July 31, 2012 7:39 pm
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Finance must escape the shadows

Ingram Pinn illustration©Ingram Pinn






There are two ways finance can inflict disaster upon us. The first involves the collapse of a large, systemic institution: the Knickerbocker Trust at the start of the last century, Lehman Brothers at the start of this one.



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The second involves a convulsion in a particular market: tulips in 1637, various forms of “shadow banking” in 2008. The past three years have brought much debate and modest progress on regulating the megabanks, and the Libor scandal has added fresh impetus to these efforts. But shadow-bank reform has remained, well, shadowy. This is because nobody wants to grapple with the basic question of what money really is.






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To understand the stakes, start with one pillar of the shadow banking world: asset-backed securities. Because these IOUs seemed safe before the crisis, they were treated effectively as money: for example, traders used them to make downpayments on derivatives positions and settle up if they made a wrong bet. Many asset-backed securities were sold to money market mutual funds, which enhanced their cash-equivalence further. The money market funds never lost value and you could write cheques against them. Or consider the enormousrepomarket. Anybody who owned securitiesgovernment bonds, corporate bonds or the aforementioned asset-backed ones – could use this market to swap them for cash. Indeed, in the run-up to the crisis, even synthetic collateralised debt obligations, consisting of nothing more substantial than a bunch of Wall Street promises, could be turned into money with few questions asked. Financiers were conjuring money out of nothing. By no means was this the exclusive province of central banks. .
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Of course, private money is an old phenomenon. Banks used to issue private banknotes; and even the humble current account is based on the audacious notion that a $100 entry on a statement from your friendly bank manager is as real and reliable as $100 worth of wheat or gold. But, however pedigreed, private money is susceptible to panics. And so, over the years, uncertain private promises have given way to solid public ones. Starting in 1863, the Feds replaced private banknotes with greenbacks. In 1934 they panic-proofed bank accounts by instituting deposit insurance.





The big question about shadow banking is whether the authorities should perform this alchemy again. To a certain extent, they have already, as Federal Reserve governor Daniel Tarullo described in a recent speech. In the heat of the crisis there was a run from money market funds, which lost a tenth of their deposits in a two-day period; meanwhile, the repo market threatened to collapse. To prevent catastrophe, the Feds rushed to the rescue. As in 1863 and 1934, flimsy private promises were fortified by government.





Now that the crisis has receded, what next? On both sides of the Atlantic there is an earnest push to fix the plumbing of the shadow banking system: regulators want money market funds to hold capital buffers; they aim to reduce the repo market’s precarious reliance on vast financing from clearing banks. But, though these initiatives are valuable, policy makers are not grappling with the core dilemma. Should asset-backed securities, money market funds and repo be viewed as a private system? Or should they be entitled to expect more rescues in the futurerescues that depend ultimately on emergency lending from the central bank?





The right judgment on these questions must depend on another one: if governments formalised the backstop, whom would they serve? One answer is savers. Particularly in the US, the explosion in securitisation was partly a response to a global craving for safe assets. In the four years leading up to the crisis, foreign official purchasers bought roughly 80 per cent of all new Treasury and semi-government agency bonds that were created. The US was not issuing enough official reserve assets to satiate investors so unofficial reserve assets multiplied to fill the gap. A second answer is that backstopping the shadow banks would promote the efficiency of finance. Before securitisation, banks made loans and held them; investors who bought bank shares got an opaque bundle of exposures.




Now, thanks to securitisation, investors can cherry-pick the risks that suit them. Better risk-management options for investors means cheaper capital for borrowers. To preserve that advantage, the Fed should be as willing to rescue shadow banks as normal banks.





How persuasive are these answers? Both invite robust retorts. Savers may crave safe assets, but nowhere is it written that Uncle Sam must provide them in unlimited amounts. Indeed, Wall Street’s promiscuous creation of seemingly safe securities pulled excess capital into the country, fuelling an overvaluation in the dollar and a current account deficit that policy makers should not want to underwrite.





Likewise, the claim of shadow bank efficiency should be treated with caution. Banks securitise assets partly to transfer them to unregulated funds that don’t have capital cushions; the driver is regulatory arbitrage, not efficiency. Similarly, the complex shadow bank lending chains that link banks to money market funds to hedge funds may theoretically be productive: they shift capital around the system to the players that deploy it best. But serpentine lending chains involve a risk of breakage. Must taxpayers be on the hook for that?




