Crisis Talk - The World Bank Group

The US Dollar: The worst choice (except for every other option)

Barry Eichengreen has written a piece in this month's Foreign Affairs outlining the difficulties of replacing the dollar with an alternative reserve currency (subscription required).

Professor Eichengreen sets the stage with the usual talking points over the dollar's weaknesses:

• Confidence in the US-championed global financial system is waning
• The US government will continue to issue staggering amounts of debt
• In order for central banks to acquire dollars, the US must run a current-account deficit, which aggravates global imbalances and puts further downward pressure on the dollar
• The political logic for supporting the dollar has weakened, as the US is no longer seen as the military protector of Europe and Asia

In spite of this cocktail of structural weaknesses, there is an "inconvenient truth" to the dollar: its global importance hasn't changed as a result of the crisis. Based on the Federal Reserve's holdings of US Treasuries on behalf of its foreign counterparts, "foreign authorities have continued to accumulate dollars, and even accelerated their purchases in the first half of the 2009."

What gives? Why stick to a currency that is so clearly flawed? Why buy into a system that many respected economists warn is destined to fail?

Crisis Roundup: Debt Edition

Lessons from Japanese borrowing 

The pros and cons of financial innovation...

...with a rebuttal

Meanhwile, Paul Krugman and Jim Hamilton duke it out over the dangers of government debt... 

...while Menzie Chinn and Jeffry Frieden are unambiguous in their views of consumer debt. Quite simply, it created the crisis

Lastly, sometimes pictures are better than words

Spain's Real Estate Blues

Last week, I questioned whether the good news coming out of the eurozone's core economies, France and Germany, would be enough to drive the continent towards a recovery. One of the biggest obstacles to such a recovery is the Spanish real estate sector, which some are dubbing, "a hole in Europe's balance sheet." A new report by Variant Perception, an economic consultancy, paints a grim picture of the Spanish housing market (emphasis mine):

Spain had the mother of all housing bubbles. To put things in perspective, Spain now has as many unsold homes as the US, even though the US is about six times bigger. Spain is roughly 10% of the EU GDP, yet it accounted for 30% of all new homes built since 2000 in the EU. Most of the new homes were financed with capital from abroad.

The value of outstanding loans to Spanish developers has gone from just €33.5 billion in 2000 to €318 billion in 2008, a rise of 850% in 8 years. If you add in construction sector debts, the overall value of outstanding loans to developers and construction companies rises to €470 billion. That's almost 50% of Spanish GDP. Most of these loans will go bad.

Bernanke's Challenges: Look North

Now that we are due for at least four more years of a Bernanke Fed, what will Act Two look like? The New York Times invited several economists to forecast the challenges lying ahead for Mr Bernanke.

Chief among these challenges is unwinding the massive stimuli and support mechanisms that the Fed introduced in order to "prevent another Great Depression" (in the words of Barack Obama). This will involve a deceleration of monetary easing as the Fed balances growth and recovery with inflation and the credibility of the dollar.

Iceland may be an interesting case study of what's ahead. Just as Iceland was a precursor to the severity of the credit crunch, it may be the first to feel the withdrawal symptoms of diminishing government stimulus policies. Robert Wade argues:

Credit Suisse: Where's the Asian Bubble?

Credit Suisse has released a new report (Asia: Show me the bubble) claiming that concerns of an Asian bubble are overblown:

It has become fashionable to argue that Asia’s monetary conditions are too loose and that too much domestic liquidity is creating asset price bubbles. Reflecting prevailing “wisdom” among market analysts, The Economist last week declared that (1) “Asia’s monetary conditions are too loose,” (2) “capital is already rushing in,” (3) “[central bank] foreign exchange intervention to hold down their currencies causes domestic liquidity to swell,” and (4) “the obvious solution is to let exchange rates rise.”

There is nothing “obvious” about any of the above, in our view. The entire region is being painted with a China-brush, which does not wholly apply.

Crisis Roundup

The end of an era for the rich?

The view from Jackson Hole; or, the case against Bernanke. 

