the region’s debt began to look like a serious problem. The bank’s exposure to the five countries is down by 44 percent since 2009, said Mr. Dubrowski. Also important, the new S.E.C. disclosure request could reveal the extent to which a bank has bought credit protection from banks based in the stressed European countries.

The fear is that a bank, say, in Italy, would be unable to pay out on its swaps if the country’s government went into default. Morgan Stanley implicitly recognizes that in its European disclosures. Alone among the five banks, it broke out the amount of default protection it had bought from banks in the five peripheral countries, about $1.43 billion.

Credit-default swaps can be dangerous because they have the ability to hit one side of the trade with a demand for a overwhelmingly large payout if a default occurs. Right now, it costs a bank $401,000 a year to insure $10 million of Italian government debt for five years, according to Markit, a data provider. If Italy took a serious turn for the worse, and its government debt seemed in real danger of default, that swap price would rapidly spike higher, as happened with Greece.

If that occurred, the bank that sold the protection might then have to post a lot of cash to ensure it would make good on the swap. Large cash calls like that might drain some banks of liquid assets, causing systemic stress.

If an important part of the financial system overhaul were in place by now, there may be fewer questions about whether banks will be able to meet cash calls in stressed times. The change involves directing most swaps trades to clearinghouses, whose job is to ensure that the money flows underlying a trade are made. Clearinghouses would standardize collateral payments across the default swap market, and they might demand higher amounts of collateral than banks currently demand from each other.

Recognizing this weakness in the derivatives market, finance ministers and central bankers from the Group of 20 leading industrialized nations said in 2009 that they wanted to have clearing in place for all standardized derivatives by the end of 2012.

Yet, as of June last year, only 9.4 percent of the $29.6 trillion credit-default swap market is centrally cleared, according to the Bank for International Settlements. Notably, the credit-default swaps that pay out if a European government defaults appear to have been held back from central clearing by the British regulator, the Financial Services Authority. The F.S.A. declined to comment on why it has not yet approved these swaps.

As things stand, banks still may be able to avoid using their default swaps, except, perhaps, those on Greece. That’s because the European Central Bank has taken stronger actions to prevent the crisis worsening, like making $620 billion of cheap loans to European banks in December. But the bank’s moves do little to actually reduce European government debt levels.

Until those come down, the banks are betting on their hedges, imperfect as they may be.