Wherever you come down on these questions, what is really striking is their absence from the public square. It has been politically easier to chase bankers and their bonuses than to reckon with these fundamental problems: is quasi-money real money? If so, under what conditions? Yet until we resolve these issues, large swaths of finance will exist in limbo.




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There will be implicit guarantees but not explicit ones. There will be moral hazard but no honest recognition that its consequences must be managed. Whatever your preferred understanding of money, this intellectual muddle promises the worst of both worlds.




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The writer is a senior fellow at the Council on Foreign Relations and a Financial Times contributing editor



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Copyright The Financial Times Limited 2012.




July 30, 2012 7:31 pm

The Achilles heel of America’s financial system




What is the weakest link in America’s financial system today? That is not a question many have asked recently. After all, US banks look pretty healthy these days, at least relative to the horrors of eurozone banks. And the unfolding Libor saga has dominated much of the political debate and regulatory attention.





But while the markets are distracted by Libor, an intense fight is bubbling, largely ignored, about one weak link in the systemAmerica’s vast money market funds. And while it may not be producing the same fireworks as Libor, investors should watch this battle, since it could have big implications for the wider financial world.



The issue is whether this $2.6tn money market fund sector is vulnerable to “runs”. Before 2008, few observers ever asked that question, since the funds were considered extremely dull. After all, they are supposed only to invest in “safeassets (think highly rated bonds) and they pay low returns. Moreover, it was widely assumed that money market funds would never break the buck” (return less than 100 per cent of investors’ cash).





But 2008 shattered that assumption: when Lehman Brothers collapsed, one fund did break the buck. And that sparked a panic. For despite the dull-as-ditchwater reputation, the sector has an Achilles heel: unlike bank accounts, money market funds are not covered by any deposit insurance, and investors can redeem their money at will. That creates a “cliffproblem, as a recent paper* from the New York Federal Reserve says: if investors fear a fund will break the buck, they have an incentive to run, as fast as they can.





The good news is that the initial crisis of 2008 did not spiral into a truly devastating money market run. That was largely because the US government stepped in to provide a backstop for the system.




Since then the Securities and Exchange Commission has introduced some small reforms: it has forced money market funds to purchase more short-term liquid assets and to offer better disclosure, in an effort to bolster confidence.





However, the bad news is that the US government is now banned from providing more backstops. And these modest changes have not resolved that “cliff risk: the same incentives are in place for investors to run in a crisis. As a result, money market fund managers are a very skittish bunch. Last summer, for example, they dumped eurozone assets en masse in a distinctly destabilising way. That stampede could easily be repeated.




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One US government agency, for example, recently conducted a secretive analysis to assess what would happen if some corporate borrowers defaulted, or the eurozone woes got worse. They found that so many funds would break the buck that the conclusions were considered too alarming to publish.





Is there any solution? The SEC, for its part, is pushing two reform ideas: it wants the funds to hold cash reserves, to absorb losses, and to operate with floating net asset values, to educate investors that these investments cannot be treated like a bank account. Last week’s New York Fed paper proffered another idea: investors should be “gated” in a crisis, or forced to leave a small proportion in the fund to absorb losses; a mere 2-4 per cent could prevent runs, it says. To my mind, such ideas look very sensible; if implemented in co-ordination, they could probably reduce the systemic risks. But the SEC is now facing intense pressure from the financial industry to drop these ideas. In particular, fund managers argue that reforms would potentially load new costs on the funds – and thus reduce returns.




This, they add, would make investors less willing to put money into these funds, given that yields are already being crushed by the low interest rate environment.




A recent survey from the Association of Finance Professionals, for example, suggests that many corporate treasurers will shift money from funds to banks if reforms go ahead. As a result, the debate – and the sector – is stuck. Nobody in Washington will publicly say that they want the money market funds to shrink, even if this creates a more stable system; after all, American companies and local governments raise huge amounts of finance from these funds. But nobody wants the government to backstop these funds; or for them to remain so vulnerable to runs. Little surprise, then, that it remains unclear when – or if – the SEC will summon the courage to implement those sensible reforms.





Until then, everyone had better hope nothing happens to create a new panic among money market fund managers or their investors; or we may all come to regret this shameful and dangerous $2.6tn policy fudge.





* The Minimum Balance at Risk; Federal Reserve Bank of New York staff report number 564, July 2012.




Copyright The Financial Times Limited 2012.