Is the United States following in the footsteps of Japan? Michael Mandel believes we are in the midst of a lost decade:

I think we need to wrap our minds around the fact that we’re not having a boom followed by a bust…we’re having a bad decade followed by a slow digging-out process.

Sobriety Checkpoint

Today's Crisis Talk is dedicated to a visual tour of the crisis.  Enjoy.

US housing (c/o Economist)

IMF Weighs in on Recovery; World Bank Discusses Finance in Africa

The IMF and World Bank have both released reports discussing their latest thoughts on the global and regional effects of the financial crisis. 

Olivier Blanchard, the IMF's chief economist, has published his views on Sustaining a Global Recovery, arguing that the path out of the crisis for emerging markets is much simpler than in developed economies:

If past is prologue, the world economy likely will return to its past growth rate. But, especially in advanced countries, the period of above-average growth, characteristic of normal recoveries, may be short-lived or nonexistent.

Blanchard exposes two caveats to recent good news about growth:

Today in China: Panda Put or Cliff Dive?

In light of yesterday's 6 percent drop in the Shanghai composite, there is increasing speculation about the sustainability of the buildup in Chinese equity markets (see recent post).

China’s stimulus efforts, led by increased bank lending, have caused the economy to look more and more frothy:

Is there a China bubble brewing?  If so, will the Chinese government intervene to avoid a crash (the panda put option)? Or are we in for a sharp correction?  Let's see where the market pundits stand:

Muhammad Yunus on the Crisis

Muhammad Yunus was in Washington this week to receive the Presidential Medal of Freedom from Barack Obama. He stopped by the World Bank on Friday to give a talk at the IFC which addressed, among other things, the financial crisis. (His own Grameen Bank has not been affected by the crisis).

Yunus argued that the current crisis is actually an amalgam of many crises which came to a head in 2008: finance, food, energy, environmental (ongoing) and social (income, poverty, health; also ongoing).  He believes that the crisis offers a tremendous opportunity to change the modern financial system, and warns against trying to re-implement the old system.

Weekend Reading

Bred DeLong marvels at the insatiable appetite for US Treasuries. 

Are we in another real estate bubble? Goldman Sachs thinks so.

Do central banks lose their independence as inflation goes up?

Calculated Risk provides an unofficial list of "problem banks" in the Untied States.

Christina Romer, Chair of Barack Obama's Council of Economic Advisers, says (surprise!) that the stimulus is working, and explains, in great detail, how.

And finally, what happened to Bernie Madoff's money? Here's a one-month snapshot. 

Europe's Recovery: Half full or half empty?

A few weeks ago I pondered if Europe was the biggest loser in the crisis. In light of today's upbeat economic news coming out of France and Germany, was I being too harsh? 

Alas, Europe is not a homogeneous body, and this certainly holds true for its economies. The eurozone's northern members are doing better than those on the Med. Growth within the Europe is uneven and often unrelated. For example, Germany seems to be growing in spite of Europe, tying its export-led fortunes to the winds of Asia.

Furthermore, while good news tends to stay within national borders, bad news can spill over. Stronger exports in Germany cannot fix Spain's unemployment woes, and effective consumer stimulus efforts in France will not cure Ireland's Celtic Tiger hangover. Yet, a currency peg collapse in the Baltics, or a Hungarian debt crisis, can spread damage to Scandinavian and Austrian banks, and beyond. 

Trade Finance in Times of Crisis Revisited

Editor’s Note: Jean-Pierre Chauffour and Thomas Farole are, respectively, Lead Economist and Senior Trade Specialist in the World Bank’s International Trade Department. They are authors of an upcoming paper, "Trade Finance in Crisis: Market Adjustment or Market Failure?" and have been invited by Crisis Talk to share their thoughts on trade finance and the crisis.

World leaders at their April 2009 G-20 Summit agreed to massively support trade finance. Yet, little is known about the singularity of the issues related to trade finance in the context of the global economic crisis. Why should international trade finance be a particular issue of concern in the current circumstances? Are there specific market or government failures associated with trade finance that justify a special and differential treatment of the issue by policymakers? If so, what would then be the most appropriate policy instruments to address those concerns?