America’s Other 30%

Stephen S. Roach

31 July 2012
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NEW HAVENThe American consumer is but a shadow of its former almighty self. Personal consumption in the United States expanded at only a 1.5% annual rate in real (inflation-adjusted) terms in the second quarter of 2012 – and that was no aberration. Unfortunately, it continues a pattern of weakness that has been evident since early 2008.



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Over the last 18 quarters, annualized growth in real consumer demand has averaged a mere 0.7%, compared to a 3.6% growth trend in the decade before the crisis erupted. Never before has the American consumer been this weak for this long.

 

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The cause is no secret. Consumers made huge bets on two bubbleshousing and credit. Reckless monetary and regulatory policies turned the humble abode into an ATM, allowing families to extract dollars from bubbles and live beyond their means.


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Both bubbles have long since burst, and US households are now dealing with post-bubble financial devastationnamely, underwater assets, record-high debt, and profound shortages of savings. At the same time, sharply elevated unemployment and subpar income growth have combined to tighten the noose on over-extended consumers.



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As a result, American households have hunkered down as never before. Consumers are diverting what little income they earn away from spending toward paying down debt and rebuilding savings. That is both logical and rational – and thus not something that the US Federal Reserve can offset with unconventional monetary easing.



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American consumers’ unprecedented retrenchment has turned the US economy’s growth calculus inside out. Consumption typically accounts for 70% of GDP (71% in the second quarter, to be precise). But the 70% is barely growing, and is unlikely to expand strongly at any point in the foreseeable future. That puts an enormous burden on the other 30% of the US economy to generate any sort of recovery.



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In fact, the other 30% has not done a bad job, especially considering the severe headwinds coming from consumers’ 70%. The 30% mainly consists of four componentscapital spending by firms, net exports (exports less imports), residential construction, and government purchases. (Technically, the pace of inventory investment should be included, but this is a cyclical buffer between production and sales rather than a source of final demand.)



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Given the 0.7% trend in real consumption growth over the past four and a half years, the US economy’s anemic 2.2% annualized recovery in the aftermath of the Great Recession is almost miraculous. Credit that mainly to the other 30%, especially to strong exports and a rebound in business capital spending.
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By contrast, the government sector has been moving in the opposite direction, as state and local governments retrench and federal purchases top out after post-crisis deficit explosions. The housing sector has started to recover over the past five quarters, but from such a severely depressed level that its growth has had little impact on the overall economy.



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Given the strong likelihood that consumers will remain weak for years to come, America’s growth agenda needs to focus on getting more out of the other 30%. Of the four growth components that fall into this category, two have the greatest potential to make a differencecapital spending and exports.



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Prospects for these two sources of growth will not only influence the vigor, or lack thereof, of any recovery; they could well be decisive in bringing about an important shift in the US growth model.



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The 70/30 split underscores the challenge: the US must face up to a fundamental rebalancing weaning itself from excessive reliance on internal demand and drawing greater support from external demand.



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Capital spending and exports, which together account for about 24% of GDP, hold the key to this shift. At just over 10% of GDP, the share of capital spending is well below the peak of nearly 13% in 2000. But capital spending must exceed that peak if US businesses are to be equipped with state-of-the-art capacity, technology, and private infrastructure that will enable them to recapture market share at home and abroad. Only then could export growth, impressive since mid-2009, sustain further increases. And only then could the US stem the rising tide of import penetration by foreign producers.



The other 30% is also emblematic of a deeper strategic issue that America faces – a profound competitive challenge. A shift to external demand is not there for the asking. It must be earned by hard work, sheer determination, and a long overdue competitive revival.



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On that front, too, America has been falling behind. According to the World Economic Forum’s Global Competitiveness Index, the US slipped to fifth place in 2011-2012, from fourth place the previous year, continuing a general downward trend evident since 2005.



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The erosion is traceable to several factors, including deficiencies in primary and secondary education as well as poor macroeconomic management. But the US also has disturbingly low rankings in the quality of its infrastructure (#24), technology availability and absorption (#18), and the sophistication and breadth of its supply-chain production processes (#14).




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Improvement on all counts is vital for America’s competitive revival. But meeting the challenge will require vigorous growth from America’s other 30% – especially private capital spending. With the American consumer likely to remain on ice, the same 30% must also continue to shoulder the burden of a sluggish economic recovery.



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None of this can occur in a vacuum. The investment required for competitive revival and sustained recovery cannot be funded without a long-overdue improvement in US saving. In an era of outsize government deficits and subpar household saving, that may be America’s  toughest challenge of all.




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Stephen S. Roach was Chairman of Morgan Stanley Asia and the firm's Chief Economist, and currently is a senior fellow at Yale University’s Jackson Institute of Global Affairs and a senior lecturer at Yale’s School of Management. His most recent book is The Next Asia.


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Copyright Project Syndicate - www.project-syndicate.org



Markets Insight

July 31, 2012 3:19 pm

Time for something different from the ECB

By Ralph Atkins

 

Like a whodunit writer, Mario Draghi is good at building suspense and a “yikes, how will he solve this one?” sensation. In December, when the eurozone last faced meltdown, the European Central Bank president wrongfooted markets by providing unlimited three-year loans to the eurozone financial system: the pundits had expected a revamped government bond-buying programme.




Eight months later, the uplifting effects of the longer-term refinancing operations, which saw the ECB pump more than €1tn into banks, have faded. Last week, Spanish two-year bond yields at one point climbed above 7 per cent, a euro-era high.






A day later, Mr Draghi gave a strong hint that he was planning another twist in the eurozone debt crisis. “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough,” he told a London conference.






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Once again the ECB’s existing bond-buying instrument is unlikely to be his weapon of choice, at least in its current form. After taking over the ECB presidency in November, Mr Draghi concluded that the “securities markets programme” – launched in May 2010 by Jean-Claude Trichet, his predecessor – was seriously flawed. Although the ECB acquired €212bn in crisis-hit eurozone governments’ bonds, investors were far from overawed. Instead, opposition to the programme from Germany’s conservative Bundesbank called into question the ECB’s commitment to bringing down bond yields.






Almost as bad, in the eyes of ECB hardliners, the bank compromised its political independence by wheeling-and-dealing with eurozone governments. Exactly a year ago, the SMP was expanded significantly to include Italian and Spanish government debtonly for Silvio Berlusconi, Italy’s then prime minister, to renege on reform pledges secured by Mr Trichet.






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That experience explains why Mr Draghi in December opted instead for three-year LTROs; providing liquidity to banks against collateral was clearly the job of a central bank. The SMP was “neither eternal nor infinite”, the ECB president said then, making clear his aim of winding it down as soon as possible.






If the SMP were now reactivated for a limited period, investors would simply see a selling opportunity. Other events have further reduced its attractiveness. Earlier this year, the ECB gave itselfseniorstatus in bond markets by refusing to take part in a writedown of Greek government debt. That has created fears it would take priority in any future restructurings.






So, something different is required this time. One option being discussed would see the ECB acting alongside the European Financial Stability Facility – the European Union’s bailout fund – which would join sovereign debt market intervention after imposing conditions on governments. In other words, the EFSF would do the messy job of dealing with politicians. But the ECB, with its unlimited firepower, would still have to provide most of the muscle.






The ECB is responsible for the effective implementation of its monetary policy. But, with eurozone interest rates diverging so much, that is clearly not happening. Fears about banks’ funding had been eased by the LTROs, Mr Draghi said last week: “We took care of that” (though presumably further three-year LTROs are possible). Where the problem was a lack of capital, in contrast, there was little the ECB could do: governments would have to take responsibility.





But Mr Draghi identified another dimension being priced into crisis-hit governments’ bond yields: “convertibilityrisk, that of a possible eurozone break-up leading to redenomination into another, weaker currency.








The ECB president’s acknowledgment that catastrophic outcomes were being priced into the market could pave the way for a correspondingly bold response, such as an unequivocal ECB pledge to dowhatever it takes” to bring bond yields down, perhaps below a predetermined level or cap.





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Mr Draghi has left a lot of unanswered questions, however. Will the ECB overcome the “seniorityproblem of a revamped bond-buying programme by finally taking losses on its Greek bonds? How will he keep the Bundesbank on side, or at least prevent it undermining the credibility of any ECB intervention? Will it somehow try to distinguish between “convertibilitypremiums and other factors driving up bond yields?





The unscripted nature of his comments last weekahead of Thursday’s ECB policy decision – suggests Mr Draghi was trying to bounce some members of its governing council into backing a plan for which he had not yet secured sufficient support. Does that mean a decision could be delayed? Will politicians have to act first, for instance in dealing with Spain? Thursday’s meeting will be a nail-biter.






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Copyright The Financial Times Limited 2012.