Central Bank Intervention, Volatility and the Interbank Market

The IMF held an unofficial conference yesterday on "The Effects of Central Bank Intervention on the Interbank Market During the Sub-Prime Crisis." The presentation was led by Economist Ceslo Brunetti from Johns Hopkins University. 

Brunetti and his team analyzed data from Milan-based e-MID, the only electronic, regulated interbank market in the world, in order to measure volatility in bid-ask spreads, transaction prices, and trading volume. They compared data from the pre-crisis period (Jan 2006-April 2008), and the first stages of the crisis (Aug 2007-April 2008).  

A contrast of these two periods found that whenever the European Central Bank took action, regardless of what it was, volatility increased. When new liquidity provisions were announced, vulnerable banks increased their borrowing from the ECB directly, leaving only large, sound financial institutions in the e-MID market, which reduced overall liquidity and increased volatility:

Making Goods vs Making Money: China, finance and rent-seeking

Simon Johnson has written an excellent essay contrasting the growth of traditional industry in China with America's fastest growing sector in the past 40 years: finance. 

Johnson argues that America's current bloated financial system absorbs more money than it produces, transforming it into a rent-seeking industry:

Finance in its modern American form is not productive.  It is not conducive to further sustained economic growth.  The GDP accruing from these activities is illusory – most of finance is simply a tax on what is done by more productive members of society and a diversion of talent away from genuinely productivity-enhancing activities.

Finance is rent-seeking.  The sector has devoted great resources to tilting all playing fields in its direction.  Consumers are taken advantage of; consumer protection is vehemently opposed.  And great risks are taken, with the downside handed off to the government (and the consumers again, as taxpayers).  This downside protection allows an overexpansion of debt-financed finance – reaching the preposterous levels seen in mid-2008 and now re-emerging.

Fear and the Dollar: A New Relationship?

There is growing speculation that we have reached the end of an era for the US dollar. Out with the dollar as an instrument of market safety in tough times; in with the dollar as a pulse of the strength (or weakness) of the American economy. 

That's right, Bloomberg and the FT both ran stories yesterday which argue that the relationship between the dollar and the euro is beginning to be based more on economic fundamentals, and less on risk appetite. 

Previously, when bullish investors looked for higher yields, hot money would flow into emerging markets. This flow resulted in a weakening of the dollar, often at the expense of the euro (and GBP and CHF).

These patterns may have been fundamentally altered by the crisis.

Weekend Reading (and Listening)

What exactly is quantitative easing, and how do we measure its effectiveness? Buttonwood explains.

Is the Credit Crisis the largest outlay in American History? Some are arguing it is more costly than WWII. (via Ritholtz)

Zero Hedge shows us the Fed's balance sheet:

Foreign holdings of USTs and Agencies increased by $23.5 billion monthly to $2,810 billion from $2,787 billion in the prior month. This is now less than 20% of the comparable increase in Securities Held Outright by the Federal Reserve, implying foreign purchasers are starting to fall far behind in their purchases of US securities relative to the Fed's monetization rate.

Our East Asia blog writes on China's import surge.

Simon Johnson discusses bubbles and Goldman Sachs.

The IMF's new blog asks, "After averting a second Great Depression, what should policy makers do to foster recovery?"

The New Yorker's James Surowiecki and Ryan Lizza discuss the state of the stimulus (audio).

Reinventing the Dismal Science

A few weeks ago, I wrote a piece on Robert Skidelsky's views on the future of the dollar. In today's FT, Skidelsky gives his two cents on reforming the economic sciences, or as he puts it, "how to rebuild a shamed subject". 

Skidelsky argues that economics went wrong when the public grew overconfident in economists' ability to predict outcomes, a feature which distinguished it from other social sciences. Over the past decades, economics has become a mathematical science, disregarding any type of human dimension. 

In order to regain its credibility, the study of economics needs to shift away from mathematical models and re-adopt Keynes' ideas of political economy, which take into account human behavior.

Is Britain Back?

Paul Krugman and The Economist's Free Exchange blogger are beginning to think so. As is Daragh Maher, FX strategist at Calyon, who believes that sterling has become "the recovery currency":

Policy stimulus is helping drive a recovery in the UK. The catalyst for a re-think on sterling is already evident with early signs of improvement in the economic cycle and the financial sector.

The latest signs of health are coming from the services sector, which is growing at its fastest pace in over a year. Markets have been rapidly buying up Sterling, which has reached a 9-month high:

IMF Enters Recession Blogosphere

Our colleagues across the street have begun blogging on the Great Recession. Check it out!

China: Bubble on the Horizon?

A new paper has been released by former Morgan Stanley Analyst Andy Xie that is garnering much chatter in the blogosphere. It addresses two of my favorite issues, China and the dollar. Surprisingly, the author is bearish on the former and bullish on the latter. 

The paper, via Big Picture, is well worth reading in its entirely. Xie's assertions are quite harsh:

Chinese asset markets have become a giant Ponzi scheme. The prices are supported by appreciation expectation. As more people and liquidity are sucked in, the resulting surging prices validate the expectation, which prompts more people to join the party. This sort of bubble ends when there isn’t enough liquidity to feed the beast

Dynamic Provisioning: The Experience of Spain

Editor's Note: The World Bank has released the seventh brief in its Crisis Response series. The latest contribution, written by Jesus Saurina, director of the Financial Stability Department at Banco de España, discusses anticyclical loan loss provisions.

Dynamic loan loss provisions can help deal with procyclicality in banking. By allowing earlier detection and coverage of credit losses in loan portfolios, they enable banks to build up a buffer in good times that can be used in bad times. Their anticyclical nature enhances the resilience of both individual banks and the banking system as a whole.

While there is no guarantee that they will be enough to cope with all the credit losses of a downturn, dynamic provisions have proved useful in Spain during the current financial crisis. They could be an important prudential tool for emerging economies, where banks dominate financial intermediation.

Click here to download a PDF of the brief.

IMF and BIS Weigh in on US Response, Prognosis

The IMF has just released its annual economic review of the United States, which is prepared by staff economists in consultation with their US government counterparts. The paper provides an extremely thorough, technical overview of the birthplace of the crisis, with several case studies ranging from labor productivity to the performance of the dollar (which it finds "moderately overvalued"). It analyzes several fiscal indicators at the national and state level, concluding that America's fiscal (im)balance poses the greatest challenge to the nation's economic health.

Not surprisingly, the American authorities interviewed for the study were more optimistic about the prospects for quick recovery.

A Spark in International Trade

Editor's Note: This post was co-authored by Caroline Freund and Matias Horenstein, a consultant with the World Bank's Development Economics and Chief Economist group.

After five months of severely depressed world trade, there is finally some good news. Eighteen countries now report trade data for the month of June, and almost all of them exhibit an increase in imports and exports. On average, imports were up 9 percentage points and exports 5 percentage points relative to the previous month (Figure 1). Although trade was still 25 percent lower than in June of last year, this is the first generalized spark in trade flows since the beginning of the crisis. (The group of 18 appears to be a representative sample. It closely tracks a wider sample of 65 countries reporting data through May, which make up 96 percent of trade.)

Walking the (Crisis) Talk

By now it's no secret that Simeon Djankov, chief economist of the Financial and Private Sector Development Vice Presidency of the World Bank Group and regular contributor to Crisis Talk, has been appointed as Bulgaria's finance minister. (You can read about Simeon's appointment at Reuters, Forbes, and SETimes.) He will have his work cut out for him. The impact of the financial crisis on the real sector has meant that Bulgaria has seen declining budget revenues. Never one to rest on his laurels, Simeon has already set out an impressive goal for Bulgaria: adoption of the Euro by 2012 or 2013.

Update: In a more recent article in Forbes than the one I linked to above, Simeon explains the difficult task he faces:

'The situation we have inherited is much worse than what the previous government has said,' he said. 'It is necessary to fill a gap of 2.5 billion levs ($1.81 billion) so that we can achieve a balanced budget'.